1- 1

Introduction to Risk & Return-Learning objectives

 Over a Century of Capital Market History

 Measuring Portfolio Risk
 Calculating Portfolio Risk
 Beta and Unique Risk
 Diversification & Value Additivity
 1- 2

The Value of an Investment of $1 in 1900

$100,000

Common Stock 15,578

$10,000
US Govt Bonds
T-Bills
Dollars

$1,000

147
$100
61

$10

$1

2004
900 910 920 930 940 950 960 970 980 990 000
1 1 1 1 1 1 1 1 1 1 2

Start of Year
 1- 3

The Value of an investment of Rs.1 in 1978-79

14000 12696
12000
10000
8000
6000
4000 2727
2000 1105
0

G-Sec Bonds Stock

 1- 4

The Value of an Investment of $1 in 1900

Real Returns
$1,000
719
Equities
Bonds
Bills
$100
Dollars

$10
6.81

2.80

$1

2004
900 910 920 930 9 40 9 50 960 970 980 990 000
1 1 1 1 1 1 1 1 1 1 2

Start of Year
 19
78

500
1000
1500
2000
2500

0
-7
19 9
80
-
19 8 1
82
-8
19 3
84
-8
19 5
86
-8
19 7
88
-8
19 9
90

G-Sec
-
19 9 1
92
-9
19 3
94
Bond -9
19 5
96
-9
19 7
98
Stock

-9
20 9
00
-
20 01
02
-0
20 3
04
-0
5
The Value of an investment of Rs.1 in 1978-79

175
506
2301
1- 5
 1- 6

Average Market Risk Premia (by country)

Risk premium, %
11
10
9
8
7
6 10.7
5 9.3
10
8.1 8.2 8.6
4 6.6
7.6
6.3 6.4
3 4.7 5.1 5.3 5.8 5.9 5.9
4.3
2
1
0
Average
Switzerland
Belgium

Germany

Italy
Denmark

Sweden
Ireland

South Africa
Australia
USA

Japan
Spain

UK

France
Canada

Netherlands

Country
Sensex has registered an excess return of about 13% in the
last 26 years.
 1- 7

Rates of Return 1900-2003

US Stock Market Index
Returns
80%
Percentage Return

60%

40%

20%

0%

-20%
1900 1920 1940 1960 1980 2000
-40%

-60%

Year
Source: Ibbotson Associates
 1- 8

Measuring Risk
Histogram of Annual US Stock Market Returns
# of Years 24
24
19
20
15 13
16
12
12 10

8
4 3
4 1 1 2
0
Return %
0 to 10
-50 to -40

-40 to -30

-30 to -20

-20 to -10

-10 to 0

10 to 20

20 to 30

30 to 40

40 to 50

50 to 60
 Stock Index Returns in India 1- 9

(1979-2005)
Rate of return, percent

1.00
0.80
0.60
0.40
0.20
-
(0.20)
(0.40)
1979-80 1984-85 1989-90 1994-95 1999-00 2004-05
 1- 10

Measuring Risk

Variance - Average value of squared deviations

from mean. A measure of volatility.

Standard Deviation - Average value of squared

deviations from mean. A measure of volatility.
 1- 11

Measuring Risk

Diversification - Strategy designed to reduce risk

by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that firm.
Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.”
 1- 12

Measuring Risk

Portfolio rate
of return (
=
fraction of portfolio
in first asset )(
x
rate of return
on first asset )
+
( in second asset )(
fraction of portfolio
x
rate of return
on second asset )
 1- 13

Measuring Risk
Portfolio standard deviation

0
5 10 15
Number of Securities
 1- 14

Measuring Risk
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
 1- 15

Portfolio Risk
The variance of a two stock portfolio is the sum of these
four boxes

Stock 1 Stock 2
x 1x 2σ 12 
Stock 1 x 12σ 12
x 1x 2ρ 12σ 1σ 2
x 1x 2σ 12 
Stock 2 x 22σ 22
x 1x 2ρ 12σ 1σ 2
 1- 16

Portfolio Risk
Example
Suppose you invest 47% of your portfolio in
Reliance Energy and 53% in Grasim Industries.
The expected return on your Reliance Energy
stock is 17% and on Grasim is 14%. The expected
return on your portfolio is:

Expected Return  (.47 17)  (.53 14)  15.41%

 1- 17

Portfolio Risk
Example
Suppose you invest 47% of your portfolio in Reliance Energy and 53%
in Grasim Industries. The expected return on your Reliance Energy
stock is 17% and on Grasim is 14%. The standard deviation of their
annualized daily returns are 37% and 33%, respectively. Assume a
correlation coefficient of 1.0 and calculate the portfolio variance.

Reliance Energy Grasim

Reliance Energy x12 12  (0.47) 2  (37) 2 x1 x2 121 2
 (0.47)  (0.53) 1 (37)  (33)
Grasim x1 x2 12 1 2 x22 22  (0.53) 2  (33)2
 (0.47)  (0.53) 1 (37)  (33)
 1- 18

Portfolio Risk
Example
Suppose you invest 47% of your portfolio in Reliance Energy and 53%
in Grasim Industries. The expected return on your Reliance Energy
stock is 17% and on Grasim is 14%. The standard deviation of their
annualized daily returns are 37% and 33%, respectively. Assume a
correlation coefficient of 1.0 and calculate the portfolio variance.

Portfolio variance = [(0.47)2  (37)2] + [(0.53)2  (33)2] +2 (0.47  0.53  1  33  37)

= 1216.61

The standard deviation is 1216.61  34.88 percent

 1- 19

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 )

 1- 20

Portfolio Risk
The shaded boxes contain variance terms; the remainder
contain covariance terms.

1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes

N
1 2 3 4 5 6 N
STOCK
 1- 21

Beta and Unique Risk

1. Total risk =
Expected
diversifiable risk +
stock
market risk
return
2. Market risk is
measured by beta,
beta
the sensitivity to
market changes +10%
-10%

- 10% +10% Expected

market
-10% return

Copyright 1996 by The McGraw-Hill Companies, Inc

 1- 22

Beta and Unique Risk

Market Portfolio - Portfolio of all assets in the

economy. In practice a broad stock market
index, such as the Nifty or Sensex, is used
to represent the market.

Beta - Sensitivity of a stock’s return to the

return on the market portfolio.
 1- 23

Beta and Unique Risk

 im
Bi  2
m
 1- 24

Beta and Unique Risk

 im
Bi  2
m
Covariance with the
market

Variance of the market

 1- 25

Risk & Return-Learning Obejctives

 Markowitz Portfolio Theory
 Risk and Return Relationship
 Validity and the Role of the CAPM
 1- 26

Markowitz Portfolio Theory

 Combining stocks into portfolios can reduce
standard deviation, below the level obtained
from a simple weighted average calculation.
 Correlation coefficients make this possible.
 The various weighted combinations of
stocks that create this standard deviations
constitute the set of efficient portfolios.
portfolios
 1- 27

Markowitz Portfolio Theory

Price changes vs. Normal distribution
Grasim Industries - Daily % change 1994-2006
Proportion of days

0.16

0.14

0.12

0.1

0.08

0.06

0.04

0.02

0
3

04
2

09

00

01

02

03

04

05

06

07

08

09

10

11

12
.1

.0
.1

.1

.1

.0

.0

.0

.0

.0

.0
.

0.

0.

0.

0.

0.

0.

0.

0.

0.

0.

0.

0.

0.
-0

-0
-0

-0

-0

-0

-0

-0

-0

-0

-0

-0

-0

Daily price changes, percent

 1- 28

Markowitz Portfolio Theory

Standard Deviation VS. Expected Return
Investment A
20
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
 1- 29

Markowitz Portfolio Theory

Standard Deviation VS. Expected Return
Investment B
20
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
 1- 30

Markowitz Portfolio Theory

Standard Deviation VS. Expected Return
Investment C
20
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
 1- 31

Markowitz Portfolio Theory

Standard Deviation VS. Expected Return
Investment D
20
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
 1- 32

Efficient Frontier
•Each half egg shell represents the possible weighted combinations for two
stocks.
•The composite of all stock sets constitutes the efficient frontier

Expected Return (%)

Standard Deviation
 1- 33

Efficient Frontier
Example Correlation Coefficient = .4
Stocks  % 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%
 1- 34

Efficient Frontier
Example Correlation Coefficient = .4
Stocks  % 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

 1- 35

Efficient Frontier
Example Correlation Coefficient = .3
Stocks  % 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%
 1- 36

Efficient Frontier
Example Correlation Coefficient = .3
Stocks  % 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
 1- 37

Efficient Frontier

Return

Risk
(measured
as )
 1- 38

Efficient Frontier

Return

B
AB
A

Risk
 1- 39

Efficient Frontier

Return

B
N
AB
A

Risk
 1- 40

Efficient Frontier

Return

B
ABN AB N

Risk
 1- 41

Efficient Frontier
Goal is to move
Return up and left.
WHY?

B
ABN AB N

Risk
 1- 42

Efficient Frontier

Return

Low Risk High Risk

High Return High Return

Low Risk High Risk

Low Return Low Return

Risk
 1- 43

Efficient Frontier

Return

Low Risk High Risk

High Return High Return

Low Risk High Risk

Low Return Low Return

Risk
 1- 44

Efficient Frontier

Return

B
ABN N
AB
A

Risk
 1- 45

Security Market Line

Return

Market Return = rm .
Risk Free Efficient Portfolio

Return = rf
Risk
 1- 46

Security Market Line

Return

Market Return = rm .
Risk Free Efficient Portfolio

Return = rf

1.0 BETA

SML Equation = rf + B ( rm - rf )
 1- 47

Capital Asset Pricing Model

R = rf + B ( r m - rf )

CAPM
 1- 48

Consumption Betas vs Market Betas

Stocks Stocks
(and other risky assets) (and other risky assets)

Wealth is uncertain

Market risk Standard Consumption

makes wealth Wealth
CAPM CAPM
uncertain.
Consumption is
uncertain

Wealth = market
Consumption
portfolio