MSO402: INTRODUCTION

TO FINANCIAL
MANAGEMENT

RISK AND RETURN

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Risk and Return

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Characteristics of Individual Securities

• The characteristics of individual securities that are of

interest are the:
– Returns
– Variance and Standard Deviation
– Covariance and Correlation

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Are the returns independent consideration?
• We should know the price of the security.
• How are these determined?? Market
•Are the markets efficient?
• But the expected returns (ER ) is a prediction based on future
prices.
• Predictions are to be made on historical data.
•How risky are the stocks and what have been their returns
historically.
•Statistical Properties of Stocks.

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Pattern of Stock Price Changes

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Pattern of Stock Price Changes

• Stock Prices follow random walk.

• The pattern shows that prices move in random manner with a trend (drift)
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 Pt= Price of the asset at the end of the holding period
(current price)

Different measures of Returns Pt−n = Price of the asset at the beginning of the holding
period (initial price)

• Holding Period Returns dividend yield percentage

𝑃𝑡 −𝑃𝑡−𝑛
𝐻𝑃𝑅 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + 𝑋 100 Here n is your holding time
𝑃𝑛

• Effective Annualized Returns

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𝐸𝐴𝑅 = (1 + 𝐻𝑃𝑅𝑇 ) ൗ𝑇 −1

• Average Returns – Arithmetic Mean or Geometric Mean

𝐺. 𝑀. = [(1 + 𝑅1 )(1 + 𝑅2 )……(1+𝑅𝑛 )]1/n -1

• The GM is always less than the AM, except when all the return values
being considered are equal. The difference between GM & AM depends on
the variability of distribution – the greater the variability, the greater is the
difference
• • Relationship = (1 + GM)2 ≈ (1 + AM)2 – (SD)2
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 Different measures of Returns
• Expected Returns – Probability-Weighted average of the rates of returns.
𝐸 𝑅 = ෍ 𝑝 𝑖 𝑟(𝑖)
𝑖

σ𝑇1 𝑟𝑖𝑡 𝑤𝑡
𝐸(𝑟𝑖𝑡 ) = = 𝜇𝑖
𝑇

•Here, 𝑟𝑡 is the returns of the stock over time, 𝑤𝑡 weight of time periods.
Usually it is assumed that the time period is given equal weights.
• Expected Returns from CAPM model: 𝑅𝑖 = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓 )
•Risk –adjusted Returns: Returns per unit of risk.
𝑅𝑝/𝑠 −𝑅𝑓
• Sharpe Ratio:
𝜎𝑝/𝑠

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Different measures of Returns

• Simple Returns
𝑃𝑡 −𝑃𝑡−1
• 𝑅𝑡 =
𝑃𝑡

• Log Returns
𝑃𝑡
• 𝐿𝑜𝑔 𝑅𝑡 = 𝐿𝑛
𝑃𝑡−1

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 Different measures of Returns
Inputs
Asset T1 T2 T3
A 1000 1900 2500
B 700 500 800
C 800 600 700
Portfolio 2500 3000 4000

Normal Returns Log Returns

Asset Weight T2 T3 LN(2/0) Add Asset Weight T2 T3 LN(2/0) Add
A A
B B
C C
Portfolio Portfolio

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Different measures of Returns
Normal Returns
Asset Weight T2 T3 LN(2/0) Add
A 30% 90% 32% 150% 122%
B 20% -29% 60% 14% 31%
C 50% -25% 17% -13% -8%
Portfolio 100% 20% 33% 60%

Log Returns
Asset Weight T2 T3 LN(2/0) Add
A 30% 64% 27% 92% 92%
B 20% -34% 47% 13% 13%
C 50% -29% 15% -13% -13%
Portfolio 100% 18% 29% 47% 47%

• Log returns are time additive.

• The product of normally distributed returns is not normal.
• The sum of normally distributed variables follows a normal distribution.

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Risk
• Investment risk pertains to the probability of earning a return less
than that expected.
• The greater the chance of a return far below the expected return,
the greater the risk.

Variance:
σ𝑇1 (𝑟𝑖𝑡 −𝐸(𝑟𝑖𝑡 ))2
𝜎𝑖2 =
𝑇−1
Standard Deviation:
𝜎𝑖 = 𝜎𝑖2

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Risk
A higher Sharpe Ratio means that the investment is giving
better returns for the amount of risk taken.
A lower Sharpe Ratio indicates that the return generated by
the investment is not adequately compensating for the level of
risk.

higher sd higher risk

Which Stock is riskier?

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Risk
Systematic Risk – undiversifiable
Examples: US-China trade war, Russia- Ukraine war, Arab Spring 2011,
Recession in US, Business Cycles.

Unsystematic/Idiosyncratic Risk – diversifiable (as we go on increasing

the no. of stocks)
Example: Business Risk (increasing operating leverage), Financial Risk
(increasing financial leverage), Regulatory Risk

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Statistical Properties of Stock Return

• Facts Observed for the Indian Stock Market:

• Return on more risky assets has been higher on average than return on
less risky assets
• The risky assets have wide dispersion of returns.
• Most of the stocks are negatively skewed and are leptokurtic – Fat Tails

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Statistical Properties of Stock Returns

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Statistical Properties of Stock Returns

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Statistical Properties of Stock Returns
Covariance:
𝐶𝑜𝑣[𝑟𝑖𝑡 , 𝑟𝑗𝑡 ] = 𝐸[ 𝑟𝑖𝑡 − 𝜇𝑖 𝑟𝑗𝑡 − 𝜇𝑗 ]
Correlation:
𝐸[ 𝑟𝑖𝑡 − 𝜇𝑖 𝑟𝑗𝑡 − 𝜇𝑗 ]
𝜌 = 𝐶𝑜𝑟𝑟[𝑟𝑖𝑡 , 𝑟𝑗𝑡 ] =
𝜎𝑖 𝜎𝑗
Here, 𝑖 & 𝑗are two different stock returns.
−1 < 𝜌 < 1
Inference: How closely the two stocks move.

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Scatter Plots of Two Assets

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Portfolio Theory

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 Basic Elements of Investments
• The investment opportunity
•Portfolio of assets
•A Model for financial assets – Reward per unit of risk.
• The investor
•A Model for investors – Risk aversion & Utility.
• The optimal portfolio selection

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 Risk Aversion
• Investor does (or should) Risk Aversion
consider expected return a 70%
desirable thing and variance
of return an undesirable thing. 60% More Averse

• For every additional unit of 50%

risk, investors demand more

40%
and more returns.
• If 𝜎𝑖 is represented on x-axis 30%
Less
and 𝐸(𝑟𝑖 ) is represented on y- 20% Averse
axis – risk aversion will be
concave shaped. 10%

• More risk averse (A) investor 0%

(pessimist) – undervalues 0% 5% 10% 15% 20%

return and overvalue risk, and A=4 A=6

vice-versa.
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Utility

Expected
• Utility is welfare that an investor Portfolio Return (%) Risk (%)
achieves for an investment L 7 5
decision. M 9 10
H 13 20
• 𝑈 = 𝐹 𝐸(𝑟𝑝 , 𝜎𝑖 , 𝐴)
1
• 𝑈 = 𝐸(𝑟𝑝 ) − A 𝜎𝑝2
2
• 𝑈 is the utility value, 𝐴 (ranges
from 0 – 10) is the risk Utility Score Utility Score of Utility Score
aversion, A of Portfolio L Portfolio M of Portfolio H

1 2 0.0675 0.08 0.09

is the scaling factor. 5 0.0638 0.065 0.03
2
• Utility is different than expected
return and risk aversion.
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 What is a Portfolio?
•A portfolio is simply a specific combination of securities, usually defined by
portfolio weights that sum to 1.

𝑤 = {𝑤1 +𝑤2 + 𝑤3 + ⋯ … … . +𝑤𝑛 } = 1

•Portfolio weights:
Price/Shar Portfolio
• Sum to 0 – Risk free portfolios Assets Shares e Investment Weight
• Positive – Long position TCS 50 ₹ 3,900 ₹ 1,95,000 38%

• Negative – Short position Adani Green 100 ₹ 1,550 ₹ 1,55,000 30%

Gold ETF 2000 ₹ 54 ₹ 1,08,000 21%
Sovereign
Bond 1000 ₹ 60 ₹ 60,000 12%
Total ₹ 5,18,000 100%

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Portfolio – Example!
•Your broker informs you that you only need to keep ₹4,00,000 in your
investment account to support the portfolio of 50 shares of TCS, 100
shares of Adani Green, and 2,000 shares of Gold ETF; in other words, you
can buy these stocks on margin. You withdraw rest ₹50,000 to use for
other purposes. Your portfolio is summarized by the following weights:

Portfolio
Assets Shares Price/Share Investment Weight
TCS 50 ₹ 3,900 ₹ 1,95,000 48.75%
Adani Green 100 ₹ 1,550 ₹ 1,55,000 38.75%
Gold ETF 2,000 ₹ 50 ₹ 1,00,000 25%
Sovereign Bond 1,000 ₹ 50 -₹ 50,000 -12.5%
Total ₹ 4,00,000 100%

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Portfolio – Example!

•You planned to purchase a car that costs ₹10,00,000 by paying 20% of

the purchase price and getting a loan for the remaining 80%. What are
your portfolio weights for this investment?

Portfolio
Assets Share Price Investment Weight
₹
Car 1 10,00,000 ₹ 10,00,000 500%
Loan 1 ₹ 8,00,000 -₹ 8,00,000 -400%
Total ₹ 2,00,000 100%

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Portfolio – Example!

•Suppose you have Rs 10,000 to invest. One risky asset A offers you an
expected return of 4.5% p.a., and risk of 14.5% p.a. You would like to
earn an expected return that is higher than 4.5%. How is it possible, given
there exist a risk-free asset offering a return of 3% p.a.?

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Why is Portfolio needed?
•Don’t put all your eggs in one basket!

•Portfolio provides diversification for reducing the risks.

• Systematic Risk – undiversifiable

Examples: US-China trade war, Russia- Ukraine war, Arab Spring 2011,
Recession in US, Business Cycles.

• Unsystematic/Idiosyncratic Risk – diversifiable (as we go on increasing the

no. of stocks)
Example: Business Risk (increasing operating leverage), Financial Risk
(increasing financial leverage), Regulatory Risk

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Why is Portfolio needed?

•How do we construct a good portfolio? Risk and Reward

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Risk and Reward Assumptions

•Investors like high expected returns but dislike high volatility

• Investors care only about the expected return and volatility of their overall
portfolio.
• Portfolio risk depends not only on the individual risk but also on the
interactive risk.

•How much does a stock contribute to the risk and return of a portfolio, and
how can we choose portfolio weights to optimize the risk/reward
characteristics of the overall portfolio?

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 Mean – Variance Analysis
•Objective:
•Assume investors focus only on the expected return and variance (or standard deviation)
of their portfolios: higher expected return is good, higher variance is bad.

Risk & Return

35%
North- 30%
30% west
25% G
25% E
20% 20%
Retruns

20%
15% D F
15% C
12% 12%
A B
10%

5%

0%
0% 2% 4% 6% 8% 10% 12% 14% 16%
Risk (σ)

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 Mean – Variance Analysis

•Basic Properties of Portfolio Mean and Risk:

•𝑅𝑝 = 𝑤1 𝑅1 + 𝑤2 𝑅2 + ⋯ … … . +𝑤𝑛 𝑅𝑛

•𝐸(𝑅𝑝 ) = 𝑤1 𝐸(𝑅1 ) + 𝑤2 𝐸 𝑅2 + ⋯ … … . +𝑤𝑛 𝐸 𝑅𝑛 , here 𝐸(𝑅𝑖 ) is 𝜇𝑖

•Variance:

•𝑉𝑎𝑟(𝑅𝑝 ) = 𝐸(𝑅𝑝 − 𝜇𝑝 )2

= 𝐸[(𝑤1 𝑅1 − 𝜇1 + 𝑤2 𝑅2 − 𝜇2 + ⋯ … … . . +𝑤𝑛 𝑅𝑛 − 𝜇𝑛 )2 ]

•For two assets 𝑖 & 𝑗:

𝐸[𝑤𝑖 𝑤𝑗 (𝑅𝑖 − 𝜇𝑖 ) (𝑅𝑗 − 𝜇𝑗 )] = 𝑤𝑖 𝑤𝑗 𝐶𝑜𝑣𝑖𝑗
= 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗

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 Mean – Variance Analysis
•Portfolio variance is the weighted sum of all the variances and covariances
(Variance-Covariance Matrix):
𝑤1 𝑅1 − 𝜇1 𝑤2 𝑅2 − 𝜇2 … … 𝑤𝑛 𝑅𝑛 − 𝜇𝑛
𝑤1 𝑅1 − 𝜇1 𝑤12 𝜎12 𝑤1 𝑤2 𝜎12 𝑤1 𝑤𝑛 𝜎1𝑛
𝑤2 𝑅2 − 𝜇2 𝑤2 𝑤1 𝜎21 𝑤22 𝜎22 𝑤2 𝑤𝑛 𝜎2𝑛
………. ………. ………. ……….
………. ………. ………. ……….

𝑤𝑛 𝑅𝑛 − 𝜇𝑛 𝑤𝑛 𝑤1 𝜎𝑛1 𝑤𝑛 𝑤2 𝜎𝑛2 𝑤𝑛2 𝜎𝑛2

• There are n variances and n2 − n covariances

• Covariances dominate portfolio variance
•Positive covariances increase portfolio variance; negative covariances decrease portfolio
variance (diversification)

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 Mean – Variance Analysis
•For two asset cases:
Factors Affecting Portfolio Risk
•𝑅𝑝 = 𝑤1 𝑅1 + 𝑤2 𝑅2 ▪ Respective Weights
▪ Individual security risk
•𝐸(𝑅𝑝 ) = 𝑤1 𝐸(𝑅1 ) + 𝑤2 𝐸 𝑅2 ▪ Coefficient of correlation or Interactive
Risk
•Variance:

•𝑉𝑎𝑟(𝑅𝑝 ) = 𝑤12 𝜎12 + 𝑤12 𝜎12 + 2𝑤1 𝑤2 𝐶𝑜𝑣[𝑅1 𝑅2 ]

= 𝑤12 𝜎12 + 𝑤12 𝜎12 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝜌12

𝐶𝑜𝑣[𝑅1 𝑅2 ]
ℎ𝑒𝑟𝑒, 𝜌12 = 𝜎1 𝜎2

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 Mean – Variance Analysis
•Investors want to minimize the portfolio risk.

•𝜎(𝑅𝑝 ) = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝐶𝑜𝑣[𝑅1 𝑅2 ]

•Objective function: Minimize 𝜎(𝑅𝑝 ) w.r.t 𝑤1

• Put 𝑤2 = 1 − 𝑤1

𝜎22 −𝐶𝑜𝑣12
•𝑤𝑚𝑖𝑛1 =
𝜎12 +𝜎22 −2𝐶𝑜𝑣12

• No other portfolio can have a lower risk.

•Can the portfolio risk be reduced to zero?

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 Mean – Variance Example

•From January 2023 – June 2023, BPCL had an average monthly return of
0.081% and a std dev of 1.427%. Bajaj Auto had an average return of
0.291% and a std dev of 1.338%. Their correlation is -0.06. How would a
portfolio of the two stocks perform?

•𝐸(𝑅𝑝 ) = 𝑤1 ∗ 0.081 + 𝑤2 ∗ 0.291

•𝑉𝑎𝑟(𝑅𝑝 ) = 𝑤12 ∗ 1.4272 +𝑤22 ∗ 1.3382 +2𝑤1 ∗ 𝑤2 ∗ 1.427 ∗ 1.338 ∗ −0.06

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 Mean – Variance Example
•Mean/SD Trade-Off for Portfolios of BPCL and Bajaj Auto

0.35%

0.30%

0.25%
Expected Returns

0.20%

0.15%

0.10%

0.05%

0.00%
0.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20% 1.40% 1.60%

Risk (σ)

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 Mean – Variance Example
•Suppose the correlation between BPCL and Bajaj Auto. What if it equals –1.0? -0.7? 0.0?
1.0?
Portfolio Opportunity Set
0.35%

0.30%

0.25%

0.20% Corr -0.06 Return

Corr +1 Return
0.15% Corr -1 Return
Corr -0.7 Return
0.10%

0.05%

0.00%
0.00% 0.50% 1.00% 1.50%

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 Mean – Variance Example
Construct a minimum variance portfolio of securities X and Y from the
following information:
Security X Y
Expected Return 15 9
S.D. 5.3 2
CovXY -10

Calculate the portfolio return as well as risk. (Answer: Weight X = 27%; Y

= 73%)

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