Chapter 7: 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.

7.1. 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.

7.1.1. 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:

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 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)
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.

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7.1.2. 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,

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.

7.1.2.1. 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.
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 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.

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   Probi (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

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 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.
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:
COV AB
 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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(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:
COV AB
 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.

7.1.2.2 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:
 p  (wA ) 2 ( A ) 2  (wB ) 2 ( B ) 2  2(wA )(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:

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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 wA2   B2 wB2   C2 wC2  2wA wB Cov A, B  2wB wC CovB,C  2wA 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 standard deviation of a two-asset portfolio using
correlation coefficient.

 p  (wA ) 2 ( A ) 2  (wB ) 2 ( B ) 2  2(wA )(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%

7.1.3. 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:

Chapter 7 Page 7
Case (a): Correlation coefficient of -1
Case (a): Correlation coefficient of -1 This is a perfect negative
Expected Standard Correlation correlation. So, the
Asset Return Deviation Coefficient greatest diversification
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%
90.00% 10.00% 5.90% 9.5%
Risk of the portfolio is
80.00% 20.00% 6.80% 4.0%
almost eliminated at
70.00% 30.00% 7.70% 1.5% 70% invested in asset
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%
0.00% 100.00% 14.00% 40.0%
Case (b): Correlation coefficient of +1

Expected Standard Correlation It is indicates a perfect

Asset Return Deviation Coefficient positive correlation.

A 5.0% 15.0% 1
B 14.0% 40.0%
Portfolio Components Portfolio Characteristics
Weight of Expected Standard
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%
60.00% 40.00% 8.60% 25.0% Here, there is no
reduction of portfolio
50.00% 50.00% 9.50% 27.5%
risk. Thus, diversification
40.00% 60.00% 10.40% 30.0% is not possible.
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%

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7.2. 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.

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

Chapter 7 Page 9
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 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.

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.

Chapter 7 Page 10
 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.

7.3. 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 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) - βirm
rm = the rate of return on the market index
βi = measures the expected change in ri given a change in rm, βi = Covi,m/2m
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:

Chapter 7 Page 11
 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)

7.3. 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.

7.3.1. 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.

Chapter 7 Page 12
(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.

 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, σ i,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
Km = the expected return on the market portfolio

Chapter 7 Page 13
 (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.

Example 2: 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.

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

Chapter 7 Page 14
 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.

7.3.2. 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 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:

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 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) = i + i1[RP1] + i2[RP2] + … … .. + in[RPn]

where: i = the expected return on an asset with zero systematic risk (i.e. RFR)
RPj = the risk premium related to the jth risk factor
in= 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.

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 j (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 (RP2 = 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 (x,1 = 0.50)
 The response of asset x to changes in the GDP factor is 1.50 (x,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 ij, the greater the sensitivity of asset i to changes in the jth risk factor. Thus, the response coefficients

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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) = i + i1[RP1] + i2[RP2]

= 0.04 + i1 (0.02) + i2 (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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