MSO402: INTRODUCTION

TO FINANCIAL
MANAGEMENT

RISK AND RETURN

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Risk and Return

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Characteristics of Individual Securities

• The characteristics of individual securities that are of

interest are the:
– Returns
– Variance and Standard Deviation
– Covariance and Correlation

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Are the returns independent consideration?
• We should know the price of the security.
• How are these determined?? Market
•Are the markets efficient?
• But the expected returns (ER ) is a prediction based on future
prices.
• Predictions are to be made on historical data.
•How risky are the stocks and what have been their returns
historically.
•Statistical Properties of Stocks.

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Pattern of Stock Price Changes

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Pattern of Stock Price Changes

• Stock Prices follow random walk.

• The pattern shows that prices move in random manner with a trend (drift)
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 Different measures of Returns
• Holding Period Returns
Here n is your holding time

• Effective Annualized Returns

• Average Returns – Arithmetic Mean or Geometric Mean

……(1+ 1/n -1

• The GM is always less than the AM, except when all the return values
being considered are equal. The difference between GM & AM depends on
the variability of distribution – the greater the variability, the greater is the
difference
• • Relationship = (1 + GM)2 ≈ (1 + AM)2 – (SD)2
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 Different measures of Returns
• Expected Returns – Probability-Weighted average of the rates of returns.

•Here, is the returns of the stock over time, weight of time periods.
Usually it is assumed that the time period is given equal weights.
• Expected Returns from CAPM model:
•Risk –adjusted Returns: Returns per unit of risk.
/
• Sharpe Ratio:
/

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Different measures of Returns

• Simple Returns
•

• Log Returns
•

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 Different measures of Returns
Inputs
Asset T1 T2 T3
A 1000 1900 2500
B 700 500 800
C 800 600 700
Portfolio 2500 3000 4000

Normal Returns Log Returns

Asset Weight T2 T3 LN(2/0) Add Asset Weight T2 T3 LN(2/0) Add
A A
B B
C C
Portfolio Portfolio

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Different measures of Returns
Normal Returns
Asset Weight T2 T3 LN(2/0) Add
A 30% 90% 32% 150% 122%
B 20% -29% 60% 14% 31%
C 50% -25% 17% -13% -8%
Portfolio 100% 20% 33% 60%

Log Returns
Asset Weight T2 T3 LN(2/0) Add
A 30% 64% 27% 92% 92%
B 20% -34% 47% 13% 13%
C 50% -29% 15% -13% -13%
Portfolio 100% 18% 29% 47% 47%

• Log returns are time additive.

• The product of normally distributed returns is not normal.
• The sum of normally distributed variables follows a normal distribution.

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Risk
• Investment risk pertains to the probability of earning a return less
than that expected.
• The greater the chance of a return far below the expected return,
the greater the risk.

Variance:

Standard Deviation:

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Risk

Which Stock is riskier?

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Risk
Systematic Risk – undiversifiable
Examples: US-China trade war, Russia- Ukraine war, Arab Spring 2011,
Recession in US, Business Cycles.

Unsystematic/Idiosyncratic Risk – diversifiable (as we go on increasing

the no. of stocks)
Example: Business Risk (increasing operating leverage), Financial Risk
(increasing financial leverage), Regulatory Risk

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Statistical Properties of Stock Return

• Facts Observed for the Indian Stock Market:

• Return on more risky assets has been higher on average than return on
less risky assets
• The risky assets have wide dispersion of returns.
• Most of the stocks are negatively skewed and are leptokurtic – Fat Tails

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Statistical Properties of Stock Returns

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Statistical Properties of Stock Returns

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Statistical Properties of Stock Returns
Covariance:

Correlation:

Here, are two different stock returns.

Inference: How closely the two stocks move.

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Scatter Plots of Two Assets

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Portfolio Theory

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 Basic Elements of Investments
• The investment opportunity
•Portfolio of assets
•A Model for financial assets – Reward per unit of risk.
• The investor
•A Model for investors – Risk aversion & Utility.
• The optimal portfolio selection

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 Risk Aversion
• Investor does (or should) Risk Aversion
consider expected return a 70%
desirable thing and variance
of return an undesirable thing. 60% More Averse

• For every additional unit of 50%

risk, investors demand more

40%
and more returns.
• If 𝜎 is represented on x-axis 30%
Less
and is represented on y- 20% Averse
axis – risk aversion will be
concave shaped. 10%

• More risk averse investor 0%

(pessimist) – undervalues 0% 5% 10% 15% 20%

return and overvalue risk, and A=4 A=6

vice-versa.
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Utility

• Utility is welfare that an investor Portfolio

Expected
Return (%) Risk (%)
achieves for an investment L 7 5
decision. M 9 10
H 13 20
•
•
• is the utility value, (ranges
from 0 – 10) is the risk Utility Score Utility Score of Utility Score
aversion, A of Portfolio L Portfolio M of Portfolio H
2 0.0675 0.08 0.09
is the scaling factor. 5 0.0638 0.065 0.03

• Utility is different than expected

return and risk aversion.
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 What is a Portfolio?
•A portfolio is simply a specific combination of securities, usually defined by
portfolio weights that sum to 1.

•Portfolio weights:
Price/Shar Portfolio
• Sum to 0 – Risk free portfolios Assets Shares e Investment Weight
• Positive – Long position TCS 50 ₹ 3,900 ₹ 1,95,000 38%

• Negative – Short position Adani Green 100 ₹ 1,550 ₹ 1,55,000 30%

Gold ETF 2000 ₹ 54 ₹ 1,08,000 21%
Sovereign
Bond 1000 ₹ 60 ₹ 60,000 12%
Total ₹ 5,18,000 100%

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Portfolio – Example!
•Your broker informs you that you only need to keep ₹4,00,000 in your
investment account to support the portfolio of 50 shares of TCS, 100
shares of Adani Green, and 2,000 shares of Gold ETF; in other words, you
can buy these stocks on margin. You withdraw rest ₹50,000 to use for
other purposes. Your portfolio is summarized by the following weights:

Portfolio
Assets Shares Price/Share Investment Weight
TCS 50 ₹ 3,900 ₹ 1,95,000 48.75%
Adani Green 100 ₹ 1,550 ₹ 1,55,000 38.75%
Gold ETF 2,000 ₹ 50 ₹ 1,00,000 25%
Sovereign Bond 1,000 ₹ 50 -₹ 50,000 -12.5%
Total ₹ 4,00,000 100%

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Portfolio – Example!

•You planned to purchase a car that costs ₹10,00,000 by paying 20% of

the purchase price and getting a loan for the remaining 80%. What are
your portfolio weights for this investment?

Portfolio
Assets Share Price Investment Weight
₹
Car 1 10,00,000 ₹ 10,00,000 500%
Loan 1 ₹ 8,00,000 -₹ 8,00,000 -400%
Total ₹ 2,00,000 100%

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Portfolio – Example!

•Suppose you have Rs 10,000 to invest. One risky asset A offers you an
expected return of 4.5% p.a., and risk of 14.5% p.a. You would like to
earn an expected return that is higher than 4.5%. How is it possible, given
there exist a risk-free asset offering a return of 3% p.a.?

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Why is Portfolio needed?
•Don’t put all your eggs in one basket!

•Portfolio provides diversification for reducing the risks.

• Systematic Risk – undiversifiable

Examples: US-China trade war, Russia- Ukraine war, Arab Spring 2011,
Recession in US, Business Cycles.

• Unsystematic/Idiosyncratic Risk – diversifiable (as we go on increasing the

no. of stocks)
Example: Business Risk (increasing operating leverage), Financial Risk
(increasing financial leverage), Regulatory Risk

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Why is Portfolio needed?

•How do we construct a good portfolio? Risk and Reward

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Risk and Reward Assumptions

•Investors like high expected returns but dislike high volatility

• Investors care only about the expected return and volatility of their overall
portfolio.
• Portfolio risk depends not only on the individual risk but also on the
interactive risk.

•How much does a stock contribute to the risk and return of a portfolio, and
how can we choose portfolio weights to optimize the risk/reward
characteristics of the overall portfolio?

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 Mean – Variance Analysis
•Objective:
•Assume investors focus only on the expected return and variance (or standard deviation)
of their portfolios: higher expected return is good, higher variance is bad.

Risk & Return

35%
North- 30%
30% west
25% G
25% E
20% 20%
Retruns

20%
15% D F
15% 12% 12% C
A B
10%

5%

0%
0% 2% 4% 6% 8% 10% 12% 14% 16%
Risk (σ)

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 Mean – Variance Analysis

•Basic Properties of Portfolio Mean and Risk:

•𝑅 = 𝑤 𝑅 + 𝑤 𝑅 + ⋯ … … . +𝑤 𝑅

•𝐸(𝑅 ) = 𝑤 𝐸(𝑅 ) + 𝑤 𝐸 𝑅 + ⋯ … … . +𝑤 𝐸 𝑅 , here 𝐸(𝑅 ) is 𝜇

•Variance:

•𝑉𝑎𝑟(𝑅 ) = 𝐸(𝑅 − 𝜇 )

= 𝐸[(𝑤 𝑅 − 𝜇 +𝑤 𝑅 − 𝜇 + ⋯ … … . . +𝑤 𝑅 − 𝜇 ) ]

•For two assets 𝑖 & 𝑗:

𝐸[𝑤 𝑤 (𝑅 − 𝜇 ) (𝑅 − 𝜇 )] = 𝑤 𝑤 𝐶𝑜𝑣
=𝑤 𝑤 𝜎 𝜎 𝜌

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 Mean – Variance Analysis
•Portfolio variance is the weighted sum of all the variances and covariances
(Variance-Covariance Matrix):
𝑤 𝑅 − 𝜇 𝑤 𝑅 − 𝜇 …… 𝑤 𝑅 − 𝜇
𝑤 𝑅 − 𝜇 𝑤 𝜎 𝑤 𝑤 𝜎 𝑤 𝑤 𝜎
𝑤 𝑅 − 𝜇 𝑤 𝑤 𝜎 𝑤 𝜎 𝑤 𝑤 𝜎
………. ………. ………. ……….
………. ………. ………. ……….

𝑤 𝑅 − 𝜇 𝑤 𝑤 𝜎 𝑤 𝑤 𝜎 𝑤 𝜎

• There are n variances and n2 − n covariances

• Covariances dominate portfolio variance
•Positive covariances increase portfolio variance; negative covariances decrease portfolio
variance (diversification)

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 Mean – Variance Analysis
•For two asset cases:
Factors Affecting Portfolio Risk
•  Respective Weights
 Individual security risk
•  Coefficient of correlation or Interactive
Risk
•Variance:

[ ]
=

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 Mean – Variance Analysis
•Investors want to minimize the portfolio risk.

•Objective function: Minimize w.r.t

• Put

• =

• No other portfolio can have a lower risk.

•Can the portfolio risk be reduced to zero?

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 Mean – Variance Example

•From January 2023 – June 2023, BPCL had an average monthly return of
0.081% and a std dev of 1.427%. Bajaj Auto had an average return of
0.291% and a std dev of 1.338%. Their correlation is -0.06. How would a
portfolio of the two stocks perform?

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 Mean – Variance Example
•Mean/SD Trade-Off for Portfolios of BPCL and Bajaj Auto

0.35%

0.30%

0.25%
Expected Returns

0.20%

0.15%

0.10%

0.05%

0.00%
0.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20% 1.40% 1.60%

Risk (σ)

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 Mean – Variance Example
•Suppose the correlation between BPCL and Bajaj Auto. What if it equals –1.0? -0.7? 0.0?
1.0?
Portfolio Opportunity Set
0.35%

0.30%

0.25%

0.20% Corr -0.06 Return

Corr +1 Return
0.15% Corr -1 Return
Corr -0.7 Return
0.10%

0.05%

0.00%
0.00% 0.50% 1.00% 1.50%

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 Mean – Variance Example
Construct a minimum variance portfolio of securities X and Y from the
following information:
Security X Y
Expected Return 15 9
S.D. 5.3 2
CovXY -10

Calculate the portfolio return as well as risk. (Answer: Weight X = 27%; Y

= 73%)

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