Chapter 8

Risk and Return

Capital Market
Theory

Portfolio Returns and Portfolio Risk

With appropriate diversification, you can
lower the risk of your portfolio without
lowering the portfolios expected rate of
return.
Those risks that can be eliminated by
diversification are not necessarily rewarded
in the financial marketplace.

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8-2

Calculating the Expected Return of a

Portfolio
To calculate a portfolios expected rate of
return, we weight each individual investments
expected rate of return using the fraction of
the portfolio that is invested in each
investment.

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Calculating the Expected Return of a

Portfolio (cont.)

E(rportfolio) = the expected rate of return on a

portfolio of n assets.
Wi = the portfolio weight for asset i.
E(ri ) = the expected rate of return earned by
asset i.
W1 E(r1) = the contribution of asset 1 to the
portfolio expected return.
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8-4

Evaluating Portfolio Risk: Portfolio

Diversification
The effect of reducing risks by including a
large number of investments in a portfolio is
called diversification.
The diversification gains achieved will depend
on the degree of correlation among the
investments, measured by correlation
coefficient.

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8-5

Portfolio Diversification (cont.)

The correlation coefficient can range from
-1.0 (perfect negative correlation), meaning
that two variables move in perfectly opposite
directions to +1.0 (perfect positive
correlation). Lower the correlation, greater will
be the diversification benefits.

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8-6

Diversification Lessons
1. A portfolio can be less risky than the
average risk of its individual investments in
the portfolio.
2. The key to reducing risk through
diversification - combine investments
whose returns are not perfectly positively
correlated.

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8-7

Calculating the Standard Deviation

of a Portfolios Returns

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8-8

Figure 8-1 Diversification and the

Correlation CoefficientApple and CocaCola

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8-9

Figure 8-1 Diversification and the

Correlation CoefficientApple and CocaCola (cont.)

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The Impact of Correlation Coefficient

on the Risk of the Portfolio
We observe (from figure 8.1) that lower the
correlation, greater is the benefit of
diversification.
Correlation between
investment returns

Diversification
Benefits

+1

No benefit

0.0

Substantial benefit

-1

Maximum benefit.
Indeed, the risk of
portfolio can be
reduced to zero.

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Systematic Risk and Market Portfolio

According to the CAPM, the relevant risk of an
investment relates to how the investment
contributes to the risk of this market portfolio.
CAPM assumes that investors chose to hold
the optimally diversified portfolio that includes
all of the economys assets (referred to as the
market portfolio).

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Systematic Risk and Market Portfolio

(cont.)
To understand how an investment contributes
to the risk of the portfolio, we categorize the
risks of the individual investments into two
categories:
Systematic risk, and
Unsystematic risk

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8-13

Systematic Risk and Market Portfolio

(cont.)
The systematic risk component measures
the contribution of the investment to the
risk of the market portfolio. For example:
War, recession.
The unsystematic risk is the element of
risk that does not contribute to the risk of
the market and is diversified away. For
example: Product recall, labor strike, change
of management.
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8-14

Diversification and Unsystematic

Risk
Figure 8-2 illustrates that, as the number of
securities in a portfolio increases, the
contribution of the unsystematic risk to the
standard deviation of the portfolio declines
while the systematic risk is not reduced. Thus
large portfolios will not be affected by
unsystematic risk.

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8-15

Figure 8.2 Portfolio Risk and the Number

of Investments in the Portfolio

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8-16

Systematic Risk and Beta

Systematic risk is measured by beta
coefficient, which estimates the extent to
which a particular investments returns vary
with the returns on the market portfolio. In
practice, it is estimated as the slope of a
straight line (see figure 8-3).

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8-17

Figure 8.3 Estimating Home Depots

(HD) Beta Coefficient

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8-18

Figure 8.3 Estimating Home Depots

(HD) Beta Coefficient (cont.)

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8-19

Beta
Table 8-1 illustrates the wide variation in
Betas for various companies. Utilities
companies can be considered less risky
because of their lower betas. For example,
based on the beta estimates, a 1% drop in
market could lead to a .74% drop in AEP but a
much greater 2.9% drop in AAPL.

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8-20

Table 8.1 Beta Coefficients for

Selected Companies

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8-21

Calculating Portfolio Beta

The portfolio beta measures the systematic
risk of the portfolio.

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8-22

Calculating Portfolio Beta (cont.)

Example Consider a portfolio that is comprised
of four investments with betas equal to 1.50,
0.75, 1.80 and 0.60 respectively. If you invest
equal amount in each investment, what will be
the beta for the portfolio?
= .25(1.50) + .25(0.75) + .25(1.80) + .25 (0.60)
= 1.16

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8-23

The Security Market Line and the

CAPM
CAPM describes how the betas relate to the
expected rates of return. Investors will
require a higher rate of return on
investments with higher betas.
Figure 8-4 provides the expected returns
and betas for portfolios comprised of market
portfolio and risk-free asset.

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8-24

Figure 8.4 Risk and Return for Portfolios

Containing the Market and the Risk-Free Security

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8-25

Figure 8.4 Risk and Return for Portfolios

Containing the Market and the Risk-Free Security
(cont.)

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8-26

The Security Market Line and the

CAPM (cont.)
The straight line relationship between the
betas and expected returns in Figure 8-4 is
called the security market line (SML), and
its slope is often referred to as the reward to
risk ratio.

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8-27

The Security Market Line and the

CAPM (cont.)
SML is a graphical representation of the CAPM.
SML can be expressed as the following
equation, which is often referred to as the
CAPM pricing equation:

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8-28

Using the CAPM to Estimate the

Expected Rate of Return
Equation 8-6 implies that higher the
systematic risk of an investment, other things
remaining the same, the higher will be the
expected rate of return an investor would
require to invest in the asset.

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