 Measuring Risk

 Portfolio Risk – Portfolio theory

 Beta and Unique Risk – Security Market

Line
 Diversification

 Capital Asset Pricing Model (CAPM)

 Rate of return = (Annual Income + Ending
price - Beginning price) / Beginning price
Eg., Price at the beginning of the year =
Rs.60
Dividend paid at the end of the year =
Rs.2.40
Price at the end of the year = Rs.69
Hence, ROR = 19%.
 Current yield = annual
income/beginning price
 Capital gains yield = ending price-
beginning price/beginning price
 RoR = current yield +capital gains yield
 The probability of an event represents
the likelihood of its occurrence
State of the Probability Company A Company B
economy of (RoR %) (RoR %)
occurrence
Boom 0.30 16 40

Normal 0.50 11 10

recession 0.20 6 -20

 The Value of an Investment of $1 in 1926
S&P 6402
Small Cap
1000 Corp Bonds 2587
Long Bond
T Bill

64.1
10 48.9
Index

16.6

1
0.1
1925 1940 1955 1970 1985 2000

Source: Ibbotson Associates Year End

 Rates of Return 1926-
2000: US Economy
60
Percentage Return

40

20

-20

Common Stocks
-40
Long T-Bonds
T-Bills
-60
26

30

40

45

50

55

65

70

80

90

95

00
35

60

75

85

20
Year
Source: Ibbotson Associates
Risk premium, %
11
10
9
8
7
6
9.9 10 11
5 8.5 9.9
4 8
7.1 7.5
3 6 6.1 6.1 6.5 6.7
5.1
2 4.3
1
0
Ire

Aus

It
Swi
Can

Jap
Spa

Ger
USA
Neth

Fra
Den

Swe
UK
Bel

Country
Variance - Average value of squared
deviations from mean. A measure of
volatility.

Standard Deviation - Average value of

squared deviations from mean. A measure of
volatility.
Coin Toss Game-calculating variance and
standard deviation
(1) (2) (3)
Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%
Diversification - Strategy designed to reduce
risk by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that
firm. Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk
that affect the overall stock market. Also
called “systematic risk.”
Portfolio rate
of return (
=
in first asset )(
fraction of portfolio
x
rate of return
on first asset )
(
+
fraction of portfolio
in second asset )(
x
rate of return
on second asset )
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
 1. Total risk =
Expected
diversifiable risk +
stock
market risk
return
2. Market risk is
measured by beta,
beta
the sensitivity to
market changes +10%
-10%

- 10% +10% Expected

market
-10% return

opyright 1996 by The McGraw-Hill Companies, Inc

Market Portfolio - Portfolio of all
assets in the economy. In practice
a broad stock market index, such
as the S&P Composite, is used to
represent the market.

Beta - Sensitivity of a stock’s return

to the return on the market
portfolio.
 σ im
Bi = 2
σm
 σ im
Bi = 2
σm
Covariance with the
market

Variance of the market

 E (Rj) = Rf +ßj [E (Rm) - Rf]
Where,
E (Rj) = expected return on security j
Rf = risk-free return
ßj = beta of security j
E (Rm) = expected return on market portfolio
Risk premium = ßj [E (Rm) - Rf]
 Markowitz Portfolio Theory
 Risk and Return Relationship

 Testing the CAPM

 Combining stocks into portfolios can reduce
standard deviation, below the level obtained
from a simple weighted average calculation.
 Correlation coefficients make this possible.

 The various weighted combinations of stocks

that create this standard deviations
constitute the set of efficient portfolios.
portfolios
Price changes vs. Normal distribution
Microsoft - Daily % change 1990-2001

0.14

0.12

0.1

0.08

0.06

0.04

0.02

0
-9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9
 Standard Deviation VS. Expected Return
Investment A

20
18
16
14
12
10
8
6
4
2
0
-50 0 50
 Standard Deviation VS. Expected Return
Investment B

20
18
16
14
12
10
8
6
4
2
0
-50 0 50
 Expected Returns and Standard Deviations vary given
different weighted combinations of the stocks

Goal is to move up and

Expected Return
(%) left.
WHY?

Standard
Deviation
 Each half egg shell represents the possible weighted
combinations for two stocks.
 The composite of all stock sets constitutes the efficient frontier
Example Correlation Coefficient = .4
Stocks σ % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%

Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%
Let’s Add stock New Corp to the portfolio
Example Correlation Coefficient = .3
Stocks σ % of Portfolio Avg
Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%

NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20
Example Correlation Coefficient = .3
Stocks σ % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%

NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%

NOTE: Higher return & Lower risk

How did we do that? DIVERSIFICATION
SML Equation = rf + B ( rm - rf )
 Capital Asset Pricing Model

R = rf + B ( rm -
rf )