1. The difficulty in using the subjective
Probability Distribution
It is difficult to describe the probability
distribution of an individual.
It is not certain that an individual’s
probability distribution is in accordance
with the probability distribution of investors
of market as a whole, which is more
relevant in determining cost of equity.
2. The objective way to describe
random variable – historical data
We can measure risk and return employing
historical returns. We basically believe that
history will repeat itself.
Expected Return E R R T
i it
t
T
( ) ( ) /
1
Standard Deviation
i
it i
t
T
R E R
T
( ( ))2
1
1
3. The problems in using historical
data in estimating risk and return
Some of firms, start-up or private firms,
may lack of stock trades information in
estimating realized risk and return.
This historical estimation sometimes may
not be representative for future
expectations.
4. Risk and return for two assets
E RA
( ) E RB
( )
A B
wA
wB
A B
Expected return
Standard deviation
Investment ratio
Expected return for the portfolio E R w E R w E R
p A A B B
( ) ( ) ( )
Standard deviation for the portfolio
p A A B B A B AB
w w w w
( ) /
2 2 2 2 1 2
2
AB Aj A
j
N
Bj B j A B AB
R E R R E R P
[ ( )][ ( )]
1
p A A B B A B AB
w w w w
( ) /
2 2 2 2 1 2
2
5. The definition of Covariance
The covariance is to measure the co-
movement of two random variable.
When covariance is positive, then the two
random variables tend to move into same
direction.
When covariance is negative, then the two
random variables tend to more to opposite
directions.
6. Risk and return for three assets
E RA
( ) E RB
( ) E RC
( )
A B C
wA wB
wC
A B C
Expected return
Standard deviation
Investment ratio
Expected return for the portfolio
E R w E R w E R w E R
p A A B B C C
( ) ( ) ( ) ( )
Standard deviation for the portfolio
p A A B B C C A B AB A C AC B C BC
w w w w w w w w w
( ) /
2 2 2 2 2 2 1 2
2 2 2
7. Risk and return for N assets
E R w E R
P k k
k
N
( ) ( )
1
2 2 1/ 2
1 1 1
( ) , ,
N N N
p i i i j ij
i i j
w w w i j
w w w w
n
n
1 2 3
1
...
2 2
2 2
1 1 1
2
2 2 2
2
1 1
( ) ( ) , ,
1 1
( ) ( ) ( )
1 1
(1 ) ,
N N N
p i ij
i i j
i ij
i ij
i j
n n
n n n
n n
n n
Expected return
Standard deviation
8. Risk Diversification
When number of assets increases, the
majority of risk for the portfolio comes from
the co-movement among assets. The
distinctive risk comes from each asset
becomes less important.
9. How diversification works
A B
Expected return 10% 14%
Standard deviation 4% 6%
Investment ratio 50% 50%
, 1 1
AB A B AB AB
( ) ( ) ( ) 10%*50%+14%*50%=12%
p A A B B
E R w E R w E R
10. 1
AB
p A A B B A B AB A A B B A B A B A A B B
w w w w w w w w w w
( ) ( ) [( ) ]
/ / /
2 2 2 2 1 2 2 2 2 2 1 2 2 1 2
2 2
( . . . . ) ( . % . %) %
/ /
0 5 6 0 5 4 2 0 5 0 5 6 4 1 0 5 6 0 5 4 5
2 2 2 2 1 2 1 2
0
AB
p A A B B A B AB
w w w w
( ) /
2 2 2 2 1 2
2
%
13
)
0
4
6
5
.
0
5
.
0
2
4
5
.
0
6
5
.
0
( 2
/
1
2
2
2
2
1
AB
p A A B B A B AB
w w w w
( ) /
2 2 2 2 1 2
2 =
( . . . . ( )) ( . % . %) %
/
0 5 6 0 5 4 2 0 5 0 5 6 4 1 0 5 6 0 5 4 1
2 2 2 2 1 2
=
=
11. Combining Stocks with Different
Returns and Risk
Assets may differ in expected rates of
return and individual standard deviations
Negative or small positive correlations
reduce portfolio risk
Combining two assets with -1.0 correlation
is able reduces the portfolio standard
deviation to zero.
12. Constant Correlation with Changing Weights
i
Asset E(R )
1 .10 .07 rij = 1.00
2 .20 .10
Case W1 W2 E(Ri) E(Fport)
f 0.00 1.00 0.20 0.1000
g 0.20 0.80 0.18 0.0940
h 0.40 0.60 0.16 0.0880
i 0.50 0.50 0.15 0.0850
j 0.60 0.40 0.14 0.0820
k 0.80 0.20 0.12 0.0760
l 1.00 0.00 0.10 0.0700
13. Portfolio Risk-Return Plots for Different Weights
-
0.05
0.10
0.15
0.20
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
E(R)
Rij = +1.00
1
2
With two perfectly
correlated assets, it
is only possible to
create a two asset
portfolio with risk-
return along a line
between either
single asset
14. Constant Correlation with Changing Weights
Case W1 W2 E(Ri) E(F
port)
f 0.00 1.00 0.20 0.1000
g 0.20 0.80 0.18 0.0812
h 0.40 0.60 0.16 0.0662
i 0.50 0.50 0.15 0.0610
j 0.60 0.40 0.14 0.0580
k 0.80 0.20 0.12 0.0595
l 1.00 0.00 0.10 0.0700
i
Asset E(R )
1 .10 .07 rij = 0.00
2 .20 .10