03.

Fundamentals of Risk and Return III

Session Plan
Diversification
Portfolio Risk Calculation
Types of Risks (Systematic and Unsystematic Risk)
Capital Asset Pricing Model (CAPM)

1.

Diversif
ication

Dont put all your eggs in one basket

The idea is to spread your risk across a number of assets or investments. While pointing
us in the right direction, this is a rather naive approach to diversification. It would seem
to imply that investing $10,000 evenly across 10 different securities makes you more
diversified than the same amount of money invested evenly across 5 securities. The catch
is that naive diversification ignores the covariance (or correlation) between security returns.
The portfolio containing 10 securities could represent stocks from only one industry and
have returns that are highly positively correlated. The 5-stock portfolio might represent various
industries whose security returns might show negative correlation and, hence, low portfolio
return variability.
Meaningful diversification, combining securities in a way that will reduce risk, is illustrated
in figure below. Here the returns over time for security A are cyclical in that they move with the
economy in general. Returns for security B, however, are mildly countercyclical. Thus the
returns for these two securities are negatively correlated. Equal amounts invested in both
securities will reduce the dispersion of return, that is standard deviation, on the portfolio of
investments.
This is because some of each individual securitys variability is offsetting. Benefits of
diversification, in the form of risk reduction, occur as long as the securities are not positively
correlated.

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2. Portfolio Risk Calculation

Although the portfolio expected return is a straightforward, weighted average of returns on the
individual securities, the portfolio standard deviation is not the weighted average of individual
security standard deviations.
for a large portfolio the standard deviation depends primarily on the weighted covariance
among securities. The weights refer to the proportion of funds invested in each security, and
the covariances are those determined between security returns for all pairwise combinations of
securities.

Covariance (Cov)=

=
WA the weight of asset A in the portfolio;

WB the weight of asset B in the portfolio

A the standard deviation of asset A

the standard deviation of asset B

Corr the correlation coefficient between asset A and B

3. Types of Risks (Systematic and Unsystematic Risk)

We have stated that combining securities that are not perfectly, positively correlated helps
to lessen the risk of a portfolio. How much risk reduction is reasonable to expect, and how
many different security holdings in a portfolio would be required? Below figure helps provide
answers.
Research studies have looked at what happens to portfolio risk as randomly selected stocks
are combined to form equally weighted portfolios. When we begin with a single stock, the risk
of the portfolio is the standard deviation of that one stock. As the number of randomly
selected stocks held in the portfolio is increased, the total risk of the portfolio is reduced.

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The first part, systematic risk, is due to risk factors that affect the overall market such as
changes in the nations economy, tax reform by Congress, or a change in the world energy
situation. These are risks that affect securities overall and, consequently, cannot be diversified
away. In other words, even an investor who holds a well-diversified portfolio will be
exposed to this type of risk.
The second risk component, unsystematic risk, is risk unique to a particular company or
industry; it is independent of economic, political, and other factors that affect all securities in
a systematic manner. A wildcat strike may affect only one company; a new competitor may
begin to produce essentially the same product; or a technological breakthrough may make an
existing product obsolete. For most stocks, unsystematic risk accounts for around 50 percent
of the stocks total risk or standard deviation. However, by diversification this kind of risk
can be reduced and even eliminated if diversification is efficient.

Therefore not all of the risk involved in holding a stock is relevant, because part of this risk can
be diversified away. The important risk of a stock is its unavoidable or systematic risk. Investors
can expect to be compensated for bearing this systematic risk. They should not, however, expect
the market to provide any extra compensation for bearing avoidable risk. It is this logic that lies
behind the capital-asset pricing model.

4. Capital Asset Pricing Model (CAPM)

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Total risk faced by a firm is of 2 types; firm specific (un-systematic or diversifiable) and market
(systematic or non-diversifiable) risk. Therefore the return of a security will be impacted by the
market conditions as well. The specific risk can be eliminated if the investor holds the market
portfolio. Market portfolio is the combination of the weighted sum of every asset in the market.
The expected return of a market portfolio is equal to the expected return of the market as a
whole. Having a market portfolio can reduce the specific risk by diversification.

Systematic Risk Measurement Beta ()

Beta is the measure of the degree of assets return movement in response to market return
volatilities. The Beta coefficient is a measure of non-diversifiable (market) risk.
Beta can be computed in the similar manner,

Beta coefficient
RM - return of the market

RA - return of the asset A

SD Standard deviation

If Beta coefficient is 1, that indicates that the asset's returns will move with the market. Beta
coefficient is less than 1 indicates that the assets returns will be less volatile than the market
returns. These are known as defensive assets. A beta of greater than 1 indicates that the assets
return will be more volatile than the market return. These are known as aggressive assets.
For instance, if a beta value of asset A is 1.3, that indicates asset As returns are 30% more
volatile than market returns.
CAPM Formula
CAPM measures the expected return of a portfolio with the given systematic risk and risk free
return. Here the non-diversifiable risk is measured by Beta.

E(RA) Expected return of asset A

Rf Risk free rate of return

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E(RM) Market expected return

A Beta coefficient of asset A

Risk Premium
A risk free investment will yield a certain return. The investor will only accept additional risk
unless he is given a higher return than the risk free return. The additional return he gets from
exposing himself to risk is known as the risk premium. As at any given point an investors
expected return would be risk free return plus risk premium. Simply risk premium can be
explained as the investors reward for bearing systematic risk (market risk).
Risk Free Rate
Government securities by definition have no risk of default. Minimum return an investor expects
for any investment is the money he could have invested in a government security. This can also
expressed as the compensation for the time value of money of an investment.

Theory Review Questions

1. An investor wishes to invest in a security A, which has a beta of 1.2. Currently a risk free
security would yield a return of 10%. If the expected market return is assessed at 13% what
would be the return required by the investor for the security A.
2. In the above example what would be the required rate of return on security A if the beta is
assess as 1.
3. Based on the market returns and Abance PLC stock return, it was evident that the stock
moves closely with the market returns in the same direction. However Abance PLC stock is
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20% more volatile than the market. If the risk premium expected by the investors is 12% than
the government Treasury bond rate of 8%, determine the required rate of return of the stock
using CAPM model.
4. JKH stock has beta of 1.4 and expected market return of 15%. If the risk free return is 8%
determine the return on the market portfolio.
5. There are 2 investment opportunities available for an investor in X PLC and Y PLC. The
expected returns of the assets are 12% and 15% for X and Y.The investor wishes to invest
30% in X PLC and 70% in Y PLC. The standard deviations of individual assets are computed
as 6% and 8% for X and Y respectively. Also, the market information suggests that the 2
investments are to be correlated negatively. The covariance of the assets is assessed as
-72.Compute the portfolio standard deviation. (15.2 Finance end exam 04 Marks)
6. There are 2 investment opportunities available for an investor in X PLC and Y PLC. The
expected returns (E[R]) of the assets are 20% and 18% for X and Y investments. The investor
wishes to invest in equal sum of money in each of the investments. The standard deviations of
individual assets are computed as 5% and 4% for X and Y respectively. Also, the market
information suggests that the 2 investments have a zero correlation.
Compute the portfolio standard deviation using above information.

You are educated. Your certification is in your degree. You may think of it as the
ticket to the good life. Let me ask you to think of an alternative. Think of it as your
ticket to change the world
- Tom Brokaw

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