An Introduction to Risk and Return

Professor Banikanta Mishra, WHU-Koblenz, Fall 2000

We learnt in stock-valuation that ks = RF + Risk Premium

Risk Premium should be equal to Amount of Risk x Risk-Premium per Unit

Risk

But, how do we measure risk?

To measure risk, we must understand how investors gauge risk. And, to

understand this, we must understand how investors make their portfolio
choices.

Let us specifically analyze how investors choose between two assets.

First of all, we learnt that we should compare returns of the assets, not
their cash-flows.
Second, we realized that, if return on one asset stochastically dominates
that on the other, the choice is simple: choose the dominant asset.
But, what if the assets do not dominate each other, as usually is the case?
In that case, we must fall back on what we learnt in economics: an
investor would choose that asset which gives her the maximum utility.
Utility, as we know, is a function of return and risk. So, we must come up
with ways to measure return and risk.

Most would easily agree that return is measured by the Arithmetic-Mean or

the Expected Rate of Return. Thus, return for both asset-1 and asset-2
(details in the Appendix at the end) should be taken as 12%.

But, why is risk relevant?

Risk comes into the picture because a typical investor is risk-averse, that is,
the higher the risk of an asset, the higher is the return required by the
investor to buy the asset. This risk-aversion leads investors to refuse to play
a fair-game (a risky game with expected payoff equal to investment). This
also makes them dislike a mean-preserving-spread (a situation where the
mean remains unchanged, but the dispersion around the mean increases).

Obviously, a risk-averse investor chooses the lowest-risk portfolio among

ones with the same return, the highest-return portfolio among ones with the
same risk, and the highest utility portfolio in all other cases.

But, we are back to our old question: how do we measure risk?

Risk arises from uncertainty. Uncertainty is the lack of certainty: the

possibility of more than one outcome. Risk is the possibility that one or more
of these outcomes is "unfavorable".

What is deemed unfavorable? It depicts situations where the realized-return

on the asset falls below a certain benchmark. The benchmark may be 0%,
the risk-free rate, return on some index (like the market-index), or the asset's
own ERR. Though the risk-free rate is probably the best benchmark, asset's
own ERR is the most popular.

Thus, we may define risk as a measure of the possibility of having the

realized-return(s) in some state(s) less than the asset's own ERR.

The simplest measure in this light is just "the probability of the asset giving
less than its ERR". Using this risk-measure, we get that asset-1 has a risk of
2/3, while asset-2 has a risk of 1/3. If we use this measure, we would prefer
asset-2 to asset-1, since they both have the same return of 12%.

The above measure, unfortunately, does not take into account how much less
than its ERR does the asset give in the unfavorable states. So, we modify the
above measure to come up with LPM1 = Pr ob * (Re alized Re turn ERR) ,
s'

where s' refers to only those states in which the Realized Return is less than
the ERR, and Realized Return - ERR is referred to as deviation (or Excess
Return) for that state. Using this measure, we obtain that asset-1 has a risk
of 8%/3, while asset-2 has a risk of 9%/3.

To magnify larger deviations, we can square them and end up with LPM 2 =
Pr ob * Deviation 2 . This is one of the best risk-measures and is clearly
s'

better than variance, the most popular measure. This measure is also known
as the semi-variance.

A measure similar to the above is Variance =

Pr ob * Deviation
s

, where s is

the set of all states. The problem with this measure is that it takes positive
deviations (realized-return exceeding the benchmark / ERR) also as risk.
Thus, it is valid only when return distributions are symmetrical, as in normal.
But, since this is the most popular measure, we will accept this as our
measure of risk.

Using this measure, we find that asset-1 is preferred to asset-2, since asset-1
has a variance of 0.0035 (corresponding standard deviation of 5.89%), while
asset-2 has a variance of 0.0041 (standard-deviation of 6.38%).

But, should we put all our money in asset-1? No, we should not put all our
eggs in one basket. Why? Because, by putting our money in different assets,
we can diversify away firm-specific, industry-specific, and country-specific
risk, though we cannot get rid of world-specific risk. We would receive a
reward (in terms of risk-premium) only for bearing the non-diversifiable (or
systematic) world-specific risk, not for bearing any of the diversifiable risks
(firm-specific, industry-specific, or country-specific risk).

Our "optimal" portfolio therefore should not have any diversifiable risk.
Diversification works because the return on different assets is not perfectly
positively correlated with one another and may even be negatively correlated,

which means that, when some stocks do badly, others may not do as badly
and compensate for the bad performance of the former.

How do we create this optimal portfolio? When we compare portfolios with

different means and variances, we have to compare the utilities of the
portfolios, knowing that the investor would prefer the higher-variance asset iff
(if and only if) it has a higher ERR than the lower-variance asset and the extra
return it gives more than offsets the extra risk it entails. Clearly, for portfolios
with the same mean, the optimal one is the one with the lowest variance (or
standard-deviation). Similarly, for portfolios with the same variance, the
optimal one is that with the highest mean.

In our simple case of asset-1 and asset-2, since both have the same mean, all
portfolios of asset-1 and asset-2 would have the same mean of 12%, though
they would differ in their variances. Clearly, a risk-averse investor would
choose the portfolio with the lowest variance. The proportion in which asset-1
and asset-2 should be mixed can be found as follows: w 2* = [ 1 (1 - 2
12) ] / [ 12 + 22 - 2 1 2 12 ] and w1* = 1 - w2*.

If asset-1 and asset-2 are the only assets with 12% ERR, then the above
proportions would give us the "optimal 12%-mean (ERR) portfolio", because,
for a 12%-mean, this portfolio gives us the lowest variance that we can
achieve. We can similarly construct lowest-variance-portfolios for any meanreturn (any ERR). That will give us the set of the lowest-variance-portfolios.
All investors would choose one of these lowest-variance-portfolios, depending
upon their risk-aversion.

But, how would we assess the risk of each individual stock that is in the
portfolio? As we can see, the weighted average of the variances (or standarddeviations) of the individual stocks does not equal the variance (or standarddeviation) of the optimal-portfolio. That is not the way it should be. The risk
of a stock should be the "contribution the stock makes to the risk of the
portfolio in which it is held". Statistically, that translates into the condition
that the weighted-average of the risks of the stocks should be equal to the
risk of the portfolio, that is Riskpf = w1 Risk1 + w2 Risk2. But, we have already
accepted that the risk of a portfolio is the variance of the portfolio. Can the
two above conditions be reconciled?

Yes. If we measure the risk of an individual stock by its covariance with the
portfolio in which it is held, then the risk of the portfolio would turn out to be
the weighted average of the risk of the stocks in the portfolio. Moreover, the
risk of the portfolio automatically becomes the variance of the portfolio, as
the covariance of the portfolio with itself is nothing but its own variance. That
is, pf,pf = w1 1,pf + w2 2,pf and pf,pf = 2pf.

Thus, we can go a step further and say that the risk of any asset (stock or
portfolio of stocks) i is measured by its covariance with the optimal portfolio
(call it pf) of which it is a part. We will denote this covariance by i,pf. As we
said above, this "automatically" makes the risk of the optimal portfolio equal
to its variance, 2pf.

We can standardize the above risk-measure by setting the risk of the optimal
portfolio to one. In that case, the standardized risk of the optimal portfolio
3

would be equal to 1 and that of any other asset (stock or portfolio of stocks) i
equal to i,pf / 2pf . We can refer to this variable as the of the asset, since it
is exactly like the obtained from regressing the return on the asset i on the
return on the optimal portfolio pf. As in the case of non-standardized risk
(measured by covariance), the standardized-risk (measured by ) of a
portfolio is the weighted-average of the standardized-risks of the individual
assets comprising the portfolio. That is, pf = w1 1 + w2 2. As we know, for
the optimal portfolio pf, pf = 1 by construction.

What if we explicitly bring in a risk-free asset, which we have ignored in our

analysis so far? In that case, we can combine each of the lowest-variance
portfolios with the risk-free asset and create new portfolios. Interestingly, in
this case, the combination of the risk-free asset and a specific lowest-variance
portfolio would dominate all other combinations. This particular lowestvariance-portfolio is the market-portfolio. All combinations of the marketportfolio and the risk-free asset would lie along the CML (Capital Market Line).
Only these combinations would be the efficient portfolios and the return on
any efficient-portfolio would satisfy the condition: (r e - RF) / e = (rM - RF) / M,
where RF is the risk-free rate, rM is the ERR of the market-portfolio, re is the
return on the efficient-portfolio, and i is the standard-deviation of the
portfolio i (e or M).

Investors would put different proportions in the risk-free asset and the
market-portfolio depending on the degree of their risk-aversion. The less riskaverse an investor, the higher the fraction of her investment that she would
put in the market-portfolio; relatively low risk-averse investors will, in fact,
borrow money at the risk-free rate (put a negative proportion in the risk-free
asset) and put all their money in the risky market-portfolio.

The most distinguishing character of the market-portfolio is that it contains all

stocks (all financial asset to be theoretically correct), with the proportion of
each stock in the portfolio equal to the market-value of the stock as a
fraction/percentage of the total market-value of all stocks. Simply put, the
weight of asset-i in the portfolio wi = Market-Value of Asset-i / Market-Value of
All Assets in the Market-Portfolio.

Thus, the risk of any asset (stock or portfolio of stocks) i is now measured by
its covariance with the market-portfolio (call it M). We will denote this
covariance by i,M. This "automatically" makes the risk of the market-portfolio
equal to its variance.

We can standardize this risk-measure by setting the risk of the marketportfolio to one. In that case, the standardized risk of the market-portfolio
would be equal to 1 and that of any other asset (stock or portfolio of stocks) i
equal to i,M / 2M . We can refer to this variable as the of the asset, since it
is exactly like the obtained from regressing the return on the asset i on the
return on the market-portfolio M. By construction / design,

Now, we are in a position to measure the Risk-Premium Per Unit Risk (RPPUR)
also. It makes sense to require that the RPPUR be the same on all assets,
since this is like the "price of risk". If it is not the same, risk-averse investors
would tend to buy the assets with the highest RPPUR.

If the RPPUR is going to be the same for all assets, we can choose any
reference asset. The obvious choice for the reference-asset is the optimal
portfolio, the Market Portfolio. It has a non-standardized risk of 2M and its
total Risk-Premium is KM - RF, where KM is the ERR on the Market Portfolio and
RF is the Risk-free Interest-Rate. Its RPPUR is, therefore, (K M - RF) / 2M if the
risk is measured by the non-standardized risk.

Using our knowledge above, we can now measure k s using the nonstandardized risk-measure as follows:
ks = RF + Risk Premium = RF + (Risks x RPPUR) = RF +
( s,M x

k M RF

M2

)=

RF +

s,M
M2

(KM - RF) = RF + s (KM - RF)

If we take the standardized risk-measure, then the RPPUR for the Market
Portfolio would be (KM - RF) / 1, since the standardized risk of the Market
Portfolio is 1 (). Since the standardized risk of the stock is given by its s,
the above equation will then be as follows:
ks = RF + ( s x

k M RF
), which is , as expected, identical to the earlier equation.
1

Thus, the Capital Asset Pricing Model may be expressed as follows: ks = RF +

s (KM - RF)

Appendix
Col 1
State

Col 2
Prob

1
2
3

1/3
1/3
1/3

Col 3
Return
on 1:
X
20%
10%
6%

Col 4
X - X

Col 5
Col 42

Col 6
Return
on 2: Y

Col 7
Y - Y

Col 8
Col 72

Col 9
Col 4 x
Col 7

8%
-2%
-6%

64%2
4%2
36%2

17%
16%
3%

5%
4%
-9%

25%2
16%2
81%2

40%2
-8%2
54%2

Col 10

104%2
122%2
86%2
2
2
12%
35%
12%
41%
29%2
1 = STD1 = 35%2 = 5.89% AND 2 = STD2 = 41%2 = 6.38%
12 = Covar1,2= 29%2 => 12= Corr1,2= 12 / (1 x 2)= 29%2 / (5.89 x 6.38) %2 =
0.763
[ Alternatively, 12 = Corr1,2 = 86%2 / (104 x 122) %2 = 0.763 ]
w2* = [ 1 (1 - 2 12) ] / [ 12 + 22 - 2 1 2 12 ] =
[5.89% x (5.89% - 6.38% x 0.763)]/ [5.89% 2 + 6.38%2 - 2 x 5.89% x 6.38% x
0.763]= 33.3%
AND w1* = 1 - 33.3% = 66.7%

Sum
Sum/3

w1 = % in 1
0
25
33.3
50

w2 = % in 2
100
75
66.7
50
5

pf = STD of Portfolio
6.38%
5.98%
5.89%
5.76%

66.7
75
100

33.3
25
0

5.72%
5.73%
5.89%

Pxerox

Retxerox

Wilshire

Retwilsh

Crossprod

42
11722.00
41 3/4
-0.595% 11697.47 -0.209% -0.0000359
40 1/2
-2.994% 11607.90 -0.766% 0.0000611
41 15/16
3.549% 11713.80 0.912% 0.0005178
42 13/16
2.086% 11703.30 -0.090% -0.0000441
42 3/16 -1.460% 11892.90 1.620% 0.0001204
41 1/8
-2.519% 11879.10 -0.116% 0.0000040
42 3/16
2.584% 12092.60 1.797% 0.0008551
42 3/4
1.333% 12035.80 -0.470% -0.0001710
32 1/2 -23.977% 12170.40 1.118% -0.0024058
31 15/16 -1.731% 12197.10 0.219% 0.0000099
31
-2.935% 12017.58 -1.472% 0.0001078
29 13/16 -3.831% 11754.70 -2.187% 0.0003568
29 1/8
-2.306% 11751.20 -0.030% 0.0000004
27 7/16 -5.794% 11446.60 -2.592% 0.0009339
23 13/16 -13.212% 11456.00 0.082% -0.0000759
24 9/16
3.150% 11534.40 0.684% 0.0003597
26 3/16
6.616% 11765.80 2.006% 0.0017589
25 3/4
-1.671% 11719.60 -0.393% -0.0000219
25 3/8
-1.456% 11875.20 1.328% 0.0000990
25 3/8
0.000% 11825.20 -0.421% -0.0000959
25 1/16 -1.232% 11736.80 -0.748% -0.0000744
Average
Variance

-2.209%

0.013% 0.0001076
0.00014

Covariance (stock, market) = s,M = 0.0001076

Variance (Market) = 2M = 0.00014
Beta of Stock = s = s,M / 2M = 0.0001076 / 0.00014 = 0.77