Portfolio risk

UNIT II
 Portfolio Expected Return
n
E(RP) =  wi E(Ri)
i=1
where E(RP) = expected portfolio return
wi = weight assigned to security i
E(Ri) = expected return on security i
n = number of securities in the portfolio
Example A portfolio consists of four securities with expected returns of 12%, 15%, 18%, and
20% respectively. The proportions of portfolio value invested in these securities are 0.2, 0.3,
0.3,and 0.20 respectively.
The expected return on the portfolio is:
E(RP) = 0.2(12%) + 0.3(15%) + 0.3(18%) + 0.2(20%)
= 16.3%
 Portfolio Risk

The risk of a portfolio is measured by the variance (or

standard deviation) of its return. Although the expected
return on a portfolio is the weighted average of the
expected returns on the individual securities in the
portfolio, portfolio risk is not the weighted average of the
risks of the individual securities in the portfolio (except
when the returns from the securities are uncorrelated).
 Measurement Of Comovements

In Security Returns

• To develop the equation for calculating portfolio risk we

need information on weighted individual security risks
and weighted comovements between the returns of
securities included in the portfolio.

• Comovements between the returns of securities are

measured by covariance (an absolute measure) and
coefficient of correlation (a relative measure).
Computation of Portfolio Variance From the
Covariance Matrix
Two-Security Portfolio: Risk

  w   w   2wD wE CovrD , rE 
2
p
2
D
2
D
2
E
2
E

 = Variance of Security D
2
D

 2
E = Variance of Security E

CovrD , rE  = Covariance of returns for

Security D and Security E
Covariance
Cov(rD,rE) = DEDE

D,E = Correlation coefficient of

returns
D = Standard deviation of
returns for Security D

E = Standard deviation of
returns for Security E
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Example
 Determine the expected return and standard deviation of the
following portfolio consisting of two stocks that have a correlation
coefficient of .75.

Portfolio Weight Expected Standard

Return Deviation
ABC .50 .14 .20
XYZ .50 .14 .20
Calculation of return and risk
 Expected Return = .5 (.14) + .5 (.14)= .14 or 14%
 Standard deviation
= √ { (.52x.22)+(.52x.22)+(2x.5x.5x.75x.2x.2)}
= √ .035= .187 or 18.7%
 Lower than the weighted average of 20%.
 Portfolio Risk : 2 – Security Cas

p = [w12 12 + w22 22 + 2w1w2 12 1 2]½

Example : w1 = 0.6 , w2 = 0.4,

1 = 10%, 2 = 16%
12 = 0.5
p = [0.62 x 102 + 0.42 x 162 +2 x 0.6 x 0.4 x 0.5 x 10 x 16]½
= 10.7%
 Efficient Frontier
For A Two Security-Case
Security A Security B
Expected return 12% 20%
Standard deviation 20% 40%
Coefficient of correlation -0.2

Portfolio Proportion of A Proportion of B Expected return Standard deviation

wA wB E (Rp) p
1 (A) 1.00 0.00 12.00% 20.00%

2 0.90 0.10 12.80% 17.64%

3 0.759 0.241 13.93% 16.27%

4 0.50 0.50 16.00% 20.49%

5 0.25 0.75 18.00% 29.41%

6 (B) 0.00 1.00 20.00% 40.00%

 Portfolio Options And

The Efficient Frontier

Expected
return , E(Rp)

20% 6 (B)

3•
2•
12% 1 (A)

Risk,  p
20% 40%
Feasible Frontier Under Various Degrees Of Coefficient of
Correlation

Expected
return , E (Rp)

20% B (WB = 1)

•
12% A (WA = 1)

Standard deviation,  p
The Efficient Set of Portfolios
• According to Markowitz’s approach, investors should
evaluate portfolios based on their return and risk as
measured by the standard deviation
 Efficient portfolio – a portfolio that has the smallest
portfolio risk for a given level of expected return or the
largest expected return for a given level of risk
The Efficient Set of Portfolios
 The construction of efficient portfolios of financial assets
requires identification of optimal risk-expected return
combinations attainable from the set of risky assets
available
 Efficient portfolios can be identified by specifying an
expected portfolio return and minimizing the portfolio
risk at this level of return
The Efficient Set of Portfolios
 Risk averse investors should only be interested in
portfolios with the lowest possible risk for any given
level of return
 Efficient set (frontier) – is the segment of the minimum
variance frontier above the global minimum variance
portfolio that offers the best risk-expected return
combinations available to investors
 Portfolios along the efficient frontier are equally “good”
The Efficient Set of Portfolios
The Attainable Set and the Efficient Set of Portfolios
 Correlation Effects
 The amount of possible risk reduction through
diversification depends on the correlation.
 The risk reduction potential increases as the
correlation approaches -1.
 If  = +1.0, no risk reduction is possible.

 If  = 0, σP may be less than the standard deviation of either

component asset.
 If  = -1.0, a riskless hedge is possible.

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Correlation effect
Therefore, the standard deviation of the portfolio with perfect positive
correlation is jus the weighted average of the component standard
deviations. In all other cases, the correlation coefficient is less than 1,
making the portfolio standard deviation less than the weighted average of
the component standard deviations

The lowest possible value of the correlation coefficient is - 1,

representing perfect negative correlation. In this case, equation is
 Correlation Coefficients
 When ρDE = 1, there is no diversification

 P  wE E  wD D
 When ρDE = -1, a perfect hedge is possible

D
wE   1  wD
 D  E

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Correlation coefficient (-1)
For example, when E (rd)= 12% and E(re)= 20%

SD (d)= 20% SD (e)=40% and correlation coefficient is -1,

Find out the weights that will drive down portfolio risk to
zero.
Matrix Used to Calculate the
Variance of a Portfolio
Number of Variance and Covariance Terms
as a Function of the Number of Stocks
in the Portfolio
Role of covariance
 Putting together the variance and covariance parts of the
general expression for the variance of a portfolio yields.

 The variance of the return on a portfolio with many

securities is more dependent on the covariances
between the individual securities than on the
variances of the individual securities
Diversification
Diversification
Diversification
Diversification
 expresses the variance of our special portfolio as a weighted
sum of the average security variance and the average
covariance
 Now, let’s increase the number of securities in the portfolio
without limit. The variance of the portfolio becomes:
Diversification
 This example provides an interesting and important result. In
our special portfolio, the variances of the individual securities
completely vanish as the number of securities becomes large.
However, the covariance terms remain. In fact, the variance
of the portfolio becomes the average covariance Cov .
 We often hear that we should diversify. In other words, we
should not put all our eggs in one basket. The effect of
diversification on the risk of a portfolio can be illustrated in
this example. The variances of the individual
securities are diversified away, but the covariance
terms cannot be diversified away
Diversification
Total Risk
 Portfolio Risk and Diversification
p % Total risk
35

Diversifiable
20 Risk

0
Systematic Risk

10 20 30 40 ...... 100+
Number of securities in portfolio
Systemic Risk vs. Nonsystemic Risk
 Systemic Risk
The risk that comes from the individual exposure of
assets to their individual risk factors. Can be diversified
away.

 Nonsystemic Risk
The risk that comes from the common exposure of assets
to economy-wide risk factors. Can’t be diversified away.
 Diversification:
The ‘Free Lunch’ of Finance

An investor can achieve higher returns for a given level of risk

through diversification.
Three ways to diversify:
1. Diversification across sectors and industries.
2. Diversification across asset classes.
3. Diversification across regions and countries.