Risk and Return:

Portfolio Theory
Dr. Rilina Basu
Department of Economics
Jadavpur University

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E ( R) = p1 R1 + p2 R2
where p2 = 1 − p1

E ( R ) = pR 1 + (1 − p ) R 2
n
E (R ) = ∑
i =1
piRi
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Risk: Variability of returns

Reward for bearing risk is the risk premium

Expected Return: Return on a risky asset
expected in the future
For eg. There are two states of nature good
and bad with equal probability of occurrence
i.e.1/2, rg = 70% rb = -20%
E(R)= 0.5 (0.7) + 0.5 (-0.2) = 25%
Risk premium = Expected Return – Risk free
Rate

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Variability of returns for this example

70% - 25% and -20% - 25%

Variance = σ2 = o.5 (0.45)2 + 0.5 (- 0.45) 2

= 0.2025
Now suppose you include another asset with a
different set of returns and variabilities

Qs. Which one would the investor prefer?

Ans. Alternative theories
a) Investor Preferences b) Mean variance theory

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Standard Deviation or Variance

σ 2
= ∑ p i ( R i − E ( R )) 2

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Portfolio: A group of assets such as stocks
and bonds held by an investor

Portfolio weights : The % of a portfolios total
weight that is invested in a particular asset

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Suppose there are two assets A and B, with A
and B having returns 40% and 0% if the
market is good and A and B having 0% and
40% if the market is bad. The probability of
market being either is 0.5.

Both A and B have same expected return and
same variance

Both A and B are equally risky to investor

Does combining A and B help the investor?

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If equal investments are made in each, then
the return on the portfolio is same as the
expected return in each of the assets.

When economic conditions are good, A gives
40% and B 0%, so return on portfolio 20%, and
same if the market is bad.

Thus by investing equal amounts in A and B,
rather than the entire amount in either A or B,
the investor is able to eliminate the risk
altogether.

However, it depends on the association
between the two assets.

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E ( R p ) = w1 E ( R1 ) + (1 − w1 ) E ( R2 )

Where
Rp = portfolio return
Wi = weights

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The portfolio variance or sd depends on co
movement of returns on two assets.

Co-variance of returns on two assets
measures heir co movement.
n
Covxy = ∑ [Rx − E ( Rx )] Ry − E ( Ry ) × Pi
[ ]
i =1

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Positive co-variance: Assets’ returns could be
above their average returns at the same time
or the could be below their average returns at
the same time. Positive relation between two
returns

Negative co-variance: A’s returns could be
above its average return while B’s return
could be below its average return and vice
versa. Negative relation between the two
returns.

Zero covariance: Returns on A and B show no
pattern.

Correlation 1.0, 0 or -1

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 2 2 2 2 2
σ p =σ xw x +σ yw y + 2wxwyCovarxy
2 2 2 2
=σ xw x +σ yw y + 2wxwyσxσy ρxy
The minimum variance portfolio is called the optimum portfolio.
However, investors may not always strive for the minimum variance
portfolio. A risk averse investor will have a trade-off between risk and
return. Her choice of portfolio will depend on her risk preference.

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Suppose Asset A has an expected return
of 10 percent and a standard deviation of
20 percent. Asset B has an expected
return of 16 percent and a standard
deviation of 40 percent. If the correlation
between A and B is 0.6, what are the
expected return and standard deviation for
a portfolio comprised of 30 percent Asset
A and 70 percent Asset B?

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rˆP = w A rˆA + (1 − w A )rˆB
= 0.3(0.1) + 0.7(0.16)
= 0.142 =14.2%.

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σp = WA2 σ2A + (1− WA )2 σ2B + 2WA (1− WA )ρ AB σA σ B

= 0.32 (0.22 ) + 0.72 (0.42 ) + 2(0.3)(0.7)(0.6)(0.2)(0.4)

= 0.320

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σ p = σ 2 x w 2 x + σ 2 y w 2 y + 2 w x w yσ xσ y ρ xy
= σ x wx + σ y w y

The sd of the returns of the portfolio is just the weighted average of the
standard deviations of individual securities. There is NO advantage of
diversification when the returns of securities have perfect positive
correlation i.e. ρAB = 1

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 ρAB = +1.0: Attainable Set of Risk/Return
Combinations

20%
Expected return

15%

10%

5%

0%
0% 10% 20% 30% 40%
Risk, σ p

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 2 2 2 2
σ p = σ x w x + σ y w y − 2 wx w yσ xσ y ρ xy
= σ x wx − σ y w y
Portfolio return incrreases and portfolio risk decreases as higher
proportion of risky asset is included.
In this case it is possible to diverse away all risk and get a risk-less
portfolio.

σ x w x − σ y w y = σ x w x − σ y (1 − w x ) = 0
σ x w x = σ y (1 − w x )
σ y
w x =
σ x + σ y

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 ρAB = -1.0: Attainable Set of Risk/Return
Combinations

20%
Expected return

15%

10%

5%

0%
0% 10% 20% 30% 40%
Risk, σ p

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The risk return impact of portfolios under the assumptions
of perfect positive and perfect negative correlations

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The returns of the two securities are
independent of one another

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 Security 1 Security 2

2 2
Security 1 wσ1 1 w1w2σ 12

Security 2 w1w2σ 21 wσ2 2

2 2

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The minimum variance portfolio is also called
optimum portfolio. Optimum weights in such
a portfolio are:
2
σ −Covxy
y
w* = 2
σ x + σ y2 − 2Covxy

When correlation is zero, then
2
σ y
w* = 2 2
σ +σ
x y
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Portfolio A dominates portfolio B if it has
higher return and lower risk
E( RA ) ≥ E( RB );σ A ≤ σ B

Portfolios below E (slide 21), are inefficient
portfolios.

Portfolio E and all portfolios above it
dominate any portfolio on the downward
sloping curve.

Which one is chosen? Depends on investor.

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While 2 security portfolios are located on a
single curve, multiple portfolios lie on a much
broader area.

A risk averse investor will prefer a portfolio
with highest expected return for a given level
of risk or a portfolio with the minimum risk
for a given level of expected return.

Principle of Dominance

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 1 2 … … … n

1
w 12 σ 12 w 1 w 2 σ 12
w1wnσ1n
2
w1w2σ21 w 22 σ 2
2

…. …

….

n
wnw1σn1 w n2 σ 2
n

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 Efficient Set

Feasible Set

Risk, σ p
Feasible and Efficient Portfolios
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A n efficient portfolio is one that offers:
t h e most return for a given amount of risk,
or
t h e least risk for a give amount of return.
The collection of efficient portfolios is
called the efficient set or efficient
frontier.
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 1 1
σ p2 = n  2  × average var iance + n ( n − 1)  2  × average cov ariance
n  n 

21  1
σ =   × avg var iance + 1 −  × avg cov ariance
p
n  n
When n approaches infinity, portfolio variance becomes equal to
average co variance.
Variance of the individual securities disappear and only the covariance
remains if number of securities in a portfolio increases by a large
number.

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Systematic Risk or Market risk represents that
portion of risk which is attributable to
economy wide factors like GDP growth rate,
G, Money supply etc. These factors are
beyond the purview of the investors and
cannot be diversified.

It basically reflects the sensitivity of the
security return to market movements.

It is measured by β.

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Non systematic risk or Unique Risk represents
that portion of its risk which stems from
firm-specific factors like development of a
new product, a labour strike etc. It is possible
to diversify this risk away.

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Total Risk = Systematic Risk + Unsystematic
Risk

Systematic risk is the covariance of individual
securities

The difference between variance and
covariance is the unsystematic risk

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A risk free asset has zero variance i.e. it has
zero risk of default. Government treasury bills

Portfolio Return
E(RP ) = wE(Ri ) + (1− w)Rf

Portfolio Risk σ p = wσi

σ p
w =
σ i
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Substituting this expression for X into the
expression for expected return on the
combination provides

σp σp
E ( R p ) = (1 − )rf + E (RA )
σA σA

Rearranging the terms,

E (R A ) − rf
E (RP ) = rf + ( )σ p
σ A

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Thus all combinations of risk-free lending or
borrowing with portfolio A lie on a straight
line in expected return standard deviation
space. The intercept of the line is RF and the
slope is E ( R ) − r
A f

σ A

. Therefore, the existence of a risk-free lending

and borrowing rate implies that there is a single
portfolio of risky assets that is preferred to all
other portfolios. Furthermore, in return
standard deviation space, this portfolio plots on
the ray connecting the risk-free asset and a
risky portfolio that lies furthest in the direction.

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An investor may borrow funds at the risk free
rate and invest more than 100% in the risky
asset OR

An investor may invest less than 100% in the
risky asset and lend out at the risk free rate

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There can be different portfolios which can
be created using different portfolio of risky
assets and a risk free asset

Capital allocation line is the locus of such
different combinations.

Given a risk averse individual, higher return
for a given level of risk is always preferable.

So highest CAL will be chosen which is
tangential to the efficient frontier.

It is called the Capital Market Line.

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The capital allocation line consisting of the
risk free security and the market portfolio is
called the capital market line.

Market portfolio consists of all risky assets
where each asset is held in proportion of its
market value. It is the optimum risky
portfolio. The β of the market portfolio is 1.

The Capital market Line is an efficient set of
risk free and risky assets and it shows the
risk-return trade off in the market
equilibrium.
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Intercept: Rf
 E(R ) − Rf 

Slope of CML =  M 
 σ M 

Expected Return on a portfolio on CML is:

 E(RM ) − Rf 
E(RP ) = Rf +  σ P
 σM 

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 IB I
Return, r p 2 B
1

Optimal
IA Portfolio
2
IA Investor B
1

Optimal Portfolio
Investor A

Risk σ p
Optimal Portfolios
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Indifference curves reflect an
investor’s attitude toward risk as
reflected in his or her risk/return
trade-off function. They differ
among investors because of
differences in risk aversion.
A n investor’s optimal portfolio is
defined by the tangency point
between the efficient set and the
investor’s indifference curve.
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Numerical problems from all possible sources

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