Chapte

2
Risk & Return r

LEARNING OBJECTIVES
After studying this chapter you should be able to:

Define risk.
Differences between risk and uncertainty
Classification of risks with example.
Distinguish between systematic risk and non-systematic risk
Problems with the CAPM approaches
CAPM with its assumptions.
Define CAPM./ What are the components of CAPM equation?
“Most of the financial decisions are trade off between risk and return.”-Explain.
Why do most investor’s hold diversified portfolios?
If corporate managers are risk averse, does this mean they will not take risk? Explain.
What is the CAPM approach for calculating cost of equity?
Risk and return are the opposite sides of a coin."—Explain.
The Capital Asset Pricing Model (CAPM)
The Sharp-Linter and Black versions,
Estimating and interpreting beta;
The market model.

Mathematical Problems, Solution, Formula &

Exercise
3.01. Risk

Risk is the uncertainty of something happing or the possibility of a less than

desirable return. Risk can be defined as the chance that some unfavorable events
will occur.
(i) Risk is the variability of returns from those that are expected. -Van Home.
(ii) Risk to the variability of the actual return from the expected returns
associated with a given asset. -Khan & Jain.
Risk is the uncertainly or the probability that actual returns will deviate from
expected returns. However, traditionally risk has been defined in terms of
uncertainty.
3.02. Differences between risk and uncertainty

The differences between Risk and Uncertainty are as follows:

Topics Risk Uncertainty

If no information is available
Risk can be defined as the to formulate a probability
1. Definition chance that some unfavorable distribution of the cash flows
events will occur. the situation is known as
uncertainty.

Risk is formed by information It is formed by no information

2. Form
with probability distribution. with probability distribution.

3. Measure Measured by statistical It can not be measured.

concept.
Probability of occurrence Probability of occurrences
4. Occurrence
of outcome is known to all. of outcome is unknown.

5. Tools Measurement tools are standard There is no tool for

deviation and variance. measurement.
6. Income Risk is related with income. It is related without income.
7. Avoidance Risk is avoidable. It is unavoidable.

8. Insurance By insurance it can be It is no insurable.

9. Control It can be controlled. It is not controllable.

10. Risk Mgt. Risk Mgt. is required to avoid it. Risk management is not
required.

2.03.Classification of risks

Systematic risk is uncontrollable by an organization and macro in nature.

Unsystematic risk is controllable by an organization and micro in nature.
Systematic Risk:
Systematic risk is due to the influence of external factors on an organization.
Such factors are normally uncontrollable from an organization's point of view.
Systematic risk is a macro in nature as it affects a large number of
organizations operating under a similar stream or same domain. It cannot be
planned by the organization.
Types of risk under the group of systematic risk are listed as follows:
1. Interest rate risk.
2. Market risk.
3. Purchasing power or Inflationary risk.
The types of risk grouped under systematic risk are depicted below.
Now let's discuss each risk classified under the group of systematic risk.

1. Interest rate risk: Interest-rate risk arises due to variability in the interest
rates from time to time. It particularly affects debt securities as they
carry the fixed rate of interest.
The interest-rate risk is further classified into following types.
1.Price risk.
2. Reinvestment rate risk.
The types of interest-rate risk are depicted below.

The meaning of various types of interest-rate risk is discussed below.

Price risk arises due to the possibility that the price of the shares, commodity,
investment, etc. may decline or fall in the future.
Reinvestment rate risk results from fact that the interest or dividend earned
from an investment can't be reinvested with the same rate of return as it
was acquiring earlier.

2. Market risk: Market risk is associated with consistent fluctuations seen in

the trading price of any particular shares or securities. That is, it is a risk
that arises due to rise or fall in the trading price of listed shares or
securities in the stock market.
The market risk is further classified into following types.
1. Absolute risk.
2. Relative risk.
3. Directional risk.
4. Non-directional risk.
5. Basis risk.
6. Volatility risk.
The types of market risk are depicted in the following diagram.

The meaning of different types of market risk is briefly discussed below.

Absolute Risk is the risk without any content. For e.g., if a coin is tossed, there
is fifty percentage chance of getting a head and vice-versa.
Relative risk is the assessment or evaluation of risk at different levels of
business functions. For e.g. a relative risk from a foreign exchange
fluctuation may be higher if the maximum sales accounted by an organization
are of export sales.
Directional risks are those risks where the loss arises from an exposure to the
particular assets of a market. For e.g. an investor holding some shares
experience a loss when the market price of those shares falls down.
Non-Directional risk arises where the method of trading is not consistently
followed by the trader. For e.g. the dealer will buy and sell the share
simultaneously to mitigate the risk.
Basis risk is due to the possibility of loss arising from imperfectly matched
risks. For e.g. the risks which are in offsetting positions in two related but
non-identical markets.
Volatility risk is the risk of a change in the price of securities as a result of
changes in the volatility of a risk factor. For e.g. volatility risk applies to the
portfolios of derivative instruments, where the volatility of its underlying is
a major influence of prices.
3. Purchasing power or inflationary risk: Purchasing power risk is also known as
inflation risk. It is so, since it emanates (originates) from the fact that it
affects a purchasing power adversely. It is not desirable to invest in
securities during an inflationary period.
The purchasing power or inflationary risk is classified into following types.
Demand inflation risk.
Cost inflation risk.
The types of purchasing power or inflationary risk are depicted below.

Demand inflation risk arises due to increase in price, which result from an
excess of demand over supply. It occurs when supply fails to cope with the
demand and hence cannot expand anymore. In other words, demand inflation
occurs when production factors are under maximum utilization.
Cost inflation risk arises due to sustained increase in the prices of goods and
services. It is actually caused by higher production cost. A high cost of
production inflates the final price of finished goods consumed by people.

Unsystematic Risk: Unsystematic risk is due to the influence of internal factors

prevailing within an organization. Such factors are normally controllable from
an organization's point of view.
Unsystematic risk is a micro in nature as it affects only a particular
organization. It can be planned, so that necessary actions can be taken by
the organization to mitigate (reduce the effect of) the risk.
The types of risk grouped under unsystematic risk are depicted below.
1. Business or liquidity risk.
2. Financial or credit risk.
3. Operational risk.
The types of risk grouped under unsystematic risk are depicted below.

Now let's discuss each risk classified under the group of unsystematic risk.

1. Business or liquidity risk

Business risk is also known as liquidity risk. It is so, since it emanates
(originates) from the sale and purchase of securities affected by business
cycles, technological changes, etc.
The business or liquidity risk is further classified into following types.
1. Asset liquidity risk.
2. Funding liquidity risk.

The types of business or liquidity risk are depicted and explained below.

Asset liquidity risk is the risk of losses arising from an inability to sell or
pledge assets at, or near, their carrying value when needed. For e.g. assets
sold at a lesser value than their book value.
Funding liquidity risk is the risk of not having an access to sufficient funds to
make a payment on time. For e.g. when commitments made to customers are
not fulfilled as discussed in the SLA (service level agreements).

2. Financial or credit risk

Financial risk is also known as credit risk. This risk arises due to change in the
capital structure of the organization. The capital structure mainly comprises
of three ways by which funds are sourced for the projects.
These are as follows:
1. Owned funds. For e.g. share capital.
2. Borrowed funds. For e.g. loan funds.
3. Retained earnings. For e.g. reserve and surplus.

The financial or credit risk is further classified into following types.

1. Exchange rate risk.
2. Recovery rate risk.
3. Credit event risk.
4. Non-Directional risk.
5. Sovereign risk.
6. Settlement risk.

The types of financial or credit risk are depicted and explained below.

Exchange rate risk is also called as exposure rate risk. It is a form of financial
risk that arises from a potential change seen in the exchange rate of one
country's currency in relation to another country's currency and vice-versa.
For e.g. investors or businesses face an exchange rate risk either when they
have assets or operations across national borders, or if they have loans or
borrowings in a foreign currency.
Recovery rate risk is an often neglected aspect of a credit risk analysis. The
recovery rate is normally needed to be evaluated. For e.g. the expected
recovery rate of the funds tendered (given) as a loan to the customers by
banks, non-banking financial companies (NBFC), etc.
Sovereign risk is the risk associated with the government. In such a risk,
government is unable to meet its loan obligations, reneging (to break a
promise) on loans it guarantees, etc.
Settlement risk is the risk when counterparty does not deliver a security or its
value in cash as per the agreement of trade or business.

3. Operational risk
Operational risks are the business process risks failing due to human errors.
This risk will change from industry to industry. It occurs due to breakdowns
in the internal procedures, people, policies and systems.
The operational risk is further classified into following types.
1. Model risk.
2. People risk.
3. Legal risk.
4. Political risk.

The types of operational risk are depicted and explained below.

Model risk is the risk involved in using various models to value financial
securities. It is due to probability of loss resulting from the weaknesses in
the financial model used in assessing and managing a risk.
People risk arises when people do not follow the organization’s procedures,
practices and/or rules. That is, they deviate from their expected behavior.
Legal risk arises when parties are not lawfully competent to enter an agreement
among themselves. Furthermore, this relates to regulatory risk, where a
transaction could conflict with a government policy or particular legislation
(law) might be amended in the future with retrospective effect.
Political risk is the risk that occurs due to changes in government policies. Such
changes may have an unfavorable impact on an investor. This risk is
especially prevalent in the third-world countries.

2.04. Business risk

 1. Business or liquidity risk
Business risk is also known as liquidity risk. It is so, since it emanates
(originates) from the sale and purchase of securities affected by business
cycles, technological changes, etc.
The business or liquidity risk is further classified into following types.
Asset liquidity risk.
Funding liquidity risk.
The types of business or liquidity risk are depicted and explained below.

Asset liquidity risk is the risk of losses arising from an inability to sell or
pledge assets at, or near, their carrying value when needed. For e.g. assets
sold at a lesser value than their book value.
Funding liquidity risk is the risk of not having an access to sufficient funds to
make a payment on time. For e.g. when commitments made to customers are
not fulfilled as discussed in the SLA (service level agreements).

2.05. Distinguish between systematic risk and non-systematic risk

The differences between systematic and unsystematic risk are as follows:

Systematic Risk Unsystematic Risk

This type of risk affects over all This type of risk is unique to a
securities in a market. security or a company.
This risk is dependent of political or This risk is independent of political
economic factors. or economic factors.
It is also known as Market Risk. It is also known as Diversifiable Risk.
This risk arises from management It occurs due to imbalance in the
inefficiency, unsuccessful planning political situation or fluctuation in
etc. the market etc.
It can be reduced by holding large It can be reduced by holding better
number of securities. portfolios of company’s securities.

Capital Asset Pricing Model (CAPM)

2.06 Define CAPM

The CAPM provides the framework for determining the equilibrium expected

return for risky assets. It uses the results of capital market theory to drive

the relationship between expected return and systematic risk of individual

securities and portfolio. The CAPM has implications for:

Risk-return relationship for an individual security.

Risk-return relationship for an efficient portfolio.

Identification of under and over valued assets traded in market.

Pricing of assets not yet traded in the market.

Effect of leverage on cost of equity capital.

Capital Budgeting decisions and cost of capital.

Risk of the firm through diversification of project portfolio.

We will discuss the model in two sections.

(A) The equation and
(B) Graphically show the model by security market line (SML).

The Equation of CAPM:

In the CAPM, the expected return on an asset varies directly with its
systematic risk and the risk premium of the market portfolio. The risk
premium for an asset or portfolio is a function of its beta. The risk premium
added to the risk-free rate is directly proportional to beta. The following
three aspects are needed to apply the CAPM
(i) Risk-free Rate of Return
(ii) Risk Premium on Market Portfolio
(iii) Portfolio Beta.
The Security Market Line (SML):
The SML equation is expressed as follows:

where
E[Ri] = the expected return on asset i,
Rf = the risk-free rate,
E[Rm] = the expected return on the market portfolio,
β i = the Beta on asset i, and
E[Rm] - Rf = the market risk premium.
The graph below depicts the SML. Note that the slope of the SML is equal to
(E[Rm] - Rf) which is the market risk premium and that the SML intercepts
the y-axis at the risk-free rate.

In capital market equilibrium, the required return on an asset must equal its
expected return. Thus, the SML equation can also be used to determine an
asset's required return given its Beta.

The Beta (i)

The beta for a stock is defined as follows:

where
im = the Covariance between the returns on asset i and the market portfolio
and
2m = the Variance of the market portfolio.
Note that, by definition, the beta of the market portfolio equals 1 and the beta
of the risk-free asset equals 0.
An asset's systematic risk, therefore, depends upon its covariance with the
market portfolio. The market portfolio is the most diversified portfolio
possible as it consists of every asset in the economy held according to its
market portfolio weight.

Example Problems

1. Find the expected return on a stock given that the risk-free rate is 6%, the
expected return on the market portfolio is 12%, and the beta of the stock
is 2.

2. Find the beta on a stock given that its expected return is 16%, the risk-free
rate is 4%, and the expected return on the market portfolio is 12%.

2.07.Some problems with the CAPM approaches

CAPM has the following limitation/ Criticism of CAPM:

All markets are not efficient i.e. share prices may not reflect all available
information.
Different investors have different motives about the expected return and risk
of securities.
All investors decisions may not based on single time period.
Investors have to pay interest for lending or borrowing.
There are some taxes and transaction costs associated with an investment.
All markets are not competitive.
It does not consider the time value of money.
The quantity of risky securities in the market may be flexible or unknown.

2.08. Assumptions of CAPM

As in all financial theories, a number of assumptions, including perfect capital

markets, were made in the development of the CAPM.
 All investors can borrow or lend an unlimited amount at a given risk free rate of
interest and there is no restrictions on short sales of any asset.
 All investors have identical estimation of the expected values. Variance and
covariance of return among all assets that is investors have homogeneous
expectations.
 All assets are perfectly divisible and perfectly liquid.
 Individual seeks to minimize the expected utility.
 There are no transaction costs involved.
 There are no taxes.
 All investors are price takers i.e. they assume that their own buying and selling
price or activity will not affected by stock price.
 The quantities of all assets are given and fixed.
 Market efficiency must be perfect.
 Single time period.

2.09.The CAPM and the Efficient Frontier

Using the CAPM to build a portfolio is supposed to help an investor manage their

risk. If an investor were able to use the CAPM to perfectly optimize a

portfolio’s return relative to risk, it would exist on a curve called the efficient

frontier, as shown in the following graph.

Image by Julie Bang © Investopedia 2022

The graph shows how greater expected returns (y-axis) require greater

expected risk (x-axis). Modern Portfolio Theory (MPT) suggests that starting

with the risk-free rate, the expected return of a portfolio increases as the risk

increases. Any portfolio that fits on the Capital Market Line (CML) is better

than any possible portfolio to the right of that line, but at some point, a

theoretical portfolio can be constructed on the CML with the best return for

the amount of risk being taken.

The CML and efficient frontier may be difficult to define, but they illustrate an

important concept for investors: there is a trade-off between increased return

and increased risk. Because it isn’t possible to perfectly build a portfolio that

fits on the CML, it is more common for investors to take on too much risk as

they seek additional return.

In the following chart, you can see two portfolios that have been constructed to

fit along the efficient frontier. Portfolio A is expected to return 8% per year

and has a 10% standard deviation or risk level. Portfolio B is expected to return

10% per year but has a 16% standard deviation. The risk of Portfolio B rose

faster than its expected returns.

The efficient frontier assumes the same things as the CAPM and can only be

calculated in theory. If a portfolio existed on the efficient frontier it would be

providing the maximal return for its level of risk. However, it is impossible to
know whether a portfolio exists on the efficient frontier because future

returns cannot be predicted.

This trade-off between risk and return applies to the CAPM and the efficient

frontier graph can be rearranged to illustrate the trade-off for individual

assets. In the following chart, you can see that the CML is now called

the Security Market Line (SML). Instead of expected risk on the x-axis, the

stock’s beta is used. As you can see in the illustration, as beta increases from 1

to 2, the expected return is also rising.

The CAPM and SML make a connection between a stock’s beta and its expected

risk. Beta is found by statistical analysis of individual, daily share price returns

in comparison with the market's daily returns over precisely the same period. A

higher beta means more risk but a portfolio of high-beta stocks could exist

somewhere on the CML where the trade-off is acceptable, if not the theoretical

ideal.
The value of these two models is diminished by assumptions about beta and

market participants that aren’t true in the real markets. For example, beta does

not account for the relative riskiness of a stock that is more volatile than the

market with a high frequency of downside shocks compared with another stock

with an equally high beta that does not experience the same kind of price

movements to the downside.

2.10.The Sharp-Linter and Black versions

Beginning with Sharpe (1964) and Lintner (1965), economists have systematically

studied the asset pricing theory or, precisely, the portfolio choice theory of a

consumer. Sharpe (1964) and Lintner (1965) introduced the Capital Asset

Pricing Model (CAPM) to investigate the relationship between the expected

return and the systematic risk. From the day CAPM was developed, it was

regarded as one of the primary models to price an equity or a bond portfolio.

However, economists of the later generation worked out an Intertemporal

Capital Asset Pricing Model (ICAPM) and Arbitrage Pricing Theory (APT) which

are more sophisticated in comparison with the original CAPM (e.g. Merton, 1973;

Ross, 1976). These models and also models for pricing options as developed by

Black and Scholes (1973) effectively predict asset returns for given levels of

risks which are useful information to an investor in the case of selecting his

portfolio or a banker in the case of monitoring the financial health of a company.

Over last four decades, investors, bankers and market researchers used such

models to predict asset returns in normal market conditions. The “normal

market condition” essentially means equity prices are not driven by any

sentiment or stocks are not systematically overvalued or undervalued by the

market players. In such circumstances, markets act like efficient markets (e.g.

Fama, 1970; Fama, 1991; Fama, 1998). But, an anomaly arises when such

conditions are not applicable for a capital market.

2.11. What is Beta in Finance?
The beta (β) of an investment security (i.e., a stock) is a measurement of its

volatility of returns relative to the entire market. It is used as a measure of

risk and is an integral part of the Capital Asset Pricing Model (CAPM). A

company with a higher beta has greater risk and also greater expected returns.

The beta coefficient can be interpreted as follows:

β =1 exactly as volatile as the market

β >1 more volatile than the market

β <1>0 less volatile than the market

β =0 uncorrelated to the market

β <0 negatively correlated to the market

Here is a chart illustrating the data points from the β calculator (below):
Examples of beta

High β – A company with a β that’s greater than 1 is more volatile than the

market. For example, a high-risk technology company with a β of 1.75 would have

returned 175% of what the market returned in a given period (typically

measured weekly).

Low β – A company with a β that’s lower than 1 is less volatile than the whole

market. As an example, consider an electric utility company with a β of 0.45,

which would have returned only 45% of what the market returned in a given

period.

Negative β – A company with a negative β is negatively correlated to the

returns of the market. For example, a gold company with a β of -0.2, which

would have returned -2% when the market was up 10%.

What are Equity Beta and Asset Beta?

Levered beta, also known as equity beta or stock beta, is the volatility of

returns for a stock, taking into account the impact of the company’s leverage

from its capital structure. It compares the volatility (risk) of a levered company

to the risk of the market.

Levered beta includes both business risk and the risk that comes from taking

on debt. It is also commonly referred to as “equity beta” because it is the

volatility of an equity based on its capital structure.

Asset beta, or unlevered beta, on the other hand, only shows the risk of an

unlevered company relative to the market. It includes business risk but does not

include leverage risk.

Levered Beta vs Unlevered Beta

Levered beta (equity beta) is a measurement that compares the volatility of

returns of a company’s stock against those of the broader market. In other

words, it is a measure of risk, and it includes the impact of a company’s capital

structure and leverage. Equity beta allows investors to assess how sensitive a

security might be to macro-market risks. For example, a company with a β of 1.5

denotes returns that are 150% as volatile as the market it is being compared to.

When you look up a company’s beta on Bloomberg, the default number you see is

levered, and it reflects the debt of that company. Since each company’s capital

structure is different, an analyst will often want to look at how “risky” the

assets of a company are regardless of the percentage of its debt or equity

funding.

The higher a company’s debt or leverage, the more of its earnings that are

committed to servicing the debt. As a company adds more debt, the uncertainty

of the company’s future earnings also rises. It increases the risk associated

with the company’s stock, but it is not a result of the market or industry risk.
Therefore, by removing the financial leverage (debt impact), the unlevered beta

can capture the risk of the company’s assets only.

Calculation of Levered Beta

There are two ways to estimate the levered beta of a stock. The first, and

simplest, way is to use the company’s historical β or just select the company’s

beta from Bloomberg. The second, and more popular, way is to make a new

estimate for β using public company comparables. To use the comparables

approach, the β of comparable companies is taken from Bloomberg and the

unlevered beta for each company is calculated.

Unlevered β = Levered β / ((1 + (1 – Tax Rate) * (Debt / Equity))

Levered beta includes both business risk and the risk that comes from taking on

debt. However, since different firms have different capital structures,

unlevered beta is calculated to remove additional risk from debt in order to view

pure business risk. The average of the unlevered betas is then calculated and

re-levered based on the capital structure of the company that is being valued.

Levered Beta = Unlevered Beta * ((1 + (1 – Tax Rate) * (Debt / Equity))

Note: In most cases, the firm’s current capital structure is used when β is re-

levered. However, if there is information that the firm’s capital structure might

change in the future, then β would be re-levered using the firm’s target capital

structure.

2.12. Interpreting Beta

A security’s β should only be used when its high R-squared value is higher than

the benchmark. The R-squared value measures the percentage of variation in

the share price of a security that can be explained by movements in the

benchmark index. For example, a gold ETF will show a low β and R-squared in

relation to a benchmark equity index, as gold is negatively correlated with

equities.
A β of 1 indicates that the price of a security moves with the market. A β of

less than 1 indicates that the security is less volatile than the market as a

whole. Similarly, a β of more than 1 indicates that the security is more volatile

than the market as a whole. Companies in certain industries tend to achieve a

higher β than companies in other industries.

For example, the β of most technology companies tends to be higher than 1.

Also, a company with a β of 1.30 is theoretically 30% more volatile than the

market. Similarly, a company with a β 0f 0.79 is theoretically 21% less volatile

than the market.

For a company with a negative β, it means that it moves in the opposite direction

of the market. Theoretically this is possible, however, it is extremely rare to

find a stock with a negative β.

2.13. Beta Coefficient Meaning

The Beta is calculated in the CAPM model (Capital Asset Pricing Model) for

calculating the rate of return of a stock or portfolio.

The Beta calculation in excel is a form analysis since it represents the slope of

the security’s characteristic line, i.e., a straight line indicating the relationship
 between the rate of return on a stock and the return from the market. It can

further be ascertained with the help of the below Beta formula:

β = Covariance of Market Return with Stock Return / Variance of Market

Return

2.14. The meanings of beta coefficient –

 If the coefficient is 1 it indicates that the stock /security price is

moving in line with the market.

 If the coefficient <1; the return of the security is less likely to respond

to the market movements.

 If the coefficient > 1, the returns from the security are more likely to

respond to market movements, thereby also making it volatile;

Beta Coefficient Example

If Apple Inc’s (AAPL) beta is 1.46, it indicates that the stock is highly volatile

and 46% more likely to respond to market movement. On the other hand, say

Coca-Cola has a β coefficient of 0.77, indicating the stocks are less volatile and

23% less likely to respond to movement in the market.

As a trend, it has been observed that utility stock has a CAPM Beta of less than

1. On the other hand, technology stocks have a Beta coefficient of greater than

1, indicating a likelihood of higher returns with more associated risks.

2.15. Market Model

The CAPM is one of the most thoroughly researched models in financial economics.

When beta is estimated in practice, a variation of CAPM called the market model is often

used. To derive the market model, we start with the CAPM:

Since CAPM is an equation, we can subtract the risk – free rate from both sides, which

gives us:

This equation is deterministic, that is, exact. In a regression, we realize that there is some

indeterminate error. We need to formally recognize this in the equation by adding epsilon,

which represents this error:

Finally, think of the above equation in a regression. Since there is no intercept in the equation,

the intercept is zero. However, when we estimate the regression equation, we can add an

intercept term, which we will call alpha:

This equation, known as the market model, is generally the model used for estimating beta.

FORMULA OF Risk & Return

1.Expected Return/E (R ) = ∑ Ri ×Pi

2.Expected Return Portfolio /E (Rp) = ∑ E R×wi
3.Standard deviation /
σ= √∑ ( R −E ) ×P
i R
2
i
 √
2 2
4 . σ p= ∑ W A2 σ A2 +W 2B σ B2 +W C
σ
C
+2 W A W B COV AB +2 W B W C COV BC + 2W C W A COV CA

σ
E
5.Co-efficient of Variation /CV= R

σp
E
6.Co-efficient of Variation Portfolio /CVp= Rp

7.COV P = ∑ (R A−ER A )( RB −ERB )×Pi

2
8.Variance= σ
COV AB
9.Correlation coefficient (Beta)/ β = σAσB

10.CAPM/ R E =Rf +(R m−R f )β

Problem.1
. 1.

Security A has an expected return of 7 percent, a standard deviation of expected

returns of 35 percent, a correlation co-efficient with the market of -0.3, and a

beta co-efficient of -1.5. Security B has an expected return of 12 percent, a

standard deviation of returns of 10 percent, a correlation with the market of 0.7,

and a beta co-efficient of 1.0.Which security is riskier? Why?

Solution

Given that,

Security A: Security B:

Expected Return= 7% Expected Return= 12%

 Standard Deviation= 35% Standard Deviation= 10%

correlation co-efficient with the market of -0.3 correlation co-efficient

with the market of 0.7

Beta co-efficient of -1.5 Beta co-efficient of 1.0

σ
E( R )
Co-efficient of variation/CV=

.35 .10
=5 =0.833
Security A: = . 07 Security B: = .12

Decision: From above calculation we see that the Security A is more riskier than

security B, Because CV is higher than security B.

Problem.2.
1.
Alpha Company is considering two mutually exclusive project, A and B costing

Tk.40,000 and Tk. 45,000 respectively. Following are the expected NPV and

probability distribution of two project:

Project-A Project-B

NPV Probabilit NPV Probabilit

y y

3,500 0.1 4,000 0.3

6,000 0.4 6,000 0.2

0.2 13,00 0.3

12,000 0

0.3 15,00 0.2

 16,000 0

Requirements:

Calculate the expected NPV of each project

Standard deviation of each project

CV of each project

Which project should be chosen? Give reasons.

Solution

n
∑ ( NPV × Pi )
Expected NPV = i = 1

Req : (i) Project A = ( 3,500 × .1 ) + ( 6,000 × .4 ) + ( 12,000 × .2 ) + ( 16,000 × .3 ) = 9,950

Project B = ( 4 ,000 × .3 ) + ( 6,000 × .2 ) + ( 13,000 × .3 ) + ( 15,000 × .2 ) = 9,300

Req : (ii) Standard deviation (σ ) = √∑ ( NPV −Expected NPV ) ×P 2

i

A= √(3,500−9,950)2 ×.1+(6,000−9,950)2 ×.4+(12,000−9,950)2×.2+(16 ,000−9,950)2×.3

= √ 2, 22, 22, 500 = 4,714

B=√( 4,000−9,300)2 ×.3+(6,000−9,300 )2×.2+(13,000−9,300)2 ×.3+(15,000−9,300 )2 ×.2

= √2 , 12 , 10 , 000

= 4,605
 σ
Req : (iii) CV = Expected NPV
4,714
= .473
Project A = 9,950
4,605
= .495
Project B = 9,300
Req : (iv) Decision: Project A should be accepted, because project A’s C.V is

lower than Project B.

Problem.3.
1.
A company is considering Project X and Y with the following information :

Project X Project Y

Probability Return Probability Return

1 .10 40% .10 40%

2 .20 10 .2 20%

3 .40 0 .4 10%

4 .20 -5 .2 0%

5 .10 -10 .10 -

20%

(i) Calculate the expected value of return for each of the two projects. Which

provides the largest expected return?

(ii) Calculate the standard deviation for each of the two projects. Which appears

to have the greater risk?

(iii) Calculate the coefficient of variation/CV, for each of the two projects. Which

appears to have the greater relative risk?

Solution
n
∑ Ri ¿ pi
Req(i) E (R ) = i =1

Project X= ( .40 × .10 ) + ( .10 × .20 ) + ( 0 × . 40 ) + (−.05 × .20 ) + (− .10 × .10 )

= .04 + .02 + 0 + - .01 + - .01 = 4 %

Project Y= ( .40 × .10 ) + ( .20 × .20 ) + (.10 × .40 ) + ( 0 × .20 ) + (− .20 × .10 )
= .04 + .04 + .04 + 0 -.02 = 10 %

Project Y is largest expected return

Req(ii):Calculation of Standard deviation( σ )= √∑ ( R −R ) ¿ P

i
− 2
i

−
[ R = Expected Return]

Project( σ )X =

√(.40−.04)2×.10+(.10−.04)2×.20+(0−.04)2×.40+(−.05−.04)2×.20+(−.10−.04)2×.10
= 0.1337 or 13.37%

Project ( σ )Y =

√(.40−.10)2×.10+(.20−.10)2×.20+(.10−.10)2×.40+(0−.10)2×.20+(−.20−.10)2×.10
= .1483 or 14.83%

Decision: Project Y is greater risk than Project X, Because Project Y standard

deviation is higher than Project X.

σ
− −
Req.(iii): Calculation of coefficient of variation/CV= R [R = Expected Return]
 .1337
=3 . 34
Project X= . 04

.1483
=1 .483
Project Y = .10

Decision: Project X is greater risk than Project Y, Because Project X CV is

higher than Project Y.

Problem.4.
1.

Stocks X and Y have the following probability distributions of expected future

returns :—

Probability Stock-x Stock Y

0.1 -10% -35%

0.2 2 0

0.4 12 20

0.2 20 25

0.1 38 45

An investor seeks your opinion as to which stock he should invest his money in

Which stock would you recommend that the investor buy? Explain.

Solution

n
∑ Ri ¿ pi
E (R ) = i = 1

Stock X= (−.10 × .1 ) + ( .02 × .2 ) + ( .12 × .4 ) + ( .20 × .2 ) + ( .38 × .1 ) = 12 %

 Stock Y= (−.35 × .1 ) + ( 0 × .2 ) + ( .20 × .4 ) + ( .25 × .2 ) + ( .45 × .1 ) = 14 %

Calculation of Standard deviation( σ )= √∑ ( R −R ) ¿ P

i
− 2
i
[
−
R = Expected

Return]

Stock X = √(−.10−.12)2×. 1+(. 02−.12)2×.2+(. 12−. 12)2×.4+(.20−.12 )2×. 2+(. 38−.12)2×. 1

= .1219

Stock Y = √(−.35−.14)2×.1+(0−.14)2×.2+(.20−.14)2×. 4+(.25−.14)2×.2+(.45−.14)2×.1

= .2034

σ
− −
Req.(iii): Calculation of coefficient of variation/CV= R [ R = Expected Return]

.1219
=1 .029
Stock X= .12

.2034
=1. 45
Stock Y = .14

I recommended that stock X should be invested by investor because CV is lower

than stock Y.

Problem.5.
1.
 At present, suppose the risk-free rate is 12% and the expected return on the

market portfolio is 16% and the expected returns for four stocks are listed

together with their expected beta:

Stock Expected Return Expected

Beta

A 18% 1.35

B 15% 0.85

C 16% 1.20

D 20% 1.75

On the basis of three expectations, Which stocks are overvalued and undervalued?

Solution

ExpectedReturn. Actual
Portfolio Difference
E( R ) = Rf + β ( K m − R f ) return

E( R) = 12 % + 1.35 (16 % − 12 %) 1 Und

0.
= 12 % + (1.35 × 4 %) % 8 er
A = 17.40 % 60
valu
%
% e

E( R) = 12 % + .85 (16 % − 12 %) 1 - Ove

= 12 % + (.85 × 4 %) % 5 0. r
B = 15.40 %
40 valu

% % e

E( R) = 12 % + 1.20 (16 % − 12 %) 1 Und

- .
= 12 % + (1.20 × 4 %) % 6 er
C = 16.80 % 8
valu
%
% e
 E( R) = 12 % + .75 (16 % − 12 %) 2 Und
= 12 % + (.75 × 4 %) % 0 1 er
D = 19 %
% valu

% e

Problem.6.
1.
Risk-return features of two securities Share Moon and Share Mars are given below

Share Share

Moon Mars

Expected 15 20

return(%)

Standard 10 15

deviation(%)

Covariance(%) 120

Requirements :

What is the correlation between the two securities?

What is the expected return and risk of a portfolio in which Moon and

Mars have been combined in equal proportions?

Solution

Given,

Moon
E (R) = 15

Mars
E (R) 20
σ moon
= 10
σ mars
= 15

Co var iance(moon, mars)

= 120

a) We know,
 CO V (moon , mars ) 120
σ moon σ mars =
Correlation= 10 × 15 = 0.8

W moon
b) = 0.5
W mars
= 0.5

Expected Return Portfolio /E (Rp) = ∑ E R×wi =0.5 ¿ .15 + 0.5 ¿ .20 = 17.5

σ p= √∑ W moon
2σ
moon
2
2 +W mars σ
mars
2 +2W moon W mars COV moon , mars

= √ ∑ (.50)2(10)2 +(.50)2 (15 )2+2(.50)(.50)120

Problem.7.
1.
LAMSTEC BD, is considering investing in either of two mutually exclusive projects

X and Y. The firm has 14% cost of capital and the risk-free rate is currently 9%.

The initial investment, expected cash inflows and certainty equivalent factors

associated with each of the projects are shown in the following table:—

Initial Project X Tk. 40,000 Project Y Tk. 56,000

Investment

Year Cash inflows Certainty CCertainty Equivalent factors

equivalent a

factors s
Taka T
h
1 20,000 .90 2 .95
2 16,000 .80 2 .90
3 12,000 .60 1 .85
 4 10,000 .50 2 .80
5 10,000 .40 1 .80
You are required to calculate the certainty equivalent net present value for each

project. Which is preferred using this risk-adjusted technique?

Solution

CIFt ×Certaint y Factor t

∑ (1+R f )n
Certainty equivalent net present value(NPV) x = -

COF 0

=
[
20 ,000×. 90 16 , 000×. 80 12, 000×.60 10 , 000×. 50 10 , 000×. 40
(1+.09 )1
+
(1+. 09)2
+
(1+. 09 )3
+
(1+. 09 )4
+
(1+. 09)5 ]
−40 ,000

= (1011.16)

CIFt ×Certa int y Factor t

∑ (1+ R f )n
Certainty equivalent net present value(NPV) Y = - COF

=
[
20 ,000×. 95 25 , 000×. 90 15 ,000×. 85 20, 000×. 80 10 ,000×. 80
(1+.09 )1
+
(1+. 09)2
+
(1+.09 )3
+
(1+. 09)4
+
(1+.09) 5 ]
−56 , 000

= 6,748.59

Decision: Project Y is preferred using this risk adjusted technique.

Problem.8.
1.
The ABC Steel Company has two divisions: Health Foods and Specialty Metals.

Each division employs debt equal to 30 percent and preferred stock equal to 10

percent of its total requirements, with equity capital used for the remainder. The

current borrowing rate is 15 per cent and the company's tax rate is 40 per cent.
At present preferred stock can be sold yielding 12 percent. The beta values of 1.10

for Health Foods and 1.50 for Specialty Metals have been identified. The risk free

rate is currently 12 percent and the expected return on the market portfolio is 17

percent.

Using CAPM approach, what weighted average required returns on the investment

would you recommend for these two divisions?

Solution

Given,
β HF
= 1.10 Borrowing Rate = 15 %
β SM
= 1.50 Tax Rate = 40 %

Rf
= 12 %
E ( R m)
= 17 %

We know, According to CAPM

E ( R i)
= [ ]
R f + E (R m) − R f β i

∴ E ( R HF )
= 12 + (17 – 12) 1.10 = 17.50
∴ E ( R SM )
And = 12 + (17 – 12) ¿ 1.50 = 19.50

Problem.9.
.

Mr.Rahman creates a portfolio having a standard deviation of 32%. The return on

the treasury bill which is tax free is 3.5%. If the expected market return is 16%
and the market standard deviation is estimated to be 22%, calculate the expected

return on the portfolio created by Mr. Rahman.

Solution

σ
Standard deviation portfolio, P = 32 %

R
Risk free rate of return, f = 3.5 %
E ( R m)
Market return, = 16 %
σ
Market standard deviation, m = 22 %
E ( RP)
=?

σ p 32
β= = =1. 45
σ m 22

E ( RP)
= [
Rf + ( Rm ) − R f β
= ] 3.5 + [ 16 − 3.5 ] 1.45 = 21.625%

Problem.10.
1.

You are considering acquiring shares of common stock in the Madison Beer

Corporation. Your rate of return expectations are as follows:-

Rate Probability

of

return

-0.10 0.30
 0.08 0.10

0.10 0.30

0.25 0.30

Compute the expected return on this investment.

Solution

n
∑ Ri ¿ pi
E (R ) = i = 1

= (-0.10 x 0.30)+(.08 x 0.10)+(0.10 x 0.30)+(0.25 x 0.30) = 8.3%

Problem.11
. 1.
Suppose the required rate of return on a portfolio with beta of 1.2 is 18% and

the risk free e is 6%. According to the CAPM what is the expected rate of

return on the market portfolio? Given that,

β =1.2
Solution
Rm
=?
Rf
E(R )= R(f ) + ( Rm − R f )β =.06
E(R )
=.18
⇒. 18=. 06+( Rm−. 06 )1 . 2
⇒. 18=. 06−1. 2 Rm−. 072
⇒. 18=−. 012+1 .2 Rm
. 192
Rm= =. 16
1.2
Rm= 16 %

Problem.11
. 1.

Apparel is considering investing in either of two mutually exclusive projects X

and Y. The firm has 14.00% cost of capital and T-Bill rate is currently 7.00%.
 The initial investment, expected cash inflows and certainty equivalent factors

associated with each of the projects are shown in the following table :—

Initial Project X Tk. 40,000 Project Y Tk. 66,000

investment
Ye Cash Certainty Cash inflows Certainty equivalent
ar inflows equivalent factors factors
1 Tk. 20,000 .90 Tk. 20,000 .95

2 16,000 .80 25,000 .90

3 12,000 .60 15,000 .85

4 10,000 .50 20,000 .80

5 10,000 .40 10,000 .80

Requirement:

You are required to calculate the certainty equivalent net present value for each

project. Which is preferred using this risk-adjusted technique?

Solution

CIFt ×Certaint y Factor t

∑ (1+R f )n
Certainty equivalent net present value(NPV) x = -

COF 0

=
[
20 ,000×. 90 16 , 000×. 80 12, 000×.60 10 , 000×. 50 10 , 000×. 40
(1+. 07 )1
+
(1+. 07 )2
+
(1+. 07 )3
+
(1+. 07 )4
+
(1+. 07 )5 ]
−40 , 000

=
 CIFt ×Certa int y Factor t
∑ (1+ R f )n
Certainty equivalent net present value(NPV) Y = - COF

=
[
20 ,000×. 95 25 , 000×. 90 15 ,000×. 85 20 , 000×. 80 10 ,000×. 80
(1+. 07 )1
+
(1+. 07 )2
+
(1+. 07 )3
+
(1+.07 ) 4
+
(1+. 07 )5 ]
−66 , 000

Decision: Project Y is preferred using this risk adjusted technique.

Suggested Questions

2.1.Define risk. (2006, 2008)

2.2.Write precisely the differences between risk and uncertainty? (2011)

2.3.Explain the classification of risks with example. (2008)

2.4.What is business risk? Distinguish between systematic risk and non-

systematic risk? (2007, 2013,2014)

2.5.Identify some problems with the CAPM approaches (2007)

2.6.Explain the CAPM with its assumptions. (2008)

 2.7.Define CAPM./ What are the components of CAPM equation? (2006,

2011,2013)

2.8.“Most of the financial decisions are trade off between risk and return.”-

Explain. (2011)

2.9.What is market risk? What is meant by efficient portfolio selection of

markowitz? (2011)

2.10.Why do most investor’s hold diversified portfolios? (2011)

2.11.Why an investment’s covariance with a market index is assumed to be a

better measure of the investment’s than the investment variance? (2009)

2.12.If corporate managers are risk averse, does this mean they will not take

risk? Explain. (2011)

2.13.What is the CAPM approach for calculating cost of equity?(2014)

2.14.Risk and return are the opposite sides of a coin."—Explain.(2014)

Exercises

Exercise 1:

Norman Company, a custom golf equipment manufacturer, wants to choose the

better of two investment, A and B. Each requires an initial outlay of Tk. 10,000 and

each has a most likely annual rate of return of 15%. Management has made
pessimistic and optimistic estimates of the returns associated with each. The

three estimates of each assets, are given below :

Annual rate Asset Asset

Pessimistic 13% 7%
of return : -A -B
Most likely 15% 15%
Optimistic 17% 23%
Calculate Range of each Asset.

Exercise2:

Year Return
A B
1996 0.22 0.23
1997 0.20 0.19
1998 0.16 0.18
1999 0.18 0.25
2000 0.14 0.15

Calculate :

Expected Return

Standard Deviation

Co-efficient of variation.

Which security is most acceptable? Why?

Exercise 3:

Metal Manufacturing has isolated four alternatives for meeting its need for

increased production capacity. The data gathered relative to each of these

alternatives is summarized in the following table :

Alternative Expected Standard

A 20%
return (x) 7.00%
deviation of
B 22% 9.50%
C 19% 6.00%
 D 16% 5.50%
Requirements:

Calculate the co-efficient of variation for each alternative.

If the firm wishes to minimize risk, which alternative do you recommend? Why?

Exercise 4:

Mr. Aslam is considering an investment in one of two. Give the information that

follows, which investment is better based on risk (as measured by the standard

deviation) and return?

Security ABC

Probabilit Return
0.30 0.19
0.40 0.15
0.30 0.11

Security XYZ

Probabilit Return
0.20 0.22
0.30 0.06
0.30 0.14
0.20 -0.05

Exercise 5:

Mr. Masaf has prepared the following information regarding two investments under

consideration. Which investment should be accepted? Also calculate variance

Security X

Probabilit Return
0.30 0.27
0.50 0.18
0.20 -0.02

Security Y
 Probabilit Return
0.20 0.15
0.30 0.06
0.40 0.10
0.10 0.04

Exercise 6:

Novex Chemicals in considering three possible capital projects for next year. Each

project has a 1-year life, and project return depend on next year's state of the

economy. The estimated rates of return are shown in the table :

State of Probability of each Rate of Return if

x Y Z
Recission 0.25 1 9 1
Normal 0.50 1 1 1
0 % 4
Boom 0.25 1 1 1

Requirement:

Find each project's expected rate of return, variance, standard deviation and co-

efficient of variation

Rank the alternative on the basis of (i) expected return (ii) Risk. Which alternative

would you choose?

Exercise 7:

The possible outcomes of two assets, X and Y is given below:

State of Probabilit Return (%)

Economy y X Y
A 0.10 -8 14

B 0.20 10 -4
C 0.40 8 6
D 0.20 5 15
E 0.10 -4 20
Calculate the expected rate of return of individual asset.
Exercise 8:

Mr. Shahin has the following two investment opportunities A and B :

Economic Probabilit Return (%)

A
Good Bad 0.60 0.40 30 10 20 25

Calculate the Expected rate of return, standard deviation and variance.

Exercise 9:

Micro-Pub. Inc. is considering the purchase of one of two microfilm cameras. Rand

S. Both should provide benefits over a 10 years period and each requires an initial

investment of Tk.4,000 Management has constructed the following table of

estimates of rate of return and probabilities for pessimistic, most likely and

optimistic results :

Camera-R Camera-S
Am Pro Amount
Initial Tk. 1.00 Tk. 1.00
Annual
investmen 400 400
Pessimisti 20 0.2 15% 0.2
Most 25 0.5 25 0.5
Optimistic 30 0.2 35 0.2
Determine the range for the rate of return for each of the two camera.

Determine the expected value of return for each camera.

Purchase of which camera is riskier. Why?

Historical Data (Past Data), Without Probability

Exercise 10:

You have been asked for your advice in selecting a portfolio of assets and have

been given the following data :

Ye Expected Return
As As Asse
ar
20 12 16 12%
 20 14 14 14
20 16 12 16
No Probabilities have been supplied. You have, been told that you can create two

portfolios-one consisting of assets A and B and the other consisting of A and C

by investing equal proportions (50%) :r each of the two component assets.

Requirements:

What is the expected return for each asset over the 3 period?

What is the standard deviation for each asset's return?

What is the expected return for each of the two portfolios?

Exercise 11:

Maximum & Minimum Portfolio Standard Deviation with Correlation Novex owns a

portfolio of two securities with the following expected returns, standard

deviations weights :

Security .,Expected Return Standard Deviation Weight

X . 12% 15% 0.40

Y 15% 20% 0.60

What are the maximum and minimum portfolio standard deviations for varying

levels of correlation between two securities?

Exercise 12:

Portfolio Expected Return

Mr. Awlad Hossain owned five securities at the beginning of the year in the

following amounts and with _the, following current and expected end-of-year

prices
Securities No. of shares Current price Expected Year

End Price
A 100 50 65
B 150 30 40
C 75 20 25
D 100 25 32
E 125 40 47
What is the Hossain's portfolio Expected Return?

Exercise 13:

Mr. Niher buys Tk. 30,000 of stock X and sells short Tk. 10,000 of stock Y, using

all of the proceedings to buy more of stock X. The correlation between the two

securities is 0.45. The expected returns of stock X and Y are 15% and 10% with

the standard deviation of 10% and 12% respectively, What are the expected

return and standard deviation of Mr. Niher's portfolio?

Expected Weight Standard

Stock Return (W) Deviation
A 0.14 0.30 0.07

B 0.16 0.70 0.10

Calculate : (a) Return on portfolio.

Portfolio standard deviation

Expected return and standard deviation

Exercise 14:

There are two assets and three states of the economy :

State of Probabilit Rate of Return if State

Stock-A Stock-B
Recession 0.20 -0.15 0.20
Normal 0.50 0.20 0.30
 Boom 0.30 0.60 0.40
Requirements : (a) What are the expected returns and standard deviation for

these two stocks? Suppose you have Tk. 20,000 total. If you put Tk. 15,000 in

stock-A and the remainder in stock-B, what will be the expected return and

standard deviation on your portfolio?

Portfolio expected return and portfolio standard deviation with correlation.

Exercise 15:

The common stocks of Blatz Company and Stratz, Inc., have expected returns of

15 percent and 20 percent, respectively, while the standard deviations are 20

percent and 40 percent. The expected competation co-efficient between the two

stocks is 0.36. What is the expected value of return and standard deviation of a

portfolio consisting of (a) 40 percent Blatz and 60 percent Shratz? (b) 40 percent

Stratz and 60 percent Blatz?

Capital-Asset Pricing Model (CAPM)

Exercise 16:

From the following information, determine expected rate of return by using the

CAPM approach.

Required rate of return on risk free security, 10%

Required rate of return on market portfolio of investment is 16%

The firm's beta is 2

Exercise 17:

The Green Line Ltd. wishes to calculate its expected rate of return by using

CAPM approach. The following information are available. RF = 8%

|3=1.3

Rm = 15%

Compute expected rate of return

 Exercise 18:

Suppose the risk-free rate is 8%. The expected return on the market is 16%. If

a particular stock h beta of 0.70.

What is its expected return based on the CAPM

It another stock has an expected return of 24%, what must its beta (β) be?

Exercise 19:

individual has Tk. 35,000 invested in a stock that has a beta of 0.8 and Tk. 40,000

invested stock with a beta of 1.4. If these are the only two investments in her

portfolio, what is her portfolio’s beta?

Expected and required rates of return

Exercise 20:

Assume that the risk-free rate is 5 percent and the market risk premium is 6

percent. What is the expected return for the overall stock market? What is the

required rate of return on a stock that has a beta of 1.2?

Required rate of return

Exercise 21:

Assume that the risk-free rate is 6 percent and the expected return on the

market is 13 percent. What is the required rate of return on a stock that has a

beta of 0.7?

Portfolio required return

Exercise 22:

Suppose you are the money manager of a Tk. 4 million investment fund. The fund

consists of 4 stocks with the following investments and betas :

Sto In Be
A Tk 1.5
B 6, (0.
C 10 1.2
 D 20 0.

If the market's required rate of return is 14 percent and the risk-free rate is

6 percent, what is the fund's required rate of return?