Professor Chinco

FIN3000
Principles of Finance
Chapter 11
Today’s topics

Historical performance

What is a “risk premium”?

How to measure risk?

Diversification benefits
Historical
performance
Market Indexes

U.S. stock-market indices:

Dow Jones Industrial Average (The Dow): Index of the investment

performance of a portfolio of 30 “blue-chip” stocks

Standard & Poor’s Composite Index (S&P 500): Index of the investment
performance of a portfolio of 500 large stocks

Also see: Russell 2000, Wilshire 5000, etc

Stock market indices for other markets: Nikkei Index (Tokyo), FTSE
index (London), MSCI (world stock market index)
Suppose you invested $1 in stocks (equities), Treasury bonds (long term), or
Treasury bills (short term) starting at market open January 3rd 1900. Here’s
how much money you’d have as of year t. Notice anything about these lines?
What is a “risk
premium”?
Risk Premium

Maturity Premium: difference between expected return on

long-term Treasury bonds and expected return on short-
term Treasury Bills.
Market Risk Premium: difference between expected return
on stocks and expected returns on short-term bonds.
 Rate of return, %

-50
-22.5
5
32.5
60

1900
1903
1906
1909
1912
1915
1918
1921
1924
1927
1930
1933
1936
1939
1942
1945
1948
1951
Rates of Return

1954
1957
Year 1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
Common Stocks (1900-2022)

1993
1996
1999
2002
2005
2008
2011
2014
2017
 Class problem
What was the market risk premium for each period?

E[Return] Risk
Stocks T Bills Premium
1900-1928: 12.0% 4.9% 7.1%
1929-1957: 9.8% 1.0% 8.8%
1958-1987: 11.8% 6.0% 5.8%
1987-2022: 12.5% 3.1% 9.4%
 Class problem
What was the market risk premium for each period?

E[Return] Risk
Stocks T Bills Premium
1900-1928: 12.0% 4.9% 7.1%
1929-1957: 9.8% 1.0% 8.8%
1958-1987: 11.8% 6.0% 5.8%
1987-2022: 12.5% 3.1% 9.4%
 Class problem
What was the market risk premium for each period?

E[Return] Risk
Stocks T Bills Premium
1900-1928: 12.0% 4.9% 7.1%
1929-1957: 9.8% 1.0% 8.8%
1958-1987: 11.8% 6.0% 5.8%
1987-2022: 12.5% 3.1% 9.4%
 Class problem
What was the market risk premium for each period?

E[Return] Risk
Stocks T Bills Premium
1900-1928: 12.0% 4.9% 7.1%
1929-1957: 9.8% 1.0% 8.8%
1958-1987: 11.8% 6.0% 5.8%
1987-2022: 12.5% 3.1% 9.4%
 Class problem
What was the market risk premium for each period?

E[Return] Risk
Stocks T Bills Premium
1900-1928: 12.0% 4.9% 7.1%
1929-1957: 9.8% 1.0% 8.8%
1958-1987: 11.8% 6.0% 5.8%
1987-2022: 12.5% 3.1% 9.4%
Rates of We have two ways to estimate
E[Return] for risky assets:
Return –
Expected #1) E[Return] = historical average
Return
#2) E[Return] = riskless rate
+ risk premium

Riskless rate is return on

Treasury bills.
Using risk premium to compute E[Return]

Suppose in 2022, we want to

estimate E[Return] for
common stocks in 2023.

Expected interest rate

normal risk #1) Historical average of
market return = on Treasury +
premium stock returns from 1900 to
(2022) bills (2022)
2022 is 11.3% per year.

#2) We can base our

9.4% = 1.7 + 7.7 forecast on the 2022
Treasury bill rate and a
forecasted market risk
premium.
Risk premia for different
countries
Country risk premiums (1900-2022)
How to measure
risk?
Histograms offer a way
to gauge risk

The spread of possible

investment returns for
(a) common stocks
(b) treasury bonds and
(c) treasury bills

Investment risk depends

on the dispersion of
possible outcomes
Histograms offer a way
to gauge risk

Common stocks have the

widest dispersion in
outcomes and are thus
the most risky.

The return has been

anywhere between -45%
and +60%.

How do we quantify the

dispersion in returns?
Volatility Variance: Average value of squared
deviations from mean.

Standard Deviation = Square root of

The graph below shows the Normal
variance. Also called “volatility”.
Distribution

Variance and standard deviation

measures dispersion of data points.
For example, if a group of data
follows normal distribution, we
know 68% of data points are within
1 standard deviation of the
average, 95% of data points are
within 2 standard deviations of the
average, and 99.7% of data points
are within 3 standard deviations of
the average.
Coin toss example

Jump to Soulver
Translating Measuring the variation in past stock
returns:
this to Consider each stock return as one data
point from the underlying distribution
stock data Calculate the average return
Calculate the variance and standard
deviation

We often assume the spread of returns

in the past is a reasonable indication
of what could happen in the future.
Past stock return variation is a
measure for the stock’s riskiness.
A worked example
Stock-market volatility 1900-2020
Diversification
benefits
Notice anything weird?
Ticker Company Standard Deviation (%)
X U.S. Steel 72.4
MRO Marathon Oil 43.7
NEM Newmont Mining 41.9
AMZN Amazon 26.3
BA Boeing 21.6
INTC Intel 20.5
CPB Campbell Soup 19.5
PCG Pacific Gas & Electric 19.4
GOOG Alphabet 19.3
F Ford 18.7
GE GE 18.6
DIS Disney 18.2
UNP Union Pacific 18.1
IBM IBM 17.4
WMT Walmart 16.4
SBUX Starbucks 15.8
PFE Pfizer 15.2
XOM ExxonMobil 13.9
MCD McDonald's 13.0
KO Coca-Cola 12.5
S&P500 9.4
Calculating a portfolio’s
expected return is easy

Portfolio rate fraction of portfolio rate of return on

= ×
of return in first asset first asset

fraction of
rate of return on
+ portfolio in second ×
second asset
asset
Calculating The market portfolio consists of
individual stocks.

portfolio e.g. S&P 500 index is value-weighted

index of 500 largest stock in U.S.

return market.

volatility Market portfolio has lower volatility

than each individual stock.
is slightly
more Since all stocks in the market portfolio
do not fluctuate together (not perfectly

involved correlated).

Diversification reduces volatility.

Example: Restaurant profits
Suppose you earn $1 for every customer that eats at your restaurant. Over 20
days, Alice and Bob each eat at your restaurant 10 times.
Mean daily profit from each customer: ( 10 10
20 ) · $1 + ( 20 ) · $0 = $0.50. Mean
daily profit from both customers: 2 ⇥ $0.50 = $1.
Variance of daily profits from each customer:
10
20 ⇥ ($1 $0.50)2 + 10
20 ⇥ ($0 $0.50)2 = $0.25 (23)

Variance of daily profits from both customers:

I Scenario #1: Alice and Bob never show up on same day. Alice shows up
on day 1, Bob shows up on day 2, Alice shows up on day 3,
etc. . . Variance of total daily profits ($1 every day):
20
20 ⇥ ($1 $1)2 = $0 (24)
I Scenario #2: Alice and Bob only ever show up together. Both show up
on day 1, neither shows up on day 2, both show up on day 3,
etc. . . Variance of total daily profits ($2 every other day):
10
20 ⇥ ($2 $1)2 + 10
20 ⇥ ($0 $1)2 = $1 (25)
Example: Restaurant profits
Suppose you earn $1 for every customer that eats at your restaurant. Over 20
days, Alice and Bob each eat at your restaurant 10 times.
Mean daily profit from each customer: ( 10 10
20 ) · $1 + ( 20 ) · $0 = $0.50. Mean
daily profit from both customers: 2 ⇥ $0.50 = $1.
Variance of daily profits from each customer:
10
20 ⇥ ($1 $0.50)2 + 10
20 ⇥ ($0 $0.50)2 = $0.25 (23)

Variance of daily profits from both customers:

I Scenario #1: Alice and Bob never show up on same day. Alice shows up
on day 1, Bob shows up on day 2, Alice shows up on day 3,
etc. . . Variance of total daily profits ($1 every day):
20
20 ⇥ ($1 $1)2 = $0 (24)
I Scenario #2: Alice and Bob only ever show up together. Both show up
on day 1, neither shows up on day 2, both show up on day 3,
etc. . . Variance of total daily profits ($2 every other day):
10
20 ⇥ ($2 $1)2 + 10
20 ⇥ ($0 $1)2 = $1 (25)
Example: Restaurant profits
Suppose you earn $1 for every customer that eats at your restaurant. Over 20
days, Alice and Bob each eat at your restaurant 10 times.
Mean daily profit from each customer: ( 10 10
20 ) · $1 + ( 20 ) · $0 = $0.50. Mean
daily profit from both customers: 2 ⇥ $0.50 = $1.
Variance of daily profits from each customer:
10
20 ⇥ ($1 $0.50)2 + 10
20 ⇥ ($0 $0.50)2 = $0.25 (23)

Variance of daily profits from both customers:

I Scenario #1: Alice and Bob never show up on same day. Alice shows up
on day 1, Bob shows up on day 2, Alice shows up on day 3,
etc. . . Variance of total daily profits ($1 every day):
20
20 ⇥ ($1 $1)2 = $0 (24)
I Scenario #2: Alice and Bob only ever show up together. Both show up
on day 1, neither shows up on day 2, both show up on day 3,
etc. . . Variance of total daily profits ($2 every other day):
10
20 ⇥ ($2 $1)2 + 10
20 ⇥ ($0 $1)2 = $1 (25)
Example: Restaurant profits
Suppose you earn $1 for every customer that eats at your restaurant. Over 20
days, Alice and Bob each eat at your restaurant 10 times.
Mean daily profit from each customer: ( 10 10
20 ) · $1 + ( 20 ) · $0 = $0.50. Mean
daily profit from both customers: 2 ⇥ $0.50 = $1.
Variance of daily profits from each customer:
10
20 ⇥ ($1 $0.50)2 + 10
20 ⇥ ($0 $0.50)2 = $0.25 (23)

Variance of daily profits from both customers:

I Scenario #1: Alice and Bob never show up on same day. Alice shows up
on day 1, Bob shows up on day 2, Alice shows up on day 3,
etc. . . Variance of total daily profits ($1 every day):
20
20 ⇥ ($1 $1)2 = $0 (24)
I Scenario #2: Alice and Bob only ever show up together. Both show up
on day 1, neither shows up on day 2, both show up on day 3,
etc. . . Variance of total daily profits ($2 every other day):
10
20 ⇥ ($2 $1)2 + 10
20 ⇥ ($0 $1)2 = $1 (25)
Example: Restaurant profits
Suppose you earn $1 for every customer that eats at your restaurant. Over 20
days, Alice and Bob each eat at your restaurant 10 times.
Mean daily profit from each customer: ( 10 10
20 ) · $1 + ( 20 ) · $0 = $0.50. Mean
daily profit from both customers: 2 ⇥ $0.50 = $1.
Variance of daily profits from each customer:
10
20 ⇥ ($1 $0.50)2 + 10
20 ⇥ ($0 $0.50)2 = $0.25 (23)

Variance of daily profits from both customers:

I Scenario #1: Alice and Bob never show up on same day. Alice shows up
on day 1, Bob shows up on day 2, Alice shows up on day 3,
etc. . . Variance of total daily profits ($1 every day):
20
20 ⇥ ($1 $1)2 = $0 (24)
I Scenario #2: Alice and Bob only ever show up together. Both show up
on day 1, neither shows up on day 2, both show up on day 3,
etc. . . Variance of total daily profits ($2 every other day):
10
20 ⇥ ($2 $1)2 + 10
20 ⇥ ($0 $1)2 = $1 (25)
Example: Restaurant profits
Suppose you earn $1 for every customer that eats at your restaurant. Over 20
days, Alice and Bob each eat at your restaurant 10 times.
Mean daily profit from each customer: ( 10 10
20 ) · $1 + ( 20 ) · $0 = $0.50. Mean
daily profit from both customers: 2 ⇥ $0.50 = $1.
Variance of daily profits from each customer:
10
20 ⇥ ($1 $0.50)2 + 10
20 ⇥ ($0 $0.50)2 = $0.25 (23)

Variance of daily profits from both customers:

I Scenario #1: Alice and Bob never show up on same day. Alice shows up
on day 1, Bob shows up on day 2, Alice shows up on day 3,
etc. . . Variance of total daily profits ($1 every day):
20
20 ⇥ ($1 $1)2 = $0 (24)
I Scenario #2: Alice and Bob only ever show up together. Both show up
on day 1, neither shows up on day 2, both show up on day 3,
etc. . . Variance of total daily profits ($2 every other day):
10
20 ⇥ ($2 $1)2 + 10
20 ⇥ ($0 $1)2 = $1 (25)
Example: Restaurant profits
Suppose you earn $1 for every customer that eats at your restaurant. Over 20
days, Alice and Bob each eat at your restaurant 10 times.
Mean daily profit from each customer: ( 10 10
20 ) · $1 + ( 20 ) · $0 = $0.50. Mean
daily profit from both customers: 2 ⇥ $0.50 = $1.
Variance of daily profits from each customer:
10
20 ⇥ ($1 $0.50)2 + 10
20 ⇥ ($0 $0.50)2 = $0.25 (23)

Variance of daily profits from both customers:

I Scenario #1: Alice and Bob never show up on same day. Alice shows up
on day 1, Bob shows up on day 2, Alice shows up on day 3,
etc. . . Variance of total daily profits ($1 every day):
20
20 ⇥ ($1 $1)2 = $0 (24)
I Scenario #2: Alice and Bob only ever show up together. Both show up
on day 1, neither shows up on day 2, both show up on day 3,
etc. . . Variance of total daily profits ($2 every other day):
10
20 ⇥ ($2 $1)2 + 10
20 ⇥ ($0 $1)2 = $1 (25)
Example: Gold and auto stocks
Example: Gold and auto stocks
Assume 25% in Gold and 75% in Auto
Role of correlations

We can see portfolio return is in

between the two asset returns, but
standard deviation is much lower than
either, due to Diversification.
Diversification can reduce standard
deviation dramatically since the two
stocks have very low (in this case,
negative) correlation.
Correlation between two asset returns
can range from -1 to 1. As long as
correlation is smaller than 1, we will
see some benefit from diversification.
Example: Gold and auto stocks
Sensitivity analysis
Investment opportunity frontier

We trace out
the possible
combinations of
expected
portfolio
return and
portfolio risk.
The plot is
called the
investment
opportunity
frontier.
More is only
slightly better.

The benefit of
diversification
increases as number
of not perfectly
correlated stocks
are added in a
portfolio.

The improvement is
slight when the
number of stocks is
large (over 20).
Diversifiable and
nondiversifiable risk

Diversification allows you to reduce your risk by holding

assets with returns are not perfectly correlated.

Idiosyncratic/diversifiable/specific risk: fluctuations

in returns that are specific to a particular firm. These
are the risks that can be diversified away.

Systematic/nondiversifiable/market Risk: fluctuations in

returns that affect the entire economy and hence cannot
be diversified away.
 Here’s a pretty picture showing
same idea

The risk that can be eliminated by diversification is called

Specific Risk; the risk that you can’t avoid regardless of how
much you diversify is known as market risk.
For a well-diversified portfolio, only the market risk matters.
Today’s topics

Historical performance

What is a “risk premium”?

How to measure risk?

Diversification benefits