CHAPTER THREE

CHAPTER Risk, Return and Portfolio

3 Theory
Discussion Points:
 Expected Return
 Risk
 Portfolio Expected Return and Risk
 Systematic and Unsystematic Risk
 Portfolio Theory and Risk Diversification
 Capital Asset Pricing Model (CAPM)
 The Arbitrage Pricing Model
 Risk Preferences
I. Risk, Return and Portfolio Theory

 Risk and return are most important concepts in finance.

In fact, they are the foundation of the modern finance
theory. What is risk? How is it measured? What is
return? How is it measured?
 Risk in general is the quantifiable likelihood of loss or
less-than expected returns.
 Many definitions of risk depend on specific application
and situational contexts. Frequently, risk is considered
as an indicator of threat. It can be assessed qualitatively
or quantitatively.
 …Cont’d
Risk, Return &… Cont’d
 Qualitatively, risk is considered proportional to the expected
losses which can be caused by an event and to the
probability of this event. The harsher the loss and the more
likely the event, the greater the overall risk.

Measuring risk is often difficult; the probability is assessed by

the frequency of past similar events, but rare failures are hard
to estimate, and loss of human life is generally considered
beyond estimation.
Examples of risk include: credit risk, inflation risk, liquidity risk,
market risk, interest-rate risk, etc.
 Risk, Return &… Cont’d …Cont’d
Risk in Finance
 In finance, risk is the probability
that an investment’s actual
return will be different than
expected. This includes the
possibility of losing some or all
of the original investment.
 Risk is usually measured by
calculating the standard
deviation of the historical
returns or average returns of a
specific investment.
 Risk, Return &… Cont’d
Risk Vs. Return
 A fundamental concept in finance is the relationship
between risk and return.
 The compensation required by investors to invest in
ventures where returns are not certain is over and
above the compensation they require for the pure
time value of their money.
 Thus, the greater the amount of risk that an investor
is willing to take on, the greater the potential return.
The reason for this is that investors need to be
compensated for taking on additional risk.
 Risk, Return &… Cont’d
 In general, investors require a rate of return that
reflects at least:
a) their time value of money, and
b) their risk taking
c) the purchasing power loss (due to inflation)
 For example, a government Treasury Bond is considered to
be one of the safest investments and, when compared to a
corporate bond, provides a lower rate of return. The reason
for this is that a corporation is much more likely to go
bankrupt than the government.
 Because the risk of investing in a corporate bond is higher,
investors are offered a higher rate of return.
 Risk, Return &… Cont’d
☻From the perspective of the
possible variability in the expected
outcomes, for example, a The more certain
government bond that guarantees its the return
holder Birr 100 interest after 30 days expected from an
has no risk, since there is no
variability associated with the
asset, the less the
return. variability, and
☻However, an investment in a firm’s therefore the
common stock that may earn over lower the risk.
the same period from Birr 0 to Birr
200 is very risky due to the variability
of the expected return..
 Risk, Return &… Cont’d
Measuring Risk
☻Risk is measured with Probability
probability, which is merely
Distributions
number that represents the
Probability
chances of occurrence of
different possible outcomes. distribution
☻Probabilities give hints describes the
about the intensity of risk outcomes and
involved in investments. their associated
probabilities.
 Risk, Return &… Cont’d
Example:
☻ABC Company is considering
investing Birr 100,000 in short term
investment. Let’s call this investment,
Investment X. Based on some research,
we believe that the rate of return to be
earned on investment X is directly
related to how the Ethiopian economy
performs in the near future. The table
below shows possible rates of return
on the short-term investment the firm
planned to make and probabilities for
the possible performance of the
national economy.
 Risk, Return &… Cont’d

State of Probability Rate of Return on

Economy Investment X (%)
Good 0.2 20
Average 0.6 10
Bad 0.2 0
 Risk, Return &… Cont’d
Measures of Central Tendency
►A probability distribution may be summarized by measures of
central tendency.
►Central tendency refers to the value that the outcomes tend to
cluster around.

►There are several measures of central tendency but finance

usually emphasizes the importance of the expected value.

Expected Value E(X) – is the probability weighted

average of the possible outcomes.
 Risk, Return &… Cont’d
 In general,
n

Expected Value of X = E(X) = Ẍ = ∑PiXi

i=1

where, n = the number of possible outcomes

i = the ith possible outcome
P = probability of the occurrence of i

 From the data given in the table, we can calculate the expected rate of
return for investment X as follows:
E(X) = [(0.2x0.2) + (0.6x0.1) + (0.2x0)] = 0.1

NB: An investment with a higher expected value will be considered

better and one with lower expected value is bad.
 Risk, Return &… Cont’d
Measures of Dispersion
 Dispersion refers to the
spreading or scattering of the
possible outcomes in the
probability distribution.
 In other words, dispersion
measures how likely it is that
an outcome will vary from the
central tendency.
 Two of the widely used
measures of dispersion are
variance and standard
deviation.
 Risk, Return &… Cont’d

Variance
Variance indicates the weighted dispersion of outcomes around
the expected value, with probabilities serving as weights.
For a random variable X with values X1, X2, X3,…,Xn, and
corresponding probabilities P1, P2, P3,…, Pn, the variance is:
n

Variance of x = σx2 = ∑pi (xi - ẍ)2

i=1
 Risk, Return &… Cont’d

 For investment X, the variance of the possible return rate

is:

σx2 = 0.2(0.2-0.1)2 + 0.6(0.1-0.1)2 + 0.2(0-0.1)2

= 0.004
 Variance shows the likelihood that the actual value of X
will vary from the expected value, and to what degree.
The lower the variance, the more likely it is for the actual
and the expected values to be similar.
 Risk, Return &… Cont’d

•  
 Risk, Return &… Cont’d

•  
 Risk, Return &… Cont’d

Example
 To illustrate the use of the coefficient of variation,
let us add another investment venture, investment
Y, to our investment X based on our earlier
assumption under the three different investment
climates.
State of Probability Rate of Return on
Economy Investment Y
Good 0.2 0.4
Average 0.6 0.1
Bad 0.2 -0.1
 Risk, Return &… Cont’d

•  
 Risk, Return &… Cont’d

 In the example above, a comparison of investment X

with investment Y reveals that Y has a higher expected
return rate, but also has a higher associated risk.
If only one of X or Y has to be selected, the coefficient of
variation would serve the purpose.
Since X has a lower risk per unit of return (CVx = 0.63)
unlike that of Y (CVy = 1.33), investment X should be
preferred. The one with the lowest coefficient of
variation (the lowest risk per unit of return) is the better.
 Risk, Return &… Cont’d

Risk and Return: Financial Asset Portfolios

 So far we are concerned on individual assets
considered separately. However, most investors
actually hold a portfolio of assets.
 Portfolio refers to a bundle or group of assets or
securities such as stocks and bonds held by an
investor.
 If the investor holds a well-diversified portfolio,
then his concern should be the expected return
and risk of the portfolio rather than individual
assets or securities.
 Risk, Return &… Cont’d

Example: Portfolio Return

 To illustrate assume a simple
portfolio composed of the two
investments, X and Y, already
discussed in the foregoing sections.
Assume further that the portfolio of
X and Y is composed of 50%
investment in each. Thus, the weight,
w, given for each is 0.5. That is, wx =
0.5, and wy = 0.5. Weights of
investments in portfolios should sum
to 1.0. It is possible now to calculate
the expected portfolio return.
 Risk, Return &… Cont’d

•  
 Risk, Return &… Cont’d

Measuring Portfolio Risk

 Like in the case of individual assets or securities, the risk of a
portfolio could be measured in terms of its variance or
standard deviation.

However, the variance or standard deviation of a portfolio is

not simply the weighted average of variances (or standard
deviations) of individual securities.

The portfolio variance (or standard deviation) is affected by the

association of movement of returns of the two securities.
Covariance of two securities measures their co-movement.
 Risk, Return &… Cont’d

Measures of Co-movement
 The co-movement concept
is very important in
developing the concept of
risk.
 Co-movement refers to the
association of movement
between two variables.
There are two measures of
co-movement: correlation
and covariance.
 Risk, Return &… Cont’d

•  
 Risk, Return &… Cont’d

•  
 Risk, Return &… Cont’d

 How is the portfolio variance affected by the correlation

coefficient? Let’s take an example.
Example:
Securities A and B are equally risky, but they have different
expected returns:
___________________________________________________
E(Ra) = 0.16 E(Rb) = 0.24
Wa = 0.50 Wb = 0.50
σa2 = 0.04 σb2 = 0.04
σa = 0.20 σb = 0.20
__________________________________________________
 What is the portfolio variance if (a) Corrab = +1.0, (b) Corrab = - 1.0, (c) Corrab = +0.10,
and (d) Corrab = - 0.10?
 Risk, Return &… Cont’d

 Corrab = +1.0, i.e., perfect positive correlation: the returns of the

two securities A and B are perfectly positively correlated, the
portfolio variance will be:

σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(1.0)(0.2)(0.2)

= 0.01+0.01+0.02 = 0.04

 As can be seen above, the portfolio variance is just equal to the

variance of individual securities. Thus, the combination of
securities A and B is as risky as the individual securities.
 Risk, Return &… Cont’d

 Corrab = - 1.0, i.e., perfect negative correlation: If the returns of

securities A and B are perfectly negatively correlated, the
portfolio variance is:

σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(-1.0)(0.2)(0.2)

= 0.01+0.01 – 0.02 = 0

 As can be shown above, the portfolio variance is zero. It means

that the combination of securities A and B completely reduces
the risk.
 Risk, Return &……Cont’d
Cont’d

 Weak positive correlation (Corrab = +0.10): the portfolio

variance under weakly positive correlation is computed below:

σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(0.1)(0.2)(0.2)

= 0.01+0.01+0.002 = 0.022

 As can be evident above, the portfolio variance is less than the

variance of individual securities, hence reduces the risk.
 Risk, Return &… Cont’d

 Weak negative correlation (Corrab = - 0.10): the

portfolio variance under weakly negative correlated
returns of two securities A and B is:

σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(- 0.10)(0.2)(0.2)

= 0.01+0.10 – 0.002 = 0.018

 The above calculation revealed that the portfolio

variance has reduced more than when returns were
weakly positively correlated.
 Risk, Return &… Cont’d

It is clearly indicated in the above example that a

total reduction of risk is possible if the returns of the
two securities are perfectly negatively correlated,
though, such a perfect negative correlation will not
generally be found in practice. Securities do have a
tendency of moving together to some extent, and
therefore, risk may not be totally eliminated.
 Risk, Return &… Cont’d

Covariance How is co-variance calculated?

Three steps are involved in the
Covariance shows how calculation of covariance
between two securities.
the two variables co-
Step 1. Determine the expected
vary. returns for the securities.
Covariance states not 2. Determine the deviation of
only how well two possible returns from the
variables ‘track’ with expected return for each security.
3. Determine the sum of the
each other but also how
product of each deviation of
likely each variable is to returns of two securities and
vary from the track. probability.
 Risk, Return &… Cont’d

•  
 Risk, Return &… Cont’d

•  
 Risk, Return &… Cont’d

•  
 Risk, Return &… Cont’d

 As σp increases, the riskiness of

a portfolio of assets increases.
 With the portfolio composed
of 50% investment in asset X
and 50% investment in Y, the
expected rate of return is 11%
and the portfolio standard
deviation of rate of return
(risk) is 11.14%.
 Choosing different values for
Wx and Wy leads to different
risk-return results.
 Risk, Return &… Cont’d

Diversification and Portfolio Risk

The Principle of Diversification
 The process of spreading an investment across several
assets (and thereby forming a portfolio) is called
diversification.
 The principle of diversification tells us that spreading an
investment across many assets (diversifying) will help in
minimizing, even in eliminating some of the risk. However,
diversification cannot eliminate all risk.
 There is a minimum level of risk that cannot be eliminated
simply by diversifying. Thus, diversification reduces risk,
but up to a point. Put another way, some risk is
diversifiable and some is not.
 Risk, Return &… Cont’d

Types of Risk
☺ The total risk of a security can be viewed as consisting
of two parts:

Total Diversifiable Nondiversifiable

= +
Risk Risk Risk
 Risk, Return &… Cont’d

Diversifiable Risk
 Diversifiable risk represents the
portion of an asset’s risk that is
associated with random causes
that can be eliminated through
diversification.
 It is attributable to firm-specific
events such as strikes, lawsuits,
regulatory actions and loss of a
big contract in a bid.
 Diversifiable risk is also called
unsystematic risk. It is also
referred to as unique risk, or
asset-specific risk.
 Risk, Return &… Cont’d

☺Examples of unsystematic risk are:

♠ workers declare strike in a company
♠ a formidable competitor enters the
market
♠ the firm loses a big contract in a bid
♠ the government increases custom
duty on the material used by the firm
♠ the company is not able to get
adequate quantity of raw materials from
the suppliers
♠ the company experts leave to another
company
 Risk, Return &… Cont’d

Nondiversifiable Risk
◙ This part of the risk arises on account
of the economy-wide uncertainties and
the tendency of individual securities to
move together with changes in the
market.
◙ This part of the risk cannot be
reduced through diversification, and it
is called systematic, or markets risk.
◙ Investors are exposed to market risk
even when they hold well-diversified
portfolios of securities.
 Risk, Return &… Cont’d

◙ Examples of systematic
risk are:
◘ the government changes the
interest rate policy
◘ the increase in corporate tax
rate
◘ the government resorts to
massive resource financing
◘ the increase in inflation rate
◘ the NBE promulgates a
restrictive credit policy
 Risk, Return &… Cont’d

 The unsystematic risk can be reduced as more and more

securities are added to a portfolio. How many securities
should be held by an investor to eliminate unsystematic
risk?
 In USA, it has been found that unsystematic risk can
be eliminated by holding about 15 securities (Evans
et al., Diversification and the reduction of Dispersion,
Journal of Finance, Dec. 1968, pp. 761–69) .
 In Indian context, a portfolio of about 40 shares can
almost totally reduce the unsystematic risk (Gupta, L.
C., Rates of Return on Equities: The Indian Experience,
1981 pp. 30–35) .
 Risk, Return &… Cont’d

►Can Systematic risk be

eliminated through
diversification? Let’s
► The answer is no, because,
Measure
the systematic risk affects
almost all assets to some Nondivers
degree. Hence, no matter -ifiable
how many securities investors
put into a portfolio,
Risk
systematic risk cannot be
eliminated or reduced.
 Risk, Return &… Cont’d

Measuring Nondiversifiable (Systematic) Risk

 Since the systematic risk is the most important determinant
factor of an asset’s expected return, we need some way of
measuring the level of systematic risk for different
investments.
 The specific measure that we will use is called the beta
coefficient, denoted by the Greek letter β.
 A beta coefficient, or beta for short, tells us how much
systematic risk a particular security has relative to an
average assets.
 By definition, an average asset has a beta of 1.0 relative to
itself.
 Risk, Return &… Cont’d

 The beta coefficient, β, is used to measure

nondiversifiable (systematic) risk. It is an index of the
degree of movement of an asset’s return in response
to a change in the market return.
 The beta coefficient for an asset can be found by
examining the asset’s historical returns relative to
the returns for the market.
 The market return is the return on the market
portfolio of all traded securities.
 Risk, Return &… Cont’d

•  
 Risk, Return &… Cont’d

Obtaining and Interpreting Betas

 Beta coefficients for actively traded securities can
be obtained from published sources.
 The beta coefficient for the market is to be equal to
1.0; all other betas are viewed in relation to this
value.
 Asset betas may take on values that are either
positive or negative, but positive betas are the
norm
 The majority of beta coefficients fall between 0.5
and 2.0.
 Risk, Return &… Cont’d

◙ Some selected beta coefficients and their associated

interpretations are presented in the table below:
Beta Comment Interpretation
2 Move in same Twice as responsive, or risky, as the market
1 Direction as Same response or risk as the market
0.5 market Only half as responsive, or risky, as the market
0 Unaffected by market movement
-0.5 Move in opposite Only half as responsive, or risky, as the market

-1 Direction as Same response or risk as the market

-2 market Twice as responsive, or risky, as the market

NB: A stock that is twice as responsive as the market is expected to experience a 2%

change in its return for each 1% change in the return of the market portfolio, whereas
the return of a stock that is half as responsive as the market is expected to change by
half of 1% for each 1% change in the return of the market portfolio.
 …Cont’d
Risk, Return &… Cont’d

Portfolio Betas
 Given the beta of each asset comprising the
portfolio, the beta of a portfolio can be easily
estimated by using the betas of the individual
assets it includes.
 Let wi represent the proportion of the portfolio’s
total Birr value represented by asset i and βi equal
the beta of asset i. Then portfolio beta, βp, is given
by the following equation: n
βp = (wi* βi) + (wk* βk) + … + (wn* βn) = ∑ (wi* βi)
i=1

☻Portfolio betas are
interpreted in exactly the
same way as individual
asset betas. ☻They indicate
the degree of responsiveness
of the portfolio’s return to
changes in the market
return.
…Cont’d
Risk, Return &… Cont’d
■ For example, when the
market return increases by
10%, a portfolio with a beta of
0.75 will experience a 7.5%
increase in its return (.75*10%)
whereas a portfolio with a
beta of 1.25 will experience a
12.5% increase in its return
(1.25*10%).
■ Low-beta portfolios are less
responsive and therefore less
risky than high-beta portfolios.
 …Cont’d
Risk, Return &… Cont’d

Illustration
►Ghibe Corporation wishes
to assess the risk of two
Now portfolios: portfolio A and
Let’s portfolio B. Both portfolios
contain five assets, with the
Take proportions and betas
shown below.
Example Required: Compute the beta
of each of the two portfolios
 …Cont’d
Risk, Return &… Cont’d

Portfolio A Portfolio B
Asset Proportion Beta Proportion Beta
01 0.1 1.65 0.1 0.8
02 0.3 1.0 0.1 1.0
03 0.2 1.3 0.2 0.65
04 0.2 1.1 0.1 0.75
05 0.2 1.25 0.5 1.05
Totals 1.00 1.00

βA = (0.10*1.65) + (.3*1.0) + (0.2*1.3) + (0.2*1.1) + (0.2*1.25) = 1.20

βB = (0.10*0.8) + (0.10*1.0) + (0.2*0.65) + (0.1*0.75) + (0.5*1.05) = 0.91
 …Cont’d
Risk, Return &… Cont’d

Risk & Required Rate of Return

►How can we relate risk and the required rate of
return? Provided that an investor has measured the
level of systematic risk prevalent in an asset, then
how can s/he determine the rate of return that is
commensurate with the asset’s risk?
►The issue of relating risk with the required rate of
return can be addressed using a model called capital
asset pricing model (CAPM).
 …Cont’d
Risk, Return &… Cont’d
The Capital Asset Pricing Model (CAPM)
► The basic theory that links together risk and return for all
assets is commonly called the capital asset pricing model
(CAPM).
► Using the beta coefficient, β, to measure nondiversifiable risk,
the CAPM is given by the following equation:
Kj = RF + [(Km – RF) βj]
where,
Kj = required rate of return
RF = risk-free rate of return, commonly measured by the return on the
government treasury bonds
βj = beta coefficient or index of nondiversifiable risk for asset j
Km = market return; the return on market portfolio of assets
 …Cont’d
Risk, Return &… Cont’d

Example:
IBX Company wishes to determine the required rate of
return on an asset – Asset X – that has a beta, βx, of 1.45.
The risk free rate of return is found to be 7.5%; the return
on the market portfolio of assets is 11%.
Required: Calculate the required rate of return, Kx.
Kx = RF + [(Km – RF) βx]
Kx = 7.5% + [(11% - 7.5%)1.45]
Kx = 7.5% + [(3.5%)1.45]
= 7.5% + 5.075
►Therefore, Kx = 12.575%
 …Cont’d
Risk, Return &… Cont’d

♥ The 3.5% (11% - 7.5%) is the

market risk premium, i.e., the
premium paid by the average assets
in the market.
♥ When this market risk premium is
adjusted for the asset’s index of risk
(beta) of 1.45, we get the asset’s risk
premium of 5.075 (1.45*3.5%).
♥ Finally, when the asset’s risk
premium (5.075%) is added to the
7.5% risk-free rate, we will get a
12.575% required rate of return.
 …Cont’d
Risk, Return &… Cont’d

►Other things being equal,

the higher the beta (the
extent of systematic risk), the High return
higher the riskiness of an investments are
asset, and the greater the associated with
return required by investors; those that have high
and the lower the beta (the systematic risk, and
level of systematic risk), the assets with low
lower the risk, and the lower systematic risk have
the required return. This is low return potential.
what is known as the risk-
return trade-off.
 …Cont’d
Risk, Return &… Cont’d

Assumptions of CAPM
CAPM is based on a number of assumptions. Some of the
important assumptions are here under:
1) Market efficiency: the capital markets are assumed to be
efficient. Efficiency implies that share markets reflect all
available information.
2) Risk aversion: Investors are assumed to be risk averse.
They evaluate a security’s return and risk in terms of the
expected return and standard deviation respectively.
They prefer the highest expected returns for a given level
of risk.
 …Cont’d
Risk, Return &… Cont’d

3) Homogeneous expectations: All investors are

assumed to have the same expectations about the
expected return and risk of securities.
4) Single time period: All investors’ decisions are
based on single time period.
5) Risk-free rate: All investors can lend or borrow at
a risk-free rate of interest.
 …Cont’d
Risk, Return &… Cont’d

The Security Market Line

►When the capital asset pricing
model is depicted graphically, it is
called the security market line (SML).
►The SML, which is a straight line,
reflects the required return in the
market place for each level of
nondiversifiable risk.
►In the graph below, risk as
measured by beta, β, is plotted on the
x-axis, and rrr, Krf are plotted on the
y-axis. The risk-return trade-off is
clearly represented by the SML.
 …Cont’d
Risk, Return &… Cont’d

SML
Required 14.0
Return (%)
12.0
Expected Market
10.0 Return = 8%
8.0

6.0 Market Risk

Premium =
5%
4.0
Risk-free
0.02 return = 3%
2.00
0
0 0.5 1 1.5 2 2.5 X Non-diversifiable
0 Risk, β,
Fig. 2.1 The Security Market Line (SML) with Anthony Co.’s asset Z data shown.

Implications & Relevance
of CAPM
►CAPM is based on a
number of assumptions.
Given those assumptions,
it provides a logical basis
for measuring risk and
linking risk and return.
…Cont’d
Risk, Return &… Cont’d
Implications
CAPM has the following
implications:
a) Investors will always
combine a risk-free asset
with a market portfolio
of risky assets. They will
invest in risky assets in
proportion to their
value.
 …Cont’d
Risk, Return &… Cont’d

b) Investors will be
compensated only for that risk
which they cannot diversify.
Beta is the most appropriate
measure of an asset’s risk.
c) Investors can expect returns
from their investment
according to the risk. This
implies a linear relationship
between the asset’s expected
return and its beta.
 Risk, Return &… Cont’d

♣ In general, the concepts of risk and return as

developed under CAPM have intuitive appeal and
they are quite simple to understand.
♣ Financial managers use these concepts in a
number of financial decision making such as:
■ valuation of securities,
■ cost of capital measurement,
■ investment risk analysis, etc.
♣ However, despite its intuitive appeal &
simplicity, CAPM suffers from a number of
practical problems
 …Cont’d
Risk, Return &… Cont’d

Limitations of CAPM
a) It is based on unrealistic assumptions:
☻CAPM is based on a number of assumptions that
are far from the reality. For example, it is very
difficult to find a risk-free security.
☻ A short-term highly liquid government security is
considered as a risk-free security. It is unlikely that
the government will default, but inflation causes
uncertainty about the real rate of return.
 Risk, Return &… Cont’d

☻The assumption of the equality of the

borrowing and lending rates is not correct. In
practice, these rates differ.
☻ Further investors may not hold highly
diversified portfolios.
►Under these circumstances, CAPM may not
accurately explain the investment behavior of
investors and beta may fail to capture the risk of
investment.
 …Cont’d
Risk, Return &… Cont’d

b) It is difficult to test the validity of beta:

☻Most of the assumption of CAPM may not be very critical
for its practical validity. We need to establish that beta is
able to measure the risk of the security & that there is
significant correlation between beta and the expected
return.
☻ The empirical results has given mixed results. The earlier
tests showed that there was a positive correlation between
returns & betas. However, the relationship was not as strong
as predicted by CAPM.
☻ Moreover, this results also revealed that returns were also
related to other measures of risk, including the firm-specific
risk.
 Risk, Return &… Cont’d

c) Stability of data:
☻ Beta is a measure of a security’s future risk. But
investors do not have future data to estimate beta.
What they have are past data about the share price
and the market portfolio. Thus, they can only estimate
beta based on historical data.
☻ Investors can use historical data as the measure of
future risk only if it is stable over time. Most research
has shown that the betas of individual securities are
not stable over time. This indicates that historical betas
are poor indicators of the future risk of securities.
 …Cont’d
Risk, Return &… Cont’d

Risk Preferences
♥ Different managers or firms might possibly have different
risk preferences. The three basic risk preference behaviors
are risk-averse, risk-indifferent, and risk-seeking behaviors.
♥ The risk-indifferent manager does not require an increase
in required return as risk increases. That is, the manager is
indifferent to the increment in risk.
♥ For the risk seeking manager, the required return
decreases for an increase in risk. Theoretically, because such
managers enjoy risk, they are willing to give up some return
to take more risk. Such an individual would willingly assume
all risk in the economy and hence not likely to exist.
 …Cont’d
Risk, Return &… Cont’d

♥ On the other hand, a risk-averse manager requires

an increase in required return for every increase in
risk. Because such managers shy away from risk, they
need a higher return if they are to accept a given
level of risk.
♥ Generally, managers tend to be risk-averse, and
such risk-averse manager has been assumed in our
discussions in this chapter. The SML is positively
sloped for risk-averse managers only.
END OF CHAPTER THREE