Chapter 11

Return and Risk

FINA 211
Michael Keefe
 Topics
• Measuring risk and return
– Mean
– Variance and standard deviation
– Covariance and Correlation
• Finding the efficient set
• Systematic vs. Unsystematic risk
• Capital Asset Pricing Model
 Portfolios and Risk
• Adding more assets decreases the volatility of
the portfolio
• Covariance and Correlation of asset returns
become important measures of risk
• The NZX50 and S&P500 are portfolios of stocks
• Previously, I looked at the NZX50 and the
difference between geometric and average
returns
• Let’s evaluate the S&P500 as well
Inspection suggests series are correlated
NZ50 S&P500
Monthly 1+ Monthly 1+
Date Adj Close Return Return Adj Close Return Return
1/30/2007 4152.98 1438.24
2/1/2007 4037.13 -2.79% 97.21% 1406.82 -2.18% 97.82%
3/1/2007 4107.14 1.73% 101.73% 1420.86 1.00% 101.00%
4/2/2007 4194.64 2.13% 102.13% 1482.37 4.33% 104.33%
5/1/2007 4302.35 2.57% 102.57% 1530.62 3.25% 103.25%
6/1/2007 4234.29 -1.58% 98.42% 1503.35 -1.78% 98.22%
7/2/2007 4213.3 -0.50% 99.50% 1455.27 -3.20% 96.80%
8/1/2007 4118.97 -2.24% 97.76% 1473.99 1.29% 101.29%
9/3/2007 4268.9 3.64% 103.64% 1526.75 3.58% 103.58%
10/1/2007 4209.07 -1.40% 98.60% 1549.38 1.48% 101.48%
11/1/2007 4062.89 -3.47% 96.53% 1481.14 -4.40% 95.60%
12/3/2007 4041.38 -0.53% 99.47% 1468.36 -0.86% 99.14%
1/3/2008 3670.64 -9.17% 90.83% 1378.55 -6.12% 93.88%
2/1/2008 3582.72 -2.40% 97.60% 1330.63 -3.48% 96.52%
3/3/2008 3470.43 -3.13% 96.87% 1322.7 -0.60% 99.40%
4/1/2008 3624.8 4.45% 104.45% 1385.59 4.75% 104.75%
5/1/2008 3624.23 -0.02% 99.98% 1400.38 1.07% 101.07%
6/3/2008 3194.61 -11.85% 88.15% 1280 -8.60% 91.40%
7/1/2008 3336.28 4.43% 104.43% 1267.38 -0.99% 99.01%
8/1/2008 3353.24 0.51% 100.51% 1282.83 1.22% 101.22%
9/1/2008 3090.22 -7.84% 92.16% 1166.36 -9.08% 90.92%
10/1/2008 2820.86 -8.72% 91.28% 968.75 -16.94% 83.06%
11/3/2008 2710.96 -3.90% 96.10% 896.24 -7.48% 92.52%
 Sample Statistics

NZ50 S&P500
Return Monthly Annual Monthly Annual
Arithmetic -0.643% -7.446% -0.502% -5.861%
Geometric -0.735% -8.477% -0.665% -7.698%
Buy and Hold -0.735% -8.475% -0.665% -7.698%

Neither investment proved fortuitous

 Other Sample Statistics
NZ50 SD 4.244%
S&P500 SD 5.683%
NZ S&P Cov 0.189%
Correlation 78.45%
Correlation (Excel) 79.29%

NZ 50 and S&P 500 Returns are highly correlated but not perfectly.
Hence, owning both reduces volatility.

What matters is our expectations of the future.

We now use decision trees to look forward.
We evaluate the expected return of a portfolio using the TRUE (rather
than sample) expected returns, variance, and correlations.

EXPECTATIONS AND RETURNS

 RWJ Question 11.8

State Probability Stock A Stock B Stock C

Boom 0.65 0.07 0.15 0.33
Bust 0.35 0.13 0.03 (0.06)

a.weights 0.33 0.33 0.33

b.weights 0.20 0.20 0.60
 RWJ 11.8 Continued
Recall E[1 X  2Y ]  1 E[ X ]  2 E[Y ] so that
First we calculate each stock's expected return
E[ RA ]  .65*.07  .35*.13  .091
E[ RB ]  .65*.15  .35*.03  .108
E[ RC ]  .65*.33  .35*(-.06)  .1935

a) What is the expected return (equal weighted)

E[(1/ 3) RA  (1/ 3) RB  (1/ 3) RC ]  (1/ 3) E[ RA ]  (1/ 3) E[ RB ]  (1/ 3) E[ RC ]
 (1/ 3) E[ RA ]  E[ RB ]  E[ RC ]
 (1/ 3){0.091  0.108  0.1935}
=13.08%
b) What is the expected return (non equal weighted)
E[(.20) RA  (.20) RB  (.60) RC ]  (.20) E[ RA ]  (.20) E[ RB ]  (.60) E[ RC ]
 (.20)(0.091)  (.20)(0.108)  (.60)(0.1935)
 15.59%
 RWJ 11.8 – part b
Decision Tree Depiction of Portfolio Returns
Boom
RPortfoli o   R A
1 Boom   R B
2 Boom   R C
3 Boom

 .20*.07  .20*.15  .60*.33

Boom-.65
 .242

o  1 RBust  2 RBust  3 RBust

Bust A B C
Bust-.35 RPortfoli
 .20*.13  .20*.03  .60*(.06)
 .004

Who is N? E[ RPortfolio ]  Prob[ Boom]* RPortfolio

Boom
 Prob[ Bust ]* RPortfolio
Bust

 .65*.242  .35*( .004)

  0.1559

1. Conditional on the boom state occurring, is the return of the portfolio

stochastic?
2. Is the expected return true or a sample estimate?
 RWJ 11.8 How precise is the expectation of
the portfolio return?
Var[ RPortfolio ]  E[( RPortfolio   ) 2 ]
 Prob[ Boom]*( RPortfolio
Boom
  ) 2  Prob[ Bust ]*( RPortfolio
Bust
  )2
 .65(.242  .1559) 2  .35(.004  .1559) 2
 .65(0.00741)  .35(0.02556)
 Portfolio
2
 0.01376
 Portfolio  11.73%

1. Is this a true measure of the volatility or a

sample estimate?
2. Is the distribution a bell curve?
 RWJ 11.8 Alternative estimate of the Variance of
the Portfolio
The variance of a portfolio is defined as:
VAR[ A RA  B RB  C RC ]   A2VAR[ RA ]  B2VAR[ RB ]  C2VAR[ RC ]  2 ABCOV [ RA , RB ]
 2 AC COV [ RA , RC ]  2BC COV [ RB , RC ]
Plugging in the weights into the above equation we find:
VAR[.20 RA  .20 RB  .60 RC ]  .04VAR[ RA ]  .04VAR[ RB ]  .36VAR[ RC ]  .08COV [ RA , RB ]
 .24COV [ RA , RC ]  .24COV [ RB , RC ] where
VAR[ RA ]  E[( RA   A ) 2 ]  .65(.07  .091) 2  .35(.13  .091) 2  0.000819
VAR[ RB ]  E[( RB   B ) 2 ]  .65(.15  .108) 2  .35(.03  .108) 2  0.003276
VAR[ RC ]  E[( RC  C ) 2 ]  .65(.33  .1935) 2  .35(.06  .1935) 2  0.034602
COV [ RA , RB ]  .65(.07  .091)(.15  .108)  .35(.13  .091)(.03  .108)  0.001638
COV [ RA , RC ]  .65(.07  .091)(.33  .1935)  .35(.13  .091)(.06  .1935)  0.0053235
COV [ RB , RC ]  .65(.15  .108)(.33  .1935)  .35(.03  .108)( .06  .1935)  0.010647
Substitute variance and covariance values to find
 Portfolio
2
 0.013767
 Portfolio  11.73%
 RWJ 11.25
State Probability Stock A Stock B
Bear 0.33 0.102 (0.045)
Normal 0.33 0.115 0.148
Bull 0.33 0.073 0.233

E[ RA ]  (1/ 3)(.102)  (1/ 3)(.115)  (1/ 3)(.073)  .0967

 R  (1/ 3)(.102  .0967) 2  (1/ 3)(.115  .0967) 2  (1/ 3)(.073  .0967) 2 
1/2
A

 .0176
E[ RB ]  (1/ 3)(.045)  (1/ 3)(.148)  (1/ 3)(.233)  .1120
 R  (1/ 3)(.045  .112)  (1/ 3)(.148  .112)  (1/ 3)(.233  .112)
B
2 2

2 1/2

 .1163
 RWJ 11.25 continued
• Now we have the basic information
• Questions – What are the covariance and
correlations between the stocks?
COV ( RA , RB )  E[( RA   A )( RB   B )]
 (1/ 3)(.102  .0967)(.045  .1120)  (1/ 3)(.115  .0967)(.148  .1120)
(1/ 3)(.073  .0967)(.233  .1120)
 0.001014
COV ( RA , RB ) 0.001014
R    49.64%
A , RB
 RA  RB (.0176)(.1163)
Minimize the variance for a given return OR maximize the return for a
given variance

EFFICIENT SET
 The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
Portfolo Risk and Return Combinations
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8% 12.0%

Portfolio Return
11.0%
25% 2.6% 8.0%
10.0%
30% 1.4% 8.2%
9.0%
35% 0.4% 8.4%
8.0%
40% 0.9% 8.6%
7.0%
45% 2.0% 8.8%
6.0%
50.00% 3.08% 9.00%
5.0%
55% 4.2% 9.2% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
60% 5.3% 9.4%
65% 6.4% 9.6% Portfolio Risk (standard deviation)
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2% Some portfolios offer higher
85% 10.9% 10.4%
90% 12.1% 10.6% return for the same risk –
95%
100%
13.2%
14.3%
10.8%
11.0%
efficient set
 Portfolios with Various Correlations
return
 = -1.0 100%
stocks

 = 1.0
100%
 = 0.2
bonds


• Relationship depends on correlation coefficient
-1.0 < r < +1.0
• If r = +1.0, no risk reduction is possible
• If r = –1.0, complete risk reduction is possible
The Efficient Set with many securities

return t fro
nt ier
i en
c
effi
minimum
variance
portfolio

Individual Assets

P
The section of the opportunity set above the minimum variance
portfolio is the efficient frontier.
 Riskless Borrowing and Lending –
Capital Market Line (CML)

L
return
CM 100%
stocks
Balanced
fund

rf
100%
bonds


To achieve the highest return for a given level of risk, investors allocate
their money across the T-bills and a balanced (diversified) mutual fund.
The variance of a large portfolio is more dependent on covariance terms
than variance terms

DIVERSIFICATION
 Portfolio Variance
Variance Covariance
Stocks Terms Terms
1 1 0
2 2 1
3 3 3
4 4 6 The covariance terms become
5 5 10 increasingly important in their
6 6 15 relative contribution to the
total variance of a portfolio as the
7 7 21 number of stocks increases.
8 8 28
9 9 36
10 10 45
25 25 300
50 50 1225
Portfolio Risk and Number of Stocks

In a large portfolio, firm specific (idiosyncratic) risk

 can be diversified away, but systematic risk can not.

Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
 Risk: Systematic and Unsystematic
• A systematic risk is any risk that affects a large
number of assets, each to a greater or lesser degree.
• An unsystematic risk is a risk that specifically affects a
single asset or small group of assets.
• Unsystematic risk can be diversified away.
• Examples of systematic risk include uncertainty
about general economic conditions, such as GNP,
interest rates or inflation.
• On the other hand, announcements specific to a
single company are examples of unsystematic risk.
Investors will only pay for risk they can’t diversify away

CAPITAL ASSET PRICING MODEL

(CAPM)
Under homogenous expectation all investors
estimate the same market portfolio

L
return
CM 100%
stocks
E[ RM ]
Market
Portfolio
Rf
100%
bonds

M
Y E[ RM ]  R f
The slope of the CML is 
X M
 All investors hold the market portfolio
• Prices must adjust so there is no excess demand
• In equilibrium all assets are held in proportion to portfolio
market weights
• Essentially, there is no benefit to adjusting your portfolio
(note – no new information)
• Under these conditions the risk return trade-off can be
derived
• This is the slope of market portfolio on the efficient frontier
Y E[ Ri ]  E[ RM ]
 for very small changes
X ( i , M   M ) /  M
2
 Equating the slopes
E[ Ri ]  E[ RM ] E[ RM ]  R f

( i , M   M ) /  M
2
M
( i , M   M2 )
 M  E[ Ri ]  E[ RM ]   E[ RM ]  R f 
M
( i , M   M2 )
E[ Ri ]  E[ RM ]   E[ RM ]  R f 
 M2
 i,M
E[ Ri ]  E[ RM ]   E[ RM ]  R f  (  i  1) where  i  2
M
 E[ Ri ]  R f  i  E[ RM ]  R f  which is the CAPM formula
 Relationship Between Risk & Return
SML (Security Market Line)
Expected return

E[ Ri ]  RF  βi ( E[ RM ]  RF )

E[ RM ]
RF

1.0 b
 Capital Asset Pricing Model Summary
• Investors only pay for non-diversifiable risk as measured by i
• Expected Return is a function of risk free rate, risk premium,
and beta of E[ Ri ]  R f  i ( E[ RM ]  R f )
• Homogenous expectation implies common view of market
portfolio such that:   Cov i
(R , R )
 (R )
2
i M

M
• The Beta of the asset can also be expressed in terms of
correlation Cov( R , R )
By definition:  Ri , RM  i M

 ( Ri ) ( RM )
 Cov( Ri , RM )   R , R  ( Ri ) ( RM )
i M

Cov( Ri , RM )  Ri , RM  ( Ri )
 i  
 ( RM )
2
 ( RM )
 Tutorial Question 11.12
• Information
– Beta = 1.15
– Expected Market Return = 11%
– Risk Free Rate = 5%
• Question – What is the expected return on the stock?
E[ Ri ]  R f  i ( E[ RM ]  R f )
 .05  1.15(.11  .05)
 11.90%
 Tutorial Question 11.13
• Information
– Stock Expected Return = 10.2%
– Risk Free Rate = 4%
– Market Risk Premium = 7%
• Question – What is the Beta of the stock?
E[ Ri ]  R f  i ( E[ RM ]  R f )
E[ Ri ]  R f
i  Ratio of
E[ RM ]  R f Risk premium of stock
to
.102  .04 .062 Risk premium of market
i    .89
.07 .07
 Tutorial Question 11.14
• Information
– Expected Return of Stock = 13.4%
– Beta = 1.60
– Risk Free Rate = 5.5%
• Question – What is the expected return on the market portfolio?

E[ Ri ]  R f   i ( E[ RM ]  R f )
 i ( E[ RM ]  R f )  E[ Ri ]  R f
E[ Ri ]  R f
E[ RM ]  R f 
i
Beta in denominator adjusts the size of
E[ Ri ]  R f second term to always be a constant.
E[ RM ]  R f  • If large risk premium, Beta is >1
i
• If small risk premium, Beta is <1
.0134  .055
 .055   10.44%
1.6
 Tutorial Question 11.32
• Information
– Risk Free Rate = 4.2%
– Expected Return on Market Portfolio = 10.9%
– Variance on Market Portfolio = .0382
– Portfolio Z has a correlation with the market portfolio of .28
– Portfolio Z has a variance of .3285
• Question – What is the expected return Cov( RZof, Rportfolio
M) Z?
E[ RZ ]  R f   Z ( E[ RM ]  R f ) and  Z  so
 2 ( RM )
Cov( RZ , RM )
E[ RZ ]  R f  ( E[ RM ]  R f ) and Cov ( RZ , RM )   R , R  ( Ri ) ( RM ) so
 2 ( RM ) i M

R , RM  ( RZ )  ( RM )
E[ RZ ]  R f  Z
( E[ RM ]  R f )
 ( RM )
2

 ( RZ ) (.3285)1/ 2
E[ RZ ]  R f   RZ , RM ( E[ RM ]  R f )  .042  .28 (.109  .042)  9.7%
 ( RM ) (.0382)1/ 2

Correlation Coefficient between [-1 1] is scaled by ratio of standard deviation of

stock and market portfolios
 Tutorial Question 11.10 – Beta of a portfolio
• Information
– Stocks Q, R, S, and T
– Betas - .75, 1.90, 1.38, 1.16
– Portfolio Weights – 10%, 35%, 20%, and 35%
• Question – What is the portfolio Beta?
E[ i 1 i Ri ]   i 1 i E[ Ri ]
N N

  i 1 i R f   i ( E[ RM ]  R f )
N

  i 1 i R f   i 1 i  i ( E[ RM ]  R f )
N N

 R f  i 1 i  ( E[ RM ]  R f ) i 1 i  i
N N

 R f  ( E[ RM ]  R f ) i 1 i  i
N


4
i 1
i i  .10*.75  .35*1.90  .20*1.38  .35*1.16  1.42
 The Big Picture
• Efficient frontier
– Optimization problem
• Fix the return
• Solve the weights that minimize the variance
– Set of points (higher points) is the efficient frontier
• Under homogenous expectations all investors define the same efficient frontier
and hence market portfolio exists in equilibrium
• If all investors can borrow and lend at the risk free rate, they will either:
– Lend (earn risk free rate) and purchase relatively low quantity of market
portfolio (high risk aversion)
– Borrow (pay risk free rate) and purchase relatively high quantity of market
portfolio (low risk aversion)
• Hence , individual investor risk aversion is unrelated to asset expected return
• Investors can diversity non-systematic (idiosyncratic) risk.
• Because of the benefits diversification, only systematic risk is priced.
• Under CAPM, Beta represents systematic risk – risk you can not diversify away!
Matrices provide a notational more efficient way to express the expected
return and variance of a portfolio. The deriviation of the CAPM requires
one to find the slope of the market portfolio on the efficient frontier.

ADDITIONAL MATERIAL
 Using Matrix notation one quickly sees the importance
of covariance terms
VAR[ A RA  B RB  C RC ]   A2VAR[ RA ]  B2VAR[ RB ]  C2VAR[ RC ]
2 AB COV [ RA , RB ]  2 AC COV [ RA , RC ]  2BC COV [ RB , RC ]
 A, A  A, B  A,C 
 
VAR[ A RA  B RB  C RC ]=  A B C   B , A  B ,B  B ,C  A B C 
   
 C , A C , B C ,C 
3x1
1x3
3x3
Using matrix math and optimization routines, financial packages
solve for the efficient frontier as a set of points
Find the  A , B , C to Maximize E[ A RA   B RB  C RC ]
subject to Constant=VAR[ A RA  B RB  C RC ] Defines a set
of points
OR
Find the weights that minimize the variance for a given return
Deriving the slope of the market portfolio on the
efficient frontier
Assume an investor allocates
 percentage in asset i
1- percent in the market portfolio
 E[R p ]   E[ Ri ]  (1   ) E[ RM ] (1)
1/2
  P   2 i2  (1   )2  M2  2 (1   ) i ,M  (2)
Take the derivatives of (1) and (2) w.r.t. 
E[R p ]
  E[ Ri ]  E[ RM ]

E[ p ] 1 2 2 1/2
    i  (1   )2  M2  2 (1   ) i ,M   2 i2  2(1   ) M2  2 i ,M  4 i ,M 
 2
But at equilibrium the market portfolio is optimum so   0
E[R p ]
  E[ Ri ]  E[ RM ]
  0

E[ p ] 1 2 2 1/2 2 i , M  2 M2  i , M   M2
  (1)  M   2(1) M  2 i ,M  
2

  0 2  2  M2 
1/2
M
Thus, the slope of the Market portfolio on the efficient frontier for any asset i is
E[R p ] /  E[ Ri ]  E[ RM ]

E[ p ] /  ( i ,M   M2 ) /  M
 0