BUSINESS FINANCE/

FINANCIAL MARKETS & INSTITUTIONS

[B Sc (Hons) in Management]

SEMINAR 6
Risk & Return

Covariance/Correlation vs Portfolio Risk

The riskiness of a portfolio depends on

➙ the measure of risk of each asset in the portfolio (σ)

➙ the weight of each asset (w)

➙ the measure of "co-movement" between returns of

portfolio assets is called the covariance = cov(x,y)

in a portfolio, pairs of assets that DO NOT move

together can have huge diversification benefits
Diversification Effects

1. If you include 2 or more assets into your portfolio, there are

diversification effects (i.e., lower risk) arising from the fact
that the assets do not move together at all times (i.e., ρ <+1)

2. However, not all risk can be eliminated by way of

diversification. Total risk consists of the following 2
categories :
Systematic Risk Unsystematic Risk
Other Names  Market Risk  Unique Risk
 Non-diversifiable Risk  Diversifiable Risk
Examples  Government tax cut  A firm’s technical wizard
 Interest rate rises leaves
 A competitor enters a
firm’s product market
Diversification Effects
Total risk
 Systematic Risk

 Systematic risk principle states that the expected return on a risky

asset depends only on the asset’s systematic risk.

 The amount of systematic risk in an asset relative to an average

risky asset (market portfolio) is measured by the beta coefficient.

Std Dev Beta

Security A 30% 0.60
Security B 10% 1.20

9. Security A has greater total risk but less systematic risk (more
non-systematic risk) than Security B.
Beta : Measure of Market Risk

A measure of the sensitivity of the asset’s returns to changes in

the market return:

β=0 the asset’s returns are independent of the

market
β = 0.5 the asset’s returns are one half as responsive
as the market
β = 1.0 the asset’s returns will move exactly as the
market
β= 1.5 the asset’s returns will increase (decrease) by
50% more than the market for any given
increase (decrease) in the market returns

The higher the degree of systematic risk (β), the higher the
return expected by investors
Capital Asset Pricing Model (CAPM)

1. Investors require a risk premium for holding risky assets. So how

much should the risk premium be?

 Market risk premium = [ E (rs) - rf ]

 How much market risk premium they receive depends on the extent of
their systematic risk exposure, β

4. Thus, components of an asset’s expected return :

 Risk-free rate, (rf) - the pure time value of money

 Market risk premium, [ E (rs) - rf ] - the reward for bearing systematic risk
 Beta coefficient, β - a measure of the amount of systematic risk present in
a particular asset
CAPM = E ( R i ) = R f + [ E ( R M - R f ) ] × β i
Market Risk Premium

Risk Premium
Capital Asset Pricing Model (CAPM)

 Given a risk free rate of 5% and an expected market return of 10%,

what is the required return for share Z with a beta of 1.5?
Graphic depiction of CAPM
Asset expected
return (E (Ri)) Security Market Line (SML)

E (RM)

Rf
Asset
beta (β i)

M = 1.0
The equation for the SML:
Y = a + bX E( R i ) = R f + [ E( R M - R f ) ] × β i
= intercept + slope X
CML vs SML

 The Capital Market Line CML gives the risk return

relationship for efficient portfolios where risk is total risk (σ)

 The Security Market Line (SML) gives the risk return

relationship for individual stocks where risk is only
systematic risk (β)
Calculation of Systematic risk (β)

β - is the measure for systematic risk for an individual asset

β = ρi,m σm σi = cov(i,m)
σm 2 σ m2

(the covariance between the market return and the

individual asset’s return divided by the variance of the
market)

(NB: The beta coefficient of the market is always equal to 1)

 Example

 Analysts have forecast that share X will return 7% by year end,

share Y will return 12.5% and share Z will return 14%.

 Given a risk free rate of 5% and an expected market return of

10%, what is the required return for share X with a beta of 0.8,
share Y with a beta of 1.2 and share Z with a beta of 1.8? Are
these shares fairly priced?

E(Ri) = Rf + E[Rm - Rf] βi

Rx =
RY =
RZ =
 Example

FX = forecast of X

. .
% R
FY = forecast of Y

.. .
14 FY
Z FZ
11 y FZ = forecast of Z
10
9 M
X
FX
5

0.
8 β
1.
1.

1.
0

8
2
 Example

Share X
Share X is overpriced. The share is forecasted to generate a return
which is lower than the equilibrium return from the CAPM.

Investors will sell share X pushing the price down until the return
increases until it sits on the SML.

Share Y
Share Y is underpriced. The share is forecasted to generate a
return which is higher than the equilibrium return from the CAPM.

Investors will buy share Y pushing the price up until the return
decreases until it sits on the SML.

Share Z
Share Z is fairly priced.
Example

Investors expect the market rate of return in S’pore in 2006

to be 14%. A stock with a beta of 0.8 has an expected
return of 12%.
• If market return turns out to be only 10%, what is
your best guess for the return on this stock?
• At the same time, if the central bank doubles the
Treasury Bill rate, what would be the expected
return?
Arbitrage Pricing Theory

• CAPM – single factor theory

Required return is a function of only 1 factor, ie, the
relationship between a security’s return and the
market return (or beta)
• APT – multi factor theory
Required return is a function of any number of risk (or
economic) factors
Eg. 3-factor : Kj = a + p1b1j + p2b2j + p3b3j