PORTFOLIO RISK AND RETURN

RETURN ON FINANCIAL ASSETS

Total Return

Periodic Capital Gain

Income or Loss
 HOLDING PERIOD RETURN
A holding period return is the return from
holding an asset for a single specified period of
time.
Pt  Pt 1  Dt Pt  Pt 1 Dt
R  
Pt 1 Pt 1 Pt 1
 Capital gain  Dividend yield

105  100 2
R   5%  2%  7%
100 100
 ARITHMETIC OR MEAN RETURN

The arithmetic or mean return is the simple

average of all holding period returns.

Ri1  Ri 2    RiT 1  RiT 1 T

Ri    Rit
T T t 1

 50%  35%  27%

Ri   4%
3
 MEASURES OF CENTRAL TENDENCY
These measures also describe where the data are centered.

•Weighted Mean 

-The sum of the observations times each

observation’s weight (proportional
representation in the sample), where the
weight is chosen to meet a statistical or
financial goal. Example: Portfolio return

5
 MEASURES OF DISPERSION
Dispersion measures variability around a measure of central tendency.
If mean return represents reward, then dispersion represents risk.

• Range  Range = Maximum value – Minimum value

- The distance between the maximum value in the data and the minimum
value in the data.
- For the country return data, the range is [–2.97% – (–44.05%)] = 41.08%

σ𝑛 ത
𝑖=1 𝑋𝑖 −𝑋
• Mean Absolute Deviation (MAD) MAD =
𝑛
- The arithmetic average of the absolute value of deviations from the mean.
- For the country return data, the MAD is 7.04%.

6
 MEASURES OF DISPERSION
Dispersion measures variability around a measure of central tendency.
If mean return represents reward, then dispersion represents risk.

• Variance is the average squared deviation from the mean.

σ𝑛
𝑖=1 𝑋𝑖 −μ
2
- Population variance σ2 =
𝑛

σ𝑛 ത
𝑖=1 𝑋𝑖 −𝑋
2
- Sample variance  𝑠2 =
𝑛−1

• Sample variance is “penalized” by dividing by n – 1 instead of n to account for

ത is an estimate of the true
the fact that the measure of central tendency used, 𝑋,
population parameter, m, and so has some uncertainty associated with it.
• Standard deviation is the square root of variance.

7
VARIANCE OF A PORTFOLIO OF ASSETS
Variance can be determined for N securities in a portfolio
using the formulas below. Cov(Ri, Rj) is the covariance of
returns between security i and security j and can be
expressed as the product of the correlation between the
two returns (ρi,j) and the standard deviations of the two
assets, Cov(Ri, Rj) = ρi,j σiσj.
 N 
  Var RP   Var  wi Ri 
2
P
 i 1 

 w w CovR , R 
N
 i j i j
i , j 1

 w w CovR , R 
N N
  wi2Var Ri   i j i j
i 1 i , j 1, i  j
VARIANCE AND STANDARD DEVIATION OF A
SINGLE ASSET

Population Sample

 R  R 
T T

 R  m 
2 2
t t
2  t 1
s2  t 1
T T 1
  2 s  s2
 CHEBYSHEV’S INEQUALITY
This expression gives the minimum proportion of values, p, within k
standard deviations of the mean for any distribution whenever k > 1.

k Interval around the Mean p

1.25 0.36
1.50 0.56
2.00 0.75
2.50 0.84
3.00 0.89
4.00 0.94

10
 CHEBYSHEV’S INEQUALITY
Focus on: Calculating Proportions Using Chebyshev’s Inequality
• For our country data, the mean is –31.25% and the sample standard deviation
is 9.95%.
• Lower cutoff at 1.25 standard deviations:
–31.25% – 1.25 (9.95%) = – 43.6875%
• Upper cutoff at 1.25 standard deviations:
–31.25% + 1.25 (9.95%) = – 18.8125%
k Lower Cutoff Upper Cutoff Actual p Chebyshev’s p
1.25 –43.69% –18.81% 0.875 0.36
1.50 –46.18% –16.32% 0.938 0.56
2.00 –51.16% –11.34% 0.938 0.75
2.50 –56.13% –6.37% 0.938 0.84
3.00 –61.11% –1.39% 0.938 0.89
4.00 –71.07% 8.57% 1.000 0.94

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FORMULAS FOR PORTFOLIO RISK AND
RETURN
E  Rp  
N

w E R 
i 1
i i

N
 2p  
i 1, j 1
wi w j Cov(i, j )

w
i 1
i 1

Given: Cov(i, j )  ij i  j and Cov(i, i )  i2

N N
Then:  2p   i i
w 2

i 1
 2

i , j 1,i  j
wi w j ij i  j

p   2p
SYSTEMATIC AND NONSYSTEMATIC RISK
Can be eliminated by diversification

Nonsystematic
Risk

Total Risk

Systematic
Risk
CAPITAL ASSET PRICING MODEL (CAPM)
Beta is the primary
determinant of expected return

E  Ri   R f  i  E  Rm   R f 
E  Ri   3%  1.5 9%  3%   12.0%
E  Ri   3%  1.0 9%  3%   9.0%
E  Ri   3%  0.5 9%  3%   6.0%
E  Ri   3%  0.0 9%  3%   3.0%
 ASSUMPTIONS OF THE CAPM
Investors are risk-averse, utility-maximizing, rational
individuals.
Markets are frictionless, including no transaction costs or
taxes.

Investors plan for the same single holding period.

Investors have homogeneous expectations or beliefs.

All investments are infinitely divisible.

Investors are price takers.

EXHIBIT 6-7 THE SECURITY MARKET LINE
(SML)
E(Ri)

SML

The SML is a
Expected Return

graphical
M
E(Rm) βi = βm representation
of the CAPM.

Rf Slope = Rm – Rf

1.0

Beta
 PORTFOLIO BETA
Portfolio beta is the weighted sum of the betas of the
component securities:
N
 p   wii  (0.40  1.50)  (0.60  1.20)  1.32
i 1

The portfolio’s expected return given by the CAPM is:

E  R p   R f   p  E  Rm   R f 
E  R p   3%  1.32 9%  3%   10.92%
APPLICATIONS OF THE CAPM

Estimates of
Expected
Return

CAPM
Applications

Security Performance
Selection Appraisal
 EXHIBIT 6-12 SECURITY SELECTION
USING SML

Undervalued
Ri

C (𝑅 = 20%, β = 1.2)
Return on Investment

SML

Overvalued
15
%
A (𝑅 = 11%, β = 0.5)
B (𝑅 = 12%, β = 1.0)

Rf = 5%

𝛃𝒎 = 1.0

Beta
DECOMPOSITION OF TOTAL RISK FOR A
SINGLE-INDEX MODEL
R i  R f  i R m  R f   e i

Total variance = S ystematic variance + Nonsystematic variance

i2  i2 m2  ei2  2Cov R m , e i   i2 m2  ei2

Zero
EXHIBIT 6-13 DIVERSIFICATION WITH
NUMBER OF STOCKS

Non-Systematic Variance

Total
Variance

Variance
Variance of Market Portfolio

Systematic Variance

1 5 10 20 30
Number of Stocks