Topic: Risk and Return
At the end of this chapter, you will be able to:
Review the relationship of risk and return in corporate environment
Explain the relevance and importance of asset pricing theories
Analyze applications and limitations of CAPM
Analyze applications and limitations of APT.
Introduction
Financial return is either measured in absolute dollar amount or by percentage return. In
most financial measures rate of return is quoted as percentage change in return. It is referred
to as the yield of investments of required return or cost of capital in financing decisions.
Figure 1: Yield of investments of required return (1)
In corporate finance the shareholders expect the rate of return either within the holding
period of such investment or for the periodic reporting period. Hence investment horizon is
relevant to the measurement of rate of return.
Figure 2: Yield of investments of required return (2)
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Past and expected returns are measured differently. Past or actual return is based on
change in price as well as dividend yield that arise from such past investment trends.
Expected return however takes into consideration the possible outcome that arise from an
investment decision. It could hence be a simple or weighted average return based on the
possible outcomes.
Figure 3: Calculating Variance and Standard Deviation
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The nature of risk varies with the perspectives and context within which risk is analyzed. In
corporate finance risk is ultimately viewed from the perspective of the shareholders' as the
overall goal is to maximize shareholders wealth.
In general risk relates to uncertainty of outcome of business decisions. Measurable financial
risk is derived after assigning probability to the various financial outcomes. In other words
with reduce uncertainty implies reduce risk. Statistical notation for risk measurement, sigma
(s) is commonly used as financial risk measure.
When individual financial assets are held collectively as a group described as portfolio, the
nature of risk and return changes according to the composition of the portfolio. Any
investment decision of additional stock to be included in the portfolio is evaluated in terms of
the incremental return earned as well as risk assumed by the investor.
A simple addition of weighted return results in the portfolio return as each return is viewed as
independent outcomes. However the additional risk assumed is non additive but rather
cumulative with correlation between the new addition with existing portfolio of stocks. Hence
the portfolio risk varies with the correlation between the new addition and the existing
portfolio.
By increasing the variety of stocks within a portfolio the portfolio risk as a whole decreases
as long as the additional stock has a correlation of less than 1 with the existing portfolio. In
this manner it is an incentive to increase the variety of stocks. However with increasing
number of stocks the risk reduction effects decrease less significantly and monitoring costs
increase accordingly. Hence cost benefit consideration needs to be made between risk
reduction and incremental monitoring cost.
Furthermore the portfolio risk is efficiently diversified (reduced) with increasing variety of
stocks up to 40 to 50 stocks type portfolio. Beyond which no portfolio reduction is anticipated
for a given level of external factors such as economic condition and technological innovation.
Unlike the diversifiable risk the non-diversifiable risk remains constant throughout the
diversification process. This risk component is also described as systematic risk that is
described further in the following section.
Capital Market Theory
Capital market theories generally explain and predict the behavior of security returns be
closely examining the relationships between security returns and factors influencing them.
The discussion of CMT begins with the explanation of the nature of security return and return
as described earlier. The discussion then extended to understanding how these returns
behave individually as well as collectively in a portfolio.
As a portfolio of assets (securities) the individual security returns are analyzed both
mathematically and empirically in terms of the magnitude and direction of the return with the
occurrence of a particular event or outcome. For example simple relationship could be drawn
between returns from selling ice cream as compared to umbrella. On hot days return from ice
cream sales will be higher than umbrella sales and vice versa on wet days. This inverse
relationship is measured by correlation of the two activities and it is expected to be negative
correlation. Hence an expected return on any day with selling of both ice cream and umbrella
will be an average return with lower risk.
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When such activities are translated into security returns a continuum of relationships can be
expected from a perfect negative (-1) correlation to a perfect positive (+1) correlation. Any
correlation less than one (+1) of a stock will result in overall reduction of portfolio risk for
holding more than on asset (security).
By exploring possible combinations of portfolio return for varied stocks an efficient frontier is
drawn to reflect an efficient set of portfolios that result in minimum portfolio risk for a given
return. This forms the basis for efficient portfolio theory of assets. All assets in this portfolio
are risky assets.
With the presence of risk free borrowing or lending (assets), the portfolio of assets are not
restricted to risky assets but may include risk free assets. Hence the efficient frontier of
portfolio of risky assets needs to be extended to include the risk free assets. Investment
choice includes lending (investment) or borrowing (financing) with a risk free asset that has
zero equity risk. Hence factors influencing equity returns and volatility would not expect to
influence risk free asset with zero comparable risk.
Risk free asset with fixed determinable return and zero risk is represented as a point on the
vertical (return) axis. By drawing a simple tangent from the efficiency frontier to the point a
Capital market line is developed. This line represents the portfolio return and risk of both risk
and risk free assets for various combinations. The maximum portfolio risk will generate the
market return. On the contrary no portfolio risk of total risk free assets will generate the risk
free return.
Capital Asset Pricing Model (CAPM)
What is CAPM?
CAPM or Capital Asset Pricing Model addresses the relationship between an individual stock
in terms of its risks and return in relation to market portfolio. The market portfolio comprises
of all the stocks listed in the securities exchange.
For every security or share it has both individual risk and return. With CAPM the contributory
risk the stock adds to the portfolio is measured to estimate its expected return.
This model evolves from a basic understanding of the expected risk (variance) and return
of each security. This is then followed by understanding the covariance and correlation
between two securities for varying degrees of exhibited price behavior due to economic
events or announcements.
Finally the model is demonstrated with a portfolio of dissimilar securities (assets), which
exhibit an efficient frontier. Based on the efficient frontier an investor would be able to
determine the impact of choosing an additional security to the total portfolio return.
With increasing number of dissimilar securities in a portfolio the total risk shall decline up to a
point where marginal decrease is anticipated for every increase in security type. A distinction
is made between diversifiable and non-diversifiable risk. The former also known as firm
specific risk is eliminated. The latter also known as systematic risk is prevalent with the
portfolio influenced by systemic external conditions.
No correlation exists between a risk security (asset) and risk free security. A portfolio of the
two security types will produce a line that is tangent to the efficient frontier of risky market
portfolio. The Capital Market Line (CML) represents the relationship between portfolio
return and portfolio risk under optimal portfolio conditions including market equilibrium of
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homogenous expectations. Risk free asset return as point of determinable return is used as
origin to tangent of the market portfolio.
Nature of Beta and Its Characteristics
By transforming the Capital Market Line to Security Market Line the expected return of the
security in replace of the portfolio ratio is to be determined. Beta in SML represents the
systematic risk of the individual security. The higher the Beta the higher the risk of the
security which than implies the higher the security return.
Arbitrage Price Theory (APT)
The Arbitrage pricing Theory (APT) extends the study on the relationship of security return
beyond the systematic market risk as explicated by the market model.
The APT with formulation of factor model or also known as the k-factor model decomposes
each return into predicted R, Systematic return m, and idiosyncratic.
K-factor models estimate several betas including GNP, Inflation and change in interest rates.
Summary
A detailed review of risk and return within the corporate environment was explained.
Furthermore a theoretical exposition of the various asset pricing models and their limitations
were discussed. This topic will form the basis for theoretical foundations in corporate finance
decisions.
Questions
1. Given the following information, what is the expected return on a portfolio which is invested 70
percent in stock A and 30 percent in stock B?
State of Probability of Return if State Occurs
Economy State of Economy Stock A Stock B
Boom 10% 15% 17%
Normal 75% 10% 9%
Recession 15% 4% 5%
2. You own a portfolio which is 20 percent invested in U.S. Treasury bills, 30 percent invested in Stock
A with a beta of 1.23, 10 percent invested in stock B with a beta of .95, and the remainder is
invested in stock C. Stock C is equally as risky as the market. The risk-free rate of return is 4.2
percent and the expected return on the market is 11 percent. What is the portfolio beta?
3. The risk-free rate of return is 4 percent and the expected return on the market is 13.5 percent. What
is the expected return for a stock with a beta of 1.16?
