Module 1:

Characteristics of the
Opportunity Set Under Risk
FIN 4315 – Portfolio Analysis
Professor Diego Leal

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Key Points
• Investment under NO risk (certainty)

• What is risk?

• Portfolio returns & risk

• Expected return and variance of combinations of assets

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Investment under certainty (i)
• Investor will receive with certainty $10,000 in each of 2 years
• Only asset available is a savings account - 5% per year
• Investor can borrow money at a 5% rate

Decision ---- how much should investor consume vs save?

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Investment under certainty (ii)
Consider these 3 possibilities:

1) save nothing and consume $10,000 in each period

2) save all in the 1st period and consume everything in 2nd period

3) consume everything in 1st period and not worry about 2nd period

Let’s see where that get’s us….

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Investment under
certainty (iii)
If we want to consume everything in period
1, we would borrow:

Thus, if we consume all in period 1, we would

enjoy :

10,000 + 9,524 = 19,524.

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Investment under certainty (iv)
• In general…

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Investment under certainty (iv)
• How to select among all possibilities?

• Investor must detail preference for

consumption in period 1 vs period 2

• We use investor’s utility function

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Key Points
• Investment under NO risk (certainty)

• What is risk?

• Portfolio returns & risk

• Expected return and variance of combinations of assets

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Understanding Risk (I)
• Until now, we have considered only cash flows that have no risk
• But in many settings, cash flows are risky

• Example: Imagine “Asset A” is risky. Assume risk-free rate is 4% and

both “good” and “bad” scenarios occur with same likelihood
Security Price Today Cash Flow in 1 Year
Bad Scenario Good Scenario
Risk free bond $1,058 $1,100 $1,100
Asset A (risky) $1,000 $800 $1,400

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Understanding Risk (II)
Security Price Today Cash Flow in 1 Year
Bad Scenario Good Scenario
Risk free bond $1,058 $1,100 $1,100
Asset A (risky) $1,000 $800 $1,400

Expected Payoff of “risk-free” bond =

Expected Payoffs are
identical!

Why are the prices today

Expected Payoff of risky Asset A bond = not the same?

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Understanding Risk (III)
• The “Expected Payoffs” of risk-free bond and asset A are identical.
• Why are their prices today not the same?

Investors are risk averse

• Given two assets that pay the same average amount, investors prefer
the safer asset to the riskier one

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Risk Premium
• What is the return of the risk-free bond?

• What is the (expected) return of asset A?

• The “risk premium” is the additional return that an investor expects to receive to
compensate for the risk of a security
• Risk-premium = 10% - 4% = 6%
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Approach to Valuation

Require estimates of:

1. Cash flows
2. Discount rate

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Intuition on Discount Rate

• Time preferences
• We prefer $$ today to $$ in future
• Rather consume (invest) now than later
• Suggests discount rate be positive

• Risk aversion
• No one likes risk
• We require compensation for taking risks in form of higher expected return
• Suggests discount rate be positive
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What is Risk?
• Dispersion in possible outcomes (some better than others)
• No dispersion = no risk (same payoff no always)

• Greater dispersion = greater risk

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 Asset A

Payoff Asset A:
$107 w/ chance 100%

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 Asset B

Payoff Asset B:
$99 w/ chance 25%
$107 w/ chance 50%
$115 w/ chance 25%
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Measuring expected returns
• Expected value average of the expected values,
weighed by their probability of occurrence:

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Compare Asset Returns
Which asset has higher anticipated payoff?
A. Asset A B. Asset B C. Same for Both

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Measuring Risk
• Variance = average squared deviation from mean

• Represents dispersion of given distribution

• Variance - natural measure of risk

• Standard deviation = square root of variance

• Higher variance (or standard deviation) represents

greater dispersion, hence, greater risk

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Measuring Risk and Return
• We are contemplating ABC Corp’s stock (risky asset)

• How do we conceptualize ABC’s uncertain future stock price?

• Using probability (distributions)

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Expected (Mean) Return
• Calculated as a weighted average of the possible returns, where the
weights correspond to the probabilities

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Variance and Standard Deviation
• Variance
The expected squared deviation from the mean

Var ( R ) = E  R  E  R   =  R PR × R  E  R 
 
2 2

 

Var  RBFI  = 25% × (0.20  0.10) 2 + 50% × (0.10  0.10) 2

+ 25% × (0.40  0.10) 2 = 0.045

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Variance and Standard Deviation
• Standard Deviation
• The square root of the variance
SD( R ) = Var ( R )

SD( R ) = Var ( R ) = 0.045 = 21.2%

• In finance, also referred to as its volatility

• Easier to interpret because same units as the returns themselves
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Key Points
• Investment under NO risk (certainty)

• What is risk?

• Portfolio returns & risk

• Expected return and variance of combinations of assets

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Portfolios
• Portfolio is basket of assets

• Weight for each asset is fraction of portfolio held in that asset

• Weights will sum to 1.0
• Weights based on market values

• Just like single asset (stock), portfolio has return & standard deviation

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Portfolio Returns
• Return on portfolio (RP) is weighted sum of returns on its components

• Note this also holds in expectation:

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Practice Question #1
Suppose you invest $100,000 & buy 200 shares of Apple @ $200 per share
($40,000) & 1000 shares of Coca-Cola @ $60 per share ($60,000). If Apple
up to $240 & Coca-Cola falls to $57 per share & neither paid dividends:

• What are initial portfolio weights?

• What is new value of portfolio?

• What return did portfolio earn?

• If no buy or sell after price change, new portfolio weights?

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Practice Question #1 - cont
Suppose you invest $100,000 & buy 200 shares of Apple @ $200 per share &
1000 shares of Coca-Cola @ $60 per share ($60,000). If Apple up to $240 &
Coca-Cola falls to $57 per share & neither paid dividends:

• What are initial portfolio weights?

• What is new value of portfolio?

• Still hold 200 Apple & 1000 Coca-Cola

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Practice Question #1 - cont
Suppose you invest $100,000 & buy 200 shares of Apple @ $200 per share & 1000 shares of Coca-
Cola @ $60 per share ($60,000). If Apple up to $240 & Coca-Cola falls to $57 per share & neither
paid dividends:
• What return did the portfolio earn?

Alternatively:

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Practice Question #1 - cont
Suppose you invest $100,000 & buy 200 shares of Apple @ $200 per share &
1000 shares of Coca-Cola @ $60 per share ($60,000). If Apple up to $240 &
Coca-Cola falls to $57 per share & neither paid dividends:

• If you don’t buy or sell any shares after price change, new portfolio weights?

• New value of Apple shares = 200(240) = $48,000

• New value of Coca-Cola shares = 1000(57) = $57,000

• Total portfolio value = $105,000

• =0.46,

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Portfolio Volatility
• Portfolio volatility not linear average of individual assets volatilities

• Determinants of portfolio volatility :

• Asset weights
• Volatilities of component assets
• How component assets returns co-move

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Practice Question #2
• A portfolio’s volatility can be determined given only the weights
and volatilities of each of its components.

A. True B. False

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 Diversification: Illustration
Consider the following portfolios (A & B)

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Diversification: Illustration
PORTFOLIO A PORTFOLIO B

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Observations
• Portfolios have lower risk than their components

• Different asset combinations within portfolio result in different

reductions in risk

• Diversification: spreading risk across multiple assets so gains in some

assets may offset losses in others

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Correlation of Two Stock Returns
• Definition:

• What determines correlation?

1. Exposure to same common risk
2. Direction of that exposure

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On Correlation

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Correlation Matrix

When do stocks returns tend to move together?

- If affected by similar events
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Scatter Plots

Correlation 0.06 Correlation 0.58

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WHY SO LOW? Module 1 - Opportunity set under risk
WHY SO HIGH?
Portfolio Variance

Can write:

• What if one component’s variance increases?

• What if assets:
• Positively correlated?
• Negatively correlated?
• Uncorrelated?

• Formula can also be presented for N>2 stocks

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Practice Question #3: Selecting a Stock
Portfolio with standard deviation of 40% & expected return 12%. You
are considering adding one of two stocks in following table. If after
adding stock you have 25% of your money in new stock & 75% of your
money in your existing portfolio, which one you add?
A. Apple
B. Google

Expected Return St. Dev. Corr. w/ portfolio

return
Apple 15% 20% 0.50
Google 15% 30% 0.20

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Practice Question #3: Selecting a Stock
Both stocks have same expected return. Pick stock which gives portfolio lowest
risk.

Portfolio with AAPL

Portfolio with GOOG

Portfolio less risky if Google included!

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Practice Question #4: Portfolio Volatility
Two stocks with same volatility are combined in a portfolio. All else
equal, for which value of correlation will portfolio have highest
volatility?
A. 1.00
B. 0.00
C. 0.40
D. -0.40

Higher correlation implies higher portfolio volatility.

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Portfolio Risk: Experiment
• Experiment:
• Select stock @ random & write standard deviation

• Select 2nd stock @ random, put it in portfolio with 1st stock, &
compute standard deviation for portfolio

• Continue process by selecting additional stocks, one @ a

time

• Plot portfolio standard deviation as function of number

of securities in portfolio

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 The Outcome

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Figure 12.4.
Module 1 - Opportunity set under risk
Types of Risk
• Stand-alone risk: total risk of asset; measured by standard deviation

• Systematic risk: part of asset’s stand-alone risk that cannot be

eliminated by diversification—driven by macroeconomic news
• A.k.a. market risk, non-diversifiable risk, common risk

• Idiosyncratic risk: part of security’s stand-alone risk that can be

eliminated by diversification—driven by firm-specific news
• A.k.a. firm-specific risk, diversifiable risk

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 Stock Portfolios

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Figure 11.7.
Module 1 - Opportunity set under risk
 Risk-Return Tradeoff Revisited

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Risk & Return
• In competitive markets, asset’s expected return should be directly
related to its systematic risk

• Investors are not compensated (with expected return) for bearing

idiosyncratic risk

• Why - It can be freely diversified away!

Diversified investor would continue buying stock until expected return only
represents compensation for systematic risk

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