Risk and return in capital

markets

Chapter 11
Instructor: Barbara Chambers

1
Learning objectives
•Compute the average return and volatility of returns from a set of
historical asset prices.

•Identify which types of securities have historically had the highest

returns and which have been the most volatile.

•Understand the trade-off between risk and return for large portfolios
versus individual shares.

•Explain the difference between common and independent risk.

•Explain how diversified portfolios remove independent risk, leaving

common risk as the only risk requiring a risk premium.

2
What is Risk? How do we measure Risk?

• In finance, risk is often defined as the possibility

that a return deviates (is different from) the
expected return.

• In finance, we measure risk using volatility or

standard deviation.

3
What is the relationship between Risk and Return?

https://tool.vanguardinvestments.com.
au/volatilityindexchart/ui/advisor.html

https://www.asx.com.au/courses/shares/cou
rse_09/index.html?shares_course_09

Reading:
https://www.asx.com.au/documents/resource
s/shares_course_03.pdf?shares_course_03_te 4
xt
 Risk vs Return 1980 -2013
Asset Class Average Return Average Risk
(p.a.) (p.a.)
Australian Shares 14.1% 22.7%
Australian Bonds 9.9% 6.9%
Cash 8.4% 4.3%
International Shares 12.8% 21.0%
International Shares 13.0% 17.7%
(hedged)
International Bonds 11.0% 6.4%
(hedged)
A-REITS 11.9% 17.9%

Source: Russell Investments

5
Historical trade-off between risk and return
• For large portfolios, investments with higher
volatility, as measured by standard deviation, tend
to have higher average returns.
• Why?
• Investors are generally risk-averse (dislike risk)
and demand compensation (in form of higher
expected returns) for bearing undiversifiable risk.
• Undiversifiable risk is risk that cannot be eliminated by holding a large portfolio of 20-
30 or more different stocks.
6
Why does a Portfolio of shares reduce risk?
- A Simple Example
Bad Economy Good Economy
Return Return

Security 1 0% 48%

Security 2 50% 0%

50% in Security 1 25% 24%

and 50% in
Security 2

Assume bad and good economy are equally likely.

7
Why does a Portfolio of shares reduce risk?
- A Simple Example
Bad Good Expected Standard
Economy Economy Return Deviation of
Return Return Return
Security 1 0% 48% 24% 24%

Security 2 50% 0% 25% 25%

50% in 25% 24% 24.5% 0.5%

Security 1
and 50% in
Security 2

Assume bad and good economy are equally likely.

8
11.3 Historical trade-off between risk and return
The returns of individual shares

• Larger shares have lower volatility overall.

• Even the largest shares are typically more volatile than a portfolio of
large shares.
• The standard deviation of an individual security does not explain the
size of its average return.
• A stock returns’ standard deviation measures total risk, both firm-
specific risk and market risk.

9
11.4 Common versus independent risk
Types of risk:
• Common risk is linked across outcomes (e.g., an earthquake is likely to
either damage all or none of the houses)
• Also called systematic risk, market risk, undiversifiable risk.
• Independent risk is where risk bears no relation to each other (e.g., theft in
one house has no effect on another house chance of being burgled)
• Also called firm-specific risk, unsystematic risk, non-systematic risk,
unique risk, diversifiable risk, idiosyncratic risk.
• Diversification
• Strategy designed to reduce independent risk by spreading a portfolio
across many investments.
10
 The Importance of Diversification

http://www.criticalcommons.org/Members/fsustavros/c
lips/cse-4-8-fun-with-dick-and-jane-personal-finance-1
/view

1
1
11.5 Diversification in share portfolios

Unsystematic versus systematic risk

•Share prices are impacted by two types of news:

1. Company or industry-specific news (Unsystematic risk)
– e.g. decline in oil prices impacting new shale oil
exploration companies making them unprofitable
2. Market-wide news (Systematic risk) – e.g. RBA
increasing interest rates

12
The Effect of Diversification on Portfolio Volatility
Returns(%)
Company 2008 2009 2010 2011 2012 Mean Std
Telstra -12 -2 -9 32 41 10 22.7
BHP -22 44 7 -24 3 1.6 19.4
Portolio -17 21 -1 4 22 5.8 14.6
Return Correlation -0.22

1
3
 Risk and Diversification

The diversification effect or the reduction in portfolio

risk takes place with the addition of added securities
until about 20 or 30 are included in the portfolio
11.5 Diversification in share portfolios

Diversifiable risk and the risk premium

• The risk premium for diversifiable risk is zero.

• Investors are not compensated for holding unsystematic risk.

Stock’s Risk Premium=

Stock’s Required Return – Risk Free Rate

15
11.5 Diversification in share portfolios

The importance of systematic risk

•The risk premium of a security is determined by its
systematic risk and does not depend on its
diversifiable risk.
•There is no relationship between volatility and
average returns for individual securities.

16
11.2 Historical risks and returns of shares

Computing historical returns:

• Realized returns
• Individual investment realized returns
• The realized return from your investment in the share from t to t+1 is:

(Eq. 11.1)
Divt 1  Pt 1  Pt Divt 1 Pt 1  Pt
Rt 1   
Pt Pt Pt
 Dividend Yield  Capital Gain Yield

17
11.2 Historical risks and returns of shares

Computing historical returns

• Individual investment realized returns

• For quarterly returns (or any four compounding periods that make
up an entire year) the annual realized return, Rannual, is found by
compounding:

1  Rannual  (1  R1 )(1  R2 )(1  R3 )(1  R4 )

(Eq. 11.2)

18
Example 11.2: Compounding realized returns
Problem:

Suppose you purchased Matilda share 1 Nov 1, 2013 and held it for one year,
selling on 31 Oct, 2014. What was your annual realized return?

Solution:

Plan:

•We need to analyze the cash flows from holding Matilda share for each quarter.
In order to get the cash flows, we must look up Matilda share price data at the
purchase date and selling date, as well as at any dividend dates. From the data
we can construct the following table to fill out our cash flow timeline: 

19
 Example 11.2: Compounding realized returns
Plan (cont’d):

•Next, compute the realized return between each set of dates using Eq. 11.1. Then
determine the annual realized return similarly to Eq. 11.2 by compounding the
returns for all of the periods in the year.

20
Example 11.2: Compounding realized returns

Execute:

•In Example 11.1, we already computed the realized return as 8.51%.

We continue as in that example, using Eq. 11.1 for each period until we
have a series of realized returns. For example, from 15 Nov 15, 2013 to
15 Feb, 2013, the realized return is:

Divt 1  Pt 1  Pt 0.08  (25.93  27.39)

Rt 1    0.0504, or  5.04%
Pt 27.39

21
Example 11.2: Compounding realized returns

Execute (cont’d):

•The table below includes the realized return at each period.

22
Example 11.2: Compounding realized returns

Execute (cont’d):

•We then determine the one-year return by compounding.

1  Rannual  (1  R1 )(1  R2 )(1  R3 )(1  R4 )  1  R5 

1  Rannual  (1.0851)(0.9496)(0.9861)(1.0675)(0.9473)  1.0275
Rannual  1.0275  1  .0275 or 2.75%

23
11.2 Historical risks and returns of shares

Average annual returns

•Average annual return of a security

•Used to estimate expected returns
1
R  ( R1  R2  ...  RT ) (Eq. 11.3)
T

24
11.2 Historical risks and returns of shares

The variance and volatility of returns

• Variance:
1
Var  R  
T 1
 ( R1  R ) 2  ( R2  R ) 2  ...  ( RT  R ) 2  (Eq. 11.4)

• Standard deviation:

SD( R )  Var  R  (Eq. 11.5)

R =mean(average) security return

T =Number of Periods=Sample Size

25
Example 11.3: Computing historical volatility

Problem:

Using the data below, what is the standard deviation of the

Australian All Ordinaries Index returns for the years 2002-
2011?

26
Example 11.3: Computing historical volatility

Execute:

•In the previous section we already computed the average annual return
of the Index during this period as 9%, so we have all of the necessary
inputs for the variance calculation.

•Applying Eq. 11.4, we have:

27
 Using the HP 10bll+ calculator to calculate Sample
Standard Deviation and Sample Mean

Procedure Key Operation

Clear statistics memory

Enter data -8.1 15.9 27.6

21.1 25 18

-40.4 39.6 3
-11.4
Calculate Sample Standard
Deviation
Calculate Sample Mean

2
8
Calculating Sample Standard Deviation by hand
1. Calculate the mean(average) return.

2. For each individual return calculate the difference from the

mean return. Differences should add to zero.

3. Square the differences in (2).

4. Sum the differences in (3).

5. Divide by (Sample Size-1).

6. Square Root (5) to get the Return Sample Standard Deviation.

Sample Standard Deviation is in the same units as the original data therefore if the original data
(return) is a percentage, the standard deviation is a percentage.

2
9
Example 11.3: Computing historical volatility

Execute (cont'd):

•Alternatively, we can break the calculation of this equation out as follows:

•Summing the squared differences in the last row, we get 0.5.

•Finally, dividing by (10-1=9) gives us 0.5/9 =0.056

•The standard deviation is therefore:

30
Example 11.3: Computing historical volatility

Evaluate:

•Our best estimate of the expected return for the Index is its
average return, 9%, but it is risky, with a standard deviation
of 23.6%.

31
Table 11.3: Summary of tools for working with historical
returns

32
Systematic risk and the
equity risk premium

Chapter 12

33
 Learning objectives
•Calculate the expected return and volatility (standard
deviation) of a portfolio.

•Understand the relation between systematic risk and the

market portfolio.

•Measure systematic risk.

•Use the Capital Asset Pricing Model (CAPM) to compute the

cost of equity capital for a share.

34
 12.1 The expected return of a portfolio
Portfolio weights
• The fraction of the total portfolio held in each investment in the portfolio:

Value of investment i (Eq. 12.1)

wi 
Total value of portfolio
• Portfolio weights add up to 100% (that is, w1 + w2 + … + wN = 100%).

(Eq. 12.2)

35
 12.1 The expected return of a portfolio
The expected return of a portfolio
•The weighted average of the expected returns of the
investments within it, using the portfolio weights:

E  RP   w1 E  R1   w2 E  R2   ...  wn E  Rn 

(Eq. 12.3)

36
 Table 12.1: Summary of portfolio concepts

37
 12.2 The volatility of a portfolio
Investors care about return, but also risk.
•When we combine shares in a portfolio, some risk is
eliminated through diversification.
•Remaining risk depends upon the degree to which the
shares share common risk.
•The volatility of a portfolio is the total risk, measured as
standard deviation, of the portfolio.

38
 12.2 The volatility of a portfolio
• Table 12.2 shows returns for three hypothetical shares,
along with their average returns and volatilities.
• Note that while the three shares have the same volatility
and average return, the pattern of returns differs.
• When the airline shares performed well, the oil share did
poorly, and when the airlines did poorly, the oil share did
well.

39
 Table 12.2: Returns for three shares, and portfolios of pairs
of shares

40
 12.2 The volatility of a portfolio
• This example demonstrates two important truths.
•By combining shares into a portfolio, we reduce risk
through diversification.
•The amount of risk that is eliminated depends upon the
degree to which the shares move together.
• Combining airline shares reduces volatility only slightly
compared to the individual shares.
• Combining airline and oil shares reduces volatility below
that of either share.

41
 12.2 The volatility of a portfolio
Measuring shares’ co-movement: Correlation
• To find the risk of a portfolio, we need to know:
• The risk of the component shares.
• The degree to which they move together.

• Correlation ranges from ‑1 to +1, and measures the degree

to which the returns share common risk.

42
 Figure 12.2: Correlation

43
 12.2 The volatility of a portfolio
• Correlation is scaled covariance and is defined
as:

Cov( Ri , R j )
Corr ( Ri , R j ) 
SD( Ri ) SD( R j )
 12.2 The volatility of a portfolio
• Share returns tend to move together if they are affected
similarly by economic events.
• Shares in the same industry tend to have more highly
correlated returns than shares in different industries.
• Table 12.3 shows several shares’:
• Volatility of individual share returns.
• Correlation between them.
• The table can be read across rows or down columns.

45
 Table 12.3: Estimated annual volatilities and correlations for selected shares
(based on monthly returns, December 2007–December 2012)

46
 12.2 The volatility of a portfolio
Computing a portfolio’s variance and standard deviation
• The formula for the variance of a two-share portfolio is:
Accounting for the Accounting for the
risk of stock 1 risk of stock 2
      Adjustment
  for how much the two stocks move together
        
Var ( RP )  w12 SD( R1 ) 2  w22 SD( R2 ) 2  2w1w2Corr ( R1 , R2 ) SD( R1 ) SD ( R2 )

(Eq. 12.4)
W1=weight in share 1 W2=weight in share 2
W1+W2=1 use decimal for W1 and W2

Var(Rp)=Portfolio Variance
remember to square root to get portfolio standard deviation

SD(R1 )=The standard deviation of Share 1’s Return

SD(R1 )=The standard deviation of Share 1’s Return
47
12.2 The volatility of a portfolio
• Expected return of a portfolio is equal to the
weighted average expected return of its shares.
• Risk of the portfolio is lower than the weighted
average of the individual shares’ volatility, unless
all the shares all have perfect positive correlation
with each other.
 Example 12.3: Computing the Standard Deviation of a two-share
portfolio’s Returns

What is the standard deviation of a portfolio with equal

amounts invested in Woodside and Qantas?
Solution:
Weight Return’s Correlation with
Plan: Standard Woodsides’ Share
Deviation Returns
Woodside 0.50 0.087 1
Qantas 0.50 0.107 0.32

• With the portfolio weights, volatility, and correlations of the shares in the
two portfolios, we have all the information we need to use Eq. 12.4 to
compute the variance of each portfolio.
• After computing the portfolio’s variance, we can take the square root to
get the portfolio’s standard deviation.
49
 Example 12.3: Computing the volatility of a two-share portfolio
Execute
• For the portfolio of WPL(Woodside) and QAN (Quantas):

• The standard deviation in this case is:

50
 Figure 12.4: Volatility of an equally weighted portfolio versus the
number of shares

51
 12.3 Measuring systematic risk
Role of the market portfolio
• The sum of all investors’ portfolios must equal the portfolio
of all risky securities in the market.
• The market portfolio is the portfolio of all risky investments,
held in proportion to their value.
• Thus, the market portfolio contains more of the largest
companies and less of the smallest companies.
• The market portfolio is value-weighted.
• Value-weighted means that shares are held in proportion
to their market value (market capitalization).
Market Value of a Firm   Number of Shares Outstanding    Price per share 
52
 12.3 Measuring systematic risk
Share market indexes as the market portfolio
• In practice we use a market proxy—a portfolio whose return
should track the underlying, unobservable market portfolio.
• The most common proxy portfolios are market indexes.
• A market index reports the value of a particular portfolio.
– Dow Jones Industrial Average
– S&P 500
– All Ordinaries Index
– www.unisuper.com.au/learning-centre/videos/five-quest
ions-for-the-chief-investment-officer/five-questions-for-t
he-chief-investment-officer-june-2018
– (from 5minutes 48 seconds: index strategies)

53
 S&P 500 versus ASX 200

http://www.spindices.com/multimedia-center/sp-500-versus-s-p-asx-200

54
 S&P 500
S&P Dow Jones U.S. indices are designed to reflect the U.S.
equity markets and, through the markets, the U.S. economy.
The S&P 500 focuses on the large-cap sector of the market;
however, because it represents more than 70% of the total US
stock market capitalisation, it also represents the market.
Companies in the S&P 500 are considered leading companies
in leading industries.
Source:http://au.spindices.com/index-family/us-
equity/market-cap

55
ASX 200

56
Is the ASX200 or the S&P 500 a better proxy for the
market portfolio? Explain why.

Discuss this question in groups of three (two minutes)

57
 12.3 Measuring systematic risk
Market risk and beta
• We compare a share’s historical returns to the market’s
historical returns to determine a share’s beta (β):
• The sensitivity of an investment to fluctuations in the
market portfolio.
• Use excess returns – security return less the risk-free
rate.
• The percentage change in the share’s return that we
expect for each 1% change in the market’s return.

58
 12.3 Measuring systematic risk
• The beta of the overall market portfolio is 1.
• Many industries and companies have betas
higher/lower than 1.
• Differences in betas by industry are related to
the sensitivity of each industry’s profits to the
general health of the economy.

59
 Example 12.5: Total risk versus systematic risk
Problem:
Suppose that in the coming year, you expect SysCo’s share to have a
standard deviation of 30% and a beta of 1.2, and UniCo’s share to
have a standard deviation of 41% and a beta of 0.6.
Which share carries more total risk and which has more systematic risk?

Standard Deviation Beta (β)

(Total Risk) (Systematic Risk)

SysCo 30% 1.2

UniCo 41% 0.6

60
 Example 12.5: Total risk versus systematic risk
Execute:
• Total risk is measured by standard deviation; therefore,
UniCo’s share has more total risk.
• Systematic risk is measured by beta. SysCo has a higher
beta, and so has more systematic risk.

Evaluate:
• As we discuss in the Common Mistake box on P. 372, a
share can have high total risk, but if a lot of it is diversifiable,
it can still have low or average systematic risk.

61
 12.3 Measuring systematic risk
Estimating beta from historical returns
•Beta is the expected percentage change in the excess
return of the security for a 1% change in the excess return
of the market portfolio.
• It represents the amount by which risks that affect the
overall market are amplified or dampened in a given share
or investment.
• Security returns that move one for one with the market, on
average have a beta of one. Security returns that move
more than the market have a beta greater than one and
ones that move less than the market, a beta of less than
one.
62
 12.3 Measuring systematic risk
In practice, we use linear regression to estimate
beta.
• The output is the best-fitting line that represents
the historical relation between the share and the
market.
• The slope of this line is our estimate of beta.
• Tells us how much the share’s excess return
changed for a 1% change in the market’s excess
return.

63
 Figure 12.7: Scatterplot of monthly returns for Qantas versus the S&P/ASX
500, Dec 2007–Dec 2012

64
12.4 Putting it all together: The capital asset pricing model

•We wish to compute the cost of equity capital

• Cost of capital is the best available

expected return offered in the market on a
similar investment.
•To compute the cost of equity capital, we
need to know the relation between the share’s
risk and its expected return.
65
12.4 Putting it all together: The capital asset pricing model
The CAPM equation relating risk to expected return

• Only systematic risk determines expected returns.

• Firm-specific risk is diversifiable and does not require extra return.
• The expected return on any investment comes from:
• A risk-free rate of return to compensate for inflation and the time
value of money, even with no risk of losing money.
• A risk premium that varies with the systematic risk.
•Expected Return =
Risk-free rate + Risk Premium for Systematic Risk.
66
12.4 Putting it all together: The capital asset pricing model

(Eq. 12.6)

Expected Expected
Risk- Stock’s
Return Market
67
free Beta
on Equity Risk
Interest
Premium
Rate
12.4 Putting it all together: The capital asset pricing model(CAPM)

•The CAPM says that the expected return on any investment is equal to
the risk-free rate of return plus a risk premium proportional to the amount
of systematic risk in the investment.

• The risk premium is equal to the market risk premium times the
amount of systematic risk present in the investment, measured by its
beta (βi).
• The market risk premium is the expected return on the market minus
the risk-free rate.
• We use the CAPM equation to estimate the investment’s required
return.
68
Example 12.6: Computing the expected return for a share
Problem:

Suppose the risk-free return is 5% and you measure the market risk premium to be 7%.
Qantas stock has a beta of 1.59. According to the CAPM, what is Qantas’ shares
expected return?

Solution:

Plan:

•We can use Eq 12.6 to compute the expected return according to the CAPM. For that
equation, we will need the market risk premium, the risk-free return, and the share’s
beta. We have all of these inputs, so we are ready to go.

69
Example 12.6: Computing the expected return for a share

Execute:
• Using Eq. 12.6:

Evaluate:

• Because of Qantas’ beta of 1.59, investors will require a risk

premium of 11.13% over the risk-free rate for investments in its
share to compensate for the systematic risk of Qantas share.
This leads to a total expected return of 16.13%.

70
12.4 Putting it all together: The capital asset pricing model

The security market line

• The CAPM implies a linear relation between a share’s beta and its expected
return.
• This line is graphed in Figure 12.9 as the line through the risk-free investment
(with a beta of zero) and the market (with a beta of one); it is called the
security market line (SML).

• Recall that there is no clear relation between a share’s standard deviation

(volatility) and its expected return.
• The relation between risk and return for individual securities is only
evident when we measure market risk rather than total risk.
71
Figure 12.8(b): Expected return, volatility and beta

The graph above is known as the security market line

(SML). The SML plots Beta on the horizontal axis and CAPM
72

Expected Return on the vertical axis. (0,Risk-free rate)

and
(1,Expected Market Return) are two points on the SML.
 Example 12.7: A negative beta share
Problem:
Suppose the share of Bankruptcy Auction Services, Inc. (BAS) has a negative
beta of -0.30. How does its expected return compare to the risk-free rate,
according to the CAPM? Does your result make sense?
Solution:
Plan:
• We can use the CAPM equation, Eq. 12.6, to compute the expected return of
this negative beta share just like we would a positive beta share. We don’t
have the risk-free rate or the market risk premium, but the problem does not
ask us for the exact expected return, just whether or not it will be more or
less than the risk-free rate. Using Eq. 12.6, we can answer that question.

73
 Example 12.7: A negative beta share
Execute:
• Because the expected return of the market is higher than the risk-free
rate, Eq. 12.6 implies that the expected return of Bankruptcy Auction
Services (BAS) will be below the risk-free rate. As long as the market
risk premium is positive (as long as people demand a higher return for
investing in the market than for a risk-free investment), then the
second term in Eq. 12.6 will have to be negative if the beta is
negative.
• For example, if the risk-free rate is 5% and the market risk premium is
7%,
• E[RBAS] = 5% - 0.30(7%) = 2.9%.
• (See Figure 12.8: the SML drops below rf for β < 0.)

74
 Example 12.7: A negative beta share
Evaluate:
•This result seems odd—why would investors be willing to
accept a 2.9% expected return on this share when they can
invest in a safe investment and earn 5%?
•The answer is that a savvy investor will not hold BAS alone;
instead, the investor will hold it in combination with other
securities as part of a well-diversified portfolio.
•These other securities will tend to rise and fall with the
market.

75
 Example 12.7: A negative beta share
Evaluate (cont’d):
• But because BAS has a negative beta, its correlation with
the market is negative, which means that BAS tends to
perform well when the rest of the market is doing poorly.
• Therefore, by holding BAS, an investor can reduce the
overall market risk of the portfolio. In a sense, BAS is
“recession insurance” for a portfolio, and investors will pay
for this insurance by accepting a lower return.

76
12.4 Putting it all together: The capital asset pricing model (CAPM)
The CAPM and portfolios
• We can apply the SML to portfolios as well as individual
securities.
• The market portfolio is on the SML, and according to the
CAPM, other portfolios (such as mutual funds) are also
on the SML.
• Therefore, the expected return of a portfolio should
correspond to the portfolio’s beta.
• The beta of a portfolio made up of securities each with
weight wi is:
 P  w11  w2  2  ...  wn  n (Eq. 12.7)
 Example 12.8: The expected return of a portfolio
Problem:
Suppose Woolworths (WOW) has a beta of 0.3, whereas the beta of
Qantas (QAN) is 1.59. If the risk free interest rate is 5% and the market
risk premium is 7%, what is the expected return of an equally weighted
portfolio of Woolworths and Qantas, according to the CAPM?
Solution:
Plan:
• We have the following information:
rf = 5%, E[RMkt] - rf = 7%
WOW: βWow= 0.7, wWOW = 0.50
QAN: βQAN= 1.1, wQAN = 0.50

78
 Example 12.8: The expected return of a portfolio
Execute
we can compute the beta of the portfolio using Eq. 12.7:
βP = wWOWβWOW + wQANβQAN

βP = (0.5)(0.3) + (0.5)(1.59) = 0.945

• We can then find the portfolio’s expected return from the
CAPM:
E[RP] = rf + βP(E[RMkt] – rf)

E[RP] = 5% + 0.945(7%) = 11.62%

79
 Chapter quiz .. Answer in groups of three
1. How is the expected return of a portfolio related to the
expected returns of the shares in the portfolio?
2. What determines how much risk will be eliminated by
combining shares in a portfolio?
3. What is the market portfolio?
4. What does beta tell us?
5. What does the CAPM say about the required return of a
security?
6. What is the security market line?

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