Systematic Risk & SML

Financial Management

Banikanta Mishra
Ravenshaw University
January March 2009

Systematic Risk Historically

A typical NYSE stock has a STDEV of around 49% per year
A portfolio of 500 large NYSE stocks has 20% annual STDEV

Why?
As we keep adding stocks randomly to our portfolio,
STDEV reduces
But the larger our existing portfolio,
the lower is the (marginal) reduction in risk
We may loosely call this
The Principle of Diminishing Marginal Risk-Reduction

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Professor Banikanta Mishra

The Risk That Wont Go Away

There is a MINIMUM level of risk that cannot be diversified

This is the non-diversifiable risk or the market-risk that affects ALL shares
If I hold only the shares of one computer company (Dell, IBM, or HP),
I am exposed to the risk that my company may lose market-share to
the other computer companies
If I hold shares of all US computer companies, I am protected against this.
But, I am exposed to the risk that US computer firms may not do well.
If I hold shares of all industries in USA, I am protected against this risk.
But, I am exposed to the risk that US economy may NOT do well.
If I hold shares across different countries, I am protected against this risk.
But, what if the Global Equity-Market does not do well?
I CANNOT protect my portfolio against this NON-DIVERSIFIABLE risk.
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Professor Banikanta Mishra

The Market Portfolio

So, except the risk-free asset,
every asset and every portfolio would have some
Non-Diversifiable or Systematic Risk.
Sub-optimal portfolios would have, in addition,
Diversifiable or Unsystematic Risk
Best-diversified portfolio is Market portfolio,
which has no Diversifiable or Unsystematic Risk
The theoretical Market Portfolio consists of all assets,
with weight on any asset j equal to
the fraction of total market value accounted for by the asset j
MVj
n

where MVj is the Market Value of Asset j

MVk

k 1

and is the sum of the MVs of all assets

In practice, any broad-based Market Index can be taken as the Market Portfolio
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Professor Banikanta Mishra

Non-Diversifiable or Systematic Risk

Repeat:
every asset and every portfolio would have some Non-Diversifiable Risk.
The ERR and the RRR on any asset or portfolio would depend
ONLY on its own Non-Diversifiable or Systematic Risk

We know we can measure a portfolios Systematic Risk by its Variance.

How do we measure the Systematic Risk of an asset, call it Asset-i
Non-Standardized: Covariance with the Market Portfolio = siM
Standardized: Covariance / Variance of the Market PF =

s iM
2
sM

The above Standardized Risk is what we call the Beta of Asset-i

So, i
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siM

s s
iM i M
2
2
sM
sM

Professor Banikanta Mishra

How do We Compute eta?

Through regression analysis of historical data
MARKET MODEL
Rit = a + i RMt + eit
Where
Rit is the return on Asset-i in period t,
RMt is the return on Market Portfolio in period t,
a = intercept, = slope, e = error-term
Period is usually taken as daily or monthly
60 monthly returns (last five years) or
250 daily returns (last one year) is
taken as an appropriate large sample sizes
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Professor Banikanta Mishra

Computing Beta: An Example

Mean
Variance (s2)
STDEV (s)

Stock (i)
Rit

Market (M)
RMT

-0.60%
2.99%
3.55%
2.09%
-1.46%
-2.52%
2.58%
1.33%
-2.98%
-1.73%
-2.94%
-0.12%

-0.21%
-0.77%
0.91%
-0.09%
1.62%
-0.12%
1.80%
-0.47%
1.12%
0.22%
-1.47%
-2.19%

0.0174%

0.0297%

0.0579%
2.4060%

0.0144%
1.1983%

Covariance* (Stock, Market) = si,M =

0.003231%

Correlation (Stock, Market) = i,M =

0.1164

Beta of Stock = i = si,M /

s2M

0.23
s2M=

Beta of Stock= i = ( i,M si sM) /

Beta of Stock = Slope of Regresssion Line=

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0.23
0.23

Beta from Regression

R
E
T
U
R
N

+
+

O
N

S
T
O
C
K

Slope = i

+
+
Return on Market

+
+
+

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What Does this eta Mean?

measures how the stock moves on the average
with the Market
during a particular period (day, week, month, year)
If market moves by 1% during that period,
the stock moves - on the average - by % during that period
For example,
If Market goes up (down) by 1% during a period,
our stock-i is expected to move up (down) by 0.23%
during that period
During any particular period, it can actually will
move up (or down) by more or less than 0.23%

If another stock, say j, has a of 1.10,

then it would move up or down on the average - by 1.10%
when Market moves up or down by 1% during a period
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Professor Banikanta Mishra

eta: High, Average, Low

As we just saw,
if < 1.0,
then it moves less than the Market,
=> less SYSTEMATIC RISK than Market
DEFENSIVE ASSET
if > 1.0,
then it moves more than the Market
=> more SYSTEMATIC RISK than Market
AGGRESSIVE ASSET
if = 1.0,
then it moves same as the Market,
=> same SYSTEMATIC RISK as Market
NEUTRAL ASSET
Can < 0?
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eta and Total Risk

eta does NOT measure Total Risk
Therefore, low eta does NOT mean low Total Risk
But, that does not matter
As we care ONLY about Systematic Risk
Why?
ONLY the Systematic Risk determines the Risk Premium
and thus influences an assets RRR and ERR
Security

STDEV

Beta

LB

25%

0.80

HB

18%

1.20

Which asset is more risky? Which asset will have higher RRR?
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Portfolio Beta
Suppose that you have $5,000 to invest NOW
You put in 25% ($1,250) in LB and 75% ($3,750) in HB
What is your Portfolio now?
n
p wi (where
w i is the fraction of total VALUE accounted for by asset i)
i
i1
So, here, p wLB LB wHB HB 25% x 0.80 75% x 1.20 1.10

Suppose, by the end of the year,

your LB holding would increase in value to $1,800
and your HB holding would increase in value to $4,200
What would then be your Portfolio at the year-end (t=1)?
p wLB LB wHB HB 30% x 0.80 70% x 1.20 1.08
because, at year-end, LB would account for 30% (=1800/6000) of Portfolio VALUE
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Portfolio Beta with RF Asset

Suppose that you have $5,500 NOW which you invest as follows
1/11

RF $500
=0

= 1.00

10/11

Risky Assets $5,000

= 1.10

25%

LB $1,250
= 0.80

75%

HB $3,750
= 1.20

We have seen that the of the above Risky Assets portfolio is1.10.
So, of the Overall $5,500 Portfolio is
1
10

p w Riskfree Riskfree w Risky Risky x 0.00

x 1.10 1.00
11
11

500
1250
3750
Would this equal
0
0.80
1.20 ?
5500
5500
5500
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s and RRRs
As we have already said,
ERR (or RRR) of an asset depends ONLY on its Systematic Risk
Since Beta measures the Systematic Risk,
ERR (or RRR) depends only on
Suppose we compute the of each asset
and plot it against their Rs (ERRs or RRRs)
How would that relationship look?
A famous theory Capital Asset Pricing Model (CAPM) - says:
IT WOULD BE A STRIAGHT LINE
Ri = Rf + i (RM - Rf)
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CAPM
Ri = Rf + i (RM - Rf)
Ri is the RRR or ERR on asset-i

Rf is the Pure Time Value of Money component

i is the Amount of Systematic Risk of the Asset

RM - Rf Is the per-unit Reward for Bearing the Systematic Risk

(per-unit here refers to per 1.0 unit of )

RM - Rf is called the Market Risk Premium (MRP),

since it is the Risk Premium on the Market Portfolio

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SML: Security Market Line

R
Slope = RM - Rf

Intercept = Rf

If an asset has a of ZERO, its R would be Rf

As increases from ZERO onwards, R increases by RM - Rf

for every 1.0 increase in
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SML with Numbers

R
Slope = 2%

Intercept = 5%

If an asset has a of ZERO, its R would be 5%

As increases from ZERO onwards, R increases by 2%
for every 1.0 increase in

So, if an asset has a of 0.80, its R would be 5% + (0.80 x 2%) = 6.60%

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An Implication of SML
If asset-xs is d more than asset-ys
then asset-xs RRR is d (RM - Rf) more than asset-ys
and, therefore, xs ERR should also be d (RM - Rf) more than ys

Example
Rf = 5%

LB = 0.8

RM - Rf = 2%

HB = 1.20

RRRLB = 6.60%

RRRHB = 7.40%

Check: HBs is 0.40 more than LBs

and, as expected,
HBs RRR is 0.40 x 2% = 0.80% more than LBs RRR
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Another Implication of SML

Reward to Risk Ratio
(the Risk Premium per Unit Risk or Risk Premium Per Unit Beta)

is the same across all assets

and is equal to the Market Risk Premium
Example
Rf = 5%

RM - Rf = 2%

LB = 0.8

HB = 1.20

RRRLB = 6.60%

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RRRHB = 7.40%

RPLB = RRRLB - Rf = 6.60% - 5% = 1.60%

RPHB = 7.40% - 5% = 2.40%

RP per Unit Beta = 1.60% / 0.80 = 2%

RP per Unit Beta = 2.40% / 1.20 = 2%

Professor Banikanta Mishra

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Reward-to-Risk Ratio & Selection

Reward to Risk Ratio = (Ri Rf) / i

is used in choosing between assets

Example
Rf = 5.00%

RM - Rf = 2.00%

LB = 0.8

HB = 1.20

ERRLB = 7.10%

ERRHB = 8.00%

RP per Unit Beta =

RP per Unit Beta =

(Reward-to-Risk Ratio for Asset-LB)

(Reward-to-Risk Ratio for Asset-HB)

(7.10% - 5.00%) / 0.80 = 2.625%

(8.00% - 5.00%) / 1.20 = 2.500%

So, CHOOSE LB.

(But, which one gives higher Excess Return = ERR RRR ?)
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Mispriced Assets
If an asset lies above the SML,
it has a higher Reward-to-Risk Ratio
than the Market Risk Premium

and is thus underpriced or undervalued

If an asset lies below the SML,

than the Market Risk Premium

it has a lower Reward-to-Risk Ratio
and is thus overpriced or overvalued

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Solving for Unknowns

One-Asset Case
Ri = Rf + i (RM - Rf)
or
Ri = Rf + i MRP
Four variables: Ri, Rf, i, AND (RM - Rf) or MRP or RM
Given any THREE, we can solve for the FOURTH one
Two-Assets Case
Ri = Rf + i (RM - Rf)
Rj = Rf + j (RM - Rf)
Six variables: Ri, Rj, i, j, Rf, AND (RM - Rf) or MRP or RM
Given any FOUR, we can solve for the OTHER TWO
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CALCing

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Asset-i

Market

2%
-1.90%
0.75%
0.92%
-0.05%

3%
-1.20%
1.10%
0.70%
0.00%

i =

0.94
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What Have We Learnt So Far?

The two attributes of a security that investors focus on:
1. Expected Rate of Return (ERR)
or Average Return or Mean Return

2. Risk
The risk that actually matters is NOT the
Total risk = Systematic risk + Unsystematic risk
but the Systematic or Non-diversifiable Risk
(since unsystematic risk is diversifiable)
For a well-diversified portfolio,
that has no diversifiable or unsystematic risk,
Variance measures both Total and Systematic Risk

For individual assets or non-diversified portfolios, measure

Non-standardized Risk by Covariance (with Market)
Standardized Risk by Beta (with respect to Market)
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Example-1a
Suppose an asset with of 1.25 has an RRR of 12%.
What are Rf and Rm?
(Or, what is MRP?)

Only TWO variables given. Need ONE MORE variable.

a. If Rf = 7%, then Rm=?
12% = 7% + 1.25 (Rm 7%) => Rm = 11%

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Professor Banikanta Mishra

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Example-1a
Suppose an asset with of 1.25 has an RRR of 12%.
What are Rf and Rm?
(Or, what is MRP?)
Only TWO variables given. Need ONE MORE variable.
a. If Rf = 7%, then Rm=?
12% = 7% + 1.25 (Rm 7%) => Rm = 11%

b. If MRP = 4%, then Rf =? [=> Rm=?]

12% = Rf + (1.25 x 4%) => Rf = 7% [ => Rm = 7% + 4% = 11%]
c. If Rm = 11%, then Rf =?
12% = Rf + 1.25 (11% Rf ) => Rf = 7%
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Professor Banikanta Mishra

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Example-1b
Suppose Rf = 8%.
What is the RRR of an asset with of 1.50?
Only TWO variables given. Need ONE MORE variable.
a. If Rm = 13%, then?
RRR = 8% + 1.50 (13% - 8%) = 15.50%

b. If MRP = 5%, then?

RRR = 8% + (1.50 x 5%) = 15.50%

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Example-2a
Suppose an asset with of 1.25 has an RRR of 12%.

What should be the RRR for an asset with of 0.75?

Only THREE variables given. Need ONE MORE variable.
a. If Rf = 7%, then?
12% = 7% + (1.25 x MRP) => MRP = 4%
=> RRR another = 7% + (0.75 x 4%) = 10%
b. If MRP = 4%, then?
12% = Rf + (1.25 x 4%) => Rf = 7%
RRR another = 7% + (0.75 x 4%) = 10%
c. If Rm = 11%, then?
12% = Rf + [1.25 x (11% - Rf) ] => Rf = 7%
=> RRR another = 7% + [0.75 x (11% - 7% ] = 10%
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Example-2b
Suppose an asset with of 1.50 has an RRR of 15.50%.

AND an asset with of 0.80 has an RRR of 12.00%.

a. What is the RRR on an asset with = 1.20?
15.50% = Rf + (1.50 x MRP)
12.00% = Rf + (0.80 x MRP)
MRP = 5%, Rf = 7%
So, RRRanother = 5% + (1.20 x 7%) = 13.40%
b. What is Rm=?
As shown above, MRP = 5% and Rf = 7% => Rm = 7% + 5% = 12%
c. What is Rf=?
As shown above, Rf = 7%
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Example-1a
Suppose an asset with of 1.25 has an RRR of 12%.
What are Rf and Rm?
(Or, what is MRP?)
Only TWO variables given. Need ONE MORE variable.
a. If Rf = 7%, then Rm=?
12% = 7% + 1.25 (Rm 7%) => Rm = 11%

b. If MRP = 4%, then Rf =? [=> Rm=?]

12% = Rf + (1.25 x 4%) => Rf = 7% [ => Rm = 7% + 4% = 11%]
c. If Rm = 11%, then Rf =?
12% = Rf + 1.25 (11% Rf ) => Rf = 7%
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Professor Banikanta Mishra

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Example-1b
Suppose Rf = 8%.
What is the RRR of an asset with of 1.50?
Only TWO variables given. Need ONE MORE variable.
a. If Rm = 13%, then?
RRR = 8% + 1.50 (13% - 8%) = 15.50%

b. If MRP = 5%, then?

RRR = 8% + (1.50 x 5%) = 15.50%

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Professor Banikanta Mishra

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Example-2a
Suppose an asset with of 1.25 has an RRR of 12%.

What should be the RRR for an asset with of 0.75?

Only THREE variables given. Need ONE MORE variable.
a. If Rf = 7%, then?
12% = 7% + (1.25 x MRP) => MRP = 4%
=> RRR another = 7% + (0.75 x 4%) = 10%
b. If MRP = 4%, then?
12% = Rf + (1.25 x 4%) => Rf = 7%
RRR another = 7% + (0.75 x 4%) = 10%
c. If Rm = 11%, then?
12% = Rf + [1.25 x (11% - Rf) ] => Rf = 7%
=> RRR another = 7% + [0.75 x (11% - 7% ] = 10%
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Professor Banikanta Mishra

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Example-2b
Suppose an asset with of 1.50 has an RRR of 15.50%.

AND an asset with of 0.80 has an RRR of 12.00%.

a. What is the RRR on an asset with = 1.20?
15.50% = Rf + (1.50 x MRP)
12.00% = Rf + (0.80 x MRP)
MRP = 5%, Rf = 8%
So, RRRanother = 8% + (1.20 x 5%) = 14.00%
b. What is Rm=?
As shown above, MRP = 5% and Rf = 8% => Rm = 8% + 5% = 13%
c. What is Rf=?
As shown above, Rf = 8%
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