CH-6 Portfolio Theory

CHAPTER 6: PORTFOLIO THEORY

In finance context, a portfolio is a collection of securities that are combined and considered as a
single asset. In other word, portfolio is defined as a combination of financial assets such as
stocks, bonds and cash equivalents held by an investor. Combining assets into a portfolio has
risk-reducing effects. Modern portfolio theory proposes that securities should be managed
within a portfolio (instead of individually) for this reason. Portfolio theory is a theory that
explains how the risk-averse investors can construct portfolios that optimize expected return
based on given level of market risk, emphasizing that risk is an inherent part of higher return.
According to modern portfolio theory, it is possible to construct an efficient frontier of optimal
portfolios.

Most investors do not hold financial securities in isolation. Instead, they prefer to hold a
portfolio of several securities. Then, a portion of an individual stock's risk can be eliminated,
i.e., diversified away. Combining different securities into portfolios is done to achieve
diversification.

Diversification has two faces:

(i) Diversification results in an overall reduction in portfolio risk (return volatility over
time) with little sacrifice in returns, and
(ii) Diversification helps to immunize/vaccinate the portfolio from potentially
catastrophic events such as the complete failure of one of the constituent investments.
If only one investment is held, and the issuing firm goes bankrupt, the entire portfolio value
and returns are lost. If a portfolio is made up of many different investments, the outright
failure of one is more than likely to be offset by gains on others, helping to make the portfolio
immune to such events.

6.1. Portfolio Risk and Return

The risk-return characteristic of the portfolio is obviously different from the characteristics of
the assets that makeup that portfolio, especially with regard to risk. By recalling what we have
been discussed earlier regarding the calculation of the expected return, variance, and standard
deviation of an individual security; let us see computation risk and return of the portfolio, in
this section.

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6.1.1. Expected Return of Portfolio

The expected return on any portfolio is easily calculated as a weighted average of the
individual securities expected returns. The percentage of a portfolio’s total value which is
invested in each asset is known as portfolio weights, which will denote by Wi. The combined
portfolio weights are assumed to sum to 100 percent of total investable funds, or 1.0, indicating
that all portfolio funds are invested. That is, wA + wB + … + wn = 1 or 100%

In other word, the expected return of a portfolio is the weighted average of the returns of the
individual assets that make up the portfolio. A formula to calculate expected return of a
portfolio is presented as follows:
n
ER p   ( wi  ERi )
i 1

Where: ERp = the expected return on the portfolio,

ERi = the expected return of stock i.
wi = the proportion (weight ) of the portfolio invested on stock i, and

In simple:
 For two assets portfolio:ERP = (WA x ERA) + (WB x ERB)
 For three assets portfolio:ERP = (WA x ERA) + (WB x ERB) + (WC x ERC)
 For n number of assets:ERP = (WA x ERA) + (WB x ERB) + (WC x ERC) + ….. (Wn x ERn)
The portfolio weight of a particular security is the percentage of the portfolio’s total value that
is invested in that security. The sum of all securities weights is equal to 1.

Example 1: Suppose that Mr. Tola invested his 7,000 Birr on two stocks; specifically, ETB 2,000
on stock ‘A’ and ETB 5,000 on the stock ‘B’. Again assume that the expected return from stock
‘A’ is 14% and expected return of stock ‘B’ is 6%. Considering these information, calculated the
expected return of the portfolio.
Given:
ERA = 14%, ERB = 6%,
wA = weight of security A = ETB2,000 / ETB7,000 = 0.28 = 28.6%
wB = weight of security B = ETB5,000 / ETB7,000 = 0714 = 71.4% or it is (1 - 28.6%)
Solution:
For two assets portfolio:ERP = (WA x ERA) + (WB x ERB)
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ERP = (0.286 x 14%) + (0.714 x 6%)

= 4.004% + 4.288% = 8.288%
Note: By changing the weights of assets that incorporated in the portfolio, different portfolio
returns can be achieved.

Example 2: The effect on Portfolio Return by Changing Relative Weights in A and B. Assume
Mr. Tola invested equally on the both stocks, that is, 50 % on the stock ‘A’ and 50% on the stock
‘B’. In example1above; ERA = 14% and ERB = 6%. What is portfolio return?
Solution:ERp= (0.50 x 14%) + (0.50 x 6%)
= 7% + 3% = 10%
Further, see the below Table understand the effect of changing relative weights in A and B on
portfolio return.

6.1.2. Portfolio Risk

The remaining computation in investment analysis is that of the risk of the portfolio. Risk is
measured by the variance (or standard deviation) of the portfolio's return, exactly as in the case
of each individual security. Typically, portfolio risk is stated in terms of standard deviation
which is simply the square root of the variance. It is at this point that the basis of modern
portfolio theory emerges, which can be stated as follows: Although the expected return of a
portfolio is a weighted average of its expected returns, portfolio risk (as measured by the
variance or standard deviation) is not a weighted average of the risk of the individual securities
in the portfolio. Symbolically,

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But not:

Precisely, investors can reduce the risk of a portfolio beyond what it would be if risk were, in
fact, simply a weighted average of the individual securities' risk. In order to see how this risk
reduction can be accomplished, we must analyze portfolio risk in detail.

6.1.2.1 Analyzing Portfolio Risk

Risk Reduction: To begin our analysis of how a portfolio of assets can reduce risk, assume that
all risk sources in a portfolio of securities are independent. As we add securities to this
portfolio, the exposure to any particular source of risk becomes small. According to the Law of
Large Numbers, the larger the sample size, the more likely it is that the sample mean will be
close to the population expected value. Risk reduction in the case of independent risk sources
can be thought of as the insurance principle, named for the idea that an insurance company
reduces its risk by writing many policies against many independent sources of risk. Here, we
are assuming here that rates of return on individual securities are statistically independent
such that any one security's rate of return is unaffected by another's rate of: return.

Diversification: Diversification is the key to the management of portfolio risk, because it allows
investors; significantly to lower portfolio risk without adversely affecting return. The insurance
principle illustrates the concept of attempting to diversify the risk involved in a portfolio of
assets (or liabilities).

Random Diversification: Random or naive diversification refers to the act of randomly

diversifying without regard to relevant investment characteristics such as expected return and
industry classification. An investor simply selects a relatively large number of securities
randomly. For simplicity, we assume equal dollar amounts are invested in each stock.

Portfolio risk is not simply a weighted average of the individual security risks. Rather, as
Markowitz first showed, we must account for the interrelationships among, security returns in
order to calculate portfolio risk, and in order to reduce portfolio risk to its minimum level for
any given level of return. The reason we need to consider these, interrelationships, or co
movement, among securities return.
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In order to remove the inequality sign from above Equation and to develop a formula that will
calculate the risk of a portfolio as measured by the variance or standard deviation, we must
account for the following three factors. This means that; the riskiness of a portfolio that is
constructed from different risky assets is a function of three different factors:
 the riskiness of the individual assets that make up the portfolio
 the relative weights of the assets in the portfolio
 the degree of co-movement (correlation coefficient) of returns of the assets making
up the portfolio

Thus, in order to calculate portfolio variance or standard deviation; we need the actual co-
movement/covariance between securities in a portfolio. Covariance is an absolute measure of
the co-movements between securities returns used in the calculation of portfolio risk.
I. Covariance
The covariance is an absolute measure of association between the returns for a pair of
securities. Covariance is the expected value of the product of deviations of returns from the
mean/average. The formula for calculating covariance on an expected basis is:
n
COV AB   Prob i (rA,i  ER A,i ) (rB ,i - ERB ,i )
i 1

Where;
COVAB (or σAB) = the covariance between securities A and B
rA,i = possible returns of security A
ERA,i = the expected value of the return on security A
rB,i = the possible returns of security B
ERB,i = the expected value of the return on security B
Probi = the probability of scenario i

The covariance primarily provides information about whether the association between two
securities is positive, negative, or zero. That is, value of covariance can be:

1) Positive, indicating that the returns on the two securities tend to move in the same
direction at the same time; when one increases (decreases), the other tends to do the same.
When the covariance is positive, the correlation coefficient will also be positive.

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2) Negative, indicating that the returns on the two securities tend to move inversely; when
one increases (decreases), the other tends to decrease (increase), When the covariance is
negative, the correlation coefficient will also be negative.
3) Zero, indicating that the returns on two securities are independent and have no tendency
to move in the same or opposite directions together.
In general, the covariance value not tell us to which extent the returns of these two assets move
together, but it is useful to know the degree to which the returns of two assets move together;
i.e. correlation coefficient.

II. Correlation Coefficient

Even though the covariance is a supreme measure, it cannot be compared with one another.
Thus, to obtain the relative measure, the correlation coefficient is useful. Correlation coefficient
is the measure of to which extent the returns of any two securities are related. In other word,
correlation coefficient is the measure of the relative co-movements between returns of two
securities. However, it indicates only degree of relationship, not causation (i.e. it not indicates
the cause & effect relationship). It is represented by ρij (pronounced "rho"). A formula to
measure the correlation coefficient given the covariance and standard deviation of the two
assets, is:
COVAB
 AB 
 A * B
Where: COVAB is the covariance between securities A and B
σA is standard deviation of security A
σB is standard deviation of security B

It is value of relative measure of association/relationship is ranges in between +1.0 and -1.0. Its
value may be:

(i) Perfect positive correlation (correlation coefficient = +1) occurs when the returns from
two securities move up and down together in proportion. If these securities were
combined in a portfolio, the ‘offsetting’ effect would not occur.
(ii) Perfect negative correlation (correlation coefficient = -1) takes place when one security
moves up and the other one down in exact proportion. Combining two securities that
have perfect negative correlation in a portfolio would increase the diversification effect.
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CH-6 Portfolio Theory

(iii)Uncorrelated (correlation coefficient = 0) occurs when returns from two securities move
independently of each other. That is, if one goes up, the other may go up or down or may
not move at all. As a result, the combination of these two securities in a portfolio may or
may not create a diversification effect. However, it is still better to be in this position than
in a perfect positive correlation situation.
Importance of Correlation
 Correlation is important because it affects the degree to which diversification can be
achieved using various assets.
 Theoretically, if two assets returns are perfectly negatively correlated, it is possible to
build a riskless portfolio with a return that is greater than the risk-free rate.

III. Relating the Correlation Coefficient and Covariance

The covariance and the correlation coefficient can be related in the following manner:
COVAB
 AB 
 A * B
This equation shows that the correlation coefficient is simply the covariance standardized by
dividing by the product of the two standard deviations of returns. Given this definition of the
correlation coefficient, the covariance can be written as;
σAB = ρAB *σA*σB
In general, by knowing the correlation coefficient, we can calculate the covariance because the
standard deviations of the assets’ rates of return will already be available. Knowing the
covariance, we can easily calculate the correlation coefficient. To this end, knowing either
covariance or correlation coefficient of the pairs of assets in the portfolio, we can easily
calculate the risk of the portfolio.

6.1.2.2. Calculating Portfolio Risk

Risk on a portfolio of securities includes correlations or co-movements of the individual
security returns in addition to the weighted impact of individual security risks. Let us first
consider the simplest possible case, two securities, in order to see what is happening in the
portfolio risk equation. The standard deviation of a two-asset portfolio (say; Stock A and B)
measured by using either of the following two formulas:
(i) Standard deviation of a two-assets portfolio using correlation coefficient:
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CH-6 Portfolio Theory

 p  ( w A ) 2 ( A ) 2  ( wB ) 2 ( B ) 2  2( w A )( wB )(  A, B )( A )( B )

Factor that takes into account the degree of co-

movement of returns. It can have a negative value
if correlation is negative.
(ii) Standard deviation of a two-asset portfolio using covariance:

When the number of assets the portfolio increases a formula to calculate its riskiness is
different from the above two formulas.

For the three-asset portfolio, a formula of standard deviation using correlation coefficient is:

 p   A2 wA2   B2 wB2   C2 wC2  2wA wB  A, B A B  2wB wC  B ,C B C  2wA wC  A,C A C

Standard deviation of a three-asset portfolio using covariance is calculated as follows:

 p   A2 w A2   B2 wB2   C2 wC2  2 w A wB Cov A, B  2wB wC Cov B ,C  2 w A wC Cov A,C

Example: Assume that stock X has a standard deviation of return of 10%. Stock Y has a standard
deviation of return of 20%. Again assume that you invest 60% of the funds in stock X and 40%
in stock Y. If correlation coefficient between stocks is 0.5, what is the standard deviation of this
portfolio?

Given: σX = 10%, WX = 60%, PXY= 0.5

σY= 20%, WY = 40%, σP=?
Solution: From the given, it is clear to a formula of s tandard deviation of a two-asset portfolio
using correlation coefficient.

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 p  ( w A ) 2 ( A ) 2  ( wB ) 2 ( B ) 2  2( w A )( wB )(  A, B )( A )( B )

 p  (0.6) 2 (0.1) 2  (0.4) 2 (0.2) 2  2(0.6)(0.4)(0.5)(0.1)(0.2)

= 0.122 or 12.2%

6.1.3. Potential diversification

The potential of an asset to diversify a portfolio is dependent upon the degree of co-movement
of returns of the asset with those other assets that make up the portfolio. In a simple, two-asset
case, if the returns of the two assets are perfectly negatively correlated it is possible (depending
on the relative weighting) to eliminate all portfolio risk. This is demonstrated by the following
example:

Case (a): Correlation coefficient of -1

This is a perfect negative
Standard Correlatio correlation. So, the
greatest diversification
Expected Deviatio n potential
Asset Return n Coefficient
A 5.0% 15.0% -1
B 14.0% 40.0%

Portfolio Components Portfolio Characteristics

Weight of Weight Expected Standard
A of B   Return Deviation
100.00% 0.00% 5.00% 15.0%
Risk of the portfolio is
90.00% 10.00% 5.90% 9.5% almost eliminated at
70% invested in asset A
80.00% 20.00% 6.80% 4.0%
70.00% 30.00%   7.70% 1.5%
60.00% 40.00% 8.60% 7.0%
50.00% 50.00% 9.50% 12.5%
40.00% 60.00% 10.40% 18.0%
30.00% 70.00% 11.30% 23.5%
20.00% 80.00% 12.20% 29.0%
10.00% 90.00% 13.10% 34.5%

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0.00% 100.00% 14.00% 40.0%

Case (b): Correlation coefficient of +1
It is indicates a perfect
Standard
positive correlation.
Expected Deviatio Correlation
Asset Return n Coefficient
A 5.0% 15.0% 1
B 14.0% 40.0%

Portfolio Components Portfolio Characteristics

Expected Standard
Weight of A Weight of B   Return Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 17.5%
80.00% 20.00% 6.80% 20.0%
70.00% 30.00% 7.70% 22.5%
Here, there is no
60.00% 40.00% 8.60% 25.0% reduction of portfolio
50.00% 50.00% 9.50% 27.5% risk. Thus, diversification
is not possible.
40.00% 60.00% 10.40% 30.0%
30.00% 70.00% 11.30% 32.5%
20.00% 80.00% 12.20% 35.0%
10.00% 90.00% 13.10% 37.5%
0.00% 100.00% 14.00% 40.0%
6.2. EFFICIENT FRONTIER
The efficient frontier describes the relationship between the expected return of a portfolio and
the risk (volatility) of the portfolio. It can be drawn as a curve on a graph of risk against
expected return of a portfolio. The efficient frontier shows the best return that can be expected
for a given level of risk or the lowest level of risk needed to achieve a given expected rate of
return. It is a line created from the risk-reward graph, comprised of optimal portfolios.

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CH-6 Portfolio Theory

The efficient frontier is a key concept of modern portfolio theory. Things get rather more
interesting in post-modern portfolio theory which has an infinite number of efficient frontiers.
The efficient frontier for each investor depends on their risk acceptance and preferences. The
efficient frontier is usually used to describe the curve that is drawn in the absence of a risk free
asset. When a risk free asset available the curve becomes a straight line, i.e. securities market
line.

The market portfolio lies in the efficient frontier, at the point at which it touches the securities
market line. The efficient frontier is extremely important to the theory of portfolio construction
and valuation. Every possible asset combination can be plotted in risk-return space, and the
collection of all such possible portfolios defines a region in this space. The line along the upper
edge of this region is known as the efficient frontier.

Combinations along this line represent portfolio of risky assets only, it not include the risk-free
asset which has a lowest level of risk for a given level of return. Conversely, for a given level of
risk, the portfolio lying on the efficient frontier represents the combination offering the best
possible return. Mathematically, the efficient frontier is the intersection of the set of portfolios
with minimum variance and the set of portfolios with maximum return.

Markowitz's Efficient Portfolios

Markowitz's approach to portfolio selection is that an investor should evaluate portfolios on the
basis of their expected returns and risk as measured by the standard deviation. He was the first
to derive die concept of an efficient portfolio, which is defined as one that has the smallest
portfolio risk for a given level of expected return or the largest expected return for a given

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level of risk. Investors can identify efficient portfolios by specifying an expected portfolio
return and minimizing the portfolio-risk at this level of return. Alternatively, they can specify a
portfolio risk level they are willing to assume and maximize the expected return on the
portfolio for this level of risk. Rational investors will seek efficient portfolios, because these
portfolios are optimized on the two dimensions of most importance to investors, expected
return and risk.

To begin our analysis, we must first determine the risk-return opportunities available to an
investor from a given set of securities. A large number of possible portfolios exist when we
realize that varying-percentages of an investor's wealth can be invested in each of the assets
under consideration investors should be interested in only that subset of the available portfolios
known as the efficient set.

The assets generate the attainable set of portfolios, or the opportunity set. The attainable set is
the entire set of all portfolios that could be found from a group of n securities. However, risk-
averse investors should be interested only in those portfolios with the lowest possible risk for
any given level of return. All other portfolios in the attainable set are dominated.

Using the inputs described earlier; expected returns, variances, and co variances; we can
calculate the portfolio with the smallest variance, or risk, for a given level of expected return
based on these inputs. Given the minimum-portfolios, we can plot the minimum variance
frontier. Point V represents, the market minimum-variance portfolio, because no other
minimum-variance portfolio has a smaller risk. The bottom segment of tile minimum variance
frontier (VA) is dominated by portfolios on the upper segment (VB). For example, since
portfolio B has a larger return than portfolio A for the same level of risk, investors would not
want to own portfolio A.

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CH-6 Portfolio Theory

The segment of the minimum-variance frontier above the market minimum variance portfolio,
VB, offers the best risk-return combinations available to investors from this particular set of
inputs, this segment is referred to as the efficient set of portfolios. This efficient set is
determined by the principle of dominance; portfolio B dominates portfolio A if it has the same
level of risk but a larger expected return or the same expected return but a lower risk.

The solution to the Markowitz model revolves around the portfolio weights, or percentages of
investable funds to be invested in each security. Because the expected returns, standard
deviations, and correlation coefficients for the securities being considered are inputs in, the
Markowitz analysis, the portfolio weights are the only variable that can be manipulated to
solve the portfolio problem of determining efficient portfolios.

To select an optimal portfolio of financial assets using the Markowitz Principles/analysis;

investors should;
(i) Identify optimal risk-return combinations available from the set of risky assets being
considered by using the Markowitz efficient frontier analysis. This step; uses the inputs
from, the expected returns, variances, and covariances for a set of securities.
(ii) Choose the final portfolio from among those in the efficient set based on an investor's
preferences.
Even if portfolios are selected arbitrarily, some diversification benefits are gained. This results
in a reduction of portfolio risk. However, to take; the full information set into account, we use
portfolio theory as developed by Markowitz, Portfolio theory is nonnative, meaning that it tells
investors; how they should act to diversify optimally. It is based on a small set of assumptions,
including;
(i) A single investment period; for example, one year.
(ii) Liquidity of positions; for example, there are no transaction costs.
(iii)Investor preferences based only on a portfolio's expected return and risk; as
measured by variance or standard deviation.
6.3. SINGLE INDEX MODEL
Single index model is a model which assumes that the co-movement between stocks is due the
single common influence by market performance . Hence, the measure of this index (i.e. single

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CH-6 Portfolio Theory

common factor), can be found by relating the stock return to the return on a stock market
index. Mathematical formula for single index model is:
E(ri) = αi + βirm + ei
where:
E(ri) = return on stock i
αi = component of stock i’s return that is independent of the market’s performance; αi= E(ri) -
βi r m
rm = the rate of return on the market index
βi = measures the expected change in ri given a change in rm, βi = Covi,m/s2m
ei =unexpected component (residual)

These equations show that the stock return is influenced by the market (beta), has a firm
specific expected value (alpha) and firm-specific unexpected component (residual). According
to single index model; expected return, variance and covariance can be estimated as follows
when they are used to represent the joint movement of stocks:
Mean return of stock, E(r)i= αi + βirm
Variance of a stock’s return, σ2i = β2iσ2m + σ2ei
Covariance of returns between stocks i& j, σij = βiβjσ2m
where: σ2m = market variance, and
σ2ei = unique risk factor (firm specific risk)

6.4. CAPITAL MARKET THEORY

Following the development of portfolio theory by Markowitz, two major theories have been
derived. These are: capital market theory and arbitrage pricing theory. Arbitrage Pricing
Theory (APT) specifies several risk factors or its multifactor asset valuation model. Capital
market theory extends Markowitz’s portfolio theory, by assuming the existence of a risk-free
asset additionally and it develops a model for pricing all risky assets; i.e. the CAPM.

Capital market theory and capital asset pricing model (CAPM) were developed almost
concurrently. CAPM considered the underlying assumptions of the Markowitz portfolio theory,
however, additionally it assuming the existence of a risk-free asset, i.e. an asset with zero
variance.

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6.4.1. Capital Assets Pricing Model (CAPM)

What is CAPM?The CAPM was introduced by Jack Treynor, John Lintner, William Sharpe and
Jan Mossin in the early 1960’s. CAPM is models that establish the linear relationship between
un-diversifiable risk (systematic risk) and expected return. According to CAPM, the investor
needs to be compensated in two ways, for time value of money (risk free rate) and for taking
systematic risk. A security’s expected return is risk free rate plus a premium based on the
systematic risk of security. The CAPM assumes any asset’s systematic risk is captured by one
risk factor, i.e. the market risk factor. Adding one new stock to a well-diversified portfolio
affects the risk of the portfolio depending upon the asset’s degree of market risk, as measured
by its Beta. Investing in risky assets such as the market portfolio should carry a premium
compared to the risk-free rate. Otherwise, investors will not take the risk. The risk premium on
the market portfolio, measure as the difference between the market return and the risk-free
rate is called the market risk premium. If investors are mainly concerned with the risk of their
portfolio rather than the risk of the individual securities in the portfolio, how should the risk of
an individual stock be measured?

Assumptions of CAPM
(i) Investors are risk averse individuals and they maximise their expected utility of their end of
period wealth.
(ii) Investors have the same one period of time horizon.
(iii) Investors are price takers (no single investor can affect the price of a stock) and have
homogenous expectation about asset returns that have a joint normal distribution.
(iv) Investors can borrow or lend money at the risk-free rate of return.
(v)The quantities of assets are fixed. All assets are marketable and perfectly divisible.
(vi) Asset markets are frictionless and information is costless and simultaneously available
to all investors.
(vii) There are no market imperfections such as no taxes, no transaction costs or no
restrictions on short selling.

Thus, although these assumptions do not realistic in the real world, they are used to make the
model simpler for us to use for financial decision making. Most of these assumptions can be
relaxed.
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 The CAPM requires that in equilibrium the market portfolio must be an efficient
portfolio.

 As long as all assets are marketable, divisible and investors have homogenous
expectations, all individuals will perceive the same efficient set and all assets will be
hold in equilibrium.

 If every individual holds a percentage of their wealth in efficient portfolios, and all
assets are held, then the market portfolio must be also efficient because the market is
simply the sum of all individual holdings and all individual holdings are efficient.

 Without the efficiency of the market portfolio the capital asset pricing model is un-
testable.

In a competitive market, the expected risk premium varies in direct proportion to beta.

 i.e., Expected risk premium = beta ´ market risk premium.

The risk of each stock is measured by its beta and the risk premium varies in direct proportion
to beta. All stocks will lie along the SML and the expected return on a stock can be calculated
by adding the risk premium to the risk-free rate. i.e., Expected return= risk premium + risk-free
rate

For an individual risky asset, the relevant risk measure is the covariance of its returns with the
return on the market portfolio. An alternative measure called beta is also used. The beta
coefficient of an asset i, βi, used to measure covariance, is defined as:

where,σi,M= is the covariance of the return on the asset i and the return on the market portfolio
σ2M= is the variance of return on the market portfolio.

Thus, the equation used for CAPM is as follows:

Ki = Krf+ βi(Km - Krf)

Where: Ki = the required return for the individual security i.

Krf= the risk-free rate of return
βi= the beta of the individual security
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Km = the expected return on the market portfolio

(Km - Krf) is called the market risk premium, i.e. expected return on the market portfolio
minus risk-free rate of return.
This equation can be used to find any of the variables listed above, given the rest of the
variables are known.

Example 1: Find the required return on a stock given that the risk-free rate is 8%, the expected
return on the market portfolio is 12%, and the beta of the stock is 2.
Ki = Krf+ βi(Km - Krf)
Ki = 8%+ 2(12% - 8%)
Ki = 16%
Note that you can then compare the required rate of return to the expected rate of return. You
would only invest in stocks where the expected rate of return exceeded the required rate of
return.

Example2: Find the beta on a stock given that its required return is 12%, the risk-free rate is
4%, and the expected return on the market portfolio is 10%.
12%= 4%+ βi(10% - 4%)
βi= (12% - 4%)
(10% - 4%)
βi= 1.33

Note that beta measures the stock’s volatility (or risk) relative to the market.
 The least risky investment is T-bills, since the return on them is fixed, it is unaffected by
what happens to the market. (beta = 0),
 The riskier investment is market portfolio of common stocks (average beta = 1)
 Risk premium (excess return) is expected returns minus risk free return.
 The relationship between systematic risk and expected return in financial markets is
usually called the security market line (SML).

Security Market Line (SML)

The relationship between an individual security’s expected rate of return and its systematic risk
as measured by beta will be linear, this relationship is called as Security Market Line.

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The graph depicts the SML of Securities A, B, and C:

 Beta = 1.0 implies as risky as market

 Securities A and B are more risky than the market: Beta >1.0
 Security C is less risky than the market: Beta <1.0

Now, if everyone holds the market portfolio, and if beta measures each security’s contribution
to the market portfolio risk, then it’s no surprise that the risk premium demanded by investors
is proportional to beta. This is what the CAPM says.

Critique of CAPM:
 Unrealistic assumptions: CAPM is not without controversy. It rests on some critical (and
questionable) assumptions.
 Not testable: An empirical test does not confirm CAPM.
 CAPM does not explain differences of returns for securities that differ; over time,
dividend yield, size effect.

6.4.2. Arbitrage Pricing Theory (APT)

According to APT also, only the systematic risk is relevant in determining expected returns
(similar to CAPM). However, there may be several systematic (non-diversifiable) risk factors
such as; economic growth, interest rates, and inflation (different from CAPM, which assumes
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only one risk factor) that is systematic or macroeconomic in general and that affect the returns
of all stocks to some degree. Since firm specific risks are easily diversified out of any well-
diversified portfolio, they are not relevant in determining the expected returns of securities
(similar to CAPM).

The basic idea behind Arbitrage Pricing Theory is to calculate the returns in absence of
arbitrage-condition of artificially overpricing or under-pricing a product. In other language,
arbitrage is the process of earning profit by taking advantage of differential pricing for the
same asset. Arbitrage Pricing Theory applies to economies that are regulated by the Law of One
Price. The Law of one price states that two identical goods can’t be sold at different price, but be
sold with the same price. If they sell at different price arbitrage takes up.

APT Assumes:
 Only systematic or non-diversifiable risk matters, but there may be several of these
macroeconomic risk factors that affect the returns of well-diversified portfolios. Such
common risk factors might happen to be are; unexpected changes in economic growth,
interest rates, and inflation.
 Investors must agree on what the relevant risk factors are. There must be a linear
relationship between the risk exposure or sensitivity (its loadings on the risk factors) and
expected return of a security.

A representation of APT model which holds ‘ n’ number of risk factors common stock, would
look like the following:
E(Ri) = ai + bi1[RP1] + bi2[RP2] + … … .. + bin[RPn]

where: ai = the expected return on an asset with zero systematic risk (i.e. RFR)
RPj = the risk premium related to the jth risk factor
bin= the pricing relationship between the risk premium and the asset; that is, how
responsive asset i is to the nth risk factor. These are called factor betas

For example: In order to illustrate how the model works we will assume that there are two
common factors: one related to unexpected changes in the level of inflation and another related
to unanticipated changes in the real level of GDP.

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If we further assume that the risk premium related to GDP sensitivity is 0.03 and a stock that is
sensitive to GDP has a bj (where j represents the GDP factor) of 1.5, this means that this factor
would cause the stock’s expected return to increase by 4.5 percent (= 1.5 × 0.03). To develop
this notion further, consider the following example of two stocks and a two factor model.

First, consider these risk factor definitions and sensitivities:

 Unanticipated changes in the rate of inflation. The risk premium related to this factor is
2 percent for every 1 percent change in the rate (RP1 = 0.02)
 Unexpected changes in the growth rate of real GDP. The average risk premium related to
this factor is 3 percent for every 1 percent change in the rate of growth (RP 2 = 0.03)
 The rate of return on a zero-systematic risk asset (i.e., zero beta) is 4 percent (RFR = 0.04)

Assume also that there are two assets (x and y) that have the following response coefficients to
these common risk factors:
 The response of asset x to changes in the inflation factor is 0.50 (bx,1 = 0.50)
 The response of asset x to changes in the GDP factor is 1.50 (bx,2 = 1.50)

These factor sensitivities can be interpreted in much the same way as beta in the CAPM; that is,
the higher the level of bij, the greater the sensitivity of asset ito changes in the jth risk factor.
Thus, the response coefficients listed indicate that if these are the major factors influencing
asset returns, therefore, its expected return should be greater. The overall expected return
equation will be:

E(Ri) = ai + bi1[RP1] + bi2[RP2]

= 0.04 + bi1 (0.02) + bi2 (0.03)
Therefore, for assets x:
E(Rx) = 0.04 + (0.50)(0.02) + (1.50)(0.03)
= 0.0950 = 9.50%

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