RISK AND RETURN

RETURN

Return =

𝑅𝑒𝑡𝑢𝑟𝑛 = 𝐷𝑜𝑙𝑙𝑎𝑟 𝑅𝑒𝑡𝑢𝑟𝑛

𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑
 RETURN

Income received on an investment plus any

change in market price, usually expressed as a
percent of the beginning market price of the
investment.

R = Dt + (Pt - Pt-1 )
Pt-1
 RETURN EXAMPLE

Buy for $100 a security that would pay $7 in cash to

you and be worth $106 one year later. The return
would be…….

Pt = $106
Dt = $7
Pt-1 = $100
R = ?
R = 7 + (106 - 100 ) = 13%
100
 RETURN RELATIVE

The total return for an investment for a given time

period stated on the basis of 1.0

RR= TR+1
0.13+1= 1.13
Standalone Risk and Return
 Measuring Historical Returns

TR and RR are useful for a given ,single time

period ,however we often want to calculate some
measure of the “average” return over time on an
investment.

Two commonly used measures of average

Arithmetic Mean
Geometric Mean
 Arithmetic Mean Return

The arithmetic mean is the “Simple average” of

a series of returns.

X
 X
n

R
 TR
n
 Arithmetic Mean Return

The arithmetic mean is the “Simple average” of

a series of returns.
 Geometric Mean Return

The Geometric mean is the one return that if,

earned in each of the n years of an
investment’s life, gives the same total dollar
result as the actual investment.
 Geometric Mean Return

It is calculated as the nth root of the product of all of the n

return relative of the investment

( 1  TR1 )( 1  TR2 )...( 1  TRn )1/n  1

Arithmetic mean versus Geometric
mean

• Arithmetic mean does not measure the

compound growth rate over time
– Does not capture the realized change in wealth
over multiple periods
– Does capture typical return in a single period
• Geometric mean reflects compound,
cumulative returns over more than one period
 Adjusting Returns for Inflation

• Returns measures are not adjusted for

inflation
– Purchasing power of investment may change over
time

TRIA 
1  TR   1
1  IF 
 RISK

The variability of returns from those that are

expected is called risk.

What rate of return do you expect on your investment

are exactly match your actual earn?

 All the security have risk factor or not?

 RISK EXAMPLE

 Assume that you will buy one year treasury bill with
8% yield. after one year, you will realize government
guaranteed 8% return…not more ,not less.

 Buy a share of common stock for one year and

anticipate cash dividend. At the end of year, may be
price too much high then expected return,may be
less than you started with.
 Measuring RISK

• Standard Deviation measures the deviation of

returns from the mean

  X  X  2 1/ 2
s 
 n  1 
 
 Measuring Risk of historic
Returns

• Standard Deviation measures the deviation of

returns from the mean

  
1/ 2
 2

s   RR
 n 1 
 
 Coefficient of Variation

The coefficient of variation is the ratio of the

standard deviation divided by the return on the
investment; it is a measure of risk per unit of
return.

CV = s / R
 Coefficient of Variation

The highest the coefficient of variation ,the riskier

the investment.

It is a measure of RELATIVE risk.

EXPECTED RETURN AND RISK
 Expected Return

• The future is uncertain.

• Investors do not know with certainty whether the
economy will be growing rapidly or be in recession.
• Investors do not know what rate of return their
investments will yield.
• Therefore, they base their decisions on their
expectations concerning the future.
• The expected rate of return on a stock represents the
mean of a probability distribution of possible future
returns on the stock.
 USING PROBABILITY DISTRIBUTIONS TO
MEASURE RETURN and RISK

Probability Dist. : A set of possible values that a

random variable can assume and their associated
probabilities of occurrence.
 EXPECTED RETURN

Expected rates of return are calculated by determing the possible

returns for some investment in the future, and weighting each
possible return by its own probability.

R = S ( Ri )( Pi )

R is the expected return for the asset,

Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities
 EXAMPLE
Stock BC
Ri Pi (Ri)(Pi)
-.15 .10 -.015
-.03 .20 -.006 The expected
.09 .40 .036 return for BC is
.21 .20 .042 .090 or 9%
.33 .10 .033
Sum 1.00 .090
 STANDARD DEVIATION

n
s= S
i=1
( R i - R ) 2
( P i )

A statistical measure of the variability of the

distribution around its mean. it is the square
root of the variance.
 EXAMPLE

Stock BC
Ri Pi (Ri)(Pi) (Ri -R)2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
 COEFFICIENT OF VARIATION

The ratio of the standard deviation of the

distribution to the mean of that distribution. it is a
measure of relative risk.

CV = s
R

Reason for use:

Adjustment of size
 EXAMPLE

INVESTMENT A INVESTMENT B
Expected return,R .08 .24
Standard
deviation, .06 .08
Coefficient of
variation,CV .75 .33

 Investment A is more risky than investment B

Risk and Return of Portfolio
 RISK AND RETURN IN PORTFOLIO CONTEXT

PORTFOLIO

A combination of two or more securities or assets.

 DETERMINING PORTFOLIO RETURN

The Return of a portfolio is simply a weighted average of the

returns of the individual assets comprising that portfolio.
n
RP = S ( Wj )( Rj )
i=1

RP is the return for the portfolio,

Wj is the weight (investment proportion) for the jth asset in the
portfolio,
Rj is the return of the jth asset,
n is the total number of assets in the portfolio.
 DETERMINING PORTFOLIO EXPECTED
RETURN

The Expected Return of a portfolio is simply a weighted average of

the expected returns of the individual assets comprising that
portfolio. n
E(RP = S ( Wj )( E(R)j )
i=1

RP is the expected return for the portfolio,

Wj is the weight (investment proportion) for the jth asset in the
portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the portfolio.
 PORTFOLIO STANDARD DEVIATION
Modern Portfolio Theory

It is also known as Markowitz portfolio theory

(Harry Markowitz 1952).

Portfolio Risk is not simply a weighted average

of individual security risk rather, inter-
relationships among the securities must be
consider while calculating portfolio risk.
 Portfolio Risk

1) Weighted average of individual security risk

2) Weighted co-movement between securities
PORTFOLIO STANDARD DEVIATION

Portfolio Risk is not simply the weighted average

of risk.

n
sp2 ≠ S ( Wi)(si2)
i=1
PORTFOLIO STANDARD DEVIATION

The variance/standard deviation of a portfolio

reflects not only the variance/standard deviation
of the stocks that make up the portfolio but also
how the returns on the stocks which comprise
the portfolio vary together.

Two measures of how the returns on a pair of

stocks vary together are the covariance and the
correlation coefficient.
PORTFOLIO STANDARD DEVIATION

Covariance is a measure that combines the variance

of a stock’s returns with the tendency of those
returns to move up or down at the same time other
stocks move up or down.

Since it is difficult to interpret the magnitude of the

covariance terms, a related statistic, the correlation
coefficient, is often used to measure the degree of
co-movement between two variables. The
correlation coefficient simply standardizes the
covariance.
 WHAT IS COVARIANCE?

s jk = s j s k r jk
sj is the standard deviation of the jth asset in the
portfolio,
sk is the standard deviation of the kth asset in the
portfolio,
rjk is the correlation coefficient between the jth and
kth assets in the portfolio.
 Correlation

The Correlation Coefficient between the returns on two stocks

can be calculated as follows:

sA,B Cov(RA,RB)
Corr(RA,RB) = rA,B = sAsB = SD(RA)SD(RB)

Where:
rA,B=the correlation coefficient between the returns on stocks A and B
sA,B=the covariance between the returns on stocks A and B,
sA=the standard deviation on stock A, and
sB=the standard deviation on stock B
 DIVERCIFICATION
DON’T PUT ALL YOUR EGGS IN ONE BASKET.

Diversification requires that you own securities that don’t behave

alike.
 CORRELATION COEFFICIENT
The tendency of the two variables to move
together(r).

Its range is from

-1.0 (perfect negative correlation)
0 (no correlation), to
+1.0 (perfect positive correlation).
 Returns distribution for two perfectly
positively correlated stocks (r = 1.0)

Stock M Stock N Portfolio MN

25 25 25

15 15 15

0 0 0

-10 -10 -10

 Returns distribution for two perfectly
negatively correlated stocks (r = -1.0)

Stock W Stock M Portfolio WM

25

15

0 0 0

-10 -10
 WHAT IS COVARIANCE?

The Covariance between the returns on two stocks can be

calculated as follows:
N
Cov(RA,RB) = sA,B = S (RAi - RA)(RBi - RB)/ n-1
i=1

Where:
sA,B = the covariance between the returns on stocks A and B
N = the number of states
pi = the probability of state i
RAi = the return on stock A in state i
E[RA] = the expected return on stock A
R = the return on stock B in state i
 WHAT IS COVARIANCE?

The Covariance between the returns on two stocks can be

calculated as follows:

Cov(RA,RB) = sA,B = S pi(RAi - E[RA])(RBi - E[RB])

i=1

Where:
sA,B = the covariance between the returns on stocks A and B
N = the number of states
pi = the probability of state i
RAi = the return on stock A in state i
E[RA] = the expected return on stock A
RBi = the return on stock B in state i
E[R ] = the expected return on stock B
 Portfolio Risk

1) Weighted average of individual security risk

2) Weighted co-movement between securities
 Example

You are creating a portfolio of Stock D and Stock BW (from

earlier). You are investing $2,000 in Stock BW and $3,000 in
Stock D. Remember that the expected return and standard
deviation of Stock BW is 9% and 13.15% respectively. The
expected return and standard deviation of Stock D is 8%
and 10.65% respectively. The correlation coefficient
between BW and D is 0.75.

What is the expected return and standard deviation of

the portfolio?
 Example

WBW = $2,000 / $5,000 = .4

WD = $3,000 / $5,000 = .6

RP = (WBW)(RBW) + (WD)(RD)
RP = (.4)(9%) + (.6)(8%)
RP = (3.6%) + (4.8%) = 8.4%
 Example

sP = .0028 + (2)(.0025) + .0041

sP = SQRT(.0119)
sP = .1091 or 10.91%
A weighted average of the individual standard
deviations is INCORRECT.
 Example

Stock C Stock D Portfolio

Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26
The portfolio has the LOWEST coefficient of
variation due to diversification.
Diversification and the Correlation
Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly, positively

correlated reduces risk.
 Total Risk = Systematic Risk +
Unsystematic Risk

Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk is the variability of return on stocks or

portfolios associated with changes in return on the
market as a whole.

Unsystematic Risk is the variability of return on stocks

or portfolios not explained by general market
movements. It is avoidable through diversification.
 EXAMPLE

Systematic risk:-
War, inflation, political events.

Unsystematic Risk:-
Strikes, regulatory actions, lose of a key account.
Total Risk = Systematic Risk + Unsystematic
Risk
 Modern Portfolio Theory

Harry Markowitz wrote an article titled Portfolio

Selection that was published in 1952 and is the basis
ofModern Portfolio Theory.

In that paper, he laid out his mathematical arguments

in favor of portfolio diversification. Markowitz shared
the Nobel Prize in Economics in 1990 with two other
scholars “for their pioneering work in the theory of
financial economics.”
 Modern Portfolio Theory

Before Markowitz , investor dealt loosely with the

concepts of return and risk . They know that not to
“ putt all your eggs in one basket” Markowitz was the
first to develop the concept of diversification in a
formal way. He quantified the concept and show that
how diversification reduces risk of portfolio when
securities are correlated.
 Efficient Portfolio

 Markowitz was the first to introduce the concept of

Efficient portfolio

 A Portfolio with the Highest level of expected return

for a given level of risk or a portfolio with the lowest
risk for a given level of return.
 Efficient Portfolio

 Investor can identify efficient portfolios by specifying

an expected portfolio return and minimizing the
portfolio risk at this level of return .

 Alternatively, they can specify a portfolio risk level

they are willing to assume and maximize the expected
return on the portfolio for this level of risk.
 Efficient Frontier

 The efficient frontier is a concept in

Modern portfolio theory introduced by
Harry Markowitz and others.

 A combination of assets, i.e. a portfolio, is referred

to as "efficient" if it has the best possible expected
level of return for its level of risk
EFFICIENT FRONTIER
EFFICIENT FRONTIER
EFFICIENT FRONTIER
EFFICIENT FRONTIER
 CAPITAL MARKET THEORY

It is extension of Modern Portfolio theory.

The capital market theory builds upon the

Markowitz portfolio model.
 CAPITAL MARKET THEORY

It is extension of Modern Portfolio theory.

The capital market theory builds upon the

Markowitz portfolio model.
 CAPM ASSUMPTIONS

1. Capital markets are efficient.

2. Homogeneous investor expectations over a given
period.
3. All investors can borrow or lend money at the Risk-free
rate of return.
4. All investors have the same one period time horizon
 CAPM ASSUMPTIONS

5. There is no personal income taxes

6. There is no inflation
7. There is no transaction cost
 Risk free Asset

An Asset with zero Variance

Provides the risk free rate of return
It will be an intercept value on a portfolio graph between
expected return and standard deviation

Since it has zero variance , it will also have zero correlation

with all other risky assets.
 Risk free Asset

An Asset with zero Variance

Provides the risk free rate of return
It will be an intercept value on a portfolio graph between
expected return and standard deviation

Since it has zero variance , it will also have zero correlation

with all other risky assets.
What happens when a risk-free asset is added
to a portfolio of risky assets

Expected Return - When the Risk-Free Asset is Added

Given its lower level of return and its lower level of risk, adding
the risk-free asset to a portfolio acts to reduce the overall return of
the portfolio. 
What happens when a risk-free asset is added
to a portfolio of risky assets

Expected Return - When the Risk-Free Asset is Added

Given its lower level of return and its lower level of risk, adding
the risk-free asset to a portfolio acts to reduce the overall return of
the portfolio. 
What happens when a risk-free asset is added
to a portfolio of risky assets

Standard Deviation - When the Risk-Free Asset is Added

As we have seen, the addition of the risk-free asset to the portfolio of
risky assets  reduces an investor's expected return. Given there is
no risk with a risk-free asset,  the standard deviation of a portfolio
is altered when a risk-free asset is added. 
What happens when a risk-free asset is added
to a portfolio of risky assets
What happens when a risk-free asset is added
to a portfolio of risky assets
 CAPITAL ASSET
PRICING MODEL (CAPM)

CAPM is a model that describes the relationship

between risk and expected (required) return; in
this model, a security’s expected (required)
return is the risk-free rate plus a premium
based on the systematic risk of the security.
 CAPITAL MARKET LINE

THE TRADE OF BETWEEN EXPECTED RETURN

AND RISK FOR EFFICIENT PORTFOLIOS.
CAPITAL MARKET LINE
 CAPITAL MARKET LINE

The expected return for any portfolio on the CML is

equal to the risk free rate Plus a risk premium. The risk
premium is the product of market price of risk and the
amount of risk for the portfolio under consideration.
 CAPITAL MARKET LINE

Only efficient portfolios consisting of risk free asset and

portfolio M lie on the CML.

CML must always be upward sloping

On historical basis , the CML can be downward sloping

The CML can be used to determine the optimal expected
return associated with different portfolio risk levels.
 MARKET PORTFOLIO

The portfolio of all risky assets , with each asset

weighted by the ratio of its market value to the
market value of all risky asset.
 SECURITY MARKET LINE(SML)

The depiction of the Capital asset Pricing model as a graph

that reflects the required rate of return in the market place
for each level of non-diversifiable risk (Beta).

CAPM can be divided into two

parts:-

•Risk Free of interest Rj = Rf + bj(RM - Rf)

•Risk Premiun
 SECURITY MARKET LINE

Rj = Rf + bj(RM - Rf)

Rj is the required rate of return for stock j,

Rf is the risk-free rate of return,
bj is the beta of stock j (measures systematic risk of
stock j),
RM is the expected return for the market portfolio.
 WHAT IS BETA?
An index of systematic risk.
It measures the sensitivity of a stock’s returns
to changes in returns on the market portfolio.

The beta for a portfolio is simply a weighted

average of the individual stock betas in the
portfolio.
 BETA COEFFICIENT.

THREE PARTS

1. Driving beta from the return data.

2. Interpreting betas.
3. Portfolio betas.
DRIVING BETA FROM THE RETURN DATA.

Narrower spread
EXCESS RETURN is higher correlation
ON STOCK
Rise
Beta = Run

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line
BETA COEFFICIENTS AND THEIR INTERPRETATIONS

Beta Comment Interpretation

2.0 Twice as responsive as the market
Move in same
1.0 direction as Market Same response as the market
0.5 Only half as responsive as the market
0 Unaffected by market movement
-0.5 Only half as responsive as the market
Move in opposite
-1.0 direction to Market Same response as the market
-2.0 Twice as responsive as the market
SECURITY MARKET LINE(SML)

Rm
 RETURNS AND STOCK PRICES.

 CAPM provides a mean by which to estimate the

required rate of return on a security.

 This return can then be used As the discount rate in

the dividend valuation model.