Risk And Return

Hardik Gandhi

Measures of
Historical Rates of Return
Where:
Dividend P1 P0
HPR
P0
20 220 - 200

200
0.20 or 20%

HPR = Holding period

return
P0 = Beginning value
= 200
P1 = Ending value
= 220
Dividend Paid During the
Year = 20

Annualizing HPR
Where:
1
N

EAR 1 HPR 1

EAR = Equivalent Annual

Return
HPR = Holding Period
Return
N = Number of years

Contd.
Example: You bought a stock for
Rs.10 and sold it for Rs.18 six years
later. What is your HPR & EAR?
Solution:
HPR

Dividend P1 P0
P0

18 - 10

10
0.80 or 80%

EAR 1 HPR

1
N

1
6

1.80 1
10.29%

Measures of
Historical Rates of Return
Arithmetic Mean

R1 R2 ... RN
AM
N
Geometric Mean

Where:
AM = Arithmetic Mean
GM = Geometric Mean
Ri = Annual HPRs
N = Number of years

GM 1 R1 1 R2 ... 1 RN

1
N

 You are reviewing an investment with the following price

history as of December 31st each year.

2005

2006

2007

2008

2009

2010

2011

2012

210

225

250

240

280

350

400

420

Calculate:
The HPR for the entire period
The annual HPRs
The Arithmetic mean of the annual HPRs
The Geometric mean of the annual HPRs

Expected Rate of Return

n

E(R i ) (Probability of Return) (Possible Return)

i 1
n

(Pi )(R i )
i 1

Probablility

Return

Pi*Ri

Probablility

Return

Pi*Ri

0.1

12

1.2

0.2

15

0.3

13

3.9

0.3

-10

-3

0.1

15

1.5

Expected

6.6

Return

Measures of Risk: Historical Returns

Where:
n

HPR
i 1

E HPRi

N 1

= Variance of the stock

HPR = Holding Period
Return i
E(HPR)i = Average HPR
(Arithmetic Mean of HPR)
N = Number of years
8

(Ri - Avg (Ri-Avg

Year
Return
Ri)
Ri)^2
1
10
2.75
7.5625
2
12
4.75
22.5625
3
-5
-12.25 150.0625
4
12
4.75
22.5625

AM (Avg
67.58333
Ri)
7.25 Variance
333
8.220908

S.D.
303

Measuring Risk: Expected Rate of

Returns
Where:
n

(Pi ) R i E(R)
2

i 1

2
2

= Variance

Ri = Return in period i
E(R) = Expected Return
Pi = Probability of Ri
occurring

10

Probablilit Retur
y
n
Pi*Ri

(RiAvg
Ri)

(Ri-Avg
Ri)^2

Pi*(RiAvg
Ri)^2

0.1

12

1.2

5.4

29.16

2.916

0.2

15

8.4

70.56

14.112

0.3

13

3.9

6.4

40.96

12.288

0.3

-10

-3

0.1

15

1.5

Expec
ted
6.6
Retur
n

-16.6 275.56
8.4

70.56

82.668
7.056

Varianc
e
119.04
10.91054
S.D.
536
11

Expected Return of a
Portfolio
The Expected Return on a Portfolio is computed
as the weighted average of the expected returns on
the stocks which comprise the portfolio.
The weights reflect the proportion of the portfolio
invested in the stocks.
This can be expressed as follows:
N

E[Rp] = wiE[Ri]
i=1

Where:

E[Rp] = the expected return on the portfolio

N = the number of stocks in the portfolio
wi = the proportion of the portfolio invested in stock i
E[Ri] = the expected return on stock i
12

Measuring Risk of a Portfolio

The variance/standard deviation of a portfolio
reflects not only the variance/standard deviation
of the stocks that make up the portfolio but also
how the returns on the stocks which comprise the
portfolio vary together.
Two measures of how the returns on a pair of
stocks vary together are the covariance and the
correlation coefficient.
Covariance is a measure that combines the variance of a
stocks returns with the tendency of those returns to
move up or down at the same time other stocks move
up or down.
Since it is difficult to interpret the magnitude of the
covariance terms, a related statistic, the correlation
coefficient, is often used to measure the degree of co13
movement between two variables.
The correlation

Measuring Risk of a Portfolio

port

2 2
w
i i w i w jCov ij
i 1

i 1 i 1

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 rij i j
14

Measuring Risk of a Portfolio

The Covariance between the returns on two stocks can be
calculated as follows:
N

Cov(RA,RB) = A,B = pi(RAi - E[RA])(RBi - E[RB]) (for Expected

Returns)
Cov(RA,RB) = A,B = (RAi - E[RA])(RBi - E[RB]) (for Historical
Returns)
i=1

Where: N-1

= the covariance between the returns on stocks A and B

N = the number of states
pi = the probability of state i
RAi = the return on stock A in state i
E[RA] = the expected return on stock A
RBi = the return on stock B in state i
E[RB] = the expected return on stock B
15

Measuring Risk of a Portfolio

The Correlation Coefficient between the
returns on two stocks can be calculated as
follows:
A,B
Cov(RA,RB)
Corr(RA,RB) = A,B = AB

SD(RA)SD(RB)

Where:
A,B=the correlation coefficient between the returns on
stocks A and B
A,B=the covariance between the returns on stocks A and
B,
A=the standard deviation on stock A, and
B=the standard deviation on stock B

16

Markowitz Portfolio Theory

Quantifies risk
Derives the expected rate of return for a portfolio of assets and an
expected risk measure
Shows that the variance of the rate of return is a meaningful
measure of portfolio risk
Derives the formula for computing the variance of a portfolio,
showing how to effectively diversify a portfolio

17

Assumptions of
Markowitz Portfolio Theory
1.

2.
3.
4.

5.

Investors consider each investment alternative as being presented

by a probability distribution of expected returns over some holding
period.
Investors minimize one-period expected utility, and their utility
curves demonstrate diminishing marginal utility of wealth.
Investors estimate the risk of the portfolio on the basis of the
variability of expected returns.
Investors base decisions solely on expected return and risk, so their
utility curves are a function of expected return and the expected
variance (or standard deviation) of returns only.
For a given risk level, investors prefer higher returns to lower
returns. Similarly, for a given level of expected returns, investors
prefer less risk to more risk.
18

Markowitz Portfolio Theory

Using these five assumptions, a single asset or portfolio of

assets is considered to be efficient if no other asset or portfolio
of assets offers higher expected return with the same (or
lower) risk, or lower risk with the same (or higher) expected
return.

19

Security Universe
The security universe is the
collection of all possible investments
For some institutions, only certain
investments may be eligible
E.g., the manager of a small cap stock
mutual fund would not include large cap
stocks

20

Efficient Frontier
Construct a risk/return plot of all
possible portfolios
Those portfolios that are not dominated
constitute the efficient frontier

21

Efficient Frontier (contd)

Expected Return

No points plot above

the line

All portfolios
on the line
are efficient

100% investment in security

with highest E(R)

Points below the efficient

frontier are dominated

100% investment in minimum

variance portfolio
Standard Deviation

22

Combining Stocks with Different Returns and Risk

Asset
1
2
Case
a
b
c
d
e

E(R i )

Wi

.20

.50

.10

Correlation Coefficient
+1.00
+0.50
0.00
-0.50
-1.00

.50

.0049

.07

.0100

.10

Covariance
.0070
.0035
.0000
-.0035
-.0070

23

Combining Stocks with Different

Returns and Risk
Assets may differ in expected rates of
return and individual standard deviations
Negative correlation reduces portfolio risk
Combining two assets with -1.0 correlation
reduces the portfolio standard deviation to
zero only when individual standard
deviations are equal

24

Constant Correlation
with Changing Weights
Asset
1
Case 2
f
g
h
i
j
k
l

E(R i )
.10

r ij = 0.00
2

W1 .20

0.00
0.20
0.40
0.50
0.60
0.80
1.00

1.00
0.80
0.60
0.50
0.40
0.20
0.00

E(Ri )
0.20
0.18
0.16
0.15
0.14
0.12
0.10
25

Constant Correlation
with Changing Weights

Case

W1

W2

E(Ri )

E( port)

f
g
h
i
j
k
l

0.00
0.20
0.40
0.50
0.60
0.80
1.00

1.00
0.80
0.60
0.50
0.40
0.20
0.00

0.20
0.18
0.16
0.15
0.14
0.12
0.10

0.1000
0.0812
0.0662
0.0610
0.0580
0.0595
0.0700

26

Constant Correlation
with Changing Weights
Asset
1

E(R i )
.10

r ij = 0.00

Constant correlation with changing weig

2

.20
2

Case

W1

f
g
h
i
j
k

0.00
0.20
0.40
0.50
0.60
0.80

1.00
0.80
0.60
0.50
0.40
0.20

E(R i )
0.20
0.18
0.16
0.15
0.14
0.12
27

Constant Correlation
with Changing Weights
Case

W1

W2

E(Ri )

f
g
h
i
j
k
l

0.00
0.20
0.40
0.50
0.60
0.80
1.00

1.00
0.80
0.60
0.50
0.40
0.20
0.00

0.20
0.18
0.16
0.15
0.14
0.12
0.10

E(

port )

0.1000
0.0812
0.0662
0.0610
0.0580
0.0595
0.0700

28

Portfolio Risk-Return Plots for

Different Weights
E(R)
0.20
0.15
0.10
0.05

With two perfectly

correlated assets, it
is only possible to
create a two asset
portfolio with riskreturn along a line
between either
single asset

2
Rij = +1.00
1

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

29

Portfolio Risk-Return Plots for

Different Weights
E(R) With
0.20 negatively
correlated
assets it is
0.15
possible to
create a two
0.10 asset portfolio
with much
0.05 lower risk than
either single
asset

Rij = -0.50

j
k

f
2

Rij = +1.00
Rij = +0.50

1
Rij = 0.00

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

30

Portfolio Risk-Return Plots for

Exhibit 7.13
Different Weights
E(R)
0.20

Rij = -1.00

Rij = -0.50

0.15

0.10

0.05
-

f
2

Rij = +1.00
Rij = +0.50

1
Rij = 0.00
With perfectly negatively correlated
assets it is possible to create a two asset
portfolio with almost no risk

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

31

Estimation Issues
Results of portfolio allocation depend on
accurate statistical inputs
Estimates of
Expected returns
Standard deviation
Correlation coefficient
Among entire set of assets
With 100 assets, 4,950 correlation estimates

Estimation risk refers to potential errors

32

Estimation Issues
With assumption that stock returns
can be described by a single market
model, the number of correlations
required reduces to the number of
assets
Single index market model:

R i a i bi R m i

bi = the slope coefficient that relates the returns for security i

to the returns for the aggregate stock market
Rm = the returns for the aggregate stock market

33

The Efficient Frontier

The efficient frontier represents
that set of portfolios with the
maximum rate of return for every
given level of risk, or the minimum
risk for every level of return
Frontier will be portfolios of
investments rather than individual
securities
Exceptions being the asset with the
highest return and the asset with the
lowest risk
34

Efficient Frontier
for Alternative Portfolios
Exhibit 7.15

E(R)

Efficient
Frontier

Standard Deviation of Return

35

The Efficient Frontier

and Investor Utility
An individual investors utility curve
specifies the trade-offs he is willing
to make between expected return
and risk
The slope of the efficient frontier
curve decreases steadily as you
move upward
These two interactions will determine
the particular portfolio selected by an
individual investor
36

The Efficient Frontier

and Investor Utility
The optimal portfolio has the highest
utility for a given investor
It lies at the point of tangency
between the efficient frontier and the
utility curve with the highest possible
utility

37

Selecting an Optimal Risky Portfolio

Exhibit 7.16

E(R port )

U3
U2

U1

Y
U3
U2

X
U1

E( port )

38