Risk and return:

week Two
Week of 16 September 2024
Presented by:

What are shares?

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 How do shares come about?

3 Annual Review September 12, 2024

What do we got from shares

• Capital Appreciation
• Dividends

4 Annual Review September 12, 2024

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 Warren Buffet

Coca-Cola (KO), 400 million.

Kraft Heinz (KHC), 325.6 million.
Occidental Petroleum (OXY), 255.3 million.
American Express (AXP), 151.6 million.
Sirius XM (SIRI), 132.9 million.
Chevron (CVX), 118.6 million.
Nu Holdings (NU), 107.1 million.
Liberty Sirius XM (LSXMA), 70 million.

5 Annual Review September 12, 2024

Learning objectives
Managerial Finance 8th Edition, Lexis Nexis, Chapter 5 : Portfolio management and the capital asset pricing model

• The Learning Outcomes for this week are:

• Calculate the expected return on a two-asset and multi-share portfolio;

• Understand and apply the concept of covariance and correlation coefficient between two or more investments in a
01. Introduction 02. Results from
• portfolio
last year
• Calculate the expected risk on a two-asset and multi-share portfolio using covariance measures;
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• Understand the efficient frontier;

• Understand unsystematic and systematic risk;

• Understanding the impact of diversification on the expected return and risk of a portfolio of assets;

• Understand the capital asset pricing model ("CAPM");

• 03. Our team 04. What’s next

Understand the assumptions and limitation of modern portfolio theory 05. Closing
• Applying concepts of ethics to finance
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basic learning objectives

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 Recap of the first risk and return lecture

Risk On a single asset

Standard deviation
Comparison of two assets

1. Assets have either the same

risk or the same Return ( Mean

variance rule)

Return on a single asset

2. Assets have different risk and

Historical Data ( weighted returns ( Coefficient of variation

average) OR Expected future

data ( sum of Return*the

OR the z score)
probability for the return)

Modern Portfolio Theory

• A theory on how risk–averse investors can construct portfolios to optimize or maximize expected
return based on a given level of market risk, emphasising that risk is an inherent part of higher
reward.
• A portfolio is a collection of financial investments ( assets) like stocks, bonds, commodities.
• The modern portfolio theory argues that any given investment's risk and return characteristics
should not be viewed alone but should be evaluated by how it affects the overall portfolio's risk and
return. That is, an investor can construct a portfolio of multiple assets that will result in greater
returns without a higher level of risk.
• Why not pick the best asset instead of forming a portfolio?
• Portfolios provide diversification, reducing unnecessary risks (don’t put all your eggs in one
basket!) .
• Portfolios can customize and manage risk/reward trade-offs
• Based on statistical measures such as variance and correlation, a single investment's performance
is less important than how it impacts the entire portfolio.
• Investors are assumed to be rational; therefore, when comparing investment choices, they will
choose those investments which give greater return when investment risk is equal, and lower risk
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when investment return is equal.

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 Modern Portfolio theory Assumptions and limitations
• All investors are rational and prefer less risk rather than more for a given rate of return.
• All investors have full and equal access to all available information which results in similar expectations.
• There are no transaction costs such as brokerage; the markets are perfectly competitive; and all financial assets are divisible.
• There is no taxation.
• All investors can lend and borrow at the risk-free rate
• The CAPM is a single-period model, we are therefore assuming that the beta, risk-free rate and the expected market return will remain
constant over the life of the project.
• The use of the beta as a measure of systematic risk assumes total diversification of unsystematic risk, resulting in total risk being equal to
systematic risk. In practice, firms are unable to eliminate all unsystematic risk.
• The assumption that the government bonds are risk free, although this may not be always the case. Government bonds in some instances do
carry a small amount of risk (inflation is a case in point and in some countries default risk).
• The assumption of perfect capital market: This assumption means that all securities are valued correctly. In the real world capital markets are
clearly not perfect.

Measuring Portfolio Risk

• Amongst others, investors can use two strategies to balance a
portfolio’s risk and reward:
1. Diversification
2. Asset allocation
• The risk of a portfolio depends on:
• The riskiness of the individual shares and
• The relationship between their returns
• The risk of a portfolio is therefore measured using the standard
deviation of the portfolio. However, the standard deviation of the
portfolio will not be simply the weighted average of the standard
deviation of the two assets. We also need to consider the relationship
(covariance/correlation) between the assets.
• The standard deviation in a portfolio can therefore be calculated using
either:
• Covariance ( How two Variables differ)
• Correlation (how two variables are related
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 Measuring portfolio risk cont.
1.Correlation coefficient
• The correlation coefficient indicates the strength and direction of a linear relationship
between two random variables (How two assets move together).
• The calculated value lies between – 1 and + 1
• +1 = Strong positive Linear relationship
• 0 = No/weak linear relationship
• -1 = Strong negative linear relationship
• If 2 shares are perfectly positively correlated, diversification has no effect on risk
• If two shares are perfectly negatively correlated the portfolio is perfectly diversified.

Modern portfolio theory states

that portfolio variance can be
reduced by selecting a mix of
assets with low or negative
correlations.

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Measuring portfolio risk cont.

Example:

Lets assume that we have a 60% holding in X and a 40% holding in Y.

Calculate the portfolio standard deviation ( risk) using the correlation coefficient.
1. Proportions invested: 60 % in X and 40 % in Y
2. Standard deviation of share X and share Y: Portfolio Risk:
Use financial calculator ( stat, A+BX function, insert returns for share X and returns for share Y) __________
In order to get the variance ( shift, stat, var, ) The standard deviation of ______ is an indication of
Standard deviation X = the risk of the portfolio. It is only useful if compared
Standard deviation Y = with the standard deviation of another portfolio or
3. Variance of share X and share Y the standard deviation of the current portfolio if its
Variance X = asset composition is changed.
Variance Y =
4. Calculate the correlation Coef on share X and Y
Use financial calculator ( Shift, stat, Reg, r)
12r= ___________________ negative or positive? Very Important!!

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 Measuring portfolio risk cont.
2.Covariance
• Covariance measures how share returns move together (behavior)
• A positive covariance indicates that two assets move in tandem. A negative covariance indicates that two assets move
• in opposite directions
• By including assets that show a negative covariance, the overall volatility of a portfolio will be reduced.

• If share A’s return is high whenever share B’s return is high then A and B
have a positive covariance.
• If share A’s return is low whenever share B’s return is high, these stocks
are said to have a negative covariance.
• If the covariance is zero, there is no relationship between the variables.

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Measuring Portfolio Return

• The expected return on the portfolio is equal to the weighted average expected return of each asset in the portfolio.

• E

• sExample:

• Expected return A =
• Expected return B=
• Expected portfolio return =
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 The Efficient frontier
• The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level
of risk or the lowest risk for a given level of expected return. ( same concept as the risk and return trade off)
• Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for
the level of risk.
• Portfolios that cluster to the right of the efficient frontier are sub-optimal because they have a higher level of
risk for the defined rate of return.

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The Capital asset pricing model

• The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and the required return for assets, particularly
stocks and is therefore a measure of systematic risk.
• Eg: Most share prices go down when interest rates go up: impact of systematic ( market ) risk.
• The CAPM estimates the expected return of an asset based on its riskiness relative to the rest of the market and is dependent on three main

factors:
• Time value of money: as measured by the risk-free rate, that is reward for merely waiting for money without taking any risk
• The reward for bearing systematic risk – market risk premium
• The amount of systemic risk exposure ( beta)

Business’s use the

CAPM model to
calculate their cost
of equity

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 Risk free rate

Notes:

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The Capital asset pricing model cont.

3. Risk Premium
• A risk premium is the investment return an asset is expected to yield in excess of the risk-free rate of return.
• It represents payment to investors for tolerating the extra risk in a given investment over that of a risk-free asset.
• Risk premium (Rp) = Return on the market portfolio (Rm) – Risk-free return (Rf)

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 Systematic VS unsystematic risk
Total portfolio Risk = Market ( systematic ) risk + Firm Specific ( unsystematic) risk

Systematic ( market ) Risk Unsystematic Risk

Uncontrollable by an organisation and affects Controllable by an organisation and is firm
all firms specific

Systematic risk are non diversifiable,

Unsystematic risks are diversifiable,
inherent risks that exist in a stock
and are unique to a specific
market and cannot be eliminated by
company or Industry (Labour strike).
diversification (ie. Tax, war)

These risks arise due to various

Non-diversifiable means that an internal factors or external factors
organization can’t control, minimize, that affect only the particular
or avoid systematic risks. organization but not the entire
19 market.

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The Capital asset pricing model cont.

• Components of the CAPM formulae:
1. Rf – The risk free rate of return
1. The minimum rate of return an investor expects to receive for an investment in a risk free asset.
2. What is an example of a risk free asset.
2. Bi – Beta
1. Beta is a measurement of the volatility( systematic or market risk) of a share when compared to the performance of the market as a whole i.e.: JSE all index. (
Market return Vs asset return)
1. A beta of less than 1 means that the security will be less volatile than the market = less risky
2. A beta of greater than 1 indicates that the security’s price will be more volatile than the market = more risky.
3. For example, if a stock’s beta is 1,2, it is theoretically 20% more volatile than the market.
4. Positive Beta: asset moves with the market
5. Negative beta: asset moves opposing the market

Beta is a concept that

measures the expected
movement in a stock
relative to movements in
the overall market.

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 The Capital asset pricing model cont.
Calculating Beta on a single asset
A company has below asset and benchmark price from Jan-2018 to Dec-2018

1. Covarince = 0.16440
2. Variance of market returns = 0.6653
3. Beta = 0.2471

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The Capital asset pricing model cont.

CAPM model example:
Calculate the required return for Shares A and B according to the Capital Asset Pricing Model, and discuss whether you would advise the investor to invest in
either Share A or Share B.

For Share A
If we had to calculate the
expected return it would = 8%,
however the required return is
Share A Share B
9.3%
Risk free rate 3% 3%
An investor should not be advised
Beta 25.2/62 = 0.7 39.6/62 = 1.1
to purchase this share as this

Risk premium 12%-3% = 9 9 share under performed.

Required rate of return 9.3% 12.9%

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 The Capital asset pricing model cont.
How would we calculate Portfolio CAPM?

Beta of a portfolio:
The beta of a portfolio is the weighted sum of the individual asset betas, According to the proportions of the investments in the portfolio.
E.g., if 50% of the money is in stock A with a beta of 2.00, and 50% of the money is in stock B with a beta of 1.00,the portfolio beta is 1.50

Share A Share B

Share holding of each 50% 50%

share in the portfolio

Beta 2 1

Portfolio Berta = 50%*2 + 50%*1 = 1.5

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The Capital asset pricing model cont.

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 Ethics in finance
• A regulatory body is an organization or government agency that is responsible for legally regulating aspects of human activity in public or in a professional capacity.
• The role of the regulatory body is to establish and strengthen ethical standards and ensure consistent compliance with them.
• Examples:
• Chartered accountant – SAICA- Code of professional conduct
• Integrity: Straightforward and honest
• Professional competence and due care:

Professional Competence Professional Behaviour

Objectivity and Due Care – to: i. Comply with relevant laws and
To Attain and maintain professional regulations ii. Behave in a manner
to exercise professional or Confidentiality
Integrity: knowledge and skill at the level consistent with the profession’s
business judgement without being
required to ensure that a client or to respect the confidentiality of responsibility to act in the public
to be straightforward and honest compromised by: i. Bias; ii. Conflict
employing organisation receives interest in all professional
information acquired as a result of
in all professional and business of interest; or iii. Undue influence competent professional service, based
professional and business activities and business
relationships. of, or undue reliance on, on current technical and professional
relationships. relationships; and iii. Avoid any
individuals, organisations, standards and relevant legislation; and
conduct that the professional
technology or other factors. ii. Act diligently and in accordance with
applicable technical and professional accountant knows or should know
standards. might discredit the profession.

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Ethics in finance cont

• Major ethical issues in finance:
• Fraud in financial statements
• Fraud in financial markets
• Insider trading
• Hostile takeover.

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 Ethics in finance cont

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