Risk and Return:

Capital Asset Pricing Model

Overview

1. Portfolio Returns and Portfolio Risk

Calculate the expected rate of return and volatility for a portfolio of
investments and describe how diversification affects the returns to
a portfolio of investments.

2. Systematic Risk and the Market Portfolio

Understand the concept of systematic risk for an individual
investment and calculate portfolio systematic risk (beta).

3. The CAPM
Estimate an investor’s required rate of return using capital asset
pricing model.

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Portfolio Returns and Portfolio Risk
 By investing in many different stocks to form a portfolio, we
can lower the risk without lowering the expected return.

 The effect of lowering risk via appropriate portfolio

formulation is called diversification.

 By learning how to compute the expected return and risk on a

portfolio, we illustrate the effect of diversification.

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The Expected Return of a Portfolio

 To calculate a portfolio’s expected rate of return, we weight

each individual investment’s expected rate of return using
the fraction of money invested in each investment.

 Example : If you invest 25%of your money in the stock of Co-

op bank (C) with an expected rate of return of -32% and 75%
of your money in the stock of Safaricom with an expected
rate of return of 120%, what will be the expected rate of
return on this portfolio?
 Expected rate of return = .25(-32%) + .75 (120%) = 82%

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Calculating a Portfolio’s Expected Rate of Return
John has his first full-time job and is considering how to invest his savings. His dad
suggested he invest no more than 25% of his savings in the stock of his employer,
Bamburi, so he is considering investing the remaining 75% in a combination of a risk-free
investment in Treasury bills, currently paying 4%, and Barclays common stock. John’s
father has invested in the stock market for many years and suggested that john might
expect to earn 9% on the Bamburi shares and 12% from the Barclays shares. John
decides to put 25% in Bamburi, 25% in Barclays, and the remaining 50% in Treasury bills.
Given John’s portfolio allocation, what rate of return should he expect to receive on his
investment?

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Evaluate the expected return for John’s portfolio where he
places 1/4th of his money in Treasury bills, half in Barclays
stock, and the remainder in Bamburi stock.

Answer: 9%.

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Evaluating Portfolio Risk

 Unlike expected return, standard deviation is not generally

equal to the a weighted average of the standard deviations of
the returns of investments held in the portfolio. This is
because of diversification effects.

 The diversification gains achieved by adding more

investments will depend on the degree of correlation among
the investments.

 The degree of correlation is measured by using the

r
correlation coefficient ( ).

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Correlation and diversification
 The correlation coefficient can range from -1.0 (perfect negative
correlation), meaning two variables move in perfectly opposite
directions to +1.0 (perfect positive correlation), which means the
two assets move exactly together.
 A correlation coefficient of 0 means that there is no relationship
between the returns earned by the two assets.
 As long as the investment returns are not perfectly positively
correlated, there will be diversification benefits.
 However, the diversification benefits will be greater when the
correlations are low or negative.
 The returns on most stocks tend to be positively correlated.

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Standard Deviation of a Portfolio

 For simplicity, let’s focus on a portfolio of 2 stocks:

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Diversification effect

 Investigate the equation:

 When the correlation coefficient r =1, the portfolio standard

deviation becomes a simple weighted average:
s portfolio =| W1s 1 + W2s 2 |, when r = 1
 If the stocks are perfectly moving together, they are essentially
the same stock. There is no diversification.
 For most two different stocks, correlation is less than perfect
(<1). Hence, the portfolio standard deviation is less than the
weighted average. – This is the effect of diversification.

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Example

 Determine the expected return and standard deviation

of the following portfolio consisting of two stocks that
have a correlation coefficient of .75.

Portfolio Weight Expected Standard

Return Deviation
Safaricom .50 .14 .20
Co-op bank .50 .14 .20

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Answer

 Expected Return = .5 (.14) + .5 (.14)= .14 or 14%

 Standard deviation

= √ { (.52x.22)+(.52x.22)+(2x.5x.5x.75x.2x.2)}
= √ .035= .187 or 18.7%
 Lower than the weighted average of 20%.

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Portfolio return does not depend on correlation
Portfolio standard deviation decreases with declining correlation.

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Evaluating a Portfolio’s Risk and Return

Sarah plans to invest half of her 401k savings in a mutual fund and half
in an international fun.

The expected return on the two funds are 12% and 14%, respectively.
The standard deviations are 20% and 30%, respectively.
The correlation between the two funds is 0.75.

What would be the expected return and standard deviation for Sarah’s
portfolio?

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 solution

 Verify the answer: 13%, 23.5%

 Evaluate the expected return and standard deviation of

the portfolio, if the correlation is .20 instead of 0.75.

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Answer

 The expected return remains the same at 13%.

 The standard deviation declines from 23.5% to 19.62%

as the correlations declines from 0.75 to 0.20.
 The weight average of the standard deviation of the two
funds is 25%, which would be the standard deviation of
the portfolio if the two funds are perfectly correlated.
 Given less than perfect correlation, investing in the two
funds leads to a reduction in standard deviation, as a
result of diversification.

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Systematic Risk and Market Portfolio

 It would be an onerous task to calculate the correlations when we

have thousands of possible investments.

 Capital Asset Pricing Model or the CAPM provides a relatively

simple measure of risk.

 CAPM assumes that investors choose to hold the optimally

diversified portfolio that includes all risky investments. This
optimally diversified portfolio that includes all of the economy’s
assets is referred to as the market portfolio.

 According to the CAPM, the relevant risk of an investment relates

to how the investment contributes to the risk of this market
portfolio.

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Risk classification
 To understand how an investment contributes to the risk of the
portfolio, we categorize the risks of the individual investments into two
categories:
① Systematic risk, and
② Unsystematic risk, or idiosyncratic risk

 The systematic risk component measures the contribution of the

investment to the risk of the market. For example: War, hike in
corporate tax rate.

 The unsystematic risk is the element of risk that does not

contribute to the risk of the market. This component is diversified
away when the investment is combined with other investments.
For example: Product recall, labour strike, change of management.

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Systematic versus Idiosyncratic Risk

 An investment’s systematic risk is far more important

than its unsystematic risk.

 If the risk of an investment comes mainly from

unsystematic risk, the investment will tend to have a
low correlation with the returns of most of the other
stocks in the portfolio, and will make a minor
contribution to the portfolio’s overall risk.

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Diversification and Systematic Risk

 The figure above illustrates that as the number of securities in a

portfolio increases, the contribution of the unsystematic or
diversifiable risk to the standard deviation of the portfolio declines.

 Systematic or non-diversifiable risk is not reduced even as we

increase the number of stocks in the portfolio.

 Systematic sources of risk (such as inflation, war, interest rates) are

common to most investments resulting in a perfect positive
correlation and no diversification benefit.

 Large portfolios will not be affected by unsystematic risk but will be

influenced by systematic risk factors.

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Systematic Risk and Beta

 Systematic risk is measured by beta coefficient, which

estimates the extent to which a particular investment’s
returns vary with the returns on the market portfolio.

 In practice, it is estimated as the slope of a straight line (see

Ri = a + b Rm + e
figure 8-3):

 Beta could be estimated using excel or financial calculator, or

readily obtained from various sources on the internet (such as
Yahoo Finance and Money Central.com)

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Portfolio Beta

 The beta of a portfolio measures the systematic risk of the

portfolio and is calculated by taking a simple weighted
average of the betas for the individual investments contained
in the portfolio.

 Example : Consider a portfolio that is comprised of four

investments with betas equal to 1.5, .75, 1.8 and .60. If you
invest equal amount in each investment, what will be the
beta for the portfolio?
 Portfolio beta= 1.5*(1/4)+.75*(1/4)+1.8*(1/4)+.6*(1/4) =1.16

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The CAPM

 CAPM also describes how the betas relate to the expected

rates of return that investors require on their investments.

 The key insight of CAPM is that investors will require a higher

rate of return on investments with higher betas. The relation
is given by the following linear equation:

 Rmarket is the expected return on the market portfolio

 Rf is the risk free rate (return for zero-beta assets).

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Example
 Example What will be the expected rate of return on a stock
with a beta of 1.49 if the risk-free rate of interest is 2% and if
the market risk premium, which is the difference between
expected return on the market portfolio and the risk-free rate
of return is estimated to be 8%?

 Stock’s expected return = 2% + 1.49*8% = 13.92%.

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