Return and Risk

Assets returns

Asset returns over a given period are often uncertain

Where:
D = dividends
P = price
~ = uncertain outcome

Asset returns are characterised by:

● All possible outcomes
● Probability of each outcome

Expected Holding Period Return

 Expected HPR = mean
Expected Rate of Return

Expected rate of return on an investment is the discount rate for its cash flows:

 Expected rate of return compensates for time-value and risk:

Required rate of return

Defining Risk

§ Risk refers to the degree of uncertainty or variability (volatility) in year-to-year

returns on investment.
§ Two most basic measures of risk: variance and the standard deviation
 § How much on average the payoff deviates/ move away from the expected
value
§ The greater the volatility of returns (variance and standard deviation), the
greater the risk.
§ The greater the difference between payoff and the expected value, the greater
the risk.

 SD measures how much an asset's return varies from its average return over a
set period of time
 SD is a statistical measure representing the volatility or risk in an instrument

Key assumptions on Investor Preferences

Historical Return and Risk

Risk and Horizon
Often, we need to know:
● How do risk and return vary with horizon?
● How do risk and return change over time?

We need to know how successive asset returns are related

IID Assumption: Asset returns are IID when successive returns are independently
and
identically distributed
Pt is the asset price (including dividend). The continuously compounded
return is

Implications of the IID assumption

● Returns are serially uncorrelated

● No predictable trends, cycles or patterns in returns
● Risk (measured by variance) accumulates linearly over time:
○ Annual variance is 12 times the monthly variance

Advantages and Disadvantages of IID Assumption

Investment in the long-run

Probability and Statistics
Covariance and Correlation

Portfolio Theory
Risk components
Risks in individual asset returns have two components:
● Systematic risk: Common to most assets, non-diversifiable
● Non-systematic risk: Specific to individual assets, diversifiable
Forming portfolios can eliminate non-systematic risks. Investors hold diversified
portfolios to reduce risk

Portfolio Returns

Portfolio of Two Assets

Portfolio of Two Assets – Returns

Portfolio of Two Assets – Variance

Portfolio of Three Assets

Portfolio of Multiple Assets

Diversification

The Standard Deviation (StD) of a portfolio with two assets is less than the StD of
each individual asset due to diversification. When the assets are not perfectly
correlated, their combined risk (volatility) is reduced.
 This is because the assets' returns move independently to some degree, so when
one asset's return is high, the other might be low, reducing the overall portfolio risk.
The portfolio’s StD will be lower than the individual assets’ StDs as long as the
assets are not perfectly positively correlated.
Optimal Portfolio Selection

Portfolio Frontier

Represents the set of optimal portfolios that offer the highest possible return for a
given level of risk (or the lowest possible risk for a given level of return). These
portfolios are considered "efficient" because they provide the best trade-off between
risk and return.

Definition: The locus of all frontier portfolios in the mean-StD plane is called
portfolio frontier. The upper part of the portfolio frontier gives efficient frontier
portfolios.
Portfolio Frontier with Two Assets
 Short sales not allowed means no negative portfolio weights, limiting
investors to only long positions (buying assets, not selling them short).

 Impact on Portfolio Frontier:

 Efficient Frontier will likely have higher risk for the same expected return
compared to when short sales are allowed.
 Portfolios cannot exploit negative correlations between assets using short
positions, reducing diversification benefits.

 Risk-Return Trade-Off:

 Without short sales, the investor can’t take advantage of strategies that
reduce portfolio risk (e.g., using short positions to hedge).
 Portfolios will have higher risk for the same level of return compared to a
scenario where short sales are allowed.
 Short sales allowed means investors can take both long and short positions
in assets (buying and selling assets they do not own).

 Impact on Portfolio Frontier:

 The Efficient Frontier is typically more efficient, offering a better risk-

return trade-off than when short sales are not allowed.
 Investors can use short positions to hedge risks, reduce portfolio volatility,
and achieve higher returns for the same level of risk.

 Risk-Return Trade-Off:

 Short selling allows the creation of portfolios with lower risk for a given
return by offsetting positions in assets with negative correlations.
 Investors can use short sales to take advantage of overvalued securities
and improve diversification.
Portfolio Frontier with Multiple Assets

Observation: When more assets are included, the portfolio frontier improves, i.e.,
moves toward upper-left: higher mean returns and lower risk.

Intuition: Since one can choose to ignore the new assets, including them cannot
make one worse off.
Portfolio Frontier with a Safe Asset
When there exists a safe (risk-free) asset, each portfolio consists of the risk-free
asset and
risky assets.

Observation: A portfolio of risk-free and risky assets can be viewed as a portfolio of

two
portfolios:
1. the risk-free asset, and
2. a portfolio of only risky assets

EXAMPLE
 SHARPE RATIO The Sharpe ratio is
a measure used to
evaluate the
performance of an
investment compared
to a risk-free asset,
The Capital Asset Pricing Model (CAPM) accounting for its risk

● The capital asset pricing model relates the required rate of return for an equity to
its risk
as measured by a statistic referred to as beta.
● Beta (β) is a measure of an asset's sensitivity to market movements. It indicates
how
much the asset's return is expected to change relative to changes in the market
return.
● Expected Return-Beta Relationship: Implication of the CAPM that security risk
premiums will be proportional to beta, i.e., in terms of an equation:

 Security Market Line

and therefore, only systemic risk matters to investors who can diversify which is
measured by the beta of the security. This equation specifies the Security Market
Line
(SML).

The Security Market Line

The CAPM states that the required risk premium of a security is proportional to its
beta and the market risk premium:

Risk Premium=β×[E(rM )−rf ]

The SML serves as a benchmark to evaluate investment performance, showing the

expected return for a given level of risk (beta).
Assets on the SML:
A security is considered "fairly priced" if it lies on the SML.
● Under-priced assets plot above the SML (expected returns >required).
● Overpriced assets plot below the SML (expected returns < required).
SML vs. CML: While the CML shows risk-return for efficient portfolios (based on
standard deviation), the SML applies to individual assets, using beta to measure risk.

CAPM – Assumptions
● Investors are rational and risk-averse and seek to maximise their utility.
● There are no transaction costs or taxes associated with trading.
● Homogeneous expectations: All investors have the same expectations about asset
returns.
● Investors can lend and borrow at the risk-free rate.
● The market portfolio is efficient.
● Assets are infinitely divisible.

Applications and Limitations

● Applications: The CAPM may be used in three different contexts:
○ As a benchmark to assess fair expected return on a risky asset.
○ In capital budgeting decisions to determine the IRR for a new project.
○ Rate-making cases for regulated utilities.
● Limitations:
○ it relies on the theoretical market portfolio which includes all assets; and
○ it deals with expected as opposed to actual returns.
○ It assumes a constant beta
CAPM - The Index Model