FINANCIAL MANAGEMENT

(MBA 622)

CHAPTER FOUR

RISK & RETURN: PORTFOLIO THEORY, CAPM,

and APM

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 4.1 Meanings of Risk & Return

4.1.1 Meaning of Return

• Returns measure the financial results
of an investment
• Returns may be historical or
prospective (anticipated)
• Returns can be expressed in:
• Dollar/Birr terms
• Percentage terms
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 Example:

What is the return on an investment that costs

Br. 1,000 and is sold after 1 year for Br. 1,100?
• Dollar/Birr Return:
Birr Received - Birr Invested
Br. 1,100 - Br. 1,000 = Br. 100.
• Percentage Return:
Birr Return / Birr Invested
Br. 100 / Br. 1,000 = 0.10 = 10%.

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 4.1.2 Meaning of Risk

• Typically, returns are not known

with certainty
• Risk pertains to the probability of
earning a return less than that
expected.
• The greater the chance of a return
far below the expected return, the
greater the risk.

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 4.2 Measuring Risk

Probability
Distribution Stock X

Stock Y

Rate of
-20 0 15 50 return (%)

• Which stock is riskier? Why?

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 4.3 Risk & Return of a Single Asset

• The characteristics of individual

securities that are of interest are the:
• Expected Return
• Variance and Standard Deviation
• Coefficient of Variation

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 Measuring Expected Return

n
k̂ = k P.
i =1
i i

Where,
ḱ = expected rate of return
ki = possible future returns
Pi = probability of the return
occurring
n = total number of
possibilities
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 Measuring Risk- a Closer Look

 Standard deviation
  Variance   2

 k 
n
2
 i  k Pi .
i 1

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 Measuring Risk- a Closer…..

• Standard deviation measures the

stand-alone risk of an investment.
• The larger the standard deviation, the
higher the probability that returns will
be far below the expected return.
• Coefficient of variation (CV) is an
alternative measure of stand-alone
risk.
• CV = σ/ḱ

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 Example

Rate of Return
Scenario Probability Stock X Bond Y
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

Required: Compute the following for each

of the above assets:
1. Expected Returns (ḱ)
2. Standard Deviations (σ), and
3. Coefficients of Variation (CV)

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 4.4 Portfolio Theory & Risk
Diversification
Portfolio Theory
• Focus on portfolio risk rather than on
the risk of individual assets
• shows the possibility of constructing a
portfolio whose risk is smaller than
the sum of all its individual parts.

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 Return and Risk for Portfolios
Portfolio Return
The return on a portfolio is a weighted average of
the returns on the assets in the portfolio:
ḱp = w1ḱ1 + w2ḱ2 + … + wnḱn
Where,
ḱp = expected return of a portfolio
(P.)
ki = expected return of asset in the
P.
wi = proportion of each asset in the
P.
n =
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total number of assets in the
P.
 Return and Risk for Por…..
Portfolio Risk
• Not the simple weighted average of individual
assets’ standard deviations
• depends primarily on the ‘weighted’ co-
variances among assets
•Co-variances between asset returns for all pair
wise combinations of assets.

• σp = √∑∑ wiwj σi,j

•
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 Example

Scenario Stock Bond

Expected Returns (ḱ) 11% 7%

Risk (σ), 14.31% 8.16%

Required: Compute the following for the portfolio

of stock and bond with equal
proportion if the correlation coefficient,
ɤ1,2, is -1.0:

1. Portfolio Expected Returns (ḱp)

2. Portfolio Risk (σp)

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 Portfolio Risk/Return Two
Securities: Correlation Effects
 Relationship depends on correlation coefficient -1.0 < ɤ < +1.0
 The smaller the correlation, the greater the risk reduction
potential
 Ifɤ= +1.0, no risk reduction is possible

What would happen to the risk of portfolio as

more randomly selected stocks were added?

  would decrease because the added

p

stocks would not be perfectly correlated,

but ḱp would remain relatively constant.

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 Prob.
Large

0 15 Return
1 35% ; 2 20%.
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 4.6 Systematic Unsystematic Risks

Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Non-diversifiable risk;
Systematic Risk;
Market Risk
No.
Thus diversification can eliminate some, but not all of the
risk of individual securities.
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 Stand-alone Market Diversifiable
+
Risk = Risk Risk

 Market risk is that part of a security’s stand-alone

risk that cannot be eliminated by diversification.
 Firm-specific, or diversifiable, risk is that part of
a security’s stand-alone risk that can be eliminated
by diversification.
 Rational investors will not minimize risk by holding
only portfolios.
 They bear only market risk, so prices and returns
reflect this lower risk.

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 How is market risk measured for
individual securities?

 Market risk, which is relevant for stocks held

in well-diversified portfolios, is defined as the
contribution of a security to the overall
riskiness of the portfolio.
 It is measured by a stock’s beta coefficient,
which measures the stock’s volatility relative
to the market.
 What is the relevant risk for a stock held in
isolation?
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 Definition of Risk When Investors
Hold the Market Portfolio
 Researchers have shown that the best
measure of the risk of a security in a large
portfolio is the beta ()of the security.
 Beta measures the responsiveness of a
security to movements in the market portfolio.
Cov(ki , k M )
i 
 (k M )
2

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 How are betas calculated?

 Run a regression with returns on the stock

in question plotted on the Y axis and
returns on the market portfolio plotted on
the X axis.
 The slope of the regression line, which
measures relative volatility, is defined as
the stock’s beta coefficient, or .
 Analysts typically use four or five years’ of
monthly returns to establish the regression
line. Some use 52 weeks of weekly
returns.
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 Estimating with regression

Security Returns
i ne
c L
i
r ist
c te
ara
Ch Slope = i
Return on
market %

ki =  i + ikm + ei
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 Use the historical stock returns to
calculate the beta for XYZ.
Year Market XYZ
1 25.7% 40.0%
2 8.0% -15.0%
3 -11.0% -15.0%
4 15.0% 35.0%
5 32.5% 10.0%
6 13.7% 30.0%
7 40.0% 42.0%
8 10.0% -10.0%
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9 -10.8% -25.0%
 Calculating Beta for XYZ

kXYZ
40%

20%

0% kM
-40% -20% 0% 20% 40%
-20%

k XYZ = 0.83kM + 0.03

-40% 2
R = 0.36

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 How is beta interpreted?

 If b = 1.0, stock has average risk.

 If b > 1.0, stock is riskier than average.
 If b < 1.0, stock is less risky than
average.
 Most stocks have betas in the range of
0.5 to 1.5.

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 4.7 Capital Asset Pricing Model
(CAPM)
 The Capital Asset Pricing Model (CAPM) - an
equilibrium model of the relationship between risk
and return
 Expected Return on the Market:
k M k F  Market Risk Premium
 Expected return on an individual security:

k i k F  β i ( k M  k F )
Market Risk Premium
This applies to individual securities held within well-
diversified portfolios.
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 Expected Return on an Individual
Security
 This formula is called the Capital Asset Pricing
Model (CAPM)
Expected
return on = Risk-free + Beta of the × Market risk
rate security premium
a security

k i k F  β i ( k M  k F )

• Assume i = 0, then the expected return is kF.

• Assume i = 1, then k i k M
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 4.8 Security Market Line (SML)

Expected return k i k F  β i ( k M  k F )

kM

kF

1.0 

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 4.9 Implications & Relevance of CAPM

1. Implications
 Expected return is a function of:
1. Beta
2. risk free return
3. market return
2. Relevance
 CAPM tells us size of risk/return
tradeoff
 CAPM tells us the price of risk

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 4.10 The Arbitrage Pricing Model (APM)

• Arbitrage Pricing Theory: 1976, Ross

• Assumes:
• several factors affect Exp Return
• does not specify factors
• Implications
• Exp Return is a function of several factors, F
each with its own 

ki  k f 1 F1   2 F2   3 F3  ....   N FN

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 End of Chapter Four!

THANK YOU
For
Your
ATTENTION!

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