PROFITABILITY, RISK

CAPM
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 Lesson Objectives
Part 1: Profit and Risk
The concept of profit and risk.
◦Return and risk of a security.◦Return and
risk of a portfolio.
Lecture Part 2: ModelCAPM
Contents ◦The composition of risk.◦Diversification
of investments.
◦Capital Asset Pricing Model
(CAPM).◦Security Market LineSML.

Credit to Th.S Nguyễn Thị Thu Trang 1

Lesson Objectives
Measure the return
and risk of a particular Distinguish between Explain how the
security as well as a systematic and portfolio diversified.
portfolio. unsystematic risk.

Applying CAPM
Model in stock
investment.

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We need to measure the expected return and risk of a security and
consider how the portfolio helps to reduce risk.

Section 1:Profit and Risk

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PROFIT
• return is the income or amount earned from an
investment.
• rate of return is the percentage between the income
and the value of the investment spent.

Cap Gain Yield + Did Yield

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Profit
•There is a reward for taking the risk.
Trade-off
•The bigger the reward, the higher the
between benefits
and risks. risk.

Expected return •Historical data.

•Probability data (expected future
(average return). outcome).

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 Risk(σ) is defined as the difference between
actual return and expected return.
Consists of 2 components:
◦Systemic risk.
Rủi Ro ◦Unsystematic risk.
Measure the risk
◦Coefficient of Variance(σ2) or standard
deviation (𝜎)

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 Expected profit
◦ n: number of observations.
◦ Ri profit of observation i.
Historical Return Variance(risk):
Data
◦ Note: n-1 must be used to generate an
unbiased estimate.

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Historical Data

Year Profit (%) Q: Given the data,

calculate the expected
2014 -25.5
return and the standard
2015 19.7 deviation of the return
2016 15.9 (risk)?
2017 12.3
2018 22.2

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Probability Data
Expected profit:
◦ n is the number of different
observations.
◦ Pi is the probability of the
observation i.
◦ Ri The expected return of the
observation i.
Profit (risk) method:

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Probability Data
Q: Given the data, calculate the
State of the Pi Ri (%) expected return and the standard
economy deviation of the return (risk)?

Depression 1/4 -15

Normal 2/4 25
Booming 1/4 30

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Risk Comparison - Case 1
Q: Should I invest in stock A or B?
E (R) σ
Stock A 15% 20%
Stock B 15% 14%

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Risk Comparison - Case 2
Q: Should I invest in stock A or B?
E (R) σ
Stock A 19% 15%
Stock B 16% 15%

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Risk Comparison–General Principle
Q: Between 2 stocks, which investment to choose?
E (R) σ CV
Stock A 15% 19%
Stock B 12% 14%
Using coefficient of variance (CV):
◦Measurement of the level of risk for a percentage of expected
return
◦

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 ▪Portfolio is a collection of one or several
different asset classes.
▪Combining different assets in a portfolio
helps to reduce the risk level of the portfolio.
Why?
Minimizing ▪Return of various assets in
Investment A portfolio does not always move in the same
direction.
Risk ▪Effects of diversification.

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Covariance And Correlation Coefficient
Covariance (Covariance, 𝛔ij)
◦ Reflects the linear correlation of returns on two assets.
◦ Covariance can be negative or positive, reflecting a positive or negative relationship
between two assets.
◦ The smaller the absolute value of the covariance, the lower the strength (strongness) of the
relationship.
Correlation Coefficient (Correlation Coefficient, 𝛒ij)
◦ Measures the linear correlation of returns between two assets.
◦ Expresses the strength of the correlation.

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Portfolio Expected Return
• Portfolio expected return is the weighted average of expected
return for each asset in the portfolio.
•Weight (wi) = % of portfolio in each asset.
•Expected profit

n = number of assets in portfolio

wi= % investment of asset i in portfolio
Ri= return on assets

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Variance (Risk) Of Portfolio
Risk

◦ n = number of assets in the portfolio

◦ wi = % investment of asset i in portfolio
◦ 𝜎ij= Covariance between asset i and assets j
Covariance of a portfolio of 2 assets

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Portfolio Profit and Risk
BHP NAB Given the information given in the
E(Ri) 3.1% 4.9% table on the left, assuming that 50%
invested in BHP and 50% invested in
σ 7.9% 8.5%
NAB, what is the expected return and
𝜌 with 1 -0.33 standard deviation of the portfolio?
BHP

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We need to understand the systematic risk of securities and derive an
asset pricing model to estimate the required return for the security.

Part 2: Capital Asset Pricing Model-CAPM

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Diversify
A strategy to reduce risk by combining two or more assets with varying
returns.

If the correlation coefficient between two securities is less than 1, we have

the benefit of diversification.

For example, if you own 50 internet company stocks, your portfolio is not
diversified.
However, if you own 50 stocks spread across 20 different industries, your
portfolio can be diversified.

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Portfolio Diversification

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Types of Risks Investors Must Face
•Incorporating assets in a portfolio eliminates unsystematic risk.
•However, there is a minimal level of non-diversifiable risk, which is
systemic risk.
• Thus, investors only face systemic risk.
•What does this have to do with the definition of profit?
• Required rate of return: The rate of return that investors demand as
compensation for carrying a uniform level of risk.
(market risk).

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Relationship between Keeping Stock Profits
And Market Returns
Assume that the returns of HSC stock and the market portfolio
VNIndex correspond to 4 different situations depending on 2
economic conditions.
Tình huống Nền kinh tế LN thị trường LN của HSC
I Tăng trưởng 15% 25%
II Tăng trưởng 15 15
III Suy thoái -5 -5
IV Suy thoái -5 -15

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RelationshipKeeping Stock Profits
And Market Returns
Assuming the probability of economic growth and recession is
equal, we have:

State of the economy Market profit HSC's expected profit

Growing 15% (0.5x0.25) + (0.5x0.15) = 20%
Depressing -5% (0.5x(-0.05) + (0.5x(-0.15)) = -10%

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Stock-Specific Line-SCL

HSC profit
margin (%) Stock Specific Line
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Beta is the slope of the stock

characteristic curve
Beta = (20+10)/(15+5)=1,5
-5
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market rate
) of return %
DMĐT
-10

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Systematic Risk Measurement
▪β is a measure of sysematic risk.
▪βmeasures the sensitivity of stock returns to market returns
What does Beta tell us?
▪ β = 1 implies that the asset has systematic risk similar to the overall
market average risk
▪ β <1 implies that the asset has a lower systematic risk than the market
average risk
▪ β > 1 implies that the assets has a higher systemic risk than the market.
▪ β = 0 implies that the asset has no systematic risk.
▪ For example. β of 0.65 tells us that if the market index rises 1%, the
average gain for this stock is 0.65%

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Quiz
σ 𝜷
Stock A 20% 1.25
Stock B 30% 0.25

Which stock is riskier?

Which stock has higher systematic risk?
Which stock has higher expected return?

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The Relationship Between Risk And Return
✓ Risk free rate of return Rf.
✓The risk premium for investing in a market portfolio Rm-
Rf.
✓The risk premium for investing in securities: 𝛽i R m − R f
✓Capital Asset Pricing Model (CAPM)
E(Ri) = Rf + 𝜷i [E(RM)– Rf]

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Stock Market Line,SML
SML biểu diễn mối quan hệ giữa lợi nhuận kỳ vọng của chứng khoán và
rủi ro thị trường của nó.

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SML - Quiz
Which stocks are priced right, and which aren't? Which
stocks are undervalued? High valuation?