Risk & Return (Portfolio)

Risk & Return (Portfolio)
Basic Terminologies
Required Return: This
comprises of two element;
risk-free return and risk
premium
Risk-free return: This is
the return required by
investors to compensate
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Compiled by F O Boateng
Risk-free return serves as

compensation to investors
for inflation and consumption
preference. That is, the fact
they are deprived from using
their funds whilst tied up in
investment. T/Bill rate
normally used as surrogate.
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Risk Premium: This is the risk

that the future actual return
from a security may vary
from the expected return.
Thus,
if
an
investor
undertakes a risky investment
he needs to receive a greater
return than the risk-free rate
for compensation.
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For an instance, if an
investor holds shares in Q
plc. The shares of Q plc are
twice as risky as the market
with the assumption that, the
market returns is 11% and
the T/Bill rate is 6%. In this
scenario, the required rate of
return is calculated as:
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Required Return = Risk-free

rate (T/B) + [(market returns
risk-free rate (T/B)] x
6% + (11% - 6%) x 2
6% + 10
16%
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Thus 16% is the return

that the investor requires
to compensate for the
perceived level of risk in
A plc, i.e, it the discount
rate that needs to be
used to appraise an
investment in Q plc.
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Unsystematic/Specific
Risk: This refers to the impact
on a companys cash flow of
largely random events like
industrial relations problems,
equipment
failure,
R&D
achievement,
changes
in
senior management team etc.
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These random factors tend to

cancel out as the number of
investments in a portfolio
increase.
Systematic/Market
Risk:
These are general economic
(macro-economic) factors that
affect the cash flows all
companies in the stock market
in a consistent manner, e.g.,
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countrys economic
growth rate, corporate tax
rate, unemployment level,
and interest rates. Since
the factors can cause
returns to move in the
same direction, they
cannot cancel out.
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Expected Return: investors

receive their returns from
shares in the form of dividends
and capital gains/losses. The
formula for computing annual
returns on a share is:
Annual return = D1 + (P1
P0)
P0
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Where:
D1 = dividend per
share
P1 = year end share
price
P0 = share price at the
beginning
of the year.
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11
Illustration :
Assuming that a dividend of

5pessewas per share was
paid during the year on a
share whose value was 100
pessewas ath the beginning
of the year and 117pessewas
at the end of the year. The
annual returns would be:
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5 + (117 100) x 100

=22%
100
The total return is made up
of a 5% dividend yield and a
17% capital gain.
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THE CONCEPT OF RISK
Risk as defined in finance

literature is generally based
on the variability of the
actual return from the
expected return. Statistical
measures of variability are
the
variance
and
standard deviation (the
square root of the variance).
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The variance of returns is

apparently the weighted sum
of squared deviations from the
expected returns. The reason
for squaring the deviation is to
ensure that both positive and
negative deviations contribute
equally to the measure of
variability. Please consider the
following worked example:

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15
RISK AND RETURN ON TWO-ASSET

PORTFOLIOS.
ILLUSTRATION
The following table gives information

about four investments: A plc, B plc,
C plc and D plc. Assume that the
investor has decided to construct a
two-asset portfolio and that he has
already decided to invest 50% of the
funds in A plc. He is currently trying
to decide which one of the other
three investments into which will
invest the remaining 50% of his funds
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Returns on investments (%)

Market Conditions
plc
Boom
0.1
Normal
0.8
Recession
0.1
Probab
A plc B plc C plc D
30
20
10
30
20
10
10
20
30
Expected return
Standard deviation
20
20
20
20
4.47 4.47 4.47 4.47
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10
20
10
17
THE EXPECTED RETURN OF A TWO-ASSET

PORTFOLIO
This is computed as;
Rport = XRA + (1-x)RB,
Where; x = the proportion of funds invested in A.
(1-x) = the proportion of funds invested in B.
Therefore, Rport A+B = (0.5 * 20) + (0.5 * 20) =
20%
Rport A+C = (0.5 * 20) + (0.5 * 20) = 20%
Rport A+D = (0.5 * 20) + (0.5 * 20) = 20%
The expected return of a two-asset portfolio (Rport)
is simply the weighted average of the expected
returns of the individual investments.
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Given from the above, the expected

return is same for all portfolios, as
such; the investor will opt for the
portfolio that has the lowest risk as
measured by the portfolios standard
deviation
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THE STANDARD DEVIATION OF A

TWO-ASSET PORTFOLIO
From the scenario above, the
standard deviation of all individual
investments is 4.47%. Notably, you
may think that it does not really
matter which portfolio the investor
chooses as the standard deviation of
the portfolios should be the same
(because the deviations of the
individual investments are all same).
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However,
this
analysis
is
completely out of gear! This
is because a standard deviation
of a portfolio (port) is not
simply the weighted average
of the standard deviation of the
individual investment but is
generally
less
than
the
weighted average.
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This effect is caused by the

extent to which returns of
the two investments co-vary
or co-relate (i.e. move up
and down together),
measured by using either
covariance or correlation
coefficient terms.
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MEASURING COVARIABILITY
Covariance (absolute measure)
Positive covariance indicates
that the returns moves in the
same direction
Negative covariance indicates
that the returns move in
opposite direction
Zero covariance indicates that
the returns are independent
of each other.
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The formula for computing

covariance is; Cova,b =
a,bab
Correlation coefficient is a
relative mesaure of covariability
The formula for the standard
deviation of returns of a twoasset portfolio is: (port) =
a2x2 + b2(1-x)2 + 2X(1-x)
a,bab
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From the illustration above,

(assuming the correlation
coefficient of returns are;
+1, 0, and -1 for portfolios (A+B), (A+C) AND (A+D)
respectively) then the
portfolio risk for various
combination of investment
can be computed as folows;
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port (A+B) = (4.472 x 0.52) + (4.472 x

0.52) + (2 x 0.5 x 0.5) + 1(4.47 x
4.47)
= 4.47
port (A+C) = (4.472 x 0.52) + (4.472 x 0.52)
+ (2 x 0.5 x 0.5) 1(4.47 x 4.47)
= 0.00
port (A+D) = (4.472 x 0.52) + (4.472 x
0.52) + (2 x 0.5 x 0.5) 0(4.47 x 4.47)
= 3.16
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Summary
The expected return on a share
comprises of a dividend yield and
a capital gain/loss in percentage
terms,
The required rate of return on a
risky investment comprise the
risk-free rate and risk premium,
Total risks is normally measured
by the standard deviation of
returns (),
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Portfolio theory demonstrates

that it is possible to reduce risk
without having a consequential
reduction in return, i.e. the
portfolios expected return is
equal to the weighted average of
the expected returns on the
individual investments, whilst the
portfolio risks is normally less
than the weighted average of the
risk of individual investments.
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The extent of reduction is

basically influenced by
the way the returns on
investments co-vary,
normally measured by
correlation coefficient,
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A portfolios total risk

consists of systematic
and unsystematic risk.
However, a well
diversified portfolio
suffers from systematic
risk as the unsystematic
risk has been diversified,
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MEASUREMENT OF SYSTEMATIC
RISK
It is known that investors who hold welldiversified portfolios will find that the
risk affecting the portfolio is wholly
systematic. Unsystematic risk has been
diversified away. These investors may
want to measure the systematic risk of
each individual investment within their
portfolio, or of a potential new
investment to be added to the portfolio.
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A single investment is affected by

both systematic and
unsystematic risk but if an
investor owns a well-diversified
portfolio then only the systematic
risk of that investment would be
relevant. If a single investment
becomes part of a well-diversified
portfolio the unsystematic risk
can be ignored.
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The systematic risk of an

investment is measured by
the
covariance
of
an
investment's return with the
returns of the market.
Once the systematic risk of
an investment is calculated, it
is then divided by the market
risk, to calculate a relative
measure of systematic risk.
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This relative measure of risk is

called the beta' and is usually
represented by the symbol .
If an investment has twice as
much systematic risk as the
market, it would have a beta
of two. There are two different
formulae for beta. The first is:
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You must commit both

formulae to memory, as they
are not given on the exam
formulae sheet. The formula
that you need to use in the exam
will be determined by the
information given in the question.
If you are given the covariance,
use the first formula or if you are
given the correlation coefficient,
use the second formula.
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Example 2
You are considering investing in Y
plc. The covariance between the
company's returns and the return
on the market is 30%. The
standard deviation of the returns
on the market is 5%.
Calculate the beta value:
e = 30% = 1.2
52%

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Example 3
You are considering investing in Z
plc. The correlation coefficient
between the company's returns and
the return on the market is 0.7. The
standard deviation of the returns
for the company and the market
are 8% and 5% respectively.
Calculate the beta value:
e = 0.7 x 8% = 1.12
5%
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Investors make investment

decisions about the future.
Therefore, it is necessary to
calculate the future beta.
Obviously, the future cannot
be foreseen. As a result, it is
difficult to obtain an estimate
of the likely future comovements of the returns on a
share and the market.
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However, in the real world the

most popular method is to
observe the historical
relationships between the
returns and then assume that
this covariance will continue into
the future. You will not be
required to calculate the
beta value using this
approach in the exam.
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TheCAPMFormula
The capital asset pricing model
(CAPM) provides the required
return based on the perceived
level of systematic risk of an
investment:
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The calculation of the

required return
Example 4
The required return on a share
will depend on the systematic
risk of the share. What is the
required return on the following
shares if the return on the
market is 11% and the risk free
rate is 6%?
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The shares in B plc have a beta

value of 0.5
Answer: 6% + (11% - 6%) 0.5 =
8.5%
The shares in C plc have a beta
value of 1.0
Answer: 6% + (11% - 6%) 1.0 =
11%
The shares in D plc have a beta
value of 2.0
Answer: 6% + (11% - 6%) 2.0 =
16%.
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Obviously, with hindsight

there was no need to
calculate the required return
for C plc as it has a beta of
one and therefore the same
level of risk as the market
and will require the same
level of return as the
market, ie the RM of 11%.
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The meaning of beta
The CAPM contends that shares

co-move with the market. If the
market moves by 1% and a
share has a beta of two, then
the return on the share would
move by 2%. The beta
indicates the sensitivity of
the return on shares with
the return on the market.
Some companies' activities are
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more sensitive to changes in the

market - eg luxury car
manufacturers - have high betas,
while those relating to goods and
services likely to be in demand
irrespective of the economic cycle
- eg food manufacturers - have
lower betas. The beta value of 1.0
is the benchmark against which
all share betas are measured
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Beta > 1 - aggressive shares

These shares tend to go up faster
then the market in a rising (bull)
market and fall more than the
market in a declining (bear) market.
Beta < 1 - defensive shares
These shares will generally
experience smaller than average
gains in a rising market and smaller
than average falls in a declining
market.
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Beta = 1 - neutral shares

These shares are expected
to follow the market.
The beta value of a share
is normally between 0 and
2.5. A risk-free investment
(a treasury bill) has a = 0
(no risk).
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Basic exam application of

CAPM
Capital investment
decisions
The calculation of Ke in the
WACC calculation to enable
an NPV calculation
A shareholder's required return
on a project will depend on the
project's perceived level of
systematic risk.
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Different projects generally have

different levels of systematic risk
and therefore shareholders have a
different required return for each
project. A shareholder's required
return is the minimum return the
company must earn on the project
in order to compensate the
shareholder. It therefore becomes
the company's cost of equity.
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Example 5
E plc is evaluating a project
which has a beta value of 1.5.
The return on the GSE All-Share
Index is 15%. The return on
treasury bills is 12%.
Required:
What is the cost of equity?
Answer:
5% + (15% - 12%) 1.5 = 9.5%
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Stock market investment

decisions
When we read the financial
section of newspapers, it is
commonplace to see analysts
advising us that it is a good time
to buy, sell, or hold certain shares.
The CAPM is one method that may
employed by analysts to help
them reach their conclusions.
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An analyst would calculate the

expected return and required
return for each share. They
then subtract the required return
from the expected return for
each share, ie they calculate the
alpha value (or abnormal return)
for each share. They would then
construct an alpha table to
present their findings.

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Example 6
We are considering investing in F plc or
G plc. Their beta values and expected
returns are as follows:
Beta values
Expected returns
F plc 1.5 18%
G plc
1.1 18%
The market return is 15% and the riskfree return is 5%.
Required:
What investment advice would you give
us?
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Answer:
Alpha table:
Expected
Required
return returns values
Alpha
F plc
18%
5% + (15% - 5%) 1.5 = 20%
-2
Gplc
8%
5% + (15% - 5%) 1.1 = 16%
+2%
Sell shares in F plc as the expected return does
not compensate the investors for its perceived
level of systematic risk, it has a negative alpha.
Buy shares in G plc as the expected return more
than compensates the investors for its perceived
level of systematic risk, ie it has a positive alpha.
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The preparation of an alpha

table for a portfolio (the
portfolio beta is a weighted
average)
A common exam-style question is
a combined portfolio theory and
CAPM question. A good example
of this is the Boateng plc question
at the end of this article where
you are asked to calculate the
alpha table for a portfolio.
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The expected return of the

portfolio is calculated as normal (a
weighted average) and goes in
the first column in the alpha table.
We then have to calculate the
required return of the portfolio. To
do this we must first calculate the
portfolio beta, which is the
weighted average of the individual
betas. Then we can calculate the
required return of the portfolio
using the CAPM formula.
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Example 7
The expected return of the portfolio A + B is
20%. The return on the market is 15% and
the risk-free rate is 6%. 80% of your funds
are invested in A plc and the balance is
invested in B plc. The beta of A is 1.6 and
the beta of is 1.1.
Required:
Prepare the alpha table for the Portfolio
(A + B)
Answer:
(A + B) = (1.6 .80) + (1.1 .20)
= 1.5
R portfolio (A + B) = 6% + (15% - 6%) 1.5 =
19.50%
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Alpha table
Expected return
value
Required return
Alpha
Portfolio (A + B) 20%
19.50% 0.50%
The Alpha Value
If the CAPM is a realistic model (that is, it
correctly reflects the risk-return
relationship) and the stock market is
efficient (at least weak and semi-strong),
then the alpha values reflect a temporary
abnormal return. In an efficient market,
the expected and required returns
are equal, ie a zero alpha.
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Investors are exactly

compensated for the level of
perceived systematic risk in
an investment, ie shares are
fairly priced. Arbitrage profit
taking would ensure that any
existing alpha values would
be on a journey towards zero.
.
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Remember in Example 6 that the

shares in G plc had a positive alpha
of 2%. This would encourage
investors to buy these shares. As a
result of the increased demand, the
current share price would increase,
thus the expected return would fall.
The expected return would keep
falling until it reaches 16%, the level
of the required return and the alpha
becomes zero
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The opposite is true for shares

with a negative alpha. This
would encourage investors to
sell these shares. As a result of
the increased supply, the current
share price would decrease thus
the expected return would
increase until it reaches the level
of the required return and the
alpha value becomes zero.
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It is worth noting that when the

share price changes, the expected
return changes and thus the alpha
value changes. Therefore, it can be
said that alpha values are as
dynamic as the share price. Of
course, alpha values may exist
because CAPM does not perfectly
capture the risk-return relationship
due to the various problems with
the model.
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Problems with CAPM

1. Investors hold well-diversified
portfolios
CAPM assumes that all the company's
shareholders hold well-diversified portfolios
and therefore need only consider
systematic risk. However, a considerable
number of private investors in the UK do
not hold well-diversified portfolios.
2. One period model
CAPM is a one period model, while most
investment projects tend to be over a
number of years.
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3.Assumes the stock market is a

perfect capital market
This is based on the following
unrealistic assumptions:
no individual dominates the market
all investors are rational and riskaverse
investors have perfect information
all investors can borrow or lend at
the risk-free rate
no transaction costs.
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4. Estimation of future based on

past
A scatter diagram is prepared of the
share's historical risk premium plotted
against the historical market risk
premium usually over the last five
years. The slope of the resulting line of
best fit will be the b value.
The difficulty of using historic data
is that it assumes that historic
relationships will continue into the
future. This is questionable, as betas
tend to be unstable over time.
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Exam style question
Boateng plc
Boateng plc is considering investing
in one of two short-term portfolios of
four short-term financial investments.
The correlation between the returns
of the individual investments is
believed to be negligible
(zero/independent/no correlation).
See Portfolio 1 and Portfolio 2. The
market return is estimated to be
15%, and the risk free rate 5%.
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Investment Amounts Expected Totalrisk Beta

invested
return
million
10
20%
0.7
40
22%
10
1.2
30
24%
11
1.3
20
26%
1.4
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Investment Amounts Expected Totalrisk Beta

invested return
million
20
18%
0.8
40
20%
1.1
20
22%
12
1.2
20
16%
13
1.4
Required: Estimate the risk and return of

the two portfolios using the principles of
both portfolio theory and CAPM and decide
which one should be selected
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Answer
The CAPM calculations - the
application of CAPM
principles in the exam means
the preparation of the alpha
table to find the portfolio with
the largest positive alpha.
See Portfolio 1 Solution and
Portfolio 2 Solution.
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The required return: 5 + (15 - 5) 1.22 = 17.20%

Portfolio 2 Solution
The required return: 5 + (15 - 5) 1.12 = 16.20%
Investment
Investment
weightings
Portfolio
Expectedreturn
expectedreturn Beta
(%)
(%)
Portfoliobeta
.1
20
2.00
0.7
.07
.4
22
8.80
1.2
.48
.3
24
7.20
1.3
.39
.2
26
5.20
1.4
.28
23.20
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1.22
72
Investment
Investment
weightings
Expectedreturn(%)
Portfolioexpected
return(%)
Beta
.2
18
3.60
0.8 .16
.4
20
8.00
1.1 .44
.2
22
4.40
1.2 .24
.2
16
3.20
1.4 .28
19.20
10/19/15
Portfolio
beta
1.12
73
Alpha table:
Expected
returns
Required
returns
Alpha
values
Portfolio 1
23.20%
17.20%
6.00%
Portfolio 2
19.20%
16.20%
3.00%
Portfolio 1 is chosen because it

has the largest positive alpha
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Key issues:
1. The beta is a relative measure of

systematic risk. It indicates the
sensitivity of the return on a share with
the return on the market. If the market
moves by 1% and a share has a beta
of two, then the return on the share
would move by 2%.
2. We may have to calculate the beta
from basic data using the following two
different formulae:
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3. Ensure that you know how to calculate the

required return using the CAPM formula:
Required Return = RF + (RM - RF) beta
10/19/15
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Risk & Return (Portfolio)

Risk-free return serves as

Risk Premium: This is the risk

Required Return = Risk-free

Thus 16% is the return

These random factors tend to

Expected Return: investors

Assuming that a dividend of

5 + (117 100) x 100

THE CONCEPT OF RISK

Risk as defined in finance

The variance of returns is

following worked example:

RISK AND RETURN ON TWO-ASSET

The following table gives information

Returns on investments (%)

A plc B plc C plc D

THE EXPECTED RETURN OF A TWO-ASSET

Given from the above, the expected

THE STANDARD DEVIATION OF A

This effect is caused by the

The formula for computing

From the illustration above,

port (A+B) = (4.472 x 0.52) + (4.472 x

Portfolio theory demonstrates

The extent of reduction is

A portfolios total risk

A single investment is affected by

The systematic risk of an

This relative measure of risk is

You must commit both

Investors make investment

However, in the real world the

The calculation of the

The shares in B plc have a beta

Obviously, with hindsight

The meaning of beta

The CAPM contends that shares

more sensitive to changes in the

Beta > 1 - aggressive shares

Beta = 1 - neutral shares

Basic exam application of

Different projects generally have

Stock market investment

An analyst would calculate the

present their findings.

The preparation of an alpha

The expected return of the

Investors are exactly

Remember in Example 6 that the

The opposite is true for shares

It is worth noting that when the

Problems with CAPM

3.Assumes the stock market is a

4. Estimation of future based on

Exam style question

Investment Amounts Expected Totalrisk Beta

Investment Amounts Expected Totalrisk Beta

Required: Estimate the risk and return of

The required return: 5 + (15 - 5) 1.22 = 17.20%

Portfolio 1 is chosen because it

1. The beta is a relative measure of

3. Ensure that you know how to calculate the