RISK AND

RETURN
RELATIONSHIP
 Capital
Capital Asset
Asset
Pricing
Pricing Model
Model (CAPM)
(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.
 CAPM
CAPM Assumptions
Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
4. Market portfolio contains only
systematic risk
 What
What is
is Beta?
Beta?
An index of systematic risk.
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.
 Characteristic
Characteristic Lines
Lines and
and
Different
Different Betas
Betas
EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

EXCESS RETURN
ON MARKET PORTFOLIO
 Security
Security Market
Market Line
Line

Rj = Rf + j(RM – Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures systematic risk of
stock j),
RM is the expected return for the market portfolio.
 Security
Security Market
Market Line
Line
Rj = Rf + j(RM – Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
M = 1.0
Systematic Risk (Beta)
 Determination
Determination of
of the
the Required
Required
Rate
Rate of
of Return
Return
Lisa Miller at Basket Wonders is attempting to
determine the rate of return required by their stock
investors. Lisa is using a 6% Rf and a long-term
market expected rate of return of 10%.
10% A stock
analyst following the firm has calculated that the
firm beta is 1.2.
1.2 What is the required rate of return
on the stock of Basket Wonders?
 BWs
BWs Required
Required Rate
Rate of
of
Return
Return
RBW = Rf + j(RM – Rf)
RBW = 6% + 1.2(
1.2 10% – 6%)
6%
RBW = 10.8%
The required rate of return exceeds the market rate of return as BW’s beta
exceeds the market beta (1.0).
 Determination
Determination of
of the
the Required
Required
Rate
Rate of
of Return
Return
Small-firm Effect
Price/Earnings Effect
January Effect

These anomalies have presented serious

challenges to the CAPM theory.
PORTFOLIO THEORY
Introduction
Calculating Two Asset Portfolio Expected Returns and Standard
Deviations
Estimating measures of the Extent of Interactions-Covariance and
Correlations
Efficient Portfolios
Introduction to Portfolio
Theory
The link existing between portfolio risk and portfolio return was
first quantified by Harry Markowitz in 1952 in his journal article
entitled “Portfolio Selection”.
He founded the so called Modern Portfolio Theory (MPT).
Given a choice between two assets with equal rates of return,
risk-averse investors will select the asset with the lower level of
risk.
Meaning of a Portfolio
An investment Portfolio means; “owning more than one
financial security”.
The objective is to increase the portfolio's value by selecting
investments that you believe will go up in price.
The portfolio is built or constructed by buying additional stocks,
bonds, mutual funds, or other investments.
Meaning of a Portfolio
•Portfolio
– is a financial term denoting a collection of investments held by an
investment company, hedge fund, financial institution or individual
•In principle, a portfolio is designed according to the investor's risk
tolerance, time frame and investment objectives
The Portfolio Concept
•The concept of portfolio is considered to be addressing the old
adage that “Do not put all your eggs in one basket”
•That is “ Spread your eggs in different baskets so that if one
basket falls at least you will have eggs in other basket(s)”
•In investment world “ Do not put all your funds in one
investment – DIVERSIFY”
Modern Portfolio Theory
(MPT)
The theory was developed by Markowitz and is based on the
assumption that investors are risk averse.

This means that;given a choice between two

assets with equal rates of return, most
investors will select the asset with the lower
level of risk.
These portfolios are said/assumed to be mean–variance
efficient.
Other MPT Assumptions
To prefer higher returns all else being equal;
To have developed identical expectations regarding the
anticipated returns, standard deviations, and co-variances of all
securities.
Capital Market is assumed to be perfect, such that:
MPT Assumptions
Information is instantly and costless available to all investors;
There are no taxes or transactions costs;
Investors can borrow or lend at the risk free rate of interest; and
No market participant can exercise any market power.
MPT
According to MPT, you can reduce your investment risk by
creating a well diversified portfolio that includes enough different
types of stocks.
Modern portfolio theory states that the risk for individual stock
returns has two components i.e. systematic risk and unsystematic
(firms’ specific) risk.
MPT
Systematic Risk (Un-diversifiable risk) - These are market or
industry wide risks that cannot be eliminated or diversified away.
Interest rates, recessions and wars are examples of systematic
risks.
Unsystematic Risk - Also known as “firm specific risk or
diversifiable risk", this risk is specific to individual stocks and can
be diversified away as you increase the number of stocks in your
portfolio, e.g.. Labor strike, management style, etc.
Diversification Theory
Naïve Diversification
 Risk can be reduced by combining as many assets or stocks in
a portfolio
The way how assets are correlated is not important
Only unsystematic or firm's specific risks are eliminated.
Naïve Diversification
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
Naïve Diversification
Evidence from numerous studies indicates;
Risk falls as the number of securities increases but at a
decreasing rate
Virtually all the possible risk reduction is achieved with portfolios
of 15 or so securities
About 60-67 per cent of risk can be eliminated, but there is some
residual risk that cannot be diversified away
The risk that cannot be diversified away reflects the positive co-
variances among securities i.e. systematic risks
Diversification Theory
Modern/ Scientific/ Markowitz Diversification
This concept was established by Harry Markowitz in 1952.
The main issue is the correlation of assets or stocks
That is to say; not every diversification of investment reduces
risk
Modern Diversification
 Diversification only reduces risk when assets or stocks are
negatively correlated
 Total
Total Risk
Risk =
= Systematic
Systematic Risk
Risk +
+
Unsystematic
Unsystematic Risk
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.
 Total
Total Risk
Risk =
= Systematic
Systematic Risk
Risk +
+
Unsystematic
Unsystematic Risk
Risk
Factors such as changes in the nation’s
STD DEV OF PORTFOLIO RETURN

economy, tax reform by the Country

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Total
Total Risk
Risk =
= Systematic
Systematic Risk
Risk +
+
Unsystematic
Unsystematic Risk
Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Portfolio
Portfolio Risk
Risk and
and Expected
Expected
Return
Return Example
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. 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.
0.75
What is the expected return and standard deviation of the portfolio?
Correlation Coefficients/
Scale
Perfect negative Correlation
This occurs when the correlation coefficient between two assets
is -1. Here, there is a possibility of eliminating risk.
Perfect positive Correlation
This occurs when the correlation coefficient between two assets
is +1. Here, there is no possibility of eliminating risk.
Correlation Coefficients/
Scale
No correlation (Independent assets)
This occurs when the correlation coefficient between two assets
is zero (0). Here, there is a possibility of reducing risk but not
eliminating it all.
MEASURING EXPECTED
RETURN AND RISK
EXPECTED RETURN
For an Individual Asset – It is the sum of the product of returns
and the corresponding probability of the returns.
For a Portfolio of Assets –The expected rate of return for a
portfolio of investments is simply the weighted average of the
expected rates of return for the individual investments in the
portfolio.
EXPECTED RETURN
Given a probability distribution of returns, the expected return
can be calculated using the following equation:

N
E ( R)   (PR
i 1
i i )
EXPECTED RETURN
E(R) = the expected return on the stock
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i.
EXPECTED RETURN
Example 1
The table below provides a probability
distribution for the returns on stocks A and B
State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%

Calculate the expected return for each stock

EXPECTED RETURN
The expected return for stock A and B would be calculated as
follows:
E(R)A = 0.2(5%) + 0.3(10%) + 0.3(15%) + 0.2(20%) = 12.5%
E(R)B = 0.2(50%) + 0.3(30%) + 0.3(10%) + 0.2(-10%) = 20%
So we see that Stock B offers a higher expected
return than Stock A. However, the risk aspect is
not considered.
 EXPECTED RETURN OF TWO
ASSETS
The Expected Return on a two assets Portfolio is computed as the
weighted average of the expected returns on each stocks which comprise
the portfolio.
The weights reflect the proportion of the portfolio invested in the stocks.
This can be expressed as follows:
EXPECTED RETURN OF
TWO ASSETS

E ( RP )  WA E ( RA )  WB E ( RB )
EXPECTED RETURN OF
TWO ASSETS
Example 2
Given that, the expected return on stock A is 12.5% and the
expected return on stock B is 20%. A portfolio formed on two
assets A and B, comprises of 75% on A and 25% on B. Calculate
the expected rate of return of a portfolio.
EXPECTED RETURN OF
TWO ASSETS
The expected rate of return of a portfolio is:

E ( RP )  0.75(0.125)  0.25(0.20)
E ( RP )  0.1438  14.38%
EXPECTED RETURN OF
N ASSETS
If a portfolio constitutes of N assets, an expected return can be
calculated using the following formula:

N
E ( RP )  Wi E ( Ri )
i 1
MEASURING RISK
The Variance of Returns for an Individual Investment
The standard deviation is calculated as the positive square root of
the variance:

SD ( R )    Variance
MEASURING RISK
Standard Deviation (δ) is a measure of total risk. It should be in
decimal places or in percentages.
The variance of the returns for an individual investment is given
by;

n
Variance ( R j )   2
j   P i ( R ji  E ( R j )) 2

i 1
The Variance of
Individual Investment
Example 3

The table below provides a probability

distribution for the returns on stocks A and B
State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%

Given that, E(RA) = 12.5% and E(RB) = 20%. Calculate

the standard deviation of stock return A and stock
return B
The Variance of
Individual Investment
The variance and standard deviation for stock A and B are
calculated as follows:
δ2A = 0.2(.05 - 0.125)2 + 0.3(0.1 -0.125)2 + 0.3(0.15 - 0.125)2 + 0.2(0.2 -
0.125)2 = 0.002625
δA = √ (0.002625) = 0.0512 = 5.12%
δ2B = 0.2(0.50 - 0.20)2 + 0.3(0.30 - 0.20)2 + 0.3(0.10 - 0.20)2 + 0.2(-0.10
- 0.20)2 = 0.042
δB = (.042)0.5 = .2049 = 20.49%
The Variance of
Individual Investment
Although Stock B offers a higher expected return than Stock A,
also it is riskier since its variance and standard deviation are
greater than Stock A's.
Thus; which Stock is preferable? . Stock A is preferable to stock
B.
However, this is only part of the picture because most investors
choose to hold securities as part of a diversified portfolio.
THE VARIANCE OF
RETURNS OF A
PORTFOLIO
Two basic concepts in statistics, Covariance and correlation, must
be understood before we discuss the formula for the variance of
the rate of return for a portfolio.
Covariance is a measure of the degree to which two variables
“move together” relative to their individual mean values over time.
 COVARIANCE
The Covariance between the returns on two stocks A and B can be
calculated as follows:

N
Cov ( RA , RB )   A, B   Pi ( RAi  E ( RA ))( RBi  E ( RB ))
i 1
COVARIANCE
δA,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(RB) = the expected return on stock B
 CORRELATION
The Correlation Coefficient of Assets A and B is obtained by
standardizing (dividing) the covariance by the product of the
individual standard deviations; i.e.

Cov( RA , RB )  A, B
Corr ( RA , RB )   A, B  
SD( RA ) SD( RB )  A B
 Covariance and
Correlation
Example 4
From example 3, calculate the covariance and correlation between stock
A and B.
The covariance between stock A and stock B is as follows:
δA,B=0.2(.05-0.125)(0.5-0.2)+0.3(0.1-0.125) (0.3-0.2)+0.3(.15-.125)
(0.1-0.2)+0.2(0.2-.125)(-0.1-.2) = -.0105
Covariance and
Correlation
The correlation coefficient between stock A and stock B is as
follows:

 0.0105
 A, B   1.00
(0.0512)(0.2049)
Covariance and
Correlation
From the above computation, is there a possibility of eliminating or
reducing unsystematic risk if A and B are to form a portfolio?
Why?
 VARIANCE FORMULA
The Variance on a Two-Asset Portfolio can be calculated as
follows:

Var ( RP )  WA  A  WB  B  2WAWB Cov( RA , RB )

2 2 2 2
 VARIANCE FORMULA
OR;

Var ( RP )  WA  A  WB  B  2WAWB  AB A B

2 2 2 2
Variance and Standard
Deviation
Example 5
From example 4, calculate the variance and standard deviation of
a portfolio consisting of 75% of stock A and 25% of stock B.
The standard deviation of a portfolio is given by;
δ2p=(0.75)2(0.0512)2+(0.25)2(0.2049)2+
2(0.75)(0.25)(-1)(0.0512)(0.2049)= .00016

δp = .00016 = .0128 = 1.28%

Calculations Summary
The above calculations can be summarized and analyzed as
follows:

Expected Return Variance Standard Deviation

Security A 12.5% 0.00263 5.12%
Security B 20.0% 0.0420 20.49%
Portfolio 14.38% 0.00016 1.28%
EFFICIENT PORTFOLIO
An Efficient Portfolio is the one that offers the highest return for
a given level of risk or lowest risk for a given level of return
Efficient Portfolios are on efficient frontiers. They are a
combination of investments which maximizes the expected return
for a given standard deviation.
Such portfolios dominate all other possible portfolios in an
opportunity set or feasible set.
OPTIMAL PORTFOLIO
Optimal Portfolio is the one which allow investor to get onto the
highest indifference curve (IC). Graphically is a point where IC is
tangent to the efficient frontier
Note that:
Any two investors are likely to have different utility functions.
Thus, their optimal portfolios are likely to differ.
EFFICIENT PORTFOLIO
Consider two stocks - a high risk/high return technology stock
(Google) and a low risk/low return consumer products stock
(Coca Cola)
EFFICIENT PORTFOLIO
EFFICIENT PORTFOLIO
Any portfolio that lies on the upper part of the curve is efficient: it
gives the maximum expected return for a given level of risk.
A rational investor will only hold a portfolio that lies somewhere on
the efficient frontier.
The maximum level of risk that the investor will assume is
determined by the position of the portfolio on the line.
MINIMUM STANDARD DEVIATION FOR
THE COMBINATIONS OF TWO
SECURITIES
If fund is to be split between two securities; A and B, and x is the
fraction to be allocated to A, then the value for x which results in
the lowest standard deviation is given by;
x=

 B  COV ( R A , RB )
2

 A   B  2COV ( R A , RB )
2 2
Computing Minimum Standard
Deviation for the Combinations of
Two Securities
OR;

VAR( R B ) - COV ( R A R B )
x=
VAR( R A ) + VAR( R B ) - 2 COV ( R A R B )
THE END

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