Risk and Return
CAPITAL
MARKET
THEORY
Oleh :
Habib Kusuma (12)
Marisa Hanifah (19)
Putri Zuhria (26)
Richo Mukti Ardiyanto (28)
Portfolio Returns and Portfolio
Risk
In this chapter, we can lower the risk of our
portfolio without lowering the portfolios expected
rate of return with appropriate diversification.
Calculating the Expected Return of a Portfolio
The expected rate of return for a portfolio of
investments is simply a weighted average of the
expected rates of return of the individual
investments in that portfolio.
Expected Portfolio Returns =
(Fraction of Portfolio Invested in Asset 1 x Expected
Rate of Return on Asset 1) + (Fraction of Portfolio
Invested in Asset 2 x Expected Rate of Return on
Asset 2) +
(Fraction of Portfolio Invested in Asset n x Expected
Rate of Return on Asset n)
Portfolio Expected Rate of Return
E(rportfolio) = [W1 x E(r1)] + [W2 x E(r2)] +
[W3 x E(r3)] + . [Wn x E(rn)]
E(rportfolio)= the expected rate of return on a
portfolio of n assets.
Wi
E(ri)
= the portfolio weight for asset i.
= the expected rate of return
earned by asset i.
Example
If we invest in two group in 50 : 50, group one has
a expected return 12% and group two has a
expected return 8%. So,
E(rportfolio) = [W1 x E(r1)] + [W2 x E(r2)]
= (0,5 x 12 %) + (0,5 x 8 %)
= 10 %
Evaluating Portfolio Risk
Portfolio Diversification
Combining investments in a portfolio leads to risk
reduction.
This effect of reducing risks by including a large
number of investments is called diversification.
Effect : the standar deviation of a portfolios return
is typically less than the average of standard
deviations of the returns of each of the portfolios
individual investments.
Example
Shop sell two products, sunglasses and umbrella.
Sunglasses has 20% rate of return in sunny
season and 0% in rainy. Umbrella has 20% rate of
return in rainy and 0% in sunny.
If :
A. Sunny season as long as rainy season so
expected rate of return is 10%. Not 0% if just invest
in one product.
B. Product is sunglasses and sunscreen, it has no
benefit because of perfect correlated (just in one
season)
And to ensure that problem, that not every single
investment is correlated, than we use correlation
coefficient.
The diversification benefits will be greater when
the correlations are low or negative.
Correlation between investment
returns
Diversification benefits
+1
None. No risk has been eliminated
because there is no realized by
combining the investment since they
move together perfectly.
There is substansial value to
diversification
1
Diversification is extremely effective
in portfolio risk. In fact, it is possible
to select the portfolio weight for two
investment whose returns are
perfectly negatively correlated, such
that all variability is eliminated from
the portfolio return and standard
deviation is zero
Diversification Lessons
Portfolio can be less risky than the average risk of
its individual investment.
To reduce that, is to combine investments that do
not move together ( has a negative correlation )
Checkpoint 8.1
Penny Simpson has a doorprize. And he want to
invest no more than 25% in the stock of EMR, so
he considering investing the remaining 75% in a
combination of a riskfree investments in U.S.
He expected to earn 8% on the Emerson shares
and 12% from the Starbucks shares, and 4% from
treasury bills.
So he decides to put 25% in Emerson, 25% in
Starbucks, 50% in Treasury bills.
So what rate of return should he expect?
STEP 1 : Picture the problem
14%
12%
10%
8%
Treasury bills
EMR
Starbucks
6%
4%
2%
0%
Category 1
E (Return)
Weight
Step 2 : Decide
on a solution
strategyProduct
U.S
treasury
bills
4.0%
0.50%
2.0%
EMR
8.0%
0.25%
2.0%
SBUX
12.0%
0.25%
3.0%
7.0%
Step 3 : Solve
E(rportfolio) = (1/2 x 0.04 ) + ( x 0.08 ) + ( x 0.12 ) =
0.07 or 7%
Step 4 : Analyze
So, the expected return is 7%.
Calculating the Standar
Deviation of Portfolios Return
= The standard deviation in portfolio return
= The proportion of portfolio that is invested in asset i
= The standard deviation of rate of return earned by asset i
= The correlation coefficient between the rates of
return earned by asset I and j
Example
Patty
received $ 20.000, invest in Coca Cola and
in Apple. Standard deviation is 0,20. and the
correlation coefficient is 0,75.
So, =
=
= 0,187
If the correlation is perfect positive, the costandard
deviation is alike weighted average of each
investments.
Systematic Risk and Market
Portfolio
It would be an onerous task to calculate the
correlations when we have thousands of possible
investments.
Capital Asset Pricing Model or the CAPM provides
a relatively simple measure of risk.
Systematic Risk and Market
Portfolio (cont.)
CAPM assumes that investors chose to hold the
optimally diversified portfolio that includes all
risky investments. This optimally diversified
portfolio that includes all of the economys assets
is referred to as the market portfolio.
Systematic Risk and Market
Portfolio (cont.)
According to the CAPM, the relevant risk of an
investment relates to how the investment
contributes to the risk of this market portfolio.
Systematic Risk and Market
Portfolio (cont.)
To understand how an investment contributes to
the risk of the portfolio, we categorize the risks of
the individual investments into two categories:
Systematic risk, and
Unsystematic risk
Systematic Risk and Market
Portfolio (cont.)
The systematic risk component measures the
contribution of the investment to the risk of the
market. For example: War, hike in corporate tax
rate.
The unsystematic risk is the element of risk
that does not contribute to the risk of the
market. This component is diversified away
when the investment is combined with other
investments. For example: Product recall, labor
strike, change of management.
Systematic Risk and Market
Portfolio (cont.)
An investments systematic risk is far more important than its
unsystematic risk.
If the risk of an investment comes mainly from unsystematic risk,
the investment will tend to have a low correlation with the returns of
most of the other stocks in the portfolio, and will make a minor
contribution to the portfolios overall risk.
Diversification and
Unsystematic Risk
Figure 82 illustrates that as the number of
securities in a portfolio increases, the contribution
of the unsystematic or diversifiable risk to the
standard deviation of the portfolio declines.
Diversification and
Systematic Risk
Figure 82 illustrates that systematic or nondiversifiable risk is not reduced even as we
increase the number of stocks in the portfolio.
Systematic sources of risk (such as inflation, war,
interest rates) are common to most investments
resulting in a perfect positive correlation and no
diversification benefit.
Diversification and Risk
Figure 82 illustrates that large portfolios will not
be affected by unsystematic risk but will be
influenced by systematic risk factors.
Systematic Risk and Beta
Systematic risk is measured by beta coefficient,
which estimates the extent to which a particular
investments returns vary with the returns on the
market portfolio.
In practice, it is estimated as the slope of a
straight line (see figure 83)
Figure 8.3 cont.
Figure 8.3 cont.
Beta
Beta could be estimated using excel or financial
calculator, or readily obtained from various
sources on the internet (such as Yahoo Finance
and Money Central.com)
Beta (cont.)
Table 81 illustrates the wide variation in Betas for
various companies. Utilities companies can be
considered less risky because of their lower betas.
For example, a 1% drop in market could lead to a .
74% drop in AEP but much larger 2.9% drop in
AAPL.
Calculating Portfolio Beta
The portfolio beta measures the systematic risk of
the portfolio and is calculated by taking a simple
weighted average of the betas for the individual
investments contained in the portfolio.
Calculating Portfolio Beta
(cont.)
Calculating Portfolio Beta
(cont.)
Example 8.2 Consider a portfolio that is comprised
of four investments with betas equal to 1.5, .75,
1.8 and .60. If you invest equal amount in each
investment, what will be the beta for the
portfolio?
Calculating Portfolio Beta
(cont.)
Portfolio Beta
= .25(1.5) + .25(.75) + .25(1.8) + .25 (.6)
= 1.16
8.3. The Security Market Line
and the CAPM
The key insights of the CAPM are that investments
with the same beta have the same expected rate
of return and that investors will require a higher
rate of return on investment with higher betas
For example, lets consider the relation between
the beta and expected return of a portfolio, WM
equals 80%, and 20% in a riskfree security. The
market portfolio has a beta of 1.0 and, and
assume that the expected return for the market
portfolio ,E(rM) is 11%. The riskfree security has a
beta of 0, and assume it offers a 6% riskfree
return. The expected rate of return is...
D1 :
WM = 80% = 0,8
E(rM) = 11%
rf = 6%
D2 : Expected rate of return
D3 :
We
also can calculate the portfolio beta, which
says that a portfolio beta should be equal to the
weighted average of the individual assets betas
that make up the portfolio.
The
straight line relationship between the betas
and expected return is called the security market
line, and its slope is often referred to as the
rewardtorisk ratio.
We can measure the slope of the security market
line.
Using the CAPM to Estimate
Expected Rates of Return
The CAPM provides a theory of how risk and
expected return are connected or traded off in the
capital market.
For example beta for Google is 0,75. If the riskfree rate of interest in economy is currently about
6%, and if the market risk premium, which is the
difference between the expected return on the
market portfolio and the riskfree rate of return is
estimated to be 5%, then the expected rate of
return is ...
825 Portfolio beta and
security market line
The portfolio expected return,k,_ p, equals a weighted average
of the individual stock's expected returns.
k,_ p
= (10%)(12%) + (25%)(11%) + (15%)(15%) + (30%)(9%)
+ (20%)(14%)
=
15.8%
The portfolio beta, p, equals a weighted average of the individual
stock betas
p =
(1.20)
=
(10%)(1.00) + (25%)(0.75) + (15%)(1.30) + (30%)(0.60) + (20%)
0.95
Plot the security market line and the individual
stocks
16
14
14
12
10
return exp
15
12
11
9
stock
Linear (stock)
4
2
0
0.5 0.6 0.7 0.8 0.9
beta
1.1 1.2 1.3 1.4
A "winner" may be defined as a stock that falls
above the security market line, which means
these stocks are expected to earn a return
exceeding what should be expected given their
beta or systematic risk. In the above graph, these
stocks include 2, 3, and 5. "Losers" would be
those stocks falling below the security market
line, which are represented by stocks 1 and 4 ever
so slightly.
Our results are less than certain because we have
problems estimating the security market line with
certainty. For instance, we have difficulty in
specifying the market portfolio
816.capital asset pricing
model
RiskFree,Rate + Expected Market  RiskFree,Return
Rate
x Beta
=
Required,Rate of,Return
A
3.75%
12.5%
C
3.75%
8.75%
(10%
3.75%)
0.80 =
D
3.75%
11.25%
(10%
3.75%)
1.20 =
3.75%
8.44%
(10%
+
(10%
3.75%)

3.75%)
1.40 =
x
0.75 =
818 .capital asset pricing
model
Required,Rate of,Return = RiskFree,Rate +
(Market Return  RiskFree Rate) X Beta
= 3.5% + (10.5%  3.5%) x 0.765
= 8.855%
819. .capital asset pricing
model
If the expected market return is 10.3 percent and
the risk premium is 5.3 percent, the riskless rate
of return is 5 percent (10.3%  5.3%). Therefore;
Tasaco = 5% + (10.3%  5%) x 0.864 = 9.58%
LBM
11.48%
Exxos
= 5% + (10.3%  5%) x 0.693 =
= 5% + (10.3%  5%) x 0.575 = 8.05%