1

Chapter Two

Risk , Return, and Asset

Pricing
 Lessons from capital market history
2

 Financial Markets allow companies,

governments and individuals to increase
their utility.
 Financial markets also provide information
about the returns that are required for
various levels of risk.
 There is a reward for bearing risk.
 The greater the potential reward, the

greater the risk.

 This is called the risk-return trade-off.
 Cont’d………
3

A $1 investment in different types of

portfolios: 1926-99
Index Note: 1. Stocks produce a higher return 
$10,000 higher risk $6,640.79

2. Stocks are more volatile than bonds. $2,845.63

$1,000
Small-company
stocks

$100
$40.22
Large-company
stocks $15.64
$10 Long-term
government bonds $9.39

Inflation

$1
Treasury bills

$0.1
1925 1935 1945 1955 1965 1975 1985 1995 1999
Year-end
 Cont’d…………Average Returns
4

 Simply add up the yearly returns and

divide by the number of observations
 The result is the historical average of the
individual values.
 Cont’d……Average Returns
(1926 – 2011)
5

Investment Average Return

Large stocks 11.7%
Small Stocks 18.7%
Long-term Corporate 6.6%
Bonds
Long-term Government 5.5% (1926 -
Bonds 1999)
U.S. Treasury Bills 3.6% (Risk-
free rate)
Inflation (Consumer Price 3.2% (1926 -
Index) 1999)
 Cont’d………. Risk
6
Premium
 Risk Premium – the excess return required
from an investment in a risky asset over
that required from a risk-free investment.
 The “extra” return earned for taking on

risk
 Treasury bills are considered to be risk-

free
 The risk premium is the return over and

above the risk-free rate

 Cont’d………The Variability of
Returns
7

Frequency Distribution
 The number of times the annual return on

a large stock portfolio fell within each 10

percent range
12
13
12
13

11
1988 1997
1990 1986 1999 1995
1981 1979 1998 1991
1994
1977 1972 1996 1989
1993
1969 1971 1983 1985
1992
1962 1968 1982 1980
1987
1953 1965 1976 1975
1984
1946 1964 1967 1955
4 1978
1940 1959 1963 1950
1970
1952 1945
1939 1960 1961 3
2 1949 1938
1973 1934 1956 1951 2
1932 1944 1943 1936
1 1 1966 1948
1929 1926 1942 1927 1956
1974 1957 1947 1935 1954
1930 1941 1928 1933
1936 1937
0 Return (%)
-50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90
 Variance and Standard
8
Deviation
 We want to measure the “spread” in
returns
 How far the actual return deviates
from the average in a typical year?
 A measure of how volatile the return is.
 Volatile – tendency to vary widely
 Variance and standard deviation are
the most commonly used measure of
volatility
 The greater the volatility the greater the
uncertainty
 Variance = sum of squared deviations
 Cont’d…………..
9

Year Actual Average Deviation from the Squared Deviation

Return Return Mean (Average)
1 -.20 .175 -.375 .140625

2 .50 .175 .325 .105625

3 .30 .175 .125 .015625

4 .10 .175 -.075 .005625

Totals .70 / 4 = . .000 .267500

175

Variance = sum of squared deviations from the mean / (number

of observations – 1)
= .26750 / (4-1) = .0892
 Cont’d…………
10

 The larger the variance, the more the actual

returns tend to differ from the average return.
 The larger the variance or standard
deviation, the more spread out the returns
will be.

 Notice that the standard deviation for the

small-stock portfolio is more than 10 times
larger than the T-bill portfolio’s standard
deviation.
 Cont’d………..
11

Historical average returns, standard

deviations, and frequency
Average Standard
distributions:
Series 1926 – 2011.
Return Deviation Distribution
Large-company
stocks 11.7% 20.3
Small-company *
stocks 18.7 39.2
Long-term
corporate bonds 6.6 7.0
Long-term
government 5.5 9.3
Intermediate-term
government 5.4 5.8
U.S. Treasury
bills 3.6 3.1

Inflation 3.2 4.5

-90% 0% 90%
1933 small-company stock total return was 142.9 percent.
 What is a Portfolio?
12

 Portfolio is a collection of investment vehicles

assembled to meet one or more investment
goals.
 Growth-Oriented Portfolio: primary
objective is long-term price appreciation
 Income-Oriented Portfolio: primary
objective is current dividend and interest
income
 Capital preserving Portfolio: primary
objective is getting marginal income without
depleting capital
 Efficient Portfolio
13

A portfolio that provides the highest

return for a given level of risk.
Given the choice between two equally
risky investments, an investor will
chose the one with the highest
potential return.
Given the choice between two
investments offering the same return,
an investor will choice the one that
has the least risk.
 Portfolio Return and Risk Measures

14

 Return on a Portfolio is the weighted

average of returns on the individual
assets in the portfolio.

 Standard Deviation of a Portfolio

return is Calculated using all of the
individual assets in the portfolio.
 Return on Portfolio
15

 Investors have different motives for

investing
 Regular income—dividend/interest
 Capital gains or capital appreciation
 Hedge against inflation i.e. Positive real

returns.
 Safety of funds– regular returns and

refund on maturity
 Components of Returns

16

 Return is measured by taking the income

plus the price change.
 The term yield is also used in respect of
fixed income securities.
 The expected return may differ from
realized returns and this variation is a risk
factor.
 Total return is calculated by income
received + price change divided by
purchase price of asset.
 Quantitative methods of
17 Investment Analysis
Investment income and risk
 A return is the ultimate objective for any
investor.
 The main characteristics of any investment
are investment return and risk.
 However, to compare various alternatives
of investments, the precise quantitative
measures for both of these characteristics
are needed.
 Return on investment & expected
rate of return
18

 Many investments have two components

of their measurable return:
 Capital gain or loss;
 Some form of income.
 The rate of return is the percentage

increase in returns associated with the

holding period:
Rate of return = Income + Capital
gains/Purchase price
 Such type of rate of return is called
holding period return, because its
 Cont’d……
19

 Investor can‘t compare the alternative

investments using holding period returns,
if their holding periods (investment
periods) are different.
 Statistical data which can be used for the
investment analysis and portfolio
formation deals with a series of holding
period returns.
 For example, investor knows monthly
returns for a year of two stocks.
 How he/ she can compare these series
 Cont’d………
20

n
ř = Σ ri; where, ri - rate of return in
period i; __i= 1
n - number n observations.
n
 But, both holding period returns and
sample mean of returns are calculated
using historical data.
 However, what happened in the past for
the investor is not as important as what
happens in the future, because all the
 Cont’d…………
21

 Of course, no one investor knows the

future, but he/ she can use past
information and the historical data as well
as to use his knowledge and practical
experience to make some estimates about
it.
 Investor must think about several
“scenarios” of probable changes in
macro economy, industry and
company which could influence asset
prices and rate of return.
 Theoretically, it could be a series of
 Cont’d………
22

 But for the same asset, the sum of all

probabilities of these rates of returns must
be equal to 1 or 100 %.
 It is called simple probability
distribution.
 The expected rate of return E(r) of

investment is the statistical measure

of return, which is the sum of all possible
rates of returns for the same investment
weighted by probabilities:
n
E(r) = Σ pi × ri where; pi - probability of
 Investment risk
23

 Risk can be defined as a chance that the

actual outcome from an investment will
differ from the expected outcome.
 The more variable the possible outcomes
that can occur, the greater the risk.
 Risk is associated with the dispersion in
the likely outcome, and dispersion refers
to variability.
 The risk of investments can be measured
with such common absolute measures
used in statistics;
 Cont’d……….
24

 Variance is the potential deviation of each

possible investment rate of return from
the expected rate of return:
n
δ2(r) = Σ pi × [ ri - E(r) ]2
i=1
 Variance and the standard deviation are
similar measures of risk and can be used
for the same purposes in investment
analysis; however, standard deviation in
practice is used more often.
 Relationship between risk and return

25

 The expected rate of return and the

variance or standard deviation provide
investor with information about the nature
of the probability distribution associated
with a single asset.
 But, how does one asset having some
specific trade-off b/n return and risk affect
the other one with the different
characteristics of return and risk in the
same portfolio in selecting one asset in
 Cont’d.............
26

 The statistics that can provide the

investor with the information to answer
these questions are covariance and
correlation coefficient.
 Covariance and correlation are related
and they generally measure the same
phenomenon – the relationship
between two variables.
 Cont’d… Covariance
27
 It is difficult to conclude if the
relationship between returns of two
assets is strong or weak, taking into
account the absolute number of the
sample variance.
 However, what is very important using
the covariance for measuring relationship
between two assets – the identification of
the direction of this relationship.
 Covariance is the expected product of
the deviations of two returns from their
means.

 Cont’d.............
28

 In analyzing relationship between the

assets in the same portfolio using
covariance, it is important to identify
which of the three possible outcomes
exists:
 positive covariance (“+”),
 negative covariance (“-”) or
 zero covariance (“0”).
 If the positive covariance between two
assets is identified the common
recommendation for the investor would
be not to put both of these assets to the
 Correlation
29

 While the sign of the covariance is easy to

interpret, its magnitude is not.
 In order to control for the volatility of
each stock and quantify the strength of
the relationship between them, we can
calculate the correlation between two
stock returns,
 Correlation is a barometer of the degree
to which the returns share common risk
and tend to move together.
 Correlation Coefficient is a measure of
 Cont’d...........
30

 The correlation between two stocks has

the same sign as their covariance, so it
has a similar interpretation. Dividing by
the volatilities ensures that correlation is
always between -1 and +1, which allows
us to gauge the strength of the
relationship between the stocks.
 Perfectly Positively Correlated describes
two positively correlated series having a
correlation coefficient of +1
 Perfectly Negatively Correlated describes
two negatively correlated series having a
 Cont’d…………
31

 The correlation coefficient between two

assets is closely related to their covariance.
Corr (Ri, Rj ) = Cov(Ri, Rj)
SD(Ri)SD(Rj)
 The more close the absolute measure of the
correlation coefficient to 1.0, the stronger the
relationship between the returns of two assets.
 When correlation coefficient equals 0, there is
no linear relationship between the returns on
the two assets.
 Cont’d…………..
32

 Combining two assets with zero

correlation with each other reduces the
risk of the portfolio. While a zero
correlation between two assets returns is
better than positive correlation, it does
not provide the risk reduction results of a
negative correlation coefficient.
 Cont’d…………..
33

 The coefficient of determination

(Det.IJ) is calculated as the square of
correlation coefficient:
 The coefficient of determination shows
how much variability in the returns of one
asset can be associated with variability in
the returns of the other.
 For example, if correlation coefficient
between returns of two assets is
estimated + 0.80, the coefficient of
determination will be 0.64.
 Interpretation: about 64% of the
 Correlation: Why
Diversification Works!
34

 To reduce overall risk in a portfolio, it is

best to combine assets that have a
negative (or low-positive) correlation.
 Uncorrelated assets reduce risk
somewhat, but not as effectively as
combining negatively correlated assets.
 Investing in different investments with
high positive correlation will not provide
sufficient diversification.
 Combining Negatively Correlated Assets to
Diversify Risk
35
 Why Use International
Diversification?
36

 Offers more diverse investment

alternatives than only local based
investing
 Foreign economic cycles may move
independently from local economic cycle
 Foreign markets may not be as “efficient”
as local markets, allowing true gains from
superior research
 International
37
Diversification
 Advantages:
 Broader investment choices

 Potentially greater returns and reduced

portfolio risk
 Disadvantages:
 Currency exchange and political risk
 Less convenient to invest than local stocks

 More expensive to invest – high

transaction costs
 Components of Risk

38

 Diversifiable (Unsystematic) Risk

 Results from uncontrollable or random

events that are firm-specific

 Can be eliminated through diversification

 Non-diversifiable (Systematic) Risk

 Attributable to forces that affect all

similar investments
 Cannot be eliminated through
diversification
 Portfolio Risk and Diversification

39
 Portfolio theory – mean
variance analysis
40

 Investing usually needs to deal with

uncertain outcomes.
 That is, the unrealized return can take on
any one of a finite number of specific
values, say r1, r2, …, rS.
 This randomness can be described in
probabilistic terms. That is, for each of
these possible outcomes, they are
associated with a probability, say p1, p2,
…, pS.
 For asset i, its expected return is:
 What do we know about
portfolio risk?
41

 Most stocks are positively correlated.

 Average correlation between two stocks

is 0.65.
 If the stocks in the portfolio are not
perfectly correlated, the standard
deviation of the portfolio will be less than
the weighted average of the standard
deviation of the stocks in the portfolio.
 When we add more securities in the
portfolio, we can lower the risk of the
portfolio even further.
 Cont’d............
42

Stand-alone Risk in Individual

Securities
 Stand-alone risk consists of:
 Diversifiable risk/unsystematic, unique,

or idiosyncratic risk
 Company or industry specific
 Non-diversifiable risk/systematic,
portfolio, or market risk
 Related to market as a whole
 It shows the degree to which a stock
moves systematically with other
stocks.
 Illustration on Risk and return analysis

43

1. Stocks L and M have yielded returns for the past

two years
Years Return (%)
L M
1995 12 14
1996 18 12
1. What is the expected return on portfolio made
up of 60% of L and 40% of M?
2. Find out the risk (standard deviation) of each
stock
3. What is the covariance and coefficient of
correlation between stock L and M?
 Cont’d.........
44

2. Stock Y and Z have the following

parameters
Stock Y Stock Z
 Expected return 2030

 Expected variance 1625

 Covariance YZ 20

Required
 Is there any advantage of holding a

combination of Y and Z,
 Cont’d...............
45

3. The expected rates of return and possibilities of

their occurrence for Alpha company and Beta
company stocks are as follows:
Probability Return on Alpha stockReturn on beta
stock
0.05 -2.0 -3
0.2 9 6
0.5 12 11
0.2 15 14
0.05 26 19
1. Find out the expected rates of return for alpha
and beta
2. If an investor invests equal proportion on both
stocks , what would be the return
 Cont’d..........
46

4. A financial analyst is analyzing two investment alternatives of Y

and Z. the estimated rate of return and their chances of
occurrence for the next year are given below.
Probability of occurrence Rates of Return
Y Z
0.2 22% 5%
0.6 14% 15%
0.2 -4% 25%
Required
1. Determine each alternative expected rate of return, variance

and standard deviation

2. Is Y comparatively riskless

3. Determine the portfolio risk that consists 60% of Y and 40 % of

Z.
4. If the financial analyst wishes to invest half in Z and another

half in Y, would it reduce risk? Explain.

 Risk return and security market line

47

Systematic Risk Principal

 The reward for bearing risk depends

only on the systematic risk of an

investment since unsystematic risk can be
diversified away.
 This implies that the expected return on

any asset depends only on that asset’s

systematic risk.
 If investors are well diversified, they only

care how a stock correlates with the rest

of their portfolio (the “market portfolio”).
The variance of that stock (∂2) is,
 Measuring Systematic Risk

48

 Beta (β) measures a stock’s market (or

systematic) risk.
 It shows the relative volatility of a given

stock compared to the average stock.

An average stock (or the market
portfolio) has a beta = 1.0.
 Beta shows how risky a stock is if the
stock is held in a well-diversified
portfolio.
 β=1 → stock has average risk.
 β>1 → stock is riskier than average.
 More on Beta

49

Beta measures the sensitivity of a security to

market-wide risk factors.
Bi = COV (Ri,Rm) = SDi,SDm
Variance Rm SD²m

 Note that stock i’s beta has two

components:
 Covariance of returns between stock i and
market portfolio.
 Variance of return on market portfolio
 Cont’d……….
50

 Suppose the market portfolio tends to

increase by 47% when the economy is strong
and decline by 25% when the economy is
weak. What is the beta of a type S firm
whose return is 40% on average when the
economy is strong and -20% when the
economy is weak? What is the beta of a type
I firm that bears only idiosyncratic, firm-
specific risk?
 The systematic risk of the strength of the
economy produces a 47% - (-25%) = 72%
change in the return of the market portfolio.
The type S firm’s return changes by 40% - (-
 Cont’d…………
51

 The return of a type I firm has only firm-

specific risk, however, and so is not
affected by the strength of the economy.
Its return is affected only by factors
specific to the firm. Because it will have
the same expected return, whether the
economy is strong or weak, βI = 0%/72%
= 0.
 Portfolio Betas

52

 The beta of a portfolio (βP) is the weighted

average of the betas from its constituent
securities.
βP = w1 β1 + w2 β2 + … + wN βN for N
securities
 Example 1: You have $6,000 invested in

IBM, $4,000 in GM. You estimate that

IBM has a beta of 0.95 and GM has a
beta of 1.15. What is the beta of your
portfolio?
βP = 0.6*0.95 + 0.4*1.15 = 1.03
 Beta and Risk Premium

53

• Consider a portfolio which consists of stock A

with a beta of 1.2 and expected return of 18%,
and a Treasury bill with a 7% return.
• E(RP) = wARA + wFRF=(wA)(18%) + (wF)
(7%)
WA • Beta
WF P = wA.bA+wF.bF=(wA)(1.2
E(Rp) ) Beta p

0 1
0*18% + 1*7% = 7% 0*1.2 = 0

.25 .75
.25*18% + .75*7% = 9.75 0.25*1.2 = .3

.50 .50
.50*18% + .50*7% = 12.5 0.50*1.2 =0.6

.75 .25
.75*18% + .25*7% = 5.25 0.75*1.2 = .9

1.00 0
1*18% + 0*7% = 18% 1*1.2 = 1.2
 Capital Asset Pricing Model (CAPM)
54

 A model describes the relationship

between risk and expected (required)
return.
 In this model a security expected
(Required) return is equal to risk free rate
and risk premium based on the
systematic risk of the security.
Rj = Rf + Bj (Rm – Rf)
Rj = Required (expected) rate of return of security
j
Rf = Risk free rate of short term gov’t bond
Bj = It is the systematic risk of security “j” which
 The Security Market Line (SML)
55

 Security market line (SML) is the

representation of the CAPM. It displays
the expected rate of return of an
individual security as a function of
systematic, non-diversifiable risk.
 Reward to Risk Ratio

56

 We can vary the amount invested in each

type of asset and get an idea of the
relation between portfolio expected
return and beta:

Reward to Risk Ratio = (E(Rp) – Rf)

Beta p
 It estimates the expected risk
premium per unit of risk.
 We can also calculate the reward to risk

ratio for all individual securities.

 What happens if two securities
have different reward-to-risk
57
ratios?
If E(RA) –Rf > E(RB) –Rf
betaA betaB
 Investors would only buy the securities
(portfolios) with a higher reward-to-risk ratio.
Here, it would be A.
 Eventually, all securities will have the same

reward-to-risk ratio.
 Because the reward-to-risk ratio is the same

for all securities, it must hold for the market

portfolio too.
Result:
E(RA) –Rf = E(RB) –Rf = ...... = E(RM) –Rf =
E(RM) –Rf
 Cont’d............
58

Example of CAPM
 Suppose the risk-free rate is 4%, the

market risk premium is 8.6%, and a stock

has a beta of 1.3. Based on the CAPM,
what is the expected return on this stock?
What would the expected return be if the
beta were to double?
E(R) = Rf + Beta[E(RM) – Rf] = 4% +
1.3*8.6% = 15.18%
E(R) = Rf + Beta[E(RM) – Rf] = 4% +
2.6*8.6% = 26.36%
59

End of Chapter