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 RISK DIVERSIFICATION, CML, SML, CAPM

WARES BE GOOFING
80060008 2851
Understand Risk Return Relationship

Concept of diversification
t
Variance Covariance Correlation

Efficient frontier
to
CAL CML SML
to
systematic res
unsystematic risk

what B Beta 2
to
CARMI

SUCCESSRBI@ANUJJINDAL.IN 1
 RISK DIVERSIFICATION, CML, SML, CAPM

RISK AND RETURN; DIVERSIFICATION

• Risk is present in every decision and every investment. the purpose of financial
manager is not to avoid or eliminate risk but to assess it properly so as to determine
the required return based on the level of risk.
• Every investor is risk averse but level of risk tolerance varies from person to person.

ii
The objective of portfolio manager is to create the right portfolio according to risk
tolerance level of investor. I use the word “portfolio manager” because to optimize
risk-return relationship by minimizing risk, a portfolio (collection) of investments is
created in order to diversify risk. Risk
• Diversification allows an investor to reduce portfolio risk without necessarily averse
reducing portfolio’s expected return. Rememberthis vs
Questions to answerto Risk
Is every investor risk averse1 what is the cliff tolerance
between risk
aversion and risk tolerance
is ofa
Importance diversification
what portfolio

longterm Marginrequired
of Rt
immomneediately
Types of Investors: Level required or
short TA
F 94term 9 not
Investor Risk Tolerance Investment Liquidity needs Income needs
Horizon
Individuals Depends on the Depends on the Depends on the Depends on the
individual individual individual individual
Banks Low Short High Pay interest
Endowments High Long Low Spending level
Insurance Low Long- life High Low
Short- property
Mutual funds Depends on the Depends on the High Depends on the
fund fund fund
Defined benefit High Long Low Depends on age
pension

SUCCESSRBI@ANUJJINDAL.IN 2
 RISK DIVERSIFICATION, CML, SML, CAPM

Quiz:

1. Which of the following is a benefit of diversification?

a. Increase in expected rate of return
b. Decrease in volatility of returns
c. Increase in probability of high returns

Answer- b
high or very low returns become less likely
very
Risk goes down
2. Portfolio diversification is least likely to protect against losses:
a. During severe market turmoil
b. When markets are operating normally
c. When portfolio securities have low return correlation

Answer- a

we will be covering markets in systematic risk

severe mkt turmoil is a kind
of systematic risk
To get a headstart you can google it
3. Low risk tolerance and high liquidity requirements are investment needs of:
a. Defined benefit pension plan
b. Insurance company
c. A bank
d. An endowment
e. A foundation

Answer- b
obligations
Due to regulatory

4. In a defined contribution pension plan:

a. The employee accepts investment risk
b. The plan sponsor promises a predetermined retirement income to
participants
c. The plan manager attempts to match fund’s assets to its liabilities

Answer- a contribution us Defined Benefitgoogle.FI

Defined
SUCCESSRBI@ANUJJINDAL.IN 3
 RISK DIVERSIFICATION, CML, SML, CAPM

5. Consider the following statements concerning diversification and identify the correct
one:
reding
a. Diversification allows to reduce portfolio risk without necessarily increasing
returns
b. Diversification allows to reduce portfolio return without necessarily
increasing risk.
c. Diversification allows to reduce portfolio risk and simultaneously increasing
returns
d. Diversification allows to reduce portfolio return and simultaneously
increasing risks

Answer- a

Example
AnTvestor has in
small cap from which
invested a
has very high risk along with high variation in
returns In one year it gives w 3070 returns white
in another it fails to grow at all
under diversification the investor can combine this asset
inv with a pensionfund inv which has low risks and
low to average TretumT
The result will be lower risk and higher or similar
returns we will solve it mathematically later

SUCCESSRBI@ANUJJINDAL.IN 4
 RISK DIVERSIFICATION, CML, SML, CAPM

• Risk can be diversifiable or non-diversifiable.

• Diversifiable risk is that kind of risk which can be diversified by specific techniques. it
is company specific in nature alsocalled non systematic
• Non-Diversifiable risk is that kind of risk, which cannot be diversified as it is market
specific. alsocalled systematic
• Most people invest in a portfolio of assets, as they do not want to put all their eggs
in one basket. Portfolio thus means a collection of different kinds of investments
(equity, debt, preference, derivatives etc)
• Expected return on a portfolio is the weighted average of expected returns on assets
comprising the portfolio.
EXAMPLE
aThe sales team of Dade is not as aggressive as thatof
Patanjali Due to a smaller less qualified team Pane is
losing market share and sales This is company specificrisk
a Due to financial crisis sales
of Harley davidson bikeshas
down as mass lag offs high unemployment leave peoplewith
gone
1 money This is market specific risk
no less
Variance, covariance and correlation are used to measure risk return relationship. Before
getting through to CML and SML concept, let us understand these 3 terms:

look simpleterms deviationfromexpectedreturns

in
Theyjust Higher deviation means more 295k
scary Very • Variance and standard deviation are common measures of investment risk. Both of
1
simple them are measures of variability of a distribution of returns about its mean or
concepts expected value.
t
Deviation withrespect
to mean
• Variance is square of standard deviation.

• Covariance measures the extent to which two variables move together over time.
• Positive covariance means that returns on two stocks move together.
• Negative covariance means that returns on two stocks move in opposite directions.
• Zero covariance means no linear relationship

Examples

Arf
fern
Positive
f
frnegative
covariance
covariance
SUCCESSRBI@ANUJJINDAL.IN 5
 RISK DIVERSIFICATION, CML, SML, CAPM

• The problem with covariance is that it does not tell us about degree of relationship
between returns of two variables.
• In order to create a better measure, we find correlation, which tells us the degree of
relationship as it is a pure measure bounded between -1 to +1

CORRELATION is an improvement over COVARIANCE

Examplei
covariance IDEAbetween stockA and stockB
of weak the relation is
we don't know how strong or
between stock't and stockB
16
correlation
of t.DE between
complete positive relationship
it means perfect
A and B

Quiz:

1. An investor buys a share of stock for $ 40 at time t=0. He buys another share of the
same stock for $ 50 at time t=1. He sells both shares for $ 60 each at time t=2. The
stock paid a dividend of $ 1 per share at t=1 and t=2. The internal rate of return on
investment is:
a. 22.2%
b. 23%
c. 23.8%

Answer- c

Cashflowo 40
Cash flow 50 1 I 49
Cashflow 60 2 2 122
internal Rate of Return 23.82
learnt In financial
management
video lectures

SUCCESSRBI@ANUJJINDAL.IN 6
 RISK DIVERSIFICATION, CML, SML, CAPM

2. In a five year period, the annual returns on an investment are 5%, -3%, -4%, 2% and
6%. The standard deviation of annual returns on this investment is closest to:
a. 4%
b. 4.5%
c. 20.7%

Answer- b

can recall SD is calculated about its mean

If Mean
youannual return 5 t l 3 t l 4 1216 5 1 2
Deviationsfoomineau squareit.to indranance
5 l Z lo
3 lZ
3.870 3872 14.44 ariane
4.2 f 4.272 17.64 20.7
5 240zag
8,2482
4 1.2 5.222 27.04
2 i 2 o 8 0.872 a o 64 SDI
G l 27 4.8 4.812 23
012 12 4.5570
s go

o
3. A measure of how returns of two risky assets move in relation to each other is:
a. Range
b. Covariance
c. Standard deviation

Answer- b

explainedaboic

4. Which of the following statements about correlation is least accurate?

a. Diversification reduces risk when correlation is less than +1
b. If correlation coefficient is 0, a zero variance portfolio can be constructed
c. The lower the correlation coefficient, the greater the potential benefits from
diversification

Answer- b correlation coefficient is 1

zero variance portfolio if SUCCESSRBI@ANUJJINDAL.IN 7
 RISK DIVERSIFICATION, CML, SML, CAPM

5. Which of the following statements about risk-averse investors is most accurate? A

risk averse investor:
a. Seeks out the investment with minimum risk, while return is not a major
consideration
b. Will take additional risk if sufficiently compensated for this risk
c. Avoids participation in global equity markets

Answer- b

The difference between risk averse and

risk tolerance gets us the answerhere

SUCCESSRBI@ANUJJINDAL.IN 8
 RISK DIVERSIFICATION, CML, SML, CAPM

Before going towards CML and SML, it is now importance to understand efficient frontier:

Remember ITotalRiskTl

• The above efficient frontier is calculated using correlation between risks of two
assets.

• When correlation between asset returns is +1, there is greatest portfolio risk.
• When correlation is less than +1, portfolio risk is reduced.
• For correlation of 0, there is no relation between risks of different assets in the
portfolio.
• For correlation of -1, there is negative / inverse relation between risks of different
assets in the portfolio and thus risk is reduced to 0 through diversification.

portfolio 2 Ctcpl
AandB Ctep 2
weightedaverage of
g oo
i l i
t i l i
ca i
At
correlation i l i portfolio1 step1
I 1
t
of I
l l
l
rdatooabetweenAandB changes
pst.IE created Lstep3
movement is
a semicircular
SUCCESSRBI@ANUJJINDAL.IN 9
 RISK DIVERSIFICATION, CML, SML, CAPM

• Those portfolios that have the greatest expected return for each level of risk (standard
deviation) make up the efficient frontier.
• A risk averse investor would choose portfolios that are on the efficient frontier
because all available portfolios that are not on the efficient frontier have lower
expected returns than an efficient portfolio with the same risk.

• Note that all assets used to create portfolios are risky portfolios consisting of assets
with some level of quantum of risk.
• If we combine one such risky portfolio with a risk-free asset (a risk free asset has zero
standard deviation and zero correlation of returns with any risky portfolio), we get a
straight line called as Capital Allocation Line (CAL). This line for the market is called
as Capital Market Line (CML).
are
th Theseportfolios

t
a
D c B
A combinations 2
of
assets LAB c D
risky
HP
i
e

exes
making multiple E is created by SUCCESSRBI@ANUJJINDAL.IN 10
By and Rf andD
combinations of
EF we get one
Rf combining
i e weighted average of Rf and D assets Steph
50 Rfassetand 50
of
Bassete of
 RISK DIVERSIFICATION, CML, SML, CAPM

CML and SML:

• The capital market line (CML) appears in the capital asset pricing model to depict the
rates of return for efficient portfolios subject to the risk level (standard deviation) for
a market portfolio and the risk-free rate of return. Do
The capital market line is created by sketching a tangent line from theCAL
•
same as intercept point
on the efficient frontier to the place where the expected return on a holding equals the
risk-free rate of return.
• The capital market line permits the investor to consider the risks of an additional asset
in an existing portfolio. The line graphically depicts the return top investors earn for
accepting added risk.

Theinvestor is benefitted
b combining efficient
ftp.flio
asset so that
with riskfree
risk
is diversified further
but return is not
reduced

covered
something we
in diversification also

• By following the above approach, when an investor diversifies across assets that are
not perfectly correlated, the portfolio’s risk is less than the weighted average of risks

SUCCESSRBI@ANUJJINDAL.IN 11
 RISK DIVERSIFICATION, CML, SML, CAPM

of individual securities in the portfolio. The risk that is eliminated by diversification is

called unsystematic risk (unique, diversifiable or firm specific risk).
• The risk that remains cannot be diversified away and is called the systematic risk
(non-diversifiable or market risk)

Technically, CML is:

• The capital market line (CML) appears in the capital asset pricing model to depict the
rates of return for efficient portfolios subject to the risk level(standard deviation) for a
market portfolio and the risk-free rate of return.
• The capital market line is created by sketching a tangent line from the intercept point
on the efficient frontier to the place where the expected return on a holding equals the
risk-free rate of return.
• The capital market line permits the investor to consider the risks of an additional asset
in an existing portfolio. The line graphically depicts the return top investors earn for
accepting added risk.

• Now that we have understood CML, we should be moving towards SML. However,
before moving forward to SML, let us talk about the relationship between market risk
and number of securities in the portfolio. Remember, we talked about systematic and
unsystematic risk.

Look at the below graph-

As numberof securities
in
above a
the portfolio go
18 certain number unsystematic
risk is eliminated seethe
s
flat curve only
E market risk remains

As you increase the number of stocks in a portfolio, the risk falls towards level of market
risk. So, returns from a portfolio depend upon systematic risk and not total risk (this
difference is ignored in CML. So, CML calculates total risk), since unsystematic risk has
already been diversified by creating a large portfolio.

Example- Grid
her
SUCCESSRBI@ANUJJINDAL.IN 12
 RISK DIVERSIFICATION, CML, SML, CAPM

A biotech stock with one new drug product is in clinical trials

the drug proves to be effective and safe stock returns
Ifwill be quite high
On the other hand the clinical trial
if fails the stock
might falleven to zero Thus the stock of biotechhas
high standard deviation of returns i e high total risk
The high risk of biotech is due to formspecific factors
i.e unsystematic risk is high Systematic risk is a
small portion of total risk
there is another stock of let's say Haney Davidson
If which has less unsystematic risk but high
market risk the firm combine biotech with
may
his
Harley to diversify portfolio
According to capital market theory unsystematic risk can
be creating a large
diversified
but market by
risk cannot be diversified away
The same has been presented Iponoftfutofstoety
above in the

It’s time to understand “beta”, in order to understand CAPM and SML: Thr
Q.1. What is “beta”?

•
Fei
Returns of a portfolio are affected by certain specific factors like GDP growth,
correlated S
W
inflation, research expenditure of the firm, consumer confidence etc. masketnsk
• Every factor has a certain level of sensitivity towards return of the portfolio i.e. a
change in GDP might affect returns more than a change in consumer confidence. aniet.IE
ua• Beta is the measure of “sensitivity” of specific factors towards returns of the portfolio.

Having understood beta, what about the specific factors mentioned above?

The specific factors can be classified as-

a. Macroeconomic factors
b. Fundamental factors
c. Statistical factors

Various scientists have given multifactor models that can be used to identify the level and
kind of factor sensitivity.
SUCCESSRBI@ANUJJINDAL.IN 13
 RISK DIVERSIFICATION, CML, SML, CAPM

1. Fama and French Model- As per Fama and French, sensitivity of security returns is
dependent upon 3 factors →
a. Firm size
b. Firm book value to market value ratio
c. Return on market portfolio - risk free rate Kim
2. Carhart- he suggested a fourth factor → RA
a. Measuring price momentum

Single Index Model- This model uses a single factor to calculate return on a portfolio. Factor
“c” above in fama and French is the only factor used. Rm
Rf
NOTE: There are mathematical & statistical methods to calculate beta but we are not
covering them since they have never been asked and are very lengthy. They are
nowhere mentioned in the syllabus.

Quiz:

1. What is the risk measure associated with the capital market line (CML)?
a. Beta risk
b. Unsystematic risk
c. Total risk

Answer- c
CML takes total risk on X axis Smc takes Bela systematicrisk

2. As the number of stocks in a portfolio increase, the systematic risk:

a. Increases an at increasing rate
b. Decreases at a decreasing rate
c. Can increase or decrease

increase
diversified away It can
Answer- c
cannot be
a systematic risk
decrease on its own
3. Total risk is equal to:
a. Unique + diversifiable risk
b. Market + non diversifiable risk
c. Systematic + unsystematic risk

Answer- c

SUCCESSRBI@ANUJJINDAL.IN 14
 RISK DIVERSIFICATION, CML, SML, CAPM

Security Market Line (SML):

• The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the capital asset pricing model (CAPM), which shows different
levels of systematic, or market, risk of various marketable securities plotted against
the expected return of the entire market at a given point in time. Also known as the
"characteristic line," the SML is a visual of the capital asset pricing model (CAPM),
where the x-axis of the chart represents risk in terms of beta, and the y-axis of the
chart represents expected return. The market risk premium of a given security is
determined by where it is plotted on the chart in relation to the SML.

x axis Beta 1systematic risk

Y axis Expected return
• The security market line is an investment evaluation tool derived from the capital
asset pricing model, a model that describes risk-return relationships for securities, and
is based on the assumptions that investors have to be compensated for both the time
value of money and the corresponding level of risk associated with any investment,
referred to as the risk premium.

• The concept of beta is central to the capital asset pricing model and the security
market line. The beta of a security is a measure of its systematic risk that cannot be 1
eliminated by diversification. A beta value of one is considered as the overall market I do 1
If
average. A beta value higher than one represents a risk level greater than the market overall
average, while a beta value lower than one represents a level of risk below the market 1marketI
average l averageI
• The formula for plotting the security market line is as follows:
i B al
I t I
• Required Return = Risk Free Rate of Return + Beta (Market Return - Risk Free Rate risk I
of Return) below
1market
ER Rf HERM Rf averaged

s
mi
I
Il
riskof
portfolio is i
1
abovemarket1
average
L I

SUCCESSRBI@ANUJJINDAL.IN 15
 RISK DIVERSIFICATION, CML, SML, CAPM

• The main logical difference between CML and SML is that CML takes into
consideration total risk on the X-axis, whereas SML considers only Market risk,
represented by beta.

CAPITAL ASSETS PRICING MODEL:

• In finance, one of the most important things to remember is that return is a function of
risk and vice versa. This means that the more return you want or desire, the higher
your risk would be to offset your increased demand for return.

• William Sharpe is the principal originator of CAPM and he was awarded with Nobel
Prize in Economics for his theory of CAPM.

• CAPM answers the question “ what is the relationship between risk andreturn for an
efficient portfolio or an individual security?” the relationship developed by CAPM
helps borrowers to price their product efficiently and investors to find out the most
advantageous investment in terms of risk versus return.
purpose of CAPM

CAPM makes the following assumptions:

• Investors are risk averse. This means that investors do not want to take extra risk
without any additional return
• Investors can borrow and lend freely at a riskless rate of interest
• The market is perfect- no taxes, no transaction costs, competitive market
• CAPM calculates a required return based on a risk measurement. To do this, the
model relies on a risk multiplier called the beta coefficient
• Before we can use the CAPM formula, we need to understand its risk measurement
factor known as the beta coefficient. By definition, the securities market as a whole seed
has a beta coefficient of 1.0. The beta coefficients of individual companies are
calculated relative to the market's beta. A beta above 1.0 implies a higher risk than the
market average, and a beta below 1.0 implies less risk than the market average. Most
companies' betas fall between 0.75 and 1.50, but any number is possible, including
negative numbers; a negative beta would be highly unlikely, however, since it would
imply less risk than a 'risk free' investment.

The CAPM formula is sometimes called the Security Market Line formula and consists
of the following equation:

SUCCESSRBI@ANUJJINDAL.IN 16
 RISK DIVERSIFICATION, CML, SML, CAPM

above
I
r* = kRF + b(kM - kRF) is explained
It is basically the equation of a line, where:

r* = required return

kRF = the risk-free rate

kM = the average market return

b = the beta coefficient of the security

You will sometimes see the kM - kRF term replaced by kMRP. kMRP (the market risk
premium) = kM - kRF

Systematic and Unsystematic risk:

• Unsystematic risk: risk that can be eliminated through diversification is called

unsystematic risk i.e Unique risk, residual risk, specific risk, or diversifiable risk

• Systematic risk: risk that cannot be eliminated through diversification i.e market risk
or undiversifiable risk

• CAPM model measures non-diversifiable/ systematic risk through Beta:

• The beta of an asset, such as a stock, measures the market risk of that particular asset
as compared to the rest of the market — hence, it also measures volatility of the asset
compared to the general market. The beta is calculated by comparing the historical
return of an asset compared to the market return using statistical techniques

For Example:

The risk-free rate is 3%,

Rt
The beta (risk measure) of a stock is 1,
p
The expected market return over the period is 10% Em
Find the expected rate of return?
En
r* = kRF + b(kM - kRF)

3% + 1 x (10% - 3%) = 10%

For Example:
SUCCESSRBI@ANUJJINDAL.IN 17
 RISK DIVERSIFICATION, CML, SML, CAPM

If the risk-free rate equals 4% and a stock with a beta of 0.75 has an expected return of 10%,
what is the expected return on the market portfolio?

10% = 4% + 0.75(market portfolio – 4%)

8% = market portfolio – 4% 12% = market portfolio

For Example:

A particular asset has a beta of 1.2 and an expected return of 10%. Given that the expected
return on the market portfolio is 13% and the risk-free rate is 5%, the stock is:

a. appropriately priced
b. underpriced
c. overpriced;

ANSWER:

expected return should be 14.6% (5+1.2(13-5))

Since there is an inverse relationship between rate of return and price of a security, a security
with expected return of 10% will be priced higher than a security with an expected return of
14.6%. As the actual return should be 14.6%, the security is overpriced at present with
expected return of only 10%. The answer is C

In other words
I as an investor should be getting 14.6 return
but the company is offering only toy and other
investors would not like that To compensate for
lower returns new investors would price it
lower than what it is right now It means
that the stock is overpriced

SUCCESSRBI@ANUJJINDAL.IN 18
 RISK DIVERSIFICATION, CML, SML, CAPM

shaoperatio.IE
is a measure of of a portfolio in terms
efficiency
of refum a peer unit of risk for ex Pt provides 10
return for risk of B I o P2 psonodes 127 return for
Peter of 1.1 under Sharpe ratio we will
and
a
which portfolio PI or P2 is more
measure try efficient
Graphically

Alr
Ek
ch
Ry i
pv
am
i l
l l
i lI
Rg i
i
l
l
I il

Sp Gpfm
assumption
Sharpe Ratio of market
am
in order to prove that Chez is better portfolio line than
CML we need to see whether Sharpe ratio on
is better than CML Sharpe ratio or not
CAL

Sharperatio at Chez Rz
Rf_ o Gassumption
pz
return pet unitrisk is 0.6
o 6 means of
ooo ooy means
return pet unit of risk is oil
0.4 CAL is better portfolio than CML
since 0.6 y
SUCCESSRBI@ANUJJINDAL.IN 19
 RISK DIVERSIFICATION, CML, SML, CAPM

Another method to do the same is m squared

under Mt we find the extra return for a portfolio

which has the same risk as market portfolio

ER
CAW
omw
Rp Rf
1kt qpMr
mp_
rmµ
pp I l
I i
Rg I l
I i
t l
I
op TM t

M Rp Rf
r
Rm Rf
p

There are 2 morewhich are based on

measures
than total risk The above measures were
Beth rather
based on total risk
and
Traynor measure
Jensen's alpha

TREYMM MEASURE
lart Sharperatio The only difference being
denominator contains Beta
risk
that the systematic
total risk standard deviation
Tn place of investors that want to be or
NOTE
Traynor
is used for
should be well diversified are not well
be used those who
Sharpe can by
diversified
SUCCESSRBI@ANUJJINDAL.IN 20
 slope Traynor
measure ftp
Graphically
ER
SML

P
W
1
Art

sonsaisacpha
i l
i l
Ry i l
I i
l i

I
pp

Tseynoo measure
Rp Rf
Tp
Jensen's alpha xp a Rp Rf Bp Rm Rf