Risk

Risk and
and Return
Return

Investment and Portfolio Management

Chinhoyi University of Technology
 After studying Chapter 5,
you should be able to:
1. Define risk and return and show how to measure them by calculating expected
return, standard deviation, and coefficient of variation.
2. Understand the relationship (or “trade-off”) between risk and return.
3. Discuss the different types of investor attitudes toward risk.
4. Explain risk and return in a portfolio context, and distinguish between
individual security and portfolio risk.
5. Distinguish between avoidable (unsystematic) risk and unavoidable
(systematic) risk and explain how proper diversification can eliminate one of
these risks.
6. Define and explain the capital-asset pricing model (CAPM), beta, and the
characteristic line.
7. Calculate a required rate of return using the capital-asset pricing model
(CAPM).
8. Demonstrate how the Security Market Line (SML) can be used to describe this
relationship between expected rate of return and systematic risk.
9. Explain what is meant by an “efficient financial market” and describe the three
levels (or forms) to market efficiency.
 Risk and Return
Defining Risk and Return
Using Probability Distributions to Measure
Risk
Attitudes Toward Risk
Risk and Return in a Portfolio Context
Diversification
The Capital Asset Pricing Model (CAPM)
Efficient Financial Markets
 Defining Return
Income received on an investment plus any change in
market price,
price usually expressed as a percent of the
beginning market price of the investment.

Dt + (Pt - Pt-1 )
R=
Pt-1
 Return Example
The stock price for Stock A was $10 per share 1
year ago. The stock is currently trading at $9.50
per share and shareholders just received a $1
dividend.
dividend What return was earned over the
past year?
 Return Example
The stock price for Stock A was $10 per share 1
year ago. The stock is currently trading at $9.50
per share and shareholders just received a $1
dividend.
dividend What return was earned over the
past year?

$1.00 + ($9.50 - $10.00 )

R= = 5%
$10.00
 Defining Risk
The variability of returns from
those that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share of
stock?
 Determining Expected
Return (Discrete Dist.)
n
R =  ( Ri )( Pi )
i=1
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities.
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation
Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 .090
 Determining Standard
Deviation (Risk Measure)
n
=  ( Ri - R )2( Pi )
i=1

Deviation , is a statistical measure

Standard Deviation,
of the variability of a distribution around its
mean.
It is the square root of variance.
Note, this is for a discrete distribution.
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation
Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
Determining Standard
Deviation (Risk Measure)
n
= 
i=1
( R i - R ) 2
( Pi )

= .01728

= .1315 or 13.15%
 Coefficient of Variation
The ratio of the standard deviation of a distribution to the
mean of that distribution.
It is a measure of RELATIVE risk.

CV =  / R
CV of BW = .1315 / .09 = 1.46
Determining Expected
Return (Continuous Dist.)
n
R =  ( Ri ) / ( n )
i=1
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.
 Class practice Qn 1
See handout
 Determining Standard
Deviation (Risk Measure)
n
= 
i=1
( R i - R ) 2

(n)
Note, this is for a continuous distribution where the
distribution is for a population. R represents the
population mean in this example.
 Risk Attitudes
Certainty Equivalent (CE)
CE is the amount of cash someone
would require with certainty at a point in time to make
the individual indifferent between that certain amount
and an amount expected to be received with risk at the
same point in time.
 Risk Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
Averse
Risk Attitude Example
You have the choice between (1) a guaranteed dollar
reward or (2) a coin-flip gamble of $100,000 (50%
chance) or $0 (50% chance). The expected value
of the gamble is $50,000.
Mary requires a guaranteed $25,000, or more, to call off
the gamble.
Raleigh is just as happy to take $50,000 or take the risky
gamble.
Shannon requires at least $52,000 to call off the gamble.
 Risk Attitude Example
What are the Risk Attitude tendencies of each?

Mary shows “risk aversion” because her

“certainty equivalent” < the expected value of
the gamble.
Raleigh exhibits “risk indifference” because her
“certainty equivalent” equals the expected value
of the gamble.
Shannon reveals a “risk preference” because
her “certainty equivalent” > the expected value
of the gamble.
 Risk Attitude Example
Concept of utilities

Given a security`s return, its standard deviation

as well as the risk aversion coefficient of the
investor, one can compute total utility for a given
security, thus one can make a decision on which
security to take.
The following formula can be used:
U = E(ri) – 0.005Aσi2
 Use of utility function
NB
The 0.005 is a normalizing factor to reduce the size of
the variance, σ2, which is the square of the standard
deviation (σ), a measure of the volatility of the
investment and therefore its risk.
This equation is normalized so that the result is a
yield percentage that can be compared to investment
returns, which allows the utility score to be directly
compared to other investment returns, such as the
return of risk-free T-bills.
 Risk Attitude Example
Ex ample: application of utilities

A security has an expected rate of return of

20% and standard deviation of 20%. Bills
offer a sure rate of return of 7%. Which
investment alternative will be chosen by an
investor whose A=4? What if A=8.

NB this formula applies even in a portfolio

context
 Determining
Determining Portfolio
Portfolio Expected
Expected Return-
Return-
Diversifying
Diversifying into
into risky
risky securities
securities

m
RP =  ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the portfolio.
Calculating Portfolio Risk
 For a portfolio of two assets, A and B, the variance of the return on the portfolio is:

σ p2  x 2A σ 2A  x B2 σ B2  2x A x BCOV(A, B)
σ p2  x 2A σ 2A  x B2 σ B2  2x A x Bσ A σ BCORR(R ARB )

Where: xA = portfolio weight of asset A

xB = portfolio weight of asset B
such that xA + xB = 1.

for illustration look at case for 2 security portfolio in

handout.
 Determining Portfolio
Standard Deviation
m m
P =  W
j=1 k=1 j W k  jk
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Wk is the weight (investment proportion) for
the kth asset in the portfolio,
jk is the covariance between returns for the jth
and kth assets in the portfolio.
 Variance - Covariance Matrix
A three asset portfolio:
Col 1 Col 2 Col 3
Row 1 W1W11,1 W1W21,2 W1W31,3
Row 2 W2W12,1 W2W22,2 W2W32,3
Row 3 W3W13`,1 W3W23,2 W3W33,3

j,k = is the covariance between returns for the

jth and kth assets in the portfolio.
 Portfolio Risk and
Expected Return Example
You are creating a portfolio of Stock D and Stock BW
(from earlier). You are investing $2,000 in Stock BW
and $3,000 in Stock D.D Remember that the expected
return and standard deviation of Stock BW is 9% and
13.15% respectively. The expected return and standard
deviation of Stock D is 8% and 10.65% respectively. The
correlation coefficient between BW and D is 0.75.
0.75
What is the expected return and standard deviation
of the portfolio?
Determining Portfolio
Expected Return
WBW = $2,000 / $5,000 = .4
WD = $3,000 / $5,000 = .6

RP = (W )(RBW) + (W )(RD)
BW D

RP = (.4)(9%) + (.6)(
.6 8%)
8%
RP = (3.6%) + (4.8%)
4.8% = 8.4%
 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 WBW WBW BW,BW WBW WD BW,D
Row 2 WD WBW D,BW WD WD D,D

This represents the variance - covariance

matrix for the two-asset portfolio.
 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (.4)(.4)(.0173) (.4)(.6)(.0105)
Row 2 (.6)(.4)(.0105) (.6)(.6)(.0113)

This represents substitution into the variance -

covariance matrix.
 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (.0028) (.0025)
Row 2 (.0025) (.0041)

This represents the actual element values in

the variance - covariance matrix.
 Determining Portfolio
Standard Deviation
P = .0028 + (2)(.0025) + .0041
P = SQRT(.0119)
P = .1091 or 10.91%
A weighted average of the individual standard deviations
is INCORRECT.
 Determining Portfolio
Standard Deviation
The WRONG way to calculate is a weighted average
like:
P = .4 (13.15%) + .6(10.65%)
P = 5.26 + 6.39 = 11.65%

10.91% = 11.65%
This is INCORRECT.
 Summary of the Portfolio Return
and Risk Calculation
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26
The portfolio has the LOWEST coefficient of
variation due to diversification.
 Capital Allocation Across Risky and Risk-Free
Portfolios – case of diversification in money market
securities.

Control risk
Asset allocation choice
Fraction of the portfolio invested in
Treasury bills or other safe money market
securities
 The Risky Asset Example
Total portfolio value = $300,000
Risk-free value = 90,000
Risky (Vanguard & Fidelity) = 210,000
Vanguard (V) = 54%
Fidelity (F) = 46%
 The Risky Asset Example Continued

Vanguard 113,400/300,000 = 0.378

Fidelity 96,600/300,000 = 0.322
Portfolio P 210,000/300,000 = 0.700
Risk-Free Assets F 90,000/300,000 = 0.300
Portfolio C 300,000/300,000 = 1.000
 The Risk-Free Asset

Only the government can issue default-free

bonds
Guaranteed real rate only if the duration
of the bond is identical to the investor’s
desire holding period
T-bills viewed as the risk-free asset
Less sensitive to interest rate fluctuations
 Portfolios of One Risky Asset and a Risk-
Free Asset

It’s possible to split investment funds between

safe and risky assets.
Risk free asset: proxy; T-bills
Risky asset: stock (or a portfolio)
 Example

rf = 7% rf = 0%

E(rp) = 15% p = 22%

y = % in p (1-y) = % in rf
 Expected Returns for Combinations

E ( rc )  yE ( r p )  (1  y ) r f

rc = complete or combined portfolio

For example, y = .75
E(rc) = .75(.15) + .25(.07)
= .13 or 13%
Combinations Without Leverage

If y = .75, then
c = .75(.22) = .165 or 16.5%
If y = 1
c = 1(.22) = .22 or 22%
If y = 0
 c = (.22) = .00 or 0%
 Capital Allocation Line (CAL)
E(rc) = yE(rp) + (1 – y)rf
= rf +[(E(rp) – rf)]y (1)

σc = yσp → y = σc/σp (2)

From (1) and (2)

E(rc) = rf +[(E(rp) - rf)/σp]σc (CAL)

Figure 6.4 The Investment Opportunity Set
with a Risky Asset and a Risk-free Asset in
the Expected Return-Standard Deviation
Plane
 Capital Allocation Line with Leverage
Borrow at the Risk-Free Rate and invest in stock.
Using 50% Leverage,
rc = (-.5) (.07) + (1.5) (.15) = .19

c = (1.5) (.22) = .33

Figure 6.5 The Opportunity Set with Differential
Borrowing and Lending Rates
 Risk Tolerance and Asset Allocation
The investor must choose one optimal
portfolio, C, from the set of feasible choices.
Trade-off between risk and return
Expected return of the complete portfolio is
given by:
E ( rc )  r f  y  E ( rP )  r f 
Variance is:

  y
2
C
2 2
P
Figure 6.6 Utility as a Function of Allocation to the
Risky Asset, y
Analytical Solution

U = E(rc) – 0.005Aσc2 (1)

where E(rc) = yE(rp) + (1-y)rf (2)

σc = yσp
(3
Substituting (2) and (3) into (1), we obtain
U = yE(rp) + (1-y)rf – 0.005A(yσp)2

From dU/dy = E(rp) – rf – 0.01Ayσp2 = 0,

y* = (E(rp) – rf)/0.01Aσp2
 Assuming a portfolio expected return of 15%, sure
rate of 7%, portfolio standard deviation of 22% and a
risk aversion coefficient of 4. compute the percentage
of your resources you would invest in risky assets and
the corresponding expected return of complete
portfolio and its standard deviation.
y* = (E(rp) – rf)/0.01Aσp2

= (15 – 7)/0.01*4*(22)2

= 0.413
Optiomal Portfolio for risky assets
Efficient frontier: the set of portfolios offering the highest
expected return for any given standard deviation.

Expected
Return (%)

efficient frontier
minimum-variance
portfolio
Standard Deviation (%)
 Portfolio of Two Securities
0.25
Efficient Portfolio

0.20
Is one “better”?
Expected Return

Security 1 Sub-optimal Portfolio

0.15

Security 2
0.10
Minimum Variance Portfolio

0.05

0.00
0.15 0.17 0.19 0.21 0.23 0.25 0.27 0.29
Standard Deviation
 Formula for Minimum Variance
Portfolio- For one asset class
 2  1, 2 1 2
2

w1 
*

 12  2 1, 2 1 2   22
 1  1, 2 1 2
2

w2 
*

 12  2 1, 2 1 2   22
 1  w1*
 Portfolio Selection with n Risky Assets
minw  p2   wi w j ij i j  w w
i j
n

s.t. E (rp )   wi E (ri )  w r  

i 1
n

 w  w1  1
i 1
i

y Markowitz (1952): Portfolio Selection, Journal of F

 Optimal weights for 2 asset
class (debt & equity)

 E RD   Rf  2 E  E RE   Rf COVD,E
WD 
E RD   Rf  2 E  E RE   Rf  2 D  E RD   Rf  E RE   Rf COVD,E
 Example
See tutorial work sheet qn 4 and 10
 0.16

0.14

0.12
S
Expected Return

0.1 J
0.08
H
0.06
G R inefficient

0.04
F
0.02

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Standard Deviation
 Capital Market Line

0.30

100% Risky
0.25
Long risky and
0.20 short risk-free
Return

0.15 CML
0.10
Long both risky
and risk-free
0.05
100% Risk-less
0.00
0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50
Volatility
Risk Premium
Sharpe
r1  r f Ratio
rp  r f  p
1
The slope (r1  r f )  1 measure the extra expected
return the market offers for each extra risk a
investor is willing to bear
 0.16

0.14
S
0.12
◆
Expected Return

Tangent Portfolio
0.1 T
0.08
E R
0.06

0.04

0.02

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Standard Deviation
Efficient Trade-off Line

 New efficient trade-off line:

rT  r f
rp  r f   p  .06  .42165 p
T
 Compare the old trade-off line connecting points F and S.

rp  .06  .4 p

 Clearly the investor is better off.

Selecting the Preferred Portfolio
 It is important to note that in finding the optimal
combination of risky assets, we do not need to know
anything about investor preferences.

 There is always a particular optimal portfolio of risky

assets that all risk-averse investors who share the same
forecasts of rates of return will combine with the riskless
asset to reach their most-preferred portfolio.
The Rationale for Portfolio Selection
Return
Low Risk High
Risk
High
Return High
Low Risk High
Return
Risk
Low
Return Low Risk
Return
 Diversification and the
Correlation Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
 Total Risk = Systematic Risk
+ Unsystematic Risk
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk is the variability of return on stocks
or portfolios associated with changes in return on
the market as a whole.
Unsystematic Risk is the variability of return on
stocks or portfolios not explained by general market
movements. It is avoidable through diversification.
 Total Risk = Systematic
Risk + Unsystematic Risk
Factors such as changes in nation’s
STD DEV OF PORTFOLIO RETURN

economy, tax reform by the Congress,

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Total Risk = Systematic
Risk + Unsystematic Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Capital Asset
Pricing Model (CAPM)
CAPM is a model that describes the relationship between
risk and expected (required) return; in this model, a
security’s expected (required) return is the risk-free rate
plus a premium based on the systematic risk of the
security.
 Characteristic Line
Narrower spread
EXCESS RETURN is higher correlation
ON STOCK
Rise
Beta = Run

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line
 What is Beta?
An index of systematic risk.
risk
It measures the sensitivity of a stock’s returns to
changes in returns on the market portfolio.
The beta for a portfolio is simply a weighted average of
the individual stock betas in the portfolio.
 Characteristic Lines and
Different Betas
EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

EXCESS RETURN
ON MARKET PORTFOLIO
 Security Market Line
Rj = Rf + j(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures systematic
risk of stock j),
RM is the expected return for the market
portfolio.
 Security Market Line
Rj = Rf + j(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
M = 1.0
Systematic Risk (Beta)
 Security Market Line
Obtaining Betas
 Can use historical data if past best represents the
expectations of the future
 Can also utilize services like Value Line, Ibbotson
Associates, etc.
Adjusted Beta
 Betas have a tendency to revert to the mean of 1.0
 Can utilize combination of recent beta and mean
 2.22 (.7) + 1.00 (.3) = 1.554 + 0.300 = 1.854 estimate
 Determination of the
Required Rate of Return
Lisa Miller at Basket Wonders is attempting to
determine the rate of return required by their
stock investors. Lisa is using a 6% Rf and a
long-term market expected rate of return of
10%.
10% A stock analyst following the firm has
calculated that the firm beta is 1.2.
1.2 What is the
required rate of return on the stock of Basket
Wonders?
 BWs Required Rate
of Return
RBW = Rf + j(RM - Rf)
RBW = 6% + 1.2(
1.2 10% - 6%)
6%
RBW = 10.8%
The required rate of return exceeds the market rate of
return as BW’s beta exceeds the market beta (1.0).
 Determination of the
Intrinsic Value of BW
Lisa Miller at BW is also attempting to determine
the intrinsic value of the stock. She is using the
constant growth model. Lisa estimates that the
dividend next period will be $0.50 and that BW
will grow at a constant rate of 5.8%.
5.8% The stock is
currently selling for $15.

What is the intrinsic value of the stock? Is

the stock over or underpriced?
underpriced
Determination of the
Intrinsic Value of BW
Intrinsic $0.50
=
Value 10.8% - 5.8%

= $10

The stock is OVERVALUED as the

market price ($15) exceeds the
intrinsic value ($10).
$10
 Security Market Line
Stock X (Underpriced)
Required Return

Direction of
Movement Direction of
Movement

Rf Stock Y (Overpriced)

Systematic Risk (Beta)

 Risk Premium for
Factor 1

E  R p   RF  1 p ,1     K  p , K

Sensitivity of the
Portfolio to Factor 1
 Essence of the Arbitrage Pricing Theory

Given the impossibility of empirically

verifying the CAPM, an alternative model
of asset pricing called the Arbitrage Pricing
Theory (APT) has been introduced.
Essence of APT
A security’s expected return and risk are
directly related to its sensitivities to changes in
one or more factors (e.g., inflation, interest
rates, productivity, etc.)
 Essence of the Arbitrage Pricing Theory
(Continued)

In other words, security returns are generated

by a single-index (one factor) model:
rj,t  A j  β1, jI1,t  ε j,t
where:
I1,t  Val u eof Factor (1) i n pe ri od(t)
β1, j  be taof se cu ri ty(j) wi th re spe ctto Factor (1)

or, by a multi-index (multi-factor) model:

rj,t  A j  β1, jI1,t  β 2, jI 2,t  . . . + βn, jI n, t  ε j,t

 Assumptions
Ross and others developed an alternative based on the
following simplifying assumptions:
1. Capital markets are perfectly competitive,
2. Investors always prefer more wealth to less wealth,
3. In APT, the assumption of investors utilizing a mean-
variance framework is replaced by an assumption of the
process of generating security returns.
4. APT requires that the returns on any stock be linearly
related to a set of indices.
5. In APT, multiple factors have an impact on the returns
of an asset in contrast with CAPM model that suggests
that return is related to only one factor, i.e., systematic
risk
 Single-Factor APT Model
(A Comparison With the CAPM)

CAPM (Zero Beta Version) APT (One Factor

Factor = Market Portfolio Version)
Factor = “Your Choice”
Actual Returns:
Actual Returns:
rj,t  A j  β jrM, t  ε j,t rj,t  A j  β1, jI1,t  ε j,t

Expected Returns:
Expected Returns:
E(r j )  E(rz )  [E(rM )  E(rz )]β j E(r j )  E(rz )  [E(I 1 )  E(rz )]β1, j
Market Risk Premium FactorPrice*
* Note: In thetext,lambda ( ) denotes
factorprice.
 Single-Factor APT Model
(A Comparison With the CAPM)
Continued

CAPM (Zero Beta Version) APT (One Factor Version)

Continued Continued
Portfolio Variance: Portfolio Variance:

σ 2 (rp )  βp2 σ 2 (rM )  σ 2 (ε p ) σ 2 (rp )  β1,

2
p σ 2
(I1 )  σ 2
(ε p )
m m
wh e re βp  x β
j1
j j wh e re β1,p  x β
j1
j 1, j

m m
σ 2 (ε p )  
j1
x 2jσ 2 (ε j ) σ 2 (ε p )  
j1
x 2jσ 2 (ε j )

Assu m i n gC O V(ε j , ε k )  0 Assu m in gC O V(ε j , ε k )  0

 Multi-Factor APT Models

One Factor

rj, t  A j  β1, jI1,t  ε j, t

E(r j )  E(rz )  [E(I1  E(rz )]β1, j

σ 2 (rp )  β1,
2
p σ 2
(I1 )  σ 2
(ε p )
Two Factors

rj,t  A j  β1, jI1,t  β 2, jI 2,t  ε j,t

E(r j )  E(rz )  [E(I 1 )  E(rz )]β1, j  [E(I 2 )  E(rz )]β 2, j

σ 2 (rp )  β1,
2 2
p σ (I1 )  β 2 2
2,p σ (I 2 )  σ 2
(ε p )
 Multi-Factor APT Models
(Continued)
N Factors

rj,t  A j  β1, jI1,t  β 2, jI 2,t  . . . + βn, jI n, t + ε j,t

E(r j )  E(rz )  [E(I 1 )  E(rz )]β1, j
 [E(I 2 )  E(rz )]β 2, j
+....
+ [E(I n )  E(rz )]βn, j

σ 2 (rp )  β1,
2 2
p σ (I1 )  β 2
2,p σ 2
(I 2 )  . . . + β 2
n, p σ 2
(In ) + σ 2
(ε p )
 The Ideal APT Model
Ideally, you wish to have a model where
all of the covariances between the rates of
return to the securities are attributable to
the effects of the factors. The covariances
between the residuals of the individual
securities,
Cov(j, k), are assumed to be equal to
zero.
APT With an Unlimited Number of Securities
Given an infinite number of securities, if
security returns are generated by a process
equivalent to that of a linear single-factor or
multi-factor model, it is impossible to
construct two different portfolios, both
having zero variance (i.e., zero betas and zero
residual variance) with two different expected
rates of return. In other words, pure riskless
arbitrage opportunities are not available.
 Pure Riskless Arbitrage Opportunities
(An Example)
Note: If two zero variance portfolios could be
constructed with two different expected rates
of return, we could sell short the one with the
lower return, and invest the proceeds in the
one with the higher return, and make a pure
riskless profit with no capital commitment.
While all assets may be affected by growth
in GNP, the impact will differ.
Which firms will be affected more by the
growth in GNP?
The APT assumes that, in equilibrium, the
return on a zero-investment, zero-
systematic risk portfolio is zero, when the
unique effects are diversified away:
E(ri) = 0 + 1bi1 + 2bi2 + … + kbik
Look at illustrative example tutorial work sheet.
Single Index Model(Excess R)
The single-index model (SIM) is a
simple asset pricing model to measure both
the risk and the return of a stock, commonly
used in the finance industry
It is a Simplified version of Sharpe’s Market
Model
Decompose returns into market and active
components.
Postulate that active components are
uncorrelated.
SIM cont
Mathematically the SIM is expressed as:
Rit - rf = α + β (Rm – rf ) + ε
where:rit is return to stock i in period t
rf is the risk free rate (i.e. the interest rate on treasury
bills)
rmt is the return to the market portfolio in period t is
the stock's alpha, or abnormal return
SIM cont
β is the stock`s beta co efficient, or
responsiveness to the market return.
Note that Rm – rf is called the excess return on
the market, Rit - rf the excess return on the
stock are the residual (random) returns.
This can be reduced to a linear function:
Y = α + βX + ε
SIM cont
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).
Each stock's performance is in relation to the
performance of a market index (such as the
All Ordinaries).
Security analysts often use the SIM for such
functions as computing stock betas,
evaluating stock selection skills, and
conducting event studies.
Assumptions SIM
To simplify analysis, the single-index model assumes
that there is only 1 macroeconomic factor that causes
the systematic risk affecting all stock returns and this
factor can be represented by the rate of return on a
market index, such as the ZSE.
Assumptions SIM
According to this model, the return of any stock
can be decomposed into the expected excess
return of the individual stock due to firm-
specific factors, commonly denoted by its alpha
coefficient (α), the return due to
macroeconomic events that affect the market,
and the unexpected microeconomic events that
affect only the firm.
Most stocks have a positive covariance because
they all respond similarly to macroeconomic
factors.
Assumptions SIM
However, some firms are more sensitive to these factors
than others, and this firm-specific variance is typically
denoted by its beta (β), which measures its variance
compared to the market for one or more economic factors.
Covariances among securities result from differing
responses to macroeconomic factors. Hence, the
covariance of each stock can be found by multiplying their
betas and the market variance:
The single-index model assumes that once the market
return is subtracted out the remaining returns are
uncorrelated:
E  Ri   R f  i  E  Rm   R f  Single-index
model

The difference between expected

Ri  R f  i  Rm  R f   ei returns and realized returns is
attributable to an error term, ei.

The market model: the intercept, αi, and slope

coefficient, βi, can be estimated by using
Ri  i  i Rm  ei historical security and market returns. Note αi
= Rf(1 – βi).
R i  R f  i R m  R f   e i

Tota l va ria nce = S ys te ma tic va ria nce + Nons ys te ma tic va ria nce

i2  i2 m2  e2i  2Cov R m , e i   i2 m2  e2i

Zero
St. Deviation
Unique Risk
2(eP)=2(e) / n

P2M2
Market Risk

Number of
Securities
Single Factor Model
Solves the number of parameters problem:
For N assets, it requires N+1 parameters.
N active risks, 1 market volatility.
Problem with this model: it doesn’t capture observed
correlation structure in the market. Are EWZ and
Delta correlated only through their market exposure?
Advantage: simplicity makes this useful for back-of-
the-envelope calculations.
The CAPM and the Index Model
Actual Returns vs Expected Returns
CAPM is a statement about ex ante or expected returns
whereas all we can observe are actual or realized
holding period returns.
To make a leap from expected to realized returns, we
can employ the index model.
The index model beta turns out to be the same beta of
CAPM expected return-beta relationship, except we
place an observable market index instead of the
theoretical market portfolio.
The CAPM and the Index Model
The Index model and the expected return-beta
relationship.
CAPM:
E(ri)-rf= ßi[E(rm)- rf]
If the index M is the true market portfolio, we can take
the expectation of each side of the equation Ri = αi +
ßi(Rm) + ei.

E(ri)-rf= αi +ßi[E(rm)- rf]

The CAPM and the Index Model
If we compare it with CAPM equation the only
difference is αi. CAPM predicts that αi should be
zero for all assets. The alpha of a stock is expected
return in excess of the fair expected return as
predicted by CAPM. If the stock is fairly priced, its
alpha must be zero.
If we estimate the index model for several firms,
using regression equation, we should find expost
(realized) alphas average will be zero.
The CAPM and the Index Model
CAPM states that the expected value of alpha is zero
for all securities.
Index model states that realized value of alpha should
average zero.
Jensen examine the alphas realized by mutual funds
and found that frequency distribution of these alphas
seem to be distributed around zero.
Example
See hand out