RETURN AND RISK:

PORTFOLIO THEORY AND CAPITAL ASSET PRICING MODEL (CAPM)

1. Individual Securities

Expected Return

Return that an individual expects a stock to earn over the next period Actual return may be either higher or lower Formula: Expected return = Prob x Return = P x Ri

Variance () and Standard Deviation ()

Measures the variability of an individual securitys return (squared deviations of a securitys return from its expected return) To assess the volatility or variability of an individual securitys return on the expected return Formula: = P (Ri expected returni) Thus, = P (Ri expected returni)

Covariance and Correlation

- ve cov

To measure the r/ship between returns on individual securities Covariance can be stated in terms of the correlation between two securities. +ve r/ship between the 2 returns Both returns are above/below their average returns

-ve r/ship between the 2 returns One return is above the average and the other is below the average return No r/ship i.e. the 2 returns are unrelated

Zero cov

+ve cov

Covariance is difficult to be interpreted because it is in squared deviation units To solve the problem, use the correlation Correlation is between +1 and -1 Correlation can be +ve, -ve and zero and its interpretation is similar to covariance

Formula:
Covariance (AB) Prob(RA exp RA)(RB exp RB) Correlation (AB)

AB A X B
Therefore,

AB = AB

X A X

Example: Individual Securities Suppose you have invested only in two stocks, A and B. The returns on the two stocks depend on the following three states of the economy which are:
State of economy Probability Return on Stock A B
- 2.00 9.20 15.40 5.00 6.20 7.40

Recession Normal Boom

0.25 0.60 0.15

a)

Calculate the expected return on each stock. Calculate the standard deviation of returns on each stock. Calculate the covariance and correlation between the returns on the two stocks.

b)

c)

2.

Return and Risk for Portfolios

Expected return on a portfolio (Rp) = weighted average of the expected returns on the individual securities = X A RA + X B RB = Rp

Where:

XA = percentage of the portfolio in security A XB = percentage of the portfolio in security B RA and RB =expected return on security A and B respectively

Standard Deviation (SD) of a portfolio (p) = NOT the weighted average of the
standard deviations individual securities

=
XA XB A B AB

XA A

2XAXB A,B

XB B

Where:
= percentage of investment in securities A
= percentage of investment in securities B = SD of security A

= SD of security B
= Covariance of security A and B

Covariance (AB) and Correlation (AB)

Correlation (AB) = AB A X B

Therefore, AB =

AB

+ve r/ship between the 2 securities increases the variance of the entire portfolio. Therefore, the risk of the entire portfolio will be higher
-ve r/ship between the 2 securities decreases the variances (risk) of the entire portfolio. SD of a portfolio Weighted average of SD of individual securities (Due to diversification effect) <

However, it does not mean we should not invest in securities which are positively correlated, as long as the correlation () is less than perfect positive correlation( <1).
If the correlation is negative, the benefit from diversification effect is greater. At this point, the risk of investment in a portfolio is reduced. Due to diversification effect. It vanishes when =1 where the:
SD (portfolio) = weighted average of SD of individual security

Example: For Portfolio Suppose you have invested only in two stocks, A and B. The returns on the two stocks depend on the following three states of the economy which are:
State of economy Probability Return on Stock A B
- 2.00 9.20 15.40 5.00 6.20 7.40

Recession Normal Boom

0.25 0.60 0.15

Calculate:
expected return of a portfolio standard deviation of a portfolio if 40% and 60% of your funds invested in A and B respectively.

3. Efficient Set: Two Assets

Example: Stock A B Portfolio of 60% in A and 40% in B

Expected return SD 17.5% 25.86% 5.5% 11.50%

12.7%

15.44%

Graph
3 2 MV 1 1 (10% in A, 90% in B) A (100% in A)

Expected Return (%)

B (100% in B)

Standard deviation (%)

1.

Correlation (+1 to 1)
Diversification effect (DE) occurs when the correlation ()between the two securities is <1

DE is represented by the curved line which is to the left of the straight line A portfolio at point 1 is when the = 1 where no DE. (impossible) The lower the correlation, the more bend there is in the curve the lower the SD (risk) due to DE
DE rises as declines

2.

Minimum Variance Portfolio At MV The lowest possible variance or SD

Opportunity Set or Feasible Set Represented by the curved line through point B, MV and A An investor can achieve any point on the curve by selecting the appropriate mix between the two securities Depends on the stomach of the investor (risk averse/risk taker)

3.

4.

Curved line between point MV and B A portion of feasible set SD decreases as one increases expected return Point < Minimum Variance portfolio (MVP) No investor want to hold a portfolio with expected return below that of the MVP i.e. portfolio 1 Less expected return but higher SD than the MVP has. Thus, the investor only consider the curve from MV to A as the efficient set of efficient frontier.

5.

Question?????

How can an increase in the proportion of the risky security lead to a reduction in the risk of the portfolio???

Answer

Diversification Effect Correlation between the securities is ve ( < 1) which represented by the backward bending curve Thus, an addition of a small amount of risky security acts as a hedge to a portfolio composed only one security

Two-Security Portfolios with Various Correlations

return

= -1.0

100% stocks

100% bonds

= 1.0 = 0.2

Relationship depends on correlation coefficient -1.0 < < +1.0 If = +1.0, no risk reduction is possible If = 1.0, complete risk reduction is possible

4.

The Efficient Set for Many Securities

return

MV Individual Assets

P Consider a world with many risky assets; we can still identify the opportunity set of risk-return combinations of various portfolios.

The shaded area represents the feasible set when many securities are considered. The shaded area represents all the possible combinations of expected return and standard deviation of a portfolio
No combination of securities can fall outside the shaded area An investor will want to be somewhere on the upper edge between MVP and X

return
minimum variance portfolio Individual Assets

Given the opportunity set we can identify the minimum variance portfolio.

return
minimum variance portfolio Individual Assets

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

Relationship between the Variance of a Portfolios Return and the Number of Securities in the Portfolio

We can never eliminate risk no matter how many securities we have in our portfolio. The variance (risk) of portfolio drops, but can only reach a floor of covariance. i.e. the lowest risk can drop is equal the covariance Total risk of = risk individual sec (diversifiable risk) Portfolio risk + Unsystematic

Portfolio Risk as a Function of the Number of Stocks in the Portfolio

In a large portfolio the variance terms are effectively diversified away, but the covariance terms are not.

Diversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique Risk Portfolio risk cov Nondiversifiable risk; Systematic Risk; Market Risk n Thus diversification can eliminate some, but not all of the risk of individual securities.

5.

Optimal Risky Portfolio with a Risk-Free Asset

return

100% stocks

rf
100% bonds

In addition to stocks and bonds, consider a world that also has risk-free securities like T-bills (Government bond)

6.

Riskless Borrowing and Lending

An investor could combine a risky investment with an investment in a riskless or risk-free security, such as an investment in Treasury bills or government bond. SD of the risk-free security = 0

Optimal Portfolio

Is the portfolio that will give an investor the highest return. Problems associated with identifying optimal portfolio:

It is unrealistic to assume that the investors can borrow at the risk free rate. It requires knowledge of the risk and return of all risky investments. It is expensive to construct optimal portfolio small investors Market portfolio changes over time due to changes in rf rate of return, feasible sets and efficient frontier.

return

100% stocks Balanced fund

rf
100% bonds

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

return rf

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

Market Equilibrium

Possible when all investors are assumed to have homogeneous expectations for expected returns, variances and covariances. Thus, all investors have the same optimal portfolio. Homogeneous expectations:

Investors have the same expected returns, variances and covariance. Hence all investors will have the same efficient set. Thus, all investors have the same optimal portfolio of risky assets and also a diversified portfolio.

7.
return

Market Equilibrium

M rf

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

Market Equilibrium
return
100% stocks Balanced fund

rf
100% bonds

Just where the investor chooses along the Capital Asset Line depends on his risk tolerance. The big point though is that all investors have the same CML.

Market Equilibrium
return

100% stocks Optimal Risky Portfolio

rf
100% bonds

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

8.

Optimal Risky Portfolio with a Risk-Free Asset

return

100% stocks First Optimal Risky Portfolio Second Optimal Risky Portfolio

r r

1 f 0 f

100% bonds

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

9. Definition of Risk When Investors Hold the Market Portfolio

Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta (b)of the security. Beta measures the sensitivity or responsiveness of a change in the return of an individual stock to the change in return of market portfolio. Market portfolio is proxied by broad-based index

Beta measures the responsiveness of a security to movements in the market portfolio.

bi =

Cov ( Ri , RM )

Concept of beta: Market beta = 0 0.5 for every 1% movement in the market, the stock is expected to move 0.5% in the same direction (less volatile) 2.5 for every 1% movement in the market, the stock is expected to move 2.5% in the same direction. (highly volatile) -0.5 the stock is expected to move 0.5% for every 1% movement in market in different direction.

2 ( RM )

Beta is the best measure of risk of the security when hold a large and diversified portfolio.
Because, in a large and diversified portfolio, the only risk left is the systematic risk and unsystematic risk is no more relevant to the portfolio.

The Formula for Beta

bi =

Cov ( Ri , RM )

2 ( RM )

Clearly, your estimate of beta will depend upon your choice of a proxy for the market portfolio.

It means that ve beta stock is expected to do well when the market does poorly, vice versa. As a result, adding a ve beta security to a large , diversified portfolio can reduce the risk of the portfolio. CAPM is one of the model that can be used to explain the relationship between the risk and required rate of return on assets when investors hold a well diversified portfolio.

10. Relationship between Risk and Expected Return (CAPM)

Expected Return on the Market:
R M = RF Market Risk Premium

Expected return on an individual security:

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

This applies to individual securities held within welldiversified portfolios.

Expected Return on an Individual Security

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

Ri = RF i ( RM RF )
Expected return on a security
=

RiskBeta of the + free rate security

Market risk premium

Assume bi = 0, then the expected return is RF. Assume bi = 1, then Ri = RM

Relationship Between Risk & Expected Return

Expected return

Ri = RF i ( RM RF ) RM RF
1.0 b

Relationship Between Risk & Expected Return

Expected return

13.5% 3%

i = 1.5

RM =10% R i = 3% 1.5 (10% 3%) = 13.5%

RF = 3%

1.5

For example Let's say that the current risk free-rate is 5%, and the S&P 500 is expected to return to 12% next year. You are interested in determining the return that Joe's Oyster Bar Inc (JOB) will have next year. You have determined that its beta value is 1.9. The overall stock market has a beta of 1.0, so JOB's beta of 1.9 tells us that it carries more risk than the overall market; this extra risk means that we should expect a higher potential return than the 12% of the S&P 500. We can calculate this as the following:

Required (or expected) Return

Ri = R ( RM R ) F i F = 5% + 1.9(12% - 5%)
= 18.3%

What CAPM tells us is that Joe's Oyster Bar has a required rate of return of 18.3%. So, if you invest in JOB, you should be getting at least 18.3% return on your investment. If you don't think that JOB will produce those kinds of returns for you, then you should consider investing in a different company.

11. Summary and Conclusions

This chapter sets forth the principles of modern portfolio theory. The expected return and variance on a portfolio of two securities A and B are given by (weighted average)
R = x (R ) x (R ) P A A B B

2 = (x )2 (x )2 2(x )(x ) P A A B B B B A A AB

By varying xA, one can trace out the efficient set of portfolios. We graphed the efficient set for the two-asset case as a curve, pointing out that the degree of curvature reflects the diversification effect: the lower the correlation between the two securities, the greater the diversification.
The same general shape holds in a world of many assets.

The efficient set of risky assets can be combined with riskless borrowing and lending. In this case, a rational investor will always choose to hold the portfolio of risky securities represented by the market portfolio.

Then, with borrowing or lending, the investor selects a point along the CML.

return

M
rf

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

bi =

Cov( Ri , RM )

2 ( RM )

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

Ri = RF i ( RM RF )