Asset Pricing Models

Risk and Return: Portfolio
Theory and Assets Pricing

Models
 Discuss the concepts of portfolio risk and
return.
 Determine the relationship between risk
and return of portfolios.
 Highlight the difference between
systematic and unsystematic risks.
 Examine the logic of portfolio theory .
 Show the use of capital asset pricing model
(CAPM) in the valuation of securities.
 Explain the features and modus operandi
of the arbitrage pricing theory (APT).
Financial Management, Ninth Edition
© I M Pandey
Vikas Publishing House Pvt. Ltd. 2
 A portfolio is a bundle or a combination of
individual assets or securities.
 The portfolio theory provides a normative
approach to investors to make decisions to

invest their wealth in assets or securities
under risk.
◦ It is based on the assumption that investors
are risk-averse.
◦ The second assumption of the portfolio theory
is that the returns of assets are normally
distributed.
© I M Pandey
 The return of a portfolio is equal to the
weighted average of the returns of
individual assets (or securities) in the
portfolio with weights being equal to the
proportion of investment value in each
asset.
Expected return on portfolio  weight of security X × expected return on security X
 weight of security Y × expected return on security Y

© I M Pandey
 The portfolio variance or standard deviation
depends on the co-movement of returns on two
assets. Covariance of returns on two assets
measures their co-movement.
 The formula for calculating covariance of
returns of the two securities X and Y is as
follows:
Covariance XY = Standard deviation X ´
Standard deviation Y ´ Correlation XY
 The variance of two-security portfolio is given
by the following equation:
 p   x wx   y2 wy2  2wx wy Co varxy
2 2 2
  x2 wx2   y2 wy2  2 wx wy x y Corxy

© I M Pandey
 w* is the optimum proportion of
investment in security X. Investment in Y
will be: 1 – w*.
 y2  Cov xy
w* 
 x2   y2  2Cov xy

© I M Pandey
 When correlation coefficient of returns on
individual securities is perfectly positive
(i.e., cor = 1.0), then there is no advantage
of diversification.
 The weighted standard deviation of returns
on individual securities is equal to the
standard deviation of the portfolio.
 We may therefore conclude that
diversification always reduces risk
provided the correlation coefficient is less
than 1.
© I M Pandey
Portfolio Risk, p (%)
Portfolio Correlation
Weight Return (%) +1.00 -1.00 0.00 0.50 -0.25
Logrow Rapidex Rp p p p p p
1.00 0.00 12.00 16.00 16.00 16.00 16.00 16.00
0.90 0.10 12.60 16.80 12.00 14.60 15.74 13.99
0.80 0.20 13.20 17.60 8.00 13.67 15.76 12.50
0.70 0.30 13.80 18.40 4.00 13.31 16.06 11.70
0.60 0.40 14.40 19.20 0.00 13.58 16.63 11.76
0.50 0.50 15.00 20.00 4.00 14.42 17.44 12.65
0.40 0.60 15.60 20.80 8.00 15.76 18.45 14.22
0.30 0.70 16.20 21.60 12.00 17.47 19.64 16.28
0.20 0.80 16.80 22.40 16.00 19.46 20.98 18.66
0.10 0.90 17.40 23.20 20.00 21.66 22.44 21.26
0.00 1.00 18.00 24.00 24.00 24.00 24.00 24.00
Minimum Variance Portfolio
wL 1.00 0.60 0.692 0.857 0.656
wR 0.00 0.40 0.308 0.143 0.344
2
 256 0.00 177.23 246.86 135.00
 (%) 16 0.00 13.31 15.71 11.62

© I M Pandey
20
R
Cor = - 1.0 Cor = - 0.25
Portfolio return, %
Cor = + 0.50
15
Cor = + 1.0
Cor = - 1.0 L
10
0
0 5 10 15 20 25 30
Porfolio risk (Stdev, %)

© I M Pandey
 A risk-averse investor will prefer a
portfolio with the highest expected return
for a given level of risk or prefer a portfolio
with the lowest level of risk for a given
level of expected return. In portfolio
theory, this is referred to as the principle
of dominance.

© I M Pandey
 An efficient portfolio Return
is one that has the

highest expected R
returns for a given D

x
level of risk. The C

x
efficient frontier is B Q
the frontier formed

x x
P x x
x
by the set of efficient

portfolios. All other
A
Risk, 
portfolios, which lie

outside the efficient
frontier, are
inefficient portfolios.
© I M Pandey
 Risk has two parts:
◦ Systematic 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
risk cannot be reduced through diversification. It is also
known as market risk.
◦ Unsystematic risk arises from the unique uncertainties of
individual securities. It is also called unique risk.
Unsystematic risk can be totally reduced through
diversification.
 Total risk = Systematic risk + Unsystematic risk
◦ Systematic risk is the covariance of the individual
securities in the portfolio. The difference between variance
and covariance is the diversifiable or unsystematic risk.
© I M Pandey
 A risk-free asset or security has a zero
variance or standard deviation.
 Return and risk when we combine a risk-
free and a risky asset:

E ( R p )  wE ( R j )  (1  w) R f
 p  w j

© I M Pandey
RISK-RETURN ANALYSIS FOR A PORTFOLIO OF A RISKY AND A RISK-FREE SECURITIES
Weights (%) Expected Return, R p Standard Deviation (p)
Risky security Risk-free security (%) (%)
120 – 20 17 7.2
100 0 15 6.0
80 20 13 4.8
60 40 11 3.6
40 20 60 9 2.4
20 80 7 D 1.2
17.5
0 100 5 C 0.0
15
Expected Return
B
12.5
10 A
7.5
5
2.5 Rf, risk-free rate
0
0 1.8 3.6 5.4 7.2 9
Standard Deviation
© I M Pandey
 We can combine earlier
figures to illustrate the
feasible portfolios Return
consisting of the risk-free Capital Market Line (CML)
security and the portfolios Q
of risky securities. (
R
N
 We draw three lines from
the risk-free rate (5%) to
O
M
three portfolios. Each line

shows the manner in B
Capital Allocation Lines
which capital is allocated. (CALs)
This line is called the

P
capital allocation line L
(CAL). Risk, 
 The capital market line
(CML) is an efficient set of
risk-free and risky
securities, and it shows
the risk-return trade-off Financial Management, Ninth Edition
in the market equilibrium. Vikas Publishing House
© I M Pandey
Pvt. Ltd. 15
 The slope of CML describes the best price
of a given level of risk in equilibrium.
 E ( Rm )  R f 
Slope of CML   
  m 
 The expected return on a portfolio on CML
is defined by the following equation:
 E ( Rm )  R f 
E ( Rp )  R f   p
 m 

© I M Pandey
 The capital asset pricing model (CAPM) is a
model that provides a framework to
determine the required rate of return on an
asset and indicates the relationship
between return and risk of the asset.
 Assumptions of CAPM
◦ Market efficiency
◦ Risk aversion and mean-variance optimisation
◦ Homogeneous expectations
◦ Single time period
◦ Risk-free rate

© I M Pandey
 We plot the combinations
of four possible returns Alpha's
of Alpha and market. 35.0
Return
They are shown as four 30.0
points. The combinations

25.0
20.0
*
of the expected returns 15.0
points (22.5%, 27.5% and

10.0
5.0
Market
–12.5%, 20%) are also -20.0 -15.0 -10.0
0.0
-5.0 -5.0 0.0 5.0 10.0 15.0 20.0 25.0
Return
30.0
shown in the figure. We -10.0
join these two points to -15.0
form a line. This line is * -20.0

-25.0
called the characteristics

-30.0
line. The slope of the

characteristics line is the
sensitivity coefficient,
which, as stated earlier,
is referred to as beta. Financial Management, Ninth Edition
© I M Pandey
 For a given amount of systematic risk (),
SML shows the required rate of return.
E(Rj)
E(R j ) = R f + (R m ) – R f  β j
SLM
Rm
Rf
 = (covarj,m/2m)
0 1.0

© I M Pandey
 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
market value.
 Investors will be compensated only for that risk
which they cannot diversify. This is the market-
related (systematic) risk.
 Beta, which is a ratio of the covariance between
the asset returns and the market returns divided
by the market variance, is the most appropriate
measure of an asset’s risk.
 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.
© I M Pandey
 It is based on unrealistic assumptions.
 It is difficult to test the validity of CAPM.
 Betas do not remain stable over time.

© I M Pandey
 In APT, the return of an asset is assumed to
have two components: predictable (expected)
and unpredictable (uncertain) return. Thus,
return on asset j will be:
E ( R j )  R f + UR
 where Rf is the predictable return (risk-free
return on a zero-beta asset) and UR is the
unanticipated part of the return. The uncertain
return may come from the firm specific
information and the market related information:
E ( R j )  R f  ( 1 F1   2 F2   3 F3     n Fn )  URs
© I M Pandey
 Factors:
◦ industrial production
◦ changes in default premium
◦ changes in the structure of interest rates
◦ inflation rate
◦ changes in the real rate of return
 Risk premium
 Factor beta

© I M Pandey

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Asset Pricing Models

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Risk and Return: Portfolio

Theory and Assets Pricing

approach to investors to make decisions to

Financial Management, Ninth Edition

  x2 wx2   y2 wy2  2 wx wy x y Corxy

Financial Management, Ninth Edition

Financial Management, Ninth Edition

Financial Management, Ninth Edition

Financial Management, Ninth Edition

is one that has the

returns for a given D

level of risk. The C

the frontier formed

by the set of efficient

portfolios, which lie

free and a risky asset:

Financial Management, Ninth Edition

security and the portfolios Q

three portfolios. Each line

This line is called the

capital allocation line L

Financial Management, Ninth Edition

Financial Management, Ninth Edition

They are shown as four 30.0

points. The combinations

points (22.5%, 27.5% and

join these two points to -15.0

form a line. This line is * -20.0

called the characteristics

line. The slope of the

Financial Management, Ninth Edition

Financial Management, Ninth Edition

Financial Management, Ninth Edition

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