RETURN and RISK

how they are related

Part 2

1
 Expected vs. Unexpected Returns

• Realized returns are generally not equal to

expected returns.
• There is the expected component and the
unexpected component.
➢At any point in time, the unexpected return can
be either positive or negative.
➢Over time, the average of the unexpected
component is zero.
2
 Announcements and News
• Announcements and news contain both an
expected component and a surprise component.
• It is the surprise component that affects a stock’s
price and, therefore, its return.
• This is very obvious when we watch how stock
prices move when an unexpected announcement is
made or earnings are different than anticipated

3
 Investment alternatives

Economy Prob. T-Bill HT Coll USR MP

Recession 0.1 5.5% -27.0% 27.0% 6.0% -17.0%

Below avg 0.2 5.5% -7.0% 13.0% -14.0% -3.0%

Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0%

Above avg 0.2 5.5% 30.0% -11.0% 41.0% 25.0%

Boom 0.1 5.5% 45.0% -21.0% 26.0% 38.0%

4
 Why is the T-bill return independent of
the economy? Do T-bills promise a
completely risk-free return?
◼ T-bills will return the promised 5.5%, regardless
of the economy.
◼ No, T-bills do not provide a completely risk-free
return, as they are still exposed to inflation.
Although, very little unexpected inflation is likely
to occur over such a short period of time.
◼ T-bills are also risky in terms of reinvestment rate
risk.
◼ T-bills are risk-free in the default sense of the
word.
5
 How do the returns of HT and Coll.
behave in relation to the market?
• HT – Moves with the economy, and has a
positive correlation. This is typical.

• Coll. – Is countercyclical with the economy,

and has a negative correlation. This is
unusual.

6
Calculating the expected return
^
r = expected rate of return

^ N
r =  ri Pi
i =1

^
r HT = (-27%) (0.1) + (-7%) (0.2)
+ (15%) (0.4) + (30%) (0.2)
+ (45%) (0.1) = 12.4%

7
Summary of expected returns
Expected return
HT 12.4%
Market 10.5%
USR 9.8%
T-bill 5.5%
Coll. 1.0%

HT has the highest expected return, and appears to be

the best investment alternative, but is it really? Have
we failed to account for risk?
8
Calculating standard deviation

 = Standard deviation

 = Variance = 2
N
σ =  i
(r
i =1
− r
ˆ ) 2
Pi

9
Standard deviation for each investment

N ^
=  i =1
(ri − r )2 Pi
1
(5.5 - 5.5) (0.1) + (5.5 - 5.5) (0.2) 
2 2 2

 
 T − bills 2 2
= + (5.5 - 5.5) (0.4) + (5.5 - 5.5) (0.2) 
+ (5.5 - 5.5)2 (0.1) 
 
 T − bills = 0.0%  C oll = 13.2%
 HT = 20.0%  USR = 18.8%
 M = 15.2%
10
Comparing standard deviations

Prob.
T - bill

USR

HT

0 5.5 9.8 12.4 Rate of Return (%)

11
Comments on standard deviation
as a measure of risk
• Standard deviation (σi) measures total, or
stand-alone, risk.
• The larger σi is, the lower the probability
that actual returns will be closer to
expected returns.
• Larger σi is associated with a wider
probability distribution of returns.

12
 Comparing risk and return
Security Expected Risk, σ
return, r ^
T-bills 5.5% 0.0%
HT 12.4% 20.0%
Coll* 1.0% 13.2%
USR* 9.8% 18.8%
Market 10.5% 15.2%
* Seem out of place.
13
 Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.

Standard deviation 
CV = =
Expected return rˆ

14
 Risk rankings,
by coefficient of variation
CV
T-bill 0.0
HT 1.6
Coll. 13.2
USR 1.9
Market 1.4

◼ Collections has the highest degree of risk per unit

of return.
◼ HT, despite having the highest standard deviation
of returns, has a relatively average CV.
15
 Illustrating the CV as a measure
of relative risk
Prob.

A B

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger probability

of losses. In other words, the same amount of risk (as
measured by σ) for smaller returns.
16
 Portfolio construction:
Risk and return
• Assume a two-stock portfolio is created with
$50,000 invested in both HT and Collections.
• A portfolio’s expected return is a weighted
average of the returns of the portfolio’s
component assets.
• Standard deviation is a little more tricky and
requires that a new probability distribution for the
portfolio returns be devised.

17
Calculating portfolio expected return

^
r p is a weighted average :

^ N ^
r p =  wi r i
i =1

^
r p = 0.5 (12.4%) + 0.5 (1.0%) = 6.7%

18
 An alternative method for determining
portfolio expected return

Economy Prob. HT Coll Port.

Recession 0.1 -27.0% 27.0% 0.0%
Below avg 0.2 -7.0% 13.0% 3.0%
Average 0.4 15.0% 0.0% 7.5%
Above avg 0.2 30.0% -11.0% 9.5%
Boom 0.1 45.0% -21.0% 12.0%

^
r p = 0.10 (0.0%) + 0.20 (3.0%) + 0.40 (7.5%)
+ 0.20 (9.5%) + 0.10 (12.0%) = 6.7%
19
Calculating portfolio standard
deviation and CV
1
 0.10 (0.0 - 6.7) 
2 2

 2 
+ 0.20 (3.0 - 6.7) 
 p = + 0.40 (7.5 - 6.7)2  = 3.4%
+ 0.20 (9.5 - 6.7)2 
 2

+ 0.10 (12.0 - 6.7) 

3.4%
CVp = = 0.51
6.7%
20
 Comments on portfolio risk
measures
• σp = 3.4% is much lower than the σi of
either stock (σHT = 20.0%; σColl. = 13.2%).
• σp = 3.4% is lower than the weighted
average of HT and Coll.’s σ (16.6%).
• Therefore, the portfolio provides the
average return of component stocks, but
lower than the average risk.
• Why? Negative correlation between
stocks.
21
 General comments about risk
• σ  35% for an average stock.
• Most stocks are positively (though not
perfectly) correlated with the market
(i.e., ρ between 0 and 1).
• Combining stocks in a portfolio
generally lowers risk.

22
 Returns distribution for two perfectly
negatively correlated stocks (ρ = -1.0)

Stock W Stock M Portfolio WM

25 25 25

15 15 15

0 0 0

-10 -10 -10

23
 Returns distribution for two perfectly
positively correlated stocks (ρ = 1.0)

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

24
 Creating a portfolio:
Beginning with one stock and adding
randomly selected stocks to portfolio
• σp decreases as stocks added, because they would
not be perfectly correlated with the existing
portfolio.
• Expected return of the portfolio would remain
relatively constant.
• Eventually the diversification benefits of adding
more stocks dissipates (after about 10 stocks),
and for large stock portfolios, σp tends to
converge to  20%.
25
 Risk of a portfolio:
Beginning with one stock and adding
randomly selected stocks to portfolio

• Will σp decrease in a linear fashion?

• Will σp decrease non-linearly?

• Using the expression for portfolio risk, we

can examine what happens when N increases
to a large value

26
Illustrating diversification effects of
a stock portfolio
p (%)
Diversifiable Risk
35

Stand-Alone Risk, p

20
Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
27
Breaking down sources of risk

Stand-alone risk = Market risk + Diversifiable risk

• Market risk – portion of a security’s stand-alone risk

that cannot be eliminated through diversification.
Measured by beta.
• Diversifiable risk – portion of a security’s stand-
alone risk that can be eliminated through proper
diversification.
28
 Failure to diversify
• If an investor chooses to hold a one-stock portfolio (doesn’t
diversify), would the investor be compensated for the extra
risk they bear?
➢ NO!
➢ Stand-alone risk is not important to a well-diversified
investor.
➢ Rational, risk-averse investors are concerned with σp,
which is based upon market risk.
➢ There can be only one price (the market return) for a given
security.
➢ No compensation should be earned for holding
unnecessary, diversifiable risk.

29
 Capital Asset Pricing Model
(CAPM)
• Model linking risk and required returns. CAPM
suggests that there is a Security Market Line (SML)
that states that a stock’s required return equals the
risk-free return plus a risk premium that reflects the
stock’s risk after diversification.
ri = rRF + (rM – rRF) βi
• Primary conclusion: The relevant riskiness of a stock
is its contribution to the riskiness of a well-diversified
portfolio.
30
 Beta
• Measures a stock’s market risk, and shows a
stock’s volatility relative to the market.
• Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.

31
 Risk When Holding the Market
Portfolio
• Researchers have shown that the best
measure of the risk of a security in a large
portfolio is the beta () of the security.
• Beta measures the responsiveness of a
security to movements in the market
portfolio (i.e., systematic risk).
C o v ( Ri, R M )
i =
 (RM )
2

32
Estimating  with Regression
Security Returns

Slope = i
Return on
market %

Ri =  i + iRm + ei 33
 The Formula for Beta

C o v ( Ri, R M )
i =
 (RM )
2

Clearly, your estimate of beta will

depend upon your choice of a proxy
for the market portfolio.

34
 Comments on beta
• If beta = 1.0, the security is just as risky as the
average stock.
• If beta > 1.0, the security is riskier than average.
• If beta < 1.0, the security is less risky than
average.
• Most stocks have betas in the range of 0.5 to 1.5.

35
 Can the beta of a security be
negative?
• Yes, if the correlation between Stock i
and the market is negative (i.e., ρi,m < 0).
• If the correlation is negative, the
regression line would slope downward,
and the beta would be negative.
• However, a negative beta is highly
unlikely.

36
 Calculating betas
• Well-diversified investors are primarily concerned
with how a stock is expected to move relative to
the market in the future.
• A typical approach to estimate beta is to run a
regression of the security’s past returns against the
past returns of the market.
• The slope of the regression line is defined as the
beta coefficient for the security.

37
Illustrating the calculation of beta
_
ri
20 . Year rM ri
15 . 1
2
15%
-5
18%
-10
10 3 12 16
5
_
-5 0 5 10 15 20
rM
-5 Regression line:

. -10
^
r = -2.59 + 1.44 r^
i M
38
 Beta coefficients for
HT, Coll, and T-Bills
_
ri HT: β = 1.30
40

20

T-bills: β = 0
_
-20 0 20 40 kM

Coll: β = -0.87

-20
39
Comparing expected returns
and beta coefficients
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87

Riskier securities have higher returns, so the rank

order is OK.

40
 Computing beta using Excel
• A simple step-by-step approach to obtain
values in Excel

41
 Betas of select Indian stocks
• Bharti Airtel
• Cipla
• L&T
• Infosys
• Reliance Industries
• ITC
• SBI

42
 The firm (company)
Frequency of data Beta
End of month data (April 2015 – Nov 2019)
time period is 4 years and 8 months

From website on Dec 14, 2019 (Top Stock Research)

Long term beta
Weekly data (Apr 2016 – Nov 2019) 3 yrs 8 mnths

Weekly data (Apr 2017 – Nov 2019) 2 yrs 8 mnths

Weekly data (Apr 2018 – Nov 2019) 1 yr 8 mnths

From website on Dec 14, 2019 (Top Stock Research)

Weekly Two year range
From website on Dec 14, 2019 (Reuters India)
Frequency not mentioned
43
 Bharti Airtel
Frequency of data Beta
End of month data (April 2015 – Nov 2019) 1.0581
time period is 4 years and 8 months

From website on Dec 14, 2019 (Top Stock Research) 0.972

Long term beta
Weekly data (Apr 2016 – Nov 2019) 3 yrs 8 mnths 0.9715

Weekly data (Apr 2017 – Nov 2019) 2 yrs 8 mnths 1.0632

Weekly data (Apr 2018 – Nov 2019) 1 yr 8 mnths 0.8772

From website on Dec 14, 2019 (Top Stock Research) 0.856

Weekly Two year range
From website on Dec 14, 2019 (Reuters India) 0.94
Frequency not mentioned
44
 Cipla
Frequency of data Beta
End of month data (April 2015 – Nov 2019) 0.4952
time period is 4 years and 8 months

From website on Dec 14, 2019 (Top Stock Research) 0.699

Long term beta
Weekly data (Apr 2016 – Nov 2019) 3 yrs 8 mnths 0.4193

Weekly data (Apr 2017 – Nov 2019) 2 yrs 8 mnths 0.5024

Weekly data (Apr 2018 – Nov 2019) 1 yr 8 mnths 0.5212

From website on Dec 14, 2019 (Top Stock Research) 0.552

Weekly Two year range
From website on Dec 14, 2019 (Reuters India) 0.47
Frequency not mentioned
45
 L&T
Frequency of data Beta
End of month data (April 2015 – Nov 2019) 1.2635
time period is 4 years and 8 months

From website on Dec 14, 2019 (Top Stock Research) 1.34

Long term beta
Weekly data (Apr 2016 – Nov 2019) 3 yrs 8 mnths 1.2343

Weekly data (Apr 2017 – Nov 2019) 2 yrs 8 mnths 1.0480

Weekly data (Apr 2018 – Nov 2019) 1 yr 8 mnths 1.3147

From website on Dec 14, 2019 (Top Stock Research) 1.25

Weekly Two year range
From website on Dec 14, 2019 (Reuters India) 1.29
Frequency not mentioned
46
 Infosys
Frequency of data Beta
End of month data (April 2015 – Nov 2019) 0.3966
time period is 4 years and 8 months

From website on Dec 14, 2019 (Top Stock Research) 0.255

Long term beta
Weekly data (Apr 2016 – Nov 2019) 3 yrs 8 mnths 0.4901

Weekly data (Apr 2017 – Nov 2019) 2 yrs 8 mnths 0.4906

Weekly data (Apr 2018 – Nov 2019) 1 yr 8 mnths 0.4003

From website on Dec 14, 2019 (Top Stock Research) 0.421

Weekly Two year range
From website on Dec 14, 2019 (Reuters India) 0.42
Frequency not mentioned
47
 Reliance Industries
Frequency of data Beta
End of month data (April 2015 – Nov 2019) 1.2113
time period is 4 years and 8 months

From website on Dec 14, 2019 (Top Stock Research) 1.08

Long term beta
Weekly data (Apr 2016 – Nov 2019) 3 yrs 8 mnths 1.2622

Weekly data (Apr 2017 – Nov 2019) 2 yrs 8 mnths 1.5306

Weekly data (Apr 2018 – Nov 2019) 1 yr 8 mnths 1.4399

From website on Dec 14, 2019 (Top Stock Research) 1.45

Weekly Two year range
From website on Dec 14, 2019 (Reuters India) 1.22
Frequency not mentioned
48
 ITC
Frequency of data Beta
End of month data (April 2015 – Nov 2019) 0.8691
time period is 4 years and 8 months

From website on Dec 14, 2019 (Top Stock Research) 1.01

Long term beta
Weekly data (Apr 2016 – Nov 2019) 3 yrs 8 mnths 0.6544

Weekly data (Apr 2017 – Nov 2019) 2 yrs 8 mnths 0.7027

Weekly data (Apr 2018 – Nov 2019) 1 yr 8 mnths 0.6361

From website on Dec 14, 2019 (Top Stock Research) 0.568

Weekly Two year range
From website on Dec 14, 2019 (Reuters India) 0.89
Frequency not mentioned
49
 SBI
Frequency of data Beta
End of month data (April 2015 – Nov 2019) 1.6659
time period is 4 years and 8 months

From website on Dec 14, 2019 (Top Stock Research) 1.75

Long term beta
Weekly data (Apr 2016 – Nov 2019) 3 yrs 8 mnths 1.7449

Weekly data (Apr 2017 – Nov 2019) 2 yrs 8 mnths 1.8210

Weekly data (Apr 2018 – Nov 2019) 1 yr 8 mnths 1.8588

From website on Dec 14, 2019 (Top Stock Research) 1.65

Weekly Two year range
From website on Dec 14, 2019 (Reuters India) 1.65
Frequency not mentioned
50
 The Security Market Line (SML):
Calculating required rates of return

SML: ri = rRF + (rM – rRF) βi

ri = rRF + (RPM) βi

Assume the yield curve is flat and that

rRF = 5.5% and RPM = 5.0%.

51
What is the market risk premium?
• Additional return over the risk-free rate needed
to compensate investors for assuming an
average amount of risk.
• Its size depends on the perceived risk of the
stock market and investors’ degree of risk
aversion.
• Varies from year to year, but most estimates
suggest that it ranges between 4% and 8% per
year.
52
Calculating required rates of return

• rHT = 5.5% + (5.0%)(1.32)

= 5.5% + 6.6% = 12.10%
• rM = 5.5% + (5.0%)(1.00) = 10.50%
• rUSR = 5.5% + (5.0%)(0.88) = 9.90%
• rT-bill = 5.5% + (5.0%)(0.00) = 5.50%
• rColl = 5.5% + (5.0%)(-0.87) = 1.15%

53
Expected vs. Required returns
^
r r
^
HT 12.4% 12.1% Undervalued (r  r)
^
Market 10.5 10.5 Fairly valued (r = r)
^
USR 9.8 9.9 Overvalued (r  r)
^
T - bills 5.5 5.5 Fairly valued (r = r)
^
Coll. 1.0 1.2 Overvalued (r  r)
54
 Illustrating the
Security Market Line
SML: ri = 5.5% + (5.0%) bi
ri (%)
SML

HT .
rM = 10.5 ..
rRF = 5.5 . T-bills USR

-1
. 0 1 2
Risk, bi
Coll.
55
 An example:
Equally-weighted two-stock portfolio
• Create a portfolio with 50% invested in HT
and 50% invested in Collections.
• The beta of a portfolio is the weighted
average of each of the stock’s betas.

βP = wHT βHT + wColl βColl

βP = 0.5 (1.32) + 0.5 (-0.87)
βP = 0.225
56
Calculating portfolio required returns

• The required return of a portfolio is the weighted

average of each of the stock’s required returns.
rP = wHT rHT + wColl rColl
rP = 0.5 (12.10%) + 0.5 (1.15%)
rP = 6.63%
• Or, using the portfolio’s beta, CAPM can be used to
solve for expected return.
rP = rRF + (RPM) βP
rP = 5.5% + (5.0%) (0.225)
57
rP = 6.63%
 Factors that change the SML
• What if investors raise inflation expectations by
3%, what would happen to the SML?
ri (%)
 I = 3% SML2
SML1
13.5
10.5
8.5
5.5
Risk, bi
0 0.5 1.0 1.5 58
 Factors that change the SML
• What if investors’ risk aversion increased, causing the
market risk premium to increase by 3%, what would
happen to the SML?

ri (%) SML2
 RPM = 3%
13.5 SML1
10.5

5.5
Risk, bi
59
0 0.5 1.0 1.5
 Another Example:
Fama-French Three-Factor Model

• The factors chosen are variables that on past

evidence seem to predict average returns
well and may capture the risk premiums
r it =  i +  iM R M t +  iS M B SM Bt+  iH M L H M L t + e it
where:
➢ SMB = Small Minus Big, i.e., the return of a portfolio of small stocks in
excess of the return on a portfolio of large stocks
➢ HML = High Minus Low, i.e., the return of a portfolio of stocks with a
high book to-market ratio in excess of the return on a portfolio of stocks
with a low book-to-market ratio

60