RISK AND RATES

OF RETURN
1. Understand the meaning and fundamentals of risk,
return, and risk aversion.
2. Describe procedures for assessing and measuring the
risk of a single asset.
3. Discuss the measurement of return and standard
deviation for a portfolio and the concept of correlation.
4. Understand the risk and return characteristics of a
portfolio in terms of correlation and diversification, and
the impact of international assets on a portfolio.
5. Differentiate between systematic risk and unsystematic
risk.
6. The derivation and role of beta in measuring the relevant
risk of both a security and a portfolio.
7. Explain the capital asset pricing model (CAPM) and its
relationship to the security market line (SML), and the
major forces causing shifts in the SML.
8. Explain the Efficient Market Hypothesis (EMH) and
recognise some market anomalies.
 In the context of business and finance, risk is defined as
the chance of suffering a financial loss.
 Assets (real or financial) which have a greater chance of
loss are considered more risky than those with a lower
chance of loss.
 Risk may be used interchangeably with the term
uncertainty to refer to the variability of returns
associated with a given asset.
 Other types / sources of risk are listed on the following
slide.
Sources of Risk Affecting Financial Managers
and Shareholders
For a Treasury security,what is the required
rate ofreturn?
Required Risk-free
rate of = rate of
return return
Since Treasury securities are
essentially free of default risk, the rate
of return on a Treasury security is
considered the “risk-free” rate of
return.
For a corporate stock or bond,what is the
required rate ofreturn?
Required Risk-free Risk
rate of = rate of + premium
return return
How large of a risk premium should we
require to buy a corporate security?
Investor wants higher return if taking
more risk.
• Expected Return - the return that an investor
expects to earn on an asset, given its price,
growth potential, etc.

• Required Return - the return that an investor

requires on an asset, given its and market
interest rates.
Return
• Return represents the total gain or loss on an
investment.
• The most basic way to calculate return is as
follows:
Example:Return
Robin’s Gameroom wishes to determine the returns on two
of its video machines, Conqueror and Demolition.
Conqueror was purchased 1 year ago for $20,000 and
currently has a market value of $21,500. During the year, it
generated $800 worth of after-tax receipts. Demolition was
purchased 4 years ago; its value in the year just completed
declined from $12,000 to $11,800. During the year, it
generated $1,700 of after-tax receipts.
Risk of a Single Asset
Norman Company, a custom golf equipment
manufacturer, wants to choose the better of two
investments, A and B. Each requires an initial outlay
of $10,000 and each has a most likely annual rate
of return of 15%. Management has estimated the
returns associated with each investment. The three
estimates for each assets, along with its range, is
given in the following slides. Asset A appears to be
less risky than asset B. The risk averse decision
maker would prefer asset A over asset B, because
A offers the same most likely return with a lower
range (risk).
Risk of a Single Asset
Risk of a Single Asset:
Discrete ProbabilityDistributions
Risk of a Single Asset:
Continuous ProbabilityDistributions
Return Measurement for a Single Asset
If given a probability distribution of
possible future outcomes
• The expected value of a return, r-bar, is
the most likely return of an asset.
Return Measurement for a Single Asset
If given historical data for a few periods
• Calculate average return or mean return.

rt = (Pt – Pt-1 + Ct) / Pt-1

Example:
Return Measurement for aSingle Asset
Risk Measurement for a Single Asset
• The most common statistical indicator of an
asset’s risk is the standard deviation, r, which
measures the dispersion around the expected
value.
• If given a probability distribution of possible future
outcomes:

• If given historical data of few periods:

Risk Measurement for a Single Asset
• The possibility that an actual return will differ from
our expected return.
• Uncertainty in the distribution of possible outcomes.
• A more scientific approach is to examine the stock’s
standard deviation of returns.
• Standard deviation is a measure of the dispersion of
possible outcomes.
• The greater the standard deviation, the greater the
uncertainty, and, therefore, the greater the risk.
Example:
Risk Measurement fora Single Asset
Example:
Expected Return forIndividual Asset
Based only on your
expected return
calculations, which
stock would you
prefer?
 Have you
considered
RISK?

n
= 
i=1
(ki - k)2 P(ki)
Which stock would you prefer?
How would you decide?
 Summary
Orlando Orlando
Utility Technology
Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

Risk Measurement for a Single Asset:
Coefficient ofVariation
• Invest in the security that has the lowest
coefficient of variation. Minimizes the risk
per unit of expected return.
• Useful to compare risks of assets with
differing expected returns.
• Coefficient of Variation (CV)
• = Standard Deviation ÷ Expected Return
Example: Coefficient ofVariation
 Portfolio
• An investment portfolio is the collection or
combination of different investments that make
up an investor’s total holdings. A portfolio might be:
 investments in stocks and shares by an investor
 investments in capital projects by a company
• Markowitz portfolio theory concerned with
establishing guidelines for building up a portfolio of
stocks and shares, or a portfolio of projects.
 Portfolio
• If we assume all investors are rational and risk
averse, that investor will ALWAYS choose to invest in
portfolios rather than in single assets.
• Investors will hold portfolios because he or she
will diversify away a portion of the risk that is
inherent in “putting all your eggs in one basket.”
• If an investor holds a single asset, he or she will
fully suffer the consequences of poor performance.
• This is not the case for an investor who owns a
diversified portfolio of assets.
 Portfolio Return (2 AssetsPortfolio)

rP = wXrX + wYrY
• Portfolio Expected Return is a weighted average
of the expected returns of the investments in
the portfolio, weighted by the proportion of total
funds invested in each.
• Find the expected returns from Asset X and Asset
Y first. Then, find the weights of Asset X and Asset
Y in the portfolio. Sum of weights is 1 (i.e. 100%).
 Portfolio Return
• The return of a portfolio is a weighted average
of the returns on the individual assets from which
it is formed.
Example: Portfolio Return
Portfolio Risk (2 AssetsPortfolio)
• Portfolio Standard Deviation

• XY is the correlation of returns between Asset X

and Asset Y.
• X and Y are standard deviation of returns of Asset
X and Asset Y respectively.
• XY can also be calculated as:
XY = COVXY ÷ (X Y)
 Portfolio Risk
• Diversification is enhanced depending upon the
extent to which the returns on assets “move”
together.
• This movement is typically measured by a statistic
known as “correlation” as shown below.
 Portfolio Risk
• Even if two assets are not perfectly negatively
correlated, an investor can still realize diversification
benefits from combining them in a portfolio as shown
below.
Portfolio Risk (2 AssetsPortfolio)
 Correlation is a measure of how strong the returns
of two assets move in same or different direction. It
ranges from +1 to –1.
 If investments show high negative correlations,
then by combining them in a portfolio, overall risk of
the portfolio (measured by standard deviation)
would be reduced. Risk could also be reduced by
combining a portfolio of investments which have
low positive correlation, but not as much compared
to the case of negative correlation.
 If the two assets have perfect positive correlation
(+1), diversification does not reduce risks at all.
Portfolio Risk: Correlation
• Positive correlation: When one investment done
well (badly), it is likely that the other will perform
likewise. E.g. buy shares of a company making
umbrella and shares of another company making
raincoat.
• Negative correlation: When one investment done
well, the other will done badly, or vice versa. E.g.
buy shares of company making umbrella and shares
of another company making ice cream.
• No correlation: Performance of one investment is
independent from another investment. E.g. buy
shares of a company in mining and shares of a
resorts company.
Portfolio Risk: Correlation
• If you owned a share of every stock traded on
Bursa Malaysia, would you be diversified?

• Would you have eliminated all of your risk?

Common stocks portfolio

still has risk.
 Market risk (systematic risk) is nondiversifiable.
This type of risk cannot be eliminated, but can be
reduced through diversification among different
asset classes or through holding a diversified
global portfolio (domestic and international
assets). It is volatility of returns caused by factors
affecting the whole market or most companies
similarly.
 Company-unique risk (unsystematic risk) is
diversifiable. This type of risk can be eliminated
even through diversification within same asset
class. It is volatility of return caused by factors
specific to a company.
Market Risk
• Unexpected changes in interest rates.
• Unexpected changes in cash flows due to tax rate
changes, exchange rate fluctuations, foreign
competition, and the overall business cycle.
• Unexpected rise in inflation rates or commodity
prices.
Company-unique Risk
• A company’s labour force goes on strike.
• A company’s top management dies in a plane
crash.
• A huge oil tank bursts and floods a company’s
production area.
• Court decision on lawsuit against a company.
Total Risk & Unsystematic Risk
Decline as Securities AreAdded.
Portfolio Risk:
Adding Assets to a Portfolio
Portfolio
Risk (SD)
Portfolio of Domestic Assets Only

Portfolio of both Domestic and

International Assets
σM

# of Stocks

0
Portfolio Risk:
Adding Assets to a Portfolio
• Many empirical studies found that when an investor
holds 20 to 30 stocks in a portfolio, company-unique risk
is nearly eliminated.
As we know, the market compensates investors
for accepting risk - but only for market risk.
Company-unique risk can and should be diversified
away.
Shares of individual companies will have systematic risk
characteristics which are different from the market
average. Some shares will be more risky and some will
be less risky than the stock market on average. Thus, we
need to be able to measure systematic (market) risk.
 Beta
• In the early 1960s, finance researchers (Sharpe,
Treynor, and Lintner) developed an asset pricing
model that measures only the amount of systematic
risk a particular asset has.
• In other words, they noticed that most stocks go down
when interest rates go up, but some go down a whole
lot more. They reasoned that if they could measure
this variability—the systematic risk—then they could
develop a model to price assets using only this risk.
• The unsystematic (company-related) risk is
irrelevant because it could easily be eliminated
simply by diversifying.
 Beta
• Beta is a measure of market (systematic) risk.
• Specifically, beta is a measure of how an individual
asset’s returns vary with market returns. It’s a
measure of the “sensitivity” of an individual asset’s
returns to changes in the market.
• To measure the amount of systematic risk an asset
has, they simply regressed the returns for the
“market portfolio”—the portfolio of ALL
assets—against the returns for an individual
asset.
• The slope (gradient) of the regression line is the
asset’s beta.
 Beta: Market’s Beta is1
• A firm that has a beta = 1 has average market risk.
The stock is no more or less volatile than the
market.

• A firm with a beta > 1 is more volatile than the

market. E.g.: cyclical companies like auto companies
and technology companies have high betas.

• A firm with a beta < 1 is less volatile than the

market. E.g.: stable companies like public utilities
have low betas.
Interpretation ofIndividual AssetBeta
Interpretation ofIndividual AssetBeta
• If the market return rises by 2%, the return from
XYZ Bhd share with a beta of 2 will rises by 4% in
respect to the same conditions which have caused
the market return to change. If PQR Bhd share has a
beta of 0.7, its return will rise by 1.4% when market
return rises by 2%. If UVW Bhd share has a beta of
-1.3, its return will fall by 2.6% when market return
rises by 2%.
Calculating Beta usingExcel
 Collect data on individual company stock’s returns
and the market (e.g. KLCI) returns over some
periods of time.
 Click on “Tools” tab and click “Data Analysis”.
Then select “Regression”.
 Insert cells location for “Input Y Range” and “Input
X Range”. Select Line Fit Plots. Click “OK”.
 From coefficient table, look for slope (gradient)
coefficient, which is the beta of the individual
stock.
 Beta
• Beta is the slope (gradient) of characteristic line. It
shows the market risk of an individual company’s
stock.
• Variations about the characteristic line shows the
unique risk of an individual company’s stock.
• Alternatively, beta can also be calculated using
formula if sufficient information are given:
i = COVi,m ÷ m2
where COVi,m is covariance between stock i returns
and market returns. m2 is variance of market
returns (standard deviation square).
Example: CalculatingBeta
• If standard deviation of returns for the market as a
whole is 40% and the covariance of returns for the
market with returns for Menang Bhd is 19.2%, what
is the stock beta of Menang Bhd?
• Solution:
i = COVi,m ÷ m2
= 0.192 ÷ 0.42
= 1.20
 Portfolio Beta
• Portfolio beta is a weighted average of the
individual securities’ betas, the weights being the
proportion of the portfolio invested in each security.

P = wXX + wYY
Example: Portfolio Beta
Hughes has RM40,000 invested in a stock which has a
beta of 0.7 and RM20,000 invested in a stock with a beta
of 2.8. If these are the only two investments in her
portfolio, what is her portfolio’s beta?

Solution:
Portfolio Beta
= RM40,000/RM60,000 * 0.7 + RM20,000/RM60,000 * 2.8
= 1.40
Summary:
• We know how to measure risk, using standard
deviation for overall risk and beta for market risk.
• We know how to reduce overall risk to only
market risk through diversification.
• We need to know how to price risk so we will
know how much extra return we should require
for accepting extra risk.
Capital Asset PricingModel
• CAPM concerns how systematic risk is measured. By
using Security Market Line (SML), CAPM relates the
required rate of return of an asset to its systematic
risk as captured by beta. The equation basically tells us
that for a given asset, investors should be compensated
with a risk-free rate of return plus a risk premium. SML will
be upward sloping because market portfolio return is
usually and theoretically higher than risk-free rate of return.
As a result, assets with high beta will have higher required
rate of return, and assets with low beta will have lower
required rate of return. Investors will not require risk
premium for unsystematic risks because these can be
diversified away by holding a wide portfolio of investments.
CAPM Assumptions
• All investors are price takers. All assets can be sold
at going concern prices (cost of insolvency is zero).
• All investors have the same time horizon.
• All investors have the same information and interpret
it in the same manner (homogeneous expectations).
• Markets are "perfect." i.e. no transaction costs, no
taxes, short selling is allowed etc.
• All investors are risk averse.
• The market portfolio exists.
Required Risk-free Risk
rate of = rate of + premium
return return

market company-
risk unique risk

can be diversified
away
Require d
security
rate of
return
marke t
line
12% . (SML)

Risk-fre e
rate of
return
(6%)

1 Beta
 This linear relationship
between risk and required
return is known as the
Capital Asset Pricing Model
(CAPM).
The CAPMEquation:

kj = krf + j (km – krf )

where:
kj = the required return on security j
krf = the risk-free rate of interest
j = the beta of security j
km = the return on the market index
The CAPMEquation:
 (km – krf) is known as market risk premium, or risk
premium.
 (km – krf) is known as company j’s or asset’s risk
premium
 The difference between actual return (or expected
return) and required return kj generated by CAPM
would be attributable to unsystematic risk factors
unique to the company. Remember CAPM only
captures systematic risk factors.
The CAPMEquation:
• After estimating beta, which measures a specific
asset or portfolio’s systematic risk, estimates of the
other variables in the model may be obtained to
calculate an asset or portfolio’s required return.
Example: CAPM -Required Return
 Suppose the Treasury bond rate is 6%, the average
return on the KLCI index is 12%, and YTL Bhd has
a beta of 1.2.
 According to the CAPM, what should be the
required rate of return on YTL Bhd stock?
 Solution:
kj = 0.06 + 1.2 (0.12 - 0.06)
kj = 0.132 = 13.2%
According to the CAPM, YTL Bhd stock should
be priced to give a 13.2% return.
Required and Expected Returns
 All the points on the SML show the required rate of
return of individual stock or portfolio.
 If expected (or actual) return is more than required
return (lie above SML), the stock/portfolio is
underpriced or overperformed.
Decision: Buy or Invest
 If expected return is less than required return (lie
below SML), the stock/portfolio is overpriced or
under-performed.
Decision: Sell or Divest
Uses ofCAPM
• To establish the cost of a company’s equity, and
hence the company’s weighted average cost of
capital, taking into account the risk characteristics
of a company’s investments, both business and
financial risks.
• To establish the ‘correct’ equilibrium market value
of a company’s shares. Buy when underpriced
and sell when overpriced.
 Example
• The management of MCC Bhd is considering buying
one of the 2 portfolio of assets (A or B) and has been
given the following data. Calculate the expected return
of each portfolio. Which provides the largest expected
return?

% of Port A Port B
Portfolio Return Return
0.2 15% 8%
0.6 20% 24%
0.2 30% 40%
 Wt. Portfolio A Portfolio B
Return Exp Return Return Exp Return
0.2 15% 3% 8% 1.6%
0.6 20% 12% 24% 14.4%
0.2 30% 6% 40% 8%
21% 24%
Portfolio B has a higher expected return.

The management wishes to assess which portfolio has

performed better, on the basis of CAPM. They estimated
betas for A and B of 1.2 and 1.8 respectively. Risk free
rate is 8%, market return is 18%. Using CAPM, identify
which of the 2 portfolio has performed better.
Portfolio A : K = Rf + Beta (Rm-Rf)
= 8% + 1.2 (18%-8%)
= 20%
Portfolio B : K = Rf + Beta (Rm-Rf)
= 8% + 1.8 (18%-8%)
= 26%
Wt. Portfolio A Portfolio B
Return Exp Return Return Exp Return
0.2 15% 3% 8% 1.6%
0.6 20% 12% 24% 14.4%
0.2 30% 6% 40% 8%
21% 24%
Over-performed Under-performed
Inflation ShiftsSML
 Inflation ShiftsSML
• If inflation rate is 3%, nominal risk-free interest rate
will rise by 3% from 7% to 10% to prevent eroding
purchasing power of interest income. This is
predicted by Fisher effects.
• Inflation will affect every firms in the market. Hence,
an expected inflation of 3% will increase required
return on every firm by 3%. Market return rises from
11% to 14%.
• Market risk premium remains constant.
• Inflation will cause parallel upward shift in SML.
Risk Aversion Changes Slopeof SML
 Risk Aversion Changes Slopeof SML
 If investors become more risk averse, investors in the
market will require a higher risk premium to
compensate for same risk level. Market risk premium
rises from 4% to 7% when investors become more
risk averse.
 As a result of a change in investors attitude towards
risk, the slope of the SML will also change.
 The more risk averse the investors, the steeper the
SML.
Conceptually:
Nominal Real Inflation-
risk-free risk-free risk
Interest = Interest + premium
Rate Rate
IRP
krf k*
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)
This is known as the “Fisher Effect”
• Suppose the real rate is 3%, and the nominal
rate is 8%. What is the inflation rate premium?
• Solution:
(1 + krf) = (1 + k*) (1 + IRP)
(1.08) = (1.03) (1 + IRP)
(1 + IRP) = (1.0485)
IRP = 4.85%
 Efficient Market Hypothesis(EMH)
• EMH is a hypothesis that the stock market reacts
immediately to all the information available.
• In an efficient capital market, the transfer of assets
occurs with little loss of wealth.
• Thus, financial asset prices are fair prices.
• They are neither too high, nor too low.
• A long-term investor cannot earn higher than
average returns from a well-diversified share
portfolio.
• What is meant by “all available information”?
 Three Forms of Capital Market
Efficiency
• Strong form of capital market efficiency.
• Current prices reflect all information (publicly available and
private) and information contained in past price
movements.
• Semi-strong form of capital market efficiency.
• Current prices reflect publicly available information and
information contained in past price movements.
• Weak form of capital market efficiency.
• Current prices reflect only the information contained in
past price movements.
Three Forms of Capital Market
Efficiency
Strong Form
(All information affecting the asset’s value)

Semi-Strong Form
(All publicly available information)

Weak Form
(Information contained
in past prices)
 Information and PriceMovements
• In an efficient capital market, prices reflect all
available information.
• When new information arrives, prices react
instantaneously to it.
• Since new information is that which cannot be
predicted, it would arrive at random points in time.
• Price movements are random (i.e. cannot be
predicted).
 Implication of Efficiency for Investors
• Future market prices cannot be predicted based on
available information.
• Investments in these markets on average have a
zero NPV.
• The expected rate of return equals the required rate of
return.
• The expected rate of return compensates the investor for the
risk borne.
• Abnormally high returns are earned by pure “chance”.
No group of investors should be able to consistently
beat the market using a common investment strategy.
 Implication of Efficiency for Finance
Managers
• Finance managers only need to concentrate on
maximizing net present value of investments in order to
maximize the wealth of shareholders. They do not need
to worry the effect of financial results in published
accounts on share prices because investors will make
allowance for low profits or dividends in current year if
higher profits or dividends are expected in the future.
• Finance managers will not be able to misled investors
by window dressing the accounts and put an optimistic
spin on the figures.
• Finance managers do not need to identify when to
issue new shares because share prices in the market
always reflect the true worth of the company.
 Implication of Efficiency for Finance
Managers
• The market will decide what level of return it
requires for the risk involved in making an
investment in the company. It is pointless for the
finance managers to try to change the market view
by issuing different types of financial instruments.
• When a company wishes to expand by takeover,
directors do not need to waste their time to identify
takeover target companies whose shares are
undervalued, since the market will fairly value all
companies’ shares.