By Le Dang Thuy Trang, MSc.

 Rates of return – Realized return vs.

Expected return
 Relationship between risk & return through
historical record
 Measuring total risk
 Variance & Standard deviation
 Covariance & Correlation
 Risk & Diversification
 Diversification
 Asset vs. Portfolio risk
 Unique risk vs. Market risk
 Measuring market risk
 Concept of beta
 Portfolio betas
 Capital asset pricing model (CAPM)
 Using CAPM to estimate expected returns
 Security Market Line (SML)
 Realized return from an investment is the return
that actually occurs over a particular time
period. It comes in 2 forms:
 Dividend (stocks) or interest payment (bonds)
 Capital gain/loss

capital gain  dividend

Realized return 
initial share price
dividend
Dividend yield 
initial share price

capital gain
Percentage capital gain 
initial share price
 Example:You purchased shares of GE stock
at $15.13 on December 31, 2009. You
sold them exactly one year later for
$18.29. During this time GE paid $0.46 in
dividends per share. Ignoring transaction
costs, what is your realized return,
dividend yield and capital gain yield?
 Answer:
 R = (0.46 + 18.29 – 15.13)/15.13 = 23.93%
 Dividend yield = 0.46/ 15.13 = 3.04%
 Capital gain yield = (18.29 – 15.13)/ 15.13 =
20.89%
 Nominal return: measures how much money
you will have at the end of the year if you
invest today.
 Real return: measures how much more you
will be able to buy with your money at the
end of the year.
1  nominal rate of return
1  real rate of return 
1  inflation rate
 Example: Suppose inflation from December
2009 to December 2010 was 1.5%. What was
GE stock’s real rate of return, if its nominal
rate of return was 23.93%?
 Probability Distributions
 When an investment is risky, there are different
returns it may earn. Each possible return has
some likelihood of occurring. This information is
summarized with a probability distribution,
which assigns a probability, PR , that each
possible return, R , will occur.
 Assume Apple stock currently trades for $100 per
share. In one year, there is a 25% chance the share
price will be $140, a 50% chance it will be $110, and a
25% chance it will be $80.
 Expected (mean) return
 The rate of return expected to be realized from an
investment.
 Based on the probabilities of possible outcomes.
 Calculated as a weighted average of the
possible returns, where the weights correspond
to the probabilities.

n
E ( R)   Pi Ri
i 1

 E(RApple) = 0.25(40%) + 0.5(10%) + 0.25(-20%) = 0.1 or 10%

 Example: Suppose you have predicted the
following returns for stocks C and T in three
possible states of the economy. What are the
expected returns?
State Probability Stock C Stock T
Return Return
Boom 0.3 15% 25%
Normal 0.5 10% 20%
Recession 0.2 2% 1%

 RC = 0.3(15) + 0.5(10) + 0.2(2) = 9.9%

 RT = 0.3(25) + 0.5(20) + 0.2(1) = 17.7%
Source: Elroy Dimson, Paul Marsh, & Mike Staunton, Triumph of the Optimists:101 years of
Global Investment Returns (Princeton, NJ: Princeton University Press, 2002)
• Bills = Treasury bills issued by the U.S.
government with maturity of 3-months.
• Safe & relatively stable
• Bonds = Treasury bonds issued by the U.S.
government with average maturity of 10
years.
• Safe but prices fluctuate as interest rates vary.
• Equities = Diversified Portfolio of Common
Stocks
 Riskiest (residual claims)
 Greatest gains
 The “extra” return earned for taking on risk
 US Treasury bills are considered to be risk-
free
 The risk premium is the return over and
above the return on risk-free investment.

Expected Return  Return from Treasury bills  Risk Premium

 Risk: a measure of
how far the returns
may differ from the
average (spread).
 To present the
spread of possible
investment returns:
histogram.
 The bars in each
histogram show the
number of years that
the investment’s
return fell within a
specific range.
 Variance and standard deviation measure the
volatility of asset returns
 The greater the volatility, the greater the
uncertainty → riskier
 Variance
2 1
      1 T

Var ( R)    R1  R  R2  R  ...  RT  R   Rt  R
T
2 2 2

T t 1
2

 Standard deviation

SD( R)    Var ( R)
 Illustration:
Suppose a particular investment
had returns of 10%, 12%, 3% and -9% over the
last four years.

(1) (2) (3) (4)

Actual Average Deviation Squared
Return Return (1) – (2) Deviation
0.1 0.04 0.06 0.0036
0.12 0.04 0.08 0.0064
0.03 0.04 -0.01 0.0001
-0.09 0.04 -0.13 0.0169
Total 0.16 0.00 0.027
 Variance and standard deviation of the returns
are:

0.027
Var ( R)   2
 0.00675
4
SD( R)    Var ( R)  0.00675  0.0822
 Example: Two companies, Supertech Co. and
Hyperdrive Co. have experienced the following
returns in the last four years:

Year Supertech Return Hyperdrive Return

2001 -0.2 0.05
2002 0.5 0.09
2003 0.3 -0.12
2004 0.1 0.20

 What are the average returns? The variances?

The standard deviations? Which investment was
more volatile?
 Supertech Co:

Year (1) (2) (3) (4)

Actual Average Deviation Squared
Return Return (1) – (2) Deviation
2001 -0.2
2002 0.5
2003 0.3
2004 0.1
Total 0.7
 Hyperdrive Co:

Year (1) (2) (3) (4)

Actual Average Deviation Squared
Return Return (1) – (2) Deviation
2001 0.05
2002 0.09
2003 -0.12
2004 0.2
Total 0.22
 Variance and standard deviation

Supertech Hyperdrive
Variance (2)
Standard deviation ()
 TXN stock has the following probability
distribution:
Probability Return
0.25 8%
0.55 10%
0.20 12%

 What are its expected return and standard

deviation?
 Portfolio
 A collection of assets
 The risk-return trade-off for a portfolio is
measured by the portfolio expected return and
standard deviation, just as with individual assets
 Portfolio weights
 The proportion of the total investment in the
portfolio invested in each asset.
 The portfolio weights must add up to 1 or 100%.
 Example: Suppose you have $15,000 to invest and
you have purchased securities in the following
amounts. What are your portfolio weights in each
security? wVCB 
2,000
 0.133
15,000
 $2,000 of VCB 3,000
wHAG   0.2
 $3,000 of HAG 15,000
 $4,000 of KDC wKDC 
4,000
 0.267
 $6,000 of VNM 15,000
6,000
wVNM   0.4
15,000
 Portfolio expected returns
 The expected return of a portfolio is the
weighted average of the expected returns of the
respective assets in the portfolio

m
E ( RP )   w j E ( R j )
j 1
 Portfolio expected returns
 Example: Consider the portfolio weights
computed previously. If the individual stocks
have the following expected returns, what is the
expected return for the portfolio?
 VCB: 19.69%
 HAG: 5.25%
 KDC: 16.65%
 VNM: 18.24%
 E(RP) = 0.133(19.69) + 0.2(5.25) + 0.267(16.65) +
0.4(18.24) = 15.41%
 Portfolio variance:
 Step 1: Compute the portfolio return for each state
 Step 2: Compute the expected portfolio return using
the same formula as for an individual asset
 Step 3: Compute the portfolio variance and standard
deviation using the same formulas as for an individual
asset
 Portfolio variance:
 Example: Consider the following information

State Probability Stock A Stock B

Boom 0.25 15% 10%
Normal 0.60 10% 9%
Recession 0.15 5% 10%

 What are the expected return and standard deviation for

a portfolio with an investment of $6,000 in Stock A and
$4,000 in Stock B?
 Tofind the risk of a portfolio, one must
know the degree to which the stocks’ returns
move together.
 Covariance:

 The expected product of the deviations of two

returns from their means
 Covariance between Returns Ri and Rj

Cov( Ri , R j )   ij  E Ri  E Ri R j  E R j  
 If the covariance is positive, the two returns tend to
move together.
 If the covariance is negative, the two returns tend to
move in opposite directions.
 Correlation:
 A standardized measure of covariance.
CovRi , R j 
Corr Ri , R j   ij 
 i j
 The correlation between two assets must lie
between -1 and 1.
 Diversification
 Reduce risk by spreading the portfolio across
many investments
 “Do not put all eggs in one basket”–Warren
Buffet
 Diversification is not just holding a lot of assets
 For example, if you own 50 Internet stocks, you are
not diversified. However, if you own 50 stocks that
span 20 different industries, then you are diversified.
 The amount of risk that is eliminated in a
portfolio depends on the degree to which the
returns of assets in the portfolio move together.
 An asset class is a group of investments with
similar risk and return characteristics such as
bonds, stocks.
 One way to diversify your portfolio is to
invest in several asset classes.
 For example, a balanced portfolio that has
50% stocks and 50% bonds. The balanced
portfolio returns are less volatile than the
equity portfolio, and it is less likely to
experience a big loss if the market goes
down.
 Stocks within the same industry generally have prices
that move together.
 To diversify, you need to select stocks whose prices do
not move together. Variations in the returns of one
stock should offset variations in the returns of other
stocks.
 For example, a portfolio initially consists of the shares
of a bank. You add the shares of another bank. This will
reduce the risk of the portfolio by very little because
all banks are affected by the same economic
conditions, like changes in interest rates. When the
shares of a bank drop, those of other banks are likely
to drop too. To diversify the portfolio, you could add
the shares of companies from other industries, such as
energy and health care.
 The standard deviation of the returns of an
individual security measures how risky that
security would be if held in isolation.
 The contribution of a security to the risk of
the portfolio depends on how the security’s
returns vary with those of the rest of the
portfolio.
→ A security that is risky if held in isolation
may nevertheless reduce the variability of
the portfolio if its returns do not move
closely with the rest of the portfolio.
 Correlation has no effect on the expected
return of a portfolio. However, the
volatility of the portfolio will differ
depending on the correlation.
 Thelower the correlation, the lower the
volatility we can obtain. As the
correlation decreases, the volatility of
the portfolio falls.
 Market risk
 Risk factors that affect the overall stock market
 Also known as non-diversifiable risk or systematic
risk
 Includes such things as changes in GDP, inflation,
interest rates, exchange rates, etc.
 Specific risk
 Risk factors that affect only the individual firm
 Also known as unique risk, diversifiable risk or
unsystematic risk
 Can be eliminated by combining assets into a
portfolio.
 Actual firms are affected by both market-
wide risks and firm-specific risks.
 When many stocks are combined in a large
portfolio, the firm-specific risks for each
stock will average out and be diversified.
 Volatility then declines until only market risk
remains in a well-diversified portfolio.
 The market risk, however, will affect all
firms and will not be diversified.


Diversifiable Risk;
Nonsystematic Risk; Firm
Specific Risk; Unique Risk

Portfolio risk
Nondiversifiable risk;
Systematic Risk; Market
Risk

n
Thus diversification can eliminate some,
but not all of the risk of individual securities.
 The risk premium for diversifiable risk is zero
 Investors are not compensated for holding specific
risk
 The risk premium of a security is determined by its
market risk and does not depend on its specific risk
 Only market risk is rewarded
 Total risk = firm-specific risk + market risk
 For well-diversified portfolios, specific risk is
very small
 Consequently, the total risk for a diversified
portfolio is essentially equivalent to the
market risk
 Market portfolio:
 Portfolio of all assets in the economy.
 In practice a broad stock market index is used to
represent the market (e.g. S&P 500, VN-Index)
 Measuring market risk: beta ()
 Sensitivity of a stock’s returns to the returns on
the market portfolio.
  = 1: stock has the same market risk as the
overall market
  > 1: stock has more market risk than the
market
  < 1: stock has less market risk than the market
 Defensive stocks: not very sensitive to
market fluctuations → low betas (<1).
 Aggressive stocks: amplify any market
movements → higher betas (>1).
 The beta of the overall market portfolio is 1.
 The beta of the risk-free investment is 0.
 Beta of a portfolio: weighted sum of the
betas of the individual stocks in the
portfolio.
 Example: Consider the following information
Standard Deviation Beta

Security C 20% 1.25

Security K 30% 0.95

 Which security has more total risk?

 Which security has more systematic risk?
 Which security should have the higher
expected return?
 Example: Consider the following information
for the four securities
Security Weight Beta
VCB 0.133 2.685

HAG 0.2 0.195

KDC 0.267 2.161

VNM 0.4 2.434

 What is the portfolio beta?

Market Risk Premium - Risk premium of market
portfolio; the difference between the market return
and the return on risk-free Treasury bills.

Let,
rf  Risk-free rate of return
rm  Market Return
Market Risk Premium = rm  rf
 14
Example:
12

Expected Return (%)

Let, 10
market risk premium  8% Market
rf  4% 8
Portfolio
rm  12% 6 (market
return =
4
Market Risk Premium = 8% 12%)
2 rf  4%
0
0 0.2 0.4 0.6 0.8 1
Beta
 Let r = expected return on any asset

Market risk premium  rm - rf

Risk premium on any asset  r - rf
r  rf    (rm  rf )
or,*
r  rf    (rm  rf )
CAPM: Theory of the relationship between risk and
return which states that the expected risk premium
on any security equals its beta times the market risk
premium
Let:
rf  4%
rm  12%
Thus, the Market Risk Premium = 8%

Suppose   1.2

According to CAPM, the expected return on the asset is

r  rf    (rm  rf )  4%  1.2  (8%)  13.6%
 Evidence on validity of CAPM is conflicting.
 CAPM remains the leading model for estimating
required return:
 Investors require some extra return for taking on risk.
 Investors are mainly concerned about the market risk
that they cannot eliminate by diversification.
 If we know the risk-free interest rate, the
expected market risk premium and an asset’s
beta, we can use the CAPM to determine the
asset’s expected return.
 This is true whether we are talking about
financial assets or physical assets.
 Considerthe betas for each of the stocks
given earlier. If the risk-free rate is 4.15%
and the market risk premium is 8.5%, what is
the expected return for each?
Security Beta Expected Return
VCB 2.685 4.15 + 2.685(8.5) = 26.97%
HAG 0.195 4.15 + 0.195(8.5) = 5.81%
KDC 2.161 4.15 + 2.161(8.5) = 22.52%
VNM 2.434 4.15 + 2.434(8.5) = 24.84%
 Assume the economy has a 60% chance of the
market return will be 15% next year and a
40% chance the market return will be 5%
next year.
 Assume the risk-free rate is 6%.
 If Microsoft’s beta is 1.18, what is its
expected return next year?
 Suppose the stock of the 3M Company (MMM)
has a beta of 0.69 and the beta of Hewlett-
Packard Co. (HPQ) stock is 1.77.
 Assume the risk-free interest rate is 5% and
the expected return of the market portfolio
is 12%.
 What is the expected return of a portfolio of
40% of 3M stock and 60% Hewlett-Packard
stock, according to the CAPM?
Security Market Line - The relationship between
expected return and beta.

rm

rf