Risk, Return, and the

Capital
Asset Pricing Model
Muhammad Abubakr Naeem

5-1

Risk and Rates of Return

How do you determine the rate of return that an
investment in a new, fixed asset should
provide?
It will depend on the projects risk. But how do
you define risk? And how do you measure
risk?
And once youve measured the risk, how do you
determine the rate of return that is appropriate
for that risk?
5-2

Calculating Rates of Return for

Stocks
One way to express an investments return is in dollar
terms:
Dollar return = Amount to be received ) Amount
invested )
=PKR 1,100 PKR 1,000
=PKR 100
A stocks rate of return for a past or future year is
calculated by:

5-3

What is Risk?
Risk refers to the chance that some unfavorable
event will occur.
The greater the chance of lower than expected or
negative returns, the riskier the investment.
Two types of investment risk
Stand-alone risk
An assets stand-alone risk is the risk an investor
would face if she held only this one asset.
Portfolio risk
Portfolio is a combined holding of more than one
asset.
5-4

Probability Distributions
An events probability is defined as the chance that the
event will occur.
Probability Distribution A list of all the possible
outcomes of a future event together with the
probability (chance of occurrence) for each outcome.
You can calculate the mean (expected value), the
standard deviation, and the variance of a probability
distribution.

5-5

Calculating Expected Returns

for Stocks
The expected value of returns or expected return for
a stock is the weighted average of the possible outcomes
(possible returns) where the weights are the probabilities
associated with the outcomes.
If there are n possible outcomes for a given stock:

r Pr1 (k1 ) Pr2 (k 2 ) Prn (k n )

n

Pri (ki )
i 1

5-6

Measuring the Risk of Investment:

The Variance of Returns
The standard deviation, denoted by sigma(), is a measure
of the variability, tightness, or spread of a set of outcomes
expressed in a probability distribution.
Variance (2) is the standard deviation squared.
Variance is the expected value of the squared deviations.
Deviationi =(k k)
i

Variance (ki k ) Pri

2

i 1

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5-8

Coefficient of Variation (CV)

A standardized measure of dispersion
about the expected value, that shows
the risk per unit of return.

Stddev
CV
^
Mean
k

5-9

How Investors View Risk and

Return
Investors like return. They seek to maximize
return.
But investors dislike risk. They seek to avoid or
minimize risk. Why?
Because human beings possess the psychological trait
of risk aversion which is a dislike for taking risks.

Risk averse investors will diversify their

investments in order to reduce risk.
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Diversification
Definition - An investment strategy designed to
reduce risk by spreading the funds across many
investments.
It is holding a broad portfolio of investments so as not
to have all your eggs in one basket.
Since people hold diversified portfolios of securities,
they are not very concerned about the risk and return
of a single security. They are more concerned about
the risk and return of their entire portfolio.

5-11

The Expected Return on a Portfolio

of Stocks
Assume N stocks are held in the
portfolio.
in the proportion, wi
Stock i is held
N

w
i 1

1.00

k p w1k1 w2 k 2 wN k N
N

k p wi ki
i 1

5-12

The Variance of Returns for a

Portfolio of Stocks
N

Portfolio Variance p2 wi i 2 wi w j ij
2

i 1

i 1 j 1

wi i 2 wi w j ij i j
2
p

i 1

i 1 j 1

ij= the covariance between stocks i and j

ij= the correlation coefficient for stocks i and j
5-13

Correlation Coefficient
The Correlation Coefficient is a measure of the
extent that two variables move or vary together.
It ranges between 1.0 and +1.0
Positive correlation: a high value on one variable is
likely to be associated with a high value on the other.
Negative correlation: a high value on one variable is
likely to be associated with a low value on the other.
No correlation: values of each are independent of the
other

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Correlation Coefficient-Contd
It is denoted by the Greek letter, rho:
If = +1.0, perfect positive correlation
If = -1.0, perfect negative correlation
If = 0, uncorrelated or independent
ij = the correlation coefficient for returns of
stock i and stock j

5-15

How Diversification Reduces Risk

Combining stocks into a portfolio reduces the
variability of possible returns as long as the returns on
the individual stocks are not perfectly correlated, i.e.
as long as their correlation coefficients are less than
+1.0.
Assume:
Invest 60% in Stock A and 40% in Stock B
Stock A: r = 8%; = 20%,
Stock B: r = 12%; = 30%

5-16

How Diversification Reduces Risk Contd

Ptf. exp. return : rp w1r1 w2 r2 .6 * 8% .4 *12% 9.6%
Ptf. Std. Dev : p w12 12 w22 22 2( w1w2 12 1 2 ) 12%
rp

Stdev

12.00% 30.00%
11.20% 22.27%
10.40% 15.62%

13.00%
12.00%
11.00% Global Minimum Variance
10.00%

9.60% 12.00%

9.00%

8.80% 14.00%

8.00%

8.00% 20.00%

7.00%
10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

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Correlatio
n

30.000%

Standard
deviation

25.000%

24.00%
20.000%

0.5

20.78%
15.000%

16.97%
10.000%

-0.5

12.00%
5.000%

-1

0.00%
-1.5

-1

-0.5

0.000%
0

0.5

1.5

5-18

The Two Components of a

Securitys Variance (Risk)
1. Unique Risk - Also called diversifiable risk and
unsystematic risk. The part of a securitys risk
associated with random outcomes generated by events
specific to the firm. This risk can be eliminated by proper
diversification.
2. Market Risk Also called systematic risk. The part
of a securitys risk that cannot be eliminated by
diversification because it is associated with economic or
market factors that systematically affect most firms.
Market risk reflects economy-wide sources of risk that
affect most firms and, hence, the overall stock market.
5-19

Portfolio Risk Falls As You Add

Securities

5-20

You Cant Eliminate Market

Risk

5-21

This Pattern Occurs Because of the Two

Components of a Stocks Variance (Risk):
1. Unique Risk
2. Market Risk
The unique risk is diversified away when individual
stocks are combined in a portfolio.
Only market risk remains.
The amount of the market risk is determined by the
market risk of the individual stocks in the portfolio.

5-22

How Should We Measure

Portfolio Risk Now?
Diversification eliminates unique risk and leaves
market risk.
Therefore, the relevant measure of risk for a
portfolio is the portfolios beta:
Beta measure of a securitys systematic risk,
describing the amount of risk contributed by the
security to the market portfolio.
A measure of the sensitivity of the portfolios returns to
changes in the return on the market portfolio.
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How Do Investors View the Risk of a Single Security

Held in a Portfolio?
Answer: Beta Measures a Stocks Market Risk

im
Bi 2
m

Covariance with the

market

Variance of the market

5-24

How to Interpret a Beta

If i > 1, returns to stock i are amplified relative to the

market.
If i is between 0 and 1.0, returns to stock i tend to move
in the same direction as the market but not as far.
If i < 1(very rare), returns to stock i tend to move in the
opposite direction as the market.

5-25

How To Interpret a Beta-Contd

A stock with = 1 has average market risk.
A well-diversified portfolio of such stocks
tends to move by the same percentage as
the overall market moves and has the same
as the overall market.
A stock with = +.5 has below average market
risk.
A well-diversified portfolio of these stocks
tends to move half as far as the overall
market moves and has half the standard
deviation
5-26

A model that relates an assets risk

to its rate of return
The Capital Asset Pricing Model won the Nobel
Prize in economics in 1990.
A model that describes the relationship between
risk and expected return and that is used in the
pricing of risky securities.
CAPM seeks to predict:
What will be the relationship between expected return and
risk for portfolios?
What will be the relationship between expected return and
risk for individual securities?

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Capital Asset Pricing Model

ki = kRF + Bi ( kM - kRF )

CAPM
5-28

CAPM Graphically: The Security Market Line

Return
SML

kRF
BETA

5-29

The Security Market Line (SML):

Calculating required rates of return
SML: ki = kRF + (kM kRF) i
Assume kRF = 8% and kM = 15%.
The market (or equity) risk premium is RPM = kM kRF =
15% 8% = 7%.
Beta
ki
22.00
2
%
18.50
1.5
%
15.00
1
%
11.50
0.5
5-30
%

An example:
Equally-weighted two-stock portfolio
Create a portfolio with 50% invested in HT and 50%
invested in Collections.
The beta of a portfolio is the weighted average of each
of the stocks betas.
P = wHT HT + wColl Coll
P = 0.5 (1.30) + 0.5 (-0.87)
P = 0.215

5-31

Factors that change the SML

What if investors raise inflation expectations
by 3%, what would happen to the SML?
ki (%)

I = 3%

18
15

SML2
SML1

11
8
Risk, i
0

0.5

1.0

1.5

5-32

Factors that change the SML

What if investors risk aversion increased,
causing the market risk premium to increase
by 3%, what would happen to the SML?
ki (%)

RPM = 3%

SML2
SML1

18
15
11
8

Risk, i
0

0.5

1.0

1.5

5-33

Some Concerns about the CAPM

Investors seem to be concerned with both market risk
and total risk. Therefore, the SML may not produce a
correct estimate of ki.
Investors argue that there are additional risk factors,
other than the market risk premium, that must be
considered.
ki = kRF + (kM kRF) i + ???
Historical Data
Linearity Issue
Normality Issue
Stationarity Issue
5-34