Risk and Return

Expected Return = E(ki) = ki pi

where ki = the ith possible outcome
pi = the probability that the ith outcome will occur
Stand-alone Risk
i = (ki - E(ki))2 pi
Expected return on a portfolio = E(kp) = xi E(ki)
where xi = the fraction of the portfolio invested in
the ith asset
Portfolio risk (for two securities)
i = x12 12 + x22 22 + 2x1x212
where 12= 12 r12 and r12= correlation coefficient
between k1 and k2
 Effect of Portfolio Size on Portfolio Risk
Portfolio Risk

Diversifiable
Risk

Stand-Alone
Risk Market Risk

# of stocks in
portfolio
 Market Risk
Market risk is measured by (beta). Beta is a
measure of the relationship between an investment
return (as a dependent variable) and the market
return (as an independent variable)
= 1 the security return movement is the same
as the market return movement
> 1 the security return movement is higher
than the market return movement
< 1 the security return movement is lower
than the market return movement
 Required Rate of Return (k)
k = krf + krp
where, krf the risk-free return and krp = the risk premium
Capital Asset Pricing Model (CAPM)
ki = krf + (km krf) i
Required Return
SML
Security Market Line
km

krf