TOPIC 3

PORTFOLIO RISK AND

RETURN
Refer to:
Reilly, Brown & Leeds
Chapter 6

1
 At the end of this topic, students should be able to
answer the following questions:
• What do you mean by risk aversion?
• What are the basic assumptions behind the Markowitz
Portfolio Theory?
• How do we compute the expected return for a portfolio of
assets?
• What are the covariance and correlation statistics and what is
the relationship between them?
• What is the formula for the standard deviation of a portfolio of
risky assets, and how does it differ from the standard deviation
of an individual risky assets?
• Given the formula for the standard deviation of a portfolio,
how do we diversify a portfolio?
2
 Some Background Assumptions

• As an investor you want to maximize the

returns for a given level of risk.
• Your portfolio includes all of your assets and
liabilities.
• The relationship between the returns for assets
in the portfolio is important.
• A good portfolio is not simply a collection of
individually good investments.
3
• Risk Aversion
– Given a choice between two assets with equal
rates of return, risk-averse investors will select the
asset with the lower level of risk
– Evidence
• Many investors purchase insurance for: Life,
Automobile, Health, and Disability Income.
• Yield on bonds increases with risk classifications
from AAA to AA to A, etc.
– Not all Investors are risk averse
• It may depends on the amount of money
involved: Risking small amounts, but insuring
large losses
4
 Expected Rates of Return
• For An Individual Asset
– It is equal to the sum of the potential returns
multiplied with the corresponding probability of the
returns
• For A Portfolio of Investments
– It is equal to the weighted average of the expected
rates of return for the individual investments in the
portfolio

5
Markowitz Portfolio Model
Measurement of Portfolio Return

6
 Measurement of Risk
• For An Individual Asset
– Variance (σ²), Standard Deviation (σ) and
Coefficient of Variation (CV) of the individual
asset (refer to Topic 2)

• For A Portfolio of Investments

– The Covariance (COVij) and Correlation of
coefficient (ii) of each pair of the individual asset
– Beta Coefficient, βᵢ
7
 Covariance of Returns, COVij
• Covariance is a weighted average of the
expected return, Ṝi or E(Ri) of two individual
securities to show their movement
• An absolute measure of the degree to which
two variables “move together” relative to
their individual mean values over time.
• Move together means they are generally
above their means or below their means at
the same time.
8
• For two assets, i and j, the covariance of rates of
return is defined as:

COVij =  (Ri - Ṝi)(Rj - Ṝj)

n
or
COVij =  P [(Ri – E(Ri)] [(Rj –E(Rj)]

COVij = σiσj ij

Where ij is the correlation coefficient of i and j

9
• Positive covariance: rates of return for two
investments tend to move in the same
direction relative to their individual means
during the same period.

e.g If return for Stock A is high whenever stock

B's return is high, the same can be said for low
returns.

10
• Negative covariance: rates of return for two
investments tend to move in different
directions relative to mean during specific
time intervals.

• If an investor wants a portfolio whose assets

have diversified earnings, he or she should
pick financial assets that have low covariance
to each other.

11
 Correlation of Coefficient (ij)
• Measures the degree of relative correlation, ρ
between each security to every other securities in
the Portfolio
• It shows the strength of relationship between two
variables.
=ij Covij
σiσj
• Takes on value from -1 to +1.
• the only variable in the SD of portfolio formula that
can be – ve , thus reduce the overall portfolio risk
12
 ij = +1 perfect positive linear relationship

 ij = 0 no correlation / uncorrelated

 ij = -1 perfect negative linear relationship

 Beta Coefficient, βi
• Beta is the covariance measure that describes how
the expected return of one asset or portfolio is
correlated to the return of the market as a whole.

• It measures the part of the asset’s variance that

cannot be mitigated by diversification provided by
the portfolio of many risky assets, because it is
correlated with the return of other assets in the
portfolio.

• Beta represents the systematic risk of each asset or

investment

14
 Beta Coefficient, βi
βᵢ = Covᵢ,m / σ²m

βi = 0 : asset’s return not at all correlated with

the market

Positive β : asset’s return generally follows

the market

Negative β : asset’s return generally decreases in

value against the market return 15
 Understanding Risk and Returns of a
Portfolio

• The risk a portfolio depends on the

(i) Standard deviation (σ) of each security, and

• To assess the risk of a portfolio, it requires the

analysis of the covariance (COVi,j) and correlation
(i,j) that exists between each pair of the securities.

16
• According to Markowitz,
Number of COVi,j or  ij = (N2 – N)
2
where N is the number of securities in a portfolio
Example:
Calculate the number of COV or  in a 4-security
portfolio?
Number of Cov or  = (42 – 4) = 6
2
Thus, stock A B C D
COV AB AC AD BC BD CD
17
 Portfolio Risk
1.Variance of a Portfolio

σ²port =

ij

18
2. Standard Deviation of a Portfolio

19
To determine the right weight for Minimum-
Variance (Risk) Portfolio

Wi = σ2j - i,j σi σj = σ2j - Cov i,j

σ2i + σ2j - 2 i,j σi σj σ2i + σ2j - 2 Covi,j

Wj = 1 – Wi

where W = weight of fund invested in the asset i or

Asset j

However, this is only for two assets portfolio !!

18
 Developing an Efficient
Portfolio
• Managing risk through diversification
• Diversification : combining 2 or more
securities in a portfolio that would result in
lowest risk (SD) possible.
• To reduce overall risk, it is best to combine or
add to the portfolio, assets that have negative
or low positive correlation

21
 Developing an Efficient
Portfolio
• Combining negatively correlated assets can
reduce the overall variability of return (risk)
• The lower the correlation between assets
returns, the greater the potential
diversification of risk, thus minimize the risk
• Combining 2 or more securities is not to
increase return of these securities but to
reduce or eliminate the risk.
22
23
 EXAMPLE 1
(3 Assets Portfolio)

24
Below are the data that you have gathered
relating to three assets.
Period Annual rates of return (%)
Asset A Asset B Asset C
1 18 15 18
2 16 15 16
3 17 9 14
4 12 7 16
5 10 8 14

25
i) Average return of each stock
Ṝi = ∑Ri
n

ṜA = 18 + 16 + 17 + 12 + 10 = 14.6%
5

ṜB = 15 + 15 + 9 + 7 + 8 = 10.8%
5

ṜC = 18 + 16 + 14 + 16 + 14 = 15.6%

5
26
Period Annual rates of return (%)
Asset A Asset B Asset C
1 18 15 18
2 16 15 16
3 17 9 14
4 12 7 16
5 10 8 14
Ṝi 14.6 10.8 15.6

27
ii) Variance, σ2 and SD, σ for each asset
σ2 =  (Rᵢ-Ṝᵢ)² σ =  (Rᵢ-Ṝᵢ)²
n n

A [(18-14.6)² + (16-14.6)² + (17-14.6)² + (12-14.6)² + (10-14.6)²]

5
σ2 = 9.44 σ = √9.44 = 3.07

B [(15-10.8)² + (15-10.8)² + (9-10.8)² + (7-10.8)² + (8-10.8)²]

5
σ2 = 12.16 σ = √12.16 = 3.49

C [(18-15.6)² + (16-15.6)² + (14-15.6)² + (16-15.6)² + (14-15.6²]

5
σ2 = 2.24 σ = √2.24 = 1.50

28
iii) Covariance of returns = (Ri - Ṝi)(Rj-Ṝj)
n
How many COV in 3-asset portfolio?
= (N2 – N) = (3² - 3) / 2 = 3 COVs
2
that is, COVAB , COVAC , and COVBC

COVAB
= [(18-14.6)(15-10.8) + (16-14.6)(15-10.8) +
(17-14.6)(9-10.8) + (12-14.6)(7-10.8) +
(10-14.6)(8-10.8)] ÷ 5
= 14.28+5.88-4.32+9.88+12.88
= 38.60 ÷ 5
= 7.72 29
iii) Covariance of returns = (Ri - Ṝi)(Rj-Ṝj)
n

CovAC
= [(18-14.6)(18-15.6) + (16-14.6)(16-15.6) +
(17-14.6)(14-15.6) + (12-14.6)(16-15.6) +
(10-14.6)(14-15.6)] ÷ 5
= 2.24

CovBC
= [(15-10.8)(18-15.6) + (15-10.8)(16-15.6) +
(9-10.8)(14-15.6) + (7-10.8)(16-15.6) +
(8-10.8)(14-15.6)] ÷ 5
= 3.52
30
iv) Correlation of coefficient  ij = COVij
σiσj

 = 7.72 / (3.07 X 3.49) = 0.72

AB

 = 2.24 / (3.07 X 1.50) = 0.49

AC

 = 3.52 / (3.49 X 1.50) = 0.67

BC

Excel illustration_Risk and Return (Topic 3).xlsx

31
Pair-Wise Correlation Coefficient, ij

Asset A B C
A 1 0.72 0.49
B 0.72 1 0.67
C 0.49 0.67 1

32
v) If all assets were to be included in the Portfolio with
funds to be distributed at 30% in A, 30% in B and 40%
in C, determine the Portfolio Return and Risk
E(R port ) = WR

Asset A Asset B Asset C

Ṝi 14.6 10.8 15.6
Wi 0.30 0.30 0.40

Portfolio Return
E(Rp) = 0.3 (14.6) + 0.3 (10.8) + 0.4 (15.6)
= 4.38 + 3.24 + 6.24
= 13.86%
33
Portfolio Risk
Variance, σ²port = w 𝜎 + w w Covij

w 𝜎 = 0.30² (9.44) + 0.30² (12.16) + 0.40² (2.24)

= 0.8496 + 1.0944 + 0.3584
= 2.3024
n n

  w w Cov = 2[(0.30)(0.30)(7.72)] + 2[(0.30)(0.40)(2.24)]

i 1 i 1
i j ij

+ 2[(0.30)(0.40) (3.52)]
= 1.3896 + 0.5376 + 0.8448 = 2.7720

σ²port = 2.3024 + 2.7720 = 5.0744

SD, σport = √5.0744 = 2.2526
 EXAMPLE 2
(2 Assets Portfolio)
You are given the following information on joint
probability distributions of returns for two stock

Outcome Probability Stock A Stock B

1 0.25 -10% 15%
2 0.15 0 4
3 0.25 10 -10
4 0.35 25 7

Calculate the portfolio’s expected return and

risk.

36
i) Average return of each stock

E(Rᵢ) = ∑ PᵢRi

E(RA) = 0.25 (-10) + 0.15(0) + 0.25(10) + 0.35(25)

= -2.5 + 0 + 2.5 + 8.75
= 8.75 %

E(RB) = 0.25(15) + 0.15(4) + 0.25(-10) + 0.35(7)

= 3.75 + 0.60 – 2.5 + 2.45
= 4.3 %

37
 ii) Variance, σ2 and SD, σ for both stocks

σ2 =  Pᵢ[Rᵢ-E(Rᵢ)]² σ =  Pᵢ[Rᵢ-E(Rᵢ)]²
Stock A, σ2
= [0.25(-10-8.75)² + 0.15(0-8.75)² + 0.25(10-8.75)² + 0.35(25-8.75)²
= 87.8906 + 11.4844 + 0.3906 + 92.4219
= 192.1875
σ = √192.1875 = 13.8632

Stock B, σ2
= [0.25(15-4.3)² + 0.15(4-4.3)² + 0.25(-10-4.3)² + 0.35(7-4.3)²
= 28.6225 + 0.0135 + 51.1225 + 2.5515
= 82.3100
σ = √82.3100 = 9.0725
38
iii) Covariance of Return
COVij = ∑Pi [(Ri – E(Ri)] [(Rj –E(Rj)]

Stock A Stock B
Pi Ri – E(Ri) Ri-E(Rj) Pi [(Ri – E(Ri)] [(Rj –E(Rj)]
0.25 -18.75 10.70 -50.1563
0.15 -8.75 -0.30 0.3938
0.25 1.25 -14.30 -4.4688
0.35 16.25 2.70 15.3563
COVij = ∑Pi [(Ri – E(Ri)] [(Rj –E(Rj)] = -38.8750

39
iv) Correlation Coefficient, ij = COVij ÷ σiσj

ij = COVij = -38.8750/ (13.8632x 9.0725)

σiσj
= -38.8750 / 125.7737 = -0.3091

the ij is considered low and negatively correlated

-1 ------------- 0 ------------ +1
-0.3091

40
 Weight for Minimum-Variance (Risk) Portfolio
wA = σ2B - CovAB σ 2  σ σ
= B - AB A B
σ2A+ σ2B - 2 CovAB σ2A + σ2B - 2 AB σA σB

= 82.3100 - (-0.3091 x 13.8632 x 9.0725) =

192.1875 + 82.3100 – 2(-0.3091 x 13.8632 x 9.0725)

= 82.3100 - (-38.8750 ) = 121.185

192.1875 + 82.3100 - 2(-38.8750) 352.2475
wA = 0.344 (Stock A)
wB = 1 – wA
= 1 – 0.344 = 0.656 (Stock B)
v) Portfolio Return

Stock A Stock B
E (Ri) 8.75 4.3
Wi 0.344 0.656

E(Rp) = 0.344 (8.75) + 0.656 (4.3)

= 3.01 + 2.82
= 5.83%

42
vi) Portfolio Risk
Portfolio Variance, σ²p and Portfolio SD, σp
σ²p = w 𝜎 + w w Covij

w 𝜎 = 0.344² (192.1875 ) + 0.656² (82.3100)

= 22.7427 + 35.4210
+ = 58.1637
n n

  w w Cov = 2(0.344)(0.656)(-38.8750)
i 1 i 1
i j ij

= -17.5454

σ² p = 58.1637 – 17.5454 = 40.6183

SD, σp = √40.6183 = 6.3732
43
 Sharpe Market Index Model

• Purpose is to reduce the number of

correlation coefficients required in N assets,
by identifying a single risk factor that
influence returns, measured by the broad
market index.

44
• Expected return on a single asset
E(Ri) = i + i Rm

where  = alpha, i.e, the difference between

asset’s actual and expected returns
(benchmarked index, CAPM)

• The Variance of return on any single asset is:

Total risk
= Systematic risk(2i σ2m) + Unsystematic risk (σ2ie)

Variance = σi2 =  2i σ2m + σ2ie

45
• Covariance of returns between security i & j:

COVij = i j σ2m

• Correlation coefficient of returns between security

i&j

ij = COVij
i j σ2m

46
Sharpe Index model:
Expected return and Variance on a Portfolio

• Return on the portfolio: E(Rp) = p+ p (Rm)

where p=  wi i
 p =  wi  i

• Risk of the portfolio: σ²p = ²p σ2m + σ2iep

where σ2iep =  w2i σ2ie

47
 EXAMPLE 3
A B C D
 0.5 1 1.5 2
i 1.1 1.5 0.8 0.6
σ2ie 8 12 10 6
• Assume that return on market is E(Rm) is 3 and standard
deviation on market (σm) is 4.
• Calculate:
i). The expected return for each security.
ii). The variance of each security’s return.
iii). The covariance of returns between each security.
• Assuming an equally weighted portfolio,
iv). The expected return on the portfolio.
v). The variance of portfolio’s return. 48
i) The expected return for each security.
E(Ri) = i + i E(Rm)

E(RA) = 0.5 + 1.1 (3) = 3.8

E(RB) = 1.0 + 1.5 (3) = 5.5
E(RC) = 1.5 + 0.8 (3) = 3.9
E(RD) = 2.0 + 0.6 (3) = 3.8

49
ii) The variance of each security’s return.
σi2 = 2i σ2m + σ2ie

variance for

A = 1.1 2 4 2 +8 = 27.36
B = 1.5 2 4 2 + 12 = 48.00
C = 0.8 2 4 2 + 10 = 20.24
D = 0.6 2 4 2 +6 = 11.76

50
iii) The covariance of returns between each security.

Covij = i j σ2m
CovAB = 1.1 x 1.5 x 16 = 26.4
CovAC = 1.1 x 0.8 x 16 = 14.08
CovAD = 1.1 x 0.6 x 16 = 10.56
CovBC = 1.5 x 0.8 x 16 = 19.20
CovBD = 1.5 x 0.6 x 16 = 14.4
CovCD = 0.8 x 0.6 x 16 = 7.68

51
 Covariance-Variance Matrix
E(Ri) A B C D

A 3.8 27.36 26.4 14.08 10.56

B 5.5 26.4 48 19.20 14.4

C 3.9 14.08 19.20 20.24 7.68

D 3.8 10.56 14.4 7.68 11.76

Covij = σi2
52
Assuming an equally weighted portfolio, calculate

iv). The expected return on the portfolio.

R p =  p+  p R m
where  p=  w i  i
p =  w i i
Rp = [(0.25x0.5)+(0.25x1)+(0.25x1.5)+ (0.25x2)]
+
[(0.25x1.1)+(0.25x1.5)+(0.25x0.8)+(0.25x0.6)]3

= [0.125+0.25+0.375+0.5] + [0.275+0.375+0.20+0.15]3
= 1.25 + (1)3 = 4.25
53
v) The variance of portfolio’s return.
σ2p = p2σ2m + σ2iep
where σ2iep =  w2i σ2ie

σ2iep = (0.252x8) + (0.252x12) + (0.252x10) + (0.252x6)

= 0.50 + 0.75 + 0.625 + 0.375 = 2.25

²pσ2m = (1)2 (4)2 = 16

Therefore, σ2p = 16 + 2.25 = 18.25

54