INVESTMENT RISK

& RETURN CHAPTER 7

& PORTFOLIO
THEORY 1
INVESTMENT RISK
& RETURN
2
LEARNING OUTCOMES
1. Know how to calculate expected returns
2. Know how to calculate covariance, correlations, and betas
3. Understand the impact of diversification
4. Understand the systematic risk principle
5. Understand the security market line
6. Understand the risk-return tradeoff
7. Be able to use the Capital Asset Pricing Model

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EXPECTED NET PRESENT
VALUE (ENPV)
 To what extent is the net present value principle relevant in the
selection of risky investments?
Expected Net Present Value: The average of the range of possible
NPVs weighted by their probability of occurrence.

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EXAMPLE: BETTERWAY
PLC

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TYPES OF RISK
Business risk
The variability in operating cash flows or profits before interest.
A firm’s business risk depends, in large measure, on the underlying
economic environment within which it operates.
But variability in operating cash flows can be heavily affected by
the cost structure of the business, and hence its operating gearing.
A company’s break-even point is reached when sales revenues
match total costs.

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TYPES OF RISK
Financial risk
Financial risk – the risk, over and above business risk, that results
from the use of debt capital.
Financial gearing is increased by issuing more debt, thereby
incurring more fixed-interest charges and increasing the variability in
net earnings

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TYPES OF RISK
Portfolio or market risk
Portfolio or market risk – the variability in shareholders’ returns.
Investors can significantly reduce selected investment portfolios.
This is sometimes called ‘relevant risk’, because only this element
of risk should be considered by a well-diversified shareholder.

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MEASUREMENT OF RISK
(FOR SINGLE
SECURITIES)
We shall consider three statistical measures:
Standard deviation,
Semi-variance
Coefficient of variation for single-period cash flows.
STANDARD DEVIATION
 The standard deviation is a measure of the dispersion(risk) of
possible outcomes; the wider the dispersion, the higher the standard
deviation.
The expected value, denoted by is given by the equation:

And standard deviation by:

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 EXAMPLE: SNOWGLOW
PLC
State of Economy Probability of outcome Cash flow (£)
A B
Strong 0.2 700 550
Normal 0.5 400 400
Weak 0.3 200 300

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SEMI-VARIANCE
Downside risk (i.e. deviations below expected outcomes) is best
measured by the semi-variance, a special case of the variance, given
by the formula:

where SV is the semi-variance, j is each outcome value less than the

expected value, and K is the number of outcomes that are less than
the expected value.

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COEFFICIENT OF
VARIATION (CV)
Where projects differ in scale, a more valid comparison is found by
applying a relative risk measure such as the coefficient of variation.
The lower the CV, the lower the relative degree of risk.
This is calculated by dividing the standard deviation by the expected
value of net cash flows, as in the expression:

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16
 RISK DESCRIPTION
TECHNIQUES
Sensitivity Analysis
In principle, sensitivity analysis is a very simple technique, used to
locate and assess the potential impact of risk on a project’s value.
It aims not to quantify risk, but to identify the impact on NPV of
changes to key assumptions.
Sensitivity analysis provides the decision-maker with answers to a
whole range of ‘what if’ questions.

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SCENARIO ANALYSIS
Scenario analysis seeks to establish ‘worst’ and ‘best’ scenarios, so
that the whole range of possible outcomes can be considered.
It encourages ‘contingent thinking’, describing the future by a
collection of possible eventualities.

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SIMULATION ANALYSIS
Monte Carlo simulation. Method for calculating the probability
distribution of possible outcomes.
The computer generates hundreds of possible combinations of
variables according to a pre-specified probability distribution.
Each scenario gives rise to an NPV outcome which, along with other
NPVs, produces a probability distribution of outcomes.

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MULTI – PERIOD CASH
FLOW & RISK

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TUTORIAL QUESTIONS
Mystery Enterprises has a proposal costing £800.Compute the
expected NPV, standard deviation, semi-variance and coefficient of
variation.
Assuming
Probabilityindependent inter-period cashCFflows, using a 10
Year 1 Net per2 cent
Year Net CF
cost of capital, compute standard deviation
0.2 400 300
0.3 500 400
0.3 600 500
0.2 700 600
PORTFOLIO
THEORY
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BASIC PRINCIPLE
Portfolio
Collection of financial assets for the purpose of diversifying risk
and maximizing return.
Conditions for elimination of portfolio risk
Perfect negative correlation
Perfectly weighted

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EXPECTED RETURN ON A
PORTFOLIO
The expected return on a portfolio comprising two assets, A and B,
whose individual expected returns are and respectively, is given by:

where α and (1 - α )are the respective weightings of assets A and B,

with α + (1 - α) = 1

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RISK OF A PORTFOLIO
The standard deviation of a two-asset investment portfolio, σp, is:

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CORRELATION
COEFFICIENT
A measure that determines the degree to which two variable's
movements are associated.
The correlation coefficient will vary from -1 to +1.
-1 indicates perfect negative correlation, and +1 indicates perfect
positive correlation.
Correlation Coefficient is a relative measure.

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COVARIANCE
It is a measure of the interrelationship between random variables, in
this case, the returns from the two investments A and B.
Measures the extent to which their returns move together, i.e. their
co-movement or co-variability.
When the two returns move together, it has a positive value; when
they move away from each other, it has a negative value; and when
there is no co-variability at all, its value is zero.
However, unlike the correlation coefficient, whose value is restricted
to a scale ranging from to the covariance can assume any value.
It measures co-movement in absolute terms

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COVARIANCE
The covariance, between the returns on the two investments, A and B, is
given by:

Where
RA is the realized return from investment A,
ERA is the expected value of the return from A,
RB is the realized return from investment B,
ERB is the expected value of the return from B, and
pi is the probability of the ith pair of values occurring.
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FORMULA

Substituting into the expression for portfolio risk, we derive:

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CORRELATION
COEFFICIENT
TUTORIAL
Probability Year 1 Net CF Year 2 Net CF

0.2 400 300

0.3 500 400
0.3 600 500
0.2 700 600

Covariance, correlation coefficient

THE OPTIMAL
PORTFOLIO

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PORTFOLIO ANALYSIS
WHERE RISK & RETURN
DIFFER
 Let us assume that the two assets can be combined in any
proportions, i.e. the two assets are perfectly divisible, as with security
investments.
There is an infinite number of possible combinations of risk and
return.

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TUTORIAL QUESTION
CAPITAL ASSET
PRICING
40
DIVERSIFICATION AND
PORTFOLIO RISK
Diversification can substantially reduce the variability of returns
without an equivalent reduction in expected returns.
This reduction in risk arises because worse than expected returns
from one asset are offset by better than expected returns from
another.
However, there is a minimum level of risk that cannot be diversified
away, and that is the systematic portion.
PORTFOLIO RISK AND
NUMBER OF STOCKS
In a large portfolio the variance terms are
 effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk; Firm
Specific Risk; Unique Risk

Portfolio risk
Nondiversifiable
risk; Systematic
Risk; Market Risk
n
RISK: SYSTEMATIC AND
UNSYSTEMATIC
A systematic risk is any risk that affects a large number of assets,
each to a greater or lesser degree.
An unsystematic risk is a risk that specifically affects a single asset
or small group of assets.
Unsystematic risk can be diversified away.
Examples of systematic risk include uncertainty about general
economic conditions, such as GNP, interest rates or inflation.
On the other hand, announcements specific to a single company are
examples of unsystematic risk.
MEASURING
SYSTEMATIC RISK : BETA
Researchers have shown that the best measure of the risk of a
security in a large portfolio is the beta (ß) of the security.
Beta measures the responsiveness of a security to movements in the
market portfolio (i.e., systematic risk).

Cov ( Ri , RM )
i 
 ( RM )
2
ESTIMATING B WITH
REGRESSION
Security Returns
i ne
L
is tic
te r
c
a ra
Ch Slope = bi
Return on
market %

Ri = a i + biRm + ei
THE FORMULA FOR BETA
Clearly, your estimate of beta will depend upon your choice of a
proxy for the market portfolio.

Cov( Ri , RM )  ( Ri )
i  
 ( RM )
2
 ( RM )
RELATIONSHIP BETWEEN
RISK AND EXPECTED
RETURN (CAPM)
Capital Asset Pricing Model:
CAPM concludes that when an efficient capital market is in
equilibrium, i.e. all securities are correctly priced, the relationship
between risk and return is given by the security market line (SML).

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Expected Return on the Market:

R M  RF  Market Risk Premium

• Expected return on an individual security:

R i  RF  β i  ( R M  RF )
Market Risk Premium

This applies to individual securities held within well-diversified portfolios.

EXPECTED RETURN ON A
SECURITY
This formula is called the Capital Asset Pricing Model (CAPM)
R i  RF  β i  ( R M  RF )
Expected
Risk-free Beta of the Market risk
return on a = + ×
rate security premium
security

• Assume bi = 0, then the expected return is RF.

• Assume bi = 1, then

: Ri  R M
END OF CHAPTER 7