RETURN AND RISK

RETURN
Why do people invest?
By investing (saving money now instead of spending
it), individuals can tradeoff present consumption for a
larger future consumption.

They have to be compensated for:

The time the funds are committed
The expected rate of inflation
Uncertainty of future flow of funds
TYPES OF RETURN
Realized Return: Historical

Expected Return: Futuristic

Realized vs Expected
Expected more relevant
but historical returns provides a base
Quantitative Measures of Return
Holding Period Returns

Total holding period return consists of two

components:
capital appreciation or depreciation
income.
 Return Components
Returns consist of two elements:
Periodic cash flows such as interest or dividends (income
return)
Price appreciation or depreciation (capital gain or loss)

Total Return (%) =Dividend or Interest Yield

+
Capital Gain/or Loss (in %)
Measuring Returns

CFt (PE PB )
TR
PB

TR is Total Return
CFt is cash flows received as interest or dividend during a
given time period
PE is price at the end of the period or the sale price
PB is price at the beginning of the period or purchase price
 An Example
100 shares of ACC was purchased at Rs. 1000 per
share and sold one year later at Rs. 1130 per share.
A dividend of Rs. 10 per share is paid by the
company. Find the Total Returns for the year.

14%
 An investors bought 100 shares of Wipro a year back at the
prevailing market price of Rs. 500 per share. Assuming that
Wipro declared a dividend of Rs. 10 per share at the end of
the year and the share price of Wipro, end of the year, was
quoted at Rs.600 per share.
What is the return earned by the investor if he sells the
shares at the end of one year?

Capital Gain 20%; Dividend yield 2%; Total Return 22%

Average Rate of Return

The average rate of return is the sum of the various

one-period rates of return divided by the number
of periods.
Formula for the average rate of return is as
follows:
n
1 1
R = [ R1 R 2
n
Rn ]
n
R t
t =1
Returns from Stock ABC
Year Return (%)
1 19.0
2 14.0
3 22.0
4 -12.0
5 5.0

The Arithmetic mean or average return:

9.6%
 Geometric average / mean
= [(1+R1)(1+R2)..(1+Rn)]1/n 1

Year Return
1 0.19
2 0.14
3 0.22
4 -0.12
5 0.05
Year Return Return Relative (1+R)
1 0.19 1.19
2 0.14 1.14
3 0.22 1.22
4 -0.12 0.88
5 0.05 1.05

[(1.19)*(1.14)*(1.22)*(0.88)*(1.05)]1/5 1
= 1.0887 1
=.0887 = 8.87%
Which is better? AM or GM

Year January 1 December 31

2013 50 100
2014 100 50

AM = 25%
GM = 0%
Arithmetic Versus Geometric
AM does not measure the compound growth rate
over time
Butit is suited for calculation of return in a single
period for various assets

GM reflects compound, cumulative returns over

more than one period

Still, AM is used by the practitioners

Another example on average return

Year Return
1 10% Geometric average return
2 -5% (1 Rg ) 4 (1 R1 ) (1 R2 ) (1 R3 ) (1 R4 )
3 20% Rg 4 (1.10) (.95) (1.20) (1.15) 1
4 15% .095844 9.58%

r1 r2 r3 r4
Arithmetic average return
4
10% 5% 20% 15%
10%
4
Expected Returns

Expected return, E(RAsset), is an average of possible

returns from an investment, where each of these returns
is weighted by the probability that it will occur:

n
E RAsset pi Ri p1 R1 p2 R2 .... pn Rn
i 1
Example
 Expected rate of return on Bharat Food stock is:

= (0.30) (0.16) + (0.50) (0.11) + (0.20) (0.06) = 11.5%

Expected rate of return on Oriental Shipping stock is:

= (0.30) (0.40) + (0.50) (0.10) + (0.20) (-0.20) = 13.0%

RISK
It is the chance that actual return on an investment
will be different from its expected return.
Risk
Risk, in traditional terms, is viewed as a negative.
The Chinese symbols for risk give a much better description of
risk (Source: Damodaran)

The first symbol is the symbol for danger, while the second
is the symbol for opportunity, making risk a mix of danger
and opportunity.
RISK RETURN TRADE-OFF
Higher the risk, higher the expected return
List of securities with increasing risk
TreasuryBills (zero risk)
Corporate Bonds

Stocks
 RISK RETURN TRADE-OFF

25%

20%
Expected Return

15%

10%

5%

0%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

Risk
Measurement of Risk
Standard Deviation
It is a measure of the total risk of an asset or a portfolio

Beta
It is a measure of the systematic risk of a security.
It is a relative measure of risk- the risk of an individual
stock relative to the market portfolio of all stocks.
Variance and Standard Deviation

Formulae for calculating variance and standard

deviation:

Standard deviation = Variance

R
n 2
1

2
R
n 1
t
t 1

( R1 R) 2 ( R2 R) 2 ( RT R) 2
SD VAR
n 1
n is used for population and n -1 for sample
Example

Period Return
1 0.15
2 0.12
3 0.20
4 -0.10
5 0.14
6 0.09
Solution
Square of
Period Return Deviation Deviation
1 0.15 0.05 0.00250
2 0.12 0.02 0.00040
3 0.20 0.10 0.01000
4 -0.10 -0.20 0.04000
5 0.14 0.04 0.00160
6 0.09 -0.01 0.00010

Average 0.1 sum 0.05460

divide by n divide by n-1
Variance .0091 0.0109
SD .0954 0.1045
 Estimating Risk
Done by assigning probabilities to each outcome
 Risk of Expected Return

Measuring the Risk of Expected Return

The Variance Measure

Variance ( )
n

2
(Pr obability ) x Possible Expected
( )
i 1
Return Return
n
Pi [ Ri E ( Ri )]2
i 1
Risk of Expected Return
Standard Deviation (): It is the square root of the
variance and measures the total risk

n
Pi [ Ri E ( Ri )]
i 1
2
Example
Returns in finance are assumed to have
a Normal Distribution
 Completely characterized by 2 parameters: Expected
return and standard deviation of returns

You expect 68.3% of returns to lie within +/- one SD

You expect 95.4% of returns to lie within +/- two SD
You expect 99.7% of returns to lie within +/- three SD
You forecast a return of 12% for an asset and
estimate its SD of annual return to be 22%

A 68.3% probability of returns lying between

-10% (12-1*22) and 34% (12+1*22)

A 95.4% probability of returns lying between

-32% (12-2*22) and 56% (12+2*22)

A 99.7% probability of returns lying between

-54% (12-3*22) and 78% (12+3*22)
Coefficient of variation

It measures the risk per unit of expected return and is a

relative measure of risk.

provides a more meaningful basis for comparison when

the expected returns on two alternatives are not the
same
 Standard Deviation of Return
CV
Expected Rate of Return

E (R )

Lesser the value lesser the risk per unit of expected

return
 The expected return and standard deviation for
Company 1 is 4 percent and 7.56 percent respectively.
The expected return and standard deviation for
Company 2 is 10 percent and 9 percent respectively.

In which company would you invest your money ?

 SD Return CV
A 0.0756 0.04 =.0756/.04
= 1.89
B 0.09 0.10 0.09/0.10
= 0.90

B
Portfolio Risk and Return

A portfolio is a bundle or a combination of

individual assets or securities.

By investing in two or more assets whose values do

not always move in same direction at same time,
investors can reduce risk of investments or portfolio
Portfolio Return
Weighted average of the individual security
expected returns
Each portfolio asset has a weight, w, which represents
the percent of the total portfolio value

n
E(R p ) w iE(R i )
i1
 Portfolio return

You would like to create a portfolio of 3 stocks.

You would buy the mentioned quantity at the buy price
mentioned.
You are able to sell it after one year at the sell price
mentioned.

Calculate the return on the portfolio created.

Quantity Buy Price Sell Price

A 100000 10 12
B 200000 20 21
C 500000 30 33
 Quantity Buy Beginning Sell Return Wt
Price market Price
Value

A 100000 10 1,000,000 12 (12-10)/10 20% 1mn/20mn .05

B 200000 20 4,000,000 21 (21-20)/20 5% 4mn/20mn .20

C 500000 30 15,000,000 33 (33-30)/30 10% 15mn/20mn .75

Total 20,000,000

Return*Wt

20*0.05 1

5*0.20 1

10*0.75 7.5

Portfolio 9.5
return
Portfolio Risk
Portfolio risk is not the weighted average of the
risks of the individual securities in the portfolio
 Standard Deviation of a Portfolio

The Formula
n 2 2 n n
port w i i w i w jCovij
i1 i1 j1
ij
where :
port the standard deviation of the portfolio
Wi the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
i2 the variance of rates of return for asset i
Cov ij the covariance between the rates of return for assets i and j,
where Cov ij ij i j
Risk of a two asset portfolio

p w12 12 w22 22 2 cov12 w1w2

p w12 12 w22 22 2 12 w1w2 1 2

Covariance of Returns

A measure of the degree to which two variables move

together relative to their individual mean values over time
Historical covariance for two assets, 1 and 2 is:

where n is the number of periods

 A positive covariance means that the returns of the
two securities move in the same direction

A negative covariance implies that the returns of the

two securities move in opposite direction.

Zero covariance: returns are unrelated

Calculate the covariance

Time Return 1 Return 2

1 -10% 5%
2 15% 12%
3 18% 19%
4 22% 15%
5 27% 12%
 Deviation
Deviation from
Time Return 1 from mean Return 2 mean Dev1*Dev2
1 -0.1 -0.244 0.05 -0.076 0.018544
2 0.15 0.006 0.12 -0.006 -0.000036
3 0.18 0.036 0.19 0.064 0.002304
4 0.22 0.076 0.15 0.024 0.001824
5 0.27 0.126 0.12 -0.006 -0.000756
Sum=
Mean =0.144 Mean= 0.126 0.02188

Cov sum/n-1 0.00547

Covariance of Returns

Estimated Covariance
Returns on securities 1 and 2 under 5 possible
states:
State Probability Return 1 Return 2
1 0.1 -10% 5%
2 0.3 15 12
3 0.3 18 19
4 0.2 22 15
5 0.1 27 12
Estimated Covariance
Deviation Deviation
from from Prob*Dev
Prob Return 1 Product mean Return 2 Product mean 1*Dev2
0.1 -0.1 -0.01 -0.26 0.05 0.005 -0.09 0.00234
0.3 0.15 0.045 -0.01 0.12 0.036 -0.02 0.00006
0.3 0.18 0.054 0.02 0.19 0.057 0.05 0.0003
0.2 0.22 0.044 0.06 0.15 0.03 0.01 0.00012
0.1 0.27 0.027 0.11 0.12 0.012 -0.02 -0.00022
Sum =
ER 0.16 ER 0.14 0.0026
 Covariance and Correlation
The correlation coefficient is obtained by standardizing the
covariance i.e. by dividing the covariance by the product of the
individual standard deviations
A measure that determines the degree to which two variable's
movements are associated.

Computing correlation from covariance

Cov
12

12

1 2

12 the correlation coefficient of returns

1 the standard deviation of R1
2 the standard deviation of R2
Correlation Coefficient
The correlation coefficient in the example where
Covariance was 0.00547:

0.00547 / (0.14363*0.05128)
=0.74 approx

Range of correlation coefficient

+1.0 = perfect positive correlation
-1.0 = perfect negative (inverse) correlation
0.0 = zero correlation
Negative Correlation
Calculating Portfolio Risk
Encompasses three factors
Variance (risk) of each security
Covariance between each pair of securities

Portfolio weights for each security

Example
A portfolio consists of 2 securities: 1 and 2 in the proportions
0.6 and 0.4. The standard deviations are 10% and 16%. The
coefficient of correlation is 0.5
What is the SD of the portfolio?

10.74%

How would it be affected if the correlation coefficient

changes?
Changing risk due to changing correlation

Correl SD
1 12.40%
0.5 10.74%
0 8.77%
-0.5 6.21%
-1 0.40%

Can the risk be reduced to ZERO if

correlation coefficient is -1?
Formula for weights (when correlation is -1) to
drive down the risk of a 2 stock portfolio to zero

= 0.16 /(0.1+0.16)
= 0.615384615

w2 = 1- 0.615384615
= 0.384615385

SD of portfolio now is: 0

TYPES OF RISK
General component Specific component

Systematic Risk Unsystematic Risk

Or Market Risk Or Non-market Risk
Or Non-diversifiable Risk Or Diversifiable Risk
 Unsystematic risk
arises from the unique uncertainties of individual securities.
Unsystematic risk can be totally reduced through
diversification.
Sources: Business, Financial, Firm specific incidents

Systematic risk
arises on account of the economy-wide uncertainties and the
tendency of individual securities to move together with
changes in the market.
Cannot be reduced through diversification.
Sources: Inflation, interest rates, Political, Exchange rates, etc.
 Systematic and Unsystematic Risk

Standard deviation measures Total Risk

Total Risk = Systematic + Unsystematic risk.

Because investors can eliminate unsystematic risk through

diversification, market rewards only systematic risk.
Benefits of Diversification

Total Risk ()

Unique (Non-systematic) Risk Market or

systematic risk
is risk that
cannot be
eliminated from
the portfolio by
Market (Systematic) Risk investing the
portfolio into
more and
different
securities.
Number of Securities

Most of the diversification benefit can often be

achieved with as few as 15 to 20 stocks
Source: Booth and Cleary
How to measure systematic risk
With the help of BETA
Beta

im
2
m Covariance of stock
with the market

Variance of the market

CALCULATION OF BETA
Stock Market
YEAR Return (%) Return (%)
1 10 12
2 6 5
3 13 18
4 -4 -8
5 13 10
6 14 16
7 4 7
8 18 15
9 24 30
10 22 25
YEAR Return Return
Stock Market
Ri - Avg Rj Rm Avg Rm (Ri Avg Ri)* (Rm - AvgRm)^2
Ri Rm (Rm Avg Rm)
1 0.1 0.12 -0.02 -0.01 0.0002 0.0001
2 0.06 0.05 -0.06 -0.08 0.0048 0.0064
3 0.13 0.18 0.01 0.05 0.0005 0.0025
4 -0.04 -0.08 -0.16 -0.21 0.0336 0.0441
5 0.13 0.1 0.01 -0.03 -0.0003 0.0009
6 0.14 0.16 0.02 0.03 0.0006 0.0009
7 0.04 0.07 -0.08 -0.06 0.0048 0.0036
8 0.18 0.15 0.06 0.02 0.0012 0.0004
9 0.24 0.3 0.12 0.17 0.0204 0.0289
10 0.22 0.25 0.1 0.12 0.012 0.0144

Average 0.12 0.13 Total 0.0778 0.1022

Using n-1 Cov(Rj,Rm) 0.00864

VARm 0.01136

Beta 0.76125
How is beta interpreted?
Beta of the market = 1
If b = 1.0, stock has risk similar to the market.
If b > 1.0, stock is riskier than market.
If b < 1.0, stock is less risky than market.
Most stocks have betas in the range of 0.5 to 1.5.

Can a stock have a negative beta?

 Market Model and Beta

Plot of the return of the security on the return of the

market.

Ri i i Rm ei

i = expected return of stock i if markets return is zero

i(Rm )= component of return due to market movements
ei = component of return due to unexpected firm-specific
events
 Run a regression with returns on the stock in question
plotted on the Y axis and returns on the market
portfolio plotted on the X axis.

The slope of the regression line, which measures

relative volatility, is defined as the stocks beta
coefficient, or .
Estimating with regression

Security Returns

Slope = i
Return on
market %

Ri = i + iRm + ei
10-75
 Beta for the data given in the example

0.3

Stock Returns
0.25

0.2

0.15

0.1

0.05

0
-0.1 -0.05 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35
-0.04
-0.05

-0.1

Market Returns
Ways to calculate BETA in EXCEL

Function
slope 0.761252
linest 0.761252
Calculating Beta in Practice
Many analysts use the NSE or BSE 500 to find the
market return.
Analysts typically use four or five years of monthly
returns to establish the regression line.
Some analysts use 52 weeks of weekly returns.
Rf is taken from 91 day T Bills rate or 10 year GOI
Bonds rate
 Portfolio Theory

Pioneered by Harry Markowitz.

He showed how risk-averse investors can construct
Efficient Portfolios
An efficient portfolio provides:
the greatest expected return for a given level of risk, or
the lowest risk for a given expected return.

Source: Investopedia
 Sharpe took the Portfolio Theory further by adding
a risk free investment and came up with the Capital
Asset Pricing Model (CAPM)
Relationship between Risk and Expected Return

Expected return on an individual security:

R i RF i ( R M RF )

Market Risk Premium

This applies to individual securities held within well-diversified

portfolios.
Expected Return on an Individual Security

This formula is called the Capital Asset Pricing

Model (CAPM)
R i RF i ( R M RF )
Expected
Risk-free Beta of the Market risk
return on a = rate +
security premium
security

Assume i = 0, then the expected return is RF.

Assume i = 1, then Ri RM
 The capital asset pricing model (CAPM) is a model
that provides a framework to determine the required
rate of return on an asset and

indicates the relationship between return and risk

of the asset.
Relationship Between Risk & Expected Return

Expected return

Security Market Line

(SML)

R
M

RF

1.0

Limitations of CAPM

It is based on the following assumptions.

1. Investors can borrow and lend freely at a riskless rate of interest.
2. The market is perfect: there are not taxes; there are no transactions
costs; securities are completely divisible.
3. All investors have identical expectations about expected returns,
standard deviations, and correlation coefficients for all securities.
4. All investors have the same one-period investment time horizon.
5. All investors can borrow or lend money at the risk-free rate of return
(RF).
6. There are many investors, and no single investor can affect the price
of a stock through his or her buying and selling decisions. Therefore,
investors are price-takers.

Betas do not remain stable over time.

The Capital Asset Pricing Model

Determine the required Rate of Return for each

Risk-free rate is 5% and the market return is 9%
Stock A B C D E
Beta 0.70 1.00 1.15 1.40 -0.30
Applying the CAPM
E(RA) = 0.05 + 0.70 (0.09-0.05) = 0.078 = 7.8%
E(RB) = 0.05 + 1.00 (0.09-0.05) = 0.090 = 9.0%
E(RC) = 0.05 + 1.15 (0.09-0.05) = 0.096 = 9.6%
E(RD) = 0.05 + 1.40 (0.09-0.05) = 0.106 = 10.6%
E(RE) = 0.05 + -0.30 (0.09-0.05) = 0.038 = 3.8%
Implications of CAPM

Investors can expect returns from their investment according

to the risk.
It implies a linear relationship between the assets expected
return and its beta.
Challenges to CAPM
Empirical tests suggest:
CAPM does not hold well in practice:
Intercept is higher that RF
Slope is less than what is predicted by theory
Beta possesses no explanatory power for predicting stock returns
(Fama and French, 1992)
Because of the problems with CAPM, other models have been
developed including:
Fama-French (FF) Model
Arbitrage Pricing Theory (APT)

CAPM remains in widespread use despite the limitations.

Advantages include relative simplicity and intuitive logic.
CAPM in practice
Two ways to calculate required rate of return
Calculate all the components individually
http://www.investing.com/rates-bonds/india-government-
bonds for risk free rate

Calculate
the market risk premium and other
components individually
MRP for India ranges between 8 to 13% according to a
study
 Required return for a portfolio:
E(R n Asset Portfolio) = Rrf + n Asset Portfolio(E[Rm] Rrf)

Beta of a portfolio is the weights multiplied with individual betas:

n
n Asset Portfolio x i i
x11 x22 x3 3 ... xn n
i 1

Find the beta of a portfolio having 3 securities A, B, and

C with a weightage of 0.5, 0.2 and 0.3 and respective
beta of 1, 1.5 and 2

Beta of portfolio: 1.4

The Return-Risk Relationship
The expected return should be positively related to
the risk
Over long periods of time, like 20 years, the
historical relation between return and risk should
be positive
Over relatively short periods of time like one year,
the trade-off between return and risk is always
expected to be positive but may turn out to be
negative.