Unit 2

MBA/BBA/B.com /M.com/UGC Net

By
Dr. Anand Vyas
 Risk & Return: Concept of Risk,
• So far our analysis of risk-return was confined to single assets held
in isolation. In real world, we rarely find investors putting their
entire wealth into single asset or investment. Instead they build
portfolio of investments and hence risk-return analysis is extended
in context of portfolio.
• A portfolio is composed of two or more securities. Each portfolio
has risk-return characteristics of its own. A portfolio comprising
securities that yield a maximum return for given level of risk or
minimum risk for given level of return is termed as ‘efficient
portfolio’. In their Endeavour to strike a golden mean between risk
and return the traditional portfolio managers diversified funds over
securities of large number of companies of different industry
groups.
 Component & Measurement of risk,
A portfolio is composed of two or more securities. Each portfolio has risk-return characteristics of its
own. A portfolio comprising securities that yield a maximum return for given level of risk or minimum
risk for given level of return is termed as ‘efficient portfolio’. In their Endeavour to strike a golden mean
between risk and return the traditional portfolio managers diversified funds over securities of large
number of companies of different industry groups.
However, this was done on intuitive basis with no knowledge of the magnitude of risk reduction gained.
Since the 1950s, however, a systematic body of knowledge has been built up which quantifies the
expected return and riskiness of the portfolio. These studies have collectively come to be known as
‘portfolio theory’.
A portfolio theory provides a normative approach to investors to make decisions to invest their wealth
in assets or securities under risk. The theory is based on the assumption that investors are risk averse.
Portfolio theory originally developed by Harry Markowitz states that portfolio risk, unlike portfolio
return, is more than a simple aggregation of the risk, unlike portfolio return, is more than a simple
aggregation of the risks of individual assets. This is dependent upon the interplay between the returns
on assets comprising the portfolio.
I. Portfolio Return:
• The expected return of a portfolio represents weighted
average of the expected returns on the securities
comprising that portfolio with weights being the
proportion of total funds invested in each security (the
total of weights must be 100).
II. Portfolio Risk:
• Unlike the expected return on a portfolio which is
simply the weighted average of the expected returns
on the individual assets in the portfolio, the portfolio
risk, σp is not the simple, weighted average of the
standard deviations of the individual assets in the
portfolios.
III. Diversification:
• Diversification is venerable rule of investment which suggests “Don’t put all your
eggs in one basket”, spreading risk across a number of securities. Diversification
may take the form of unit, industry, maturity, geography, type of security and
management. Through diversification of investments, an investor can reduce
investment risks. Investment of funds, say, Rs. 1 lakh evenly among as many as 20
different securities is more diversified than if the same amount is deployed evenly
across 7 securities. This sort of security diversification is naive in the sense that it
does not factor in the covariance between security returns.
IV. Systematic and Unsystematic Risk:
• Thus, the variance of returns on a portfolio moving in inverse direction can
minimize portfolio risk. However, it is not possible to reduce portfolio risk to zero
by increasing the number of securities in the portfolio. According to the research
studies, when we begin with a single stock, the risk of the portfolio is the standard
deviation of that one stock. As the number of securities selected randomly held in
the portfolio increase, the total risk of the portfolio is reduced, though at a
decreasing rate. Thus, degree of portfolio risk can be reduced to a large extent
with a relatively moderate amount of diversification, say 15-20 randomly selected
securities in equal-rupee amounts.
 covariance and correlation,
• Covariance is a measure of the directional relationship between the returns on two risky assets. A
positive covariance means that asset returns move together while a negative covariance means
returns move inversely. Covariance is calculated by analyzing at-return surprises (standard
deviations from expected return) or by multiplying the correlation between the two variables by
the standard deviation of each variable.
• Covariance evaluates how the mean values of two variables move together. If stock A’s return
moves higher whenever stock B’s return moves higher and the same relationship is found when
each stock’s return decreases, then these stocks are said to have a positive covariance. In finance,
covariances are calculated to help diversify security holding.
• Covariance Applications
• Covariances have significant applications in finance and modern portfolio theory. For example, in
the capital asset pricing model (CAPM), which is used to calculate the expected return of an asset,
the covariance between a security and the market is used in the formula for one of the model’s key
variables, beta. In the CAPM, beta measures the volatility, or systematic risk, of a security in
comparison to the market as a whole; it’s a practical measure that draws from the covariance to
gauge an investor’s risk exposure specific to one security.
 Fundamental coefficient,
• The correlation coefficient is a statistical measure that calculates the strength of the relationship
between the relative movements of the two variables. The range of values for the correlation
coefficient bounded by 1.0 on an absolute value basis or between -1.0 to 1.0. If the correlation
coefficient is greater than 1.0 or less than -1.0, the correlation measurement is incorrect. A
correlation of -1.0 shows a perfect negative correlation, while a correlation of 1.0 shows a perfect
positive correlation. A correlation of 0.0 shows zero or no relationship between the movements of
the two variables.

• While the correlation coefficient measures a degree of relation between two variables, it only
measures the linear relationship between the variables. The correlation coefficient cannot capture
nonlinear relationships between two variables.

• A value of exactly 1.0 means there is a perfect positive relationship between the two variables. For
a positive increase in one variable, there is also a positive increase in the second variable. A value of
-1.0 means there is a perfect negative relationship between the two variables. This shows the
variables move in opposite directions — for a positive increase in one variable, there is a decrease
in the second variable. If the correlation is 0, there is no relationship between the two variables.
• Correlation Coefficient Formulas
• One of the most commonly used formulas in stats is
Pearson’s correlation coefficient formula. If you’re taking a
basic stats class, this is the one you’ll probably use:
• Where,
• r = Pearson correlation coefficient
• x = Values in first set of data
• y = Values in second set of data
• n = Total number of values.
 Measurement of systematic Analysis: Economic,
Industry, Company Analysis, Portfolio risk and return,
• Systematic risk can be measured using beta. Stock Beta is
the measure of the risk of an individual stock in comparison
to the market as a whole. Beta is the sensitivity of a stock’s
returns to some market index returns (e.g., S&P 500).
Basically, it measures the volatility of a stock against a
broader or more general market.
• It is a commonly used indicator by financial and investment
analysts. The Capital Asset Pricing Model (CAPM) also uses
the Beta by defining the relationship of the expected rate
of return as a function of the risk free interest rate, the
investment’s Beta, and the expected market risk premium.
• Economic Analysis:
Every common stock is susceptible to the market risk. This feature of almost all types
of common stock indicates their combined movement with the fluctuations in the
economic conditions towards the improvement or deterioration.

• Industry Analysis:
It is clear there is certain level of market risk faced by every stock and the stock price
decline during recession in the economy. Another point to be remembered is that the
defensive kind of stock is affected less by the recession as compared to the cyclical
category of stock. In the industry analysis, such industries are highlighted that can
stand well in front of adverse economic conditions.

• Company Analysis:
In company analysis different companies are considered and evaluated from the
selected industry so that most attractive company can be identified. Company analysis
is also referred to as security analysis in which stock picking activity is done. Different
analysts have different approaches of conducting company analysis like
• Value Approach to Investing
• Growth Approach to Investing
 Beta as a measure of risk,
• Interpretation of Beta:
• A beta of 1 indicates that the security’s price will move with
the market.
• A beta of less than 1 means that the security will be less
volatile than the market.
• A beta of greater than 1 indicates that the security’s price
will be more volatile than the market.
• For example, if a stock’s beta is 1.2, it’s theoretically 20%
more volatile than the market. The Beta of the general and
broader market portfolio is always assumed to be 1.
 calculation of beta,
• The beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the
entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A
company with a higher beta has greater risk and also greater expected returns.
• The beta coefficient can be interpreted as follows:
• β =1 exactly as volatile as the market
• β >1 more volatile than the market
• β <1>0 less volatile than the market
• β =0 uncorrelated to the market
• β <0 negatively correlated to the market
• Examples of beta
• High β: A company with a β that’s greater than 1 is more volatile than the market. For example, a high-risk
technology company with a β of 1.75 would have returned 175% of what the market return in a given period
(typically measured weekly).
• Low β: A company with a β that’s lower than 1 is less volatile than the whole market. As an example, consider an
electric utility company with a β of 0.45, which would have returned only 45% of what the market returned in a
given period.
• Negative β: A company with a negative β is negatively correlated to the returns of the market. For an example, a
gold company with a β of -0.2, which would have returned -2% when the market was up 10%.
 Selection of Portfolio: Markowitz’s
Theory,
• Harry M. Markowitz is credited with introducing new concepts of
risk measurement and their application to the selection of
portfolios. He started with the idea of risk aversion of average
investors and their desire to maximise the expected return with the
least risk.
• Markowitz model is thus a theoretical framework for analysis of risk
and return and their inter-relationships. He used the statistical
analysis for measurement of risk and mathematical programming
for selection of assets in a portfolio in an efficient manner. His
framework led to the concept of efficient portfolios. An efficient
portfolio is expected to yield the highest return for a given level of
risk or lowest risk for a given level of return.
 Assumptions of Markowitz Theory:
• The Portfolio Theory of Markowitz is based on the following assumptions:

• (1) Investors are rational and behave in a manner as to maximise their utility with a given level of
income or money.
• (2) Investors have free access to fair and correct information on the returns and risk.
• (3) The markets are efficient and absorb the information quickly and perfectly.
• (4) Investors are risk averse and try to minimise the risk and maximise return.
• (5) Investors base decisions on expected returns and variance or standard deviation of these returns
from the mean.
• (6) Investors choose higher returns to lower returns for a given level of risk.

• A portfolio of assets under the above assumptions is considered efficient if no other asset or portfolio
of assets offers a higher expected return with the same or lower risk or lower risk with the same or
higher expected return. Diversification of securities is one method by which the above objectives can
be secured. The unsystematic and company related risk can be reduced by diversification into various
securities and assets whose variability is different and offsetting or put in different words which are
negatively correlated or not correlated at all.
 Single Index Model,
• To simplify analysis, the single-index model assumes that there is
only 1 macroeconomic factor that causes the systematic
risk affecting all stock returns and this factor can be represented by
the rate of return on a market index, such as the S&P 500.
According to this model, the return of any stock can be
decomposed into the expected excess return of the individual stock
due to firm-specific factors, commonly denoted by its alpha
coefficient (α), which is the return that exceeds the risk-free rate,
the return due to macroeconomic events that affect the market,
and the unexpected microeconomic events that affect only the
firm. Specifically, the return of stock i is:
• The index model is based on the following:
• Most stocks have a positive covariance because they all respond similarly to
macroeconomic factors.
• However, some firms are more sensitive to these factors than others, and this firm-
specific variance is typically denoted by its beta (β), which measures its variance
compared to the market for one or more economic factors.
• Covariances among securities result from differing responses to macroeconomic
factors. Hence, the covariance (σ2) of each stock can be found by multiplying their
betas by the market variance:

• Cov(Ri, Rk) = βiβkσ2

• This last equation greatly reduces the computations, since it eliminates the need
to calculate the covariance of the securities within a portfolio using historical
returns and the covariance of each possible pair of securities in the portfolio. With
this equation, only the betas of the individual securities and the market variance
need to be estimated to calculate covariance. Hence, the index model greatly
reduces the number of calculations that would otherwise have to be made for a
large portfolio of thousands of securities.