Security Analysis & Portfolio Management

Portfolio Risk & Return

1
 Portfolio Expected Return and Risk

Expected Return Risk

The Expected
The The Risk The The
Returns
Portfolio of the Portfolio Correlation
of the
Weights Securities Weights Coefficients
Securities

2
 Portfolio Return
Portfolio is a collection/ combination/ group of assets or securities. A
large number of portfolios can be formed from a given set of assets &
each portfolio will have risk- return characteristics of its own.

Portfolio expected return = ( ) ==1 E( )

Where wj= expected return for asset j; E(rj) = expected return for
asset j & n= no. of assets in the portfolio

If the expected return of two assets i.e. L (low-risk, low-return) & H

(high-risk, high-return) are 12% & 16% respectively. If the
corresponding weights are 0.65 & 0.35, the expected portfolio return
= [(0.65 X 0.12) + (0.35 X 0.16)] = 0.134 or 13.4%

3
 Portfolio Risk
Although the E(rp) is the weighted average of the expected returns on
individual securities in the portfolio, portfolio risk (identified as , 2) is
not the weighted average of risks of the individual securities in the
portfolio (except when returns from securities are uncorrelated).

To measure risk, information are required on weighted individual

security risks & weighted comovements between the returns of
securities.

Co-movements between the returns of securities are measured by

covariance (an absolute measure) & coefficient of correlation ( a
relative measure).
Covariance is a measure that combines the variance of a stocks returns
with the tendency of those returns to move up or down at the same time
other stocks move up or down.

Since it is difficult to interpret the magnitude of the covariance terms, a

related statistic, the correlation coefficient, is often used to measure the
degree of co-movement between two variables. The correlation coefficient
simply standardizes the covariance.
4
 Portfolio Risk (Covariance)
For a portfolio consisting of two assets x and y, the
covariance shall be computed from the following formula:

]
=[
=

Calculate the covariance of two securities x and y for 4

years: For x (1-10%; 2-12%; 3-16%; 4-18%) and for y (1-
17%; 2-13%; 3-10%; 4-8%)

Covariance = -10.5 5
 Calculate the Covariance
The returns on securities 1 & 2 under five possible states of nature
are as under. Compute the covariance between the returns of two
securities.
State Probability R1 R2
1 0.10 -10% 5%
2 0.30 15 12
3 0.30 18 19
4 0.20 22 15
5 0.10 27 12

Covariance = 26.0

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 Portfolio Risk
(Covariance & Coefficient of Correlation)
Returns of two securities move in same direction Positive
Covariance & vice-versa;
If movement of returns are independent of each other, covariance
would be close to Zero
Since covariance is an absolute measure of interactive risk between
two securities, it can be standardized;
Dividing the covariance between two securities by product of the
standard deviation of each security gives a standardized measure,

called as the coefficient of correlation: =

Or, Covariance can be expressed as the product of correlation
between the securities & standard deviation of securities i.e.
Covxy = xyx y
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 Portfolio Risk
Using either the correlation coefficient or the covariance, the
Variance on a Two-Asset Portfolio can be calculated as follows:

= + +

The Standard Deviation() of the Portfolio equals the positive

square root of the variance.

Calculate portfolio variance & from the following sets of expected returns,
and correlation coefficients:
For P Er 15% & 50%; For Q - Er 20% & 30% & = -0.60

SD = 6.18%. What will be the if we take them separately?

50 and 30
A portfolio consisting of securities 1 &2 in the proportion of 0.6 & 0.4
respectively. Standard deviations of the returns on both securities i.e. are
1 = 10 & 2= 16; & the coefficient of correlation between the two returns is
0.5. What is the standard deviation of portfolio return?
10.7%
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 Portfolio Risk (2 x 2 Matrix for 2 Security Case)

The entries in top-left & bottom-

Security 1 Security 2 right represent the product of the
square of proportion invested in
each security & the variance of the
Security 1

return on respective securities.

The other two entries are same

represent the product of
proportions invested in security 1
& security 2; & the covariance of
Security 2

the returns of two securities.

Add all entries in the four sections

to get portfolio variance.

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 Correlation Coefficient and Portfolio Risk

In general, > 0 indicates positive relationship; < 0

indicates negative relationship; while = 0 indicates no
relationship (or that the variables are independent and not
related).
Here = +1.0 describes a perfect positive correlation and
= -1.0 describes a perfect negative correlation.
Thus, lower the correlation coefficient, greater is the
diversification of risk.

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 Diversification
Case 1: Returns perfectly positively correlated

Here, diversification provides only risk averaging

and no risk reduction as portfolio risk can not be
reduced below individual security risk.

Here, since correlation is 1, the whole expression

can be identifiable as the expansion of (a+b)2

Thus = ( + ) or
= ( + )
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 Positive Linear Correlation

y y y

x x x

(a) Positive (b) Strong (c) Perfect

positive positive

Scatter Plots
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 Example
P = 50, Q = 30; proportion of P & Q =0.4 & 0.6; & =
+1; what will be the ?
38
If the proportion is .75 & .25 respectively, will be
45
Being the weighted average of of individual securities,
the portfolio will lie between the two of individual
securities i.e. 50 and 30
So only risk averaging is possible not risk reduction

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 Diversification
Case 2: Returns perfectly negatively correlated

Portfolio may become entirely risk free when portfolio

returns are perfectly negatively correlated portfolio risk
can be considerably reduced & some times even
eliminated.
Here, since correlation is -1, the whole expression can be
identifiable as the expansion of (a-b)2

Thus, = ( ) or
= ( )

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 Negative Linear Correlation

y y y

x x x

(d) Negative (e) Strong (f) Perfect

negative negative

Scatter Plots
15
 Example
SD of P = 50, SD of Q = 30; proportion of P & Q =0.4 & 0.6;
& correlation coefficient = -1; what will be the of portfolio?
2 very low Portfolio risk
If the proportion of investment is 0.375 & 0.625
respectively, will be
Nil
So, on occasions risk elimination is possible
But in reality, it is rare to find securities that are perfectly
negatively correlated

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 Diversification
Case 3: Returns Uncorrelated
Here correlation coefficient () will be 0

The portfolio is less than the s of individual securities in

the portfolio leading to reduction of risk

= +

Thus combining securities with zero correlation may reduce risk

of the portfolio. By adding more and more uncorrelated
securities, the risk of the portfolio can be significantly reduced
but can not be fully eliminated.
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 No Linear Correlation

y
y

x x
(g) No Correlation (h) Nonlinear Correlation

Scatter Plots
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 Example
SD of P = 50, SD of Q = 30; proportion of P & Q =0.4 & 0.6;
& = 0; what will be the of portfolio?

26.91

Tabulation of portfolio in the three cases for different

values of among them indicates that diversification
reduces risk in all cases except when the security returns
are positively correlated

In real world, investors should try to identify securities with

negative or low positive correlation to reduce risk to a
considerable extent.
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 Case of 2 Assets (When = +1)
E(R)

E(R )
Y
Asset Y

E(R )
P
Perfectly Positive
Correlation
E(R )
X Asset X

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 Case of 2 Assets (When = -1)
E(R)
Perfectly Negative
Correlation
E(R )
Y
Asset Y

E(R )
P

E(R )
X Asset X

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 Case of 2 Assets (When = +0.5)
E(R)

E(R )
Y
Asset Y

E(R )
P

E(R )
X Asset X
Imperfect Correlation;
Between -1 and 1

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 Case of 2 Assets (When = 0)
E(R)

E(R )
Y
Asset Y

E(R )
P

E(R )
X Asset X
Zero Correlation

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 Case of Two Assets
(considering various degrees of coefficient of correlation)
E(R)
Perfectly Negative
Correlation
E(R )
Y
Asset Y

E(R )
P
Perfectly Positive
Correlation
E(R )
X Asset X
Imperfect Correlation;
Between -1 and 1

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 Test Your Understanding - 1
The return of two assets under four possible states of nature are as
follows:
State of Probability Return on Return on
nature Asset 1 (%) Asset 2 (%)

1 0.10 5 0
2 0.30 10 8
3 0.50 15 18
4 0.10 20 26

a) What is the SD of Asset 1 ? Asset 2?

B) What is the covariance between the return on Asset 1 & 2?
C) What is the coefficient of correlation between Asset 1 & 2?
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 Solution
ER1= 0.1(5%) + 0.3(10%) + 0.5(15%) + 0.1 (20%) = 13%
ER2= 0.1(0%) + 0.3(8%) + 0.5(18%) + 0.1 (26%) = 14%

SD1= [0.1(5-13)2+ 0.3(10-13)2+ 0.5(15-13)2+ 0.1(20-13)2] 1/2= 4%

SD2= [0.1(0-14)2+ 0.3(8-14)2+ 0.5(18-14)2+ 0.1(26-14)2] 1/2= 7.27%

Nature Prob R1 % Deviation R2% Deviation Product of

(1) (2) of 1 from of 2 from deviation times
(3) mean %(4) (5) mean (6) probability (7)
1 0.10 5 -8 0 -14 11.2
2 0.30 10 -3 8 -6 5.4
3 0.50 15 2 18 4 4
4 0.10 20 7 26 12 8.4

Covariance between the returns = (11.2+5.4+4+8.4) = 29

Coefficient of correlation between the two returns = [ 29 (4 X 7.27)] = 0.997
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 Test Your Understanding - 2
For Stock P ER is 16% & SD is 25%
For Stock Q ER is 18% & SD is 30%
The returns on these two stocks are negatively correlated.
What is the expected return of a portfolio constructed to
drive the SD of portfolio return to zero?

The weights that drive the SD of portfolio to 0, when returns

are perfectly negatively correlated are: [30 (25+30)]
=0.545 for P & 0.455 for Q
ER of the portfolio= {[0.545 X 16%] + [0.455 X 18%]} =
16.91%
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 Test Your Understanding - 3
ER for Stock A = 16% & Stock B = 12%
SD for Stock A = 15% & Stock B = 8%
Coefficient of correlation = 0.60
What is the covariance between stocks A & B?
What is the ER & risk of a portfolio in which A & B have weights of
0.6 & 0.4?

Covariance = AB X A X B = 0.6 X 15 X 8 = 72
ER = 0.6 X 16 + 0.4 X 12 = 14.4%
Risk (SD) = [wA2 A2 + wB2 B2 + 2wAwBCov (A,B)
= [0.36x 225 + 0.16 x 64 + 2 x 0.6 x 0.4 x 72]1/2 = 11.22%

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Portfolio Risk as a Function of the Number of Stocks in the
Portfolio
In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.

Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the risk
of individual securities.
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 Measurement of Systematic Risk
It is the variability in security returns caused by changes in the economy or
the market.
The average effect of a change in the economy can be represented by a
change in the stock market index, &
The systematic risk of a security known as can be measured by relating
the securitys with the variability in the stock market index.
For computation of , the historical returns of the security & the returns of a
representative stock market index are required.
Two statistical methods may be used for computing i.e. Correlation
Method & Regression Method.

(1) Correlation Method: =

() ()
= =
() ()

where X refers to Market Return & Y refers to return of individual security

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 Test Your Understanding
Monthly return data (in %) are presented below for ITC stock & BSE
National Index for a 12 month period. Calculate beta of ITC stock.
Month ITC Stock BSE National Index
1 9.43 7.41
2 0.00 -5.33
3 -4.31 -7.35
4 -18.92 -14.64
5 -6.67 1.58
6 26.57 15.19
7 20.00 5.11
8 2.93 0.76
9 5.25 -0.97
10 21.45 10.44
11 23.13 17.47
12 32.83 20.15 31
 Computation
( .)(. .)
=
( .)(.) ( .) (.)
= 0.935
. (.)
SD of ITC Returns = = 14.96
()

. (.)
Variance of Market Return = = = 102.16
()
SD of Market Return = = 102.16 = 10.11

. (. .)
Beta = = = = 1.384
.

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 The Beta Coefficient
How is the Beta Coefficient Interpreted?
The beta of the market portfolio is ALWAYS = 1.0

The beta of a security compares the volatility of its returns to the

volatility of the market returns:

s = 1.0 - the security has the same volatility as the

market as a whole

s > 1.0 - aggressive investment with volatility of

returns greater than the market

s < 1.0 - defensive investment with volatility of

returns less than the market

s < 0.0 - an investment with returns that are

negatively correlated with the returns of the
market

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 Measurement of Systematic Risk..
(2) Regression Method: postulates linear relationship & helps to
calculate the values of two constants namely and .

measures the change in dependent variable in response to unit

change in the independent variable, while measures the dependent
variable when the independent variable has 0 value.
Regression equation = Y = + X
()

= and =
()

is the mean value of dependent variable scores &

Where is the
mean value of independent variable scores.

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 Measurement of Systematic Risk..

For computation, return on individual security is considered as

the dependent variable & the return of market index is
considered as independent variable & so = +

With the data given for ITC stock & BSE National Index for a 12
month period in the previous slide, calculate beta of ITC stock
by regression model.

XY = 2160.49; X = 49.82; Y = 111.69; X2 = 1432.75;

n=12

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 Characteristic Line
The characteristic line is a regression line that represents the relationship
between the returns on the stock and the returns on the market over a
period of time.

The slope of the Characteristic Line is the Beta Coefficient

The degree to which the characteristic line explains the variability in the
dependent variable (returns on the stock) is measured by the coefficient of
determination. (also known as the R2 (r-squared or coefficient of
determination)).

If the coefficient of determination equals 1.00, this would mean that all of
the points of observation would lie on the line. This would mean that the
characteristic line would explain 100% of the variability of the dependent
variable.

The alpha is the vertical intercept of the regression (characteristic line).

Many stock analysts search out stocks with high alphas.
 High R2
An R2 that approaches 1.00 (or 100%) indicates that the
characteristic (regression) line explains virtually all of the
variability in the dependent variable.

This means that virtually of the risk of the security is

systematic.

This also means that the regression model has a strong

predictive ability. if you can predict what the market will
dothen you can predict the returns on the stock itself with a
great deal of accuracy.