CHAPTER 6 and 7- Risk and Return

1. 2. 3.

Basic return concepts Basic risk concepts Individual Securities

Expected Return, Variance, and Covariance

1. 2. 3. 4. 5. 6. 7. 8.

The Return and Risk for Portfolios The Efficient Set for Two Assets The Efficient Set for Many Securities Diversification: An Example Riskless Borrowing and Lending Market Equilibrium Relationship between Risk and Expected Return (CAPM) Summary and Conclusions

What are investment returns?

Investment returns measure the financial results of an investment. Returns may be historical or prospective (anticipated). Returns can be expressed in: Dollar terms. Percentage terms.
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What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100? Dollar return: $ Received - $ Invested $1,100 $1,000 = $100.

Percentage return: $ Return/$ Invested $100/$1,000 = 0.10 = 10%.

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What is investment risk?

Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk.
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Probability distribution
Stock X

Stock Y

-20

15

50

Rate of return (%)

Which stock is riskier? Why?

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Individual Securities

The characteristics of individual securities that are of interest are the:

Expected

Return Variance and Standard Deviation Covariance and Correlation

Calculate the expected rate of return on each alternative.

r = expected rate of return.

r = i Pi . r
i =1

What is the standard deviation of returns for each alternative?

=Standard deviation = Variance
=
n i= 1

( ri r ) 2 Pi .

Standard deviation measures the stand-alone risk of an investment. The larger the standard deviation, the higher the probability that returns will be far below the expected return. Coefficient of variation is an alternative measure of stand-alone risk.

Expected Return, Variance, and Covariance

Rate of Return Scenario Probability Stock fund Bond fund Recession 33.3% -7% 17% Normal 33.3% 12% 7% Boom 33.3% 28% -3%

Consider the following two risky asset world. There is a 1/3 chance of each state of the economy and the only assets are a stock fund and a bond fund.
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Expected Return, Variance, and Covariance

Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

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Expected Return, Variance, and Covariance

Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

E (rS ) = 1 (7%) + 1 (12%) + 1 (28%) 3 3 3 E (rS ) = 11%

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Expected Return, Variance, and Covariance

Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

E (rB ) = 1 (17%) + 1 (7%) + 1 (3%) 3 3 3 E (rB ) = 7%

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Expected Return, Variance, and Covariance

Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

(11% 7%) = 3.24%

2
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Expected Return, Variance, and Covariance

Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

(11% 12%) = .01%

2
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Expected Return, Variance, and Covariance

Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

(11% 28%) = 2.89%

2
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Expected Return, Variance, and Covariance

Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

1 2.05% = (3.24% + 0.01% + 2.89%) 3

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Expected Return, Variance, and Covariance

Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

14.3% = 0.0205
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The Return and Risk for Portfolios

Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

Note that stocks have a higher expected return than bonds and higher risk. Let us turn now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50% invested in stocks.
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The Return and Risk for Portfolios

Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund -7% 17% 12% 7% 28% -3% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% Portfolio 5.0% 9.5% 12.5% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:

rP = wB rB + wS rS

5% = 50% (7%) + 50% (17%)

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The Return and Risk for Portfolios

Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund -7% 17% 12% 7% 28% -3% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% Portfolio 5.0% 9.5% 12.5% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:

rP = wB rB + wS rS 9.5% = 50% (12%) + 50% (7%)

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The Return and Risk for Portfolios

Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund -7% 17% 12% 7% 28% -3% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% Portfolio 5.0% 9.5% 12.5% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:

rP = wB rB + wS rS 12.5% = 50% (28%) + 50% (3%)

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The Return and Risk for Portfolios

Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund -7% 17% 12% 7% 28% -3% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% Portfolio 5.0% 9.5% 12.5% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

The expected rate of return on the portfolio is a weighted average of the expected returns on the securities in the portfolio. E (rP ) = wB E (rB ) + wS E (rS )

9% = 50% (11%) + 50% (7%)

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The Return and Risk for Portfolios

Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund -7% 17% 12% 7% 28% -3% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% Portfolio 5.0% 9.5% 12.5% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

The variance of the rate of return on the two risky assets portfolio is
2 P = (wB B ) 2 + (wS S ) 2 + 2(wB B )(wS S ) BS

where BS is the correlation coefficient between the returns on the stock and bond funds.
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The Return and Risk for Portfolios

Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund -7% 17% 12% 7% 28% -3% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% Portfolio 5.0% 9.5% 12.5% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

Observe the decrease in risk that diversification offers. An equally weighted portfolio (50% in stocks and 50% in bonds) has less risk than stocks or bonds held in isolation.
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The Efficient Set for Two Assets

% in stocks
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50.00% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%

Risk
8.2% 7.0% 5.9% 4.8% 3.7% 2.6% 1.4% 0.4% 0.9% 2.0% 3.08% 4.2% 5.3% 6.4% 7.6% 8.7% 9.8% 10.9% 12.1% 13.2% 14.3%

Return
7.0% 7.2% 7.4% 7.6% 7.8% 8.0% 8.2% 8.4% 8.6% 8.8% 9.00% 9.2% 9.4% 9.6% 9.8% 10.0% 10.2% 10.4% 10.6% 10.8% 11.0%

P o r t f o lo R is k a n d R e t u r n C o m b in a t
1 2 .0 % 1 1 .0 % 1 0 .0 % 9 .0 % 8 .0 % 7 .0 % 6 .0 % 5 .0 % 0 .0 % 5 .0 %

Portfolio Return

100% stocks 100% bonds

1 0 .0 % 1 5 .0 % 2 0 .0 %

P o r t f o lio R is k ( s t a n d a r d d e v ia t

We can consider other portfolio weights besides 50% in stocks and 50% in bonds
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The Efficient Set for Two Assets

% in stocks
0% 0% 5% 5% 10% 10% 15% 15% 20% 20% 25% 25% 30% 30% 35% 35% 40% 40% 45% 45% 50% 50% 55% 55% 60% 60% 65% 65% 70% 70% 75% 75% 80% 80% 85% 85% 90% 90% 95% 95% 100% 100%

Risk
8.2% 8.2% 7.0% 7.0% 5.9% 5.9% 4.8% 4.8% 3.7% 3.7% 2.6% 2.6% 1.4% 1.4% 0.4% 0.4% 0.9% 0.9% 2.0% 2.0% 3.1% 3.1% 4.2% 4.2% 5.3% 5.3% 6.4% 6.4% 7.6% 7.6% 8.7% 8.7% 9.8% 9.8% 10.9% 10.9% 12.1% 12.1% 13.2% 13.2% 14.3% 14.3%

Return
7.0% 7.0% 7.2% 7.2% 7.4% 7.4% 7.6% 7.6% 7.8% 7.8% 8.0% 8.0% 8.2% 8.2% 8.4% 8.4% 8.6% 8.6% 8.8% 8.8% 9.0% 9.0% 9.2% 9.2% 9.4% 9.4% 9.6% 9.6% 9.8% 9.8% 10.0% 10.0% 10.2% 10.2% 10.4% 10.4% 10.6% 10.6% 10.8% 10.8% 11.0% 11.0%

P o rtfo lo R isk a n d R e tu rn C o m b in a tio Portfolio Return

12.0% 11.0% 10.0% 9 .0% 8 .0% 7 .0% 6 .0%

100% stocks 100% bonds

5 .0% 0 . 0 % 2 . 0 % 4 . 0 % 6 . 0 % 8 . 0 % 1 0 . 0 %1 2 . 0 %1 4 . 0 %1 6 .0 %

P o rtfo lio R isk (sta n d a rd d e v ia tio n

We can consider other portfolio weights besides 50% in stocks and 50% in bonds
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The Efficient Set for Two Assets

% in stocks
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%

Risk
8.2% 7.0% 5.9% 4.8% 3.7% 2.6% 1.4% 0.4% 0.9% 2.0% 3.1% 4.2% 5.3% 6.4% 7.6% 8.7% 9.8% 10.9% 12.1% 13.2% 14.3%

Return
7.0% 7.2% 7.4% 7.6% 7.8% 8.0% 8.2% 8.4% 8.6% 8.8% 9.0% 9.2% 9.4% 9.6% 9.8% 10.0% 10.2% 10.4% 10.6% 10.8% 11.0%

P o rt fo lo R isk a n d R e t u rn C o m b in a t i
1 2.0 %

Portfolio Return

1 1.0 % 1 0.0 % 9.0% 8.0% 7.0% 6.0%

100% stocks 100% bonds

5.0% 0 . 0 % 2 .0 % 4 . 0 % 6 . 0 % 8 . 0 % 1 0 . 0 %1 2 . 0 %1 4 . 0 %1 6 . 0 %

P o rt fo lio R isk ( s ta n d a rd d e v ia tio

Note that some portfolios are better than others. They have higher returns for the same level of risk or less. These compromise the efficient frontier.
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Two-Security Portfolios with Various Correlations

return = -1.0
100% stocks

100% bonds

= 1.0 = 0.2

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Portfolio Risk/Return Two Securities: Correlation Effects Relationship depends on correlation coefficient -1.0 < < +1.0 The smaller the correlation, the greater the risk reduction potential If = +1.0, no risk reduction is possible

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What would happen to the risk of portfolio as more randomly selected stocks were added?
p would decrease because the added

stocks would not be perfectly correlated, but rp would remain relatively constant.

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Prob. Large 2

15

Return

1 35% ; 2 20%.
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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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Stand-alone risk

Market risk

Diversifiable risk

Market risk is that part of a securitys stand-alone risk that cannot be eliminated by diversification. Firm-specific, or diversifiable, risk is that part of a securitys stand-alone risk that can be eliminated by diversification.
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Can an investor holding one stock earn a return commensurate with its risk? No. Rational investors will minimize risk by holding portfolios. They bear only market risk, so prices and returns reflect this lower risk. The one-stock investor bears higher (stand-alone) risk, so the return is less than that required by the risk.

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Conclusions As more stocks are added, each new stock has a smaller risk-reducing impact on the portfolio. In general p falls very slowly after about 40 stocks are included. By forming well-diversified portfolios, investors can eliminate part of the riskiness of owning a single stock.
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The Efficient Set for Many Securities

return

Individual Assets

Consider a world with many risky assets; we can still identify the opportunity set of riskreturn combinations of various portfolios.
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The Efficient Set for Many Securities

return
minimum variance portfolio Individual Assets

Given the opportunity set we can identify the minimum variance portfolio.
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The Efficient Set for Many Securities

return
en ffici e ti e ron tf r

minimum variance portfolio Individual Assets

The section of the opportunity set above the minimum variance portfolio is the efficient frontier.

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Optimal Risky Portfolio with a Risk-Free Asset

return

100% stocks

rf
100% bonds

In addition to stocks and bonds, consider a world that also has risk-free securities like T-bills
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Riskless Borrowing and Lending

return

L M C
Balanced fund

100% stocks

rf
100% bonds

Now investors can allocate their money across the T-bills and a balanced mutual fund

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Riskless Borrowing and Lending

return
L CM

efficient frontier

rf

With a risk-free asset available and the efficient frontier identified, we choose the capital allocation line with the steepest slope

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Market Equilibrium
return
L CM
efficient frontier

M rf

P
With the capital allocation line identified, all investors choose a point along the linesome combination of the risk-free asset and the market portfolio M. In a world with homogeneous expectations, M is the same for all investors.
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The Separation Property

return
L CM
efficient frontier

M rf

The Separation Property states that the market portfolio, M, is the same for all investorsthey can separate their risk aversion from their 44 choice of the market portfolio.

The Separation Property

return
L CM
efficient frontier

M rf

P Investor risk aversion is revealed in their choice of where to stay along the capital allocation linenot in their choice of the line.
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Market Equilibrium
return
L M C
Balanced fund 100% stocks

rf
100% bonds

Just where the investor chooses along the Capital Asset Line depends on his risk tolerance. The big point though is that all investors have the same CML.
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Market Equilibrium
return
L M C
Optimal Risky Porfolio 100% stocks

rf
100% bonds

All investors have the same CML because they all have the same optimal risky portfolio given the risk-free rate.
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The Separation Property

return
L M C
Optimal Risky Porfolio 100% stocks

rf
100% bonds

The separation property implies that portfolio choice can be separated into two tasks: (1) determine the optimal risky portfolio, and (2) selecting a point on the CML. 48

Optimal Risky Portfolio with a Risk-Free Asset

return
L 0 CML 1 CM 100%
stocks First Optimal Risky Portfolio 100% bonds Second Optimal Risky Portfolio

r r

1 f 0 f

By the way, the optimal risky portfolio depends on the risk-free rate as well as the risky assets.

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How is market risk measured for individual securities?

Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of the portfolio. It is measured by a stocks beta coefficient, which measures the stocks volatility relative to the market. What is the relevant risk for a stock held in isolation?
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Definition of Risk When Investors Hold the Market Portfolio

Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta ()of the security. Beta measures the responsiveness of a security to movements in the market portfolio. Cov ( Ri , RM )

i =

( RM )
2
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How are betas calculated?

Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis. The slope of the regression line, which measures relative volatility, is defined as the stocks beta coefficient, or . Analysts typically use four or five years of monthly returns to establish the regression line. Some use 52 weeks of weekly returns.
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Estimating with regression

Security Returns

ine L ic ist ter c ra ha C Slope =

Return on market %

Ri = i + iRm + ei
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Use the historical stock returns to calculate the beta for XYZ.
Year 1 2 3 4 5 6 7 8 9 10 Market 25.7% 8.0% -11.0% 15.0% 32.5% 13.7% 40.0% 10.0% -10.8% -13.1% XYZ 40.0% -15.0% -15.0% 35.0% 10.0% 30.0% 42.0% -10.0% -25.0% 25.0%

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Calculating Beta for KWE

RXYZ 40% 20% 0% -40% -20% -20% -40% RXYZ = 0.83R R
2 M

RM 0% 20% 40%

+ 0.03

= 0.36
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Estimates of for Selected Stocks

Stock Bank of America Borland International Travelers, Inc. Du Pont Kimberly-Clark Corp. Microsoft Green Mountain Power Homestake Mining Oracle, Inc. Beta 1.55 2.35 1.65 1.00 0.90 1.05 0.55 0.20 0.49
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How is beta interpreted?

If b = 1.0, stock has average risk. If b > 1.0, stock is riskier than average. If b < 1.0, stock is less risky than average. Most stocks have betas in the range of 0.5 to 1.5. Can a stock have a negative beta?

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Relationship between Risk and Expected Return (CAPM)

Expected

R M = RF + Market Risk Premium

Return on the Market:

Expected return on an individual security:

R i = RF + i ( R M RF )
Market Risk Premium

This applies to individual securities held within welldiversified portfolios.

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Expected Return on an Individual Security

This formula is called the Capital Asset Pricing Model (CAPM)

Expected return on a security = Risk-free Beta of the + rate security Market risk premium

R i = RF + i ( R M RF )
Assume i = 0, then the expected return is RF. Assume i = 1, then R i = R M
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Relationship Between Risk & Expected Return

Expected return

R i = RF + i ( R M RF )

RM RF
1.0

R i = RF + i ( R M RF )
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Relationship Between Risk & Expected Return

Expected return

13.5% 3%
i = 1. 5 RF = 3%
1.5

R M = 10%
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R i = 3% + 1.5 (10% 3%) = 13.5%

Summary and Conclusions

The contribution of a security to the risk of a welldiversified portfolio is proportional to the covariance of the security's return with the markets return. This contribution is called the

beta.
i =
Cov ( Ri , RM )

2 ( RM )

The CAPM states that the expected return on a security is positively related to the securitys beta:

R i = RF + i ( R M RF )
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