Risk and Return& CAPM

Financial Management
Prof.Raviraj Gohil
Shanti business school
Historical performance of different Assets classes
What is risk ?
» Dictionary meaning “A hazard, a peril; exposure to loss”

» Skydiving, betting on horses, investment.

» Type of analyzing risk : On a stand alone basis and on portfolio

basis.

» “No investment should be undertaken unless the expected rate of

return in high enough to compensate the investor for perceived risk
of the investment “

» Risk and return go hand in hand.

Return on single asset
» Total Return = Income + Capital gain

Rate of return  Dividend yield  Capital gain yield

DIV1 P1  P0 DIV1   P1  P0 
R1   
P0 P0 P0
» The stock price for Stock A was $10 per share 1 year ago. The stock
is currently trading at $9.50 per share, and shareholders just
received a $1 dividend. What return was earned over the past year?
Let’s add some statistics
» An event’s probability is defined as change that the event will occur

» If all possible events, or outcomes, are listed, and if a probability is

assigned to each event, the listing is called probability
distribution.
Probability distribution
Expected payoff
Expected return
Expected Return
Are the two companies same ?
Probability distribution

Stock A
Stock B

-30 -15 0 15 30 45 60
Returns (%)

» The tighter or more peaked the probability distribution is it is more

likely that actual outcome would closed to expected value and vise a
versa. So more spread in the distribution more risky is the
asset.
Average Rate of Return

» The average rate of return is the sum of the various one-period rates
of return divided by the number of period.

» Formula for the average rate of return is as follows:

n
1 1
R = [ R1  R 2    R n ] 
n n
R t
t =1
Risk of Return

» Risk refers to uncertainty of return.

» Uncertainty could be in terms of time and difference in return.

» Difference in return can be found out with the help of Standard

deviation and variance.

Standard deviation = Variance

 
n 2
1
2  
n  1 t 1
Rt  R
C a l c u l a t e Av e r a g e r e t u r n a n d S t a n d a r d d e v i a t i o n

Year Return
2015 30%
2016 -10%
2017 -19%
2018 40%
Calculating historical risk and return

Deviation for
Year Return mean Squred deviation
2015 30% 19.700% 0.038809
2016 -10% -20.300% 0.041209
2017 -19% -29.300% 0.085849
2018 40% 29.700% 0.088209
Average 10.30%Sum of Sd 0.254076
  Variance SD/ N-1 0.084692
    Std deviation 29.10%
Portfolio Risk
Risk in portfolio context
» Risk can be analyzed in stand alone basis and well as portfolio basis
» Portfolio is basket of securities
» Asset held as part of portfolio is less risky than held as single
investment ( Because risk is spread..!!!)

» “The risk and return of an individual security should be

analyzed in terms of how that security affects the risk and
return of the portfolio in which it is held.”

» Condition 1 : Coin tossing, Heads $20,000, tails -$16,000

» Condition 2 : Coin tossing for 100 times, $200 for heads, $-

160 for tails.
Measuring Return

Portfolio rate
of return (
=
in first asset )(
fraction of portfolio
x
rate of return
on first asset )
+
(in second asset )(
fraction of portfolio
x
rate of return
on second asset )
Portfolio Risk

The variance of a two assets portfolio is the sum of these four

boxes

Stock 1 Stock 2
x1x 2 σ12 
Asset 1 x12 σ12
x1x 2ρ12σ1σ 2
x1x 2 σ12 
Asset 2 x 22 σ 22
x1x 2ρ12σ1σ 2
Portfolio Risk

Expected Portfolio Return  (x 1 r1 )  ( x 2 r2 )

Portfolio Variance  x 12σ 12  x 22σ 22  2( x 1x 2ρ 12σ 1σ 2 )

Correlation
coefficient
“rho”
Coefficient of variation
» The ratio of the standard deviation of a distribution to the mean of
that distribution.
» It is a measure of RELATIVE risk.

CV = s / R

» The Coefficient of variation shows the risks per unit of return,

and it provides a more meaningful basis for comparison when
the expected returns on two alternatives are not the same.

» Higher the ratio riskier the asset …!!

Covariance and correlation coefficient
Covariance :
s jk = s js kr
jk

sj is the standard deviation of the jth asset in the portfolio,

sk is the standard deviation of the kth asset in the portfolio,

rjk is the correlation coefficient between the jth and kth assets in the
portfolio.
» Correlation coefficient
» A standardized statistical measure of the linear relationship between
two variables. Correlation is a scaled version of covariance
» Its range is from -1.0 (perfect negative correlation), through 0 (no
correlation), to +1.0 (perfect positive correlation).
Diversification and correlation
coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
» As both the securities will not move in same direction.
Portfolio Risk

Example
Suppose you invest 60% of your portfolio in Wal-Mart and 40% in
IBM. The expected dollar return on your Wal-Mart stock is 10%
and on IBM is 15%. The expected return on your portfolio is:

Expected Return  (.60  10)  (.40  15)  12%

Portfolio Risk

Example
Suppose you invest 60% of your portfolio in Wal-Mart and 40% in
IBM. The expected dollar return on your Wal-Mart stock is 10% and
on IBM is 15%. The standard deviation of their annualized daily
returns are 19.8% and 29.7%, respectively. Assume a
correlation coefficient of 1.0 and calculate the portfolio
variance.

Wal - Mart IBM

x1x 2ρ12σ1σ 2  .40  .60
Wal - Mart x12 σ12  (.60) 2  (19.8) 2
 1 19.8  29.7
x1x 2ρ12σ1σ 2  .40  .60
IBM x 22 σ 22  (.40) 2  (29.7) 2
1 19.8  29.7
Portfolio Risk

Example
Suppose you invest 60% of your portfolio in Wal-Mart and 40% in
IBM. The expected dollar return on your Wal-Mart stock is 10% and
on IBM is 15%. The standard deviation of their annualized daily
returns are 19.8% and 29.7%, respectively. Assume a correlation
coefficient of 1.0 and calculate the portfolio variance.

Portfolio Variance  [(.60) 2 x(19.8) 2 ]

 [(.40) 2 x(29.7) 2 ]
 2(.40x.60x19.8x29.7)  564.5

Standard Deviation  564.5  23.8 %

Portfolio Risk
Example Correlation Coefficient = .4
Stocks s % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%

Return : r = (15%)(.60) + (21%)(.4) = 17.4%

Standard Deviation:
= (282)(.62) + (422)(.42) + 2(.4)(.6)(28)(42)(.4)
= 28.1 CORRECT

Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Portfolio Risk
Example Correlation Coefficient = 0.4
Stocks s % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%

Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%

Let’s Add stock New Corp to the portfolio

Portfolio Risk
Example Correlation Coefficient = .3
Stocks s % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%

NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%

NOTE: Higher return & Lower risk

How did we do that? DIVERSIFICATION

The reason for that is lower correlation of new stock with

portfolio
Why diversification works ?
» If you add a asset in a portfolio which has less than 1 correlation with
the portfolio it will reduce the risk.

» If the new asset has -1 correlation coefficient then portfolio risk

would be a lowest.

» If the new asset has correlation coefficient of 1 then diversification

will be ineffective (i.e. It will not reduce risk).

» Statistically if you add up to 40 stocks in the portfolio the risk will go

down after that adding a new stock in the portfolio will not reduce
the risk or increase the return because the benefit of diversification
will be offset by the cost of adding new stock in the portfolio.
Systematic risk and unsystematic risk
» Total Risk = Systematic Risk + Unsystematic Risk

» Systematic Risk is the variability of return on stocks or portfolios

associated with changes in return on the market as a whole.
(Interest rate, War, Tax regime, Political instability)

» It is also called “ Market risk” or “Non diversifiable risk “

» Unsystematic Risk is the variability of return on stocks or portfolios

not explained by general market movements. It is stock/ company
specific. It is avoidable through diversification. (product failure,
winning or losing a contract, Lawsuit, Strike)

» It it also called “Unique risk” or “diversifiable risk”

To
Tottaall RRiisskk == SSyysstteem
maattiicc RRiisskk ++U
Unnssyysstteem
maattiicc
RRiisskk

Factors such as changes in nation’s

economy, Inflation, tax policy,
STD DEV OF PORTFOLIO RETURN

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

To
Tottaall RRiisskk == SSyysstteem
maattiicc RRiisskk ++ U
Unnssyysstteem
maattiicc
RRiisskk

Factors unique to a particular company

or industry. For example, the death of a
key executive or loss of a governmental
STD DEV OF PORTFOLIO RETURN

defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Expected Risk and Preference

» A risk-averse investor will choose among investments with the

equal rates of return, the investment with lowest standard deviation.
Similarly, if investments have equal risk (standard deviations), the
investor would prefer the one with higher return

» A risk-neutral investor does not consider risk, and would always

prefer investments with higher returns

» A risk-seeking investor likes investments with higher risk

irrespective of the rates of return. In reality, most (if not all)
investors are risk-averse

34
Capital asset pricing model
» CAPM is a model that describes the relationship between risk and
expected (required) return; in this model, a security’s expected
(required) return is the risk-free rate plus a premium based on the
systematic risk of the security.
» The primary conclusion of CAPM is “ The relevant risk of an
individual stock is its contribution to the risk of well
diversified portfolio”.

» CAPM Assumptions :
» Capital markets are efficient.
» Homogeneous investor expectations over a given period.
» Risk-free asset return is certain(use short to intermediate-term
Treasuries as a proxy).
» Market portfolio contains only systematic risk (use S&P 500 Index or
similar as a proxy).
Characteristic line

Narrower spread
EXCESS RETURN is higher correlation
ON STOCK
Rise
Beta = Run

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line
What is Beta?
» An Measure of systematic risk.
» It measures the sensitivity of a stock’s returns to changes in returns on the
market portfolio.
» The beta for a portfolio is simply a weighted average of the individual stock
betas in the portfolio. EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

EXCESS RETURN
ON MARKET PORTFOLIO
Security Market line

Rj = Rf + bj(RM - Rf)

Rj is the required rate of return for stock j,

Rf is the risk-free rate of return,
bj is the beta of stock j (measures systematic
risk of stock j),
RM is the expected return for the market
portfolio
Security market line

Rj = Rf + bj(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
bM = 1.0
Systematic Risk (Beta)
Beta and Unique Risk

» Market Portfolio - Portfolio of all assets in the economy. In practice a

broad stock market index, such as the S&P Composite, is used to
represent the market.

» Beta - Sensitivity of a stock’s return to the return on the market

portfolio.
Beta and Unique Risk

 im
Bi  2
m
Beta and Unique Risk

 im
Bi  2
m Covariance with the
market

Variance of the market

Beta
Calculating the variance of the market returns and the covariance
between the returns on the market and those of Infosys. Beta is the ratio of
the variance to the covariance (i.e., β = σ im/σm2)

(1) (2) (3) (4) (5) (6) (7)

Product of
Deviation Squared deviations
Deviation from average deviation from average
Market Infosys from average Infosys from average returns
Month return return market return return market return (cols 4 x 5)
1 -8% -11% -10% -13% 100 130
2 4 8 2 6 4 12
3 12 19 10 17 100 170
4 -6 -13 -8 -15 64 120
5 2 3 0 1 0 0
6 8 6 6 4 36 24
Average 2 2 Total 304 456
Variance = σm 2 = 304/6 = 50.67
Covariance = σim = 456/6 = 76
Beta (β) = σim /σm 2 = 76/50.67 = 1.5
Key points to remember for beta
» A stock’s risk consist of two components market risk and diversifiable
risk.
» Diversifiable risk can be eliminated by holding portfolio of stocks so
investor remains with only market risk.
» Investor must be rewarded for bearing market risk, Higher the risk
higher the expected return.
» Beta is the measure of market risk, It shows the movement of stock
in comparison to market.
» The beta of portfolio is weighted average betas of individual assets in
the portfolio.
» Since beta determines how the stock affects the risk of a diversified
portfolio, beta is most relevant measure of any stock’s risk.
Thank You 