Chapter Two

Risk-Return Analysis and Portfolio Theory

“Risk comes from not knowing what you are doing”

….Warren Buffet
 What is Risk?
Risk and return are most important concepts in
finance.
In fact, they are the foundation of the modern
finance theory.
Risk is defined as uncertainty of loss.
Risk exists if there is something you don’t want to
happen – having a chance to happen!!!
It is chance that the actual outcome from an
investment will differ from the expected outcome.
 What is Risk….
The Chinese symbols ( 危 机 ) reveals
“danger”,and “opportunity”, respectively
making risk a mix of danger and opportunity.
You cannot have one, without the other.
Risk is neither good nor bad. It is just a fact of
life. The question that businesses have to
address is therefore not whether to avoid risk
but how best to incorporate it into their
decision making.
 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.
 Risk Attitudes
Risk-neutral investor:
– One whose utility is unaffected by risk; when chooses to
invest, investor focuses only on expected return.
Risk-averse investor:
– One who demands compensation in the form of higher
expected returns in order to be induced into taking on
more risk.
Risk-seeking investor:
– One who derives utility from being exposed to risk, and
hence, may be willing to give up some expected return
in order to be exposed to additional risk.
 Probability Distribution
Stock X

Stock Y

Rate of
-20 0 15 50 return (%)
 Which stock is riskier? Why?
 Measuring Stand-Alone Risk

1. Expected Rate of Return

2. Standard Deviation

3. Coefficient of Variation
 Expected Returns
Expected returns are based on the probabilities
of possible outcomes

In this context, “expected” means average if the

process is repeated many times

The “expected” return does not even have to be a

possible return n
E ( R )   pi Ri
i 1
 Variance and Standard Deviation
Variance and standard deviation still measure the
volatility of returns
Using unequal probabilities for the entire range
of possibilities
Weighted average of squared deviations

n
σ 2   pi ( Ri  E ( R)) 2
i 1

Standard deviation is the square root of the

variance
 Portfolios
Meaning of Portfolio
– A combined holding of more than one stock, bonds,
real estate, or any other asset

Why create a portfolio?

– To diversify/reduce/mitigate risk of a single security

– All securities in the portfolio may not move together

– If one goes down, others will go up and compensate

for the loss of the first one
 Portfolios…
 A portfolio won't remove risk related to the
market as a whole ("market risk").

 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
 Feasible and Efficient Portfolios
 The feasible set of portfolios represents all
portfolios that can be constructed from a given
set of stocks.

 An efficient portfolio is one that offers:

– the most return for a given amount of risk, or
– the least risk for a give amount of return.

 The collection of efficient portfolios is called the

efficient set or efficient frontier.
Expected IB IB 1
Return, rp 2

Optimal Portfolio
IA2
Investor B
IA1

Optimal Portfolio
Investor A

Risk p
Optimal Portfolios
 Portfolio Expected Returns
 The expected return of a portfolio is the weighted average of the
expected returns for each asset in the portfolio
 Two-Security Portfolio: Return

E ( r p )  w D E ( rD )  w E E ( rE )
 J-Security Portfolio: Return
m
E ( RP )  wj 1
j E(R j )
 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: 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 DCLK
•DCLK: 2/15 = .133
– $3000 of KO
•KO: 3/15 = .2
– $4000 of INTC
•INTC: 4/15 = .267
– $6000 of KEI
 DCLK – Double click •KEI: 6/15 = .4
 KO – Coca-Cola
 INTC – Intel
 KEI – Keithley Industries
 The sum of the weights = 1
 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?
– DCLK: 19.69%
– KO: 5.25%
– INTC: 16.65%
– KEI: 18.24%

 E(RP) = .133(19.69) + .2(5.25) + .167(16.65) + .4(18.24)

= 13.75%
 Example: Portfolio Variance
 Consider the following information
– 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?
 Example: Portfolio Variance…
 If A and B are your only choices, what percent are
you investing in Asset B?

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%

 Example: Portfolio Variance…
 Portfolio (solutions to portfolio return in each
state appear with mouse click after last question)
Portfolio return in boom = .5(30) + .5(-5) = 12.5
Portfolio return in bust = .5(-10) + .5(25) = 7.5
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%
 Example: Portfolio Variance…
 The expected return on a portfolio is simply the
weighted average of the expected returns on the
individual assets in the portfolio.
 However, the riskiness of a portfolio is generally not
weighted average of the standard deviation of the
individual assets in the portfolio.
 The portfolio’s risk will be smaller than the weighted of the
assets standard deviation
 Note that the variance is NOT equal to
.5(384) + .5(216) = 300 and
 Standard deviation is NOT equal to
.5(19.6) + .5(14.7) = 17.17%
 Another Way to Calculate Portfolio
Variance
Portfolio variance can also be calculated using the
following formula:
2
P ( )2
= w A A + wB B =
 P2 = w A2  A2 + wB2  B2 + 2w A wB COV ( A, B )

COV ( A, B ) COV ( A, B ) =  A B  A, B
 A, B =
 A B

 P2 = w A2  A2 + wB2  B2 + 2w A wB  A, B A B
 Example: Portfolio Variance…
 Portfolio variance using covariance:
CovA, B = P boom [( R A E( R A )( RB E( RB )]+ Pbust [( R A E( R A )( RB E( B )]
                        
At boom At bust

=.4(30-6)(-5-13) + .6(-10-6)(25-13) = -288

2 2 2 2 2
P = w A A + wB B + 2w A wB COV ( A, B )
 P2 = (0.5 )2 (19.6 )2 + (0.5 )2 (14.7 )2 + 2(0.5 )(0.5 )( 288)
=(.5)2(384) + (.5)2(216) + 2(.5)(.5)(-288) = 6
Standard deviation = 2.45%
 Diversification
 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
 If we hold only one asset, or assets in the same
industry, then we are exposing ourselves to risk
that we could diversify away
 Portfolio Diversification: Which risk is Diversifiable ?

 The risk that can be eliminated by combining

assets into a portfolio.
 Often considered the same as unsystematic,
unique or asset-specific risk.
 The diversification gains achieved by adding
more investments will depend on the degree of
correlation among the investments.
 The degree of correlation is measured by using
the correlation coefficient.
 Portfolio risk
 Correlation is a statistical measure of how 2 assets move
in relation to each other.
 the tendency of two variables to move together

 Returns of perfectly positively correlated stocks would

move up and down together, and a portfolio consisting of
two suck stocks would be exactly as risky as the
individual stocks

 If the correlation between stocks A and B = -1, what is

the standard deviation of the portfolio?
 Portfolio Diversification (cont.)
 The correlation coefficient can range from -1.0
(perfect negative correlation), meaning two
variables move in perfectly opposite directions to
+1.0 (perfect positive correlation), which means
the two assets move exactly together.

 A correlation coefficient of 0 means that there is

no relationship between the returns earned by the
two assets.
Different Correlation Coefficients
Different Correlation Coefficients
Different Correlation Coefficients
Possible Relationships between Two Stocks
 Diversification
 There are benefits to diversification whenever
the correlation between two stocks is less than
perfect (p < 1.0)

 If two stocks are perfectly positively correlated,

then there is simply a risk-return trade-off
between the two securities.
 Risk classification
 From the viewpoint of the individual investor,
the riskiness of an asset can be considered in two
ways:
A. On stand-alone basis
(Mkt Risk + firm specific risk) OR
B. In a portfolio context
In portfolio context, an asset’s risk can be
divided in two components
① Systematic risk, and
② Unsystematic risk, or idiosyncratic risk
 Total Risk = Systematic Risk + Unsystematic Risk
STD DEV OF PORTFOLIO RETURN

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Systematic Risk
 The systematic risk component measures the contribution of the
investment to the risk of the market.
 Risk factors that affect a large number of assets
 Also known as non-diversifiable risk or market risk
 Includes such Inflation, hike in corporate tax, War, interest rates, etc.
Unsystematic Risk
 The unsystematic risk is the element of risk that does not
contribute to the risk of the market.
 This component is diversified away when the investment is
combined with other investments.
 Risk factors that affect a limited number of assets
 Also known as unique risk and asset-specific risk
 Includes such things as labor strikes ,Product recall, change of
management , part shortages, etc.
 Diversification in Stock
Portfolios
As you add stocks to your portfolio,
diversifiable risk is reduced.
Portfolio standard deviation

Diversifiable
risk

Market risk
0
5 10 15
Number of Securities
 Systematic risk principle
The systematic risk principle states that the
reward for bearing risk depends only on the
systematic risk of an investment.
The expected return on a risky asset depends only
on that asset’s systematic risk since unsystematic
risk can be diversified away.
No matter how much total risk an asset has, only
the systematic risk is relevant determining the
expected return and risk premium on that asset.
 The Concept of Beta
The market risk of a stock is measured by its beta
coefficient-which is an index of the stock’s
relative volatility.
Stand-alone risk= Market risk+ firm specific risk
 Market risk the part of a security’s stand-alone
risk that can’t be eliminated by diversification,
and it is measured by beta
• Sensitivity to Systematic Risk: Beta (β)
– The expected percent change in the excess return of a
security for a 1% change in the excess return of the
market portfolio.
 Measuring Systematic Risk (cont'd)

• Interpreting Beta (β)

– A security’s beta is related to how sensitive its
underlying revenues and cash flows are to general
economic conditions.
– Stocks in cyclical industries are likely to be more
sensitive to systematic risk and have higher betas
than stocks in less sensitive industries.
 Measuring Systematic Risk
 How do we measure systematic risk?
 We use the beta coefficient to measure systematic
risk
 What does beta tell us?
– A beta of 1 implies the asset has the same systematic
risk as the overall market
– A beta < 1 implies the asset has less systematic risk
than the overall market
– A beta > 1 implies the asset has more systematic risk
than the overall market(For example=2: stock is twice
as risk as the average stock or market)
 Portfolio Beta Coefficients
 A portfolio consisting of low-beta securities will itself
have a low beta, because the beta of a portfolio is
weighted average of the individual securities beta:

b p = w1b1 + w2b2 + ....+ wn bn

 Beta portfolio: shows how volatile the portfolio is in

relation to market.
 Example: Portfolio Betas
Consider the following four securities
– Security Weight Beta
– A .133 2.685
– B .2 0.195
– C .167 2.161
– D .4 2.434
 What is the portfolio beta?
.133(2.685) + .2(.195) + .167(2.161) + .4(2.434) = 1.731
 Which security has the highest systematic risk? A
 Which security has the lowest systematic risk? B
 Capital Asset Pricing Model (CAPM)
 The CAPM was introduced by Jack Treynor, John Lintner,
William Sharpe & Jan Mossin in the early 1960’s.
 CAPM is a model that establish the linear relationship between
un-diversifiable risk (systematic risk) & expected return.
 According to CAPM, the investor needs to be compensated in
two ways, for time value of money (risk free rate) and for taking
systematic risk.
 A security’s expected return is risk free rate plus a risk premium
based on the systematic risk of security.
 CAPM…
 CAPM assumes any asset’s systematic risk is
captured by one risk factor, i.e. the market risk
factor. Adding one new stock to a well-diversified
portfolio affects the risk of the portfolio depending
upon the asset’s degree of market risk effect, as
measured by its Beta.
 Investing in risky assets such as the market portfolio
should carry a premium compared to the risk-free
rate. Otherwise, investors will not take the risk.
 The risk premium on the market portfolio, measure
as the difference between the market return and the
risk-free rate is called the market risk premium.
 CAPM…
 The CAPM defines the relationship between risk &
return. E(RA) = Rf + A(E(RM) – Rf)
Where: E(RA)… expected value of risk of a given
asset, RM... Mrkt risk, Rf… Risk free rate
 If we know an asset’s systematic risk, we can use
the CAPM to determine its expected return.
 This is true whether we are talking about financial
assets or physical assets.
 Is an equilibrium model that specifies the
relationship between risk and required rate of
return for assets held in well-diversified portfolios.
 CAPM….
1. Uses variance of actual returns around an
expected return as a measure of risk.
2. Specifies that a portion of variance can be
diversified away, and that is only the non-
diversifiable portion that is rewarded.
3. Measures the non-diversifiable risk with beta,
which is standardized around one.
4. Translates beta into expected return -
Expected Return = Riskfree rate + Beta * Risk Premium
5. Works as well as the next best alternative in most cases.

46
 What are the assumptions of the CAPM?
1.All assets are perfectly 5. Investors all think in terms
divisible. of a single holding period.(no
inflation)
2.There are no taxes and no
transactions costs. 6. All investors have identical
expectations.(same portfolio
3.All investors are price takers, of risky asset: some belief)
that is, investors’ buying and
7. Investors can borrow or
selling won’t influence stock lend unlimited amounts at the
prices (no single investor can risk-free rate.( no inflation,
affect the price of a stock). interest rate change …)
4.Quantities of all assets are 8. Capital markets are at
given and fixed. equilibrium
The security market line (SML) &Capital Market Line (CML
 The CAPM is an equilibrium model that
encompasses two important relationships:
 The security market line (SML), specifies the
equilibrium relationship between expected
return and systematic risk
 The capital market line (CML), specifies the
equilibrium relationship between expected
return and total risk for efficient portfolios.
 CAPM/SML concepts are based on expectations, yet betas
are calculated using historical data.
 A company’s historical data may not reflect investors’
expectations about future riskiness.
 SML and Different Betas

EXCESS RETURN Beta > 1

ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

EXCESS RETURN
ON MARKET PORTFOLIO
 Security Market Line
 Beta = 1.0 implies as
risky as market
 Securities A and B are
SML more risky than the
E(R) market
 Beta > 1.0
A
E(RM) B  Security C is less risky
C than the market
RF
 Beta < 1.0

0 0.5 1.0 1.5 2.0

BetaM
CAPM
 Example - CAPM
 Consider the betas for each of the assets given earlier.
 If the risk-free rate is 2.13% and the market risk
premium is 8.6%, what is the Required return for each?

Security Beta Required Return

DCLK 2.685 2.13 + 2.685(8.6) = 25.22%
KO 0.195 2.13 + 0.195(8.6) = 3.81%
INTC 2.161 2.13 + 2.161(8.6) = 20.71%
KEI 2.434 2.13 + 2.434(8.6) = 23.06%
 Limitations of the CAPM (Critique of CAPM)
1. Unrealistic assumptions: CAPM is not without controversy. It
rests on some critical (and questionable) assumptions.
2. Not testable: An empirical tests do not confirm CAPM.The
parameters of the model cannot be estimated precisely
 The market index used can be wrong.
 The firm may have changed during the 'estimation' period'
3. CAPM does not explain differences in returns for securities
that differ in time period (duration). Betas do not remain stable
over time.
 - If the model is right, there should be:
 A linear relationship between returns and betas
 The only variable that should explain returns is betas
 - The reality is that
 The relationship between betas and returns is weak
 Other variables (size, price/book value) seem to explain differences in
returns better.
 Why the CAPM still persists?
The CAPM, notwithstanding its many critics has survived
as the default model for risk in equity valuation and
corporate finance. The alternative models that have been
presented as better models (APM, Multifactor model..)
have made inroads in performance evaluation but not in
prospective analysis because:
 The alternative models (which are richer) do a much
better job than the CAPM in explaining past return, but
their effectiveness drops off when it comes to estimating
expected future returns (because the models tend to shift
and change).
 The alternative models are more complicated and
require more information than the CAPM.
54
 Why the CAPM still persists?...
 For most companies, the expected returns you get with
the alternative models is not different enough to be worth
the extra trouble of estimating four additional betas.
 The CAPM is robust(valid) since most of its assumptions
can be relaxed without significant effects on the model
 Not all of the CAPM assumptions are unrealistic:
 Some institutional investors are tax-exempt.
 Significant reduction in transaction costs by using
discount brokers and/or internet.
 For the one-period horizon of the model, inflation may be
fully (or mostly) anticipated.

55
 Arbitrage Pricing Theory (APT)
• The APT was proposed by Stephen .S.Ross and presented in his
article” The Arbitrage theory of Capital Asset Pricing” published
in Journal of Economic theory in 1976.
• Still there is a potential for APT & it may sometimes displace the
CAPM.
• The key point behind APT is the rational statement that the
market return is determined by a number of different factors.
These factors may be fundamental factors or statistical. If these
factors are essential, there to be no arbitrage opportunities there
must be restrictions on the investment process.
• By arbitrage we mean the earning of riskless profit by taking
advantage of different pricing for the same assets or security.
• The APT does not require identification of market portfolio , but
it does require the specification of the relevant macro economic
factors.
 Arbitrage Pricing Theory (APT)……
According to APT, only the systematic risk is
relevant in determining expected returns (similar to
CAPM). However, there may be several non-
diversifiable risk factors such as; economic growth,
interest rates, and inflation (different from CAPM,
since CAPM assumes only one risk factor) that are
systematic or macroeconomic in nature and thus affect
the returns of all stocks to some degree.
Firm specific risk, since it is easily diversified out of
any well-diversified portfolio, is not relevant in
determining the expected returns of securities (similar
to CAPM).
 Arbitrage Pricing Theory (APT)……
The basic idea behind Arbitrage Pricing Theory is to
calculate the returns in absence of arbitrage-condition of
artificially overpricing or under-pricing a product. In other
language, arbitrage is the process of earning profit by
taking advantage of differential pricing for the same asset.
Arbitrage Pricing Theory applies to economies that are
regulated by the Law of One Price. The Law of one price
states that two identical goods can’t but be sold with the
same price. If they sell at different price arbitrage takes up.
APT is a well-known method of estimating the price of
an asset. The theory assumes an asset's return is
dependent on various macroeconomic, market and
security-specific factors.
 Assumptions of APT
 Only systematic or non-diversifiable risk matters, however
there may be several of these macroeconomic risk factors
that affect the returns of well-diversified portfolios. Such
common risk factors might happen to be are; unexpected
changes in economic growth, interest rates, and inflation.

 Investors must agree on what the relevant risk factors are.

There must be a linear relationship between the risk exposure
or sensitivity (its loadings on the risk factors) and expected
return of a security.
 Assumptions of APT…
 If any asset offers an expected return that is out of equilibrium with
respect to the risk factors, then investors can build a zero-
investment portfolio in order to exploit the mispricing of the security.
This is known as an arbitrage in expectations. In other word, a
riskless arbitrage opportunity arises when an investor can construct
a zero-investment portfolio that will yield a sure profit.
 Zero investment means investors need not use any of their own
money. To construct a zero-investment portfolio, one has to be able
to sell short at least one asset and use the proceeds to purchase
(go long) one or more assets. Even a small investor, using
borrowed money in this fashion, can take a large position in such a
portfolio.
 A representation of APT model holds number of risk factors
called factor betas.
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