1. Risk, Return, and Security Market Line
Financial Management

2. Outline Risk of an investment Expected return of an investment
Portfolios:
Portfolio expected returns
Portfolio risk
Risk: Systematic and Unsystematic Risk
Diversification and Portfolio Risk
The security market line and Capital Asset Pricing Model

3. Defining Risk
Risk refers to the chance that some unfavorable event will happen
Investment risk is the probability that actual returns may deviate from expected returns
The chance that actual returns may be lower than expected return gives rise to investment risk
Higher the probability of actual returns being less than expected, higher will be investment risk

4. Returns Actual Return Expected Return
Realized return/historical return/return ex-post
Expected Return
Return ex-ante/anticipated return
A weighted average of all possible returns, where weights represent probability of each possible outcome
Multiply each possible outcome with its probability and add them up over all possible outcomes

5. Measuring Expected Return
E(r) = P1 r1 + P2r2 + … + Pnrn n
=  Pi ri
i=1
ri is the ith possible outcome and
Pi is the probability of ith outcome
Examples

6. Measuring Risk
Risk is measured by standard deviation of possible returns n
Variance (2) =  (ri – E(r))2 Pi
i=1
Standard Deviation () = (2)1/2
Examples

7. Coefficient of Variation
Standard deviation is an absolute measure of risk
We cannot rank investments only on the basis of standard deviation or on the basis of expected return
To rank investments, we need a measure of risk that is based on risk and return
Coefficient of variation is a relative measure of risk based on risk and expected return
Examples

8. Risk and return are always positively related
Higher return is associated with high risk

9. Portfolio Risk and Return
Meaning of Portfolio
A combined holding of more than one stock, bonds, real estate, or any other asset
Why create a portfolio?
To diversify/reduce/mitigate risk of a single security
All securities in the portfolio may not move together
If one goes down, others will go up and compensate for the loss of the first one

10. Portfolio Expected Return
A simple weighted average of the expected return of each security in the portfolio, where weights represent the proportion of investment in each portfolio
E(rp) = (w1× E(r1)) + (w2× E(r2)) + … +(wn× E(rn)) n
E(rp) =  wi E(ri)
i=1
Examples

11. Portfolio Risk
Risk of a portfolio is measured by standard deviation of the portfolio (p)
Standard deviation of a portfolio is not a simple weighted average of the standard deviations of each individual security in the portfolio
Theoretically, it is possible to combine two risky securities and create a zero risk portfolio without compromising returns.
Example

12. Portfolio Risk
Total risk as measured by standard deviation does not matter in a portfolio context
Total risk can be divided into two categories
Total Risk = Unsystematic Risk + Systematic Risk
Examples
In a well diversified portfolio, only systematic risk matters; unsystematic risk disappears and is zero.

13. Portfolios Risk and Beta
Systematic risk of a portfolio is measured by beta of a security
Meaning of beta
Tendency of a stock to move with the market
Sensitivity of an asset’s price to the changes in the market
Beta of a risk free security
Beta of a market portfolio
Beta of a market portfolioBeta of a market portfolio

14. Computing Portfolio Beta
A simple weighted average of the beta of each individual asset in the portfolio, where weights represent the proportion of investment in each asset in the portfolio
p = (w1× 1) + (w2× 2) + … +(wn× n) n
p =  wi i
i=1
Where wi represents proportion of total investment in security i and I represents beta of security i in the portfolio
Examples

15. Security Market Line and CAPM
Positive relationship between systematic risk and return of a portfolio
The line which gives the expected returns-systematic risk combinations of assets is called the security market line