Financial Management

Lecture 10

Dr. Harshit Rajaiya

Telfer School of Management
University of Ottawa
 Readings
• Readings: Chapter 13

2
 Overview
➢ Forming Portfolios
• Portfolio Risk and Return
• Diversification Benefits
• Systematic vs. unsystematic risk

➢ Beta of a security and a portfolio

➢ The Capital Asset Pricing Model (CAPM) and Security

Market Line (SML)

3
 Expected Returns and Risk
➢ Individual Securities
n
Expected Return: E (r ) =  ri Pi
i =1

0.5
Risk:  n

σ =  (ri − E (r ) ) Pi 
2
(i.e. standard
deviation)
 i =1 

Where :
E (r ) = Expected return
n = Number of possible states
ri = Rate of return associated with the ith possible state
Pi = Probability of the i th state occurring

4
Expected Returns and Std. Deviation Example

5
 Expected Returns and Std. Deviation Example

This is also called stand-alone risk because it is the risk if the investor holds
only one asset, next lecture we will discuss portfolio risk 6
 Portfolio Measures: Expected Return
➢ A portfolio is a specific combination of securities, usually defined
by portfolio weights that sum to 1
➢ A portfolio’s expected return is a weighted average of the
individual assets’ expected returns

N Hi
Wi =
E (rP ) =  Wi  E (ri ) I

i =1
H
i =1
i

Where:

Wi: Weight of the ith asset in the portfolio

Hi: $ amount invested in the ith asset
E(ri ): Expected return of the ith asset in the portfolio

The weights sum to 1 and the weights can be positive or negative

7
 Portfolio Expected Return: Example
Calculate the expected annual return of the following portfolio

Stock Weight in Portfolio Annual Return

a 12% 15%
b 26% 22%
c 62% 12%

N
E (rP ) =  Wi  E (ri )
i =1

𝑬 𝒓𝒑 =

8
 Portfolio Expected Return: Example
(solutions)
Calculate the expected annual return of the following portfolio

Stock Weight in Portfolio Annual Return

a 12% 15%
b 26% 22%
c 62% 12%

𝐸 𝑟𝑝 = ෍ 𝑤𝑖 ∗ 𝐸 𝑟𝑖
𝑖=1

𝑬 𝒓𝒑 = 0.12 ∗ 0.15 + 0.26 ∗ 0.22 + 0.62 ∗ 0.12 = 𝟏𝟒. 𝟗𝟔%

9
 Portfolio Measures: Portfolio Risk
➢ Portfolio standard deviation
• Two-asset case

1ൗ
σP = WA2 σ2A + WB2 σ2B + 2WA WB σA σB 𝜌AB 2

Risk of Individual Parts Diversification Benefit

σ2A ,σ2B = Variances for securities A and B, respectively

𝜌AB = Correlation between the returns of securities A and B
σA ,σB = Standard deviations of the returns of assets A and B, respectively

10
 Covariance / Correlation - Risk
◼ A way to measure whether two random variables are related, and how.
◼ Is positive when both returns are above their averages, or both are below their
averages (tend to move in the same direction)

𝑁
σ𝑁
𝑡=1 𝑟𝑎,𝑡 − 𝑟𝑎lj 𝑟𝑏,𝑡 − 𝑟𝑏lj
cov𝑎,𝑏 = cov𝑎,𝑏 = ෍(𝑟𝑎,𝑖 − 𝐸(𝑟𝑎 ))(𝑟𝑏,𝑖 − 𝐸(𝑟𝑏 ))𝑃𝑖
𝑁−1 𝑖=1

Correlation is a normalizes covariance to be bounded at -1 and +1

𝑐𝑜𝑣𝑎,𝑏
𝑐𝑜𝑟𝑟𝑎,𝑏 = 𝜌𝑎,𝑏 =
𝜎𝑎 𝜎𝑏

𝑁𝑜𝑡𝑒 𝑡ℎ𝑎𝑡 𝑡ℎ𝑒 𝑎𝑏𝑜𝑣𝑒 𝑓𝑜𝑟𝑚𝑢𝑙𝑎 𝑖𝑚𝑝𝑙𝑖𝑒𝑠 𝑡ℎ𝑎𝑡 𝒄𝒐𝒗𝒂,𝒃 = 𝝈𝒂 𝝈𝒃 𝝆𝒂,𝒃

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 Example: Portfolio Variance

➢ Consider the following information

• Invest 60% of your money in Asset A
State Probability A B
Boom .5 70% 10%
Bust .5 -20% 30%

➢ What is the expected return and standard deviation for each asset?
➢ What is the expected return and standard deviation for the
portfolio?

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Example: Portfolio Variance – Continued
If A and B are your only choices, what percent are you investing in Asset B?

Asset A: E(RA) = .5(70) + .5(-20) = 25%

• Variance(A) = .5(70-25)2 + .5(-20-25)2 = 20.25%
• Std. Dev.(A) = 45%

Asset B: E(RB) = .5(10) + .5(30) = 20%

• Variance(B) = .5(10-20)2 + .5(30-20)2 = 1%
• Std. Dev.(B) = 10%

Portfolio
• Portfolio return in boom = .6(70) + .4(10) = 46%
• Portfolio return in bust = .6(-20) + .4(30) = 0%
• Expected return = .5(46) + .5(0) = 23% or Expected return = .6(25) + .4(20) = 23%
• Variance of portfolio = .5(46-23)2 + .5(0-23)2 = 5.29%
Standard deviation = (5.29%)1/2 = 23%

13
Different Correlation Coefficients

14
Different Correlation Coefficients

15
Different Correlation Coefficients

16
Graphs of Possible Relationships
Between Two Stocks

17
 Diversification
▪ There are benefits to diversification whenever the
correlation between two stocks is less than perfect (p < 1.0)

▪ If two stocks are perfectly positively correlated, then there is

simply a risk-return trade-off between the two securities.

▪ Portfolio standard deviation is less than the weighted

average of constituent asset standard deviations whenever
the assets’ returns are imperfectly correlated ( < 1)

“The risk of the sum is less than the sum of the risks”

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Risk and Reward of the Two Asset Risky
Portfolio
Bonds Stocks
w ? ?
E(R ) 0.08 0.13
SD 0.09 0.20
Correlation 0.3

What happens to the portfolio risk and return as we chance the weights of
stocks and bonds? Let’s plot a graph:

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 Risk and Reward of the Two Asset
E(r) Risky Portfolio
80% Stocks
60% 100% Stocks
20% Bonds
Stocks
40%
Bonds
40%
Stocks
60%
Bonds
20%
Stocks
80%
Bonds
100% Bonds

N 1ൗ
E (rP ) =  Wi  E (ri ) σP = WA2 σ2A + WB2 σ2B + 2WA WB σA σB 𝜌AB 2
i =1

E.g.: if 80% stocks and 20% bonds then:

E (rP ) = 0.8 * 0.13 + 0.2 * 0.08 = 0.12 σP = 0. 82 ∗ 0. 22 + 0. 22 ∗ 0.092 + 2 ∗ 0.8 ∗ 0.2 ∗ 0.09 ∗ 0.2 ∗ 0.3
1ൗ
2 = 0.1663
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 Portfolio Variance: Diversification Effects
0.014 A
0.012

0.010
1
0.008 0.5

E(r) 0
0.006
-0.5
0.004 -0.75
-1
0.002
B
0.000
0.0000 0.0200 0.0400 0.0600 0.0800 0.1000
Standard Deviation

◼ The standard deviation of a portfolio is less than the weighted average of the
individual (asset) standard deviations as long as the assets’ returns are
imperfectly correlated (i.e.,  < 1)

◼ Diversification can substantially reduce the variability of returns without an equivalent

reduction in expected returns

◼ This risk reduction arises because worse than expected returns from one asset are
offset by better-than-expected returns from another asset. (Think about owning an
Umbrella and Sunglass firms) 21
Extensions to More Than 2 Securities

return

Individual Assets

sP
Consider a world with many risky assets
▪We can still identify the opportunity set of risk-return combinations for n-asset
risky portfolios

22
Extensions to More Than 2 Securities

return
minimum
variance
portfolio

Individual Assets

sP
Given the opportunity set we can identify the
minimum variance portfolio

23
Extensions to More Than 2 Securities

return
minimum
variance
portfolio

Individual Assets

sP

The section of the opportunity set above the minimum variance

portfolio is the efficient frontier

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 Diversification
➢ Diversification can substantially reduce the variability of
returns without an equivalent reduction in expected
returns

➢ This risk reduction arises because worse than expected

returns from one asset are offset by better-than-expected
returns from another asset

➢ However, there is a minimum level of risk that cannot be

eliminated by diversification
• Systematic risk is not diversifiable (a.k.a. market risk)
• Unsystematic risk is diversifiable (a.k.a. firm-specific risk)

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 Diversification
▪ Variance (risk) of an asset’s return can be decomposed

❑ Systematic (Market) Risk

❑ Economy-wide random events that affect almost all assets to some degree
❑ Unsystematic (diversifiable) Risk
❑ Random events that affect single security or small groups of securities

▪ Diversification Effects
❑ Unsystematic risk is significantly reduced in “large” portfolios
❑ Systematic risk is not affected by diversification since it affects all
securities in any large portfolio

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Portfolio Risk as a Function of the Number of Stocks in
the Portfolio
s In a large portfolio the variance terms are effectively diversified away,
but the covariance terms are not.
~50
%
Diversifiable Risk;
Unsystematic Risk; Firm
Specific Risk; Unique Risk;
Idiosyncratic Risk

Portfolio risk
~20
% Nondiversifiable risk;
Systematic Risk; Market Risk

n
Diversification can eliminate some but not all of the risk of individual securities.

27
 International Diversification
➢ Historically, correlations between countries’ stock exchanges were
low
• Markets were relatively “segmented”
• There is concern that global markets have become more “integrated” and as a
result, correlations among different markets have risen

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 Combine a Risky Portfolio and a Risk-free Asset

Regardless of risk tolerance a

E(r) Combinations of risk-free
rational investor would never hold
asset and tangency
a risky portfolio other than the
portfolio C tangency portfolio.
The Tangency line best risk-return
B trade off (best Sharpe Ratio, the
slope of the line)
M All investors hold combinations
of the riskless asset and the
E(rM) tangency portfolio, albeit in
A different proportions based on
their sense of risk tolerance.

rf Under some assumptions (e.g.

homogeneous expectations), the
tangency portfolio is the market
portfolio
Risk of A < Risk of B < Risk of C
s
sM
Market Portfolio - Portfolio of all assets in the economy. In practice a
broad stock market index is used to represent the market. 29
 Main lessons so far
➢ Since unsystematic risk can be diversified away by any
investors, there should be no premium for it. Only
systematic risk should affect the expected stock return

• We need a measure of risk that captures systematic risk not

total risk

➢ Under some assumptions, investors invest in the market

portfolio and risk-free asset

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 Measuring Systematic Risk
➢ How do we measure systematic risk?
• We use the beta coefficient to measure systematic risk

➢ What does beta tell us?

• A beta of 1 implies the asset has the same systematic risk as
the overall market
• A beta < 1 implies the asset has less systematic risk than the
overall market
• A beta > 1 implies the asset has more systematic risk than the
overall market

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 Beta: Systematic Risk Measure
➢ Beta - Sensitivity of a stock’s return to the return on the market
portfolio.
➢ Beta is the relevant risk to consider when a new stock is added to the
portfolio
➢ Standard deviation: risk measure for market portfolio
➢ Formula for beta:
CovjM = the covariance between the
return on asset “j” and the return on
Cov j , M
j =
the market portfolio

s 2
M
s M2 = the variance of the market

➢ Calculating Beta:
Option 1: “Manually” using the formula above.
Option 2: Running a return regression model and finding the slope coefficient:

rj ,t =  j +  j rm ,t +  j ,t
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 Stock Betas: IBM
Scatterplot of Monthly Returns
IBM vs. Value-Weighted Market
.6
r(IBMt) = 0.0048 + 1.0483r(mt)
.4

βIBM = 1.0483
Monthly IBM Returns

.2
0
-.2
-.4

-.2 -.1 0 .1
Monthly Value-weighted Market Returns

Monthly Firm Return Best Fit Line

Beta is the slope from a regression of the stock return against the market return
Useful Web Resource for Calculating Beta:
https://www.portfoliovisualizer.com/factor-analysis#analysisResults 33
 Computing Beta: An Example
Cov j , M
j =
s M2

Q: The market portfolio has a standard deviation of 20% and the

covariance between the returns on the market and those of stock
W is 0.08.

• What is the market’s beta?

• What is the beta of stock W?

• How do we interpret this value?

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Beta Coefficients for Selected
Companies

35
 Portfolio Beta
Diversification reduces variability from unique risk, but
not from market risk.
We calculate the beta of a portfolio as the weighted
average of the securities’ individual betas.
n
 p = W j  j
j =1

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 Portfolio Beta: An Example
➢ You are provided with the following information:
• Variance of the market portfolio = 0.12
• Covariance of stock Z with the market = 0.06
• Beta of stock Y = 1.8

Q: What is the beta of a $5,000 portfolio that has $3,500

invested in stock Z and the remainder in stock Y?

37
 Security Market Line
1) Beta is a measure of undiversifiable/systematic risk
2) To hold undiversifiable/systematic risk investors need to be
rewarded
3) Thus, higher beta stocks must be compensated with higher return

38
 Security Market Line
➢ The security market line (SML) is the representation of
market equilibrium
➢ The slope of the SML is the reward-to-risk ratio: (E(Rm) –
Rf) / m
➢ But since the beta for the market is ALWAYS equal to
one, the slope can be rewritten as

• Slope = E(Rm) – Rf
• E(Rm) – Rf = market risk premium
• The 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 overall stock market and
investors’ degree of risk aversion

39
Portfolio Expected Returns and Betas

Rf

40
 Reward-to-Risk Ratio: Definition
➢ The reward-to-risk ratio is the slope of the line illustrated
in the previous example
• Slope = (E(RA) – Rf) / (A – 0)=(20 – 8) / (1.6 – 0) = 7.5

➢ What if an asset has a reward-to-risk ratio of 8 (implying

that the asset plots above the line)?
• If the reward-to-risk ratio = 8, then investors will want to buy the asset. This will drive the price up and the
return down (remember time value of money and valuation). When should trading stop? When the reward-
to-risk ratio reaches 7.5

➢ What if an asset has a reward-to-risk ratio of 7 (implying

that the asset plots below the line)?
• If the reward-to-risk ratio = 7, then investors will want to sell the asset. This will drive the price down and
the return up. When should trading stop? When the reward-to-risk ratio reaches 7.5

41
 Market Equilibrium

In equilibrium, all assets and portfolios must have

the same reward-to-risk ratio and they all must
equal the reward-to-risk ratio for the market

E ( RA ) − R f E ( RM − R f )
=
A M

42
 Capital Asset Pricing Model (CAPM)
➢ CAPM forecasts the expected returns of individual stocks.

E (rj ) = rf +  j ( E (rm ) − rf )

risk-free rate Market Risk Premium

➢ Implications
• The relationship between required return & beta is linear
• The CAPM equation holds for all individual securities as well as
portfolios
• All securities and portfolios, if fairly priced, should be on the SML
• You only get rewarded for holding systematic risk because you can
always get rid of unsystematic risk by diversification.

43
 Using CAPM: Some Concerns
➢ Practical problems with estimating required returns
• Estimates of the risk-free rate & market risk premium

◼ Is the CAPM even testable?

• Proxies must be used for the “market portfolio”
• Commonly used proxies (e.g., S&P500) omit many assets

➢ Academic research shows that factors other than β

materially impact investors’ expected returns
• Multi-factor models (e.g., Arbitrage Pricing Theory)

44
 Arbitrage Pricing Theory (APT)
➢ Similar to the CAPM, the APT can handle multiple
factors that the CAPM ignores
➢ Unexpected return is related to several market factors

E ( R) = RF + E ( R1 − RF )  1 + E ( R2 − RF )   2 + ... + E ( RK − RF )   K

46
 Summary
➢ There is a reward for bearing risk

➢ Total risk has two parts: systematic risk and unsystematic risk

➢ Unsystematic risk can be eliminated through diversification

➢ Systematic risk cannot be eliminated and is rewarded with a risk

premium

➢ Systematic risk is measured by the beta

➢ The equation for the SML is the CAPM, and it determines the
equilibrium required return for a given level of risk

47