FINANCE 2 (FINE 342)

Risk and Return

Desautels Faculty of Management, McGill
University

Risk and Return

Objectives
A reminder on
what risk and expected return mean in a
financial market,
the magic of diversification
a simple model of asset pricing: the CAPM.

Risk and Return of a single security

Definitions
The return on an asset between t1 and t2 is the
ratio between the value one derives from holding
the asset from t1 to t2 and the initial value of the
asset.
Example:

You bought Apple on Jan 7th 2013 @ $523.90

On Jan 6th 2014, Apple quotes $543.98
Your return over a year is

rS

543.98 523.90
3.83%
523.90

Risk and Return of a single security

Definitions
We live in a world of uncertainty
For most assets future returns are random.
We can try to describe that uncertainty. For
instance

if US GDP growth is more than 3% in 2011, S&P 500

annual return will be above 8% in 2011
if oil price rises above $90 in 2011, S&P 500 annual
return will be below 7.5% in 2011.
Etc

Eventually, we can construct a distribution of

future returns

Risk and Return of a single security

Distribution of Returns

Monthly adj.
returns
Coca-Cola
Company
Jan 1962 to Jan
2013
(4% brackets)
-20%

-16 %

-12%

-8%

-4%

0%

4%

8%

12%

16%

20%

Risk and Return of a single security

Definitions
A distribution of returns for stock S is as follows
There are n possible states of the economy and
you know

The probability pi of each of these states

The return rSi of stock S in each of these states

Example
State of the
Economy

Probability
(pi)

Return (rSi)
of stock S

Depression

0.1

-30%

Recession

0.2

+1%

Normal

0.5

+13%

Boom

0.2

+50%

Risk and Return of a single security

Definitions
An accurate (financial) description of an asset is
the complete distribution of its returns.
But we restrict attention to only 2
characteristics of that distribution in this
course

Mean, i.e. Expected return

E(rS ) p1rS1 p2 rS2 ... pnrSn

Standard Deviation, i.e. volatility

S p1[rS1 E(rS )]2 p2 [rS2 E(rS )]2 ... pn[rSn E(rS )]2

Risk and Return of a single security

Definitions
Assumption: individuals are mean-variance
optimizers.
They care only about expected returns and
volatility.
Holding expected return constant, they prefer a
portfolio with a lower volatility.
Holding volatility constant, they prefer a portfolio
with a higher expected return.

Risk and Return

Are you mean-variance optimizer?
Probability
0.6

0.5

0.4

0.3

0.2

0.1

Return

0
-0.25

-0.1

0.1

0.25

Risk and Return of a single security

Remarks on volatility
We will use volatility S as a measure of the
total risk of an asset. An equivalent measure is
the variance of the Var(r
return.
) 2
s

An alternative
way2 of computing
volatility
2
2
2
2

S E(rs ) [E(rs)] p1rS1 p2 rS2 ... pnrSn [E(rs)]2

Risk and Return of a single security

Application 1
Back to the previous example.
State of the
Economy

Probability
(pi)

Return (rSi)
of stock S

Depression

0.1

-30%

Recession

0.2

+1%

Normal

0.5

+13%

Boom

0.2

+50%

Compute Expected Return and volatility for S.

Risk and Return of a Portfolio (PF)

2 securities
Consider two securities A and B.
There are still n possible states of the world and
you know

The probability pi of each of these states

The return rAi and rBi of securities A and B in each state

You know how to compute

E(r ), E(r )
the expected returns of A and AB B
A ,B
B
the standard deviation of A and

Can you compute the

expected return and

volatility of a portfolio
composed of A and B (say

in equal proportions)?

Risk and Return of a Portfolio

2 securities
The covariance of A and B returns is

AB p1[rA1 E(rA )][rB1 E(rB )] ... pn[rAn E(rA )][rBn E(rB )]

The correlation of A and B is

AB

Remarks:

AB

A B

Correlation is always between -1 and 1.

Covariance and correlation are symmetric:

AB BA AB BA

Risk and Return of a Portfolio

2 securities
Invest a fraction x of your wealth into A, 1-x into
B:

Expected Return of your Portfolio?

Variance of the returns of your Portfolio?

The expected return of your portfolio is

E(rPF ) xE(rA ) (1 x)E(rB )

The variance of the returns of your portfolio is

2
PF
x2A2 (1 x) 2 B2 2x(1 x)AB AB

Risk and Return of a Portfolio

Application 2
Stock A has a 10% expected return, and 20%
volatility.
Invest a fraction x of your wealth into A, 1-x into a
risk-free asset. Risk-free rate is rf=3.50%
What is the expected return of your portfolio?
What is the volatility of your portfolio?
Can you build a PF with a 12% return? What is
the volatility of that PF?

Risk and Return of a Portfolio

Application 3
State of the
Economy

Probabil
ity

A
Return

B
Return

Depression

0.1

-30%

-10%

Recession

0.2

1%

2%

Normal

0.5

+13%

+5%

Boom

0.2

+50%

+15%

Compute the expected returns and volatility of A

and B
Compute the correlation of A and B
Suppose you invest x = 40% in A and 1-x = 60% in
B, what is the expected return and volatility of your
portfolio?

Risk and Return of a Portfolio

Application 3
Expected
Return
16.00%

14.00%
12.00%
10.00%

40% A +
60% B

8.00%
6.00%
4.00%

2.00%
0.00%
5.00%

10.00%

15.00%

20.00%

(Almost) no diversification
Effect

25.00%

Volatilit
y

Risk and Return of a Portfolio

Consider the PF from application 3 (40% in A, 60% in
B).
Suppose that you find a stock C which has
The same expected return as B
A higher volatility than B
Can the following statement be true?
I can form a PF composed of A and C that has
The same expected return as the PF composed of A
& B.
A lower volatility than the PF composed of A & B.

Risk and Return of a Portfolio

Diversification
Expected
Return
16.00%

14.00%
12.00%
10.00%

40% A +
60% B

8.00%
6.00%
4.00%

2.00%
0.00%
5.00%

10.00%

15.00%

20.00%

Volatilit
25.00% y

Risk and Return of a Portfolio

Application 4
Consider security C with the following
characteristics. Compute the expected return and
volatility of a PF, with 40% in A and 60% in C
State of the
Economy

Probabil
ity

A
Return

Depression

0.1

-30%

+10%

Recession

0.2

1%

+27%

Normal

0.5

+13%

-3%

Boom

0.2

+50%

0%

E(rA ) 13.70% E(rC ) 4.90%

A 22.07%

C
Return

C 11.67%

AC 0.432

Risk and Return of a Portfolio

Diversification
E(rC)=E(rB) and C > B but A&C PF has the same
expected return and a lower volatility than A&B PF.
Diversification effect!
Expected
Return
16.00%

14.00%
12.00%
10.00%

40% A +
60% B

8.00%
6.00%
4.00%

2.00%
0.00%
5.00%

10.00%

15.00%

20.00%

Volatilit
25.00% y

Risk and Return of a Portfolio

When is there a benefit from diversification?
Diversification vs Hedging?
Should we ban certain financial products?
Read How to prevent a Financial Overdose
New York Times (MyCourses)

Risk and Return of a Portfolio

The Minimum Variance Portfolio
What is the composition (x) of the A&C PF that
minimizes its variance (hence its volatility)?

2pf (x) x2A2 (1 x) 2 C2 2x(1 x)AC AC

2pf (x)

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%

Risk and Return of a Portfolio

The Minimum Variance Portfolio (optional)
The minimum variance PF solves

Application
(22.07%) 2 (0.0111)
x
29.27%
2
2
(22.07%) (11.67%) 2 (0.0111)
*

Check that if x = 29.27%, then

pf 7.99%

Risk and Return of a portfolio

Optimal Investment Choice
If you can invest only in A and C, What PF composition
should you choose?
Expected
Return

16.0%

14.0%
12.0%
10.0%
8.0%

MV

6.0%
4.0%

2.0%
0.0%
6.00% 8.00% 10.00%12.00%14.00%16.00%18.00%20.00%22.00%24.00%

Volatilit
y

Risk and Return of a portfolio

The Efficient Frontier
It is optimal to choose a PF composition on the
efficient frontier, above the minimum variance PF
(x 29.27%).
Expected
Return

16.0%

14.0%
12.0%
10.0%
8.0%

MV

6.0%
4.0%

2.0%
0.0%
6.00% 8.00% 10.00%12.00%14.00%16.00%18.00%20.00%22.00%24.00%

Volatilit
y

Risk and Return of a Portfolio

More than 2 securities
Consider N securities indexed by i = 1,2, N.
You know

The expected returns

E(ri )

The volatility

of each of them

of each of them

The correlation

ij

between each of them

Invest a proportion
x1, x2,, xN in each asset (x1+x2+

+xN= 1)

Risk and Return of a Portfolio

More than 2 securities
The expected return is linear

The volatility is

Sum of variances
multiplied by squared
weights

Sum of
correlations for all
possible pairs of
securities
multiplied by
weights and

Risk and Return of a Portfolio

Example: 3 securities
Consider 3 securities with the following
characteristics
Securities

Expected
Returns

10%

14%

5%

Volatility

18%

15%

10%

12 0.5

13 0.8

23 0.3

Correlations

What is the expected

return
and volatility
of a

portfolio invested in asset 1 for 20%, asset 2 for
45% and asset 4 for 35%?

Risk and Return of a Portfolio

Example: 3 securities
Securities

Expected
Returns

10%

14%

5%

Volatility

18%

15%

10%

12 0.5

13 0.8

23 0.3

Correlations

E(rPF ) 20% *10% 45% *14% 35% * 5% 10.05%

2

2
2
2
2
2
pf (20%) * (18%) (45%) * (15%) (35%) * (10%) 2

2 20% 45% 0.5 18% 15%

2 20% 35% 0.8 18% 10%
2 45% 35% (0.3) 15% 10% 0.0101

pf 0.0101 10.05%

Risk and Return of a Portfolio

Limits to diversification
Consider N securities indexed by i = 1,2, N.
Assume that

All securities have the same variance

2
All pairs of securities have the same correlation
ij

Consider a portfolio equally weighted in each

security.
Volatility?

1 2 1 2
pf 1 ij
N N
What happens as N becomes larger?

Risk and Return of a Portfolio

Limits to diversification
Diversification allows to eliminate part of the risk
of a portfolio.
The risk that can be eliminated through
diversification is idiosyncratic.
There is a limit to diversification, even when the
number of assets is large and all assets are
imperfectly correlated.
The risk that cannot be diversified is
systematic.
How do you construct a portfolio that is only
exposed to systematic risk?

The CAPM
Optimal Portfolio

Expected
Return

Optimal PF of
risky assets

Risk-free
rate

Frontier of the riskreturn couples you can

achieve by combining
risky assets.

Risky assets
Volatilit
y

The CAPM
Optimal Portfolio
Out of all combinations of risky assets, there is
one which is optimal for everyone =>
Everybody holds the same portfolio of risky
assets.
Therefore this portfolio must be the market
portfolio.
Therefore the only risk that matters is the
risk of the market PF. The market risk is the
(only) systematic risk.
Investors choose the combination between the
market PF and the risk-free asset depending on
their preferences for risk.

The CAPM
Optimal Portfolio
Optimal PF of
risky assets

Expected
Return

Why does an investor

chooses A rather than
B?

A
Risk-free
rate
Volatilit
y

The CAPM in action

Passive (index) funds
Passive mutual funds, or more recently
exchange-traded funds simply track an index.

Source: The Economist

The CAPM
Required Return of an asset
The only risk which justifies a compensation is
the risk of the market portfolio.
Any risk premium (paid over the risk-free rate)
reflects only the exposure of an asset to the risk
of the market portfolio.
The measure of this exposure is

cov(rS,rM )

M2

The CAPM
Required Return of an asset
Denoting rf the risk-free rate, the celebrated
CAPM formula gives the expected return of any
asset S (individual security or portfolio)
E(rS ) rf E(rM ) rf

E(rM ) rf

is the market risk premium.

The CAPM
Application 5
Consider security A
State of the
Economy

Probabil
ity

A
Return

Market
PF
Return

Depression

0.1

-30%

-5%

Recession

0.2

1%

+2%

Normal

0.5

+13%

8%

Boom
0.2
12%
Compute
As expected
return.+50%
Compute As .
Suppose that rf=3.00%. According to the CAPM
should you buy A?

The CAPM
Beta questions
Which of these two industries has the highest
Beta: food or automobile?
Which of these two firms has the highest Beta:
Gap or Ralph Lauren?
Give examples of industries with low betas
Give examples of industries with high betas

The CAPM
of a Portfolio
is essentially a covariance linearity: of a PF =
weighted average of s of the securities in that PF.
Consider N securities indexed by i = 1,2, N.
i is the exposure to market risk of security i.
Invest a proportion x1, x2,, xN in each asset (x1+x2+
+xN= 1)

PF x11 x2 2 ... xN N

The CAPM
Expected returns and Prices
You are able to forecast the average price E(P1)
of a security S in one year. S does not pay
dividends.
You know S hence E(rS) using the CAPM. What is
S value, V0, today?

Same question if S pays a dividend D in one year

The CAPM
Expected returns and Prices
More generally if you know A for an asset A,
Derive E(rA) using the CAPM for any asset A
Forecast expected cash-flows CFi from
holding A from year 1 to n.
The value of A today is just

CF1
CF2
CFn
VA

2 ...
n
1 E(rA ) 1 E(r )
1 E(rA )
A

The CAPM in action

Generating alphas
A popular measure for the performance of active
portfolio management is Jensens alpha

(r rf ) PF (r rf )
PF

Where rPF is the realized return of the fund, rM is

the realized return of the market, PF is the
exposure to market risk of the portfolio.

Is a good
measure of performance?
According to the CAPM, is it possible to
generate persistent positive s?

The CAPM
Estimating Beta
Beta?
For traded companies:
Compile Past Market Data: (monthly) excess
returns of the stock and excess returns of the
market (excess return = total return risk-free
rate).
Estimate the model, that is, run a regression
of the stock excess returns over the market
excess return. See exercise

The CAPM
Beta in practice
For non-traded (i.e. private) companies, use
comparables.
You need to correct for the leverage! (more
on this later).

Risk and Return

Did you understand the CAPM?
According to the CAPM,
If security A is riskier (has a higher volatility)
than security B, what can you say about the
expected return on A compared to the expected
return on B?
What should your portfolio look like?
Should you get a higher expected return on a
stock which is positively or negatively correlated
with the market portfolio?