RISK, RETURN & SML

Outline of this chapter

• How to calculate expected return & expected risk on a single (=1)
asset or portfolio (=2,3…) of assets
• What is “diversification”?
• Types of risk
• Risk-return trade-off
• We’re looking at future returns
• Returns are unknown. Uncertainties
• Different return may occur with different probabilities
• E(R) = expected return for some year in the future
• E(σ) = expected standard deviation of future R’s
EXPECTED RETURN & VARIANCES
• When we talk about future, we always deal with uncertainty
• For any company’s shares of stock we may want to calculate for next
year’s
• Expected return
• Expected variance (or exp. Standard deviation) of returns
EXPECTED RETURN & VARIANCES
• In real life, we are never able to predict future!
• And so actual returns are generally not equal to expected return
• We say that actual return R has the expected component E(R) & the
unexpected component U :
R = E(R) + U
In any year in t
he future, the
can be either p unexpected re
ositive or nega turn “U”
Example: tive.
Based on our a
nalysis we exp
= 15% ect next year ’s
return E(R)
1 year later, th
e actual return
We have a -3% turns out to be
unexpected re 12%
turn : “U” <0
QUESTION
• What do the expected and the unexpected components of return
depend on?
• Answer: “Information!”
• Expected component “E(R)”: Depends on investors’ information about
the stock, and on their understanding today of the importance factors
that will influence the stock next year
• Unexpected component “U”: If new information (announcement,
news, etc.) is revealed between today and next year, this will change
the stock return next year, which was previously unanticipated.
EXPECTED RETURN & VARIANCES
• It’s common in finance to give names to states of economy

Return on stock of company “ABC” next year: Return on stock of company “XYZ” next year:

3 states of economy: 2 states of economy:

“boom” =………………………… R = 35% “good” = …………………………………. R= 15%
“normal”=………………………… R = 12% “bad”=……………………………………. R = 4%
“recession” = ……………………. R= -3%

• States of economy can be equally likely or not equally likely

• All probabilities must equal 100%
EXPECTED RETURN & VARIANCES
• Expected return:

Expected return = E(R) =

Probability of state 1 x Rstate1 + Probability of state 2 x Rstate2 + …+ Probability of state N x RstateN

• Expected risk:

Variance = Var(R) = σ2=

Probability(Rstate1-E(R)2 + probability of state 2 (Rstate2-E(R))2 +…+probability
fo state N (RstateN-E(R))2

Standard deviation = st.dev. =variance (R)

EXPECTED RETURN & VARIANCES
• We will compare investments into 2 different stocks
• We will again have 3 possible states
“boom”
“normal”
“recession”
EXPECTED RETURN & VARIANCES
State Probability of state R on stock of Firm “A” R on stock of firm “B”
Boom 20% 30% -5%
Normal 50% 12% 7%
Recession 30% -10% 15%

Stock “A”
E(RA) = 0.2 x 0.30 + 0.5 x 0.12 + 0.3 x (-0.10) = 0.09 or 9%
σ2A = 0.2 x (0.30-0.09)2 + 0.5 x (0.12-0.09)2 + 0.3 x (-0.10-0.-09)Which
2 stock is more
= 0.0201
σA = attractive to investors?

Stock “B”
Which stock is riskier?
E(RA) = 0.2 x (-0.05) + 0.5 x 0.07 + 0.3 x 0.15 = 0.07 or 7%
σ2A = 0.2 x (-0.05-0.07)2 + 0.5 x (0.07 – 0.07)2 + 0.3 x (0.15 – 0.07)2 = 0.0048
σA =
 WHAT IS PORTFOLIO?
• General calculations of Expected Return, Variance, and Standard
Deviation of portfolio returns are the same as for an individual
security

2 or more financial securities:

✓ : E.g. stocks of 2+ different companies
✓ : E.g. stocks & bonds
✘ : E.g 2 + shares of stock of one company

Except we first need to calculate portfolio return for each state

For this we need to know the “weights” of stocks in the portfolio
WHAT IS PORTFOLIO?
• Group of assets such as stocks and bonds held by investors
• Portfolio weight – The percentage of a portfolio’s total value invested
in a particular asset
• Expected return – Average return on a risky asset expected in the
future
• Variance – Common measure of volatility
PORTFOLIO E(R) AND PORTFOLIO
RISK
• Example: Buy 100 shares of stock Y. Each costs $90
Buy 300 shares of stock Z. Each costs $75
• What are the weights of Y and Z in the portfolio?
• Weight of Y = 100/400 = ¼ and Weight of Z = 300/400 = ¾
• Invest a total of 100 x $90 = $9,000 in stock Y ✓
• Invest a total of 300 x $75 = $22,500 in stock Z ✓
$31,500 Total investment

• Weight of stock Y = $9,000/$31,500 = 0.2857 or 28.57%

• Weight of stock Z = $22,500/$31,500 = 0.7143 or 71.43%
• Risk Premium= there is a reward, on average, for bearing risk
• Defining relationship between an asset’s risk and its required return
• Two type of risks: Systematic and unsystematic
• To diversified investor, only systematic risk matters
EXPECTED RETURN OF PORTFOLIO
• E(R)p = WLE(R) + W E(R)
L U U

• Where:
E(R)p : Expected return of portfolio
W : Weight of asset L
L

WUE(R)U: Weight of asset U

EXAMPLE
• Calculate the expected return of a portfolio with three stocks:
Stock A has a expected return of 3% and makes up 25% of the portfolio
Stock B has a expected return of 1% and makes up 50% of the portfolio
Stock C has a expected return of 9% and makes up 25% of the portfolio

• Expected return = (0.25 x 3%) + (0.5 x 1%) + (0.25 x 9%) = 3.5%

EXPECTED RETURN STATE
• Find the expected return of the portfolio below. The portfolio has
equal investments in each assets
State of Probability Returns
economy state of
economy Stock A Stock B Stock C

Boom 0.5 10% 15% 20%

Bust 0.5 8% 4% 0%

• Stock A = (0.5 x 10%) + (0.5 x 8%) = 9%

• Stock B = (0.5 x 15%) + (0.5 x 4%) = 9.5%
• Stock C = (0.5 x 20%) + (0.5 x 0%) = 10%
EXPECTED RETURN STATE
State of Economy Probability State of Returns
Economy
Stock A Stock B Stock C

Boom 0.5 10% 15% 20%

Bust 0.5 8% 4% 0%
Expected Return 9% 9.5% 10%

Expected Return Portfolio = ((1/3)x9%) + ((1/3) x 9.5%) + ((1/3) x 10%) = 9.5%

STOCK VARIANCE
Recall, to calculate the variance of the stock:
1. Find the expected return
2. Calculate the return deviation (Return for state-Expected return)
3. Square the return deviation
4. Multiply squared return deviation by probability of each state
5. Add results to find variance
EXAMPLE: STEP 1 (FIND THE
EXPECTED RETURN)
• Consider the expected return of ABC Corp., what is the variance of
the stock?
State of Economy Probability of State of ABC Corp
Economy
Boom 0.2 70%
Bust 0.8 -20%
Expected return -2%

• The next step is to calculate the return deviation of the equity

STEP 2 (CALCULATE THE RETURN
DEVIATION)
• The next step is to calculate the return deviation of the equity
• Boom state, 70% - (-2%) = 72%
• Bust state, -20% - (-2%) = -18%
STEP 3 (SQUARE THE RETURN
DEVIATION)
State of economy Probability of State ABC Corp. Return Deviation
•State of Economy of Economy
•Probability of State of Economy
Boom 0.2 70% 72%
Bust 0.8 -20% -18%
Expected Return -2%

72% ^ 2 = 51.8%
-18% ^ 2 = 3.2%
STEP 4 (Multiply squared return deviation by
probability of each state)

State of Economy Probability of State ABC Corp. Return Deviation Squared Deviation
of Economy
Boom 0.2 70% 72% 51.8%
Bust 0.8 -20% -18% 3.2%

0.2 x 51.8% = 10.4%

0.8 x 3.2% = 2.6%
STEP 5 (FIND STOCK VARIANCE)
State of Probability of ABC Corp. Return Squared Product
Economy State of Deviation Deviation
Economy
Boom 0.2 70% 72% 51.8% 10.4%
Bust 0.8 -20% -18% 3.2% 2.6%
Expected Return -2%

Sum product results to find stock variance:

10.368% + 2.592% = 12.96%
PORTFOLIO VARIANCES
• Calculating the portfolio variance is not like calculating the expected
return of a portfolio
• For example, if a portfolio split 50/50 between stock A and Stock B
with variances of 45% and 10%
• Portfolio variance = 0.5 x 45% + 0.5 x 10%
• This is wrong
QUIZ
• Consider the portfolio below, what would be the portfolio’s variance?
It is 50% invested in stock A and 25% in each of stock B and C.
State of Probability Returns
economy State of
Economy Stock A Stock B Stock C

Boom 0.5 10% 15% 20%

Bust 0.5 8% 4% 0%
Boom, (0.5 x 10%) + (0.25 x 15%) + (0.25 x 20%) = 13.75%
Bust, (0.5 x 8%) + (0.25 x 4%) + (0.25 x 0%) = 5%
• 0.5 x 13.75% + 0.5 x 5% = 9.375%

dst
DIVERSIFICATION EFFECT
In the text book:
• “Diversification” is the process of spreading an investment across
assets (and thereby forming a portfolio)”
• The principle of diversification tells us that spreading an investment
across many assets will eliminate some of the risk

• Turns out, we can never eliminate risk completely!

SYSTEMATIC AND UNSYSTEMATIC
RISK
• When investing in assets that are not perfectly correlated, the
portfolios overall risks will be less than the weighted average risk of
the security in it
• Diversification is good
• We saw in our previous example that:
• If hold only 1 stock, risk is high (σ is high)
• If hold a portfolio of 2 stocks, risks may be lower (i.e,
σportfolio is lower)
• If hold a portfolio of 100 stocks, risk may become even
smaller
Total risk = diversifiable risk + undiversifiable risk
UNSYSTEMATIC RISK
• The risk that is eliminated through diversification
• Also known as: company-specific risk; Diversifiable risk; Specific Risk
• Can be eliminated completely through diversification (i.e., by investing
in portfolio)
• Depends on firm-specific events
SYSTEMATIC RISK
• The risk that is inherent to the whole market and cannot be
diversified away
• Also known as: undiversifiable risk; Market risk
• Can NOT be eliminated. Minimum level of risk that will always be
present
• Depend on economy-wide events
DIVERSIFICATION AND PORTFOLIO
RISK
• Standard deviation declines as the number of securities is increased.
• Some of the riskiness associated with individual assets can be
eliminated by forming portfolios.
• Unsystematic risk is essentially eliminated by diversification, so a
relatively large portfolio has almost no unsystematic risk
SYSTEMATIC RISK PRINCIPLE
• Systematic risk principle states that the reward for bearing risk
depends only on the systematic risk of an investment.
• Systematic risk is the crucial determinant of an asset’s expected
return, there is a way of measuring the level of systematic risk for
different investments (beta coefficient)
• Asset with larger betas have greater systematic risks, they will have
greater expected returns
BETA
• There is a way to calculate the amount of “systematic risk” in an
asset!
• All we learn is that “Systematic risk” is measured by β = Beta
• Beta shows how much systematic risk a particular asset has relative to
the market portfolio
• The “beta” for the market portfolio is always 1
• Can instead say that the “beta” for an average company’s stock is 1
 PORTFOLIO BETAS
Security Amount Invested Expected Return Beta
Stock A $1,000 8% .80
Stock B 2,000 12 .95
Stock C 3,000 15 1.10
Stock D 4,000 18 1.40

• What is the expected return on this portfolio? Stock A = 10% (1,000/10,000) Stock B= 20%, Stock C = 30% and
Stock D = 40%
• What is the beta of this portfolio?
Determine the expected return
E(Rp) = 0.10 x 8% + 0.20 x 12% + 0.30 x 15% + 0.40 x 18 % = 14.9%
Determine the portfolio beta
βp(0.10 x 0.80) + (0.20 x 0.95) + (0.30 x 1.10) + (0.40 x 1.40) = 1.16
• Since the beta is larger than 1.0, this portfolio has greater systematic risk than an average asset
 BETA Systematic risk

Stock σ (Total risk) β

Stock A 40% 0.5
Stock B 20% 1.5

Which stock should have a higher expected return?

WRONG:
40% > 20%
- So A is riskier
- So A should have a higher expected return

CORRECT:
0.5 < 1.5
- This means that a big part of A’s firm-specific risk can be eliminated by forming a portfolio
- Only non-diversifiable risk should be rewarded
- “B” has a higher non-diversifiable risk (Beta)
BETA AND C.A.P.M MODEL
• Now that we know that it is the systematic risk (Beta) that determines
the required return….

…. What is the exact relationship between the two?

It is described by
Capital Asset Pricing Model (CAPM)
SECURITY MARKET LINE

All assets should lie

on this straight line

Expected annual
return on the
“market portfolio”

Risk-free asset

Beta on market
portfolio
BETA AND C.A.P.M MODEL
• Stock of firm “J” has risk: βJ = 1.6
Risk free rate is 3.8%
Expected return on the market portfolio is 12.3%

• What is the annual return would correctly compensate investors for such risk (i.e., required
return)?
E(RJ) = R(f) + βJ x (E(RM)- Rf) = 0.038 + 1.6 x (0.123- 0.038) = 0.174 or 17.4%
• What is the risk premium on “J”’s stock?
Risk premium = 17.4% - 3.8% = 13.6%
E(R) too high for given level of riskiness = Price
will rise = Return will fall = back to SML line
So this security is currently Underpriced

E(R) too low for given level of riskiness

• Price will fall
• Return will fall
• Back to SML Line
So, this security is currently overpriced
CAPITAL ASET PRICING MODEL
• Expected Return on Security = Risk free rate + Beta Expected return on
market
• E(Ri) = Rf + β x (Rm – Rf)
E(Ri) = 4.1% + 0.89 x (10%-4.1%)
• Expected return on security are used to estimate if a stock is over or
undervalued
• Risk free rate
a) Typically based on government bond yield
b) Represents the theoretical rate of return of an investment with zero risk
c) Baseline for measuring risk premium
CAPITAL ASSET PRICING MODEL
• Beta measures a stock’s volatility relative to the market
• Β>1 more volatile than market, vice versa
• Expected return on market represents the anticipated return of the
overall market, often uses S&P 500 index as a proxy for the market
• E(r) = Rf + β x (Rm – Rf)
• What does this formula mean?
• Market risk premium = expected return on market