8

Risk and Return

INTRODUCTION

Chapter 7 introduced risk and risk measurement. The chapter also showed us how
diversification enables an investor to reduce risk, but that there is a limit to risk reduction. Only
risk unique to individual securities can be diversified away; the risk that a security bears as part
of the overall economic system remains in the portfolio. This risk was termed market risk. This
chapter builds on the lessons of chapter 7 and presents formal models linking risk and expected
return. The chapter begins with a discussion on portfolio theory pioneered by Harry Markowitz.
This theory formed the basis for the most popular and widely used model of risk-return
relationship: the Capital Asset Pricing Model or CAPM. The CAPM has some empirical
evidence to support the basic conclusions derived from the model. Recently, it has been
challenged by other theories that purport to rely on assumptions less restrictive than the ones
used by CAPM. The chapter presents three alternate theories to CAPM. While CAPM is far
from perfect, it remains the most widely accepted model, primarily because of its relative
simplicity and ease of application.

KEY CONCEPTS IN THE CHAPTER

Portfolio Theory: Stock market returns of individual stocks covering relatively short periods
closely approximate the normal distribution. This enables one to describe the entire distribution
of the returns in terms of two parameters- the mean and standard deviation. Individual investors
are assumed to be risk-averse, meaning that they would like to be compensated for bearing more
risk. This also means that they like higher returns and lower risk. The standard deviation of
returns measures risk.

The portfolio theory gives the basic principles of selecting the optimal portfolio in terms of risk
and return. We learned in the last chapter that when two stocks are combined into a portfolio,
the risk (standard deviation of the portfolio) is less than the average of the two individual
standard deviations. Of course, when combining securities into a portfolio, an infinite number
of combinations are possible. But investors would choose only those which are efficient
portfolios. Portfolios are considered efficient if, for a given standard deviation, they give the
highest return, or for a given return they have the lowest standard deviation. Investors need only
consider efficient portfolios, for all other portfolios give them a poor deal.

Investors have more than two stocks to choose and we can extend the idea of efficient portfolio
to the universe of available securities. All the efficient portfolios can be identified and
depending on one’s own risk-return preference, an investor can choose the best portfolio of his
liking. The technique of quadratic programming can be used to choose the efficient portfolio of
one’s preference. If one were to graph the set of all efficient portfolios selected from all the
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stocks available it will look like the curve shown in Figure 1. Every investor will only choose a
portfolio on this curve. Any choice not on the efficient set will be dominated by a portfolio on
the efficient set. The curve BC represents all the available efficient portfolios.

Figure 1

Expected C
Return

A
Standard Deviation

Investors’ choices can be expanded by introducing the possibility of lending or borrowing at the
risk-free rate. This will allow the investors to combine investing in the stock portfolios given by
the efficient set with lending or borrowing (borrowing can be seen as negative lending). The
possibilities are shown in Figure 2.

Figure 2
S
Expected C
Return

rf B

Standard Deviation

The figure shows that investors can choose along the line starting from the risk-free rate to the
portfolio S. If the investor chooses to invest all her money in risk-free lending, she will have the
risk-free rate at zero standard deviation. Any point between r f and S will have part of the money
invested in the stock portfolio S and the remaining lent at the risk-free rate. Any investor is free
to choose points to the right of S. This would mean that the investor is borrowing money at the
risk free rate and investing that along with his own money in portfolio S. You can clearly see
that regardless of where the investor wants to be, the stock portfolio will be the same, namely the
portfolio S. In other words, S is the best of all the efficient portfolios and every investor will be
invested in this portfolio. This will also mean that every stock will be held as part of this
portfolio.

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An investor's job can be separated into two parts: first, to choose the best (risky) portfolio of
stocks S and, second, to combine it with the right amount of lending or borrowing to adjust to
the preferred level of risk. This is known as the separation theorem: the job of selecting
individual stocks in one’s portfolio can be independently of one’s risk preference. In a
competitive market, there is no reason to concentrate portfolios in particular stocks, and we can
identify S as the market portfolio. Everyone holds S. Risk preference only decides what
fraction of one’s investment goes to S.

Capital Asset Pricing Model: Capital Asset Pricing Model (CAPM) is an extension of what we
saw in Figure 2. Investing in risky assets such as the market portfolio, S, should carry a
premium compared to the risk-free rate. Otherwise, investors will not take the risk. The market
portfolio is the basic benchmark of risk in the CAPM. The risk premium on the market
portfolio, measured as the difference between the market return and the risk-free rate is called
the market risk premium. The beta for the market portfolio is 1. The CAPM postulates a linear
relationship between risk and return as shown in Figure 3. Figure 3 shows the security market
line (SML).

Figure 3
Returns

SMLS
rm

rf

0 0.5 1.0 Beta

The risk of each stock is measured by its beta and the risk premium varies in direct proportion to
beta. All stocks will lie along the SML and the expected return on a stock can be calculated by
adding the risk premium to the risk-free rate.

Expected risk premium = r  r f =  (rm  r f )

A key implication of the CAPM is that it is the risk of a stock that matters in its contribution to
portfolio risk. This is what is measured by beta and it depends on the stock’s sensitivity to
changes in the value of the market portfolio.

Validity of CAPM: Over the years, a lot of research has been done to test the validity of CAPM.
Remember, however, the CAPM is a theory about expected returns. We can only measure actual
returns. This makes it difficult to test the theory as it is conceived. Another problem in testing
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CAPM is that the market portfolio should include all assets, not just stocks traded in stock
exchanges. In practice, most of the tests use stock market indexes such as the S & P 500 as
proxies for the market portfolio.

One of the best known tests of the CAPM’s validity involved analyzing portfolio returns over
the period 1931 to 1991. The study, conducted by Fischer Black, grouped all New York Stock
Exchange stocks into 10 portfolios selected according to the ranking of the betas of their stocks.
Every year these portfolios were readjusted, using monthly data from the previous 5 years, so
that portfolio 1 always contained the 10 percent of stocks with the lowest betas, portfolio 9 the
next 10 percent, up to portfolio 10 with the highest beta stocks. The performance of these
portfolios was assessed over the 60-year period. The results showed a strong positive
relationship between beta and returns and thus broad support for the CAPM. However, it was
found that the security market line was flatter than the theory predicted and it was above the
risk-free rate.

In recent years, the relationship between beta and the risk premium has been particularly flat. It
has been argued that some of these results could be attributed to sampling errors (the realized
average returns are not the same as the previously expected ones). There is also evidence that
suggests that beta is not the only factor that affects expected returns. Firms, which are small,
and ones, which have low market-to-book ratios, seem to provide higher average returns
irrespective of their betas. It is difficult to judge the economic significance of these results. The
small-firm effect is found to be less in more recent studies. It is also possible that some of the
results which cast doubts on the validity of the CAPM can be produced by statistical strategies
(known as "data mining"). The supporters of the CAPM believe that the broad conclusions of
the theory are valid.

Consumption CAPM: The consumption CAPM is an alternate theory to the CAPM. The
CAPM assumes that investors are concerned with their wealth and uncertainty about the same.
The consumption CAPM holds that risk and expected return should be related to changes in
investors’ aggregate consumption rather than their wealth. Investors’ wealth is not directly
relevant to the stock returns. One need not worry about defining the market portfolio. However,
you have to estimate aggregate consumption and its changes. Empirically, it is observed that
estimated aggregate consumption changes rather gradually through time. This does not give a
good explanation of past average rates of return. In short, the model has not caught on and its
practical appeal seems limited.

Arbitrage Pricing Theory: The arbitrage pricing theory (APT) was the first serious challenger
to CAPM. It does not involve many of the restrictive assumptions of CAPM. It postulates that
each stock's return depends on several pervasive macroeconomic factors and the risk premium
depends on the factor weights. The general model can be written as:

Return = a + b1(factor 1) + b2(factor 2) + ……

Alternately, the risk premium: r - rf = b1(premium1) + b2 (premium2) + ……

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The APT is general and has appealing features. The market portfolio has a role in the model and
thus we need not be concerned with measuring the same. The model is general and is dependent
on the absence of arbitrage opportunities. The model does not specify either the number of
factors or identity of these factors. The major problem is that there is little agreement on what
the factors are. There have been many empirical attempts at identifying the factors. These have
been met with limited success. The APT is still a long way from replacing the CAPM as the
primary theory for risk-return relationship.

The Three-Factor Model: Eugene Fama and Kenneth French incorporate the small-firm effect
and the book-to-market ratio effect seen in empirical studies into a formal risk-return
relationship model. The model can be represented as:

r - rf = bmarket(r1market-factor) + bsize (rsize factor) + bmarket-to-book(rmarket-to-book)

The model is a practical extension of CAPM.

WORKED EXAMPLES

1. Mr. Hernandez wants to invest $10,000. He has a choice of a risky portfolio, M, of stocks
with an expected return of 15 percent and a standard deviation of 18 percent. He can also
lend and borrow at the risk-free rate of 6 percent. Show how he can construct a portfolio
with standard deviations of (a) 9 percent, (b) 27 percent, and (c) 36 percent. Calculate the
expected return for each of these portfolios.

SOLUTION

Since the standard deviation of lending or borrowing at the risk free rate is zero, the portfolio
standard deviation is the fraction invested in M multiplied by its standard deviation. Thus if he
invests half of his money ($5,000) in M, the portfolio standard deviation will be: 0.5 x 18 = 9
percent. If he borrows $5,000 and invests $15,000 ($10,000 of his own plus the borrowed
$5,000) in M, the standard deviation of his investment portfolio will be 1.5 x 18 = 27 percent.
Similarly, to get a portfolio with standard deviation of 36 percent, he will have to borrow
$10,000 and invest $20,000 in M. The expected return for each portfolio will be:

a. (0.5 x 6) + (0.5 x 15) = 10.5%

b. (1.5 x 15) – (0.5 x 6) = 19.5
c. (2 x 15) – (1 x 6) = 24%

2. The Treasury bill rate is 5 percent and the market portfolio return is expected to be 13
percent.
a. What is the market risk premium?
b. What is required rate of return on an investment which has a beta of 1.6?
c. If the expected return on Joy Wish Corp. stock is 17 percent, what is its beta?
d. If an investment with a beta of 1.8 were expected to give a return of 19 percent, would
you accept it?
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SOLUTION

a. Market risk premium = 13 – 5 = 8%

b. Required rate of return for an investment of beta of 1.6 = 5 + 1.6(13 - 5) = 17.8%
c. Return = 5 + (8) = 17,  
d. Required rate of return The investment return is less than the
required rate of return. Hence, its NPV will be negative.

3. ABC Corp. wishes to use the Fama-French 3-factor model to estimate its cost of equity
capital. The company has estimated the following factor sensitivities and factor risk
premiums:
Factors Factor Factor risk
Sensitivity premium
Market factor 1.5 5.2 percent
Size factor -0.4 3.2
Book-to-
market factor 0.2 5.4

If the risk free rate is 6 percent, estimate the cost of equity capital for the firm.

SOLUTION

Risk premium = 7.60 percent

Cost of equity capital = 6 + 7.6 = 13.60 percent.

SUMMARY

The chapter describes the basic principles of portfolio selection and the theories of which
provide formal models of the linkage between risk and return. Risk averse investors choose
portfolios based on risk and return. It makes sense to choose only efficient portfolios--portfolios
which provide the highest return for a given level of risk. In presence of the possibility of risk-
free lending and borrowing, investors will end up choosing the one portfolio that, in combination
with risk-free lending/borrowing, gives the best choices regardless of one’s own risk
preferences. This forms the basis for the widely accepted theory, Capital Asset Pricing Model.
The CAPM uses the market portfolio as the basic benchmark for risky investments and the risk
of any stock or investment is measured relative to the market portfolio. The risk measure is beta
and it reflects the stock’s sensitivity to changes in the value of the market portfolio. The risk-
return relationship is captured by the security market line and the risk premium on any stock is
proportional to its beta.

The CAPM theory finds some empirical support, though recently questions have been raised
about the strict validity of the security market line. Alternate theories of risk-return relationship
include the consumption CAPM, the arbitrage pricing theory, and the three-factor model. Each
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of these theories has intellectual appeal and might someday prove to be a replacement to the
CAPM; however for the present the CAPM still rules. The primary attraction of the CAPM is its
relative simplicity and ease of practical application. The CAPM should be seen as an
approximate and partial explanation of the risk-return trade off faced by the investor. We will
find many applications of the CAPM in the later chapters.

LIST OF TERMS

Arbitrage pricing theory Market risk premium

Capital Asset Pricing Model Normal distribution
Consumption beta Quadratic programming
Consumption CAPM Security market line
Efficient portfolios Three-factor model
Expected risk premium

EXERCISES

Fill-in Questions

1. The ________________ uses less restrictive assumptions than the CAPM does and
postulates that returns are dependent on pervasive macroeconomic factors.

2. The distribution of stock returns when considered over fairly short periods, closely follow
_______________.

3. A(n) ____________ is a portfolio that gives the highest expected return for a given standard
deviation or the lowest standard deviation for a given return.

4. Fama and French proposed the ____________.

5. Optimal portfolio selection can be done using the________________ technique.

6. The _____________ relates the risk premium to the sensitivity of the investment to changes
in consumption, and this sensitivity measure is called the ___________.

7. The _______________ relates the risk premium to sensitivity of the asset’s returns to
changes in the value of the market portfolio.

8. The expected return on a stock investment, according to CAPM, equals the risk free rate plus
_______________.

9. The difference between the expected market return and the risk-free rate is _____________.

10. According to the CAPM, the expected returns from all investments must plot along the
_____________.
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Problems

1. Pick the better investment from each of the following pairs of portfolios.
a. Portfolio A: expected return 14 percent, variance 400.
Portfolio B: expected return 13 percent, variance 441.
b. Portfolio J: expected return 20 percent, variance 529.
Portfolio K: expected return 20 percent, variance 400.
c. Portfolio R: expected return 8 percent, variance 225.
Portfolio S: expected return 9 percent, variance 225.
d. Portfolio X: expected return 12 percent, variance 380.
Portfolio Y: expected return 15 percent, variance 460.

2. Calculate the expected return for the following portfolios:

a. beta = 1.2
b. beta = 1.8
c. beta = 0.5
d. beta = 0
Assume the risk free rate to be 6 percent and the expected market risk premium to equal 15
percent.

3. Your broker is urging you to invest in one of three portfolios on which the returns are
expected to be as follows: portfolio A, 12 percent; portfolio B, 16 percent; portfolio C, 20
percent. You believe these estimates, but you also have sufficient data to calculate the betas
of the portfolios with confidence. You find the betas are 0.5 for A, 1.1 for B, and 2.0 for C.
Which portfolio is best and why? (Hint: See if you can duplicate portfolio B by some
combination of A and C.)

4. Stock J has a beta of 1.2 and an expected return of 15.6 percent, and stock K has a beta of
0.8 and an expected return of 12.4 percent. What must be (a) the expected return on the
market and (b) the risk-free rate of return, to be consistent with the capital asset pricing
model?

5. Stock A has an expected return of 14 percent and a beta of 1.1. Stock B has an expected
return of 18. The risk free rate is 5.2 percent. Assume that stock A is correctly priced (i.e. it
is on the security market line). If stock B has a beta of 1.4, is it correctly priced?

6. An alternate form of the CAPM is written as: r = rm. Write a general expression for
and find the value for  for each of the following cases: (a) beta = 1, (b) beta = 2, and (c)
beta = 0. What is the value of beta if  = zero?

7. The return on a proposed investment is expected to be 24 percent. The standard deviation is

estimated at 24 percent. The risk free rate is 6 percent. Assume the expected market risk
premium to be 9 percent. Assume that the standard deviation of market returns to be 15
percent. If the project correlates fairly highly with the economy, comment on the
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 attractiveness of the project.

8. You are told that MM Inc. stock has a beta of 1.3. Estimate its cost of equity capital.

9. A three factor APT model has the following factors and risk premiums:
Factors Risk premiums
Change in GNP 4%
Change in dollar exchange rates -2
Change in energy prices -1
Calculate the expected rates of return on the following stocks, assuming the risk-free rate to be
5.5 percent.
a. Company A: b1 = 0.5, b2 = -1.5, b3 = 0.3
b. Company B: b1 = 1.2, b2 = 0, b3 = -0.5
c. Company C: b1 = 2, b2 = 0.5, b3 = -2

10. Use the information on factor risk premiums from the worked example three-factor model
problem to calculate the required rate of return on the following stocks with factor
sensitivities to market, size, and book-to-market as follows:
a. Factor sensitivities: 1.2, 2, and 0
b. Factor sensitivities: 1.5, 0.3, and 1
c. Factor sensitivities: 0.5, 0, and 1.5

11. Can a security have a negative expected rate of return and still considered to be correctly
priced? What will be its beta?

Essay Questions

1. Explain the basic principles of portfolio theory. What is an efficient portfolio?

2. Explain the separation theorem and how it leads to all investors choosing the same portfolio
of common stocks.

3. Compare and contrast the CAPM, consumption CAPM, and the APT.

4. The CAPM can be considered a special case of the APT. Discuss.

ANSWERS TO EXRECISES

Fill-in Questions

1. Arbitrage pricing theory 6. Consumption CAPM, consumption beta

2. Normal distribution 7. Capital asset pricing model
3. Efficient portfolio 8. Risk premium
4. The three-factor model 9. Market risk premium
5. Quadratic programming 10. Security market line
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Problems

1. The efficient portfolios are:

a. Portfolio A - higher return, lower variance
b. Portfolio K - same return, lower variance
c. Portfolio S - higher return, same variance
d. Cannot decide between the two without knowing the investor’s risk preference

2. The expected returns can be calculated by the formula: r = rf + (rm - rf)

a. r = 6 + 1.2(9) = 16.8 %
b. r = 22.2 %
c. r = 10.5 %
d. r = 6 %

3. A portfolio containing 60 percent A and 40 percent C will have the same beta as that of B
but has lower return (15.2 %) than that of B. Thus, B is a better choice.

4. rf + 1.2(rm - rf) = 16, rf + 0.8(rm - rf) = 12.4 Solving for rf and rm , gives you: rf = 6 percent,
rm = 14 percent.

5. Stock A return = 5.2 + 1.1(rm - 5.2) = 14, rm = 13.2 percent.

Expected return for B, as per CAPM = 5.2 + 1.4(13.2 - 5.2) = 16.4 percent.
This is lower than the expected return given. Stock B will not be on the SML.

6. = (1 - )rf
a. If  = 1, = 0.
b. If  = 2, = - rf
c. If  = 0, = rf
If  = 0, = 1
 mp p
7. Beta for the project = , where mp is the correlation coefficient for the project returns
m
with the market returns and pand m the standard deviation of the project returns and the
market returns respectively. If the correlation coefficient is positive 1 (the highest possible
value), the beta for the project will be = 24/15 = 1.6. Substituting the values in the CAPM
formula for required rate of return, you get required return = 6 + 1.6(9) = 20.4 percent. The
project’s return is higher than this and it appears to be a good project.

8. Based on historic market risk premium of about 9.2 percent, the risk premium for this stock
will be 1.3x9.2 = 12 percent. Add this to the current risk-free rate to get an estimate of the
cost of equity capital.

9. The returns for the different stocks are:

a. r = 5.5 + 0.5(4) - 1.5(-2) + 0.3 (-1) = 10.2 %

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 b. r = 5.5 + 1.2(4) + 0 -0.5(-1) = 10.8 %
c. r = 5.5 + 2.0(4) + 0.5(-2) -2(-1) = 14.5 %

10. The returns are:

a. r = 6 + 1.2(5.2) + 2(3.2) + 0 = 18.64 %
b. r = 6 + 1.5(5.2) + 0.3(3.2) + 1(5.4) = 20.16 %
c. r = 6 + 0.5(5.2) + 0 + 1.5(5.4) = 16.70%

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