Risk & Return

• 100 Shares @ Rs. 200

• Dividend = 10% of Rs. 100 (Book value of
Share)
• Selling Price at the end of the year = Rs.225
Percentage Return
= Dividend Yield + Capital Return
Rate of return  Dividend yield  Capital gain yield
DIV1 P1  P0 DIV1   P1  P0 
R1   
P0 P0 P0
 Return on a Single Asset

• Total return = Dividend + Capital gain

Rate of return  Dividend yield  Capital gain yield
DIV1 P1  P0 DIV1   P1  P0 
R1   
P0 P0 P0

3
 Average Rate of Return
• The average rate of return is the sum of the
various one-period rates of return divided by
the number of period.
• Formula for the average rate of return is as
follows: 1 1 n
R = [ R1  R 2    R n ]   Rt
n t =1 n

4
 Risk of Rates of Return: Variance and Standard
Deviation

• Formulae for calculating variance and

standard deviation:
Standard deviation = Variance

1 n 2
2
Variance     
n  1 t 1
Rt  R 

5
 Example
• The following table gives dividend and share price data for Hind Manufacturing
Company. You are required to calculate: (i) the annual rates of return, (ii) the
expected (average) rate of return, (iii) the variance, and (iv) the standard
deviation of returns.
Dividend Per Share Closing Share Price Expected Return OR Annual Rate of
Return
2.50 12.25 -
2.50 14.20 2.50 + (14.20 – 12.25) / 12.25 = 36.32
2.50 17.50 2.50 + (17.50-14.20) / 14.20= 40.84
3.00 16.75 3 + (16.75 – 17.50) / 17.50 = 12.86
3.00 18.45 3+ (18.45 – 16.75 ) / 16.75 = 28.05
3.25 22.25 3.25 + ( 22.25 – 18.45) / 18.45 = 38.21
3.50 23.50 3.50 + (23.50 – 22.25 ) / 22.25 =21.35
3.50 27.75 3.50 + (27.75 – 23.50 ) / 23.50 = 32.98
3.50 25.50 3.50 + (25.50-27.75) / 27.75 = 4.5
3.75 27.95 3.75 + ( 27.95 – 25.50 ) / 25.50 = 24.31
3.75 31.30 3.75 + ( 31.30 – 27.95 ) / 27.95 = 25.40
Average Rate of 264.81 / 10 = 26.481 %
Return
Year (Col.1) Annual Rate of Annual Return minus Square of Deviation
Return(Col.2) Average Return (Col.3) (Col.3)2
2004 36.32 36.32 - 26.48= 9.84 9.84*9.84= 96.83
2005 40.84 40.84 – 26 .48 = 14.36 14.36*14.36= 206.20
2006 12.86 12.86 – 26.48 = -13.62 -13.62 * -13.62 = 185.50
2007 28.06 28.06 – 26.48 = 1.58 1.58 * 1.58 = 2.5
2008 38.21 38.21 – 26.48 = 11.73 11.73*11.73 *137.59
2009 21.35 21.35 – 26.48 = -5.13 -5.13* -5.13 = 26.32
2010 32.98 32.98 – 26.48 = 6.49 6.49*6.49 = 42.25
2011 4.50 4.50 – 26.48 = -21.98 -21.98 * -21.98 = 483.12
2012 24.31 24.31 – 26.48 = -2.18 -2.18 * -2.18 = 4.71
2013 25.40 25.40 – 26.48 = -1.08 -1.08 * -1.08 = 1.16
Total = 1186.2
Variance = 1186.2 / (10-1) = 131.8
Standard Deviation = Square root of 131.8 =
11.48
Expected Return : Incorporating Probabilities in Estimates

• The expected rate of return [E (R)] is the sum of the product of each outcome
(return) and its associated probability:
Rates of Returns Under Various Economic Conditions

Returns and Probabilities

9
 Example
• Star Computer System Limited has forecasted returns on its share
with the following probability distribution. Calculate the
expected return, variance and standard deviation of returns for
Star.
Return (X) Probability Return * (Return – Probability *
(P) Probability(( ERR)2 (Return –
P*X) ERR)2
-20 0.05 -20*0.05= -1 (-20-11 )2 = - -33*-33*0.05
33*-33 48.05
-10 0.05 -10*0.05= - (-10-11)2= - -21*-21*0.05
0.5 21*-21 22.05
-5 0.10 -5*0.10= - (-5-11)2 -16*-16*0.10
0.5 25.6
5 0.10 5*0.10= 0.5 (5-11)2 -6*-6*0.10 3.6
10 0.15 10*0.15= 1.5 (10-11)2 -1*-1*0.15
0.15
18 0.25 18*0.25= 4.5 (18-11)2 7*7*0.25
12.25
20 0.25 20*0.25= 5 (20-11)2 9*9*0.25 20.25
30 0.05 30*0.05= 1.5 (30-11)2 19*19*0.05
18.05
Mean or Average X= Variance 150 150
Average ERR 11%
Standard Square root 12.24%
Deviation of Variance =
 Historical Risk Premium
• The 28-year average return on the stock market is higher by
about 15 per cent in comparison with the average return on 91-
day T-bills.

• The 28-year average return on the stock market is higher by

about 12 per cent in comparison with the average return on the
long-term government bonds.

• This excess return is a compensation for the higher risk of the

return on the stock market; it is commonly referred to as risk
premium.

12
 Example
• The following are the returns during five years on a market portfolio
of shares and ‘AAA’ corporate bonds. You are require to calculate (i)
the realized risk premium of shares over the ‘AAA’ bonds in each
year; and (ii) the average risk premium of shares over ‘AAA’ bonds
during the period. Can the realized premium be negative? Why?
 Solution
• The calculations for the premium in each year and the average
premium are shown below. The average premium is 4.7 percent.
• The realized premium can be negative as the share prices in practice
show wide swings. However, over a long period of time the premium
would be positive, as shares are more risky than bonds.
 Expected Risk and Preference
• A risk-averse investor will choose among investments with
the equal rates of return, the investment with lowest
standard deviation and among investments with equal risk
she would prefer the one with higher return.

• A risk-neutral investor does not consider risk, and would

always prefer investments with higher returns.

• A risk-seeking investor likes investments with higher risk

irrespective of the rates of return. In reality, most (if not all)
investors are risk-averse.

15
Risk preferences

16
Normal Distribution and Standard Deviation

• In explaining the risk-return relationship, we

assume that returns are normally distributed.
• The spread of the normal distribution is
characterized by the standard deviation.
• Normal distribution is a population-based,
theoretical distribution.

17
Normal distribution

18
 Properties of a Normal Distribution

• The area under the curve sums to1.

• The curve reaches its maximum at the expected value (mean)
of the distribution and one-half of the area lies on either side
of the mean.
• Approximately 50 per cent of the area lies within ± 0.67
standard deviations of the expected value; about 68 per cent
of the area lies within ± 1.0 standard deviations of the
expected value; 95 per cent of the area lies within ± 1.96
standard deviation of the expected value and 99 per cent of
the area lies within ± 3.0 standard deviations of the expected
value.

19
 Probability of Expected Returns
• The normal probability table, can be used to determine the
area under the normal curve for various standard deviations.
• The distribution tabulated is a normal distribution with mean
zero and standard deviation of 1. Such a distribution is known
as a standard normal distribution.
• Any normal distribution can be standardised and hence the
table of normal probabilities will serve for any normal
distribution. The formula to standardise is:
S = R - E(R)
s

20
Normal distribution

21
 Properties of a Normal Distribution

• The area under the curve sums to1.

• The curve reaches its maximum at the expected value (mean)
of the distribution and one-half of the area lies on either side
of the mean.
• Approximately 50 per cent of the area lies within ± 0.67
standard deviations of the expected value; about 68 per cent
of the area lies within ± 1.0 standard deviations of the
expected value; 95 per cent of the area lies within ± 1.96
standard deviation of the expected value and 99 per cent of
the area lies within ± 3.0 standard deviations of the expected
value.

22
 Probability of Expected Returns
• The normal probability table, can be used to determine the
area under the normal curve for various standard deviations.
• The distribution tabulated is a normal distribution with mean
zero and standard deviation of 1. Such a distribution is known
as a standard normal distribution.
• Any normal distribution can be standardised and hence the
table of normal probabilities will serve for any normal
distribution. The formula to standardise is:
S = R - E(R)
s

23
 Example
• An asset has an expected return of 29.32 per cent and the standard
deviation of the possible returns is 13.52 per cent.
• To find the probability that the return of the asset will be zero or less,
we can divide the difference between zero and the expected value of
the return by standard deviation of possible net present value as
follows:

• S= 0 - 29.32
= – 2.17
13.52

• The probability of being less than 2.17 standard deviations from the
expected value, according to the normal probability distribution table is
0.015. This means that there is 0.015 or 1.5% probability that the return
of the asset will be zero or less.

24
Portfolio Return and Risk
 INTRODUCTION
• A portfolio is a bundle or a combination of individual assets or
securities.
• Portfolio theory provides a normative approach to investors to
make decisions to invest their wealth in assets or securities
under risk.
• The return of a portfolio is equal to the weighted average of
the returns of individual assets (or securities)
• Extend the portfolio theory to derive a framework for valuing
risky assets. This framework is referred to as the capital asset
pricing model (CAPM).
• An alternative model for the valuation of risky assets is the
arbitrage pricing theory (APT).
26
 PORTFOLIO RETURN: TWO-ASSET CASE

• The return of a portfolio is equal to the weighted average of

the returns of individual assets (or securities) in the portfolio
with weights being equal to the proportion of investment
value in each asset.
• We can use the following equatio n to calculate the
expected rate of return of individual asset:

27
 Example
• 5000 in X Stock (Return = 10%, Risk = 8%)
• 5000 in Y Stock (return = 8%, Risk = 4% )
• Weight age Risk
• Portfolio Return = W1R1 + W2R2 =
10%*0.5 + 8%*0.5 = 5+4 = 9%
• Portfolio Risk = 0.5*8 + 0.5*4 = 6%
• No, the portfolio risk of a diversified portfolio is less
than the weighted average of individual risk of the
securities.
Expected Rate of Return: Example
Suppose there is an opportunity of investing your wealth either in
asset X or asset Y. The possible outcomes of two assets in
different states of economy are as follows:
Possible Outcomes of two Assets, X and Y
Return (%)
State of Economy Probability X Y
A 0.10 –8 14
B 0.20 10 –4
C 0.40 8 6
D 0.20 5 15
E 0.10 –4 20
The expected rate of return of X is the sum of the product of outcomes and their respective
probability. That is:
E ( Rx ) = (- 8´ 0.1) + (10 ´ 0.2) + (8´ 0.4) + (5 ´ 0.2)
+ (- 4 ´ 0.1) = 5%
Similarly, the expected rate of return of Y is:
E ( Ry ) = (14 ´ 0.1) + (- 4 ´ 0.2) + (6 ´ 0.4) + (15´ 0.2)
+ (20 ´ 0.1) = 8%
 Deviation from Product of
State of Expected Deviation &
Economy Probability Returns Returns Probability
X Y X Y
A 0.1 –8 14 – 13 6 – 7.8
B 0.2 10 –4 5 – 12 – 12.0
C 0.4 8 6 3 –2 – 2.4
D 0.2 5 15 0 7 0.0
E 0.1 –4 20 –9 12 – 10.8
E(RX) E(RY) Covar = –33.0
=5 =8

30
Stat Probability X returns Y returns Deviatio Risk of X Deviati Risk of Product of
e n X (Ri – on Y (Ri Y Deviations
ERR-X) – ERR Y) (X & Y) &
probabilitie
s

A 0.1 -8 14 -8-5 = -13 -13 * 13 14-8= 6 6*6*0.1 -13 * 6*0.1

* 0.1 = = - 7.8
B 0.2 10 -4 10-5 = 5 5*5 -4-8 = -12*- 5*-12*0.2= -
*0.2 -12 12*0.2 12
C 0.4 8 6 8-5 = 3 3 *3* 0.4 6–8= -2*- 3*-2*0.4=
-2 2*0.4 -2.4
D 0.2 5 15 5-5 = 0 0 15-8 = 7 7*7*0.2 0*7*0.2 = 0

E 0.1 -4 20 -4 -5 = -9 -9*-9*0.1 20-8 = 12*12* -9*12*0.1 =

12 0.1 -10.8
ERR X = ERR Y = Variance Varianc Covariance
5% 8% of X = e of Y = = - 33
33.6 58.2
Portfolio return = 0.5 Std Dev = Std Dev
*5 + 0.5 *8 = 6.5% 5.79 % = 7.63
%
 Example
The standard deviation of securities X and Y are as follows:

s 2x = 0.1(- 8 - 5) 2 + 0.2(10 - 5) 2 + 0.4(8 - 5) 2

+ 0.2(5 - 5) 2 + 0.1(- 4 - 5) 2
= 16.9 + 3.6 + 0 + 8.1 = 33.6
s x = 33.6 = 5.80%
s 2y = 0.1(14 - 8) 2 + 0.2(- 4 - 8) 2 + 0.4(6 - 8) 2
+ 0.2(15 - 8) 2 + 0.1(20 - 8) 2
= 3.6 + 28.8 + 1.6 + 9.8 + 14.4 = 58.2
s y = 58.2 = 7.63%

The correlation of the two securities X and Y is as follows:

- 33.0 - 33.0
Corxy = = = - 0.746
5.80 ´ 7.63 44.25

Securities X and Y are negatively correlated. The correlation coefficient of

– 0.746 indicates a high negative relationship.

32
Example
 PORTFOLIO RISK: TWO-ASSET CASE

• Risk of individual assets is measured by their variance

or standard deviation.

• We can use variance or standard deviation to measure

the risk of the portfolio of assets as well.

• The risk of portfolio would be less than the risk of

individual securities, and that the risk of a security
should be judged by its contribution to the portfolio
risk.

34
Measuring Portfolio Risk for Two Assets

35
Correlation

36
 Correlation
• The value of correlation, called the correlation
coefficient, could be positive, negative or zero.
• The correlation coefficient always ranges
between –1.0 and +1.0.
• A correlation coefficient of +1.0 implies a
perfectly positive correlation while a
correlation coefficient of –1.0 indicates a
perfectly negative correlation.

37
Variance and Standard Deviation of a
Two-Asset Portfolio

38
 Portfolio Risk Depends on
Correlation between Assets

• Investing wealth in more than one security reduces portfolio risk.

• This is attributed to diversification effect.
• However, the extent of the benefits of portfolio diversification
depends on the correlation between returns on securities.
• When correlation coefficient of the returns on individual securities
is perfectly positive then there is no advantage of diversification.
The weighted standard deviation of returns on individual securities
is equal to the standard deviation of the portfolio.
• Diversification always reduces risk provided the correlation
coefficient is less than 1.

39
 Example
• An investor holds two equity shares x and y in equal proportion with the
following risk and return characteristics. The returns of these securities
have a positive correlation of 0.6. You are required to calculate the
portfolio return and risk. Further, suppose the investor wants to reduce
the portfolio risk (σp) to 15 per cent. How much should the correlation
coefficient be to bring the portfolio risk to the desired level?

Part 1
Portfolio Return = 0.5 * 24 + 0.5 * 19 = 12+9.5 = 21.5%

Portfolio Risk = Sqrt of ( (28)2 (0.5)2 + (23)2 (0.5)2 + 2 *0.5*0.5*28*23*0.6 )

= 196 + 132.25 = 521.45
= 22.83
Part 2
(15) 2 = (28)2*(0.5)2 + (23)2* (0.5)2 + 2 * 28 * 23 *0.5*0.5 Cor xy
Cor xy = (225 – 196 -132.25) / 2*28*23*0.5*0.5 = -0.321
 Example
• A portfolio consists of three securities P, Q and R with the
following parameters. If the securities are equally weighted,
how much is the risk and return of the portfolio of these three
securities?

Portfolio Return = (1/3) * 25 + (1/3) *22 + (1/3) 20 = 22.11%

Portfolio Risk = (30)2*(1/3)2 + (26)2 * (1/3)2 + (24) 2 * (1/3 )2 + 2 (1/3) ( 1/3) (30) (26)
(-0.50 ) + 2 (1/3) (1/3) (26) (24) (+0.40) + 2 (1/3) (1/3) (30)(24) (+0.60)
= 17.4%
 Portfolio Risk
• The magnitude of the portfolio risk will depend on the
correlation between the securities.
• The portfolio risk will be equal to the weighted risk of
individual securities if the correlation coefficient is + 1.0.
• For correlation coefficient of less than 1, the portfolio
risk will be less than the weighted average risk.
• When the two securities are perfectly negatively
correlated, i.e., the correlation coefficient is –1.0, the
portfolio risk becomes zero.
Minimum variance portfolio for a Portfolio with 2
Assets

• When correlation is positive or negative, the

minimum variance portfolio is given by the
following formula:

43
Example
 Portfolio Return and Risk for Different
Correlation Coefficients
P o rtfo lio R isk ,  p (% )
P or tfolio C o rre la tio n
W e ig ht Re tur n (% ) +1.00 -1.00 0.00 0.50 -0.25
Lo g ro w Ra p id ex Rp p p p p p
1.00 0.00 12.00 16.00 16.00 16.00 16.00 16.00
0.90 0.10 12.60 16.80 12.00 14.60 15.74 13.99
0.80 0.20 13.20 17.60 8.00 13.67 15.76 12.50
0.70 0.30 13.80 18.40 4.00 13.31 16.06 11.70
0.60 0.40 14.40 19.20 0.00 13.58 16.63 11.76
0.50 0.50 15.00 20.00 4.00 14.42 17.44 12.65
0.40 0.60 15.60 20.80 8.00 15.76 18.45 14.22
0.30 0.70 16.20 21.60 12.00 17.47 19.64 16.28
0.20 0.80 16.80 22.40 16.00 19.46 20.98 18.66
0.10 0.90 17.40 23.20 20.00 21.66 22.44 21.26
0.00 1.00 18.00 24.00 24.00 24.00 24.00 24.00
Minimum V ar ianc e P or tfolio
wL 1.00 0.60 0.692 0.857 0.656
wR 0.00 0.40 0.308 0.143 0.344
2
 256 0.00 177.23 246.86 135.00
 (% ) 16 0.00 13.31 15.71 11.62

45
Perfect Positive Correlation

46
There is no advantage of diversification when the returns of securities
have perfect positive correlation.

47
 Perfect Negative Correlation
• In this the portfolio return increases and the
portfolio risk declines.
• It results in risk-less portfolio.
• The correlation is -1.0.

48
49
 Limits to diversification

Since any probable correlation of securities Logrow and Rapidex will range
between – 1.0 and + 1.0, the triangle in the above figure specifies the limits to
diversification. The risk-return curves for any correlations within the limits of – 1.0
and + 1.0, will fall within the triangle ABC.
50
Zero-variance portfolio

51
Zero Correlation

52
53
 Positive Correlation
• In reality, returns of most assets have positive
but less than 1.0 correlation.

54
 EFFICIENT PORTFOLIO AND MEAN-
VARIANCE CRITERION - MPT

55
 Investment Opportunity Set:
Two-Asset Case

• The investment or portfolio opportunity set

represents all possible combinations of risk
and return resulting from portfolios formed
by varying proportions of individual securities.
• It presents the investor with the risk-return
trade-off.

56
Investment opportunity sets given different
correlations

57
 Mean-variance Criterion

• Inefficient portfolios- have lower return and higher

risk.
• Modern Portfolio Theory
• Markowitz Theory or Model

58
 Investment Opportunity Set:
The n-Asset Case

• An efficient portfolio is one that has the

highest expected returns for a given level of
risk.
• The efficient frontier is the frontier formed by
the set of efficient portfolios.
• All other portfolios, which lie outside the
efficient frontier, are inefficient portfolios.

59
 Efficient Portfolios of risky securities

An efficient portfolio
is one that has the
highest expected
returns for a given level
of risk. The efficient
frontier is the frontier
formed by the set of
efficient portfolios. All
other portfolios, which
lie outside the efficient
frontier, are inefficient
portfolios.

60
 PORTFOLIO RISK: THE n-ASSET CASE

• The calculation of risk becomes quite involved

when a large number of assets or securities
are combined to form a portfolio.
• Portfolio Risk depends upon both the Weight
ages and the Correlation between the stock.

61
 RISK DIVERSIFICATION:
SYSTEMATIC AND UNSYSTEMATIC RISK

• When more and more securities are included in a

portfolio, the risk of individual securities in the
portfolio is reduced.
• This risk totally vanishes when the number of
securities is very large.
• But the risk represented by covariance remains.
• Risk has two parts:
1. Diversifiable (unsystematic)
2. Non-diversifiable (systematic)

62
 Systematic Risk
• Systematic risk arises on account of the
economy-wide uncertainties and the tendency of
individual securities to move together with
changes in the market.
• This part of risk cannot be reduced through
diversification.
• It is also known as market risk.
• Investors are exposed to market risk even when
they hold well-diversified portfolios of securities.
63
Examples of Systematic Risk

64
 Unsystematic Risk
• Unsystematic risk arises from the unique uncertainties
of individual securities.
• It is also called unique risk.
• These uncertainties are diversifiable if a large numbers
of securities are combined to form well-diversified
portfolios.
• Uncertainties of individual securities in a portfolio
cancel out each other.
• Unsystematic risk can be totally reduced through
diversification.
65
Examples of Unsystematic Risk

66
Total Risk

67
Systematic and unsystematic risk and
number of securities

68
COMBINING A RISK-FREE ASSET AND
A RISKY ASSET

69
A Risk-Free Asset and A Risky Asset: Example
RISK-RETURN ANALYSIS FOR A PORTFOLIO OF A RISKY AND A RISK-FREE SECURITIES
Weights (%) Expected Return, Rp Standard Deviation (p)
Risky security Risk-free security (%) (%)

120 – 20 17 7.2
100 0 15 6.0
80 20 13 4.8
60 40 11 3.6
40 60 9 2.4
20 80 7 1.2
0 100 5 0.0

20
D
E x p e c te d R e tu r n

17.5
C
15
B
12.5
10 A
7.5
5
2.5 Rf, risk-free rate

0
0 1.8 3.6 5.4 7.2 9
Standard Deviation
 MULTIPLE RISKY ASSETS AND
A RISK-FREE ASSET

• In a market situation, a large number of

investors holding portfolios consisting of a
risk-free security and multiple risky securities
participate.

71
 Risk-return relationship for portfolio of risky
and risk-free securities

We draw three lines from the risk-free rate (5%) to the three portfolios.
Each line shows the manner in which capital is allocated. This line is
called the capital allocation line.
Portfolio M is the optimum risky portfolio, which can be combined with
the risk-free asset.
The capital market line (CML) is an efficient set of risk-free and risky
securities, and it shows the risk-return trade-off in the market equilibrium.
72
 Separation Theory
• According to the separation theory, the choice
of portfolio involves two separate steps.
• The first step involves the determination of
the optimum risky portfolio.
• The second step concerns with the investor’s
decision to form portfolio of the risk-free
asset and the optimum risky portfolio
depending on her risk preferences.

73
Slope of CML

74
 Example
• Expected Return of Investor = 15
15 = 18 * Wm + 8 * (1- Wm)
Wm = 0.7
Portfolio Risk = Wm * Standard Deviation of Market
Portolio
= 0.7 * 6 = 4.2%
E(Rp) = Rf + (( RM – Rf) / (stand dev of M)) stand dev
of Portfolio
= 8% + ((18 – 8) / 6 ) 4.2 = 15%
 CAPITAL ASSET PRICING MODEL (CAPM)
• The capital asset pricing model (CAPM) is a model that provides a
framework to determine the required rate of return on an asset
and indicates the relationship between return and risk of the asset.
• The required rate of return specified by CAPM helps in valuing an
asset.
• One can also compare the expected (estimated) rate of return on
an asset with its required rate of return and determine whether
the asset is fairly valued.
• Under CAPM, the security market line (SML) exemplifies the
relationship between an asset’s risk and its required rate of return.

76
 Assumptions of CAPM
Market efficiency

Risk aversion and mean-variance optimization

Homogeneous expectations

Single time period

Risk-free rate

77
Characteristics Line

78
Security Market Line (SML)

Security market line

79
Security market line with normalize systematic risk

80
IMPLICATIONS AND RELEVANCE OF
CAPM
81
 Implications
• Investors will always combine a risk-free asset with
a market portfolio of risky assets. They will invest
in risky assets in proportion to their market value.

• Investors will be compensated only for that risk

which they cannot diversify.

• Investors can expect returns from their investment

according to the risk.
82
 Limitations
It is based on unrealistic assumptions.
 It is difficult to test the validity of CAPM.
 Betas do not remain stable over time.

83
 THE ARBITRAGE PRICING THEORY (APT)
• The act of taking advantage of a price differential
between two or more markets is referred to as arbitrage.
• The Arbitrage Pricing Theory (APT) describes the method
of bring a mispriced asset in line with its expected price.
• An asset is considered mispriced if its current price is
different from the predicted price as per the model.
• The fundamental logic of APT is that investors always
indulge in arbitrage whenever they find differences in
the returns of assets with similar risk characteristics.

84
Concept of Return under APT

85
Concept of Risk under APT

86
 Steps in Calculating
Expected Return under APT

searching for the factors that affect

the asset’s return estimation of factor beta

87
 Factors

Changes in
Industrial default
production premium

Changes in the
structure of
Inflation
interest rates rate
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 Risk premium
• Conceptually, it is the compensation, over and
above, the risk-free rate of return that
investors require for the risk contributed by
the factor.

• One could use past data on the forecasted

and actual values to determine the premium.

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 Factor beta
• The beta of the factor is the sensitivity of the
asset’s return to the changes in the factor.

• One can use regression approach to calculate

the factor beta.

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