CHAPTER 8

To explore
- How risk affects the return of a security (or portfolio of
securities);
- How risk affects the value of a security (or portfolio) in
equilibrium.

Overview
1) Risk and return of a single asset
2) Risk and return of a portfolio
3) Asset Pricing
(i) Capital Asset Pricing Model (CAPM)
(ii) Arbitrage Pricing Theory (APT)
CHAPTER 8
Key Terms

• Expected Return

• Standard Deviation
- A measurement of risk

• Variance
RISK AND RETURN OF A SINGLE ASSET
RISK AND RETURN OF A SINGLE ASSET

Mean = 10+(-2)+0+5+7 / 5 = 20/5 = 4

Variance = Squared deviation / T-1

= (36+36+16+1+9)/(5-1)
= 98/4
= 24.5

Std Deviation = ?
RISK AND RETURN OF A SINGLE ASSET

• Risk is defined as the deviation of realised return

from its expectation.
• If the historical returns of an investment follow a
normal distribution, then risk can be proxied by its
standard deviation, given as:

Where
Rt = return of an investment at time t
R = is the mean return
RISK AND RETURN OF A SINGLE ASSET

Conditions when standard deviation can be used as a proxy

for risk:

1. The returns of the investment are normally distributed.

2. Investors have equal preference to both the upside and

down side deviation of returns from the mean.

3. Investors are not holding well diversified portfolio.

RISK AND RETURN OF A PORTFOLIO

Asset E(R) (Allocation ($) weight

A 10% 90 0.9

B 45% 10 0.1

C 40% 10 0.1

100 1

Don’t put all your eggs in one basket!

RISK AND RETURN OF A PORTFOLIO
k2
Forming a portfolio -> Diversification
• A portfolio is a combination of different assets held by
an investor.

• The share of the value of each individual asset over the

total value of the portfolio is referred to as the weight
of the asset in the portfolio.

• Sum of weights equals to 1.

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 RISK AND RETURN OF A PORTFOLIO
k2

Markowitz (1952) argues that combining different

investments in a portfolio can reduce the overall
standard deviation below the level obtained from
a simple weighted average calculation provided
that the investments are not all positively
correlated
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RISK AND RETURN OF A PORTFOLIO

The portfolio’s expected return is: k2

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 RISK AND RETURN OF A PORTFOLIO

The risk of a 2-asset portfolio (as measured k2

by its standard deviation) is:

 p  w   (1  w1 )   2w1 (1  w1 )Corr ( R1 , R2 ) 1 2
2 2
1 1
2 2
2
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RISK AND RETURN OF A PORTFOLIO

The risk of a 3-asset portfolio (as measured k2

by its standard deviation) is:

w   w2   w 
2 2 2 2 2 2
1 1 2 3 3
p 
 2 w1w2 12  2 w1w3 13  2 w2 w2 23
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RISK AND RETURN OF A PORTFOLIO
k2
Covariance
Measures how two random variables vary together (or
“co-vary”). Absolute measure
Covariance can be negative, positive or zero.
Its magnitude has no bounds.

Correlation Coefficient
A standardized measure of co-variation between two
random variables. Relative measure (ratio)
Always lies between -1.0 and +1.0.
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RISK AND RETURN OF A PORTFOLIO

The Correlation Coefficient between the returns on two k2

random variables (x and y) is computed as:

Correlation coefficient = Covariance between x and y

(Std Dev of x) (Std Dev of y)

 x.y
r x,y 
x y
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RISK AND RETURN OF A PORTFOLIO
Correlation Coefficient k2

A standardized measure of co-variation between two random

variables. Relative measure (ratio)
Always lies between -1.0 and +1.0.

Positive correlation
Returns of the 2 assets move in the same direction.

Negative correlation
Returns of the 2 assets move in opposite directions.

Uncorrelated
Returns of the 2 assets are independent of each other.
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RISK AND RETURN OF A PORTFOLIO
k2
Expected Return Std dev

Rose 4% 8.50%

Thorn 3% 5%

Assume equal weightage ( ie 50% invested in Rose and 50%

invested in Thorn).

Calculate Expected Return and Standard Deviation of portfolio

assuming 3 scenarios:
-When correlation coefficient = +1
-When correlation coefficient = 0
-When correlation coefficient = -1
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RISK AND RETURN OF A PORTFOLIO
k2
Expected Return Std dev

Rose 4% 8.50%

Thorn 3% 5%

Expected Returns of portfolio = 0.5(4%) + 0.5(3%)

= 3.5%
Standard deviation
When p = 1, std dev = 0.06745
When p = 0, std dev = 0.04924
When p = -1, std dev = 0.01732
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RISK AND RETURN OF A PORTFOLIO
k2
Perfect correlations

• When the returns on two stocks are perfectly positively

correlated (corr = +1), there is no diversification of the
risk.

• When the returns on two stocks are perfectly negatively

correlated (corr=-1), it is possible to diversify away ALL
of the risk by appropriate weighting of the two stocks.
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RISK AND RETURN OF A PORTFOLIO

ry

r1
r  1 r0

rx


x y

MEAN –STANDARD DEVIATION FRONTIER –

RISKY ASSETS ONLY ***
RISK AND RETURN OF A PORTFOLIO
k2
• What is on the mean- standard deviation frontier
(MSDF)of 2 assets?

• What determines the shape of the MSDF?

• When there are more than 2 assets, what happens to the

MSDF?
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RISK AND RETURN OF A PORTFOLIO

• What is the relationship between the number of available k2

securities and the gains from diversification?
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RISK AND RETURN OF A PORTFOLIO
Risk and Diversification k2
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RISK AND RETURN OF A PORTFOLIO
A security’s total risk is the sum of two parts:
Total risk = Diversifiable risk + Non-diversifiable risk k2

Unique Risk –
• Risk factors affecting only that firm. Also called
“diversifiable risk.” Examples: single product/location risk,
leadership risk.
• Diversification - reduces unique risk by spreading the
portfolio across many investments.

Market Risk –
• Economy-wide sources of risk that affect the overall stock
market. Also called “systematic risk.”
• Examples: political risk, foreign exchange risk, interest rate
risk.
• Market risk cannot be eliminated by diversification.
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RISK AND RETURN OF A PORTFOLIO
k2

• When there are more than 2 assets, what happens to the

MSDF?
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RISK AND RETURN OF A PORTFOLIO

1. For a single asset, the investor faces the entire variation of k2

returns of the asset.

2. A sensible, risk-averse investor should form portfolios with
many assets in order to eliminate “risk” or deviations /
variations in returns.
3. The portfolio’s risk will be minimised when a sufficiently
large number of assets are included in the portfolio.
4. In the absence of transaction costs, a rational investor will
combine all possible assets in the entire market in her
portfolio. The risk of such a portfolio must be the same as
the risk of the market.
5. Ultimately, everyone will hold the same most diversified
portfolio – The Optimal Portfolio or the Market
Portfolio.
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RISK AND RETURN OF A PORTFOLIO
Efficient Frontier – Portfolios of Risky Assets k2
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RISK AND RETURN OF A PORTFOLIO
• A portfolio is an efficient portfolio if k2

• It has the highest expected return for a given level of risk, or

• It has the lowest risk for a given level of return.

• Rational and risk-averse investors choose efficient portfolios over

inefficient ones.

• The set of efficient portfolios line the Efficient Frontier.

(only portfolios on the efficient frontier; no single assets)

• Area under the Efficient Frontier forms the Feasible region.

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RISK AND RETURN OF A PORTFOLIO

Introduction of a risk-free asset to a portfolio k2

• Risk free asset

E(R) = Rf
Std deviation = Zero

• Example – the US Treasury Bill is deemed to be risk free.

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RISK AND RETURN OF A PORTFOLIO

Introduction of a risk-free asset to a portfolio k2

• Asset allocation line (AAL)

The different portfolios of a risk-free asset and a risky asset.

• Optimal AAL –Capital Market Line (CML)

Comprises only efficient portfolios comprising a risk-free
asset and N risky assets.
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RISK AND RETURN OF A PORTFOLIO
k2
Capital Market Line
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RISK AND RETURN OF A PORTFOLIO
k2
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RISK AND RETURN OF A PORTFOLIO
k2
Discussion points
1. As a rational, risk-averse investor, would you prefer
to hold a portfolio on the CML or the Efficient
Frontier?

2. What does the tangent point M represent?

3. On the CML, can you hold a portfolio beyond point M?

How?
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RISK AND RETURN OF A PORTFOLIO
k2
• The market portfolio is the portfolio comprising ALL
risky assets, where the weight of each asset is the market
capitalisation (or market value) of that asset divided by
the total market capitalisation of all risky assets ( called
capitalisation weights).

• The market portfolio includes ALL risky assets

-all stocks, bonds traded on exchanges and over-the-
counter as well as non-financial assets ( e.g. real estate,
commodities, durable goods etc)
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RISK AND RETURN OF A PORTFOLIO
k2
Two – Fund Separation Theorem

• A risk-averse investor can form the optimal portfolio by combining

two funds:
1) Risk-free asset; and
2) Risky asset portfolio M (Optimal Risky Portfolio)

• The degree of risk-aversion determines thee portfolio weights placed

on the two funds.
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ASSET PRICING MODELS
k2

Objective
To determine the correct, arbitrage-free or fair
price of an asset in equilibrium.

Asset Pricing models

1) Capital Asset Pricing Model (CAPM)
2) Arbitrage Pricing Theory (APT)
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 CAPITAL ASSET PRICING MODEL (CAPM)

CAPM (Sharpe 1964 and Lintner 1965) k2

E(R) – expected return of an asset

Rf – risk-free rate of return
E(Rm) – Expected return of the market portfolio
B – asset beta
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 CAPITAL ASSET PRICING MODEL (CAPM)
k2
• Beta measures the risk of an asset relative to the market. It is the
market risk of an asset.
• This implies that we measure the covariance of the asset return
relative to the risk of the market.
• There is a linear relationship between an asset’s return and its beta. i.e.
the asset’s return has a linear relationship with its exposure to market
risk.
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CAPITAL ASSET PRICING MODEL (CAPM)
k2
Security Market Line (SML)
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CAPITAL ASSET PRICING MODEL (CAPM)
CAPM Assumptions k2

• Investors maximise their utility only on the basis of expected portfolio

returns and return standard deviations.
• Unlimited amounts can be borrowed or loaned at the risk-free rate.
• Markets are perfect and frictionless.
-No taxes on sales and purchases
-No transaction cost
-No short sale restrictions
• Investors have homogeneous beliefs about future returns; all investors
have the same information and assessment about expected returns,
standard deviations and correlations of all feasible portfolios.
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 APPLICATIONS OF THE CAPM
Expected
Under valued = Invest
Return SML
A
E(rA)

C
Over valued = Divest
B
Fairly valued
rf
BETA
1.0

Rational investors would buy Stock A to take advantage of its

undervaluation. If the market is efficient, the price
of Stock A will rise under it reaches the equilibrium.
CAPITAL ASSET PRICING MODEL (CAPM)
k2
Theoretical Limitation of CAPM

• The implementation of CAPM requires the use of proxies for the

market portfolio as the exact composition of the market portfolio is
unobservable.

• Roll (1977) argued that the unobservability of the market portfolio

makes the CAPM untestable.
Given that the quality of the proxies used for the market portfolio
cannot be guaranteed, it is not possible to test CAPM.
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CAPITAL ASSET PRICING MODEL (CAPM)
Theoretical Limitation of CAPM (continued) k2

2 possible situations (in the testing of CAPM)

• Market portfolio is efficient (CAPM is valid) but proxy chosen is

inefficient / inaccurate (incorrectly reject CAPM)

• The proxy for the market portfolio is efficient but the market portfolio
itself is not efficient ( incorrectly accept / validate CAPM)
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CAPITAL ASSET PRICING MODEL (CAPM)
k2
Practical Limitations of CAPM (Evidence against CAPM)

1. The slope of the SML has been found to be much flatter than one
would expect from the CAPM.

2. Factors other than beta (such as firm size, book-to-market ratio,

price-to-earnings ratio and dividend yield ) have been found in
empirical studies to explain ex-post returns.
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CAPITAL ASSET PRICING MODEL (CAPM)
k2
Key learning points of CAPM

1. Formula and what it tells you

2. SML – undervaluation and overvaluation of an asset
3. Theoretical and Practical limitations
4. Assumptions
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ALTERNATIVE PRICING MODELS
FACTOR MODELS
k2
Basic idea of a factor model -
All common variations in stock returns are generated in
one factor or a set of factors.

Statistical: use factors derived from factor analysis of the data set of security returns.

Macroeconomic: use observable economic time series, such as inflation and interest
rates, as measures of the shocks to security returns.

Fundamental: use the returns on portfolios associated with observed security

attributes, such as dividends yield, the book-to-market ratio, and industry identifiers.
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ALTERNATIVE PRICING MODELS
FACTOR MODELS
k2
One-factor Model
Assumes that stock returns are linearly related to one factor.

Ri = a + bF + e

a = expected returns if all factors have a value of zero.

F = value of the factor that affects the stock returns. The factor can bee
represented by macroeconomic conditions, financial conditions or
political events.
b = sensitivity of the stock returns to the factor F.
e = random error term. Mean value is zero.
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ALTERNATIVE PRICING MODELS
FACTOR MODELS
k2
General multi--factor Model
Assumes that stock returns are linearly related to a set of
factors.

Ri = a + b1F1 + b2F2+ …….+e

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ARBITRAGE PRICING THEORY (APT)
k2
Assumptions of APT
1. There are no arbitrage opportunities.
2. Returns of risky assets can be described by a factor model.
3. Financial markets are frictionless.
4. There is a large number of securities and so investors hold well
diversified portfolios. This implies that diversifiable risk does not
exist.
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ARBITRAGE PRICING THEORY (APT)
k2
Assumptions of APT
1. There are no arbitrage opportunities.
2. Returns of risky assets can be described by a factor model.
3. Financial markets are frictionless.
4. There is a large number of securities and so investors hold well
diversified portfolios. This implies that diversifiable risk does not
exist.
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ARBITRAGE PRICING THEORY (APT)
APT k2

With no arbitrage opportunities,

• it implies that assets with the same factor sensitivities must offer the
same expected returns in financial market equilibrium.

• As such, the expected risk premium on an asset depends on the sum of

expected risk premiums associated with each factor multiplied by the
asset sensitivity to each of these factors.
• Expected return of an asset
E(R) = Rf + b1F1 + b2F2 + …….
Rf = risk free rate
F1, F2 = risk premium over the risk free rate associated with factor n
b1, b2… = sensitivity to the factor
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ARBITRAGE PRICING THEORY (APT)
Expected return of an asset: k2

E(R) = Rf + b1F1 + b2F2 + …….

where
Rf = risk free rate
F1, F2 = risk premium over the risk free rate associated with factor n
b1, b2… = sensitivity to the factor.

The risk premium is affected only by macroeconomic

factors, and not unique risk ( similar to C APM).
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ARBITRAGE PRICING THEORY (APT)

Advantage k2

Does not require the identification and measurement of

the market portfolio.
Disadvantage
It does not tell us what the underlying factors are .
(CAPM collapses all the macroeconomic factors into the
market portfolio.)

**The theory is far from easy to implement.**

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