The relationship between risk and

expected returns

©1999 Thomas A. Rietz 1

Investors are concerned with
 Risk
 Returns

What determines the required compensation

for risk?
It will depend on
 The risks faced by investors
 The tradeoff between risk and return they face

©1999 Thomas A. Rietz 2

Concepts of risk for
 A single stock
 Portfolios of stocks

Risk for the diversified investor: Beta

 Calculating Beta
The relationship between Beta and Return: The
Capital Asset Pricing Model (CAPM)

©1999 Thomas A. Rietz 3

Investors demand compensation for risk
 If investors hold “diversified” portfolios, risk can be
defined through the interaction of a single
investment with the rest of the portfolios through a
concept called “beta”
The CAPM gives the required relationship
between “beta” and the return demanded on
the investment!

©1999 Thomas A. Rietz 4

Expected return: Beta
 What we expect to receive  A measure of risk
on average appropriate for
diversified investors
Standard deviation of
returns: Diversified investors
 A measure of dispersion
 Investors who hold a
of actual returns portfolio of many
investments
Correlation
The Capital Asset
 The tendency for two
returns to fall above or Pricing Model (CAPM)
below the expected return  The relationship between
a the same or different risk and return for
times diversified investors

©1999 Thomas A. Rietz 5

We describe what we expect to receive or the
expected return:

E (r ) = ∑ pi ri
i
– Often estimated using historical averages
(excel function: “average”).
Suppose you pay $300 to throw a fair die.
You will be paid $100x(The Number rolled)
The probability of each outcome is 1/6.
The returns are:
 (100-300)/300 = -66.67%
 (200-300)/300 = -33.33% …etc.

The expected return E(r) is:

 1/6x(-66.67%) + 1/6x(-33.33%) + 1/6x0% +
1/6x33.33% + 1/6x66.67% + 1/6x100% = 16.67%!
Suppose
 You buy and AAPLi contract on the IEM for $0.85
 You think the probability of a $1 payoff is 90%

The returns are:

 (1-0.85)/0.85 = 17.65%
 (0-0.85)/0.85 = -100%

The expected return E(r) is:

 0.9x17.65% - 0.1x100% = 5.88%
Recent data from the IEM shows the following
average monthly returns from 5/95 to 10/99:
 (
http://www.biz.uiowa.edu/iem/markets/compdata/compfund.html
)
AAPL IBM MSFT SP500 T-Bills
Average Return 2.42% 3.64% 4.72% 1.75% 0.35%
 Value of Investment

$-
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
Apr-95
Jul-95
Oct-95
Jan-96
Apr-96
Jul-96
Oct-96
Jan-97
Apr-97
Jul-97

Month
Oct-97
Jan-98
Apr-98
Jul-98
Oct-98
Jan-99
Apr-99
Jul-99
Oct-99
IBM
AAPL

MSFT
SP500
T-Bill(2)
 Standard Deviation in Returns:

∑ pi ( ri − E (r )) = ∑ ii
2
σ = p r 2
− E (r ) 2
Var = σ i2
i i

● Often estimated using historical averages

(excel function: “stddev”)
Recall the dice roll example:
 You pay $300 to throw a fair die.
 You will be paid $100x(The Number rolled)
 The probability of each outcome is 1/6.
 The expected return E(r) is 16.67%.

The standard deviation is:

1 1
× (−66.67%) + × (−33.33%)2 +
2

6 6
1 1
× (0%) + × (33.33%)2 +
2
= 56.93%
6 6
1 1
× (66.67%) + × (100%)2 − 16.67%2
2

6 6
Suppose
 You buy and AAPLi contract on the IEM for $0.85
 You think the probability of a $1 payoff is 90%

The returns are:

 (1-0.85)/0.85 = 17.65%
 (0-0.85)/0.85 = -100%

The expected return E(r) is:

 0.9x17.65% - 0.1x100% = 5.88%
The standard deviation is:
 [0.9x(17.65%)2 + 0.1x(-100%)2 - 5.88%2]0.5 = 35.29%
Recent data from the IEM shows the following
average monthly returns & standard deviations
from 5/95 to 10/99:
 (
http://www.biz.uiowa.edu/iem/markets/compdata/compfund.html
)
AAPL IBM MSFT SP500 T-Bills
Average Return 2.42% 3.64% 4.72% 1.75% 0.35%
Std. Dev 14.84% 10.31% 8.22% 3.82% 0.06%
 Value of Investment

$-
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
Apr-95
Jul-95
Oct-95
Jan-96
Apr-96
Jul-96
Oct-96
Jan-97
Apr-97
Jul-97

Month
Oct-97
Jan-98
Apr-98
Jul-98
Oct-98
Jan-99
Apr-99
Jul-99
Oct-99
IBM
AAPL

MSFT
SP500
T-Bill(2)
 5.0%
MSFT
4.5%

4.0%
IBM
3.5%
Average Return

3.0%
AAPL
2.5%

2.0%
S&P500
1.5%

1.0%

0.5%
T-Bill
0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation
Correlation shows the association across
random variables
Variables with
 Positive correlation: tend to move in the same
direction
 Negative correlation: tend to move in opposite
directions
 Zero correlation: no particular tendencies to move in
particular directions relative to each other
 Covariance in returns, σAB, is defined as:
σ AB = ∑ pi ( rAi − E (rA ))( rBi − E (rB )) = ∑ pi rAi rBi − E (rA )E (rB )
i i

● The correlation, ρAB, is defined as:

σ AB
ρ AB =
σ Aσ B
– ρAB is in the range [-1,1]
– Often estimated using historical averages
(excel function: “correl”)
Item Asset A Asset B Portfolio
Actual Return rAi rBi rPi
Expected Return E(rA) E(rB) E(rP)
Variance σA2 σB2 σP2
Std. Dev. σA σB σP

Correlation in Returns ρAB

Covariance in Returns σAB = σAσBρAB
Suppose
 You buy an MSFT090iH for $0.85 and a MSFT090iL
contract for $0.15.
 You think the probability of $1 payoffs are 90% &
10%
The expected returns are:
 0.9x17.65% + 0.1x(-100%) = 5.88%
 0.1x566.67% + 0.9x (-100%) = -33.33%
The standard deviations are:
 [0.9x(17.65%)2 + 0.1x(-100%)2 - 5.88%2]0.5 = 35.29%
 [0.1x(566.67%)2 + 0.9x(-100%)2 - (-33.33%)2]0.5 = 200%
The correlation
0.9 × 17.65% × (-100%) +is:
0.1 × 566.67% × (-100%) - 5.88% × (-33.33)%
=-1
35.29% × 200%
Recent data from the IEM shows the following
monthly return correlations from 5/95 to
10/99:
 (
http://www.biz.uiowa.edu/iem/markets/compdata/compfund.html
) AAPL IBM MSFT SP500 T-Bills
AAPL 1.000 0.262 0.102 0.046 -0.103
IBM 1.000 0.240 0.362 -0.169
MSFT 1.000 0.550 -0.073
SP500 1.000 -0.003
T-Bills 1.000
 $1

$0
y = 0.3777x + 0.0105
Correl = 0.262
$0

$0
IBM Return

$0

$-
-20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00%
$(0)

$(0)

$(0)

$(0)
AAPL Return
 5.0%
MSFT
4.5%

4.0%
IBM
3.5%
Average Return

3.0%
AAPL
2.5%

2.0%
S&P500
1.5%

1.0%

0.5%
T-Bill
0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation
 The standard deviation is not a linear
combination of the individual asset standard
deviations
Instead, it is given by:

σ p = w 2Aσ A2 + (1 − w A )2 σ B2 + 2w A (1 − w A )σ Aσ B ρ AB
● The standard deviation a the 50%/50%, AAPL &
IBM portfolio is:
2 0.52 × 0.14842 + 0.52 × 0.10312
σp = = 10.08%
+ 2x0.5x0.5 × 0.1484 × 0.1031× 0.262
● The portfolio risk is lower than either individual
asset’s because of diversification.
Suppose
 E(r)A = 16% and σA = 30%
 E(r)B = 10% and σB = 16%
Consider the E(r)P and σP of securities A and B
as wA and ρ vary...
 17%
16% (16%,30%)

15%
14%

13%
.R
e
tE
p
x

12%
11%

10%
(10%,16%)
9%
8%
0% 5% 10% 15% 20% 25% 30% 35%

Std. Dev.
 17%
16% (16%,30%)
Min. Var.
(11.33%,14.12%)
15%
14%
13%
.R
e
tE
p
x

12%
11%

10%
(10%,16%)
9%
8%
0% 5% 10% 15% 20% 25% 30% 35%

Std. Dev.
 17%
16% Zero Var. (16%,30%)

15% (11.33%,14.12%)
14%

13%
.R
e
tE
p
x

12%
11%

10%
(10%,16%)
9%
8%
0% 5% 10% 15% 20% 25% 30% 35%

Std. Dev.
 17%
16% (16%,30%)

15%
14% r=1
13%
r=0
.R
e
tE
p
x

12%
11% r=-1

10%
(10%,16%)
9%
8%
0% 5% 10% 15% 20% 25% 30% 35%

Std. Dev.
Suppose the fractions of the portfolio are given
by wAAPL, wIBM and wMSFT.
The expected return is:
 E(rP) = wAAPLE(rAAPL) + wIBME(rIBM) + wMSFTE(rMSFT)
The standard deviation is:

2 2 2 2 2 2
w AAPL σ AAPL + w IBM σ IBM + w MSFT σ MSFT
+ 2w AAPLw IBMσ AAPL ⋅ σ IBM ⋅ ρ AAPL,IBM
σp =
+ 2w AAPLw MSFTσ AAPL ⋅ σ MSFT ⋅ ρ AAPL,MSFT
+ 2w IBM w MSFTσ IBM ⋅ σ MSFT ⋅ ρIBM,MSFT
 1 1 1
E (RP ) = × 0.0242 + × 0.0364 + × 0.0472 = 3.59%
3 3 3
2 2 2
1 1 1
0.1484 + 0.1031 + 0.08222
2 2

3 3 3
1 1
+ 2 ⋅ 0.1484 ⋅ 0.1031⋅ 0.262
σp
2
= 3 3
1 1
+ 2 ⋅ 0.1484 ⋅ 0.0822 ⋅ 0.102
3 3
1 1
+ 2 ⋅ 0.1031⋅ 0.0822 ⋅ 0.240
3 3
= 7.75%
 5.0%
MSFT
4.5%

4.0%
Naive IBM
3.5%
Portfolio
Average Return

3.0%
AAPL
2.5%

2.0%
S&P500
1.5%

1.0%

0.5%
T-Bill
0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation
As you increase the number of assets in a
portfolio:
 the variance rapidly approaches a limit,
 the variance of the individual assets contributes less
and less to the portfolio variance, and
 the interaction terms contribute more and more.

Eventually, an asset contributes to the risk of a

portfolio not through its standard deviation
but through its correlation with other assets in
the portfolio.
This will form the basis for CAPM.
Portfolio variance consists of two parts:
 1. Non-systematic (or idiosyncratic) risk and
 2. Systematic (or covariance) risk

2 1 2  1
σp = σi +  1 − σ ij
n    n   
The market rewards risk only systematic
Non − systematic Systematic risk
risk
because diversification can get rid of non-
systematic risk
 100%
90%
80%
70%
ρ=.5
60%
50% ρ=.2
fP
tli V
r.o
a

40%
ρ=0
30%
20%
10%
0%
1 11 21 31 41 51 61 71 81 91

Number of Assets
 6%

5% MSFT

4%
IBM U
Expected Return

3%
JNJ XRX HWP
GE
2% WMT
VIA AAPL
CAT
OAT F S QUIZ
1% EK BA T
P
K DE LE NOVL
YES
0% R
0.00% 5.00% 10.00% 15.00% 20.00%
-1% Z
-2%
Standard Deviation in Return
 16%
Expected Portfolio Return and

14%

12%
Standard Deviation

10%

8%
Standard
6% Devaition
4%

2%
Average Monthly Return
0%
1

15

21
11

13

17

19

23

25
Number of Stocks in Portfolio
CAPM Characteristics:
 βi = σiσmρim/σm2
Asset Pricing Equation:
 E(ri) = rf + βi[E(rm)-rf]
CAPM is a model of what expected returns
should be if everyone solves the same passive
portfolio problem
CAPM serves as a benchmark
 Against which actual returns are compared
 Against which other asset pricing models are
compared
The value of an asset reflects
 The risk associated with that asset given
 Investors own a combination of
 The risk free asset and
 The market portfolio.
A risky asset
 Has no effect on the risk free rate.
 Effects the portfolio through its covariance with it.
The “market price of risk” is: E(Rm)-Rf
Where do these ideas come from?
Advantages:
 Simplicity
 Works well on average
Disadvantages:
 Makes many simplifying assumptions about
markets, returns and investor behavior
 How do you estimate beta? Can all aspects of risk be
summarized by beta?
 What is the true market portfolio and risk free rate?
No transactions costs
No taxes
Infinitely divisible assets
Perfect competition
 No individual can affect prices
Only expected returns and variances matter
 Quadratic utility or
 Normally distributed returns
Unlimited short sales and borrowing and
lending at the risk free rate of return
Homogeneous expectations
 Feasible Set
Expected
return (Ei)

Efficient
frontier

Std dev (σ i)
 Expected
return (Ei) B
C A

Std dev (σ i)
1. Find all asset expected returns and standard
deviations.
2. Pick one expected return and minimize
portfolio risk.
3. Pick another expected return and minimize
portfolio risk.
4. Use these two portfolios to map out the efficient
frontier.
 Expected Utility maximizing
risky-asset portfolio
return (Ei)

Std dev (σ i)
 Expected
E
return (Ei)
M D

Std dev (σ i)
The riskless asset has a standard deviation of
zero
The minimum variance portfolio lies on the
boundary of the feasible set at a point where
variance is minimum
The market portfolio lies on the feasible set and
on a tangent from the riskfree asset
 All risky assets
and portfolios
Expected
return (Ei) Market
Portfolio

Riskless Efficient
asset Minimum frontier
Variance
Portfolio
Std dev (σ i)
When the riskfree asset is introduced,
All investors prefer a combination of
1) The riskfree asset and
2) The market portfolio
Such combinations dominate all other assets
and portfolios
All investors face the same Capital Market Line
(CML) given by:
The CML gives the expected return-risk
combinations for efficient portfolios.
What about inefficient portfolios?
 Changing the expected return and/or risk of an
individual security will effect the expected return
and standard deviation of the market!
In equilibrium, what a security adds to the risk
of a portfolio must be offset by what it adds in
terms of expected return
 Equivalent increases in risk must result in equivalent
increases in returns.
 Consider the variance of the market portfolio:

● It is the covariance with the market

portfolio and not the variance of a security
that matters
● Therefore, the CAPM prices the
covariance with the market and not
variance per se
The expected return on any asset can be written
as:

E(Ri ) = R f + [ E(Rm ) − R f ] β i
σ iσ m ρ im σ im
where β i = 2
= 2
σm σm
● This is simply the no arbitrage condition!
● This is also known as the Security Market
Line (SML).
Suppose you have the following information:

rf = 3.5% E(rm)=8.5% βIBM=0.75

What should E(rIBM) be?
Answer:

E(ri ) = rf + [E(rm ) − rf ] β i
⇒ E(rIBM ) = 0.035 + [ 0.085 − 0.035] ⋅ 0.75
⇒ E(rIBM ) = 7.25%
Suppose you have the following information:

rf = 3.5% E(rm)=8.5% E(rIBM)=7.25%

What should βIBM be?
Answer:

E(ri ) = rf + [E(rm ) − rf ] β i
⇒ 0.0725 = 0.035 + [ 0.085 − 0.035] ⋅ β DE

⇒ β IBM =
[ 0.0725 − 0.035]
= 0.75
[ 0.085 − 0.035]
Suppose you have the following information:
rf = 3.5% βIBM=0.75 E(rIBM)=7.25%
What should E(rm) be?
Answer:
E(ri ) = rf + [E(rm ) − rf ] β i
⇒ 0.0725 = 0.035 + [E(rm ) − 0.035] ⋅ 0.75
⇒ [E(rm ) − 0.035] ⋅ 0.75 = 0.0725 − 0.035

⇒ E(rm )=
[ 0.0725 − 0.035]
+ 0.035 = 8.5%
0.75
Suppose you have the following
information:
E(rm)=8.5% βDE=0.75 E(rDE)=7.25%
What should rf be?
E(ri ) = rf + [E(rm ) − rf ] β i
Answer:
⇒ 0.0725 = rf + [ 0.085 − rf ] ⋅ 0.75
⇒ 0.0725 = rf + 0.085 ⋅ 0.75 − rf ⋅ 0.75
⇒ 0.0725 − 0.085 ⋅ 0.75 = rf ⋅ ( 1 − 0.75 )
0.0725 − 0.085 ⋅ 0.75
⇒ rf = = 3.5%
1 − 0.75
Let rit, rmt and rft denote historical returns for the
time period t=1,2,...,T.
The are two standard ways to estimate historical
β’s using regressions:
 Use the Market Model: rit-rft = αi + βi(rmt-rft) + eit
 Use the Characteristic Line: rit = ai + birmt + eit
 α = a + (1-b )r and β = b
i i i ft i i
Typical regression estimates:
 Value Line (Market Model):
 5 Yrs, Weekly Data, VW NYSE as Market
 Merrill Lynch (Characteristic Line):
 5 Yrs, Monthly Data, S&P500 as Market
 50%

40%

30%
AAPL Premium

20%
y = 0.1844x + 0.0182
10%
R2 = 0.0022
0%
-15% -10% -5% 0% 5% 10% 15%
-10%

-20%

-30%

-40%
S&P500 Premium
 40%

y = 0.9837x + 0.0191
30%
R2 = 0.1325

20%
IBM Premium

10%

0%
-15% -10% -5% 0% 5% 10% 15%
-10%

-20%

-30%
S&P500 Premium
 30%
y = 1.1867x + 0.027
25%
R2 = 0.3032
20%
MSFT Premium

15%

10%

5%

0%
-15% -10% -5% 0% 5% 10% 15%
-5%

-10%

-15%

-20%
S&P500 Premium
Betas for our companies
AAPL IBM MSFT SP500
Raw: 0.1844 0.9838 1.1867 1
Adjusted: 0.4563 0.9891 1.1245 1
Avg. R: 2.42% 3.64% 4.72% 1.75%
 5.00%
MSFT
4.50%
4.00%
Average Return

3.50% IBM

3.00%
2.50% AAPl
2.00%
S&P500
1.50%
1.00%
0.50%
T-Bills
0.00%
- 0.20 0.40 0.60 0.80 1.00 1.20
Beta
State what has been learned
Define ways to apply training
Request feedback of training session

©1999 Thomas A. Rietz 64

Other training sessions
List books, articles, electronic sources
Consulting services, other sources

©1999 Thomas A. Rietz 65