Class 5

Risk and return

Reading:
Brealey, Myers “Principles of Corporate Finance” (10th edition): Chapter 7
Hillier, Grinblatt, Titman “Financial Markets and Corporate Strategy” (2 nd edition): Chapter 4

Questions for discussion:

1) Briefly outline the underlying assumptions of the modern portfolio theory.
2) Explain the definitions of risk and return of a single security. What determines the rational
investor’s choice between the two risky assets?
3) Explain why it’s more convenient to use standard deviation rather than variance as a risk metric.
4) Discuss whether the following statements are true or false:
a) If stocks were perfectly positively correlated, diversification would not reduce risk.
True. The actual standard deviation for a portfolio is virtually always less than the
weighted average of the standard deviations of the securities in the portfolio due to
correlation coefficient which nearly never equals 1.
b) Diversification over a large number of assets completely eliminates risk.
What kind of risk? We have non-diversifiable / diversifiable, systematic / unsystematic,
market / firm-specific (idiosyncratic, residual, unique) risk.
c) Diversification works only when assets are uncorrelated.
False. Diversification works even if the correlation ratio is slightly below 1.
d) A stock with a low standard deviation always contributes less to portfolio risk than a stock
with a higher standard deviation.
No, it also depends on the weight in the portfolio and the correlation between the stock
returns (see the formula for variance/standard deviation).
e) The contribution of a stock to the risk of a well-diversified portfolio depends on its market
risk.
True, as all non-systemic risk has been diversified away.

Question 1 (self-study)
Lambeth Walk invests 60% of his funds in stock I and the balance in stock J. The standard deviation
of returns on I is 10%, and on J it is 20%. The expected return on I is 5%, and on J it is 8%.
Calculate the portfolio expected return and the standard deviation of portfolio returns, assuming:
a) The correlation between the stock returns is 1.0;
b) The correlation is 0.5;
c) The correlation is 0.
Portfolio expected return: 0.6 * 0.05 + 0.4 * 0.08 = 0.062 = 6.2%
a) Portfolio variance (ρ = 1): (0.6 * 0.1)2 + (0.4 * 0.2)2 + 2 * 1 * 0.6 * 0.4 * 0.1 * 0.2 = 0.0196
Portfolio standard deviation: (0.0196)0.5 = 0.14 = 14%
In this case, can you work the portfolio standard deviation easier?
b) Portfolio variance (ρ = 0.5): (0.6 * 0.1)2 + (0.4 * 0.2)2 + 2 * 0.5 * 0.6 * 0.4 * 0.1 * 0.2 =
0.0148
Portfolio standard deviation: (0.0148)0.5 = 0.1216 = 12.16%
c) Portfolio variance (ρ = 0): (0.6 * 0.1)2 + (0.4 * 0.2)2 = 0.01
Portfolio standard deviation: (0.01)0.5 = 0.1 = 10%
For each case, plot the two stocks and the portfolio on the same graph with the expected
return on the vertical axis and the standard deviation on the horizontal axis.

Question 2 (self-study)
You can form a portfolio of two stocks, A and B, whose returns have the following characteristics:
 Stock Expected return Standard deviation
A 10% 20%
B 15% 40%
The correlation between the returns on A and B is 0.5. If you demand an expected return of 12%,
what are the portfolio weights? What is the portfolio’s standard deviation?
The portfolio contains only two stocks, therefore wA + wB = 1
By the definition of expected return: 0.12 = wA * 0.1 + wB * 0.15 = wA * 0.1 + (1 – wA) * 0.15
Hence, wA = 0.6; wB = 0.4
Portfolio variance: (0.6 * 0.2)2 + (0.4 * 0.4)2 + 2 * 0.5 * 0.6 * 0.4 * 0.2 * 0.4 = 0.0592
Portfolio standard deviation: (0.0592)0.5 = 0.2433 = 24.33%

Question 3 (in class)

Here are the inflation rates and stock market and Treasury bill returns (in %):
Year Inflation Stock market return T-bill return
2015 0.2 14.5 4.8
2016 6.0 28.3 2.4
2017 9.5 43.9 1.1
2018 10.3 9.9 1.0
2019 0.5 57.3 0.3
a) What was the real return on the stock market in each year?
b) What was the average real return?
c) What was the risk premium in each year?
d) What was the average risk premium?
e) What was the standard deviation of the risk premium?
Year Real stock market Real market risk
Real T-bill return
return premium
2015 14.3% 4.6% 9.7%
2016 21.0% -3.4% 24.4%
2017 31.4% -7.7% 39.1%
2018 -0.4% -8.4% 8.1%
2019 56.5% -0.2% 56.7%
Average real return: 24.6%
Average risk premium (real): 27.6%
Standard deviation of the risk premium: 20.6%

Question 4 (in class, challenging)

You’ve got the following information about the market prices for Yandex CIA and Aeroflot PJSC
common stocks traded at the Moscow Exchange (MOEX) for the recent 5 years:
Date Yandex, price Aeroflot, price
per share (RUB) per share (RUB)
01-Jan-2015 1,075.00 38.25
01-Jan-2016 1,007.00 50.50
01-Jan-2017 1,379.00 174.17
01-Jan-2018 2,179.00 133.30
01-Jan-2019 2,212.00 107.92
01-Jan-2020 2,873.00 107.40
a) Based only on these historical data provided, which stock is a better investment from the
rational investor’s point of view?
 Will your decision change if you use monthly or weekly pricing data? Does the choice of
estimation period matter? Look for this information and make your spreadsheet.
b) Find the weights of these stocks in a minimum variance portfolio.
Provide both algebraic and MS Excel solutions.
In general, it’s not possible to say which stock will be preferred by a rational investor as the
stock with a higher risk (Aeroflot) carries a higher expected return. The investor’s choice is
determined by his/her utility function.
Year Yandex, return Aeroflot, return

2015 -6.3% 32.0%

2016 36.9% 244.9%
2017 58.0% -23.5%
2018 1.5% -19.0%
2019 29.9% -0.5%
Expected return 24.0% 46.8%
Standard deviation 26.4% 112.9%
Weight (MVP) 98.1% 1.9%
Correlation 0.153
Portfolio variance
(MVP) 0.069
Portfolio standard
deviation (MVP) 26.3%

Question 5 (in class, exam style)

You have the opportunity to invest in two stocks (M and N) with perfectly negative correlation of
returns (ρ = –1). The standard deviation of returns for each of these stocks exceeds 12%. You’ve got
the following information about the portfolios you can construct using stocks M and N only:
Weight of Weight of Portfolio Portfolio standard
Stock M Stock N expected return deviation
Portfolio 1 30% 70% 10.4% 3.3%
Portfolio 2 50% 50% 12.0% 8.5%
a) Based on the above information, calculate the standard deviations of returns for stocks M and N.
b) Is it possible to construct a risk-free portfolio using stocks M and N? If yes, calculate the
expected return of this portfolio.
c) Plot all stocks and portfolios from the previous parts on the mean-standard deviation graph.
Where can you find optimal portfolios? What determines rational investor’s choice?
a) Variances of stocks A and B:
0.32σA2 + 0.72σB2 – 2*0.3σA*0.7σB = 0.0332
0.52σA2 + 0.52σB2 – 2*0.5σA*0.5σB = 0.0852
Hence:
|0.3σA – 0.7σB| = 0.033
|0.5σA – 0.5σB| = 0.085
This system has the following numerical solutions:
1) σA = 0.38; σB = 0.21
2) σA = 0.215; σB = 0.045 (unsuitable as σB < 0.12)
3) σA = –0.38; σB = –0.21 (no economic sense)
4) σA = –0.215; σB = –0.045 (no economic sense)
Therefore, the only suitable solution is: σA = 0.38; σB = 0.21
b) Yes, it’s possible to construct a risk-free portfolio (σ P = 0) using stocks A and B as their returns
have perfectly negative correlation (ρ = –1). This is the only case when we can make a risk-free
portfolio of two risky assets.
Expected returns of stocks A and B:
0.3 E(r)A + 0.7 E(r)B = 0.104
0.5 E(r)A + 0.5 E(r)B = 0.12
Hence: E(r)A = 0.16; E(r)B = 0.08
Variance of the risk-free portfolio:
0.382 WA2 + 0.212 WB2 – 2 * 0.38WA * 0.21 WB = 02
Hence: 0.38 WA – 0.21 WB = 0
Weights of stocks A and B in the risk-free portfolio:
0.38 WA – 0.21 WB = 0
WA + WB = 1
Therefore: WA = 0.356; WB = 0.644
Expected return of the risk-free portfolio = 0.356 * 0.16 + 0.644 * 0.08 = 0.1085
c) All optimal portfolios can be found on the efficient frontier, in this case this is the straight line
between the Risk-free portfolio and Stock A (and going further if short selling of Stock B is
allowed).
Rational investors make their choice based on their attitude to risk, their utility function can be
represented by indifference curves. As a result, optimal portfolios with higher risk have higher
expected return.