Risk and Return

KSB
LEARNING OBJECTIVES
• Calculate return on a single asset.
• Determine holding period return, average return and expected
return.
• Understand the risk and its relation with standard deviation
and variance of returns.
• Compute probability of returns, expected return and Risk
measures using the normal distribution.
• Measure historical return, standard deviation and risk
premium using Indian capital market data.

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Return on a Single Asset

• Total return = Dividend + Capital gain

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Return on a Single Asset

Year-to-Year Total Returns on HUL Share

Return %
50.00 48.31
46.25

40.00

31.77
30.00

20.00

10.00 6.47

1.50
0.00
2 01 4 2015 2 01 6 2 0 17 2 0 18

-10.00

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Average Rate of Return
• Historical Return
• The average rate of return is the sum of the various
one-period rates of return divided by the number of
period.
• Formula for the average rate of return is as follows:

• AM & GM

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Risk of Rates of Return: Variance and
Standard Deviation

• Formulae for calculating variance and standard

deviation:

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Recap(last two sessions)
• Why calculate Returns? How to calculate Returns.
• Simple (Net) and Gross Returns. Historical Returns and HPR, Dividend
yield.
• How to combine a number of equal period returns in a single Return
• AM and GM –Why GM is more appropriate than AM ?
• What is SD(Variance)? How to calculate the SD of a set of Historical
returns?
• Statistics & Probability: What is a RV ? What is a probability
distribution? What is Expectation of a RV/PD? How to calculate the
expectation & Variance of a PD?
Today & Tomorrow(Next 2 Sessions)
• What is Expectation and Varaince/SD of a RV or PD?
• How to calculate EX. And SD of a (discrete) PD of Returns ex-ante ?
• Risk? How to asses it? How to measure(calculate )it? (Investnment
perspective)
• Risk Premium and Risk appetite of an investor.
• Continuous nature of Returns and use of Normal distribution to
measure both Returns and Risk –ex ante of Single Asset Portfolio ?
• Move to two asset portfolio from single asset portfolio
• -Diversification and its effect on portfolio Risk and return
Expected Return : Incorporating
Probabilities in Estimates
• The expected rate of return [E (Rt)] is the sum of the product of each
outcome (return) and its associated probability:
Returns , Probabilities and Expected Return
Variance
• The following formula can be used to calculate the
variance of returns:

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Example

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Risk (Investment perspective)
• What is Risk? How to assess it? How to measure it?
 Historical Risk Premium
• The average return on the stock market is higher by about 10 per
cent in comparison with the average return on 91-day T-bills.

• The average return on the stock market is higher by about 8 per

cent in comparison with the average return on the long-term
government bonds.

• This excess return is a compensation for the higher risk of the

return on the stock market; it is commonly referred to as risk
premium. It is 9.4% in comparison with 91-T-bills and 7.7% in
comparison with long-term government bonds.

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Expected Risk and Preference
• A risk-averse investor will choose among investments with the
equal rates of return, the investment with lowest standard
deviation and among investments with equal risk she would
prefer the one with higher return.

• A risk-neutral investor does not consider risk, and would

always prefer investments with higher returns.

• A risk-seeking investor likes investments with higher risk

irrespective of the rates of return. In reality, most (if not all)
investors are risk-averse.

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Risk preferences

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Return Distribution Discrete vs Continuous

D vs C -1 D Vs C -2
Continuous Return Distribution and its Risk
Normal Distribution and Standard Deviation

• In explaining the risk-return relationship, we assume

that returns are normally distributed.
• The spread of the normal distribution is characterized
by the standard deviation.
• Normal distribution is a population-based, theoretical
distribution.
• The area under the curve sums to1.
• The curve reaches its maximum at the expected value
(mean) of the distribution and one-half of the area
lies on either side of the mean.
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Properties of a Normal
Distribution
• Approximately 50 per cent of the area lies within ± 0.67
standard deviations of the expected value; about 68 per cent
of the area lies within ± 1.0 standard deviations of the
expected value; 95 per cent of the area lies within ± 1.96
standard deviation of the expected value and 99 per cent of
the area lies within ± 3.0 standard deviations of the expected
value.
• The distribution tabulated is a normal distribution with mean
zero and standard deviation of 1. Such a distribution is known
as a standard normal distribution.
• The normal probability table, can be used to determine the
area under the normal curve for various standard deviations.

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20

Normal distribution
Probability of Expected Returns
• Any normal distribution can be standardised and hence the
table of normal probabilities will serve for any normal
distribution. The formula to standardise is:
S=

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Normal Distribution and Investment Risk
Portfolio Risk and Return

• Portfolios are groups of assets, such as stocks and bonds, that are
held by an investor.

• One convenient way to describe a portfolio is by listing the proportion

of the total value of the portfolio that is invested into each asset.

• These proportions are called portfolio weights.

• Portfolio weights are sometimes expressed in percentages.
• However, in calculations, make sure you use proportions (i.e., decimals).
Portfolio Return and Risk
Correlation Coefficient

Scatterplot r
Correlation Coefficient

Correlation coeff how to calculate given data

Portfolios: Expected Returns

• The expected return on a portfolio is a linear combination, or weighted average, of the

expected returns on the assets in that portfolio.

• The formula, for “n” assets, is:

In the formula: E(RP) = expected portfolio return

wi = portfolio weight in portfolio asset i
E(Ri) = expected return for portfolio asset i

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Variance of Portfolio Expected Returns

• Note: Unlike returns, portfolio variance is generally not a simple weighted average of the variances of the assets in the
portfolio.

• If there are “n” states, the formula is:

• VAR(RP)=

• In the formula, VAR(RP) = variance of portfolio expected return

pi = probability of state i
E(Ri) = expected portfolio return in state s
E(Rp) = portfolio expected return

• Note that the formula is like the formula for the variance of the expected return of a single asset.

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Portfolio Risk and Return :Correlation is
the issue (N=2)
• N=2
Calculating Portfolio Risk
• For a portfolio of two assets, A and B, the variance of the return on the
portfolio is:

Where: WA = portfolio weight of asset A

WB = portfolio weight of asset B
such that WA + WB = 1.

(Important: Recall Correlation Definition!)

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Perfectly Correlated Assets (N=2)
Perfect Negatively Correlated Assets
Portfolio Risk depends on Correlation
between the Assets
Next,
• What will be the shape of the curve if we plot portfolio risk(in x-axis)
with portfolio return (Y-axis)
• How the curve will behave with changing correlation (i.e. ρ changing)
but unchanged risk &return of the individual assets?
• What is investment opportunity set (for two asset case)
ρ=1, N=2, varying weights(0% to 100%)
ρ=-1, N=2, varying weights(0% to 100%)
ρ=0, N=2, varying weights(0% to 100%)
Diversification works
 Limits to diversification

Since any probable correlation of securities L and R will range between – 1.0 and + 1.0,
the triangle in the above figure specifies the limits to diversification. The risk-return
curves for any correlations within the limits of – 1.0 and + 1.0, will fall within the triangle
ABC.
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Investment opportunity sets given different
correlations

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 Investment Opportunity Set:
Two-Asset Case

• The investment or portfolio opportunity set

represents all possible combinations of risk and
return resulting from portfolios formed by varying
proportions of individual securities.

• It presents the investor with the risk-return trade-off.

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Problem on Min Variance Portfolio
Why Diversification Works

• Correlation: The tendency of the returns on two assets to move

together. Imperfect correlation is the key reason why diversification
reduces portfolio risk as measured by the portfolio standard deviation.

• Positively correlated assets tend to move up and down together.

• Negatively correlated assets tend to move in opposite directions.

• Imperfect correlation, positive or negative, is why diversification

reduces portfolio risk.

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Why Diversification Works

• The correlation coefficient is denoted by Corr(RA, RB) or simply, A,B.

• The correlation coefficient measures correlation and ranges from:

From: -1 (perfect negative correlation)
Through: 0 (uncorrelated)
To: +1 (perfect positive correlation)

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Why Diversification Works

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Why Diversification Works

11-48
 Efficient Portfolios of risky
securities
An efficient portfolio
is one that has the
highest expected
returns for a given level
of risk. The efficient
frontier is the frontier
formed by the set of
efficient portfolios. All
other portfolios, which
lie outside the efficient
frontier, are inefficient
portfolios.
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Next, M-V criterion & Efficient Frontier
COMBINING A RISK-FREE ASSET AND
A RISKY ASSET

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Multiple Risky Assets and a Single Risk Free
Asset (CALs)
MULTIPLE RISKY ASSETS AND
CAPITAL ALLOCATION
We draw three lines from
the risk-free rate (say
5%) to the three
portfolios. Each line
shows the manner in
which capital is allocated.
This line is called the
capital allocation line.
Portfolio M is the
Risk-return relationship for portfolio of risky optimum risky portfolio,
and risk-free securities which can be combined
with the risk-free asset.
It is called the Market
Portfolio
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Capital Market Line(CML)
MULTIPLE RISKY ASSETS AND A RISK-
FREE ASSET-Capital Market Line(CML)

• The capital market line (CML) is an efficient set of risk-free

and risky securities, and it shows the risk-return trade-off in
the market equilibrium.

Risk-return relationship for portfolio of risky

and risk-free securities
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Separation Theory- Creation of
CML
• According to the separation theory, the choice of
portfolio involves two separate steps.
• The first step involves the determination of the
optimum risky portfolio.
• The second step concerns with the investor’s decision
to form portfolio of the risk-free asset and the
optimum risky portfolio depending on her risk
preferences.

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Slope of CML

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N-Asset Portfolio Risk Calculation

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Systematic and unsystematic risk and
number of securities

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RISK DIVERSIFICATION:
SYSTEMATIC AND UNSYSTEMATIC RISK

• When more and more securities are included in a

portfolio, the risk of individual securities in the
portfolio is reduced.
• This risk totally vanishes when the number of
securities is very large.
• But the risk represented by covariance remains.
• Risk has two parts:
1. Diversifiable (unsystematic)
2. Non-diversifiable (systematic)

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 Systematic Risk
• Systematic risk arises on account of the economy-
wide uncertainties and the tendency of individual
securities to move together with changes in the
market.
• This part of risk cannot be reduced through
diversification.
• It is also known as market risk.
• Investors are exposed to market risk even when they
hold well-diversified portfolios of securities.

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Examples of Systematic Risk

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Unsystematic Risk
• Unsystematic risk arises from the unique
uncertainties of individual securities.
• It is also called unique risk.
• These uncertainties are diversifiable if a large
numbers of securities are combined to form well-
diversified portfolios.
• Uncertainties of individual securities in a portfolio
cancel out each other.
• Unsystematic risk can be totally reduced through
diversification.
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Examples of Unsystematic Risk

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Total Risk

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Diversification and Risk

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CAPITAL ASSET PRICING MODEL
(CAPM)

• The capital asset pricing model (CAPM) is a model that

provides a framework to determine the required rate of return
on an asset and indicates the relationship between return and
risk of the asset.
• The required rate of return specified by CAPM helps in valuing
an asset.
• One can also compare the expected (estimated) rate of return
on an asset with its required rate of return and determine
whether the asset is fairly valued.
• Under CAPM, the security market line (SML) exemplifies the
relationship between an asset’s risk and its required rate of
return.

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IMPLICATIONS OF CAPM
• Investors will always combine a risk-free asset with a
market portfolio of risky assets. They will invest in
risky assets in proportion to their market value.

• Investors will be compensated only for that risk

which they cannot diversify.

• Investors can expect returns from their investment

according to the risk.

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Assumptions of CAPM
Market efficiency

Risk aversion and mean-variance

optimization

Homogeneous expectations

Single time period

Risk-free rate

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Security market line with normalize systematic risk

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CML vs SML
IMPLICATIONS OF CAPM
• Investors will always combine a risk-free asset with a
market portfolio of risky assets. They will invest in
risky assets in proportion to their market value.

• Investors will be compensated only for that risk

which they cannot diversify.

• Investors can expect returns from their investment

according to the risk.

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LIMITATIONS OF CAPM
 It is based on unrealistic assumptions.
 It is difficult to test the validity of CAPM.
 Betas do not remain stable over time.

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Next what?
• Estimate beta by direct method.
• Calculate beta using market model and CAPM
• Examine the difference between betas of individual
firms and the industry beta.
• Explain the determinants of beta and why it might be
unstable over time .

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Beta Estimation

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Example
Returns on Sensex and Jaya Infotech

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Example-Steps to be followed

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Cont…

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Betas for the Sensex Companies
• The BSE’s sensitivity index includes 30 highly traded shares.
• The estimates are based on daily returns for one year.

Note that Jaiprakash Associates has

the highest beta of 2.28 and
Gujarat Ambuja Cement the lowest
beta of 0.37.
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Characteristic Line
Cont…

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Characteristic Line
Market Model

𝒓 𝒋 =𝒍𝒏 ¿

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Beta Calculation: Example

Estimates for Regression Equation

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Beta Calculation: Example

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Beta Estimation in Practice
• In practice, the market portfolio is approximated by a
well-diversified share price index. We have several
price indices available in India.
• There is no theoretically determined time period and
time intervals for calculating beta. The time period
and the time interval may vary.
• The returns may be measured on a daily, weekly or
monthly basis. One should have sufficient number of
observations over a reasonable length of time.

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Beta Estimation in Practice
The return on a share and market index may be calculated
as total return; that is, dividend yield plus capital gain:

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Examples of Beta Estimation for
Companies in India

Summaries of Regression Parameters for HUL vs. Market Returns

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Characteristic Line and Beta for HUL

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Financial Management, 12e I M Pandey
 91

Characteristic Line and Beta for Infy

Copyright © 2021 Pearson India Education Services Pvt. Ltd

Financial Management, 12e I M Pandey
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Characteristic Line and Beta for MahaTel

Copyright © 2021 Pearson India Education Services Pvt. Ltd

Financial Management, 12e I M Pandey
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Characteristic Line and Beta for Ranbaxy

Copyright © 2021 Pearson India Education Services Pvt. Ltd

Financial Management, 12e I M Pandey
Betas for the Sensex Companies
• The BSE’s sensitivity index includes 30 highly traded shares.
• The estimates are based on daily returns for one year.

Note that Jaiprakash Associates has

the highest beta of 2.28 and
Gujarat Ambuja Cement the lowest
beta of 0.37.
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Does Beta Remain Stable Over Time?

• Betas may not remain stable for a company over time

even if a company stays in the same industry.
• Why?
• Because, over time, a company may witness changes
in its product mix, technology, competition or market
share. Hence, betas usually do not remain stable over
time.

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Determinants of Beta

Nature of Operating Financial

Business Leverage Leverage

Financial Management, 12e I M Pandey

Nature of Business
• If we regress a company’s earnings with the aggregate
earnings of all companies in the economy, we will obtain a
sensitivity index, which we can call the company’s accounting
beta.
• The real or the market beta is based on share market returns
rather than earnings.
• The accounting betas are significantly correlated with the
market betas. This implies that if a firm’s earnings are more
sensitive to business conditions, it is likely to have higher
beta.

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Operating Leverage and Financial Leverage

• The degree of operating leverage is defined as the

change in a company’s earnings before interest and
tax due to change in sales.
• Financial leverage refers to debt in a firm’s capital
structure. Since financial leverage increases the firm’s
(financial) risk, it will increase the beta of the firm.

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Asset Beta and Equity Beta
• For an unlevered (all-equity) firm, the asset beta and
the equity beta would be the same.
• For a levered firm, the proportion of equity will be
less than 1. Therefore, the beta of asset will be less
than the beta of equity. The beta of equity for a
levered firm is given as follows:

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CAPM and the Opportunity Cost of Equity

•From the firm’s point of view, the expected rate of return

from a security of equivalent risk is the cost of equity.
•The expected rate of return or the cost of equity in CAPM is
given by the following equation:

3-month Treasury Bills or long-term government bonds yield;

long-term average market index rate of return;long-term
average 3-month Treasury Bills or long-term government
bonds yield

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Industry Vs. Company Beta
• The use of the industry beta is preferable for those companies
whose operations match up with the industry operations. The
industry beta is less affected by random variations.

• Those companies that have operations quite different from a

large number of companies in the industry, may stick to the
use of their own betas rather than the industry beta.

• Beta estimation and selection is an art as well, which one

learns with experience.

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Thank You