1) The document provides an overview of risk and return analysis concepts including calculating investment returns, measuring risk through variance and standard deviation, and the relationship between risk and return.
2) It discusses how portfolio risk can be lower than the average risk of individual holdings due to diversification and how the minimum variance frontier models efficient portfolios with optimal risk-return tradeoffs.
3) Key concepts like beta, correlation, adjusted betas, and the benefits of additional assets are covered to explain modern portfolio theory and efficient diversification.
1) The document provides an overview of risk and return analysis concepts including calculating investment returns, measuring risk through variance and standard deviation, and the relationship between risk and return.
2) It discusses how portfolio risk can be lower than the average risk of individual holdings due to diversification and how the minimum variance frontier models efficient portfolios with optimal risk-return tradeoffs.
3) Key concepts like beta, correlation, adjusted betas, and the benefits of additional assets are covered to explain modern portfolio theory and efficient diversification.
1) The document provides an overview of risk and return analysis concepts including calculating investment returns, measuring risk through variance and standard deviation, and the relationship between risk and return.
2) It discusses how portfolio risk can be lower than the average risk of individual holdings due to diversification and how the minimum variance frontier models efficient portfolios with optimal risk-return tradeoffs.
3) Key concepts like beta, correlation, adjusted betas, and the benefits of additional assets are covered to explain modern portfolio theory and efficient diversification.
1) The document provides an overview of risk and return analysis concepts including calculating investment returns, measuring risk through variance and standard deviation, and the relationship between risk and return.
2) It discusses how portfolio risk can be lower than the average risk of individual holdings due to diversification and how the minimum variance frontier models efficient portfolios with optimal risk-return tradeoffs.
3) Key concepts like beta, correlation, adjusted betas, and the benefits of additional assets are covered to explain modern portfolio theory and efficient diversification.
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FINANCIAL MANAGEMENT
(FIN401) Lecture 1: Risk & Return Analysis By: Sana Tauseef, CFA, MBA Lecturer, Department of Economics and Finance Institute of Business Administration, Karachi Email: sasghar@iba.edu.pk
Investment return is what you get
over and above your invested capital
(Amount received Amount invested)
Return
= ____________________ Amount invested
For example, if $1,000 is invested and
$1,100 is returned after one year, the rate of return for this investment is: ($1,100 - $1,000) / $1,000 = 10%
Risk and Return Analysis
The rate of return on an investment can be
calculated as follows:
Risk is related to the probability of
having a return different from the expected return. It is measured through calculating the variance or standard deviation of the distribution of returns.
Risk and Return Analysis
Typically, investment returns are not
known with certainty
Risk and Return Analysis
Risk & Return may be
computed using historical (realized) data or prospective (anticipated) data
*Dividends are not included in the calculation of returns.
Risk and Return Analysis
Historical returns give an idea of how an
investment (stock) performed in the past
Probability
Forecasted Return Nestle Pakistan
Good
20%
70%
Average
60%
35%
Poor
20%
-5.6%
State of Economy
Expected Return
33.88%
Expected Risk
42.26%
Risk and Return Analysis
Historical returns are adjusted
based on future forecasts
Risk and Return Analysis
In an efficient market, risk and
return factors are always positively related
Std dev CV Mean
Risk and Return Analysis
Co-efficient of variation is a standardized measure of dispersion about the expected value, that shows the risk per unit of return...
Unsystematic risk is the firm-specific
risk and can be eliminated through diversification. Systematic risk is the market risk and can not be diversified away.
Risk and Return Analysis
Combining stocks in a portfolio
generally lowers risk
Risk and Return Analysis
Modern portfolio theory (meanvariance approach) was introduced
by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance. 38 years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection.
10
Rational investors choose to hold
securities as part of a diversified portfolio... average
Portfolio Risk is lesser than the
weighted average risk of component stocks
Risk and Return Analysis
Portfolio return is the weighted
return of component stocks
11
If the stocks are perfectly positively correlated,
there is no risk diversification. If the stocks are perfectly negatively correlated, there is maximum risk diversification. If the correlation is between -1 and +1, there is some risk diversification. Lower the correlation value, higher is the risk diversification.
Risk and Return Analysis
The variance/standard deviation of a
portfolio also reflects how the returns on the stocks which comprise the portfolio vary together
12
Correlation is positive but less than
+1 for most pairs of stocks between Nestle and BAHL between Nestle and
0.4816 0.2295
between Siemens and
between Nestle and Shell between Siemens and between BAHL and Shell
0.6160 0.3161 0.5711 0.5947
Correlations are calculated based on annual historical returns
(ignoring dividends) over a 14-year period (1999-2013)
the portfolio 2. Identify the efficient combinations of the selected securities 3. Pick up one combination that best suits the risk-aversion of the investor
Risk and Return Analysis
There are three steps in efficient
portfolio formation
14
Portfolio possibilities curve plots the
expected return and risk of the portfolios that can be formed using two assets. Efficient frontier shows the efficient portfolios-the combinations which offer higher returns for a given level of risk.
Risk and Return Analysis
An investors objective in using the
mean-variance approach to portfolio selection is to choose an efficient portfolio
15
Nestle BAHL
Expected Return
40.41
8.89
36.3
34.55
Standard Deviation
Assuming the correlation of +1, -1 and 0.48, we
will plot the portfolio possibilities curve and identify the efficient frontier.
8.89 34.5 Portfolio Risk 5 34.5 WAR 5 Div Benefit 0.00
15.29 21.70 24.51 24.90 28.10 34.51 40.91
20.38 6.21
0.02
0.87
7.96 22.13 36.30
34.90 35.25 35.40 35.42 35.60 35.95 36.30
14.52 29.04 35.38 34.55 27.64 13.82 0.00
Global minimum-variance combination: Weight(N)= 0.488
Risk and Return Analysis
For the pairs with perfect negative
correlation, there is maximum risk diversification and a combination of two assets exists that provides a portfolio with zero risk
19
When the correlation is -1, the minimum-variance
frontier has two linear segments. The two segments join at the global minimum-variance portfolio which has zero risk 45.00
35.00 30.00
Portfolio Return
25.00 20.00 15.00 10.00 5.00 0.00 0.00
5.00 10.00 15.00 20.00 25.00 30.00 35.00 40.00
Risk and Return Analysis
40.00
Portfolio Risk 20
Weight (Nestle) Weight (BAHL) Portfolio Return
0.2
0.4
0.5
0.45
0.6
0.8
0.8
0.6
0.5
0.55
0.4
0.2
8.89
15.29 21.70 24.90 23.30 28.10 34.51 40.91
Portfolio Risk 34.55 31.78 30.50 30.49 30.44 30.90 32.93 36.30 WAR Div Benefit
Risk and Return Analysis
For the pairs with correlation between -1 and +1, there is
some risk diversification and as we lower the correlation, holding other values constant, there are increasingly larger potential benefits of diversification
34.55 34.90 35.25 35.42 35.33 35.60 35.95 36.30
0.00
3.12
4.75
4.93
4.89
4.69
3.02
Global minimum-variance combination: Weight(N)= 0.45
0.00
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Between the extreme correlation values of -1
and +1, the minimum-variance frontier has a bullet-like shape and the frontier bows out further to the left as we lower the correlation 45.00 40.00
additional choices. A new asset permits us to move to a superior minimum-variance frontier.
Risk and Return Analysis
Would adding third asset improve the
available trade-offs between risk and return???
23
p decreases as stocks added, because
they would not be perfectly correlated with the existing portfolio. Eventually the diversification benefits of adding more stocks dissipates (after about 30 stocks), and for large stock portfolios, p consists of the market risk only.
Risk and Return Analysis
How many different stocks must we hold
in order to have a well-diversified portfolio???
24
Diversification effect increases as the
number of stocks in a portfolio increases Company-Specific Risk
Risk and Return Analysis
p (%) 35
20 Market Risk
10 20 30 40
2,000+
# Stocks in Portfolio
25
If beta = 0, the asset is risk-free.
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.
Risk and Return Analysis
Market risk is measured through Beta
Beta is the variation in the stock return relative to the return of the market portfolio
26
Betas on average are mean-reverting.
The mean-reverting level of beta is 1. If the historical beta is above 1, the adjusted beta will be below historical beta and if the historical beta is below 1, the adjusted beta will be above the historical beta.
Adjusted beta: 2/3*Historical beta+1/3*1
Risk and Return Analysis
Adjusted beta is a better forecast of
future beta than is historical beta
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Beta Calculated Over:
Mean
Standard Deviation
Minimum
Maximum
1 year
0.646
1.832
-40.029
44.646
2 years
0.626
1.166
-27.969
15.143
3 years
0.603
1.018
-20.148
9.167
4 years
0.577
0.938
-18.698
6.011
5 years
0.575
0.857
-17.798
4.297
6 years
0.572
0.803
-15.800
3.955
7 years
0.574
0.749
-13.957
3.143
8 years
0.580
0.700
-12.594
2.558
9 years
0.589
0.631
-11.394
2.456
10 years
0.593
0.579
-7.148
2.462
11 years
0.582
0.592
-6.911
2.454
12 years
0.572
0.618
-6.578
2.172
13 years
0.563
0.659
-6.471
1.791
14 years
0.561
0.637
-6.163
1.777
Average beta calculated using the total return price data on 325 stocks listed on the Karachi Stock Exchange (KSE), for the period January 1999 to December 2012. Tauseef, S. (2013). Beta Stationarity and Estimation Period: Evidence from Pakistans Equity Market.
Risk and Return Analysis
Beta instability decreases as the estimation period increases
suggesting that the historical beta coefficients calculated using longer estimation period are better in predicting the future beta coefficients...
28
CAPM makes the following
assumptions
Risk and Return Analysis
Investors need only know about expected
returns, variances and correlations to determine which asset/portfolio is optimal for them. Investors have identical views about risky assets returns, variances and correlations. All assets are marketable and can be traded in any size. Investors can borrow or lend at the risk-free rate without any limit. There are no taxes, transaction costs and 29 spreads.
CAPM concludes that:
The relevant risk of an individual stock is its contribution to the risk of a well-diversified portfolio. The return for a security/portfolio depends on: I. Risk-free rate II. Risk Premium available in the market III. Security/portfolio risk
Risk and Return Analysis
CAPM specifiesa linear relationship
between risk and required return...
30
The relationship between beta and average
returns disappear when some important fundamentals of the firm are added. The average returns are negatively related to size and positively related to book-to-market ratio.
Fama E.F. and K.R. French (1992). The Cross-Section of
Expected Stock Returns, The Journal of Finance, 47, 2, 427-465.
Risk and Return Analysis
Though CAPM is used widely model in
applications; however, the model has failed badly in the empirical tests
