Topic 5

Risk And Return

Part 1
 Rates of Return
Historical Return
The return that an asset has already produced
over a specified period of time.
Expected Return
The return that an asset is expected to produce
over some future period of time.
Required Return
The return that an investor requires an asset to
produce if he/she is to be a future investor in that
asset.
 Return On An Asset
• The gain (or loss) from an investment.
Made up of two components:
– Income stream, e.g. dividends, interest payments,
– Capital gain (or loss).
• Total return = income yield + capital gains yield.

 Percentage Return

Income paid at Change in market

end of period + value over period
Percentage return =
Beginning market value
 Percentage Return Example
P0 = $37.00 P1 = $40.33 D1 = $1.85

$1.85  $40.33 - $37.00 

% Return 
$37.00
 0.14 or 14%
 Per dollar invested we get 5% in dividends ($1.85/$37)
and 9% in capital gains ($3.33/$37) - a total return of
14%.
Calculating Expected Return On An Individual Asset

State of Probability Return

economy P A B

Recession 0.20 0.04 -0.10

Normal 0.50 0.08 0.18
Boom 0.30 0.14 0.30

Expected return Ri is a weighted average:

Ri = P(R1) x R1 + P(R2) x R2 + … + P(Rn) x Rn
Calculating Expected Return On An Individual Asset

State of Probability Return

economy P A B

Recession 0.20 0.04 -0.10

Normal 0.50 0.08 0.18
Boom 0.30 0.14 0.30

Company A
Ri = P(R1) x R1 + P(R2) x R2 + … + P(Rn) x Rn
RA = 0.20 x 0.04 + 0.50 x 0.08 + 0.30 x 0.14 = 0.09 = 9%
 Case Study
State of Probability Return
economy P A B

Recession 0.20 0.04 -0.10

-0.
Normal 0.50 0.08 0.18
Boom 0.30 0.14 0.30

Company B
Ri = P(R1) x R1 + P(R2) x R2 + … + P(Rn) x Rn
RB = 0.20 x -0.10 + 0.50 x 0.18 + 0.30 x 0.30 = 0.16 = 16%
 Risk
 How to measure risk?
Variance, standard deviation, beta.
 How to reduce risk?
Diversification.
 How to price risk?
Security market line, CAPM.
 Risk
What is the required rate of return on a Treasury Security?

Required rate of return = Risk-free rate of return

• For a Treasury security, what is the
 Treasury securities are free of default risk.
required rate of return?
 Treasury securities are securities (usually bonds) issued by a
central government. Theoretically, central governments do not go
bankrupt (because they have the ability to tax), so treasury
securities have low risk.
Risky assets on average earn a risk
 The rate of return on a Treasury security for a given period will be
the risk-free rate of return in a country for that period, e.g. if the rate
premium, ie there is a reward for bearing
of return on a 1-year Australian Commonwealth Government bond
risk.
is 4%, the one-year risk-free rate of return in Australia would be 4%.
 In reality central governments do get into financial difficulties and
may default on their debt repayments e.g. Latin American
governments in the 1980s (e.g. Mexico, Argentina), Russia in the
1990s, Greece in 2010.
 Risk
For a company security, what is the required rate of return?
Required rate of Risk-free Risk premium
return
= rate of
+
return

A risk premium is added to the required rate of return for a company

because there is greater risk with an investment in a company, i.e. there is
a greater chance that an investor will get a return different to what he/she
expects (e.g. there is a greater chance the company will default on its debt
repayments and/or will not pay a dividend)
 The question can be asked ‘How large a risk premium should we require
to buy a company (corporate) security?’
The risk premium we require depends on the investment risk.
 Investment Risk
 Typically, investment returns are not known
with certainty.
 Investment risk relates to the probability of
earning a return different from that
expected.
 The greater the chance of receiving a return
different from the expected return the
greater the investment risk.
 Distribution of Returns
 The histograms below show the distribution of returns for the two assets, Asset
A and Asset B.
Asset A Asset B

Return (%) Return (%)

 The histograms show the frequency of each return. For example, for Asset A
the 9% return (the expected return for Asset A) occurs most often, 50% of the
time, and the 4% and 14% returns each occur 25% of the time.
Slide 12
 Measuring Risk
 General idea: Asset’s price range over the past
year.
 More scientific approach: Asset’s standard
deviation of returns.
 Standard deviation is a measure of the
dispersion (range) of possible outcomes.
 The greater the standard deviation,
deviation the greater
the uncertainty, and therefore, the greater the
risk.
 Measuring Risk
 Standard Deviation of Returns: An Individual Asset

n
2
 i   ( Ri  R i ) ( PRi )
i 1

Slide 14
 Measuring Risk

n
2
 i   ( Ri  R i ) ( PRi )
i 1
Company A
( 0.04 – 0.09)2 (0.20) = 0.0005
( 0.08 – 0.09)2 (0.50) = 0.00005
( 0.14 – 0.09)2 (0.30) = 0.00075
Variance = σi2 = 0.0013 = 0.13%
Standard Deviation = σi = √0.0013 = 0.0361 = 3.61%
 Measuring Risk

n
2
 i   ( Ri  R i ) ( PRi )
i 1
Company B
(-0.10 – 0.16)2 (0.20) = 0.01352
(0.18 - 0.16)2 (0.50) = 0.0002
(0.30 – 0.16)2 (0.30) = 0.00588
Variance = σi2 = 0.0196 = 1.96%
Standard Deviation = σi = √0.0196 = 0.14 = 14%
 Measuring Risk

Range of Possible Returns: Company A

σA = 3.61%

68%

95%
1.78% 5.39% 9% 12.61% 16.22%
Mean return

Slide 17
 Measuring Risk
 Co. A: exp. ret. = 9%
 std. dev. = 3.61%,
 1 std. dev. of exp. ret. = 9% ± 3.61% = 5.39%
to 12.61%
 Therefore, 68 out of 100 returns for Co. A will
range from 5.39% to 12.61%

Slide 18
 Measuring Risk
 2 std. dev. = 2 x 3.61% = 7.22%
 2 std. dev. of exp. ret. = 9% ± 7.22%
= 1.78% to 16.22%
 Therefore, 95 out of 100 returns for Co. A
will range from 1.78% to 16.22%

Slide 19
 Measuring Risk
 3 std. dev. = 3 x 3.61% = 10.83%
 3 std. dev. of exp. ret. = 9% ± 10.83%
= -1.83% to 19.83%
Therefore, 99 out of 100 returns for Co. A
will range from -1.83% to 19.83%

Slide 20
 Measuring Risk
 Range of Possible Returns: Company B

σB = 14%

68%

95%

-12% 2% 16% 30% 44%

Slide 21
 Measuring Risk
Co. B: exp. ret. = 16%
std. dev. = 14%,
1 std. dev. of exp. ret. = 16% ± 14% = 2%
to 30%
Therefore, 68 out of 100 returns for Co. B
will range from 2% to 30%

Slide 22
 Measuring Risk
2 std. dev. = 2 x 14% = 28%
 2 std. dev. of exp. ret. = 16% ± 28%
= -12% to 44%
 Therefore, 95 out of 100 returns for Co. B
will range from -12% to 44%

Slide 23
 Measuring Risk
3 std. dev. = 3 x 14% = 42%
 3 std. dev. of exp. ret. = 16% ± 42%
= -26% to 58%
Therefore, 99 out of 100 returns for Co. B
will range from -26% to 58%

Slide 24
 Measuring Risk
Coefficient of Variation (CV)
 Coefficient of variation measures risk per unit of return -
for every unit of return how much risk is incurred?

i
CVi 
Ri

Slide 25
 Measuring Risk
Coefficient of Variation
Expected Return Std. Dev.
Share A 9% 3.61%
Share B 16% 14.0%

 CVA = 0.0361/0.09 = 0.401, i.e. for every one unit

(percent) of expected return on Share A the risk is
0.401 units (percent).
 CVB = 0.14 /0.16 = 0.875, i.e. for every one unit
(percent) of expected return on Share B the risk is 0.875
units (percent).
 Share B has more risk for each unit of expected return.
 Share B is more risky.
Slide 26
 Portfolio Analysis
 A portfolio is a collection of assets or securities.
 Portfolio Expected Return
The expected return on a portfolio is the
weighted average return of the individual
securities making up the portfolio, the weight
being the fraction of total funds invested in each
security.
 Portfolio Expected Return:
Rp = (W1)(R1) + (W2)(R2) + ... + (Wn)(Rn)
 Portfolio Analysis
 Portfolio Expected Return Example
Asset Expected Return Weight
1 0.10 0.55
2 0.15 0.45

Rp = (W1)(R1) + (W2)(R2) + ... + (Wn)(Rn)

Rp = (0.55)(0.10) + (0.45)(0.15) = 0.1225 = 12.25%

 Portfolio Analysis
Portfolio Risk
 Measures of risk - Variance & Standard Deviation of
the returns on a portfolio.
 The riskiness of a portfolio depends on:
• the measure of risk of each asset in the portfolio ( i )
• the weight of each asset in the portfolio (wi)
• the measure of "co-movement" between prices or
returns of portfolio assets (the covariance of prices or
returns (Cov(x,y)).
 In a portfolio, pairs of assets whose prices or returns
do not move together will have diversification
benefits.
 Portfolio Analysis
Diversification
 Diversification refers to spreading the risk of a
portfolio. Portfolio diversification can be achieved
by:
1. Having the shares of different companies in a
portfolio;
2. Having different types of assets in a portfolio e.g.
shares, fixed interest (bonds/debentures),
property, cash.
3. Having assets from different countries in a
portfolio e.g. Australia, China, US, Malaysia,
Japan, Europe.
 Portfolio Analysis
Asset A Returns Asset B Returns Portfolio Returns:
Return Return Return
50% A and 50% B
0.05 0.05
0.04
0.04 0.04
0.03
0.03 0.03
0.02
0.02 0.02
0.01
0.01 0.01
0
0 0
-0.01
-0.01 -0.01
-0.02
-0.02 -0.02
-0.03
-0.03 -0.03

-0.04

-0.05 1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9

Time Period
 Portfolio Analysis
The Effect of Diversification
 On the previous page we see that the returns for Assets A
and B are more varied (extreme) than is the case if they are
combined into a portfolio (with a weighting in this example of
50% each).
 Example 1: In Period 2 the return for Asset A is 4.25% and
for Asset B is -1.5%, while the return on the Portfolio is 1%.
 Example 2: In Period 5 the return for Asset A is -4.5% and
for Asset B is 2.5%, while the return on the Portfolio is -1%.
 In both these example the return on the Portfolio is less
extreme than the returns on the two assets making up the
portfolio.
 Portfolio Analysis
The Effect of Diversification
 The aim of portfolio diversification is to eliminate the
risk that comes from price changes.
 If a portfolio is optimally diversified this means the net
price change in the portfolio in a given period will be
zero.
 Example, in a two asset portfolio of Asset A and Asset
B if the portfolio is diversified correctly then if the price
of Asset A rises by 5% the price of Asset B should fall
by 5%. Therefore, the net price change will be 0%.

Slide 33
 Portfolio Analysis
The Effect of Diversification
 The question should now be asked : Then how do we
make any money out of our portfolio?
 Total return on an asset (including a portfolio) is made
up of an income yield and a capital gains yield.
 Income yield comes from the periodic income on the
asset e.g. the dividend on a share or the
coupon/interest payment on a bond/debenture.
 Capital gains yield comes from the change in the price
of an asset in a given time period.

Slide 34
 Portfolio Analysis
The Effect of Diversification
 Even if a portfolio is optimally diversified (which means
the net price change in the portfolio in a given period is
$0 (i.e. the net capital gains yield will be 0%)) a positive
return can still be earned because periodic income will
still be earned (dividends and interest/coupon payments
will still be received) which means the return on the
portfolio will be equal to the income yield.

Slide 35
 Portfolio Analysis
The Effect of Diversification
 Why would you want the net price change (capital gain) to be zero?
 This example will help to explain: Assume your portfolio is made up of the
shares of only two companies - ANZ Bank and Westpac Bank.
 If the Australian finance sector does well then you do very well with your
portfolio – the price of both ANZ Bank and Westpac Bank shares will rise
e.g. ANZ Bank by +7% and Westpac Bank by +10%. Your capital gains
yield is good.
 But what if the Australian finance sector is doing badly? This would
probably cause the price of both ANZ Bank and Westpac Bank shares to
fall e.g. ANZ Bank shares fall in price by 5% and Westpac Bank shares fall
in price by 7%. Your capital gains yield is bad..
 Portfolio theory states it’s better to eliminate the effect of price changes
(net price change/capital gains yield = 0) and receive a return on your
portfolio equal to the income yield. This will mean the returns on your
portfolio will be less varied, meaning there’s less risk in your portfolio.

Slide 36
 Portfolio Analysis
Measures of Portfolio Risk
 Covariance (cov(x,y)) - a statistical measure of the degree
to which the prices or returns on two assets "co-vary" or
move together – measures only the direction of the
relationship - can be positive or negative. Covariance can
be written as cov(x,y) or ρx,y σx σy.
 Correlation Coefficient (ρx,y) - a standardised statistical
measure of the covariance – measures both the direction
and the strength of the relationship between the prices or
returns on two assets.
 Correlation coefficient is always between -1 and +1.
 Portfolio Analysis
Correlation Co-Efficient
 Perfectly Positively Correlated Returns ρx,y = +1
- exact proportional movements in the same direction for the
prices or returns for two assets. If the price of Asset A goes up
by 1% the price of Asset B will go up by 1%.

 Perfectly Negatively Correlated Returns ρx,y = -1

- exact proportional movements in the opposite direction for the
prices or returns for two assets. If the price of Asset A goes up
by 1% the price of Asset B will go down by 1%.

 Zero Correlation ρx,y = 0

- there is no relationship between prices or returns for the two
assets. If the price of Asset A goes up by 1% the price of Asset
B will not change.
 Portfolio Analysis
Measuring Risk – Variance & Standard Deviation
For a two asset portfolio:
 Variance σp2 = (W1)2(σ1)2 + (W2)2(σ2)2 + 2(W1)(W2)(ρ1,2)(σ1)(σ2)
where (ρ1,2) is the correlation coefficient between the two assets.

 Standard Deviation
σp = (W1)2(σ1)2 + (W2)2(σ2)2 + 2(W1)(W2)(ρ1,2)(σ1)(σ2)

Slide 39
 Portfolio Analysis
Portfolio Risk
 Taking into account the correlation between each pair of assets in a
portfolio

Asset Std. Dev. Weight ρx,y

1 0. 20 0.55 0.30
2 0. 28 0.45

Variance σp2 = (0.55)2 (0.20)2 +(0.45)2 (0.28)2+2(0.55)(0.45)(0.30)(0.20)(0.28)

= 0.0363 = 3.63%

Standard Deviation = 0.0363 = 0.1905 = 19.05%

Slide 40
 Portfolio Analysis
Portfolio Diversification
 In the previous example we have a correlation coefficient ρx,y = 0.30,
meaning the prices/returns on the two assets making up the portfolio
are less than perfectly positively correlated.
 The best way to interpret this correlation coefficient of 0.30 is to say if
the price of Asset 1 goes up by 1% the price of Asset 2 will go up by
0.30%.
 Has there been any diversification (reduction of risk) in this portfolio?
 One way of checking is by comparing the portfolio’s standard deviation
with the average weighted standard deviation of the portfolio.
 The weighted average standard deviation of a portfolio is equal to W 1σ1
+ W2σ2
 In the previous example this works out to be:
(0.55) (0.20) + (0.45) (0.28) =0.236= 23.6%

Slide 41
 Portfolio Analysis
Portfolio Diversification
 Since the standard deviation of the portfolio, 19.05%, is less than the
weighted average standard deviation of the portfolio, 23.6%, we can
conclude that by combining the two assets into a portfolio we have
reduced risk.
 Whenever the standard deviation of a portfolio is less than the
weighted average standard deviation of the portfolio risk is reduced.
 Whenever the correlation coefficient between a pair of assets in a
portfolio is less than +1 the standard deviation of the portfolio will be
less than the weighted average standard deviation of the portfolio and
there will be diversification of risk and risk reduction.
 The closer the correlation coefficient between a pair of assets in a
portfolio is to -1, the greater the diversification benefits and risk
reduction in the portfolio.

Slide 42
 Portfolio Analysis
Portfolio Risk
 For portfolios with more than two assets, the "co-movement" between
each pair of assets must be considered
 For a three asset portfolio:
p2 = w1212 + w2222 + w3232
+ 2 w1 w2 
+ 2 w1 w3 
+ 2 w2 w3 

p =
w1212 + w2222 + w3232
+ 2 w1 w2 
+ 2 w1 w3 
+ 2 w2 w3 

Slide 43
 Portfolio Analysis
Correlation Coefficient
 What is the impact of different correlation coefficients (ρx,y) on portfolio
risk?
 Let’s try a range of correlation coefficients and see what happens to the
risk of the portfolio (as measured by standard deviation)?
Asset σi Wi ρx,y
1 .20 .55 -1.0, -0.5, 0, 0.5, 1.0
2 .28 .45

 σp = (0.55)2(0.20)2 +(0.45)2(0.28)2 +2(0.55)(0.45)(ρx,y)0.20)(0.28)

ρx,y = -1.0 -0.5 0 +0.5 +1.0

σp = 0.016 0.12 0.17 0.21 0.236
(min. risk) (max. risk)

Slide 44
 Portfolio Analysis
Portfolio Diversification
 Where the correlation coefficient is + 1 the Std. Dev. of the portfolio is
23.6%.:
σP = (W1)2(σ1)2+(W2)2(σ2)2+2W1W2ρ1,2σ1σ2
σP = (0.55)2(0.20)2+(0.45)2(0.28)2+2(0.55)(0.45)(+1)(0.20)(0.28)

σP = (0.3025)(0.04)+(0.2025)(0.0784)+2(0.01386)

σP = (0.0121)+(0.015876)+(0.02772)

σP = 0.055696

σP = 0.236 = 23.6%

Slide 45
 Portfolio Analysis
Portfolio Diversification
 This gives the same result as using the weighted average standard
deviation formula:
W1σ1+W2σ2:
(0.55)(0.20)+(0.45)(0.28) = 0.11+0.126 = 0.236

 Therefore, where correlation coefficient is +1 there are no

diversification benefits achieved by combining two assets in a portfolio.

Slide 46
 Portfolio Analysis
Correlation Matrix: ASX Companies
Correlation Matrix
Correlation Coefficients

 The question can be asked: Which combination of two firms will

provide the biggest diversification benefits in reducing portfolio risk?
Look for the two companies that have the lowest correlation
coefficient – AGL & WPL (ρx,y = 0.0253).

Slide 47
 Portfolio Analysis
 In general, the lower the correlation between asset prices or returns,
the greater the potential reduction of risk.
 The amount of risk reduction achieved is also dependent upon the
proportions in which the assets are combined.
 There is potentially an infinite number of asset combinations possible
in a given portfolio of assets.
 As a theoretical exercise we can make use of all risky assets and
combine them in every possible combination and plot the resulting
risk-return outcome. The graph is called the opportunity set.

Slide 48
 Portfolio Analysis
Opportunity Set
Expected
Return

Opportunity
Set

Risk σP
 Portfolio Analysis
Rebel
Expected Opportunity Set Sport P/F
Return
CBA P/F
Eastpac P/F

Billabong P/F
Alpha Sport P/F

PMA P/F

ALG P/F

Risk σP
 Portfolio Analysis
Efficient Frontier
 How does an individual choose among all possible investments?
 Investors are risk averse and rational, therefore they will choose
investments that provide the highest return for a given level of
risk or lowest risk for a given level of return. These portfolios are
known as efficient portfolios.
 Efficient portfolios are found on the upper boundary of the bullet
shaped graph of the opportunity set. The upper boundary is known
as the efficient frontier.
 Efficient portfolios on the efficient frontier provide:
a) maximum return for a given level of risk
b) minimum risk for a given level of return.
 Portfolio Analysis
Expected
Return

P/F B
15% Efficient Frontier

P/F A
12% P/F C

P
7% 10%
 Portfolio Analysis
Efficient Portfolios
 Which of the portfolios, P/F A, P/F B or P/F C are efficient?
 P/F A and P/F B are the efficient portfolios as they lie on the efficient frontier.
P/F C is below the efficient frontier so, therefore, it is not an efficient portfolio.
 Compare P/F A to P/F C – They both have the same expected return (12%),
but P/F A has lower risk (P/F A σA = 7%, P/F C σC = 10%).
 Wouldn’t you rather have P/F A? If you’re rational you would. With P/F A you
have less chance of losing your money (because it has lower risk) but you still
have the same expected return as P/F C.

 Compare P/F B to P/F C – They both have the same level of risk (σp = 10%),

but P/F B has a higher expected return than P/F C (RpB = 15%, RpC = 12%).
 Wouldn’t you rather have P/F B? If you’re rational you would. With P/F B you
have the same chance of losing your money as with P/F C (because they both
have the same standard deviation), but you have a higher expected return with
P/F B.

Slide 53
 Portfolio Analysis
Efficient Frontier
 The efficient frontier shows all possible returns open to the individual
to choose from.
 Each point on the frontier represents a particular and different
combination of risky assets.
 Which point on the frontier the individual will choose will depend on
their own attitude towards risk and return.

Slide 54
 Portfolio Analysis
Investor Risk Preference

Expected Return

15%
B
Higher risk, higher expected return

A
7% Lower risk, lower expected return

Risk σp
5% 10%

Slide 55
 Risk-Return Relationship
Risk-Averse Investor
 For a risk averse investor as the level of risk increases the investor
needs increasing amounts of expected return to compensate for
each additional unit of risk, i.e. for each 1% rise in risk (as
measured by standard deviation), expected return must increase by
more and more.
 Example: standard deviation increases from 5% to 6% and
expected return increases from 10% to 12%, and increase of 2
percentage points in expected return for a one unit increase in risk.
Then, standard deviation increases from 6% to 7% and expected
return has to increase from 12% to 15%, and increase of three
percentage points in expected return for a one unit increase in risk.

Slide 56