Chapter 8 - Risk, Return, and Portfolio Theory

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary Chapter 8 Risk, Return and Portfolio Theory
Prepared by Ken Hartviksen
CHAPTER 8 Risk, Return and Portfolio Theory
Lecture Agenda
Learning Objectives Important Terms Measurement of Returns Measuring Risk Expected Return and Risk for Portfolios The Efficient Frontier Diversification Summary and Conclusions
Concept Review Questions
CHAPTER 8 Risk, Return and Portfolio Theory 8-3
Learning Objectives
The difference among the most important types of returns How to estimate expected returns and risk for individual securities What happens to risk and return when securities are combined in a portfolio What is meant by an efficient frontier Why diversification is so important to investors
8-4
Important Chapter Terms

Arithmetic mean Attainable portfolios Capital gain/loss Correlation coefficient Covariance Day trader Diversification Efficient frontier Efficient portfolios Ex ante returns Ex post returns Expected returns Geometric mean Income yield Mark to market Market risk Minimum variance frontier Minimum variance portfolio Modern portfolio theory Nave or random diversification Paper losses Portfolio Range Risk averse Standard deviation Total return Unique (or non-systematic) or diversifiable risk Variance 8-5
Introduction to Risk and Return

Risk, Return and Portfolio Theory
Introduction to Risk and Return

Risk and return are the two most important attributes of an investment. Research has shown that the two are linked in the capital markets and that generally, higher returns can only be achieved by taking on greater risk. Risk isnt just the potential loss of return, it is the potential loss of the entire investment itself (loss of both principal and interest). Consequently, taking on additional risk in search of higher returns is a decision that should not be taking lightly.
Return %
Risk Premium
RF
Real Return Expected Inflation Rate
Ris k
8-7
Measuring Returns
Measuring Returns
Introduction
Ex Ante Returns Return calculations may be done before-thefact, in which case, assumptions must be made about the future Ex Post Returns Return calculations done after-the-fact, in order to analyze what rate of return was earned.
CHAPTER 8 Risk, Return and Portfolio Theory 8-9
Measuring Returns
Introduction In Chapter 7 you learned that the constant growth DDM can be decomposed into the two forms of income that equity investors may receive, dividends and capital gains.
D1 kc = + [ g ] = [ Income / Dividend Yield] + [ Capital Gain (or loss) Yield] P0

WHEREAS Fixed-income investors (bond investors for example) can expect to earn interest income as well as (depending on the movement of interest rates) either capital gains or capital losses.
8 - 10
Measuring Returns
Income Yield
Income yield is the return earned in the form of a periodic cash flow received by investors. The income yield return is calculated by the periodic cash flow divided by the purchase price.
[8-1]
Income yield =
CF1 P0
Where CF1 = the expected cash flow to be received P0 = the purchase price
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 11
Income Yield
Stocks versus Bonds
Figure 8-1 illustrates the income yields for both bonds and stock in Canada from the 1950s to 2005
The dividend yield is calculated using trailing rather than forecast earns (because next years dividends cannot be predicted in aggregate), nevertheless dividend yields have exceeded income yields on bonds. Reason risk The risk of earning bond income is much less than the risk incurred in earning dividend income.
(Remember, bond investors, as secured creditors of the first have a legally-enforceable contractual claim to interest.)
(See Figure 8 -1 on the following slide)
8 - 12
Ex post versus Ex ante Returns

Market Income Yields
8-1 FIGURE
Insert Figure 8 - 1
8 - 13
Common Share and Long Canada Bond Yield Gap

Table 8 1 illustrates the income yield gap between stocks and bonds over recent decades The main reason that this yield gap has varied so much over time is that the return to investors is not just the income yield but also the capital gain (or loss) yield as well.
Table 8-1 Average Yield Gap
Measuring Returns
Average Yield Gap 1950s 1960s 1970s 1980s 1990s 2000s Overall
(%) 0.82 2.35 4.54 8.14 5.51 3.55 4.58
8 - 14
Measuring Returns
Dollar Returns
Investors in market-traded securities (bonds or stock) receive investment returns in two different form:
Income yield Capital gain (or loss) yield
The investor will receive dollar returns, for example:

$1.00 of dividends Share price rise of $2.00 To be useful, dollar returns must be converted to percentage returns as a function of the original investment. (Because a $3.00 return on a $30 investment might be good, but a $3.00 return on a $300 investment would be unsatisfactory!) CHAPTER 8 Risk, Return and Portfolio Theory 8 - 15
Converting Dollar Returns to Percentage Returns
Measuring Returns
An investor receives the following dollar returns a stock investment of $25:

$1.00 of dividends Share price rise of $2.00 The capital gain (or loss) return component of total return is calculated: ending price minus beginning price, divided by beginning price
[8-2]
P $27 - $25 1P 0 Capital gain (loss) return = = = .08 = 8% P0 $25

Measuring Returns
Total Percentage Return
The investors total return (holding period return) is:

Total return = Income yield + Capital gain (or loss) yield CF + P P = 1 1 0 P0 CF P P = 1+ 1 0 P0 P0 $1.00 $27 $25 = + = 0.04 + 0.08 = 0.12 = 12% $25 $25
[8-3]
8 - 17
Measuring Returns
Total Percentage Return General Formula
The general formula for holding period return is:

Total return = Income yield + Capital gain (or loss) yield
[8-3]
CF1 + P 1P 0 = P0 CF1 P 1P 0 = + P P 0 0
8 - 18
Measuring Average Returns

Ex Post Returns
Measurement of historical rates of return that have been earned on a security or a class of securities allows us to identify trends or tendencies that may be useful in predicting the future. There are two different types of ex post mean or average returns used:
Arithmetic average Geometric mean

Arithmetic Average
[8-4]
Arithmetic Average (AM) =
r
i =1
Where:
ri = the individual returns n = the total number of observations
Most commonly used value in statistics Sum of all returns divided by the total number of observations

Geometric Mean
[8-5]
Geometric Mean (GM) = [( 1 + r1 )( 1 + r2 )( 1 + r3 )...( 1 + rn )] -1
1 n
Measures the average or compound growth rate over multiple periods.
8 - 21

Geometric Mean versus Arithmetic Average
If all returns (values) are identical the geometric mean = arithmetic average. If the return values are volatile the geometric mean < arithmetic average The greater the volatility of returns, the greater the difference between geometric mean and arithmetic average.
(Table 8 2 illustrates this principle on major asset classes 1938 2005)
8 - 22

Average Investment Returns and Standard Deviations
Table 8 - 2 Average Investment Returns and Standard Deviations, 1938-2005 Annual Arithmetic Average (%) Government of Canada treasury bills Government of Canada bonds Canadian stocks U.S. stocks
Source: Data are from the Canadian Institute of Actuaries
Annual Geometric Mean (%) 5.11 6.24 10.60 11.76
Standard Deviation of Annual Returns (%) 4.32 9.32 16.22 17.54
5.20 6.62 11.79 13.15
The greater the difference, the greater the volatility of annual returns.
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Measuring Expected (Ex Ante) Returns

While past returns might be interesting, investors are most concerned with future returns. Sometimes, historical average returns will not be realized in the future. Developing an independent estimate of ex ante returns usually involves use of forecasting discrete scenarios with outcomes and probabilities of occurrence.
Estimating Expected Returns

Estimating Ex Ante (Forecast) Returns
The general formula
[8-6]
Expected Return (ER) = (ri Prob i )

i =1
Where:
ER = the expected return on an investment Ri = the estimated return in scenario i Probi = the probability of state i occurring

Estimating Ex Ante (Forecast) Returns
Example: This is type of forecast data that are required to make an ex ante estimate of expected return.
Possible Returns on Stock A in that State 30% 12% -25%
State of the Economy Economic Expansion Normal Economy Recession
Probability of Occurrence 25.0% 50.0% 25.0%
8 - 26

Estimating Ex Ante (Forecast) Returns Using a Spreadsheet Approach
Example Solution: Sum the products of the probabilities and possible returns in each state of the economy.
(1) (3) (4)=(2)(1) Possible Weighted Returns on Possible Probability of Stock A in that Returns on Occurrence State the Stock 25.0% 30% 7.50% 50.0% 12% 6.00% 25.0% -25% -6.25% Expected Return on the Stock = 7.25% (2)
State of the Economy Economic Expansion Normal Economy Recession
8 - 27

Estimating Ex Ante (Forecast) Returns Using a Formula Approach
Example Solution: Sum the products of the probabilities and possible returns in each state of the economy.
Expected Return (ER) = (ri Prob i )

i =1
= (r1 Prob1 ) + (r2 Prob 2 ) + (r3 Prob 3 ) = (30% 0.25) + (12% 0.5) + (-25% 0.25) = 7.25%
8 - 28
Measuring Risk
Risk
Probability of incurring harm For investors, risk is the probability of earning an inadequate return.
If investors require a 10% rate of return on a given investment, then any return less than 10% is considered harmful.
8 - 30
Risk
Illustrated
The range of total possible returns on the stock A runs from -30% to more than +40%. If the required return on the stock is 10%, then those outcomes less than 10% represent risk to the investor.
Probability
Outcomes that produce harm
-30% -20%
-10%
0%
10% 20% 30% 40% Possible Returns on the Stock
8 - 31
Range
The difference between the maximum and minimum values is called the range
Canadian common stocks have had a range of annual returns of 74.36 % over the 1938-2005 period Treasury bills had a range of 21.07% over the same period.
As a rough measure of risk, range tells us that common stock is more risky than treasury bills.
Differences in Levels of Risk

Illustrated
The wider the range of probable outcomes the greater the risk of the investment. Outcomes that produce harm Probability
A is a much riskier investment than B
-30% -20%
-10%
0%
10% 20% 30% 40% Possible Returns on the Stock
8 - 33
Historical Returns on Different Asset Classes

Figure 8-2 illustrates the volatility in annual returns on three different assets classes from 1938 2005. Note:
Treasury bills always yielded returns greater than 0% Long Canadian bond returns have been less than 0% in some years (when prices fall because of rising interest rates), and the range of returns has been greater than T-bills but less than stocks Common stock returns have experienced the greatest range of returns
(See Figure 8-2 on the following slide)
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Measuring Risk
Annual Returns by Asset Class, 1938 - 2005
FIGURE 8-2
8 - 35
Refining the Measurement of Risk

Standard Deviation ()
Range measures risk based on only two observations (minimum and maximum value) Standard deviation uses all observations.
Standard deviation can be calculated on forecast or possible returns as well as historical or ex post returns.
(The following two slides show the two different formula used for Standard Deviation)
8 - 36
Measuring Risk
Ex post Standard Deviation
[8-7]
Ex post =
2 ( r r ) i i =1
n 1
Where : = the standard deviation r = the average return ri = the return in year i n = the number of observations
_
8 - 37
Measuring Risk
Example Using the Ex post Standard Deviation
Problem Estimate the standard deviation of the historical returns on investment A that were: 10%, 24%, -12%, 8% and 10%. Step 1 Calculate the Historical Average Return
Arithmetic Average (AM) =
r
i =1
10 + 24 - 12 + 8 + 10 40 = = 8.0% 5 5
Step 2 Calculate the Standard Deviation

Ex post =
(r r )
i =1 i
n 1
(10 - 8) 2 + (24 8) 2 + (12 8) 2 + (8 8) 2 + (14 8) 2 = 5 1
2 2 + 16 2 20 2 + 0 2 + 2 2 4 + 256 + 400 + 0 + 4 664 = = = = 166 = 12.88% 4 4 4
8 - 38
Ex Post Risk
Stability of Risk Over Time
Figure 8-3 (on the next slide) demonstrates that the relative riskiness of equities and bonds has changed over time. Until the 1960s, the annual returns on common shares were about four times more variable than those on bonds. Over the past 20 years, they have only been twice as variable. Consequently, scenario-based estimates of risk (standard deviation) is required when seeking to measure risk in the future. (We cannot safely assume the future is going to be like the past!) Scenario-based estimates of risk is done through ex ante estimates and calculations. CHAPTER 8 Risk, Return and Portfolio Theory 8 - 39
Relative Uncertainty
Equities versus Bonds
FIGURE 8-3
8 - 40
Measuring Risk
Ex ante Standard Deviation
A Scenario-Based Estimate of Risk
[8-8]
Ex ante =
2 (Prob ) ( r ER ) i i i i =1
8 - 41
Scenario-based Estimate of Risk

Example Using the Ex ante Standard Deviation Raw Data
GIVEN INFORMATION INCLUDES: - Possible returns on the investment for different discrete states - Associated probabilities for those possible returns
State of the Economy Recession Normal Economic Boom
Probability 25.0% 50.0% 25.0%
Possible Returns on Security A -22.0% 14.0% 35.0%
8 - 42

Ex ante Standard Deviation Spreadsheet Approach
The following two slides illustrate an approach to solving for standard deviation using a spreadsheet model.
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First Step Calculate the Expected Return
Determined by multiplying the probability times the possible return.
State of the Economy Recession Normal Economic Boom Possible Returns on Security A Weighted Possible Returns -5.5% 7.0% 8.8% 10.3%
Probability 25.0% 50.0% 25.0%
-22.0% 14.0% 35.0% Expected Return =
Expected return equals the sum of the weighted possible returns. CHAPTER 8 Risk, Return and Portfolio Theory 8 - 44

Second Step Measure the Weighted and Squared Deviations Now multiply the square deviations by First calculate the deviation of their probability of occurrence. possible returns from the expected.
Deviation of Possible Return from Expected -32.3% 3.8% 24.8% Weighted and Squared Deviations 0.02600 0.00070 0.01531 0.0420 20.50%
State of the Economy Recession Normal Economic Boom
Possible Returns on Probability Security A 25.0% -22.0% 50.0% 14.0% 25.0% 35.0% Expected Return =
Weighted Possible Returns -5.5% 7.0% 8.8% 10.3%
Squared Deviations
0.10401 0.00141 0.06126 Variance = Standard Deviation =
Second, square those deviations The sum of the weighted and square deviations from the mean. The standard deviation is the square root is the variance percent (in squared terms. of thein variance percent terms). CHAPTER 8 Risk, Return and Portfolio Theory
8 - 45

Example Using the Ex ante Standard Deviation Formula
Possible Returns on Security A Weighted Possible Returns -5.5% 7.0% 8.8% 10.3% State of the Economy Recession Normal Economic Boom
Probability 25.0% 50.0% 25.0%
-22.0% 14.0% 35.0% Expected Return =
Ex ante =
(Prob ) (r ER )
i =1 i i i
2 2 2 = P 1 (r 1 ER1 ) + P 2 ( r2 ER2 ) + P 1 ( r3 ER3 )
= .25(22 10.3) 2 + .5(14 10.3) 2 + .25(35 10.3) 2 = .25(32.3) 2 + .5(3.8) 2 + .25(24.8) 2 = .25(.10401) + .5(.00141) + .25(.06126) = .0420 = .205 = 20.5%
8 - 46
Modern Portfolio Theory

Portfolios
A portfolio is a collection of different securities such as stocks and bonds, that are combined and considered a single asset The risk-return characteristics of the portfolio is demonstrably different than the characteristics of the assets that make up that portfolio, especially with regard to risk. Combining different securities into portfolios is done to achieve diversification.
8 - 48
Diversification
Diversification has two faces:
1. Diversification results in an overall reduction in portfolio risk (return volatility over time) with little sacrifice in returns, and 2. Diversification helps to immunize the portfolio from potentially catastrophic events such as the outright failure of one of the constituent investments. (If only one investment is held, and the issuing firm goes bankrupt, the entire portfolio value and returns are lost. If a portfolio is made up of many different investments, the outright failure of one is more than likely to be offset by gains on others, helping to make the portfolio immune to such events.)
Expected Return of a Portfolio

Modern Portfolio Theory The Expected Return on a Portfolio is simply the weighted average of the returns of the individual assets that make up the portfolio:
[8-9]
ER p = ( wi ERi )
i =1
The portfolio weight of a particular security is the percentage of the portfolios total value that is invested in that security.
Expected Return of a Portfolio

Example Portfolio value = $2,000 + $5,000 = $7,000 rA = 14%, rB = 6%, wA = weight of security A = $2,000 / $7,000 = 28.6% wB = weight of security B = $5,000 / $7,000 = (1-28.6%)= 71.4%
ER p = ( wi ERi ) = (.286 14%) + (.714 6% )

i =1
= 4.004% + 4.284% = 8.288%
8 - 51
Range of Returns in a Two Asset Portfolio
In a two asset portfolio, simply by changing the weight of the constituent assets, different portfolio returns can be achieved. Because the expected return on the portfolio is a simple weighted average of the individual returns of the assets, you can achieve portfolio returns bounded by the highest and the lowest individual asset returns.
8 - 52
Example 1: Assume ERA = 8% and ERB = 10%
(See the following 6 slides based on Figure 8-4)
8 - 53
Expected Portfolio Return

Affect on Portfolio Return of Changing Relative Weights in A and B
8 - 4 FIGURE
10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00
ERB= 10%
%n ru t e R de t ce px E
ERA=8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 54

8 - 4 FIGURE
A portfolio manager can select the relative weights of the two assets in the portfolio to get a desired return between 8% (100% invested in A) and 10% (100% invested in B)
ERB= 10%
10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00
ERA=8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 55

8 - 4 FIGURE
10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00
ERB= 10%
The potential returns of the portfolio are bounded by the highest and lowest returns of the individual assets that make up the portfolio.
ERA=8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 56

8 - 4 FIGURE
10.50 10.00 9.50 9.00 8.50 8.00
ERB= 10%
The expected return on the portfolio if 100% is invested in Asset A is 8%.
ERA=8%
7.50 7.00
ER p = wA ER A + wB ERB = (1.0)(8%) + (0)(10%) = 8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 57

8 - 4 FIGURE
10.50 10.00 9.50 9.00 8.50
The expected return on the portfolio if 100% is invested in Asset B is 10%.
ERB= 10%
ER p = wA ER A + wB ERB = (0)(8%) + (1.0)(10%) = 10% %n ru t e R de t ce px E

8.00
ERA=8%
7.50 7.00
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 58

8 - 4 FIGURE
10.50 10.00 9.50 9.00 8.50 8.00
The expected return on the portfolio if 50% is invested in Asset A and 50% in B is 9%.
ERB= 10%
ER p = wA ERA + wB ERB = (0.5)(8%) + (0.5)(10%) = 4% + 5% = 9%

ERA=8%
7.50 7.00
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 59
Example 1: Assume ERA = 14% and ERB = 6%
(See the following 2 slides )
8 - 60

E(r)A= 14%, E(r)B= 6%
Expected return on Asset A = Expected return on Asset B = Weight of Asset A 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0% Weight of Asset B 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 14.0% 6.0% Expected Return on the Portfolio 6.0% 6.8% 7.6% 8.4% 9.2% 10.0% 10.8% 11.6% 12.4% 13.2% 14.0%
A graph of this relationship is found on the following slide.
8 - 61

E(r)A= 14%, E(r)B= 6%
Range of Portfolio Returns
Expected Return on Two Asset Portfolio 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00%
0. 0% 10 .0 % 20 .0 % 30 .0 % 40 .0 % 50 .0 % 60 .0 % 70 .0 % 80 .0 % 90 .0 % 10 0. 0 %
Weight Invested in Asset A
8 - 62
Expected Portfolio Returns

Example of a Three Asset Portfolio
Stock X Stock Y Stock Z
Relative Expected Weighted Weight Return Return 0.400 8.0% 0.03 0.350 15.0% 0.05 0.250 25.0% 0.06 Expected Portfolio Return = 14.70%
K. Hartviksen CHAPTER 8 Risk, Return and Portfolio Theory
8 - 63
Risk in Portfolios
Modern Portfolio Theory - MPT

Prior to the establishment of Modern Portfolio Theory (MPT), most people only focused upon investment returnsthey ignored risk. With MPT, investors had a tool that they could use to dramatically reduce the risk of the portfolio without a significant reduction in the expected return of the portfolio.
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Expected Return and Risk For Portfolios

Standard Deviation of a Two-Asset Portfolio using Covariance
[8-11]
p = ( wA ) 2 ( A ) 2 + ( wB ) 2 ( B ) 2 + 2( wA )( wB )(COVA, B )
Risk of Asset A adjusted for weight in the portfolio
Risk of Asset B adjusted for weight in the portfolio
Factor to take into account comovement of returns. This factor can be negative.
8 - 66
Expected Return and Risk For Portfolios

Standard Deviation of a Two-Asset Portfolio using Correlation Coefficient
[8-15]
p = ( wA ) 2 ( A ) 2 + ( wB ) 2 ( B ) 2 + 2( wA )( wB )( A, B )( A )( B )
Factor that takes into account the degree of comovement of returns. It can have a negative value if correlation is negative.
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Grouping Individual Assets into Portfolios

The riskiness of a portfolio that is made of different risky assets is a function of three different factors:
the riskiness of the individual assets that make up the portfolio the relative weights of the assets in the portfolio the degree of comovement of returns of the assets making up the portfolio
The standard deviation of a two-asset portfolio may be measured using the Markowitz model:
p = w + w + 2 wA wB A, B A B
2 A 2 A 2 B 2 B
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Risk of a Three-Asset Portfolio

The data requirements for a three-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae.
We need 3 (three) correlation coefficients between A and B; A and C; and B and C. a,b
B A
a,c b,c
C
2 2 2 2 2 2 p = A wA + B wB + C wC + 2wA wB A, B A B + 2 wB wC B ,C B C + 2 wA wC A,C A C
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Risk of a Four-asset Portfolio
The data requirements for a four-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae.
We need 6 correlation coefficients between A and B; A and C; A and D; B and C; C and D; and B and D. a,b
B A
a,c
a,d
D
b,c
b,d
C
c,d
8 - 70
Covariance
A statistical measure of the correlation of the fluctuations of the annual rates of return of different investments.
[8-12]
COV AB = Prob i (k A,i ki )(k B ,i - k B )

i =1
8 - 71
Correlation
The degree to which the returns of two stocks co-move is measured by the correlation coefficient (). The correlation coefficient () between the returns on two securities will lie in the range of +1 through - 1.
+1 is perfect positive correlation -1 is perfect negative correlation
[8-13]
AB =
COV AB A B
8 - 72
Covariance and Correlation Coefficient

Solving for covariance given the correlation coefficient and standard deviation of the two assets:
[8-14]
COV AB = AB A B
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Importance of Correlation
Correlation is important because it affects the degree to which diversification can be achieved using various assets. Theoretically, if two assets returns are perfectly positively correlated, it is possible to build a riskless portfolio with a return that is greater than the risk-free rate.
8 - 74
Affect of Perfectly Negatively Correlated Returns

Elimination of Portfolio Risk
Returns %
If returns of A and B are perfectly negatively correlated, a two-asset portfolio made up of equal parts of Stock A and B would be riskless. There would be no variability of the portfolios returns over time.
20%
15%
10% Returns on Stock A Returns on Stock B Returns on Portfolio 1 2 8 - 75
5%
Time 0
Example of Perfectly Positively Correlated Returns

No Diversification of Portfolio Risk
Returns %
If returns of A and B are perfectly positively correlated, a two-asset portfolio made up of equal parts of Stock A and B would be risky. There would be no diversification (reduction of portfolio risk).
20%
15%
10% Returns on Stock A 5% Returns on Stock B Returns on Portfolio 1 2 8 - 76
Time 0

Elimination of Portfolio Risk
Returns %
If returns of A and B are perfectly negatively correlated, a two-asset portfolio made up of equal parts of Stock A and B would be riskless. There would be no variability of the portfolios returns over time.
20%
15%
10% Returns on Stock A Returns on Stock B Returns on Portfolio 1 2 8 - 77
5%
Time 0

Numerical Example
Weight of Asset A = Weight of Asset B = Return on Asset A 5.0% 10.0% 15.0% Return on Asset B 15.0% 10.0% 5.0%
50.0% 50.0% Expected Return on the Portfolio 10.0% 10.0% 10.0%

ER p = ( wi ERi ) = (.5 5%) + (.5 15% )
i =1 n
Year xx07 xx08 xx09
= 2.5% + 7.5% = 10%
ER p = ( wi ERi ) = (.5 15%) + (.5 5% )

i =1
Perfectly Negatively Correlated Returns over time CHAPTER 8 Risk, Return and Portfolio Theory
= 7.5% + 2.5% = 10%
8 - 78
Diversification Potential
The potential of an asset to diversify a portfolio is dependent upon the degree of co-movement of returns of the asset with those other assets that make up the portfolio. In a simple, two-asset case, if the returns of the two assets are perfectly negatively correlated it is possible (depending on the relative weighting) to eliminate all portfolio risk. This is demonstrated through the following series of spreadsheets, and then summarized in graph format.
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Example of Portfolio Combinations and Correlation

Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient 1
Perfect Positive Correlation no diversification Both portfolio returns and risk are bounded by the range set by the constituent assets when =+1
Portfolio Components Weight of A Weight of B 100.00% 0.00% 90.00% 10.00% 80.00% 20.00% 70.00% 30.00% 60.00% 40.00% 50.00% 50.00% 40.00% 60.00% 30.00% 70.00% 20.00% 80.00% 10.00% 90.00% 0.00% 100.00%
Portfolio Characteristics Expected Standard Return Deviation 5.00% 15.0% 5.90% 17.5% 6.80% 20.0% 7.70% 22.5% 8.60% 25.0% 9.50% 27.5% 10.40% 30.0% 11.30% 32.5% 12.20% 35.0% 13.10% 37.5% 14.00% 40.0%
8 - 80

Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient 0.5
Positive Correlation weak diversification potential
When =+0.5 these portfolio combination s have lower risk expected portfolio return is unaffected.
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Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient 0
No Correlation some diversification potential
Portfolio risk is lower than the risk of either asset A or B.
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Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient -0.5
Negative Correlation greater diversification potential
Portfolio risk for more combinations is lower than the risk of either asset
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Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient -1
Perfect Negative Correlation greatest diversification potential
Risk of the portfolio is almost eliminated at 70% invested in asset A
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Diversification of a Two Asset Portfolio Demonstrated Graphically

The Effect of Correlation on Portfolio Risk: The Two-Asset Case
Expected Return
12%
AB = -0.5 AB = -1
8%
AB = 0 AB= +1
4%
0% 0% 10% 20% 30% 40%
Standard Deviation
8 - 85
Impact of the Correlation Coefficient

Figure 8-7 (see the next slide) illustrates the relationship between portfolio risk () and the correlation coefficient
The slope is not linear a significant amount of diversification is possible with assets with no correlation (it is not necessary, nor is it possible to find, perfectly negatively correlated securities in the real world) With perfect negative correlation, the variability of portfolio returns is reduced to nearly zero.

Impact of the Correlation Coefficient
8 - 7 FIGURE
15
10
) % ( no it a i ve D d r a dna tS sn ru t eRo il o ft r o Pf o
0 -1 -0.5 0 Correlation Coefficient () 0.5 1
8 - 87
Zero Risk Portfolio

We can calculate the portfolio that removes all risk. When = -1, then
[8-15]
p = ( wA ) 2 ( A ) 2 + ( wB ) 2 ( B ) 2 + 2( wA )( wB )( A, B )( A )( B )
Becomes:
[8-16]
p = w A (1 w) B
8 - 88
An Exercise to Produce the Efficient Frontier Using Three Assets

An Exercise using T-bills, Stocks and Bonds

Base Data: Expected Return(%) Standard Deviation (%) Stocks T-bills Bonds 12.73383 6.151702 7.0078723 0.168 0.042 0.102
Correlation Coefficient Matrix: Stocks 1 T-bills -0.216 Bonds 0.048 Portfolio Combinations: Weights Combination 1 2 3 4 5 6 7 8 9 10 Stocks 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% T-bills 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% Bonds 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
-0.216 1 0.380
0.048 0.380 1
Historical averages for returns and risk for three asset Each achievable classes
Portfolio Expected Standard Variance Deviation Return 12.7 0.0283 16.8% 12.1 0.0226 15.0% 11.4 0.0177 13.3% 10.8 0.0134 11.6% 10.1 0.0097 9.9% 9.4 0.0067 8.2% 8.8 0.0044 6.6% 8.1 0.0028 5.3% 7.5 0.0018 4.2% 6.8 0.0014 3.8%
portfolio combination is Historical plotted correlation on expected return, coefficients the asset risk between () space, classes found on the following slide.
Portfolio characteristics for each combination of securities
8 - 90
Achievable Portfolios
Results Using only Three Asset Classes
Attainable Portfolio Combinations
and Efficient Set of Portfolio Combinations
14.0
Portfolio Expected Return (%)
12.0 10.0 8.0 6.0 4.0 2.0 0.0
Efficient Set
Minimum Variance Portfolio
The efficient set is that set of achievable portfolio combinations that offer the highest rate of return for a given level of risk. The solid blue line indicates the efficient set.
The plotted points are attainable portfolio combinations.
0.0
5.0
10.0
15.0
20.0
Standard Deviation of the Portfolio (%)
8 - 91
Achievable Two-Security Portfolios

Modern Portfolio Theory
8 - 9 FIGURE
13 12 11 10 9 8 7 6
10
20
30
40
50
60
Standard Deviation (%)
This line represents the set of portfolio combinations that are achievable by varying relative weights and using two noncorrelated securities. 8 - 92
Dominance
It is assumed that investors are rational, wealth-maximizing and risk averse. If so, then some investment choices dominate others.
8 - 93
The Concept of Dominance Illustrated
Investment Choices
Return %
10% A B
A dominates B because it offers the same return but for less risk. A dominates C because it offers a higher return but for the same risk.
5%
5%
20%
Risk
To the risk-averse wealth maximizer, the choices are clear, A dominates B, A dominates C. CHAPTER 8 Risk, Return and Portfolio Theory 8 - 94
Efficient Frontier
The Two-Asset Portfolio Combinations
8 - 10 FIGURE
A is not attainable B,E lie on the

efficient frontier and are attainable
B C
E is the minimum
variance portfolio (lowest risk combination)
C, D are
D
attainable but are dominated by superior portfolios that line on the line above E
8 - 95
Efficient Frontier
The Two-Asset Portfolio Combinations
8 - 10 FIGURE
B C
Rational, risk averse investors will only want to hold portfolios such as B.
D
The actual choice will depend on her/his risk preferences.
8 - 96
Diversification
Diversification
We have demonstrated that risk of a portfolio can be reduced by spreading the value of the portfolio across, two, three, four or more assets. The key to efficient diversification is to choose assets whose returns are less than perfectly positively correlated. Even with random or nave diversification, risk of the portfolio can be reduced.
This is illustrated in Figure 8 -11 and Table 8 -3 found on the following slides.
As the portfolio is divided across more and more securities, the risk of the portfolio falls rapidly at first, until a point is reached where, further division of the portfolio does not result in a reduction in risk. Going beyond this point is known as superfluous diversification. CHAPTER 8 Risk, Return and Portfolio Theory 8 - 98
Diversification
Domestic Diversification
8 - 11 FIGURE
Average Portfolio Risk January 1985 to December 1997
14 12 10 8 6 4 2
) % ( no it a i ve D d r a dna tS
50
100
150
200
250
300
Number of Stocks in Portfolio
8 - 99
Diversification
Domestic Diversification
Table 8-3 Monthly Canadian Stock Portfolio Returns, January 1985 to December 1997 Number of Stocks in Portfolio 1 2 3 4 5 6 7 8 9 10 14 40 50 100 200 222 Average Monthly Portfolio Return (%) 1.51 1.51 1.52 1.53 1.52 1.52 1.51 1.52 1.52 1.51 1.51 1.52 1.52 1.51 1.51 1.51 Standard Deviation of Average Monthly Portfolio Return (%) 13.47 10.99 9.91 9.30 8.67 8.30 7.95 7.71 7.52 7.33 6.80 5.62 5.41 4.86 4.51 4.48 Ratio of Portfolio Standard Deviation to Standard Deviation of a Single Stock 1.00 0.82 0.74 0.69 0.64 0.62 0.59 0.57 0.56 0.54 0.50 0.42 0.40 0.36 0.34 0.33 Percentage of Total Achievable Risk Reduction 0.00 27.50 39.56 46.37 53.31 57.50 61.35 64.02 66.17 68.30 74.19 87.24 89.64 95.70 99.58 100.00
Source: Cleary, S. and Copp D. "Diversification with Canadian Stocks: How M uch is Enough?" Canadian Investment Review (Fall 1 999), Table 1 .
8 - 100
Total Risk of an Individual Asset

Equals the Sum of Market and Unique Risk
Average Portfolio Risk
Diversifiable (unique) risk
[8-19]
) % ( no it a i ve D d r a dna tS
Nondiversifiable (systematic) risk

Number of Stocks in Portfolio
This graph illustrates that total risk of a stock is made up of market risk (that cannot be diversified away because it is a function of the economic system) and unique, companyspecific risk that is eliminated from the portfolio through diversification.
[8-19]
Total risk = Market (systematic) risk + Unique (non - systematic) risk
8 - 101
International Diversification
Clearly, diversification adds value to a portfolio by reducing risk while not reducing the return on the portfolio significantly. Most of the benefits of diversification can be achieved by investing in 40 50 different positions (investments) However, if the investment universe is expanded to include investments beyond the domestic capital markets, additional risk reduction is possible.
(See Figure 8 -12 found on the following slide.)
8 - 102
Diversification
International Diversification
8 - 12 FIGURE
100 80 60 40 20
ks i r t necr e P
U.S. stocks
11.7
International stocks
10 20 30 40 50 60
Number of Stocks
8 - 103
Summary and Conclusions

In this chapter you have learned: How to measure different types of returns How to calculate the standard deviation and interpret its meaning How to measure returns and risk of portfolios and the importance of correlation in the diversification process. How the efficient frontier is that set of achievable portfolios that offer the highest rate of return for a given level of risk.
Concept Review Questions

Concept Review Question 1

Ex Ante and Ex Post Returns
What is the difference between ex ante and ex post returns?
8 - 106
Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.
8 - 107

Chapter 8 - Risk, Return, and Portfolio Theory

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INTRODUCTION TO

Prepared by Ken Hartviksen

CHAPTER 8 Risk, Return and Portfolio Theory

CHAPTER 8 Risk, Return and Portfolio Theory

Important Chapter Terms

CHAPTER 8 Risk, Return and Portfolio Theory

Introduction to Risk and Return

Introduction to Risk and Return

Real Return Expected Inflation Rate

CHAPTER 8 Risk, Return and Portfolio Theory

D1 kc = + [ g ] = [ Income / Dividend Yield] + [ Capital Gain (or loss) Yield] P0

CHAPTER 8 Risk, Return and Portfolio Theory

CHAPTER 8 Risk, Return and Portfolio Theory

Ex post versus Ex ante Returns

CHAPTER 8 Risk, Return and Portfolio Theory

Common Share and Long Canada Bond Yield Gap

(%) 0.82 2.35 4.54 8.14 5.51 3.55 4.58

CHAPTER 8 Risk, Return and Portfolio Theory

The investor will receive dollar returns, for example:

Converting Dollar Returns to Percentage Returns

An investor receives the following dollar returns a stock investment of $25:

P $27 - $25 1P 0 Capital gain (loss) return = = = .08 = 8% P0 $25

The investors total return (holding period return) is:

CHAPTER 8 Risk, Return and Portfolio Theory

The general formula for holding period return is:

CHAPTER 8 Risk, Return and Portfolio Theory

Measuring Average Returns

Measuring Average Returns

Arithmetic Average (AM) =

Measuring Average Returns

Geometric Mean (GM) = [( 1 + r1 )( 1 + r2 )( 1 + r3 )...( 1 + rn )] -1

Measures the average or compound growth rate over multiple periods.

CHAPTER 8 Risk, Return and Portfolio Theory

Measuring Average Returns

CHAPTER 8 Risk, Return and Portfolio Theory

Measuring Average Returns

Annual Geometric Mean (%) 5.11 6.24 10.60 11.76

Standard Deviation of Annual Returns (%) 4.32 9.32 16.22 17.54

5.20 6.62 11.79 13.15

CHAPTER 8 Risk, Return and Portfolio Theory

Measuring Expected (Ex Ante) Returns

Estimating Expected Returns

The general formula

Expected Return (ER) = (ri Prob i )

Estimating Expected Returns

State of the Economy Economic Expansion Normal Economy Recession

Probability of Occurrence 25.0% 50.0% 25.0%

CHAPTER 8 Risk, Return and Portfolio Theory

Estimating Expected Returns

State of the Economy Economic Expansion Normal Economy Recession

CHAPTER 8 Risk, Return and Portfolio Theory

Estimating Expected Returns

Expected Return (ER) = (ri Prob i )

CHAPTER 8 Risk, Return and Portfolio Theory

CHAPTER 8 Risk, Return and Portfolio Theory

Outcomes that produce harm

10% 20% 30% 40% Possible Returns on the Stock

CHAPTER 8 Risk, Return and Portfolio Theory

Differences in Levels of Risk

A is a much riskier investment than B

10% 20% 30% 40% Possible Returns on the Stock

CHAPTER 8 Risk, Return and Portfolio Theory

Historical Returns on Different Asset Classes