RISK AND RETURN

REALISED VS EXPECTED RETURN

• Realized yield is the actual return earned during the holding period for an investment. It
may include dividends, interest payments, and other cash distributions. The term
"realized yield" can be applied to a bond sold before its maturity date or a dividend-
paying security.
• Expected return is the anticipated profit or loss an investor can predict for a specific
investment based on historical. Expected return is typically calculated by multiplying the
probability of different possible outcomes by their corresponding returns, and then
summing these products.
RETURN FROM A STOCK
ARITHMETIC VERSUS GEOMETRIC
AV E R A G E S
• The geometric average return: “What was your average compound return per year over a particular period?”

• The geometric average tells you what you actually earned per year on average, compounded annually

• The arithmetic average return : “What was your return in an average year over a particular period?”

• The arithmetic average tells you what you earned in a typical year.
A R I T H M E T I C AV E R A G E R E T U R N O R
G E O M E T R I C AV E R A G E R E T U R N ?
• In this case, the arithmetic average return is probably too high for longer periods and the
geometric average is probably too low for shorter periods. One should regard long-run
projected wealth levels calculated using arithmetic averages as optimistic. Short-run
projected wealth levels calculated using geometric averages are probably pessimistic.

Marshall Blume: “Unbiased Estimates of Long-Run Expected Rates of Return,” Journal of the
American Statistical Association, September 1974, pp. 634–38
EXAMPLE
EFFICIENT MARKETS
HYPOTHESIS
• If the market is strong form efficient, then all information of every kind is reflected in stock
prices. In such a market, there is no such thing as inside information.
• The second form of efficiency, semistrong form efficiency, is the most controversial. If a
market is semistrong form efficient, then all public information is reflected in the stock
price.
• The third form of efficiency, weak form efficiency, suggests that, at a minimum, the
current price of a stock reflects the stock’s own past prices.
MARKET REACTIONS
EXPECTED RETURNS AND VARIANCES
RISK PREMIUM
• Risk premium as the difference between the expected return on a risky investment and the certain
return on a risk-free investment.
RISK MEASURES
PROBLEM: RISK AND RETURN
• Consider the following information:
State Probability ABC, Inc. Return
Boom .25 0.15
Normal .50 0.08
Slowdown .15 0.04
Recession .10 -0.03

• What is the expected return?

• What is the variance?

• What is the standard deviation?

SOLUTION
• E(R) = .25(0.15) + .5(0.08) + .15(0.04) + .1(-0.03) = 8.05%
• Variance = .25(.15-0.0805)2 + .5(0.08-0.0805)2 + .15(0.04-0.0805)2 + .1(-0.03-0.0805)2 =
0.00267475
• Standard Deviation = 5.17%
PROBLEM TWO ASSETS
Compute Expected Return and risk of individual stocks.
SOLUTION
RETURN AND NORMAL
DISTRIBUTION
R I S K AV E R S I O N
• The relationship of a person's certainty equivalent (a benchmark return) to the expected
monetary value of a risky investment defines his attitude toward risk.
• If the certainty equivalent is less than the expected value, the person is risk-averse;
• if the certainty equivalent is equal to the expected value, the person is risk-neutral;
• finally, if the certainty equivalent is more than the expected value, the person is risk-
loving.
PORTFOLIO
• A group of assets such as stocks and bonds held by an investor. The percentage of a
portfolio’s total value that is invested in a particular asset.
• Expected Return on a Portfolio
EXAMPLE
EXAMPLE

Investment made in both the stocks is 50% each.

SOLUTION
RISK
PROBLEM FOR STUDENTS
• Suppose a portfolio, which has 50 percent in Stock A and 25 percent in each of Stocks B
and C. what is the standard deviations of this portfolio?
SOLUTION

Weight Return (%)

E(RA) = 8.8% 0.5 8.80%
E(RB) = 8.4% 0.25 8.40%
E(RC) = 8.0% 0.25 8.00%
8.50%
PORTFOLIOS
• A portfolio is a collection of assets.

• An asset’s risk and return are important in how they affect the risk and return of the
portfolio.

• The risk-return trade-off for a portfolio is measured by the portfolio expected return and
standard deviation, just as with individual assets.
EXAMPLE: PORTFOLIO WEIGHTS
• Suppose you have $15,000 to invest and you have purchased
securities in the following amounts. What are your portfolio weights
in each security?

 $2000 of C  C: 2/15 = .133

 $3000 of KO  KO: 3/15 = .2
 $4000 of INTC  INTC: 4/15 = .267
 $6000 of BP  BP: 6/15 = .4
the sum of the weights = 1
PORTFOLIO EXPECTED RETURNS
• The expected return of a portfolio is the weighted average of the expected returns of the
respective assets in the portfolio.

m
E ( RP )   w j E ( R j )
j 1

• You can also find the expected return by finding the portfolio return in each possible state
and computing the expected value as we did with individual securities.
EXAMPLE: EXPECTED PORTFOLIO
RETURNS
• Consider the portfolio weights computed previously. If the individual stocks have the
following expected returns, what is the expected return for the portfolio?

 C: 19.69%
 KO: 5.25%
 INTC: 16.65%
 BP: 18.24%

• E(RP) = .133(19.69%) + .2(5.25%) + .267(16.65%) + .4(18.24%) = 15.41%

P O R T F O L I O VA R I A N C E
• Compute the portfolio return for each state:
RP = w1R1 + w2R2 + … + wmRm

• Compute the expected portfolio return using the same formula

as for an individual asset.

• Compute the portfolio variance and standard deviation using

the same formulas as for an individual asset.
E X A M P L E : P O R T F O L I O VA R I A N C E
• Consider the following information on returns and probabilities:
 Invest 50% of your money in Asset A.
State Probability A B Portfolio
Boom .4 30% -5% 12.5%
Bust .6 -10% 25% 7.5%

• What are the expected return and standard deviation for each asset?

• What are the expected return and standard deviation for the portfolio?
SOLUTION
If A and B are your only choices, what percent are you investing in Asset B? 50%
• Asset A: E(RA) = .4(30) + .6(-10) = 6%
Variance(A) = .4(30-6)2 + .6(-10-6)2 = 384
Std. Dev.(A) = 19.6%
• Asset B: E(RB) = .4(-5) + .6(25) = 13%
Variance(B) = .4(-5-13)2 + .6(25-13)2 = 216
Std. Dev.(B) = 14.7%
• Portfolio :-
Portfolio return in boom = .5(30) + .5(-5) = 12.5
Portfolio return in bust = .5(-10) + .5(25) = 7.5
SOLUTION- CONTINUE….
• Expected return = .4(12.5) + .6(7.5) = 9.5 or
Expected return = .5(6) + .5(13) = 9.5
Variance of portfolio = .4(12.5-9.5)2 + .6(7.5-9.5)2 = 6
Standard deviation = 2.45%

• What would the expected return and standard deviation for the portfolio be if we invested 3/7
of our money in A and 4/7 in B? Portfolio return = 10% and standard deviation = 0

• Portfolio variance using covariances:

COV(A,B) = .4(30-6)(-5-13) + .6(-10-6)(25-13) = -288
Variance of portfolio = (.5)2(384) + (.5)2(216) + 2(.5)(.5)(-288) = 6
Standard deviation = 2.45%
PORTFOLIO RISK: TWO ASSETS
C O R R E L AT I O N
C O R R E L AT I O N A N D P O R T F O L I O
PROBLEM FOR STUDENTS
• Consider the following information on returns and probabilities:
State Probability X Z
Boom .25 15% 10%
Normal .60 10% 9%
Recession .15 5% 10%

• What are the expected return and standard deviation for a portfolio
with an investment of $6,000 in asset X and $4,000 in asset Z?
SOLUTION
• Portfolio return in Boom: .6(15) + .4(10) = 13%
• Portfolio return in Normal: .6(10) + .4(9) = 9.6%
• Portfolio return in Recession: .6(5) + .4(10) = 7%
• Expected return = .25(13) + .6(9.6) + .15(7) = 10.06%
• Variance = .25(13-10.06)2 + .6(9.6-10.06)2 + .15(7-10.06)2 = 3.6924
• Standard deviation = 1.92%
• Compare to return on X of 10.5% and standard deviation of 3.12%
• And return on Z of 9.4% and standard deviation of .49%
• Using covariances:
• COV(X,Z) = .25(15-10.5)(10-9.4) + .6(10-10.5)(9-9.4) + .15(5-10.5)(10-9.4) = .3
• Portfolio variance = (.6 × 3.12)2 + (.4 × .49)2 + 2(.6)(.4)(.3) = 3.6868
• Portfolio standard deviation = 1.92% (difference in variance due to rounding)
EXPECTED VS. UNEXPECTED
RETURNS
• Realized returns are generally not equal to expected returns.
• There is the expected component and the unexpected
component.
 At any point in time, the unexpected return can be either positive or
negative.
 Over time, the average of the unexpected component is zero.
RETURN COMPONENT
• EXPECTED AND UNEXPECTED RETURNS

return from the

return on the stock is
stock is the part
the uncertain, or risky,
of the return that
part. (unexpected
shareholders in
information within the
the market
year).
predict or expect.
EFFICIENT MARKETS
• Efficient markets are a result of investors trading on the unexpected portion of
announcements.

• The easier it is to trade on surprises, the more efficient markets should be.

• Efficient markets involve random price changes because we cannot predict surprises.
RETURNS
• Total Return = expected return + unexpected return
• Unexpected return = systematic portion + unsystematic portion
• Therefore, total return can be expressed as follows:
Total Return = expected return
+ systematic portion + unsystematic portion
R I S K : S Y S T E M AT I C A N D
U N S Y S T E M AT I C
• systematic risk: A risk that influences a large number of assets. Also called market risk.
• unsystematic risk: A risk that affects at most a small number of assets. Also called
unique or asset-specific risk.
S Y S T E M AT I C R I S K
• Risk factors that affect a large number of assets
• Also known as non-diversifiable risk or market risk
• Includes such things as changes in GDP, inflation, interest
rates, etc.
U N S Y S T E M AT I C R I S K
• Risk factors that affect a limited number of assets

• Also known as unique risk and asset-specific risk

• Includes such things as labor strikes, part shortages, etc.

P O R T F O L I O VA R I A N C E

Notice that as N increases, the portfolio variance steadily approaches the

average covariance. If the average covariance were zero, it would be
possible to eliminate all risk by holding a sufficient number of securities.
D I V E R S I F I C AT I O N
• Portfolio diversification is the investment in several different asset classes or sectors.
• Diversification is not just holding a lot of assets.
• For example, if you own 50 Internet stocks, you are not diversified.
• However, if you own 50 stocks that span 20 different industries, then you are diversified.
D I V E R S I F I C AT I O N A N D
PORTFOLIO RISK
THE PRINCIPLE OF
D I V E R S I F I C AT I O N
• Portfolio diversification is the investment in several different asset classes or sectors.
• Diversification is not just holding a lot of assets.
• For example, if you own 50 Internet stocks, you are not diversified.
• However, if you own 50 stocks that span 20 different industries, then you are diversified.
RISK COMPONENT

Systematic risk is also called nondiversifiable risk or market risk. Unsystematic risk is
also called diversifiable risk, unique risk, or asset-specific risk. For a well-diversified
portfolio, the unsystematic risk is negligible. For such a portfolio, essentially all of the
risk is systematic.

The systematic risk principle states that the reward for bearing risk depends only on the
systematic risk of an investment. Because unsystematic risk can be eliminated at
virtually no cost (by diversifying), there is no reward for bearing it. Put another way, the
market does not reward risks that are borne unnecessarily.
M E A S U R I N G S Y S T E M AT I C R I S K
• MEASURING SYSTEMATIC RISK

• beta coefficient The amount of systematic risk present in a particular risky asset relative
to that in an average asset.

• Portfolio Beta:
B E TA T H R O U G H G R A P H
B E TA F O R S E L E C T E D S T O C K S
E X A M P L E : P O R T F O L I O B E TA
SOLUTION
D E T E R M I N A N T O F B E TA
• Cyclicality of Revenues
• Operating Leverage
• Financial Leverage
T O TA L V S . S Y S T E M AT I C R I S K
• Consider the following information:
Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95

Security K has the

• Which security has more total risk? higher total risk.

Security C has the

• Which security has more systematic risk? higher systematic risk.

Security C should have

the higher expected
• Which security should have the higher expected return? return.
PROBLEM: STUDENTS
• Consider the previous example with the following four securities.
Security Weight Beta
C .133 1.685
KO .2 0.195
INTC .267 1.161
BP .4 1.434
Which security has the highest
systematic risk? C
• What is the portfolio beta? Which security has the lowest
systematic risk? KO
Is the systematic risk of the portfolio
• .133(1.685) + .2(.195) + .267(1.161) + .4(1.434) = 1.147 more or less than the market? more
B E TA A N D R I S K P R E M I U M
Consider a portfolio made up of Asset A and a risk-free asset
R E WA R D T O R I S K R AT I O
EXTENSION- B E TA & R I S K P R E M I U M
• Suppose we consider a second asset, Asset B. This asset has a beta of 1.2 and an
expected return of 16 percent. Which investment is better, Asset A or Asset B?
S E C U R I T Y: C O M PA R E A A N D B
PORTFOLIO THEORY
• Markowitz 1952 EV theory of portfolio
“Markowitz, Harry, 1952, Portfolio selection, Journal of Finance 7, 77-91.”
• Extension to CAPM model (Sharpe, Lintner and Treynor)
EFFICIENT PORTFOLIOS AND THE
C A P I TA L M A R K E T L I N E
EFFICIENT FRONTIER
• If investors are able to borrow
and lend money at the risk-free
rate rf, they can obtain any
combination of risk and
expected return on the straight
line joining and portfolio m

Equation of the capital market line (CML) is

LARGE ASSET PORTFOLIO
• For example, whereas 45 correlation coefficients are needed for a portfolio containing 10
securities, 4,950 correlation coefficients must be computed for a portfolio containing 100
securities. In other words, a 10-fold increase in securities causes a greater than 100-fold
increase in the required calculations.
• In addition, a substantial computational undertaking is required to find the particular
portfolio of securities that minimizes portfolio risk for a given level of return or maximizes
return for a given level of risk, even for a portfolio that contains only a few securities.
SECURITY MARKET LINE
• This line, which we use to describe the relationship between systematic risk and
expected return in financial markets, is usually called the security market line (SML).
• Because all the assets in the market must plot on the SML, so must a market portfolio
made up of those assets.
S M L I N T E R P R E TAT I O N
R E V I S I T: C O M P A R E A A N D B
 I D E A L W O R L D : R I S K A N D R E WA R D
Assets A (7.5%) and B (6.67%) could not persist in a well-organized, active market, because investors
would be attracted to Asset A and away from Asset B. As a result, Asset A’s price would rise and Asset B’s
price would fall. Because prices and returns move in opposite directions, A’s expected return would decline
and B’s would rise.

This buying and selling would continue until the two assets (A and B) plotted on exactly the same line,
which means they would offer the same reward for bearing risk. In other words, in an active, competitive
market, we must have the situation that:
UNDER/OVERPRICED STOCK
EXPECTED RETURN AND RISK

An asset is said to be overvalued if its price is

too high given its expected return and risk.
Suppose you observe the following situation:

The risk-free rate is currently 6 percent. Which

one of the two securities overvalued relative to
the other?
For SWMS, this ratio is (14% − 6)/
1.3 = 6.15%. For Insec, this ratio is 5
percent.

Insec Co. is overvalued relative to SWMS Co.

C A P I TA L A S S E T P R I C I N G M O D E L
(CAPM)
• We know that its reward-to-risk ratio is the same as the overall market’s:
ABOUT CAPM
A S S U M P T I O N S A N D L I M I TAT I O N S
OF THE CAPM
• Investors hold well-diversified portfolios of securities. Hence, their return requirements are
influenced primarily by the systematic (rather than total) risk of each security.
• Securities are traded actively in a competitive market, where information about a given firm
and its future prospects is freely available.
• Investors can borrow and lend at the risk-free rate, which remains constant over time.
• There are no brokerage charges for buying and selling securities.
• There are no taxes.
• All investors prefer the security that provides the highest return for a given level of risk or the
lowest amount of risk for a given level of return.
• All investors have common (homogeneous) expectations regarding the expected returns,
variances, and correlations of returns among all securities.
R E L AT I O N S H I P B E T W E E N R I S K
AND RETURN
• What is the relationship between the risk of a security, as measured by its beta, and its
expected return?
• Security Market Line
• According to the CAPM, risk and return are related in a linearly:
R E L AT I O N S H I P B E T W E E N B E TA A N D AV E R A G E
RETURN (MID-19 60S)

• Access the text alternative for slide

images.

76
R E L AT I O N S H I P B E T W E E N B E TA A N D AV E R A G E
RETURN (19 66–2020)

• Source: F. Black, “Beta and Return,” Journal of Portfolio Management 20 (Fall 1993),
pp. 8–18. Updates courtesy of Adam Kolasinski.
• Access the text alternative for slide
images.

77
RETURN VERSUS BOOK-TO-MARKET

• http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
• Access the text alternative for slide
images.

78
N S E L I S T E D F I R M S : A N N U A L R E T U R N A N D B E TA

NSE Listed Firms: Annual Return and Beta

1.4

1.2

0.8

0.6

0.4

0.2

0
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Return Beta
NSE LISTED FIRMS: PE AND PB
120

100

80

60

40

20

0
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

P/B P/E
ARBITRAGE PRICING THEORY
• Alternative to CAPM

Return  a  b1  rfactor1   b 2  rfactor 2   b3  rfactor3   ....  noise

Expected risk premium  r  rf

 b1  rfactor1  rf   b 2  rfactor 2  rf   

81
T H R E E - FA C TO R M O D E L
• Steps to Identify Factors.
1. Identify a reasonably short list of macroeconomic factors
that could affect stock returns.
2. Estimate the expected risk premium on each of these
• factors  rfactor1  rf , etc. .
3. Measure the sensitivity of each stock to the factors
 b1 , b2 , etc. .

Reading: Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of
financial economics, 33(1), 3-56.

82
T H R E E - FA C TO R M O D E L 2

Factor Measured by
Market factor Return on market index minus risk-free interest rate
Size factor Return on small-firm stocks less return on large-firm
stocks
Book-to-market factor Return on high book-to-market-ratio stocks less return
on low book-to-market-ratio stocks

Reading: Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of
financial economics, 33(1), 3-56.

83
COMPREHENSIVE PROBLEM
• The risk free rate is 4%, and the required return on the market is
12%.

 What is the required return on an asset with a beta of 1.5?

 What is the reward/risk ratio?

 What is the required return on a portfolio consisting of 40% of the asset

above and the rest in an asset with an average amount of systematic risk?
SOLUTION
• R = .04 + 1.5 × (.12 - .04) = .16 (Use CAPM)

• The reward/risk ratio is 8% [=(0.16-.04)/1.5]

• R = (.4 × .16) + (.6 × .12) = .136

PROBLEM
• Suppose the risk-free rate is 4 percent, the market risk premium is 8.6 percent, and a
particular 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?
SOLUTION
• With a beta of 1.3, the risk premium for the stock is 1.3 × 8.6%, or 11.18 percent. The
riskfree rate is 4 percent, so the expected return is 15.18 percent.
• If the beta were to double to 2.6, the risk premium would double to 22.36 percent, so the
expected return would be 26.36 percent
PROBLEM FOR STUDENTS
SOLUTION
PROBLEM FOR STUDENTS
• Suppose the risk-free rate is 8 percent. The expected return on the market is 16 percent.
If a particular stock has a beta of .7, what is its expected return based on the CAPM? If
another stock has an expected return of 24 percent, what must its beta be?
SOLUTION
CAPM IN RESEARCH
PROBLEMS
• Star Computer System Limited has forecasted returns on its share with the following
probability distribution:
SOLUTION
PROBLEMS
• An investor holds two equity shares x and y in equal proportion with the following risk
and return characteristics:

The returns of these securities have a positive correlation of 0.6. You are required to
calculate the portfolio return and risk. Further, suppose the investor wants to reduce
the portfolio risk (σp) to 15 per cent.

How much should the correlation coefficient be to bring the portfolio risk to the desired level?
SOLUTION
PROBLEMS
• A portfolio consists of three securities P, Q and R with the following parameters:

If the securities are equally weighted, how much is the risk and return of the portfolio of these
three securities?
SOLUTION
PROBLEMS
• Brahm Corp. Ltd has an expected return of 22 per cent and standard deviation of 40 per
cent. Q Ltd. Has an expected return of 24 per cent and standard deviation of 38 per cent.
P has a beta of 0.86 and Q 1.24. The correlation between the returns of P and Q is 0.72.
The standard deviation of the market return is 20 per cent.

(a) Is investing in Q better than investing in P?

(b) If you invest 30 per cent in Q and 70 per cent in P, what is your expected rate of return
and the portfolio standard deviation?
(c) What is the market portfolio’s expected rate of return and how much is the risk-free
rate?
(d) What is the beta of portfolio if P’s weight is 70 per cent and Q is 30 per cent?
SOLUTION
PROBLEMS
 EXTENSION- THREE AND FIVE FACTORS
REGRESSION MODELS

Eugene Fama F., French, Kenneth R., (1993), “Common Risk Factors in
the Return on Stocks and Bonds,” Journal of Financial Economics, 33, pp.
3–56.

Fama, E. F., & French, K. R. (2015). A five-factor asset pricing

model. Journal of financial economics, 116(1), 1-22.
ARBITRAGE PRICING THEORY
(APT)
• Stephen A. Ross, “Return, Risk and Arbitrage,” in I. Friend and J. Bicksler, eds., Risk and
Return in Finance (Cambridge, MA: Ballinger, 1976)

• Ross’s APT relies on three key propositions and based on the law of one price: two
items that are the same cannot sell at different prices-
(1) Security returns can be described by a factor model;
(2) there are sufficient securities to diversify away idiosyncratic risk; and
(3) well-functioning security markets do not allow for the persistence of arbitrage
opportunities.
APT MODEL
• APT requires that the returns on any stock be linearly related to a set of indexes, as
shown in Equation-
CAPM VS APT
• The CAPM implying that all investors hold mean-variance efficient portfolios. If a security
is mispriced, then investors will update their portfolios toward the underpriced and away
from the overpriced securities.
• The APT suggest that each investor wants to take as large a position as possible; hence
it will not take many investors to bring about the price pressures necessary to restore
equilibrium.
END OF TOPIC