CHAPT

Risk and Return

ER 5
 LEARNING OBJECTIVES
2

 Discuss the concepts of portfolio risk and return

 Determine the relationship between risk and return of
portfolios
 Highlight the difference between systematic and
unsystematic risks
 Examine the logic of portfolio theory
 Show the use of capital asset pricing model (CAPM)
in the valuation of securities
 Explain the features and modus operandi of the
arbitrage pricing theory (APT)
 INTRODUCTION
3
 A portfolio is a bundle or a combination of individual assets
or securities.
 Portfolio theory provides a normative approach to investors
to make decisions to invest their wealth in assets or
securities under risk
 Extend the portfolio theory to derive a framework for
valuing risky assets. This framework is referred to as the
capital asset pricing model (CAPM). An alternative model
for the valuation of risky assets is the arbitrage pricing
theory (APT).
 The return of a portfolio is equal to the weighted average of
the returns of individual assets (or securities)
 PORTFOLIO RETURN:
4
TWO-ASSET CASE
 The return of a portfolio is equal to the weighted average of
the returns of individual assets (or securities) in the portfolio
with weights being equal to the proportion of investment
value in each asset.
 We can use the following equation to calculate the expected
rate of return of individual asset:
 Expected Rate of Return:
5
Example
 Suppose you have an opportunity of investing your wealth
either in asset X or asset Y. The possible outcomes of two
assets in different states of economy are as follows:
Possible Outcomes of two Assets, X and Y
Return (%)
State of Economy Probability X Y
A 0.10 –8 14
B 0.20 10 –4
C 0.40 8 6
D 0.20 5 15
E 0.10 –4 20
The expected rate of return of X is the sum of the product of outcomes and their respective
probability. That is:
E ( Rx ) = (- 8´ 0.1) + (10 ´ 0.2) + (8 ´ 0.4) + (5 ´ 0.2)
+(- 4 ´ 0.1) = 5%
Similarly, the expected rate of return of Y is:
E ( R y ) = (14 ´ 0.1) + (- 4 ´ 0.2) + (6 ´ 0.4) + (15´ 0.2)
+ (20 ´ 0.1) = 8%
 PORTFOLIO RISK: TWO-
6
ASSET CASE
 Risk of individual assets is measured by their
variance or standard deviation.

 We can use variance or standard deviation to

measure the risk of the portfolio of assets as well.

 The risk of portfolio would be less than the risk of

individual securities, and that the risk of a security
should be judged by its contribution to the portfolio
risk.
 Measuring Portfolio Risk
7
for Two Assets
 The portfolio variance or standard deviation depends on the
co-movement of returns on two assets.
 Covariance of returns on two assets measures their co-
movement.
 Three steps are involved in the calculation of covariance
between two assets:
8

Deviation from Product of

State of Expected Deviation &
Economy Probability Returns Returns Probability
X Y X Y
A 0.1 –8 14 – 13 6 – 7.8
B 0.2 10 –4 5 – 12 – 12.0
C 0.4 8 6 3 –2 – 2.4
D 0.2 5 15 0 7 0.0
E 0.1 –4 20 –9 12 – 10.8
E(RX) E(RY) Covar = –33.0
=5 =8
 Example
9

The standard deviation of securities X and Y are as follows:

s 2x = 0.1(- 8 - 5) 2 + 0.2(10 - 5) 2 + 0.4(8 - 5) 2

+0.2(5 - 5) 2 + 0.1(- 4 - 5) 2
= 16.9 + 3.6 + 0 + 8.1 = 33.6
sx = 33.6 = 5.80%
s 2y = 0.1(14 - 8) 2 + 0.2(- 4 - 8) 2 + 0.4(6 - 8) 2
+0.2(15 - 8) 2 + 0.1(20 - 8) 2
= 3.6 + 28.8 +1.6 + 9.8 +14.4 = 58.2
sy = 58.2 = 7.63%

The correlation of the two securities X and Y is as follows:

- 33.0 - 33.0
Corxy = = = - 0.746
5.80 ´ 7.63 44.25

Securities X and Y are negatively correlated. The

correlation coefficient of – 0.746 indicates a high negative
relationship.
 Measuring Portfolio Risk
10
for Two Assets
 Correlation
11
 Correlation
12

 The value of correlation, called the correlation

coefficient, could be positive, negative or zero.
 It depends on the sign of covariance since standard
deviations are always positive numbers.
 The correlation coefficient always ranges between
–1.0 and +1.0.
 A correlation coefficient of +1.0 implies a perfectly
positive correlation while a correlation coefficient
of –1.0 indicates a perfectly negative correlation.
 Variance and Standard
Deviation of a
13
Two-Asset Portfolio
 Covariance Calculation
14
Matrix
 Minimum Variance
15
Portfolio
 Portfolio Risk Depends on
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Correlation between Assets
 Investing wealth in more than one security reduces portfolio
risk.
 This is attributed to diversification effect.
 However, the extent of the benefits of portfolio diversification
depends on the correlation between returns on securities.
 When correlation coefficient of the returns on individual
securities is perfectly positive then there is no advantage of
diversification. The weighted standard deviation of returns on
individual securities is equal to the standard deviation of the
portfolio.
 Diversification always reduces risk provided the correlation
coefficient is less than 1.
 PORTFOLIO RISK-RETURN
ANALYSIS:
17
TWO-ASSET CASE
 Perfect Positive
18
Correlation
19

There is no advantage of diversification when the returns of securities

have perfect positive correlation.
 Perfect Negative
20
Correlation
 In this the portfolio return increases and the
portfolio risk declines.
 It results in risk-less portfolio.
 The correlation is -1.0.
21
 Zero-variance portfolio
22
 Zero Correlation
23
24
 Positive Correlation
25

 In reality, returns of most assets have positive but

less than 1.0 correlation.
 Limits to diversification
26

Since any probable correlation of securities Logrow and Rapidex will range
between – 1.0 and + 1.0, the triangle in the above figure specifies the limits to
diversification. The risk-return curves for any correlations within the limits of – 1.0
and + 1.0, will fall within the triangle ABC.
 Minimum variance
27
portfolio
 When correlation is positive or negative, the
minimum variance portfolio is given by the
following formula:
 EFFICIENT PORTFOLIO AND
MEAN-VARIANCE CRITERION

28
 Investment Opportunity
Set:
29
Two-Asset Case
 The investment or portfolio opportunity set
represents all possible combinations of risk and
return resulting from portfolios formed by varying
proportions of individual securities.

 It presents the investor with the risk-return trade-

off.
 Portfolio Return and Risk
for Different Correlation
Coefficients
Portfolio Risk, p (%)
Portfolio Correlation
Weight Return (%) +1.00 -1.00 0.00 0.50 -0.25
Logrow Rapidex Rp p p p p p
1.00 0.00 12.00 16.00 16.00 16.00 16.00 16.00
0.90 0.10 12.60 16.80 12.00 14.60 15.74 13.99
0.80 0.20 13.20 17.60 8.00 13.67 15.76 12.50
0.70 0.30 13.80 18.40 4.00 13.31 16.06 11.70
0.60 0.40 14.40 19.20 0.00 13.58 16.63 11.76
0.50 0.50 15.00 20.00 4.00 14.42 17.44 12.65
0.40 0.60 15.60 20.80 8.00 15.76 18.45 14.22
0.30 0.70 16.20 21.60 12.00 17.47 19.64 16.28
0.20 0.80 16.80 22.40 16.00 19.46 20.98 18.66
0.10 0.90 17.40 23.20 20.00 21.66 22.44 21.26
0.00 1.00 18.00 24.00 24.00 24.00 24.00 24.00
Minimum Variance Portfolio
wL 1.00 0.60 0.692 0.857 0.656
wR 0.00 0.40 0.308 0.143 0.344
2 256 0.00 177.23 246.86 135.00
 (%) 16 0.00 13.31 15.71 11.62

30
 Investment opportunity
sets given different
31
correlations
 Mean-variance Criterion
32

 Inefficient portfolios- have lower return and higher

risk
 Investment Opportunity
Set:
33
The n-Asset Case
 An efficient portfolio is one that has the highest
expected returns for a given level of risk.
 The efficient frontier is the frontier formed by the
set of efficient portfolios.
 All other portfolios, which lie outside the efficient
frontier, are inefficient portfolios.
 Efficient Portfolios of
34
risky securities
An efficient
portfolio is one
that has the
highest expected
returns for a given
level of risk. The
efficient frontier
is the frontier
formed by the set
of efficient
portfolios. All other
portfolios, which
lie outside the
efficient frontier,
 PORTFOLIO RISK: THE n-
35
ASSET CASE
 The
calculation of risk becomes quite involved
when a large number of assets or securities are
combined to form a portfolio.
 N-Asset Portfolio Risk
36
Matrix
37
 RISK DIVERSIFICATION:
SYSTEMATIC AND
38
UNSYSTEMATIC RISK
 When more and more securities are included in a
portfolio, the risk of individual securities in the
portfolio is reduced.
 This risk totally vanishes when the number of
securities is very large.
 But the risk represented by covariance remains.
 Risk has two parts:
1. Diversifiable (unsystematic)
2. Non-diversifiable (systematic)
 Systematic Risk
39

 Systematic risk arises on account of the economy-

wide uncertainties and the tendency of individual
securities to move together with changes in the
market.
 This part of risk cannot be reduced through
diversification.
 It is also known as market risk.
 Investors are exposed to market risk even when
they hold well-diversified portfolios of securities.
 Examples of Systematic
40
Risk
 Unsystematic Risk
41

 Unsystematic risk arises from the unique uncertainties

of individual securities.
 It is also called unique risk.
 These uncertainties are diversifiable if a large numbers
of securities are combined to form well-diversified
portfolios.
 Uncertainties of individual securities in a portfolio
cancel out each other.
 Unsystematic risk can be totally reduced through
diversification.
 Examples of
42
Unsystematic Risk
 Total Risk
43
 Systematic and
unsystematic risk and
44
number of securities
 COMBINING A RISK-FREE
ASSET AND
45
A RISKY ASSET
A Risk-Free Asset and A
Risky Asset: Example
RISK-RETURN ANALYSIS FOR A PORTFOLIO OF A RISKY AND A RISK-FREE SECURITIES

Weights (%) Expected Return, R p Standard Deviation (p)

Risky security Risk-free security (%) (%)

120 – 20 17 7.2
100 0 15 6.0
80 20 13 4.8
60 40 11 3.6
40 60 9 2.4
20 80 7 1.2
0 100 5 0.0

20
Expected Return

D
17.5
C
15
B
12.5
10 A
7.5
5
2.5 Rf, risk-free rate

0
0 1.8 3.6 5.4 7.2 9
Standard Deviation
 Borrowing and Lending
47

Risk-return relationship for portfolio of risky and risk-free securities

 MULTIPLE RISKY ASSETS
AND
48
A RISK-FREE ASSET
 In a market situation, a large number of investors
holding portfolios consisting of a risk-free security
and multiple risky securities participate.
49

Risk-return relationship for portfolio of risky

and risk-free securities
We draw three lines from the risk-free rate (5%) to the three
portfolios. Each line shows the manner in which capital is allocated.
This line is called the capital allocation line.

Portfolio M is the optimum risky portfolio, which can be

combined with the risk-free asset.
50

The capital market line

 The capital market line (CML) is an efficient set of risk-
free and risky securities, and it shows the risk-return trade-off
in the market equilibrium.
 Separation Theory
51

 According to the separation theory, the choice of

portfolio involves two separate steps.
 The first step involves the determination of the
optimum risky portfolio.
 The second step concerns with the investor’s
decision to form portfolio of the risk-free asset and
the optimum risky portfolio depending on her risk
preferences.
 Slope of CML
52
 CAPITAL ASSET PRICING
53
MODEL (CAPM)
 The capital asset pricing model (CAPM) is a model that provides a
framework to determine the required rate of return on an asset and
indicates the relationship between return and risk of the asset.
 The required rate of return specified by CAPM helps in valuing
an asset.
 One can also compare the expected (estimated) rate of return on an
asset with its required rate of return and determine whether the
asset is fairly valued.
 Under CAPM, the security market line (SML) exemplifies the
relationship between an asset’s risk and its required rate of return.
 Assumptions of CAPM
54
 Characteristics Line
55
 Security Market Line
56
(SML)

Security market line

57

Security market line with normalize systematic risk

 IMPLICATIONS AND
RELEVANCE OF CAPM

58
 Implications
59

 Investors will always combine a risk-free asset with

a market portfolio of risky assets. They will invest
in risky assets in proportion to their market value.

 Investors will be compensated only for that risk

which they cannot diversify.

 Investors can expect returns from their investment

according to the risk.
 Limitations
60

It is based on unrealistic assumptions.

 It is difficult to test the validity of CAPM.
 Betas do not remain stable over time.
 THE ARBITRAGE PRICING
61
THEORY (APT)
 The act of taking advantage of a price differential
between two or more markets is referred to as
arbitrage.
 The Arbitrage Pricing Theory (APT) describes the
method of bring a mispriced asset in line with its
expected price.
 An asset is considered mispriced if its current price is
different from the predicted price as per the model.
 The fundamental logic of APT is that investors always
indulge in arbitrage whenever they find differences in
the returns of assets with similar risk characteristics.
 Concept of Return under
62
APT
 Concept of Risk under
63
APT
 Steps in Calculating
64
Expected Return under APT
 Factors
65
 Risk premium
66

 Conceptually, it is the compensation, over and

above, the risk-free rate of return that investors
require for the risk contributed by the factor.

 One could use past data on the forecasted and

actual values to determine the premium.
 Factor beta
67

 The beta of the factor is the sensitivity of the

asset’s return to the changes in the factor.

 One can use regression approach to calculate the

factor beta.