Risk and Return: Part II

FIN 319 – Intermediate Financial Management

 Learning Objectives
LO1. Explain efficient portfolio and optimal portfolio according to
portfolio theory.
LO2. Identify basic assumptions for the capital asset pricing model
(CAPM).
LO3. Define Capital Market Line and Security Market Line.
LO4. Describe empirical tests of the CAPM.

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 Content Highlight
1. Expected Returns and Variance of Single assets & Portfolios
2. Effect of diversification (combining more stocks in a
portfolio)
3. Opportunity and Efficient set
4. The Capital Market Line (CML)
5. The Security Market Line (SML)
6. CML vs SML
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1. Expected return, variance, correlation
coefficient, covariance

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 1.1. Expected Returns
For Individual Assets
• Calculations based on Expectations of future:
𝑛

𝑟ෝ = 𝑝1 𝑟1 + 𝑝2 𝑟2 + ⋯ + 𝑝𝑛 𝑟𝑛 = ෍ 𝑝𝑖 𝑟𝑖
𝑖=1
For portfolio include two assets
• Calculations based on weighted average of expected return of
stocks in the portfolio:
𝑟ෝ p = wA 𝑟ෝ A + wB 𝑟ෝ B with wB = 1- wA
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 1.2. Variance
For Individual Assets
• Variance (or Standard Deviation):
➢ Measure the variability
➢ Measure of the amount by which the actual return might
deviate from the expected return

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 1.2. Variance
For Portfolio:
• NOT the weighted average of the individual security variances:
𝜎p2 ≠ wA 𝜎A2 + wB 𝜎B2
• Interactive risk
• Portfolio SD = 𝜎𝑝 = 𝑤𝐴2 𝜎𝐴2 + 𝑤𝐵2 𝜎𝐵2 + 2𝑤𝐴 𝑤𝐵 𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵

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 1.3. CorrelationCoefficient
• Standardized Measure of the co-movement between two variables
• Correlation coefficient between the returns of individual securities
COV(A,B)
𝜌AB = (CORREL in Excel)
𝜎A 𝜎B

• Same sign as covariance

• Always between (& including) -1.0 and + 1.0

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 1.4. Covariance
• Co (joint) Variance of two asset’s returns
• When estimating covariances from historical data
(COVAR in Excel)

• An asset’s variance is its covariance with itself.

• COV(A,B) will be large & positive if :
➢ ‘A’ & ‘B’ have large Std. Deviations and/or
➢ ‘A’ & ‘B’ tend to move together
• COV(A,B) will be negative if: Returns for ‘A’ & ‘B’ tend to move counter to each
other
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 Example
Security A has an expected rate of return of 6%, a standard
deviation of returns of 30%, a correlation coefficient with the
market of −0.75, and a beta coefficient of −0.5.
Security B has an expected return of 11%, a standard deviation
of returns of 10%, a correlation with the market of 0.25, and a
beta coefficient of 0.5.
Which security is riskier? Why?

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2. Effect of Diversification

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 2. Diversification
• Diversification Effect:
➢ Actual portfolio variance ≤ weighted sum of individual
security variances
➢ More pronounced when 𝜌 is negative

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 Portfolio Risk/Return TwoSecurities: CorrelationEffects
• Relationship depends on correlation coefficient:
-1.0 < 𝜌 < +1.0
=> The smaller the correlation, the greater the risk reduction
potential
• If 𝜌 = +1.0, no risk reduction is possible

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 Portfolio Diversification
• A risk-averse investor dislikes risk and, therefore, stays away
from high-risk stocks or investments and requires higher
rates of return as an inducement to buy riskier securities.

• Principle of Diversification: Combining imperfectly related

assets can produce a portfolio with less variability than a
“typical” asset.

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Portfolio Risk as aFunction of the Number of Stocksin
thePortfolio
Diversification can
eliminate some, but not
all of the risk of
individual securities.

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 Different Typesof Risks
• Total risk of an asset: Measured by 𝜎 or 𝜎 2
• Diversifiable risk of an asset: Portion of risk that is eliminated in a
portfolio (Unsystematic risk or )
• Non-diversifiable risk of an asset: Portion of risk that is NOT
eliminated in a portfolio (Systematic risk or )

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3. Opportunity and EfficientSets

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 3. Opportunity and EfficientSets
• Opportunity Set (Attainable or Feasible set of portfolios):
constructed with different mixes (weights) of ‘A’ & ‘B’
• To choose the Optimal portfolio, there are two separate
decisions:
1. Determine the efficient set of portfolios
2. Choose the single portfolio in the efficient set that is best
for specific investor.
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 3. Opportunity and EfficientSets
• The Feasible Set (Opportunity set): of portfolios represents all
portfolios that can be constructed from a given set of stocks.
• An Efficient Portfolio is one that offers either:
➢ the most return for a given amount of risk
➢ the least risk for a give amount of return.
• The collection of efficient portfolios is called the efficient set or
efficient frontier.

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The Opportunity Set for ManySecurities
return

Given the opportunity

set we can identify the
minimum variance
portfolio.
Individual Assets

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 3. Opportunity and EfficientSets
• The Feasible Set (Opportunity set): of portfolios represents all
portfolios that can be constructed from a given set of stocks.
• An Efficient Portfolio is one that offers either:
➢ the most return for a given amount of risk
➢ the least risk for a give amount of return.
• The collection of efficient portfolios is called the efficient set or
efficient frontier.

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return
The Efficient Frontier
The section of the
opportunity set above
the minimum variance
minimum portfolio is the efficient
variance frontier.
portfolio

Individual Assets

P
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3. Opportunity and EfficientSets

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 Opportunity and EfficientSets

Are all portfolios in the Opportunity Set equally good?

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4. The Capital Market Line (CML)

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 4. The Capital Market Line (CML)
• The Capital Market Line (CML) is all linear combinations of the
risk-free asset and risky asset (a single stock or a portfolio).

• Portfolios below the CML are inferior.

➢ The CML defines the new efficient set.
➢ All investors will choose a portfolio on the CML.

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 4. The Capital Market Line (CML)
• The straight line connecting riskless asset to the curved
opportunity set becomes the new efficient frontier or
Capital Market Line (CML).
• M (market portfolio): the tangency point between the line
and the opportunity set of risky assets.

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 4. The Capital Market Line (CML)

What does the CML tell us?

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 4. The Capital Market Line (CML)
𝑟ෝ p = wRF 𝑟ෝ RF + wB 𝑟ෝ B with wB = 1- wRF

2 2
𝜎𝑝 = 𝑤RF 𝜎RF + 𝑤𝐵2 𝜎𝐵2 + 2𝑤RF 𝑤𝐵 𝜌RF,𝐵 𝜎RF 𝜎𝐵

Since the standard deviation of risk-free rate = 𝜎RF =

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 Capital Market Line
Expected return CML– New efficient frontier
of portfolio

.
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Y

.
4
M
CML: 𝑟ෝ 𝑝 = 𝑟𝑅𝐹 + (
𝑟ෝ 𝑀− 𝑟𝑅𝐹
𝜎𝑀
)𝜎𝑝

Risk-free
rate (Rf )
Standard deviation of
portfolio’s return.
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 Investor’s choice of the “optimal”portfolio
• Investor’s choice of the “optimal”
return

portfolio is a function of their risk-

aversion (risk tolerance)

M • Investor risk aversion is revealed

in their choice of where to stay
along the capital allocation line
rf (CAL) - not in their choice of the
line.
P
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5. The Security Market Line (SML)

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5.1 What is Capital Asset Pricing Model –CAPM?
• An equilibrium model that specifies the relationship
between risk and required rate of return for assets
held in well-diversified portfolios
• The CAPM assumes markets are in equilibrium
 The expected return (ොr) = the required return (r)
 The Security Market Line (SML)
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 5. TheCapital Asset Pricing Model -CAPM
• An individual stock’s required return= the risk-free rate + a
premium for bearing risk

𝒓𝒊 = 𝒓𝒓𝒊𝒔𝒌−𝒇𝒓𝒆𝒆 𝒓𝒂𝒕𝒆 + 𝜷𝒊 × 𝑴𝒂𝒓𝒌𝒆𝒕 𝒓𝒊𝒔𝒌 𝒑𝒓𝒆𝒎𝒊𝒖𝒎

= 𝒓𝒓𝒊𝒔𝒌−𝒇𝒓𝒆𝒆 𝒓𝒂𝒕𝒆 + 𝜷𝒊 ( 𝒓𝑴 − 𝒓𝒓𝒊𝒔𝒌−𝒇𝒓𝒆𝒆 𝒓𝒂𝒕𝒆 )
• This applies to individual securities held within well-
diversified portfolios (only market risk exists)
• Assume 𝛽𝑖 = 0, = 1, <1, >1

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 5.2 Assumptions of CAPM
• All assets are perfectly divisible.
• There are no taxes and no transactions costs.
• All investors are price takers, that is, investors’ buying
and selling won’t influence stock prices.
• Quantities of all assets are given and fixed.

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 5. 3 The SecurityMarket Line -SML
• SML (also part of the CAPM ): graph between Required return
and Risk for individual stocks.
• The SML equation:
𝒓𝒊 = 𝒓RF + 𝜷𝒊 ( 𝒓𝑴 − 𝒓RF )

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 5. 4 Howarebetas calculated?
• Beta: measures the responsiveness of a security to movements
in the market portfolio.
• The slope of regression line between the return of the security
and the return of the market
• Measures only the interactive (with the market) risk of the
asset (systematic risk)
𝐶𝑜𝑣 𝑟𝑖 − 𝑟𝑀 𝜌𝑖𝑀 𝜎𝑖 𝜎𝑀 𝜎𝑖
𝛽𝑖 = 2 = 2 = 𝜌𝑖𝑀
𝜎𝑀 𝜎𝑀 𝜎𝑀
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 Beta
• 𝛽portfolio = weighted average beta of individual securities
=

What is the meaning of 𝛽𝑖 > 1, < 1, =1?

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Security Market Line

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Relationship Between Risk & Expected Return

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6. CML vs SML:

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THANK YOU!