3.

0 Portfolio theory & Asset Pricing models:Types of Risk

The possibility of variation in an outcome from what is expected . Risk differs

from uncertainty, which exists because we lack some information, we are
ignorant of all the facts.
Pure /downside risk is the possibility that something will go wrong; a threat.
Speculative risk is the possibility that things may go well; it represents an
opportunity.
Systematic risk affects the whole economy or industry, not just one entity.
Unsystematic risk affects just one entity or one asset type. If one company fails
because of poor management or poor capital structure, that only affects the
one entity
Risk-Return Trade- off
The E( R)of a project is the gain that the investor expects to earn in the future.
May differ from the actual Return in the gain that the investor has earned.
The risk of an investment is that the forecast return may or may not occur.
There is a trade –off between risk and return; the higher the risk of an investment
the higher the expected return. T Bs have very low risk.
An investor who opts for shares on the ZSE/SSX/JSE and derivative instruments,
(options and futures) would be accepting significantly more risk but for higher
returns.
Systematic and Unsystematic Risk
An asset's total risk consists of both systematic and unsystematic risk.
Systematic risk /market risk is related to the market/ cannot be diversified away
If it could then the return on the market would not be higher than the risk-free
rate.
Systematic risk is unavoidable risk/varies between projects due to legislation/
adverse trends in the economy/other external factors over which the company has
no control.
Unsystematic risk is diversifiable, firm-specific/ unique to a particular company.
Independent of political/economic factors, arising from bad labour relations
causing strikes, the emergence of improved competitor products or adverse press
reports.
Factors causing it are different for different companies and cancel each other out.
In building a portfolio of shares the investor will want to minimize unsystematic
risk.
Systematic &unsystematic risk…Fig
systematic risk
Unavoidable, the degree of systematic risk is a variable
factor between different industries
– shares in different companies will have systematic risk
characteristics different from the market average
The market considers some investments to be riskier than
others (food retailers have lower risk vs fashion industry).
A balanced portfolio of all stocks , or a unit trust which
mirrors the market, will incur systematic risk equal to the
average systematic risk in the market as a whole.
Individual investments will have their own levels of
systematic or market risk.
Total Risk

Total risk = systematic risk + unsystematic risk

Measured by the standard deviation of returns (σ )
For well-diversified portfolios, unsystematic risk is very small
Total risk for a diversified portfolio is essentially equivalent to
the systematic risk.
Systematic Risk Principle
There is a reward for bearing risk not for bearing risk
unnecessarily.
The expected return on a risky asset depends only on that
asset’s systematic risk since unsystematic risk can be
diversified away.
Expected Returns and Standard Deviation

 Er= (Pr ) (Return)


Standard Deviation

 Variance = 2 =  Pr { (R – Er)2}
Where P = probability
R = return
Er = expected return

Standard Deviation =  2
For $ Expected Returns
State of economy Prob Proj A Proj B
Strong 0.2 700 550
Normal 0.5 400 400
Weak 0.3 200 300

Required:
Calculate the expected values of projects A and B
Calculate the variance and the standard deviation of
projects A and B.
Comment on the answers for projects A and B
For $ Expected Returns --cntd
(1) (r) = Prob x Return
Project A Project B
 0.2 * 700 = 140 0.2 * 500 = 110
 0.5 * 400 = 200 0.5 * 400 = 200
 0.3 * 200 = 60 0.3 * 300 = 90
 400 400
Variance & standard deviation
Project A
Return (r) [ R – E(r) ]² [* Prob] 
700 400 (700 – 400) ² * 0.2 = 18 000
400 400 (400 – 400) ² *0.5 =0
200 400 (200 – 400) ² *0.3 = 12 000
30 000
2 = 30 000
 = 30 000
 = 173.21
Project B ---cntd
Project B
Return (r) [R – E(r) ]² [*Prob] 
550 400 (550 – 400) ² *0.2 = 4500
400 400 (400 – 400) ² *0.5 =0
300 400 (300 – 400) ² *0.3 = 3000

7500

2 = 7500
 = 7 500
=86.60
Expected Return of an assets
State of the Economy Prob(p) Return (R i)
Expansion 0.25 20%
Normal 0.50 15%
Recession 0.25 5%
Expected Return = (0.25x20%)+(0.5x15%)+(0.25x5%)
=13.75%
A portfolio of two (2) assets
E (Rp)= WAE(RA)+ WBE(RB)
Where:
E (Rp)=Expected Return of the portfolio
 WA The proportion of the portfolio invested in
=
stock A
E(RA)=Expected Return on stock A
WB =The proportion of the portfolio invested in
stock B
E(RB)= Expected Return on stock B
Portfolio Return – E(R ) of more than 1 Asset.
It is the value weighted average of the expected return of individual
securities.
The weight applied to each return will be equal to the fraction of the
portfolio invested in that security.  
Er(p) = W1 (Er)
Steps
Calculate the expected values of each of the assets that make up the
portfolio.
Find the weighted average for the expected value of each of the assets in
the portfolio.
The weights are not the probabilities but the contribution of each of the
assets to the total portfolio.
Example 1

Portfolio I has a total value of $200 000 and of this

total, asset A contributes $70 000 and B the remainder.
Assuming the expected income for A and B are $10 000
and $60 000 respectively.
Calculate the expected portfolio income.
70 000 * 10 000 +130 000 * 60 000
 200 000 200 000
 $42 500
Example 2

Security Weight Expected Return

 A 40% 20
 B 50% 15
 C 10% 10
 E(Rp)=(0.2* 0.4) + (0.5*0.15) +(0.1*0.1)
= 16.5%
E(R ) on a portfolio of two assets—ctd
Year Prob Stock A Stock B
2010 0.2 5% 50%
2011 0.3 10% 30%
2012 0.3 15% 10%
2013 0.2 20% -10%
There is a 50:50 split in the portfolio between asset A
and B
Required:
Calculate the expected return on a two asset portfolio
Solution

W A = 0.5 ; WB = 0.5
E (Rp)=Expected Return of the portfolio
E(RA)=0.20(5%)+0.30(10%)+0.30(15%)
+0.20(20%)= 12,5%
E(RB)=0.20(50%)+0.30(30%)+0.30(10%)+0.20(-
10%)= 20,0%
E (Rp)= 0.5(12,5%)+0.5(20%)=16.25%
Covariance between 2 assets
Co-Efficient Of Variation
It is a measure of the relative rather than the absolute dispersion.
 It shows the risk / unit of returns and provides a meaningful basis for
comparison when two alternatives have different expected rate of returns.
 The co-efficient of variation can be interpreted as a risk measure or in
certain circumstances as an overall criterion for acceptability.
Co-efficient of variation (CV) = 
x
Where x = expected values of net cash flows.  
The lower the Co-efficient of variation the lower the relative degree of risk.
 
Example
Consider the following
Example :Covariance / Interactive Risk

1) Where probabilities are equal

 
Covariance xy = 1/n[Rx – E(Rx)] [Ry – E(Ry)]
 Where n = number of outcomes or observations
 Rx = rate of return of x at any point
 E(Rx) = expected return on Rx
(Ry ) = rate of return of y at any point
E(Ry)= expected return on Ry
 
2) 1) Where probabilities are different
 
Covariance xy =  Pi {Rx – E(Rx)} {Ry – E(Ry)}
Example---Covariance
Covariance xy =  Pi [Rx – E(Rx)] [Ry – E(Ry)]
Example
You are given the following data for security A and B
Event Return (A) Event B Return (B)
A 20 A 5
B 15 B 10
C 10 C 15
Each event is likely to occur
Calculate the expected return, variance and standard
deviation for each security and determine the Covariance.
Solution
A E(RA) = (1/3 *20) + (1/3*15) +(1/3 *10)
= 15
B E(RB) = (1/3 *5) + (1/3*10) +(1/3 *15)
= 10
Covariance = 1/n[Rx – E(Rx)] [Ry – E(Ry)]
=1/3 [(20-15)(5-10) +(15-15)(10-10) +(10-15)(5-10)}
= -16.66667 
These securities are negatively correlated – they move in different
directions.
This is however an absolute measure and makes the interpretation
difficult especially where other relevant information is absent.
To overcome this difficulty, the correlation coefficient is used.
Correlation Coefficient

It overcomes the problems by the covariance by realising that

the movements of returns of securities should be affected by
variance or variability of these securities.
 It is a standard or adjusted covariance.
 It is a relative measure as compared to variance or standard
deviation which are absolute measures and this makes it more
useful than the covariance.
Correlation coefficient rxy = Covariance xy / (xy)
 rxy = Correlation coefficient
 x = standard deviation of x
 y = standard deviation of y
Correlation Coefficient----cntd

In our example = -16.667/(4.08*4.08)

= -1
 Interpretation of Correlation Coefficient
A correlation coefficient of –1 implies perfect negative correlation
 or inverse relation between movements of returns of 2 securities .
 If one increases by x% at any time the other will decrease by the same
magnitude.
A correlation coefficient of +1 implies perfect positive correlation between
movements of returns of 2 securities .
If one increases by x% at any time the other will increase by the same
magnitude.
A correlation coefficient of 0 implies independence between movements of
returns of 2 securities.
 
PORTFOLIO RISK – THE STANDARD DEVIATION OF A
PORTFOLIO

As opposed to the calculation of expected return

which is simply the weighted average expected return
of individual sum in the portfolio, calculation of the
standard deviation/risk is different.
It takes into account not only the weights, variances,
and standard deviation of each security but also the
covariance or correlation coefficient between pairs of
individual securities in the portfolio.
General Formula For the Portfolio Variance

²AB = W2A2A + W2B2B+ 2 WA WB CovAB

 
Since Correlation coefficient rab = Covariance ab / (AB) it implies that
Covariance ab = Correlation coefficient rab x AB
Cov ab = rab x AB
Therefore
²AB = W2A2A + W2B2B+ 2 WA WBAB rAB

 = √[ W2A2A + W2B2B+ 2 WA WBAB rAB]

The assumption of this model is that the attitude of investors in creating

portfolios is entirely depended on risk and return and the quantification of
risk.
Worked example…More questions
Form our previous example, suppose that an investor holds the following 40% of A and
60% of B calculate the portfolio risk.
 =√[ W2A2A + W2B2B+ 2 WAWBAB rAB
 =√[ (0.42*4.082)+(0.62*4.082)+(2*0.4*0.6*-1*4.08*4.08)
The Importance of Correlation Coefficient  
Effect of Changing Correlation Coefficient on Portfolio Risk with weights
constant and where securities being combined have different returns and
different standard deviations.
 
Stock Expected return Weight Standard Deviation
1 0.1 0.5 0.0049
 2 0.2 0.5 0.0100 
From the above details create a portfolio of stock 1 and 2 given that the correlation
coefficient is
a) 1 b) 0.5 c) 0 d) –0.5 e) –1
 The weights are as follows Stock 1 Stock 2
 a) 0.2 0.8
Solution b) 0.4 0.6
 c) 0.5 0.5
 d) 0.6 0.4
 e) 0.8 0.2
 Vary the weights where the correlation is kept constant for assets with
different returns and standard deviations results in different risk levels for
the portfolio being formed. Decrease the weight of the riskier asset vs the
less risky asset. Increasing the weight of the riskier asset results in higher
risk for the portfolio so formed.
 The correlation coefficient is the most important factor in risk reduction
for portfolio formed out of individual securities with different returns and
standard deviations. Draw a graph in Expected return and standard
deviations of the above portfolio.
Holding Period Returns (HPR).

This is the percentage increase in value of an investment over a given time period;
the dividend is paid at the end of the holding period.
HPR = End Price – Beg Price +Cash Dividends
Beginning Price
Suppose you are considering investing some of your money, now all invested in a
bank account, in a stock market index fund. The price of a share in the fund is
currently $100.00, and you time horizon is one year. You expect the cash dividend
during the year to be $4.00, so your expected dividend yield is 4%. Your HPR will
depend on the price one year from now. Suppose your best guess is that it will be
$110.00 per share. Then your capital gain will be $10.00, so your capital gain yield is
$10/$100 = 10%. The total holding period rate of return is the sum of the dividend
yield plus the capital gain yield, 4% + 10% = 14% or this could be calculated as: 
HPR = $110 - $100 + $4 = 14 or 14%
 $100
Dollar –Weighted Average Return

The Dollar Weighted Average Return = IRR of the

Investment.
The IRR is the return that sets the sum of NPV of all
the Cash Flows equal to the Initial Investment.
 The Dollar-Weighted Average will differ from the
Geometric Average Return and the Arithmetic average
Return because it takes into consideration the amount
of funds managed for each period. 
Average Returns- consists of arithmetic mean
returns and geometric mean returns
Arithmetic Returns
This is the simple average of a series of periodic returns.
It has the statistical property of being an unbiased estimator of the true
mean of the underlying distribution of returns
AMR=( R1+ R2……Rn)/n
Holding period quarterly returns of a mutual fund were, 1 St quarter 10%,
2nd quarter 25%, 3rd quarter (20%) and 4th quarter 25%.
Arithmetic Average = 10% + 25% - 20% + 25% = 10%
 4
the statistic ignores compounding and therefore does not represent an
equivalent single quarterly rate for the year. The arithmetic average is
useful, though, because it is the best forecast of performance in future
quarters.
GMR Same example
This is a compound annual return. When the periodic
rates of return vary from period to period, the geometric
mean return will have a value less than the arithmetic
mean GMR= Geometric Average =[(1+R1)x(1+R2)x….
(1+Rn)]¹/n
Rg=[(1+0.10) x (1 + 0.25) x (1 – 0.20) x (1 + 0.25)]¼
Rg = [(1+0.10) x (1 + 0.25) x (1 – 0.20) x (1 + 0.25)]¼ – 1 =
0,0829 or 8,29% 
Geometric return is also called time weighted average
return because it ignores the quarter to quarter variation in
funds under management .

The s² of the rate of return a measure of portfolio under a reasonable set of
assumptions,derived the formula for computing the variance of a portfolio.

The formula, not only indicated the importance of diversifying investments to
reduce total risk of a portfolio, but also showed how to effectively diversify.

Markowitz Portfolio Theory: Assumptions

Investors consider each investment alternative as being represented by a
probability distribution of ERs.

Investors maximize one-period expected utility, and their utility curves
demonstrate diminishing marginal utility of wealth.

Investors estimate the risk of the portfolio on the basis of the variability of
ERs.

Investors base decisions solely on ERs and risk, so their utility curves are a
function of ERs and the expected variance (or standard deviation) or returns
only.

A single asset or portfolio of assets is considered to be efficient if no other
asset or portfolio of assets offers higher expected return with the same (or
lower) risk, or lower risk with the same (or higher) expected return.
The Capital Asset Pricing Model

Because investors are risk averse, they will choose to hold a portfolio of securities to take advantage of the
benefits of Diversification.
They want to know how the stock will contribute to the risk and ER of their portfolios.
The s.d. of an individual stock does not indicate how that stock will contribute to the risk and return of a
diversified portfolio.
Thus, another measure of risk is needed; a measure of a security's systematic risk. This measure is provided
by the Capital Asset Pricing Model (CAPM).
Critical assumptions of CAPM
The CAPM is simple and elegant. Consider the many assumptions that underlie the model. Are they valid?
Zero transaction costs; Zero taxes; Homogeneous investor expectations; Available risk-free assets;
Borrowing at risk-free rates.
Beta as full measure of risk.
Investors are rational and want to maximize their return.
All information is freely available to investors and they are competent in interpreting that information.
Capital markets are perfectly competitive with a large number of buyers and sellers, no monopolies, no
taxes or transaction costs, and no entry or exit barriers to the market.
The Capital Asset Pricing Model (CAPM) provides an expression which relates the expected return on an
asset to its systematic risk. The relationship is known as the Security Market Line (SML) equation and
the measure of systematic risk in the CAPM is called Beta.
The Security Market Line (SML)

The SML equation is expressed as follows:

E[Ri] =Rf+β[E(Rm) - Rf] Where
 E[Ri] = the expected return on asset i,
Rf = the risk-free rate,
E[Rm] = the expected return on the market portfolio,
β. = the Beta on asset i, and
E[Rm] - Rf = the market risk premium.  
Draw the graph depicting the SML.
Relate the slope of the SML to (E[Rm] - Rf) which is the market
risk premium and that the SML intercepts the y-axis at the risk-
free rate.
Determination of the Beta

The level of systematic risk of asset x = x * Pxm

Where x = standard deviation of asset x
 Pxm= correlation of returns of x to those of the market portfolio
In financial models the systematic risk is measured by an index of the systematic
risk of the asset. This index is calculated by dividing the systematic risk of an asset
by that of the market portfolio. The market portfolio is made up of all risky assets
in the economy and therefore only systematic risk since it is fully diversified.
The index of the systematic risk is called Beta coefficient
Beta =β = x*Pxm / m
The Beta co-effiecent is the tendency of the returns of a stock to move with market
returns. The beta is therefore the sensitivity of asset returns to changes in the
returns of the market portfolio. It measures the average change to the stock price
when the market rises with an extra percent. The market portfolio will therefore
have a beta that is equal to 1
• CAPM states that β is enough to measure a security systematic
risk but the APT says that there are many systematic factors
which affect risk and that they cannot be adequately catered for
by a sing beta coefficient; a multifactor model for security
pricing.  
APT and other non- standards forms of CAPM have been used
in calculating returns more than the standard CAPM as they
are deemed to be more representative that is they have
measures of sensitivity (betas) for the type of systematic factor.
E.g. systematic factors are labour movements ; productivity
fluctuation, management skills availability, unforeseen
inflation, and unanticipated changes in interest rates.
APT----cntd
The problem in this method is in identifying which factors are important factors
and reporting the unforeseen and foreseen .The formular suggested for the APT
is as follows; Ri = ai + bifi + b2f2 + b3f3 + … + bifi + ei
Where ai = expected return of all the systematic factors – the bs have a value of
zero.
Bi= sensitivity of the stocks’ return to the I factor.
fi = value of the 1st factor that affects the stock’s return; ei = the residual error
APT may seem to be a superior measure to the CAPM, but APT is just another
model of pricing securities and is not necessarily superior to CAPM.
Tokyo Stock Exchange APT has been tested and results show that it is superior to
CAPM in selecting securities for portfolio and for explaining past returns.
Because of this it has replaced the CAPM in that market.
The CML and the Separation Theorem

The CML leads all investors to invest in the same risky asset portfolio,
the market portfolio.
Individual investors should only differ regarding their position on the
CML, which depends on their risk preferences.
In turn, how they get to a point on the CML is based on their financing
decisions
If you are relatively risk averse, you will lend some part of your
portfolio at the risk-free rate by buying some risk-free securities and
investing the remainder in the market portfolio of risky assets.
If you prefer more risk, you might borrow funds at the risk-free rate
and invest everything (all your capital plus what you borrowed, that is,
invest both personal funds plus borrowed funds) into the market
portfolio