Risk and Return

Aditya Mohan Jadhav

What is Risk
• Uncertainty?

• Exposure?

• Deviation from the expectation

• “Std. Deviation is the accepted measure of risk in financial literature”

Why?
Different Types of Returns
• Returns are the economic benefits that you obtain by investing in any
asset.

• Required Returns

• Expected Returns

• Actual Returns
Different types of investors
• Classification based on risk appetite of Investors:

• Risk Avoiding

• Risk Averse

• Risk Neutral

• Risk Taking
Risk Averse Rational Investors
• Rational – Rational Investors are those who use the same logical
function and arrive at the same set of expectations given the
information set available to them.

• Rational Investors are Risk Averse.

• Risk Averse Investors are those who demand higher returns for any
given level of Risk or lower risk for any given level of returns.
Risk – Return Relationship
• “High Risk High (Expected) Returns”

• Investors observing higher risk in any investment opportunity will

demand higher expected return.

Arbitrage and Risk-less Profit
• Arbitrage is a process by which one can obtain risk-less profit.

• Law of One Price: Two assets having similar returns should have
similar prices.

• Arbitrage basically results due to mispricing of securities i.e. when the

law of one price does not hold true.

• Arbitrage becomes risk-less by removing the exposure portion of risk.

Arbitrage and Risk-less Profit
Asset A B
Current Price 80 100
One year return 20 30

Arbitrage Opportunity?

a. Start of Year - Sell A and purchase B

b. Returns for assets at end-of-the year?
c. Strategy at End-of-the-Year?
Efficient Market Hypothesis
• Fama and French (1970), “Efficient Capital Markets: A Review of
Theory and Empirical Work”.

• Market Efficiency is a function of Information Efficiency and

Transaction Efficiency.

• Efficient Market Hypothesis depends on Information Efficiency and in

efficient market information is quickly and rapidly disseminated and
the prices reflect the information in an unbiased manner.
Efficient Market Hypothesis
Form of Efficiency Information
Weak Form Efficient Previous prices of securities reflected in security
prices. You cannot make abnormal returns using the
previous prices.
Semi-strong Form Efficient All publicly available information reflected in security
prices. You cannot make abnormal returns using the
publicly available information.
Strong Form Efficient All information (public as well as private) reflected in
security prices and abnormal returns are not possible.

Abnormal Returns = Actual Returns – Expected Returns

Calculating Expected Returns
•   or;

or;

where

pi = probability of occurrence of ri
Calculating Risk
•  or;
Example 1
Period Price Probability
0 100
1 90 0.1
2 120 0.4
3 140 0.3
4 155 0.1
5 155 0.1
Selection between two assets
• Assume two assets:

• Asset A: return = 20%; risk = 22%

• Asset B: return = 16%; risk = 16%

• Which asset will you choose?

Diversification and Portfolio
• Diversification is the process of reducing risk by combining two or
more assets whose expected returns have negative relationship with
each other.

• Portfolio: This combination of assets is known as portfolio.

Risk and Return of a two asset portfolio
• 
Example 2
Asset A B
Return 0.18 0.12
Risk 0.2 0.18
Wt. 0.4 0.6
Case 1 Correlation = 0.6
Case 2 Correlation = - 0.5
Case 3 Correlation = 0

Calculate the risk and return of the portfolio combining asset A and B in the given weights
Risk and Return for a three asset portfolio
• 
Risk and Return for an ‘n’ asset portfolio
• 
Systematic and Unsystematic Risk
• Unsystematic Risk: Unsystematic risk is the risk arising from asset
specific characteristics or decisions. Source of risk are firm’s decisions.
Ex: the decision to invest in a risky project by a firm can increase
risk for the firms stock resulting in increased unsystematic risk.

• Systematic Risk: Systematic risk is the system wide risk that impacts all
the assets in the market similarly but at a varying degree. Source of
risk external to the firm but the scope is across the market.
Ex: Demonetization impact
Diversification and Systematic Risk
• Diversification process balances out the individual characteristics of
the assets and thus cancels out the unsystematic risks that are
specific to various assets.

• Diversification process is not capable of reducing systematic risk

which impacts all the assets in the market similarly.

• Hence the portfolio owner continues to face the systematic risk port-
diversification.
Minimum Variance Portfolio
• Markowitz states that for any given number of assets the mimimum
variance portfolio is the one which provides minimum variance (risk)
for the given combination of securities.

• Subject to rp >= r* ;
where r* is the returns from the security providing lowest returns
Example 3
Asset A B
Return 0.18 0.12
Risk 0.2 0.18
Correlation -0.5
Case 1: Wt 0.3 0.7
Case 2: Wt 0.5 0.5
Case 3: Wt 0.7 0.3

Calculate the risk and return of the portfolio combining asset A and B in the given weights
Minimum Variance Portfolio in a two-asset
case
•  For a two asset case: Weights for efficient portfolio i.e. the portfolio
with minimum variance:
Markowitz Model for Efficient Frountier and
Efficient Portfolio
••  Efficient Portfolio: A portfolio is said to be efficient if there is no other
portfolio that gives higher rate of return for same level of risk or
provides same returns for a lesser degree of risk.

• Efficient Frountier: Efficient Frountier is the combination of efficient

portfolios such that each efficient portfolio provides highest returns
for the given level of risk.
i.e. Max () given
Tobin’s Separation Theorem
• The lending (investment) decisions and the borrowing decisions are
independent of each other.

• In case any borrower can borrow unlimited amounts at risk-free rate (short-
selling of risk-free asset), rationally he should borrow the required amount
and invest in any risky asset so to achieve the returns he intends to have.

• At the end of the investment period he liquidates his position in the risky
asset and returns the amount borrowed at risk-free rate (buy-back of risk-free
asset). The difference in the rates becomes his returns.
Portfolio comprising of risky asset & risk-
free asset
• 

where, w1 + w2 = 1
Example 4
Asset Risk-free Risky A
Return 0.6 0.15
Risk 0 0.18

Expectation W1 W2
Case 1: Expected Return Required from ? ?
portfolio = rp = 0.12

Case 2: Expected Risk of the portfolio = 0.25 ? ?

Case 3: Expected Return of the portfolio = ? ?

0.40
Capital Allocation Line
Capital Asset Pricing Model (CAPM)
• William Sharpe used an idea similar to that of Tobin but combined
risk-free asset with an efficient portfolio to arrive at a new portfolio
which had a linear risk-return relationship and could provide infinite
returns.

• The Capital Allocation Lines combining the risk-free assets and

efficient portfolios are superimposed on the efficient frountier to
arrive at the CAPM efficient portfolio allocation decision.
CAPM – Capital Market Line (CML)
• The Capital Allocation Line combining the risk-free asset with the efficient portfolio
which provides highest returns for any given level of risk is known as Capital
Market Line.

• This efficient portfolio is known as the market portfolio. This portfolio provides
highest return as this portfolio has achieved highest diversification. The market
portfolio has only systematic risk and does not have any unsystematic risk.

• Given that the combination of market portfolio and risk-free asset always gives the
highest return every investor should invest in the combination of market portfolio
and risk-free asset in the proportion which suits the investors risk profile.
CAPM – Security Market Line (SML)
• If everyone invests in the combination of Market Portfolio and Risk-free
asset then the only risk any investor will face is the systematic risk.

• The systematic risk in the market is the contribution of systematic risk

of each asset.

• The systematic risk in each asset is obtained by running the regression

between the asset returns and market returns. This relationship is
known as Security Market Line (SML).
SML Equation
• E(Ri) = Rf + βi (E(Rm)-Rf)

• If the actual returns are higher than expected returns then the stock
is undervalued.

• If the actual returns are lower than the expected returns then the
stock is overvalued.
SML
Example 5 – Identify overvalued or
undervalued?
Asset Returns Beta

Risk-free Asset 0.12 0

Market Portfolio 0.18 1

Stock 1 0.19 1.5

Stock 2 0.185 0.75

Stock 3 0.22 1.4

Portfolio Beta
• Portfolio beta is the weighted average of all asset betas with the same
weights in which they contribute to the portfolio.

Asset Returns Beta Weight

Stock 1 0.19 1.5 0.5

Stock 2 0.185 0.75 0.3

Stock 3 0.22 1.4 0.2

Questions