PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL (CAPM)

This Topic explains two models which can be used to take account of the risk of investments. These
are portfolio theory and the capital asset pricing model.
By the end of this topic, you should be able to:
◼ Measure risk as a variance
◼ Explain portfolio theory
◼ Measure the risk return characteristics of a two asset portfolio
◼ Comment on the risk return characteristics of a two asset portfolio
◼ Explain the difference between systematic and unsystematic risk
◼ Explain how beta values are used as a measure of systematic risk
◼ Measure a required rate of return using the CAPM equation
◼ Explain how the CAPM can be used to identify discount rates for capital projects

Introduction to portfolio theory

Portfolio theory is concerned with how investors should build a portfolio of investments that gives
them a suitable balance between return and investment risk. Portfolio theory provides a theoretical
basis for the capital asset pricing model, which is an important model in financial management.
Risk averse investors will accept risk provided that they are compensated for it by an adequate return.
However if they could reduce their risk without a reduction in return this would be even better.
This is possible by the process of diversification
Risk and return in investments
Investors invest in shares and bonds in the expectation of making a return. The return that they want
from any investment could be described as:
❑ A return as reward for providing funds and keeping those funds invested, plus
❑ A return to compensate the investor for the risk.

As a basic rule, an investor will expect a higher return when the investment risk is higher.

What is investment risk?

Investors in bonds, investors in shares and companies all face investment risk. In the case of bonds,
the risks for the investor are as follows:
❑ The bond issuer may default, and fail to pay the interest on the bonds, or fail to repay the
principal at maturity.
❑ There may be a change in market rates of interest, including interest yields on bonds. A change
in yields will alter the market value of the bonds. If interest rates rise, the market value of bonds will
fall, and the bond investor will suffer a loss in the value of his investment

In the case of equity shares, the risks for the investor are that:
❑ the company might go into liquidation; or
❑ much more significantly, the company’s profits might fluctuate, and dividends might also rise or
fall from one year to the next.

When a company invests in a new project, there will be an investment risk. This is the risk that
actual returns from the investment will not be the same as the expected returns but could be higher or
lower. This investment risk for companies is similar to the investment risk facing equity investors.

Systematic and unsystematic risk

Although investors can reduce their investment risk by diversifying, not all risk can be eliminated.
There will always be some investment risk that cannot be eliminated by diversification.
❑ When the economy is weak and in recession, returns from the market portfolio as a whole are
likely to fall. Diversification will not protect investors against falling returns from the market as a whole
❑ Similarly, when the economy is strong, returns from the market as a whole are likely to rise.
Investors in all or most shares in the market will benefit from the general increase in returns.

Therefore there are two types of risk:

❑ Unsystematic risk, which is risk that is unique to individual investments or securities, that can be
eliminated through diversification
❑ Systematic risk or market risk. This is risk that cannot be diversified away, because it is risk
that affects the market as a whole, and all investments in the market in the same way.

Measuring risk as a variance or standard deviation of expected returns

The risk of variations in annual profits and dividends can be measured. When annual returns can
differ by a large amount from normal or expected (average) returns, and there are considerable
differences in returns from one year to the next, returns are volatile.
High volatility in returns is associated with high investment risk.
Risk can be measured statistically, either from an analysis of historical returns achieved in the past, or
from probability estimates of returns in the future. The measurement of risk is a measurement of the
volatility of possible returns.
This volatility can be measured as either the variance or standard deviation of expected returns.
For an investment, we can measure both:
❑ an expected or average annual return; and
❑ a variance or standard deviation of the returns. (The standard deviation is the square root of the
variance).

Formula: Variance
Σ p(r - r)2
Where:
p = the probability of a given return on the investment
r = the amount of that return
r = the average expected return on the investment. This is the expected value (EV) of the return.
Concept of return
Investors hold securities (e.g. shares, bonds, etc.) because they hope for positive returns. Purchasers
of ordinary shares, for examples are attracted by two components of return, first, the anticipated
dividend(s) payable during the holding period, and second, the expected capital gain.
In general, for any holding period, the percentage return, R, from holding a stock is:
R = EV – BV + D × 100
BV
Where:
EV = Value of the stock at the end of the holding period
BV = Value of the stock at the beginning of the holding period
D = Dividend received during the holding period
Example: Calculating return
You bought a stock for ₦50 and it is now worth ₦55. During the period, you received a dividend at ₦2.
Calculate
i) the total return
ii) the capital gain yield
iii) the dividend yield

Expected return from a two – asset portfolio

The expected return of a portfolio consisting of assets A and B is the weighted average of the returns from the
two assets.
Formula: Expected return from a two – asset portfolio
RP = WARA + WBRB
WA = % of funds, or weight, committed to asset A
RA = % of funds, or weight, committed to asset B
WB = the expected return from asset A
RB = the expected return from asset B
Standard deviation of return for a two-asset portfolio
The overall standard deviation of the return from a two-asset portfolio can be calculated using the following
formula
Formula: Standard deviation of return for a two-asset portfolio

Illustration 1 : Expected return from a two-asset portfolio

You have ₦1,000,000 to invest in stock A and stock B. The following information is given for the two stocks.
Stock Current Price Expected price Expected
in one year dividend
A ₦40 ₦48 ₦0
B ₦50 ₦63 ₦2

a) You have decided to invest ₦750,000 on stock A and ₦250,000 on stock B. Calculate the expected
return on your portfolio.

b) Now assume you desire an expected return of 28% on your portfolio, how would you invest your
₦1,000,000?

c) Alternatively, assume you desire a return of 36%, how much should you invest in each stock.

Diversification to reduce risk

To a certain extent, an investor can reduce the investment risk – in other words, reduce the volatility
of expected returns – by diversifying his investments, and holding a portfolio of different investments.
Creating a portfolio of different investments can reduce the variation of returns from the total portfolio,
because if some investments provide a lower-than- expected return, others will provide a higher-than-
expected return. Extremely high or low returns from the overall portfolio are therefore less likely to
occur.
Similarly, a company could reduce the investment risk in its business by diversifying, and building a portfolio of
different investments. However, it can be argued that there is no reason for a company to diversify its
investments, because an investor can achieve all the diversification he requires by selecting a diversified
portfolio of equity investments.
There are two important statistical measures used to describe the association between two variables.
They are:
❑ covariance; and
❑ correlation coefficient.

Formula: Correlation coefficient

r = CovarianceXY
SDx SDy
Formula : B = Covariance with market
Variance of market
Or B = COVab
SDm × SDm
B = SDp × r
SDm
NOTE
B = Beta factor
COVab = Covariance AB
SDp = standard deviation of the project
SDm = standard deviation of the market
r = correlation coefficient
Illustration 2
The following information relates to two securities (X and Y) and how they behave under different sets of economic
conditions (described as states of the world).
State of Probability Returns from Returns from
the world (p) share share
X (Rx) Y (Ry)
A 0.3 25% 28%
B 0.5 22% 18%
C 0.2 12% 15%

Use above information to calculate the following:

❑ variance of returns and hence the standard deviation of returns on two securities;
❑ the covariance of returns on those two securities;
❑ the correlation coefficient of the returns from the two securities by rearranging the expression for
covariance; and
❑ the correlation coefficient of the returns from the two securities from the raw data.

Illustration 3
The management of Invest Plc is evaluating two projects whose returns depend on the future state of the
economy as shown below:
PROBABILITY IRR OF A IRR B
(%) (%) (%)
30 27 35
40 18 15
30 5 20

REQUIRED
I) Explain how a portfolio should be constructed to produce an expected return of 20%
II) Calculate the correlation between and assess the degree of risk of the portfolio (i) above
CAPITAL ASSET PRICING MODEL (CAPM)
The capital asset pricing model (CAPM) establishes a relationship between investment risk and expected
return from individual securities. It can also be used to establish a relationship between investment risk and
the expected return from specific capital investment projects by companies.
The CAPM assumes that investors hold diversified investment portfolios and are therefore concerned with
systematic risk only and not unsystematic risk.
Formula for the CAPM
The formula for the capital asset pricing model is used to calculate the expected return from a security
(ignoring unsystematic risk).

Formula: Capital asset pricing model (CAPM)

RE = RRF + β (RM – RRF)

Where:
RE = the cost of equity for a company’s shares
RRF = the risk-free rate of return: this is the return that investors receive on risk-free investments
such as government bonds
RM = the average return on market investments as a whole, excluding risk-free investments
β = the beta factor for the company’s equity shares.

Example: CAPM
The risk-free rate of return is 4% and the return on the market portfolio is 8.5%. What is the expected
return from shares in companies X and Y if:
a) the beta factor for company X shares is 1.25
b) the beta factor for company Y shares is 0.90?

Answer
a) Company X: RS = 4% + 1.25 (8.5 – 4)% = 9.625%
b) Company Y: RS = 4% + 0.90 (8.5 – 4)% = 8.05%.

ASSUMPTIONS of the CAPM

The CAPM is based on some simplifying assumptions. For example, the CAPM assumes:
❑ A perfect capital market, in which all investors have access to all available information about the
financial markets
❑ Uniformity of investor expectations
❑ All forecasts (expectations) are made in the context of just one time period.

Advantages and disadvantages

Advantages of CAPM

It provides a measurable relationship between risk and return.

It can be used to estimate the cost of capital for securities, notably equity shares.
It can be adapted to establishing a required (risk-adjusted) DCF return on capital investments by a
company.

Weaknesses of CAPM
It can be difficult to estimate statistically reliable values for the risk- free rate and market rate of return,
and the beta factor for a security.
It focuses on systematic risk only and ignores unsystematic risk.
Unsystematic risk is significant for an investor who does not have a well- diversified portfolio.
It makes no distinction between the ways in which a security provides its return (for example
dividends or share price increase).

The beta factor of a security

The systematic risk for an individual security is measured as a beta factor. This is a measurement of
the systematic risk of the security, in relation to the systematic risk of the market portfolio as a whole.
The beta factor for the market portfolio itself = 1.0.

Beta factor of risk-free securities

Risk-free investments provide a predictable and secure return. They have no systematic risk.
In the real world there are no risk-free investments, but short-term government debt issued in the
domestic currency can normally be regarded as very safe investments. The current yield on short-
term government debt is usually taken as a risk-free return. In the UK this is the current yield on UK
government Treasury bills.
Since they have no systematic risk, the beta factor for risk-free securities = 0.
The risk-free rate of return varies between different countries, and can go up or down. The beta factor of a
risk-free security, however, is 0 at all
Formula: Beta value
Bs = Covariance of the returns of the investment with the returns from the market
Variance of the market
B = r × SDp
SDm
Where:
B = Beta factor of security S
r = Correlation coefficient of returns form security S with the returns from the market
SDp = Standard deviation of the returns of security S
SDm= Standard deviation of the returns of the market

The capital market line

A graph showing the risk and returns of different proportions of investment in a risk free
asset and an asset with risk (the market portfolio) would be a straight line. This is called
the capital market line. The line that joins the risk free asset and the market portfolio M
is called the capital market line.
The capital market line (CML) shows all combinations of risk-free investments and
market portfolio investments that investors may select.

Security market line

The Security Market Line is derived from the capital market line. It is a graph that shows the
required return from any investment given its beta factor. Actual returns from investments can
be compared to the figure from the security market line to determine whether that investment
is under or overvalued.
Alpha factor/value
The beta factor for shares is a measure of systematic risk and it ignores variations in the
equity returns caused by unsystematic risk factors. When shares yield more or less than
their expected return (based on the CAPM), the difference is an abnormal return. This
abnormal return might be referred to as the alpha factor.
The alpha value can be seen as a measure of how wrong the CAPM is, it may be
thought of as the difference between the expected return on a security or investment,
given its systematic risk, and the actual return.
Alpha values:
a) Reflect only temporary, abnormal returns, if CAPM is a realistic model;
b) Can be positive or negative;
c) Over time, will tend towards zero for any individual share, and for a well-diversified
portfolio taken as a whole will be zero; and
d) May exist due to the inaccuracies and limitations of the CAPM.
Illustration 4
You have purchased the data from an investment bank
company Forecast total equity Standard deviation Covariance with
return of total equity market return
return
A 16.88% 6.3% 12%
B 12% 4.8% 19%
 C 14% 4.7% 24%
D 21.5% 6.9% 43%

The market return and standard deviation are 14.5% and 5% respectively and the risk free
rate is 6%. Returns and all other data relate to a one year period.
Required
a) Evaluate the ‘Alpha’ value for each of this companies’ share and explain what use
alpha values might be to financial manager.
b) Briefly discuss reasons for the existence of alpha values, and whether or not the
same alpha value would be expected to exist in one year’s time

Illustration 5
a. Capital asset pricing model (CAPL) is an equilibrium model of the trade –off
between expected portfolio return and unavailable risk.
What are the basic assumptions on which this model is based?
B currently, the rate of return on the Federal Government Bond redeemable at par in
the year 2018 is 5%. The securities of four companies, Akira plc, Bombadia plc, Courage plc
and Divine plc, have expected returns of 12%, 9.5%, 10.5% and 13% respectively. The
average expected return on market portfolio is 10% the four securities of the companies is
as stated below:
COMPANY STANDARD DEVIATION CORRELATION
COEFFICIENT
AKIRA PLC 0.080 0.975
BOMBADIA PLC 0.075 0.640
COURAGE PLC 0.090 0.740
DIVINE PLC 0.15 0.680

You are required to show which of the companies is/are overvalued