Risk Return Framework

Risk: it is defined as the uncertainty about the actual return that will earn on an investment. Risk
may be in the form of loss of capital, delay in the repayment of capital, variability of return and
nonpayment of return.
Systematic Risk
The risk, which is inherent to the entire market or system, is termed as Systematic Risk or
Uncontrollable Risk'. It is also referred to as "Undiversifiable Risk," as it affects the entire market
and not one specific stock or industry. Further, it is associated with economic, social, political and
legal aspects of all the securities in the economy. These factors are capable of exerting pressure on
all securities in the market in such a manner that all of them would move or change accordingly.
‘Systematic Risk' is unpredictable and avoiding it is next to impossible. 1t cannot be mitigated
through diversification, but can be managed only through the right asset allocation strategy.
Components of Systematic Risk
Systematic Risk' is a broad category of risk and may be classified into following sub-categories:
1. Market risk: It refers to the variability in returns resulting from fluctuations in overall market.
This arises out of changes in demand and supply pressures in the markets, structural changes in
the economy, recession, following the changing flow of information and expectations. The
totality of investor’s perception and subjective factors influence the events in the market and
give rise to the risk which is not controllable.
If there is general increase in the prices of all shares in the market, it is referred as bullish
trend. If there is general decrease in the prices of all shares in the market, it is referred as
bearish trend. The reasons for fluctuations in share prices are many and varied. During the
expansion phase the prices of shares show a bullish trend and during the recession the
prices of shares show a bearish trend.

2. Interest rate risk: It refers to the variability in a security return resulting from changes in the
level of interest rates. Such changes generally affect value of securities inversely that is other
things being equal.
Generally the interest rate on the bond is fixed based on the interest rate prevailing at the
time of issuing bonds. When the interest rate in the market changes, there arises a
difference between the coupon rate and the market interest rate. The difference causes
change in the market value of bonds. If the interest rate in the market falls below the
coupon rate of a particular bond, then that particular bond attracts investors as it offers a
higher return. As a result, the market value of the bond is higher above its face value. If the
interest rate in the market rises above the coupon rate of a particular bond, then that
particular bond will not attract investors as it offers a lower return. As a result, the market
value of the bond will fall below its face value.

3. Purchasing Power Risk: 'Purchasing power risk is the possible reduction in the purchasing
power of the expected returns. Due to a high rate of inflation, there is erosion in the purchasing
power of money which results in decrease in the returns. Increase in the rate of inflation is
swifter than the increase in the value of investment. This results in punishment to the investors
in the form of reduced return on their investment. Rising rate of inflation poses a threat to the
investor as it is a risk or possible loss for him. Inflation may be Demand Pull (characterized by
an increase in aggregate demand and supply cannot keep pace with the demand) or Cost Push'
(characterized by a reduction in the supply of goods and services, due to increased cost of
production).

Unsystematic risk: It refers to the variability in a security total return not related to the overall
market variability but caused due to the unique factors relating to that firm or industry. Also known
as Diversifiable Risk', as it can be managed and controlled, unlike 'Systematic Risk'. which is
difficult to be managed and controlled, as it is widespread and covers the entire system.
Unsystematic Risk' may be specific to an industry or company and is caused due to one or more of
the following:
1) Lack of managerial ability,
2) Technological advancement in the process of production,
3) Procurement of raw material,
4) Lack of human resources, and
5) Change in consumer preferences.
Specific causes need to be probed, company/industry wise separately, to pinpoint and take
remedial action.
Components of Unsystematic Risk
The unsystematic risk may be categorized as follows:
1. Business Risk: Business risk is a part of the unsystematic risk, which basically comes from the
operational activities of the business. Due to certain inbuilt deficiencies in the operations of a
company, its competitive advantage over the rivals is lost affecting the force of its expansion
and/or smooth flow of revenue. This fact is ultimately expressed in the form of poor 'Operating
Income' and 'Expected Dividends' of the company.
Business risk may arise due to internal causes or external causes and accordingly it is
categorized under two heads. viz. (i) Internal Business Risk, and (ii) External Business Risk.
Both are discussed in the following points:
a. Internal Business Risk: Internal business risk is related to the operational effectiveness of a
company. The operational effectiveness of a company is measured in terms of the level of its
targeted achievements and keeping the promises made to its investors.
b. External Business Risk: External business risks are the risks caused by the circumstances,
which are external to a company's business. The company has no control over these
circumstances or factors, which arc (i) Social and regulatory factors, (ii) Monetary policy of
the Central Bank of the country, (ii) Fiscal policy of the Government, (iv) Business cycle. (v)
General economic conditions, etc.
2. Financial Risk: Financial risk of a company is closely related to the manner in which the funds
have been raised to design its capital structure. Financial strength of a company depends upon
the level and stability of its earnings. An inappropriate Capital Structure' may not be able to
ensure stable earnings and as a result of such variation in earnings, the company would be
exposed to financial risk. A high level of debt component in a company's capital structure
indicates the presence of a low cost of capital, which provides financial leverage for the
shareholders. The low cost of capital ensures that:
i) Earnings of the company remain higher than the cost of capital, and
ii) EPS shows an increasing trend.
However, higher debt financing in a company may result in variability in returns to the
shareholders, which ultimately leads to an increase in the risk. There are empirical evidences that
divergence in return for shareholders of leveraged companies (with higher level of debt funds) is
higher than the unleveraged companies (with lower level of funds).
Financial risk may be classified into following subdivisions:
a. Credit Risk: Credit risk arises from the possibility of a borrower defaulting in timely
payments, as and when it falls due or makes payment with delay. Failure on the part of a
borrower in repayment is a credit risk, which directly affects the profitability of the lender.
Even a delay in repayment of borrowed funds carries a cost element with it.
b. Currency Risk: The possibility of a loss due to unfavorable movements of exchange rate in
foreign exchange market, either short-term or long-term, is referred to as the 'Currency
Risk'. A company engaged in the business of export, import, forex dealing or has foreign
 subsidiaries may be a victim of Currency Risk'. It may also affect a company which has a
competition with a foreign entity in the domestic market.
c. Country Risk: Country Risk' is a collection of risks associated with doing business in a
foreign country. It varies from one country to another. Some countries have risks, high
enough to discourage foreign investment. These risks include political risk, regulatory risk,
and economic risk.
 Political Risk: Political risk arises from the possibility of downfall in the financial health of a
country as a result of (i) unstable Government, or (ii) change of Government or (ii) distress
regarding Government's actions. Political risk is highest in the countries with political
instability. Sudden change in Government creates an environment of a doubt and
unpredictability with regard to the new Government’s policies about exchange control.
treatment with foreign business houses, etc.
 Regulatory Risk: The risk arising out of the tension that new regulations would be
introduced or the existing regulations would be implemented in a more rigorous manner is
termed as 'Regulatory Risk'. Possibility of a country's Central Bank to increase the CRR
(Cash Reserve Ratio) or SLR (Statutory Liquidity Ratio) requirements for banks operating in
that country is an example of the 'Regulatory Risk’
 Economic Risk: The possibility of a country's economic conditions becoming negative and
having a damaging impact on its financial health, especially on inflation, interest rates, and
forex rates, is termed as Economic Risk'.
For example, if the Government of a country decides to increase its spending by resorting to
market borrowing in a big way, business opportunity for the Government suppliers would
increase in the short-run. However, the financial consequences in the long run would be a
high level of interest rate for commercial and private borrowers.

3. Liquidity Risk: an investment that can be bought and sold quickly without significance price
concession is considered to be liquid. The more uncertainty about the time element and price
concession, the greater the liquidity risk.
Liquidity Risk is the probability of a security market (bond or stock) being non-marketable, making
it difficult for the holders of such security to sell them at a fair price.

Factors that influence risks

a. Wrong timing of investment
b. Wrong decision of what to invest in.
c. Nature of instrument like corporate shares, bonds, chit funds etc are highly risky while
instruments like bank deposits, post office, certificates are less risky due to their certainty
of payment of principal and interest.
d. Creditworthiness of the issuer: the securities of government and semi government bodies
are more credit worthy than those issued by the corporate sector and much less secure are
those in the unorganized sector like indigenous bankers, chit funds.
e. The longer the maturity period, the riskier is the investment normally.
f. The higher the amount invested in any security, the larger is the risk, while a judicious mix
of investments in small quantities may be less risky.
Total risk = systematic risk + unsystematic risk

Measurement of Risk
Various statistical techniques are applied to measure the approximate level of risk, which are as
follows:
1. Range: The difference between two extreme ends of returns, viz. maximum and minimum is
taken as "Range', which reflects the quantum of risk. It may be expressed in mathematical terms
as under:
Range = Maximum Value of Return - Minimum Value of Return
2. Variance and Standard Deviation: The risk can be measured with an absolute measure of
dispersion or variability. The most commonly used measure of dispersion over some period of
years is standard deviation. This technique involves measurement of the values of the variables
around its mean. The standard deviation is square root of variance. In other words, it is the
'square root of the sum of the squared deviations from the mean' divided by the ‘number of
observations'. Two companies may have the same arithmetic mean of the returns, but there
may be wide variations in returns.
ℴ = √ σ2
( X i− X͞ )
n 2
2
o =∑
i=1 n
The variance is defined as the average of the square of deviation.
ℴ =Standard Deviation
o 2 =Variance
X i = Return from the stock in period i (i = 1,………., n)
X͞ = Arithmetic mean of return
n = Number of periods

3. Coefficient of Variation: Standard Deviation' or 'Variance' is an absolute measure of risk. t

would be worthwhile, if an attempt is made to explore a relative measure also. In a hypothetical
situation, returns for two shares A and "B° may have the 'Standard Deviation' at 20% each.
However, their expected returns may be at 5%and 20% respectively. Now, in absolute terms
both 'A and B' shares carry the same level of risk, but in relative terms the risk level of share 'B'
would be lower, due to its higher expected returns.
The relationship between "Standard Deviation' and "Expected Returns' may be expressed as
Coefficient of Variation'. Itis defined as the ratio of 'Standard Deviation' to the 'Expected Value'.
Mathematically it can be exhibited as following:

Coefficient of Variation = Standard Deviation / Expected Value E(R) = ℴ / E (R)

Extreme caution needs to be taken while using the "Coefficient of Variation' as a measure of
risk. Coefficient of Variation' for an expected value of zero would be a value, viz. infinity, which
is difficult to explain. Further, its tendency is to exaggerate the risk for lower values of mean.
and minimize the risk for a higher expected value.

n
4. o 2=¿ ∑ pi X (r i −ŕ)2
i=1
ŕ = expected return
r i = different possible return for different period
pi= the probability of getting different possible return
Since the standard deviation is defined as the square root of the average of the “square of
deviation”. But in the above method we have not taken the average of the square of deviation. This
is because the different possible returns have different probabilities. Hence we have multiplied the
square of deviations by the respective probabilities.
5. Covariance
( x−x́ ) x ( y − ý )
Cov x , y =
N
An absolute measure of the degree of association between the returns for a pair of securities.
The extent to which and the direction in which two variables co vary with time.
Covariance is an absolute measure of the extent to which two sets of numbers move together
i.e., move up or move down together. The measurement of the movement is done from their
means that is the movement above/below their means is calculated.
Positive Covariance: if both the numbers are consistently above or below their respective
means at the same time, their products will be positive and the average will also be positive
value and the covariance between the two set of numbers will be positive.
Negative Covariance: if the movements in the value of the numbers of the two sets are
inconsistent, that is, if ‘x’ value is below the arithmetic mean while the ‘y’ value is above the
arithmetic mean and vice versa, then their products will be negative and the covariance will be
negative.
6. Correlation of coefficient
Cov x, y
γ xy =
ox x oy
( x−x́ ) x ( y− ý )
γ xy= 2 2
√∑ ( X−x́ ) x ( Y − ý )
The correlation of coefficient is nothing but the covariance taken not as a absolute value, but
taken relative to the standard deviations of the variables. It states the change in the value of one
variable due to the changes in the value of another variable.
Positive correlation: if the value of one variable increases with the increase in the value of
another variable or decreases with the decrease in the value of another variable is called as
positive correlation. If the percentage change in the value of one variable is same as the
percentage change in the value of another variable in the same direction is called as Perfect
positive correlation.
Negative correlation: if the value of one variable increases with the decrease in the value of
another variable or decreases with the increase in the value of another variable is called as
Negative correlation. If the percentage change in the value of one variable is same as the
percentage change in the value of another variable in the inverse direction is called as Perfect
Negative correlation.

7. Measurement of the systematic risk (ᵝ)

Risk is a measure of the variability in returns. The standard deviation of the returns provides a
measure of the total risk associated with the security. The total risk of a security is divided into
two components, viz, systematic risk and unsystematic risk.
The effect of changes in the economic conditions that leads to changes in the market return is
indicated by the stock market index. Hence the stock market index is considered as the
reference point for measuring systematic risk.
The systematic risk of a security is measured by relating the variability of return of that security
with the variability in the stock market index. If relative to the variation in the stock market
index, the return from the security shows higher variations the security is said to have a higher
systematic risk and vice versa.
Covi , m
ᵝ i=
o m2
Cov i ,m =covariance of the security ‘i’ with the market index ‘m’.
 o m2 = variance of the stock market index or variance of return of market portfolio.

γ i ,m x o i x om γ i ,m x o i
ᵝ i= 2 or ᵝ i=
om om
Return: It is the outcome of an investment. Return is a form of reward and a motivator, which
encourages an investor for making the investment.
The significance of returns in any investment decision can be determined from the following
factors:
1) lt helps potential investors in making comparison of returns expected from alternative
investment opportunities.
2) Measurement of historical (past) returns places the investors in a position to take stock of
better performance in the areas of investment.
3) Measurement of historical returns also facilitates the assessment of future returns.
Components of Return
There are two components of return, composed in an investment:
1) Current Return: The current return on any investment is the recurring stream of cash inflow
(income), in the form of dividend or interest. Current return is measured as the recurring
income in relation to the initial investment (beginning price of investment).
2) Capital Return/Gain: The capital return on an investment could be the change (appreciation
or depreciation) in the acquisition cost of the original investment. This is also referred as the
‘Capital Gain'. ‘Capital Gain' is the predominating constituent in the case of assets like equity
shares.
Thus, the total return on any investment (assets) is reflected as follows:
Total Return = Current Return+ Capital Return
An important aspect in respect of the two constituents of return can be stated as, "the current
returns can be either zero or positive (it cannot be negative), whereas the capital returns can be
negative, zero or positive".

Types of Return: Two types of Return are as follows:

1) Realized Return: Realized return is the return on an investment that has been actually
earned. There is an element of certainty and absence of risk in this type of return. An
example of bank deposit may be taken to illustrate the above. Rs 5,000 deposited in a bank
as Fixed Deposit for one year @ 10% would be worth Rs 5,500 on completion of one year.
Realized return in this case is R500.
2) Expected Return: Expected return is the return on an investment, which is anticipated or
expected over a period of time in future. There is an element of uncertainty and existence of
risk in this type of return, as the expectation may or may not come true. The uncertainty or
risk in respect of expected return and its timing get compensated by the substantial high
rate of return. The expected rate of return is the weighted average of all the possible returns
multiplied by their respective probabilities. In symbolic language, it may be expressed as
under:
n
Expected Return ŕ = ∑ r i x pi
i=1
E (r) or ŕ = expected return
r i = different possible return for different period
pi= the probability of getting different possible return
Measurement of Returns
Before taking any investment decision, an investor tries to measure risk as well as the return on
that investment. An investment decision is based upon the Risk-Return analysis. For the
measurement of returns, there are broadly two methods, viz. (i) Traditional Method of
Measurement, and (ii) Modern Method of Measurement. Both are discussed in the following
paragraphs:
1) Traditional Method of Measurement: It is the simplest and oldest method of measuring returns
on a financial asset. Yield is calculated for a particular period on the invested amount by applying
the following formula:
i) Estimated Yield = Expected Cash Income / Current Price of Assets
ii) Actual Yield = Cash Income / Amount Invested
Yield can be calculated both for bonds and shares:
i) Bonds: They generally have a maturity period. Calculation of yield on them may be carried out
either for the current period or for maturity. It is a common practice (and desirable also) to
ascertain the Yield to Maturity (YTM). However, the yield for the current period of the bonds may
also be calculated.
ii) Stock or Share: The measurement of the return on stocks is calculated by ascertaining the
dividend yields (estimated or expected yields as well as actual yields) and by applying the following
formula:
Estimated Yield =Expected Cash Dividend/Current Share Price
Actual Yield = Dividend Received/Price of Share in the Beginning of the Period
Another way of finding out return in stock is by finding out "earning yield".
Earning Yield = Earning/Price of Share
2) Modern Method of Measurements
i) Holding Period Yield (HPY): The 'Holding Period Yield' is one of the modern techniques for
measuring return. It has twin advantages as mentioned below
a) It measures the total return per rupee of the original investment.
b) Comparisons can be drawn on any asset’s expected return.
Holding period Yield = (cash payment received+ price change over the period) / purchase price of
the asset
HPY = {CFt + (Pe - Pb)} / Pb = (CFt+ Pc)/Pb
Where, CFt = cash flows during the measurement period
Pe = price at the end of the period ‘t’ or sale price
Pb = price at the beginning of period or purchase price
Pc = change in price during the period or Pe minus Pb.
Holding period Yield of a Bond: the current yield is based on the assumption that the stream of
interest income from bond investments will continue indefinitely while the holding period return
confirms total returns to a definite investment period.
HPY = ( I t + ⧍P) / Po
Where t = the subscript t stands for time and refers to a holding period
I t = the bond’s coupon interest payment during holding period t
Po = the bond’s price at the beginning of holding period t
⧍P = change in bond price over the period.
The HPY can be broken into an income yield and a percentage price change measure
HPY = I t/Po + ⧍P / Po
ii) Return and Statistical Method: Under this technique, returns are measured either through
Central Tendency or Dispersion:
a) Central Tendency: In statistics, a "Central Tendency' (also referred to as a 'Measure of Central
Tendency') is a central or typical value for a probability distribution. Measures of central tendency
are often called 'averages'. The common methods of Central Tendency' are 'Mean', 'Median', and
'Mode'.
b) Measure of Dispersion: Dispersion is a statistical term describing the size of the range of values
expected for a particular variable. It is often interpreted as a measure of the degree of uncertainty,
and thus the risk associated with a particular investment. Dispersion method facilitates, assessing
risk in receiving a return on investment. "Greater the potential dispersion greater would be the
risk".
The simplest method to calculate 'Risk' is Range. Although, it has limitations of its own, as it is
effectively useful only when samples are small. With the increase in the number of values in
Sample, it loses its effectiveness. Using the Standard Deviation Method' is the most effective way to
find out as to how the data has been scattered around a frequency distribution. Variance' is the
square of ‘Standard Deviation'.
Risk-Return Trade-off
The underlying principle behind the idea of a Risk/Return' trade-off is an essential part of the
subject of finance. In almost all the financial decisions, some form of Risk/Return' (quid pro quo) is
involved. Higher the risk, greater is the expected return". For developing a healthy financial and
investment strategy, proper evaluation and a proper mix of different risk/return trade-offs is
necessary. Figure 1.4 represent the risk/return trade-off i.e., the risk-free rate is the ratee of return
commonly required on a risk-free security such as government security.
Some examples would help in making the above concept clearer:
1) In the case of investment in equity market, with a view to have higher return from a speculative
share, an investor needs to take a higher level of risk.
2) In the case of working capital management, a lower level of inventory would yield a higher level
of the expected return (due to a low level of current assets). However, in such a scenario, there is a
risk of running out of stock, which may result in losing potential business.

Risk/Return Trade-off

Higher Risk High Potential Return

Return

Low Risk
Low Return

Standard Deviation (or Risk)

The relationship between Risk and Return' is established by the concept of 'Risk and Return
Tradeoff, which enables the investors to measure the level of Risk and 'Return' and create a
portfolio with appropriate mix of 'Risk' and 'Return' (trade-off).
In this connection, it would be worthwhile to have some idea about the "Sharpe Ratio'. The Sharpe
ratio (also known as the Sharpe Index' or the Reward-to- Variability Ratio') is a method to examine
the performance of an investment by adjusting its risk. The ratio describes how much excess return
an investor is receiving for the extra volatility that he endures for holding a riskier asset.
It calculates the average return over and above the risk-free rate per unit of portfolio risk
Ŕ p− R
Sharpe Measure (ST) = f

oi
Where,
Ri = average portfolio return
R f = risk free rate
o i = risk of portfio
The relationship between return and risk can be expressed as follows:
Return= Risk-free Rate + Risk Premium
Risk-free rate is available government from a default-risk free security. An investor taking risk from
his investment needs a risk premium above the risk-free rate. Risk-free rate is a compensation for
time and risk premium for risk. Higher the risk, higher will be the risk premium, leading to higher
expectation of return.
There is a need to maintain a proper balance between the 'Risk' and the 'Return' with a view to
maximize the market value of a company's shares. Such a balance is what is termed as 'Risk-Return
Trade-off. The 'Risk-Return Relationship' is shown in figure.
Expected Return

Risk Premium

Risk-free Rate
Return

Risk

Risk and Return of a Portfolio

Portfolio: a portfolio is a group of securities held together as investment. It is an attempt to spread
the risk all over.
Portfolio management: it is basically involving:
 A proper investment decision making of what to buy and sell.
  Proper money management in terms of investment in a basket of assets so as to satisfy the
asset preferences of investors.
 Reduce the risk and increase the returns

The weighted return of these securities in the portfolio is known as portfolio returns. Portfolio risk
uses the standard deviation along with the covariance between securities. It is not the simple
weighted average risk of various securities in the portfolio.
Measuring the return of a portfolio
The expected portfolio return is the weighted average of the expected return on individual
securities.
n
E ( R p ) = ∑ W i E ( Ri )
i=1
Where,
E ( R p) = expected return on portfolio
W i = weight of security “i” in the portfolio
E ( Ri ) = expected return on security “i”
n = Number of securities in a given portfolio

Measurement of Portfolio Risk

The portfolio risk is measured with the help of correlation. The formula used can be easily modified
for this situation.
Following is the working of correlation for the rates of
return for two types of stock M and W:
i) The correlation is used to determine the relationship between two variables x and y. The
correlation coefficient' determines the degree of relationship as a coefficient.
ii) The 'r is used for denoting correlation coefficient. The value ranges from +1.0 to -1.0 in which
+1.0 means perfect positive correlation and -1.0 means perfect negative correlation
Correlation of coefficient
Cov x, y
γ xy =
ox x oy
( x−x́ ) x ( y− ý )
γ xy= 2 2
√∑ ( X−x́ ) x ( Y − ý )
The correlation of coefficient is nothing but the covariance taken not as a absolute value, but
taken relative to the standard deviations of the variables. It states the change in the value of one
variable due to the changes in the value of another variable.
Positive correlation: if the value of one variable increases with the increase in the value of
another variable or decreases with the decrease in the value of another variable is called as
positive correlation. If the percentage change in the value of one variable is same as the
percentage change in the value of another variable in the same direction is called as Perfect
positive correlation.
Negative correlation: if the value of one variable increases with the decrease in the value of
another variable or decreases with the increase in the value of another variable is called as
Negative correlation. If the percentage change in the value of one variable is same as the
percentage change in the value of another variable in the inverse direction is called as Perfect
Negative correlation.

Why correlation
 a. Perfect positive correlation: the returns have a perfect direct linear relationship.
Knowing what the return on one security will do allows an investor to forecast perfectly
what the other will do.
b. Perfect negative correlation: the returns have a perfect inverse linear relationship
c. Zero correlation: no relationship between the returns on two securities

 Combining securities with perfect positive correlation does not reduce risk in the portfolio.
 Combining two securities with perfect negative correlation would eliminate risk altogether
 Combining two securities with zero correlation reduces the risk of the portfolio but cannot
be eliminated.

Portfolio Risk in Two Asset Model

The formula of Two-Asset case are as follows:
o 2 p = w 21 o 21 + w 22 o 22 + 2w 1 w2 p12 o 1 o 2
o p= √ w 21 o21 +w 22 o 22+2 w 1 w 2 r 12 o1 o2
Where
o 2 p = variance of the portfolio return
o p=
w 1 w2= weight of securities 1 and 2 in the portfolio
o 21 , o 22= variance of return on securities 1 and 2
r 12 o 1 o 2=covariance of the return on securities 1 and 2
o 12= r 12 o 1 o 2
Where, r 12 = correlation coefficient between the returns on securities 1 and 2
covariance
 An absolute measure of the degree of association between the returns for a pair of
securities
 The extent to which and the direction in which two variables co vary with time.
Cov( Ri R j ) = P1 ¿ -- E( Ri )] [ R j 1−E(R j)] + P2 ¿ -- E( Ri )] [ R j 2−E(R j) ] +……….+ Pn ¿ -- E( Ri)] [
R jn −E( R j)]
Where
P1, P2….. Pn = probabilities associated with states 1…………..n
Ri 1, Ri 2…….. R¿ = return on security ‘I’ in states 1,2,…..n
R j 1, R j 2…… R jn = return security ‘j’ in sates 1,2……..n
E( Ri) = expected return on securities ‘I’
E( R j) = expected return on securities ‘j’

Capital asset pricing model

The model was developed by economist called William Sharpe in 1970. His model starts with the
idea that individual investment contains two type of risk: systematic and unsystematic risk. CAPM
considers only systematic risk and assumes that unsystematic risk can be eliminated by
diversification.
Unsystematic risk can be diversified and is irrelevant while systematic risk cannot be diversified
and is relevant. It is measured by beta. Beta determines the level of expected return on a security or
portfolio.
The risk of portfolio is lowered by increasing the number of stocks which decreases the
unsystematic risk distribution by the number of stocks in the portfolio. It can be explained in figure.
The investor which do' not want to bear risk can invest in risk-free securities. The small investor
having less number of security has more risk. The investor can reduce unsystematic risk by having
a well-diversified security in the portfolio. The diversified and balanced portfolio of all securities
will make the investor's unsystematic risk equal to the systematic risk in the stock market.

Variability of Return Total Risk

Unsystematic risk

Systematic Risk

No. of Portfolios

Assumption of CAPM
 Investors are rationale and risk averse. Variance of the return and mean return are all
investors care about.
 Single investors cannot affect the price of the securities in the market. So the investors are
price takers
 All investors have equal and costless access to information
 There are no taxes or commission costs.
 Everyone is equally adept at analyzing securities and interpreting the news.
 The risk-free return is same for all the investors.
Features of the CAPM
 The CAPM is a theory that explains how the market return prices investment assets. The
CAPM is a positive theory.
 The CAPM is a model developed in an attempt to explain variation in yield rates on various
type of investment.
 CAPM is based on the idea that investors demand additional expected return (called the risk
premium), if they are asked to accept additional risk.
 The CAPM model says that the expected return, the investors would demand is equal to the
rate on a risk-free security plus a risk premium.

CAPM model
The more risk you carry, the greater the expected return
E ( Ri) = R f + β i [E ( Rm) - R f ]
Where,
E ( Ri) = expected return on security ‘i’
R f = risk free rate of interest
β i = beta of security ‘i’
E ( Rm) = expected return on market