PORTFOLIO THEORY, RISK AND RETURN

Portfolio Theory
Financial decisions are made in an uncertain environment. Firms therefore have to take risks in
making any financial decisions. Financial decisions by their very nature are never risk – free
since they pertain to the future.

Risk is having uncertainty and we can never be certain when dealing with future events. If we
are making a decision whose outcome is not certain we are risk taking. In a business the firm
might base its decision on past performance but that does not necessarily mean that past events
will prevail or determine the future. The most important concept in financial decision making is
the attitude of people to risk and the sub – total of individual’s attitude to risk will be the
organisation’s attitude to risk.
There are 3 classes of risk attitude.
I. Risk takers
II. People indifferent to risk
III. Risk averse people

i) Risk takers
Given 2 investments with the same return and different risks, a risk taker would choose an
investment with higher risk. A risk taker is an investor who is willing to take big risks to increase
the potential return on investments. For example, a risk taker would be more likely to invest in
the IPO of a company with a new and exciting product about which little is known, than to invest
in the secured bond issued by a company everyone knows and trusts. Critics maintain that risk
takers accept lower returns for their risk and, as such, they don’t invest efficiently.

ii) People Indifferent to Risk

These are people who do not consider risk in making financial decisions

iii) Risk Averse

These are investors who want the best risk-return tradeoff in making investment decisions. Given
2 assets with the same return but different risks, a Risk Averse investor will choose an
investment with lower risk. If there are 2 investments with the same risk but different returns, a
risk averse investor will choose an investment with higher returns.

Risk-Return trade-off
Investors will not take on additional risk unless they expect to be compensated with additional
return. The risk-return trade off relates the expected return of an investment to its risk. Low
levels of uncertainty (low risk) are associated with low expected returns, whereas high levels of
uncertainty (high risk) are associated with high expected returns.

It follows from the risk-return trade-off that rational investors will, when choosing between two
assets that offer the same expected return prefer the less risky one. Thus, an investor will take on
increased risk only if compensated by higher expected returns. Conversely, an investor who
wants higher returns must accept more risk. The exact trade-off will differ by Investor based on
individual risk aversion characteristics (i.e. the individual preference for risk taking).

Single Asset Evaluation

To make an investment decision, data has to be collected on the distribution of income expected
from an asset and the probabilities attached to those incomes. There are two important
measurements which need to be calculated in evaluating investment assets that is Expected
Return and Risk.

CALCULATING RETURN

Expected Return E(R)

The expected return for an asset is the weighted average rate of return using the probability of
each rate of return using the weight. It is calculated by summing the products of the rate of return
and their respective probabilities. Accept a project with the highest expected return.
N
E ( R ) = ∑ ( Pi . Ri )
i=1

Where Pi – is probability of each individual asset

Ri – return of each individual asset

Laws of Probability
a) Probabilities sum to 1
b) There is no negative probability
c) An outcome that is certain to occur has a probability of 1
d) Impossible outcomes have zero probability

Exercise 1
Consider the following information for MEDAL ltd company

State of economy Probability Return Return Return

Project A Project B Project C
Strong 0.2 70% 55% 10%
Normal 0.5 40% 40% 35%
Weak 0.3 20% 30% 85%

Question : Calculate the expected returns for Project A, Project B and Project C and advise the
company on which project to accept.

NB WE SHALL USE THIS ABOVE EXAMPLE THROUGHOUT MEASURING RISK

Measuring Risk
Risk is the chance of achieving less than expected returns – therefore it is measured by the
dispersion of possible returns around the mean E(R). We recommend projects with the lowest
risk.

1) Variance (δ2 )
It is the weighted sum of the squared deviations from the expected return. Squaring deviations
ensures that deviations that are above and below the expected value contribute equally to the
measure of variability regardless of the sign.
N
Var=∑ ( Pi [R i – E ( R ) ]2❑ )
i=1

Where Pi = probability of event i occurring

Ri = return if event i occurs
E(R) = expected return

Exercise 2
Using the above example in exercise 1 for MEDAL ltd calculate the variance for project A,
project B and Project C

2) Standard Deviation (δ)

It is the weighted average of the deviations from expected return. It provides an idea of how far
above or below the expected return is likely to be. Formula for standard deviation is the square
root of variance.

Exercise 3

a) Using the above example in exercise 1 for MEDAL ltd calculate the standard deviations
for the 3 projects A, B and C
b) What can you draw from the three projects?

3) Coefficient of Variation
It is a measure of relative rather than absolute dispersion. It shows the risk / unit of returns and
provides a meaningful basis for comparison when two alternatives have different expected rate
of returns. The co-efficient of variation can be interpreted as a risk measure or in certain
circumstances as an overall criterion for acceptability. The lower the coefficient of variation the
lower the relative degree of risk.

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

Example
Consider the following
Investment A E(r) $20 000 Standard deviation of 3000
Investment B E(r) $50 000 Standard deviation of 6000

Which investment should be chosen?

A = 3000 B = 6000
20 000 50 000
= 0.15 = 0.12

Investment B should be chosen lower CV of 12%.

In the above example, investment B has higher level of risk than investment A. B has a lower
co-efficient of variation in absolute terms. Its standard deviation is greater than that of A and B
would be selected by a risk averse – manager. Therefore for two investments with different risk
returns profiles – the Standard deviation and the variance are not good enough measures of risk
and cannot provide a good decision for investment.

Exercise 4
a) Using answers from Exercise 1 and 3 calculate the coefficient of variation for project A,
project B and project C
b) Of the 3 projects which is the best investment
c) Justify your answer

RISK AND RETURN IN PORTFOLIOS

Diversification
It is buying or holding of different securities in a portfolio for the purposes of spreading risk. The
risk of an individual asset can be measured by the variance on the returns which can be reduced
through combining two or more assets with different risk-return trade-offs. Diversification
reduces the variability when the prices of individual assets are not perfectly correlated. In other
words, investors can reduce their exposure to individual assets by holding a diversified portfolio
of assets. As a result, diversification will allow for the same portfolio return with reduced risk.
Example
Consider the effect of combining the investment in an ice-cream producer with the investment in
a manufacturer of umbrellas. For simplicity, assume that the return to the ice-cream producer is
15% if the weather is sunny and -10% if it rains. Similarly the manufacturer of umbrella benefits
when it rains 15% and looses when the sun shines -10%. Further, assume that each of the
weather states occur with probability 50%.

Obviously the prior example is extreme as in the real world it is difficult to find investments that
are perfectly negatively correlated and thereby diversify away all risk. More generally the
standard deviation of a portfolio is reduced as the number of securities in the portfolio is
increased. The reduction in risk will occur if the stock returns within our portfolio are not
perfectly positively correlated. The benefit of diversification can be illustrated graphically:

As the number of stocks in the portfolio increases the exposure to risk decreases. However,
portfolio diversification cannot eliminate all risk from the portfolio. Thus, total risk can be
divided into two types of risk:
1) Unique risk and
2) Market risk.
It follows from the graphical illustration that unique risk (the variability in return due to factors
unique to the individual project or firm) can be diversified away, whereas market risk is non-
diversifiable. Total risk declines until the portfolio consists of around 15-20 securities, then for
each additional security in the portfolio the decline becomes very slight. As diversification
allows investors to essentially eliminate the unique risk, a well-diversified investor will only
require compensation for bearing the market risk of the individual security. Thus, the expected
return on an asset depends only on the market risk.
Portfolio Risk
Before calculating risk for a portfolio we need to understand the concept of diversification,
covariance and coefficient of correlation.

Diversification
It is buying or holding of different securities in a portfolio for the purposes of spreading risk. For
this to be effective, the securities in question should have different risk-return trade-off
characteristics. Thus, different classes of securities should be included in the portfolio in order
for it to be well diversified.

Specific Risk
It is that part of total risk that can be directly identified with a particular project or firm. It is the
variability in return due to factors unique to the individual project or firm. Specific factors that
affect the company’s return like demand, management deficiency equipment failure, and
Research and Development achievements. This specific risk can be reduced through
diversification. Because specific risks for projects are independent of other bad events by stock
will be off-set by good events effects on the other.

Systematic Risk / Market Risk

It is that part of risk which cannot be diversified in any way because it is caused by factors
common to all activities. It is also known as market risk e.g. the general level of demand in the
economy, interest rates, labour costs, exchange rates etc. It therefore refers to macro economic
factors that cause reactions on stock market etc. There is no insulation against such factors by an
individual firm.

4) Co-variance

Covariance measures the way two variables relate to each other (move together). It illustrates
the linear relationship between returns of two assets. A positive covariance means that asset re-
turns move together. A negative covariance means returns move inversely.
Possessing financial assets that provide returns and have a high positive covariance with each
other will not provide very much diversification.
For example, if stock A's return is high whenever stock B's return is high and the same can be
said for low returns, then these stocks are said to have a positive covariance. If an investor wants
a portfolio whose assets have diversified earnings, he or she should pick financial assets that
have negative covariance to each other. Diversification or risk reduction will work if the returns
in creating a portfolio behave or move differently over the same period of time. The term given
to such movement is called covariance. The co-variance of returns of assets that make up a port-
folio is a measure of the extent to which the returns of each one vary with another in different
conditions. A covariance of zero implies that independence of the 2 returns’ movements of secu-
rities. Thus for the purpose of diversification assets that negatively correlated are better suited
than positively correlated.

It is calculated as follows

1) Where probabilities are equal use the following formula

Covariance xy = 1/n∑ [{Rx – E(Rx)} {Ry – E(Ry)}]

Where n = number of outcomes or observations
Rx = rate of return of asset x at any point
E(Rx) = expected return on asset x
Ry = rate of return of asset y at any point
E(Ry) = expected return on asset R

2) 1) Where probabilities are different use the following formula

Covariance xy = ∑Pi [{Rx – E(Rx)} {Ry – E(Ry)}]

Exercise 5
You are given the following data for security X and security Y

Event Return (X) (%) Return (Y) (%)

A 20 5
B 15 10
C 10 15

Assume that each event is likely to occur, calculate the covariance

Correlation Coefficient (r)

It overcomes the problems by the covariance by realising that the movements of returns of
securities should be affected by variance or variability of these securities. It is a standard or
adjusted covariance. It is a relative measure as compared to variance or standard deviation
which are absolute measures and this makes it more useful than the covariance.

rx y = Cov xy / (δx δy)

Where rxy = Correlation coefficient of x & y

 δx = standard deviation of x
δy = standard deviation of y

Interpretation of Correlation Coefficient

A correlation coefficient of –1 implies perfect negative correlation or inverse relation between
movements of returns of 2 securities that is if one increase by x% at any time the other will
decrease by the same magnitude. A correlation coefficient of 1 implies perfect positive
correlation between movements of returns of 2 securities that is if one increase by x% at any
time the other will increase by the same magnitude. A correlation coefficient of 0 implies
independence between movements of returns of 2 securities.

Single Asset Evaluation Formulas Where Probabilities Are Not Given

1) Expected return E(R) = ∑R/n

Where R = returns
n = number of years
N
2) Variance Var=∑ ( Pi [R i – E ( R ) ]2❑ )/n-1
i=1

3) Covariance

COVAB = [{Rx – E(Rx)} {Ry – E(Ry)}] / n-1

4) Correlation coefficient
rx y = Cov xy / (δx δy)
Exercise 6 : Example without probabilities

Time Stock A Returns Stock B Returns

1 10% 15%
2 6% 9%
3 8% 12%

Calculate the correlation coefficient between these two stocks.

Portfolio Return – Expected Return of a 2 Asset portfolio.

It is simply the value weighted average of the expected return of individual securities. The
weight applied to each return will be equal to the fraction of the portfolio invested in that
security.
 E(Rp2) = ∑Pi Ri

Where Pi – is probability of each individual asset

Ri – return of each individual asset

Steps
o Calculate the expected values of each of the assets that make up the portfolio.
o Find the weighted average for the expected value of each of the assets in the portfolio.
o The weights are not the probabilities but the contribution of each of the assets to the total
portfolio.

Example 1
Suppose a portfolio has a total value of $200000 and of this total, asset A contributes $70 000
and B the remainder. Assuming the expected income for A and B are $10 000 and $60 000
respectively. Calculate the expected portfolio income.

Answer

70 000 * 10 000 + 130 000 * 60 000 = $42 500

200 000 200 000

PORTFOLIO RISK – THE STANDARD DEVIATION OF A PORTFOLIO

As opposed to the calculation of expected return which is simply the weighted average expected
return of individual sum in the portfolio, calculation of the standard deviation/risk is different. It
takes into account not only the weights, variances, and standard deviation of each security but
also the covariance or correlation coefficient between pairs individual securities in the portfolio.

Variance and Standard Deviation for a 2 asset portfolio

δ²AB = W2A δ2A + W2B δ2B+ 2 [WA WB CovAB]

Since rAB = CovAB / (δAδB ) it implies that

CovAB = δA δB * rAB

Therefore;
δ²AB = W2Aδ2A + W2Bδ2B+ 2 WA WBδAδB rAB
δ AB =√[ W2Aδ2A + W2Bδ2B+ 2 WA WBδAδB rAB ]

The assumption of this model is that the attitude of investors in creating portfolios is entirely
depended on risk and return and the quantification of risk.

Exercise 7
An investor calculated the following statistics on her two stock (A and B) portfolio. Calculate the
portfolio’s standard deviation.

δA = 0.2
δB = 0.15
WA = 0.7
WB = 0.3
rab = 0.32

Expected Return for a Three Asset Portfolio

E(Rp3) = ∑Pi (Ri)

Exercise 8
Security Weight Expected Return
A 40% 20%
B 50% 15%
C 10% 10%

Calculate the expected return of the portfolio

Variance and Standard deviation for a Three Asset Portfolio

δ²ABC = W2Aδ2A + W2Bδ2B+ W2cδ2c +2 WA WB δA δB rAB+2 WA Wc δA δC rAC+2 WB WC

δB δC rBC
δ ABC = √[ W2Aδ2A + W2Bδ2B+ W2cδ2c +2 WA WB δA δB rAB+2 WA Wc δA δC rAC+2 WB
WC δB δC rBC ]

Homework

Calculate the expected return and the risk for a portfolio made up of the following:
WA =0.25, WB = 0.5 and WC =0.25

Cov AB = 5, Cov AC = 9 andCov BC = -1.3

Stock Return Risk (standard deviation)

A 6% 4%
B 8% 5%
C 10% 6%

Homework

Effect of changing weights on Portfolio standard deviation where the correlation coefficient is
constant.

Stock Expected return Standard Deviation

1 0.1 0.0049
2 0.2 0.0100
The correlation of coefficient is 0.5.
The weights are as follows Stock 1 Stock 2
a) 0.2 0.8
b) 0.4 0.6
c) 0.5 0.5
d) 0.6 0.4
e) 0.8 0.2
From the above results varying the weights where the correlation is kept constant for assets with
different returns and standard deviations results in different risk levels for the portfolio being
formed decreasing the weight of the riskier asset and increasing that of the less risky asset results
in reduced risk of the portfolio so formed while on the other hand increasing the weight of the
riskier asset results in higher risk for the portfolio so formed.

However the reduction is still less that where the weights are constant and correlation coefficient
allowed to vary, This underscores the fact that the correlation coefficient is the most important
factor in risk reduction for portfolio formed out of individual securities with different returns and
standard deviations.

homework
Effect of changing correlation coefficient on standard deviation where the securities combined
have the same risk, return and weight
Stock Return Risk Weight
1 10 5 0.5
2 10 5 0.5
Calculate the portfolio standard deviation given the following correlation coefficient.
a) 1 b) 0.5 c) 0 d) –0.5 e) –1

From the above results there are two important subjects to note
a) In a case where the 2 securities are perfectly positively correlated the standard deviation
for the portfolio is equal to the weighted average of the standard deviations forming the
portfolio. The reason is that both securities have the same standard deviations and also
constitute equal weights in the portfolio.
b) In a case where the 2 securities are negatively perfectly correlated and have the same risk
and weight, combining them will have a risk of zero.

The Efficient Frontier and Optimal Folios

The efficient frontier is a curve in expected return (ER) – standard deviation space that traces or
joins the entire portfolio for a given level of risk or the minimum risk for a given level of
expected return. In other words, it is the locus of all attainable portfolios that have the best
results for a given situation.

These investments are mean –variant efficient because

- no other portfolio or investment has a higher expected return and a lower level of risk
and
- no other portfolio investment with the same level of risk has a higher rate of return and
- no other portfolio or investment with the same level of return has a lower level of risk.
The investment that are mean variant efficient make up the efficient frontier. Given that,
investors are risk averse they would want to invest on the efficient frontier because they
obtain the best risk –return relationship.

E(Rp)
AY

x x
x x
C x B
X
δp
In the above diagram curve XY is the efficiency frontier i.e. on it lies all those securities that
have the best risk return trade-offs i.e. have either a lower risk for equal expected return or a
higher expected return for equal than portfolio lying below the curve/ frontier. Thus since
portfolios AC lie on the frontier they are better than B for example which lies in the curve. This
is because even though both A&B have the same risk (δp) but A has a higher return on the other
hand portfolio B&C have the same expected return but C has a lower standard or risk. Thus
portfolio A&C are called efficient portfolios

It would not be rational to hold a portfolio below and to the right of the efficiency frontier since
such a portfolio can be improved upon by obtaining the same expected return at lower risk or a
higher expected return at the same risk. Points above and to the left of the efficiency frontier are
not attainable and hence are not feasible. Points in ABC are feasible but not efficient since all
such points are dominated by points on the efficiency frontier. When a portfolio either yields a
lower expected return for the same risk or a higher risk for the same expected return, as an
alternative portfolio then it is said to be dominated by that alternative portfolio.

Such an approach to portfolio diversification-pioneered by Markowits-suffers from the practical

problem of enormous amount of information. It requires knowledge of the expected returns on
each asset, the standards deviations of those expected returns and the correlation of expected
returns between every pair of assets. When the available assets are numbered in thousands, the
data requirements become vast.

Optimal Portfolios
Different investors have different risk preferences- some are said to be risk-takers they enjoy
high levels whereas some are said to be risk averse i.e. they prefer lower risk or no risk at all.
Because of this, investors will have different utility functions or indifference curves which in
portfolio they specify the trade-offs between risks and return that an investor is willing to make.
This optimal portfolio is the efficient portfolio that has the highest utility for a particular investor
or one with the highest return for an investor’s risk preference. It is found by point’s tangents
between efficient frontier and the indifference curve with the highest utility for a given investor.

Ii Iii
E(Rp) Iiii
AY

x x
x x
C x B
X
δp
In the diagram, indifference curves have also been drawn to show the possible investment
choices by different investors depending on where their indifference curves are tangent to the
efficient frontier. One of the objectives of the analysis is to be able to determine the required rate
of return of an investment given a certain level of risk. The assumption is that all investors would
like to invest on the efficient frontier since it provides the best risk-return relationship. The
efficient frontier is however, a curve that is difficult to describe and use in calculating the
required rate of return. The problem can be solved by adding a risk free asset.

Capital allocation between the risky asset and the risk free asset of a portfolio
A risk free asset is one with a known return for a given holding period e.g. TB with this security
or asset there is no the variability of return in about it and expected return ER and therefore no
risk. It has no both liquidity and default risk. In addition the return of the risk free asset has no
correlation with the return on a risky asset i.e. its return is not directly affected by returns on
risky assets.
If the risk-less asset is combined with an individual asset or market portfolio, the efficiency
frontier will form a linear relationship.

THE CAPITAL MARKET LINE (CML)

Given an assumption that there is risk free lending and borrowing, risk averse investors will hold
portfolios that are made up of a market portfolio (a risky asset) and a risk free asset. The market
portfolio is held because it is mean variance efficient. The relationship obtained is illustrated
below.

DRAW THE CML GRAPH

The inclusion of the risk free asset results in a linear relationship. This is called the Capital
Market Line. All efficient portfolios will plot on the RfMZ line or the capital market line. An
investor can employ the following strategies:-
- lend all money at the risky free rate. Investor will be at Rf on the capital market line.
- Lend part of the money at risky free rate Rf and invest the remainder in the market
portfolio. The investor will be between point Rf and M on the capital market line.
- Invest all money in the market portfolio – Investor will be at point M
- Borrow money at the risk free rate and together with own funds invest in the market.
The investor will fall on the M to Z line which represent borrowing at the risk free rate
and investing in the market portfolio.
The Capital Market Line is described by the following :-
 CML(Rp) = Rf +[ E(Rm) – Rf] x δp
δm
where CML(Rp) - return on the portfolio
Rf - risk free rate
Rm - expected return on the market portfolio
δp - standard deviation of the portfolio
δm - standard deviation of the market
δp = standard deviation of the market multiply by the proportion of
wealth invested in the market portfolio

Example
The Rf is 10%, the market return is 20%, and the risk of the market is measured by the standard
deviation of 5%. Investor A wants to invest 80% of his proceeds in the market portfolio and the
remainder in risk free assets. What is the required rate of return on the portfolio

Answer

δp = 0.05 *0.8 = 0.04

Rp = 0.1+ [0.2 – 0.1]*0.04 = 18%

0.05

THE STANDARD CAPITAL ASSET PRICING MODEL

The CAPM is an equilibrium model for risk and return trade off in portfolio Theory. It is derived
from other portfolio theory models like Markowitz selection model which spells how securities
should be combined in order to create efficient and optimum portfolios. The CAPM is a
technique for predicting expected return on risky assets. It has a number of assumptions some of
which are unrealistic but nevertheless help in giving insight to more relevant issues in portfolio
analysis in the real world.

Assumptions of the CAPM

a) No transactions costs i.e. there is no cost of trading or looking for information and put
differently this way also mean transactions costs are irrelevant in decision making by
investors.
b) Investors make their decisions based on risk and return only of a period horizon i.e.
investors are expected to liquidated their position within or at the end of one period.
c) Individual financial assets are initially divisible that is investors could take any position
in a security regardless of wealthy- e.g. holding a fraction of stock.
 d) No taxes- i.e. investors are not taxed for their gains are therefore one indifferent between
receiving dividends or capital gains
e) There is unlimited lending and borrowing of funds by all investors at the same risk free
rate which is represented by return on a Treasury Bill
f) Short selling is allowed
g) There is perfect competition
h) Investors have homogenous expectations regarding return risk and covariance of
securities
i) All assets are marketable- can be converted into cash without significant loss
j) Relevant information is instantly available to all investors.

THE CAPM EQUATION

RA = Rf + β (Rm – Rf)

Where RA– expected return on asset A for an holding period

Rf- return on risk free asset (TBs).
β – beta
Rm – return on market portfolio for on holding period

This equation defines the equilibrium relations between the expected return of a security and its
market risk. Such an equilibrium relationship is represented by the capital market line.

The capital market line and the CAPM

Since the CAPM is partly derived from the Markowitz model it also states that the optimal and
or efficient portfolio should line on the capital market line which represents the market portfolio.
It also states that to determine the effect of an individual security or the risk of diversified
portfolio, it is not appropriate to consider the total riskless of that individual asset if held on its
own, but such total risk should be divided into 2 points which are market risk and non-market
risk.

Market risk

This measures the sensitivity of the individual security’s return to movements in the market
portfolio. This sensitivity measures called Beta B and can be said to measure the marginal
contribution of a stock to the risk of a market portfolio. Beta co-efficiency can be anything from
zero upwards. A beta of zero means insensitivity to the movements in the market portfolio. This
Treasury Bills have a Beta of zero as they are said to be riskless and have no correlation with the
market portfolio. A Beta of 1 means the individual security moves in tandem or in line with
market portfolio if the market or average increases or decreases by 10%, the return on that
security will also be expected to decrease or increase by the same margin. Because of this the
market portfolio has a Beta of 1 and stocks with a Beta of 1 will therefore have expected return
equal to the market return.In general terms the CAPM implies that the expected return of a
security is related to its Beta or market risk and not total risk. Market risk comes about due to
economy wide factors that affect all businesses and therefore can’t be avoided or eliminated by
diversifying. Because of this market risk is also called non-diversifiable risk or systematic risk.

Non-market risk

It is the risk that is unique to a given security i.e. it is not common to all securities e.g. shares
have risk which may not affect bonds and with careful security selection in creating a portfolio,
such risk can be eliminated. Because of this non-market risk is also called diversifiable risk, or
unique risk or unsystematic risk. Given the division of total risk into market and non-market risk
the CAPM implies that the risk of a well-diversified portfolio will only depend on the market
risk on non-diversifiable risk of its constituent security as non-market risk would have been
eliminated three diversification.

Total Risk = Systematic Risk +Non-systematic Risk

Determination of the Beta

In financial models the systematic risk is measured by an index of the systematic risk of the
asset. This index is calculated by dividing the systematic risk of an asset by that of the market
portfolio. The market portfolio is made up of all risky assets in the economy and therefore only
systematic risk since it is fully diversified. The index of the systematic risk is called Beta
coefficient (β)

Beta (β) = δA*Pam / δm

δA = standard deviation of asset A

Pam= correlation of returns of A to those of the market portfolio

The Beta co-efficient is the tendency of the returns of a stock to move with market returns. The
beta is therefore the sensitivity of asset returns to changes in the returns of the market portfolio.
The market portfolio will therefore have a beta that is equal to 1

The Security Market Line (SML), the Capital Market Line and CAPM

If the risk is measured by using the beta coefficient a linear relationship- can be derived is called
the Security Market line. The security market line is a linear relationship between market
covariance and expected between of the efficient portfolios. The capital market line also
represents the linear efficient set of the CAPM. The CAPM almost always uses above the
security market line and they are only equal if the market covariance and market standard
deviation are equal.

DRAW THE SML GRAPH

The SML is a line on which all securities whether efficient or not will plot at equilibrium.
Why All Securities Plot on the SML
- according to the CAPM , if a security is correctly priced the required rate of return
(RRR) should equal the expected rate of return (ERR). The difference between the RRR
and the ERR called alpha is zero. If an asset has a non-zero alpha there is some
mispricing of the asset.
- When the alpha is positive an investor’s RRR is higher that the ERR. This means that the
security is overpriced and the expected rate of return (ERR) will plot below the SML.
Since security returns are expected to eventually return to equilibrium the
recommendation is to sell this security since it is overpriced.
- When the alpha is negative an investor’s RRR is lower than the ERR This means that
the security is underpriced and the expected rate of return will plot above the SML.
Since security returns are expected to eventually return to equilibrium the
recommendation is to buy this security since it is underpriced.