CHAPTER 2

RISK AND RETURN

Table of Contents
RISK AND RETURN ..................................................................................................................... 9
Table of Contents ........................................................................................................................ 9
Chapter Overview ...................................................................................................................... 10
Learning Objectives: ................................................................................................................. 10
2.1 Risk and Return ................................................................................................................. 10
2.1.1 The Concept of Return .............................................................................................. 10
2.1.2 Measurement of return .............................................................................................. 11
2.1.3 The Concept of Risks ................................................................................................ 13
2.1.4 Measurement of risk .................................................................................................. 14
2.2 Portfolio Risk and Return .................................................................................................. 18
2.2.1 Standard Deviation of a Portfolio .............................................................................. 18
2.2.2 Covariance and Correlation Coefficient .................................................................... 18
2.2.3 Model ( see supplement to chapter two to explain more on this model) .................. 21
The Single-Index Model ........................................................................................................ 25
Checklist .................................................................................................................................... 27
Study Questions ......................................................................................................................... 28
SUPPLEMENT CHAPTER TWO ............................................................................................ 29

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Chapter 2 Risk and Return

Chapter Overview

Risk and Return

• The concepts of return & risk

• Measurement of return
Introduction
• Measurement of risk
• A relative measure of risk

Portfolio risk and • Covariance & correlation

return coefficient
• Markowitz model
• Sharpe index model

Learning Objectives:

After going through this chapter, you will be able to:

1. determine the expected return of a securities

2. determine the standard deviation of a securities
3. determine the correlation coefficient between the stocks
4. determine the covariance and correlation coefficient of a stocks
5. determine the portfolio return using Markowitz’s Model
6. determine the portfolio return using The Single-Index Model .

2.1 Risk and Return

Different investments have different return and risk characteristics. Some investments will give
you immediate returns with little risk, while others may give higher returns with high risk.
Identifying investments on the basis of their return and risk characteristics is not easy. Therefore,
the purpose of this section is to help investor to understand how to choose among alternative
investment assets. This selection process requires you to estimate and evaluate the expected risk-
return tradeoffs for the alternative investments available. Therefore we have to know how to
measure the rate of return and the risk involved in an investment accurately. Therefore this
section examine ways to quantify return and risk.

We will consider to measure both historical and expected rates of return and risk measures for
various assets in the following section of this chapter.

2.1.1 The Concept of Return

Return is the benefits that an investor will receive from an investment over some period.
Generally, return of an investment comprises two components:-

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Chapter 2 Risk and Return

i. Income Yield

Income received from the investment during the period in which the investment is held. For
example: share dividend, interest or coupon of bond, or rental income from property.

ii. Capital Gain/Loss

This is the difference between the value of the investment at the end of the holding period and its
original cost.

Return is normally expressed in a percentage form. In the following section we will discuss how
returns of an investment are measured.

2.1.2 Measurement of return

Historical returns

Rates of return = (Ending Value – Beginning Value) + Income X 100

Beginning Value

r = (EV – BV) + DIV X 100

BV

Example:

If you bought a investment for RM200 that pays RM10 in cash dividend and is worth RM208 one
year later, your return would therefore be :

Return = (RM10 + RM8) / RM200

= 9%

For investment in common stock, the return is known as Holding Period Return (HPR) and
involves three cash flow elements.

1. The initial stock price

2. Dividend received
3. The amount received when the stock is sold

Suppose the initial stock price was RM100, the dividend received for the year was RM5 and the
current market price for stock was RM150, therefore:

HPR = RM5 + (RM150 – RM100) / RM100

= 55%

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Chapter 2 Risk and Return

Example.

You bought a share of Mozaic stock at RM5.00 last year. At the end of this year you sell it at
RM6.50. During the year you held the share, you received dividend of RM0.50 per share.
Calculate the rate of return.

r = (EV – BV) + DIV X 100

BV

= (6.50 – 5.00) + 0.50 X 100

5.00
= 40%

Measuring Expected Return (R) using Probability Distribution

An expected return is calculated by assigning probabilities to various anticipated outcome at a

given time in the future. The expected return (Er) is calculated using the equation below:-

Er = ΣPi x annual return (where n is the number of possible occurences)

Expected rates of return

Expected return = ∑ (Probability of return) X (Possible return)

E(r) = ∑ piri

Example

Economic Condition Probability Possible outcome

Boom 0.35 0.20

Moderate 0.40 0.30
Recession 0.25 -0.10

E(r) = ∑ piri

= (0.35 X 0.20) + (0.40 X 0.30) + (0.25 X (0.10))

= 0.165 @ 16.5%

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Chapter 2 Risk and Return

Therefore, an investor with the same return and probability as shown in the example would
expect a one year return of 16.5% from investing in ABC Stock.

Average returns

Ave. return = Total return

Number of returns
⎯r = ∑r
n

Example.

Given the return for stock ABC for the past 5 years

Year Return
1 0.10
2 0.25
3 -0.05
4 0.08
5 0.12

⎯r = ∑r
n

= 0.10 + 0.25 + (0.05) + 0.08 + 0.12

5

= 0.10 @ 10%

2.1.3 The Concept of Risks

Risk is the possible variation of returns from those that are expected. Basically, a larger range of
expected returns makes the investment riskier.

An investor determines how certain the expected rate of return on an investment is by analyzing
estimates of expected returns. To do this, the investor assigns probability values to all possible
returns. These probabilities values range from zero, which means no chance of the return, to one,
which indicates complete certainty that the investment will provide the specified rate of return.

For example, an investor may know that about 30% of the time the rate of return on this particular
investment was 10%. Using this information along with future expectations regarding the
economy, one can derive an estimate of what might happen in the future.

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Chapter 2 Risk and Return

Types of Risks

In financing an investment decision, there are two types of risk: systematic risk and unsystematic
risk.

I. Systematic Risk

It is also known as non diversified risk because it is caused by general factor such as changes in
inflation rates, interest rates and market sentiments. These broad risks thus cannot be eliminated
no matter how well diversified the investment portfolio is. It consists of:-

i. Inflation risk ( purchasing power risk)

ii. Market risk
iii. Interest rate risk

II. UnSystematic Risk

It is also known as diversifiable risks that are often associated with to the type of securities or
issuing firm. These risks can be minimised by investing in a broad spectrum of securities
involving a number of different issues. It includes, business risk, financial risk, management risk
and liquidity risk.

Since non-systematic risks are diversifiable in a fully diversified portfolio, the only risk that
remains should be systematic risk.

2.1.4 Measurement of risk

Risk is characterised by the uncertainties of future returns. In other words, risk is a measure of the
variability of returns. This can be measured by the standard deviation or the variance of the
different possible returns around the expected return. Standard Deviation is the distance spanned
by one deviation above the expected value or one deviation below the expected value. Thus, the
standard deviation of an investment is very small. The investor is fairly confident of receiving a
return close to the expected return.

Standard Deviation

Standard deviation is the distance spanned by one deviation above the expected value or one
deviation below the expected value. Thus, if the standard deviation of the investment is very
small the investor is fairly confident of receiving a return close to the expected return.

The formula for Standard Deviation (SD) is:-

SD = Σ Pi x ( Return – Er )

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Chapter 2 Risk and Return

For example: ABC Stock has the following Return and the possible occurences.

Economic Event Probabilities Return

Boom 0.25 35%

Stable 0.50 15%
Recession 0.25 -2%

Er = (0.25 x 35%) + (0.50 x 15%) + (0.25 x –2%)

= 15.75%

Therefore, an investor with the same return and probability as shown in the above example would
expect a one year return of 15.75% from investing in ABC stock.

SD = √ [ 0.25 x (35% -15.75%) ] + [ 0.50 x (15% - 15.75% ) ] +

[0.25 x ( -2% - 15.75% ) ]

= 13.10%

Therefore, using this information, the investors would assess that there is a chance of getting a
return that is + or –13.10% around the expected return of 15.75%. That is one Standard Deviation
above the expected return of 15.75% is 28 85% and one standard deviation below the expected
return of 15.75% is 2.65%.

Variance and standard deviation were used to measure risk.

The formula for variance σ2 = ∑ (return – average return)2

n

= ∑ (r – ⎯r )2
n

OR

E(σ2 ) = ∑ (possible return – expected return)2 X probability

= ∑ [ r – E(r )2] p

Standard Deviation = √ variance

σ = √ σ2

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Chapter 2 Risk and Return

Example

Given the average annual price and dividend on ABC stock from 1995 to 2000 as in the table
below:

Period Price Dividend

1995 12.00
1996 12.40 0.50
1997 12.60 0.42
1998 12.30 0.00
1999 12.10 0.20
2000 12.50 0.50

Compute:

i) Annual rates of return

ii) Average return
iii) Standard deviation

Answer

i) Annual rates of return

r = (EV – BV) + DIV X 100

BV
r1996 = (12.40 – 12.00) + 0.50 X 100 = 7.5%
12.00
r1997 = (12.60 – 12.40) + 0.42 X 100 = 5.0%
12.40
r1998 = (12.30 – 12.60) + 0.00 X 100 = (3.2)%
12.60
r1999 = (12.10 – 12.30) + 0.20 X 100 = 0 %
12.30
r2000 = (12.50 – 12.10) + 0.50 X 100 = 7.4%
12.10

ii) Average return

⎯r = ∑ r
n

= 0.075 + 0.05 + (0.032) + 0.0 + 0.074

5
= 0.034 @ 3.4 %

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Chapter 2 Risk and Return

iii) Standard deviation

σ2 = ∑ (r – ⎯r )2
n
= (0.075 – 0.034)2 + (0.05 – 0.034)2 + (-0.032 – 0.034)2 +
(0.00 – 0.034)2 + (0.074 – 0.034)2 /5
= 0.00158

σ = √ 0.00158
= 0.0397 @ 3.97 %

Example

Given the possible return with probability for XYZ stock.

States of Probability of Possible Outcome

Nature Occurrence
1 0.2 0.20
2 0.4 0.05
3 0.3 -0.04
4 0.1 0.12

Compute the expected return and standard deviation.

E(r) = ∑ piri

= (0.2 X 0.20) + (0.4 X 0.05) + (0.3 X (0.04)) + (0.1 X 0.12)

= 0.06 @ 6 %

E(σ2 ) = ∑ p [ r – E(r )2]

= 0.2(0.20 – 0.06)2 + 0.4(0.05 – 0.06)2 + 0.3(-0.04 – 0.06)2+

0.1(0.12 – 0.06)2
= 0.00732

σ = √ 0.00732
= 0.086 @ 8.6%

A better risk statistic that can be used to differentiate investments with different expected return is
to use coefficient of variation.

Coefficient of Variation

Correlation is the strength of relationship between the 2 variables, range between 0 to 1 expected
return of a portfolio. A relative measure of risk using coefficient of variation are as follows:

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Chapter 2 Risk and Return

Coefficient of Variation (CV) = Standard Deviation

Return

= σ
r

Example.

Stock A has expected return of 10% and standard deviation of 12% while stock B’s return is
20% and standard deviation is 25%.

CVA = σ CVB = σ
r r

= 12/10 = 25/20

= 1.2 = 1.25

Stock B is more riskier than stock B because 1 unit of return carry 1.25 unit of risk compare to
stock A which 1 unit of return carry 1.20 unit of risk.

2.2 Portfolio Risk and Return

Topics we will discuss here will be:

• Covariance and Correlation Coefficient

• Markowitz Theory
• Sharpe Index Model

2.2.1 Standard Deviation of a Portfolio

The Standard Deviation of a portfolio depends not only on the standard deviation of each
securities but also the degree of relative correspondance or correlation between the return of each
securities to every other securities in the portfolio. A correlation coefficient measures the strength
of the relationship or dependence between two variables. The coefficient itself ranges between the
value of –1 for perfect negative correlated to 1 for perfect positive correlation. Therefore, if ‘0’
means uncorrelated and between –v and +ve means moderately (+/-) correlated.

2.2.2 Covariance and Correlation Coefficient

Covariance ( Cov ) is a statistical measure of how the returns of two assets move together. In
portfolio analysis, we usually are concerned with the covariance of rate of return rather than
prices or some other variable. A positive covariance means that the rates of return for two

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Chapter 2 Risk and Return

investments tend to move in the same direction relative to their individual means during the same
time period. In contrast, a negative covariance indicates that the rate of return for two investments
tend to move in different directions relative to their means during specified time intervals over
time. It is merely a weighted average of the expected return of each of the individual securities
where the weight W1 are equal to the proportion of the total invested funds allocated to the
respective securities.

Standardizing the covariance by the individual standard deviations yield the correlation
coefficient which can vary only in the range –1 to +1. A value of +1 would indicate a perfect
positive linear relationship between the two variables.

It can be measure with the following equation:

Cov1,2 = ∑ (r1 – ⎯r1)(r2 – ⎯r2)

n

OR

Cov1,2 = ∑ p [r1 – E(r1)] [ r2 – E(r2)]

The correlation coefficient ( ρ ) is also measure the relationship between two assets. The
correlation can take on a value from –1 to +1. Correlation and covariance are related by the
following equation:

Cov1,2 = σ1 σ2 ρ1,2

ρ1,2 = Cov1,2
σ1 σ2

Example

Stock P and Q had the following return over the past 4 years. Determine the covariance and
correlation coefficient.

Year Return Stock P Return Stock Q

1997 8 10
1998 -10 -12
1999 15 14
2000 19 24

⎯r = ∑ r
n

⎯rP = 8 + (10) + 15 + 19
4
= 8%
⎯rQ = 10 + (12) + 14 + 24
4

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Chapter 2 Risk and Return

= 9%

σ2 = ∑ (r – ⎯r )2
n

σ2P = (8 – 8)2 + (-10 - 8)2 + (15 - 8)2 + (19 – 8)2 /4

= 123.5

σP = √ 123.5
= 11.11 %

σ2Q = (10 – 9)2 + (-12 - 9)2 + (14 - 9)2 + (24 – 9)2 /4

= 173

σQ = √ 173
= 13.15 %

Cov1,2 = ∑ (r1 – ⎯r1)(r2 – ⎯r2)

n

CovP,Q = (8 – 8)(10 – 9) + (-10 – 8)(-12 – 9) +

(15 – 8)(14 – 9) + (19 – 8)(24 – 9)/4
= 137

ρP,Q = CovP,Q
σP σQ

= 137
(11.11)(13.15)
= 0.94

Example

The MRC Bhd. and TRY Bhd. have the following joint probability distribution of return for next
year.

State of Probability Return MRC Return TRY

Economy (%) (%)
Boom 0.2 14 20
Normal 0.5 -5 -2
Recovery 0.3 10 15

Determine covariance and correlation coefficient for MRCB and TRI

E(r) = ∑ piri

E(rMRC) = 0.2 (14) + 0.5(-5) + 0.3(10)

= 3.3 %

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Chapter 2 Risk and Return

E(rTRY) = 0.2 (20) + 0.5(-2) + 0.3(15)

= 7.5 %

E(σ2 ) = ∑ p [ r – E(r )2]

E(σ2MRC ) = 0.2(14 – 3.3)2 + 0.5(-5 – 3.3)2 + 0.3(10 – 3.3)2

= 70.81

σMRC = √ 70.81
= 8.41 %

E(σ2TRY ) = 0.2(20 – 7.5)2 + 0.5(-2 – 7.5)2 + 0.3(15 – 7.5)2

= 93.25

σTRY = √ 93.25
= 9.66 %

Cov1,2 = ∑ p [r1 – E(r1)] [ r2 – E(r2)]

CovM,T = 0.2 (14 – 3.3)(20 – 7.5) + 0.5(-5 – 3.3)(-2 – 7.5) +

0.3(10 – 3.3)(15 – 7.5)
= 81.25

ρM,T = CovM,T
σM σT

= 81.25
(8.41)(9.66)
= 1.00

2.2.3 Markowitz's Model ( see supplement to chapter two to explain more on this
model)

The basic portfolio model was developed by Harry Markowitz, who derived the expected rate of
return for an portfolio of assets and an expected risk measures. Markowitz showed that the
variance of the rate of return was a meaningful measures of portfolio risk.

The formula for portfolio return:

rp = ∑ wi,j ri,j
.

Portfolio risk

σ2p = Σ Σ wiwj ρij σiσj

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Chapter 2 Risk and Return

Example

Mr Ali has a portfolio of two common stocks with the following market values, returns and
standard deviations.

Stock Market Value Return Std. Deviation

BT 40,000 20 25
LR 60,000 15 18

wBT = 40,000/100,000
= 0.4

wLR = 60,000/100,000
= 0.6
Answer

Calculate portfolio return and risk if correlation for two stocks is +1, 0 and -1.

rp = ∑ wi,j ri,j

= wBT rBT + wLR rLR

= 0.4(20) + 0.6(15)
= 17 %

σ2p = Σ Σ wiwj ρij σiσj

= w2BTσ2BT + w2LRσ2LR + 2wBTwLRρB,L σBTσLR

ρ = +1,

= (0.4)2(25)2 + (0.6)2(18)2 + 2(0.4)(0.6)(+1)(25)(18)

= 432.64

σp = √ 432.64
= 20.8 %

ρ = 0,

= (0.4)2(25)2 + (0.6)2(18)2 + 2(0.4)(0.6)(0)(25)(18)

= 216.64

σp = √ 216.64
= 14.72 %

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Chapter 2 Risk and Return

ρ = -1,

= (0.4)2(25)2 + (0.6)2(18)2 + 2(0.4)(0.6)(-1)(25)(18)

= 0.64

σp = √ 0.64
= 0.8 %

It shows that when two stocks had negative correlation, it will reduce risk. ( always hold perfectly
negatively correlated)

Determination of right weighted for minimum-variance portfolio.

wi = σ2j - ρij σiσj

σ2Ii + σ2j - 2ρij σiσj

wj = 1-wi

Refer to the above example and take correlation coefficient –1.

w BT = 182 - (-1)(25)(18)
252 + 182 - 2(-1)(25)(18)
= 0.42

w LR = 1 – 0.42
= 0.58

Portfolio risk for minimum-variance portfolio

σ2p = (0.42)2(25)2 + (0.58)2(18)2 + 2(0.42)(0.58)

(-1)(25)(18)
= 0.0036

σp = √ 0.0036
= 0.06 %

The N-Securities Case

Example

The assets X, Y and Z have the following risk and return statistics:

E(rx) = 16% E(rY) = 20% E(rZ) = 22%

σX = 24% σY = 30% σZ = 34%
ρXY = 0.5 ρXZ = -0.3 ρYZ = -0.7

Determine the return and risk of a portfolio of 25% percent X, 50 percent Y and 25 percent Z.

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Chapter 2 Risk and Return

E(rp ) = ∑ wi,j ri,j

= wX E(rX)+ wY E(rY) + wZ (rZ)

= 0.25(16) + 0.50(20) + 0.25(22)

= 19.5%

σ2p = Σ Σ wiwj ρij σiσj

= w2Xσ2X + w2Yσ2Y + w2Zσ2Z + 2wXwYρXYσXσY+ 2wXwZρXZ

σXσZ+ 2wYwZρYZ σYσZ

= (0.25)2(24)2 + (0.50)2(30)2 + (0.25)2(34)2 + 2(0.25)(0.50)

(0.5)(24)(30) + 2(0.25)(0.25)(-0.3)(24)(34) + 2(0.50)(0.25)
(-0.7)(30)(34)
= 214.15

σp = √ 214.15
= 14.63%

Example

Given the following data:

Covariance-Variance Matrix
Securities Return P Q R S
P 15 84 180 220 120
Q 22 180 100 320 250
R 25 220 320 144 180
S 8 120 250 180 78

Note : Cov 1,1 = σ2 1,1

Calculate portfolio return if all securities are equally invested.

E(rp ) = ∑ wi,j ri,j

= wP E(rP) + wQ E(rQ) + wR (rR) + wS E(rS)

= 0.25(15) + 0.25(22) + 0.25(25) + 0.25(8)

= 0.25(15 + 22 + 25 + 8)
= 17.5%

σ2p = Σ Σ wiwj ρij σiσj

= w2Pσ2P + w2Qσ2Q + w2Rσ2R + w2Sσ2S + 2wPwQCovPQ+

2wPwRCovPR + 2wPwSCovPS + 2wQwRCovQR +
2wQwSCovQS + 2wRwSCovRS

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Chapter 2 Risk and Return

= (0.25)2(84) + (0.25)2(100) + (0.25)2(144) + (0.25)2(78) +

2(0.25)(0.25)(180) + 2(0.25)(0.25)(220) + 2(0.25)(0.25)(120) +
2(0.25)(0.25)(320) + 2(0.25)(0.25)(250) + 2(0.25)(0.25)(180)

= (0.25)2[84 + 100 + 144 + 78] + 2(0.25)2[180 + 220 + 120 +

320 + 250 + 180]
= 184.125

σp = √ 184.125
= 13.57 %

The Single-Index Model

The expected return on a security is

E(ri) = α + βi rm

The variance of return on any security is

Total risk = Systematic risk + unsystematic risk

σ2i = β2i σ2m + σ2ie

The covariance of returns between securities i and j,

Covij = βiβj σ2m

We can turn to the calculation of the expected return and variance of any portfolio under this
model.

Return on the portfolio

rp = αP + βP rm

where, αP = Σ wi αi
βP = Σ wi βi

The risk of the portfolio

σ2P = β2P σ2m + σ2ieP

where, σ2ieP = Σ w2i σ2ie

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Chapter 2 Risk and Return

Example
Security
J K L M
α 0.5 1 2 1.5
β 1.2 1.5 0.8 0.6
σ2ie 6 10 8 4

Given the data above and the fact that rm = 5 and σm = 6, calculate the following:
i) The expected return for each security
ii) The variance of each security’s return
iii) The covariance of returns between each security

Assuming an equally weighted portfolio, calculate the following:

iv) The expected return on the portfolio
v) The variance of portfolio’s return

i) E(ri) = α + βi rm
E(rJ) = 0.5 + 1.2 (5) = 6.5
E(rK) = 1 + 1.5 (5) = 8.5
E(rL) = 2 + 0.8 (5) = 6
E(rM) = 1.5 + 0.6 (5) = 4.5

ii) σ2i = β2i σ2m + σ2ie

σ2J = (1.2)2 (6)2 + 6 = 57.84
σ2k = (1.5)2 (6)2 + 10 = 91
σ2l = (0.8)2 (6)2 + 8 = 31.04
σ2m = (0.6)2 (6)2 + 4 = 16.96

iii) Covij = βiβj σ2m

CovJK = (1.2)(1.5)(6)2 = 64.8
CovJL = (1.2)(0.8)(6)2 = 34.56
CovJM = (1.2)(0.6)(6)2 = 25.92
CovKL = (1.5)(0.8)(6)2 = 43.2
CovKM = (1.5)(0.6)(6)2 = 32.4
CovLM = (0.8)(0.6)(6)2 = 17.28

iv) αP = Σ wi αi
= wJ αJ + wK αK + wL αL + wM αM

= 0.25(0.5) + 0.25(1) + 0.25(2) + 0.25(1.5)

= 1.25

βP = Σ wi βi
= wJ βJ + wK βK + wL βL + wM βM

= 0.25(1.2) + 0.25(1.5) + 0.25(0.8) + 0.25(0.6)

= 1.025

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Chapter 2 Risk and Return

rp = αP + βP rm

= 1.25 + 1.025(5)
= 6.375%

v) σ2ieP = Σ w2i σ2ie

= w2J σ2ieJ + w2K σ2ieK + w2L σ2ieL + w2M σ2ieM

= (0.25)2(6) + (0.25)2(10) + (0.25)2(8) + (0.25)2(4)

= 1.75

σ2P = β2P σ2m + σ2ieP

= (1.025 )2(6)2 + 1.75
= 39.57

σp = √ 39.57
= 6.29 %

Checklist
By now you should be able to:

determine the expected return of a securities

determine the standard deviation of a securities

determine the correlation coefficient between the stocks

determine the covariance and correlation coefficient of a stocks

determine the portfolio return using Markowitz’s Model

determine the portfolio return using The Single-Index Model .

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Chapter 2 Risk and Return

Study Questions

1. The following are the monthly rates of return for Tenaga and Telekom during a six month
period.

Month Tenaga Telekom

1 -0.05 0.06
2 -0.03 0.05
3 0.03 -0.02
4 0.02 -0.01
5 0.04 0.07
6 0.06 0.05

Using the data given, compute the following:

i. Expected return for each stock

ii. Standard deviation of return for each stock
iii. Based on your answer in (I) and (ii), which stock would you purchase if you are only
going to buy one. Why?
iv. The correlation coefficient between the two stocks.
v. Standard deviation for investing 60% in Tenaga and 40% in Telekom.
vi. What is the relationship between covariance and correlation coefficient between
securities?

2. Alton Gruder owns three stocks and has estimated the following joint probability of
return.

Year Stocks Return (%) Probability

A B C

1977 -5 5 3 0.2
1998 0 5 4 0.2
1999 10 0 -2 0.3
2000 15 10 5 0.3

a. calculate the expected return of each securities in Alton’s portfolio

b. calculate the expected return of the portfolio

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Chapter 2 Risk and Return

c. calculate the standard deviation of each securities in Alton’s portfolio

d. Assume that all the securities are completely uncorrelated, calculate the
standard deviation of Alton’s portfolio.

SUPPLEMENT CHAPTER TWO

The Efficient Frontier and Determination of Optimal Portfolio

The Markowitz model is premised on a risk-adverse individual constructing a diversified

portfolio that maximizes the individual’s satisfaction (i.e. generally referred to as utility) by
maximizing portfolio returns for a given level of risk. This process is depicted in figure 1 through
3, which illustrate the optimal combinations of risk and return available to investors, the desire of
investors to maximize their utility, and determination of the optimal portfolio that integrates
utility maximization within the constraint of the available portfolios.

E(r)

• C Y
• B
• A

Figure 1 : Efficient Frontier

Figure 1 illustrates the determination of the optimal portfolios available to investor. The area in
the circle represents all the possible portfolios composed of various combinations of risky
securities. This area generally referred to as the “attainable” or “feasible” set of portfolio. Some
of these portfolios are inefficient because they offer an inferior return for a given amount of risk.
For example, portfolio A is inefficient since portfolio B offers a higher return for the same
amount of risk.

All portfolios that offer the highest return for a given amount of risk are referred to as efficient.
The line that connects all of these portfolio, XY, defines the “efficient frontier” and is referred as
the “efficient set” of portfolios. Any portfolio that offers the highest return for a given amount of
risk must lie on the efficient frontier. Any portfolio that offers a lower return is inefficient and lies
below the efficient frontier in the circle area. Since inefficient portfolios will not be selected, the
efficient frontier establishes the best set of portfolios available to investors.

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Chapter 2 Risk and Return

A portfolio such as C that lies above the efficient frontier offers a superior return for the amount
of risk. Investor would prefer that portfolio to portfolio B on the efficient frontier because C
offers a higher return for the same level of risk. Unfortunately, combination C of risk and return
does not exist. It is not a feasible solution. No combination of risk and expected return that lies
above the efficient frontier is attainable.

The efficient frontier gives all the best attainable combinations of risk and return, and which
combination will be selected by the investor will depends on the individual’s willingness to bear
risk. The combining of the efficient frontier and the willingness to bear risk determines the
investor’s optimal portfolio.

The willingness to bear risk may be shown by the use of indifferent curves. A set of indifferent
curves is illustrated in the figure 2 below.

E(r)

r2 I3 I2 I1

r1

σ1 σ2 σP

Figure 2 : Indifference Map

On the indifference curve I1, the investor would be willing to accept a modest return such as r1
and bear a modest amount of risk (σ1) however, the same investor would be willing to bear more
risk for a higher return (e.g. r2 and σ2 ). The additional return is enough to induce bearing the
additional risk so the investor is indifferent between the two alternatives. Thus, all the points on
the same indifferences curve represent the same level of satisfaction. The indifferent curve in the
figure above are for risk-adverse investor. Its assumed that investor do not like bearing risk;
hence, additional return require more risk. The curves are concave from above; their slope
increase as risk increases. This indicates that investors require additional return for equal
increment of risk to maintain the same level of satisfaction.

Investors would like to earn a higher return without having to bear additional risk thus it increases
total satisfaction. Higher level of satisfaction are indicated by indifferent curve I2 and I3 , which
lie above I1. Once again the investor is indifferent between any combination of risk and return on
I2 . All combinations of risk and return on curve I2 are preferred to all combination on curve I1.
Correspondingly, all points on curve I3 are preferred to all points on I2 . Since there is an
indefinite number of level satisfaction, an indefinite number of indifference curves could be
constructed for an individual. The higher the curves, the higher level of satisfaction.

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Chapter 2 Risk and Return

The investor seeks to reach the highest level of satisfaction but is, of course, constrained by what
is available. The best combinations of risk and return available are given by the efficient frontier.
The indifference curves on the efficient frontier defines the investor’s optimal portfolio. This is
shown in the Figure 3 below which combines Figure 1 and 2.

E(r)
I3 I2 I1

Y
• O

• B
A

σ
Figure 3 : Determination of The Optimal Portfolio

The Figure 3 above shows that portfolio O is the investor’s optimal combination of risk and
return (or optimal portfolio). If the investor selects any other portfolio on the efficient frontier
(e.g. A), that portfolio would not be the individual’s best choice. While the portfolio is an
efficient combination of risk and return, it is not the optimal choice. Portfolio B is equal to
portfolio A, but B is not efficient and is inferior to portfolio O, since O offers a higher level of
return for the same amount of risk. Portfolio O must be preferred to B, and because A and B are
equal, O must be also preferred to portfolio A.

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