110 Financial Management

SUMMARY

 Risk and return concepts are basic to the understanding of the valuation of assets or securities. Return on a
security consists of the dividend yield and capital gain. The expected rate of return on a security is the sum of
the products of possible rates of return and their probabilities. Thus,
n
E( R) = R1P1 + R2 P2 +  + Rn Pn = ∑ Ri Pi
i =1

 The expected rate of return is an average rate of return. This average rate may deviate from the possible outcomes
(rates of return). Variance (σ2) and standard deviation (σ) of returns of a security can be calculated as follows:

σ 2 = [R1 − E ( R)]2 Pi + [R2 − E ( R)]2 P2 + 

n
+ [( Rn − E( R)]2 Pn = ∑[Ri − E ( R)]2 P
i =1

σ = σ2

 Variance or standard deviation is a measure of the risk of returns on a security.

 Generally, investors in practice hold multiple securities. Combinations of multiple securities are called portfolios.
 The expected return on a portfolio is the sum of the returns on individual securities multiplied by their respective
weights (proportionate investment). That is, it is a weighted average rate of return.
 In the case of a two-security portfolio, the portfolio return is given by the following equation:
E ( Rp ) = w Rx + (1 − w) Ry

 In the case of n-security portfolio, the portfolio return will be as follows:

n
E ( Rp ) = w1R1 + w 2 R2 +  + wn Rn = ∑ wi Ri
i =1

 The portfolio risk is not a weighted average risk. Securities included in a portfolio are associated with each other.
Therefore, the portfolio risk also accounts for the covariance between the returns of securities. Covariance is the
product of the standard deviations of individual securities and their correlation coefficient.
 The portfolio risk in the case of a two-security portfolio can be computed as follows:

σ p2 = w 2σ x2 + (1 − w) 2 σ y2 + 2(w)(1 − w) Cov xy
= w 2σ x2 + (1 − w) 2 σ y2 + 2(w)(1 − w)σ xσ y Corxy

σ p = σ p2

 We may observe that the portfolio risk consists of the risk of individual securities plus the covariance between
the securities. Covariance depends on the standard deviation of individual securities and their correlation.
 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.
 The minimum variance portfolio is called the optimum portfolio. The following formula can be used to determine
the optimum weights of securities in a two-security portfolio:

σ y2 − Cov xy
wx* =
σ + σ y2 − 2 Cov xy
2
x

wx* is the optimum weight of security x and 1 – wx, of security y.

 Portfolio Theory and Assets Pricing Models 111

 In the case of a n-security portfolio, the portfolio risk can be calculated as follows:

1  1
σ p2 = × average risk + 1 −  × average covariance
n  n

 As the number of securities in the portfolio increases, the portfolio variance approaches the average covariance.
Thus, diversification helps in reducing the risk.
 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.
 For a given risk, an investor would prefer a portfolio with higher expected rate of return. Similarly, when
the expected returns are same, she would prefer a portfolio with lower risk. The choice between high risk-
high return or low risk-low return portfolios will depend on the investor’s risk preference. This is refereed
to as the mean-variance criterion.
 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.
 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.
 The optimum risky portfolio is the market portfolio of all risky assets where each asset is held in proportion
of its market value. It is the best portfolio since it dominates all other portfolios. An investor can thus mix her
borrowing and lending with the best portfolio according to her risk preferences. She can invest in two separate
investments—a risk free asset and a portfolio of risky securities. This is known as the separation theorem.
 Risk has two parts: unsystematic risk and systematic risk.
 Unsystematic risk can be eliminated through diversification. It is a risk unique to a specific security. When
individual securities are combined, their unique risks cancel out.
 Systematic risk cannot be eliminated through diversification. It is a market-related risk. It arises because individual
securities move with the changes in the market.
 Investors are risk-averse. They will take risk only if they are compensated for the risk, which they bear. Since
systematic risk cannot be eliminated through diversification, they will be compensated for assuming the
systematic risk.
 The market prices the risky securities in a manner that they yield higher expected returns than the risk-free
securities. The risk-averse investors can be induced to hold risky securities when they are offered a risk premium.
The capital market line (CML) defines this relationship. The equation for CML is:
 E ( Rm ) − R f 
E ( Rp ) = R f +  σ p
 σm 

where E (Rp) is the portfolio return, Rf the risk-free return, E (Rm) the return on market portfolio, σm the standard
deviation of market portfolio and σp the standard deviation of the portfolio.
 The model explaining the risk-return relationship is called the capital asset pricing model (CAPM). It provides
that in a well-functioning capital market, the risk premium varies in direct proportion to risk.
 CAPM provides a measure of risk and a method of estimating the market’s risk-return line. The market (systematic)
risk of a security is measured in terms of its sensitivity to the market movements. This sensitivity is referred to
as the security’s beta.
 A line known as the characteristics line can represent the relationship between the security returns and the market
returns. The slope of the characteristics line is the sensitivity coefficient, which, as stated earlier, is referred to
as beta.
 Beta reflects the systematic risk, which cannot be reduced. Investors can eliminate unsystematic risk when they
invest their wealth in a well-diversified market portfolio. A beta of 1.0 indicates average level of risk while more
than 1.0 means that the security’s return fluctuates more than that of the market portfolio. A zero beta means
no risk.
112 Financial Management

 The expected return on a security is given by the following equation:

E (R j ) = R f + (Rm − R f ) β j

where Rf is the risk-free rate, Rm the market return and the measure of the security’s systematic risk. This equation
gives a line called the security market line (SML).
 In terms of the security market line, beta is the ratio of the covariance of returns of a security, j, and the market
portfolio, m, to the variance of return of the market portfolio:
Cov jm σ jσ mCorjm σj
βj = = 2
= × Corjm
Varm σ m σm
where βj is beta of the security, σj the standard deviation of return of security, σm the standard deviation of
returns of the market portfolio, σ2m the variance of returns of the market portfolio m and Corjm the correlation
coefficient between the returns of the security j and the market portfolio m.
 CAPM is based on a number of restrictive assumptions. The most significant assumption being that an investor
is compensated for a security’s systematic risk that is entirely captured by the security’s beta.
 The differences of securities’ returns may not be fully explained by their betas. The arbitrage pricing theory (APT),
resulting from the limitations of CAPM, assumes that many macro-economic factors may affect the system risk
of a security (or an asset). Thus, APT is a multi-factor model to explain the return and risk of a security. The
factors influencing security return may include industrial production, growth in gross domestic product, the
interest rate, inflation, default premium, and the real rate of return.
 The French-Foma three-factor model specifies that it is not just the beta but beta along with size and price-to-
book value which explain the portfolio returns. Thus, it questions the validity of CAPM as a standalone model.

KEY CONCEPTS
Arbitrage Portfolio opportunity set Efficient portfolio Risk-free rate of return
Arbitrage pricing theory Portfolio return Expected rate of return Risk-free security
Beta Portfolio risk Lending rate Security market line
Borrowing rate Portfolio theory Limits of diversification Separation theorem
Capital asset pricing model Principle of dominance Market portfolio Standard deviation
Capital market line Return Mean-variance analysis Subjective probability
Characteristics line Reward-risk ratio Minimum portfolio variance Systematic or market risk
Correlation coefficient Risk Objective probability Unsystematic or unique risk
Covariance Risk diversification portfolio Variance
Efficient frontier Risk premium

STUDENT’S ACTIVITIES

How much should the correlation coefficient be to bring

ILLUSTRATIVE SOLVED PROBLEMS the portfolio risk to the desired level?
PROBLEM 5.1 An investor holds two equity shares SOLUTION: The portfolio return is:
x and y in equal proportion with the following risk and E (Rp ) = 24 (0.5) + 19 (0.5) = 12 + 9.5 = 21.5%
return characteristics:
E (Rx ) = 24%; E (Ry ) = 19% and the portfolio risk is:

σ x = 28%; σ y = 23% σ p = σ p2
σ p2 = (28)2 (0.5)2 + (23)2 (0.5)2 + 2 (0.5) (0.5) (28) (23) (0.6)
The returns of these securities have a positive
correlation of 0.6. You are required to calculate the = 196 + 132.25 + 193.2 = 521.45
portfolio return and risk. Further, suppose the investor σ p = 521.45 = 22.84%
wants to reduce the portfolio risk (σp) to 15 per cent.
 Portfolio Theory and Assets Pricing Models 113
If the investor desires the portfolio standard deviation SOLUTION:
to be 15 per cent, the correlation coefficient will be as (a) It depends on your preference and risk-taking
computed below: attitude.
(15)2 = (28)2 (0.5)2 + (23)2 (0.5)2 + 2 (0.5)(0.5)(28)(23) Corxy (b) You can achieve diversification gains if you invest
225 = 196 + 132.25 + 322 Corxy in both.
(c) The slopes of the capital market line for two funds
−103.25
Corxy = = −0.321 are: aggressive fund = (16 – 10)/20 = 0.30; and
322 conservative fund: (13 – 10)/15 = 0.20. Aggressive
PROBLEM 5.2 A portfolio consists of three securities fund is preferable.
P, Q and R with the following parameters: (d) You would receive benefits of diversification if you
invest in both funds and also lend and borrow.
P Q R Cor.
Expected return (%) 25 22 20 PROBLEM 5.6 P Ltd has an expected return of 22
Standard deviation (%) 30 26 24 per cent and standard deviation of 40 per cent. Q Ltd. has
Correlation: an expected return of 24 per cent and standard deviation
PQ – 0.50 of 38 per cent. P has a beta of 0.86 and Q 1.24. The
QR + 0.40 correlation between the returns of P and Q is 0.72. The
PR + 0.60 standard deviation of the market return is 20 per cent.
(a) Is investing in Q better than investing in P? (b) If you
If the securities are equally weighted, how much is the invest 30 per cent in Q and 70 per cent in P, what is
risk and return of the portfolio of these three securities? your expected rate of return and the portfolio standard
SOLUTION: The portfolio return is: deviation? (c) What is the market portfolio’s expected rate
E (Rp ) = (25)(1 / 3) + 22(1 / 3) + 20(1 / 3) = 22.33% of return and how much is the risk-free rate? (d) What
is the beta of portfolio if P’s weight is 70 per cent and
σ p2 = (30)2 (1 / 3)2 + (26)2 (1 / 3)2 + (24)2 (1 / 3)2 Q is 30 per cent?
+2(1 / 3)(1 / 3)(−0.5)(30)(26) SOLUTION:
+2 (1 / 3)(1 / 3) (0.4)(26)(24) (a) P has lower return and higher risk than Q. The
+2 (1 / 3)(1 / 3)(0.6)(30)(24) choice of an investor will depend on his/her risk
preference. However, investing in both will yield
= 100 + 75.11 + 64 − 86.67 + 55.47 + 96 = 303.91 diversification advantage.
σ p = 303.91 = 17.43% (b) rpq = 22 × 0.7 + 24 × 0.3 = 22.6%
2
σ pq = 402 × 0.72 + 382 × 0.32 + 2 × 0.7
PROBLEM 5.3 From the following data compute
beta of security j: × 0.3 × 0.72 × 40 × 38 = 1374
2
σ j = 12%; σ m = 9% and Corjm = + 0.72 σ pq = σ pq = 1374 = 37%

SOLUTION: (c) The risk-free rate will be the same for P and Q.
Their rates of return are given as follows:
σ jσ mCorjm 12 × 9 × 0.72 77.76 rp = 22 = rf + (rm − rf ) 0.86
βj = 2
= = = 0.96
σ m 92 81 rq = 24 = rf + (rm − rf ) 1.24
PROBLEM 5.4 Calculate the expected rate of return rp − rq = −2 − (rm − rf )(−0.38)
for security i from the following information: rm − rf = −2 / −0.38 = 5.26%
R f = 10%; Rm = 18%; β i = 1.35 rp = 22 = rf + (5.26) 0.86
SOLUTION: The expected return of security i will be: rf = 22 – 4.5 = 17.5%
E (Ri ) = R f = (Rm + R f ) β i = 10% − (18% + 10%) 1.35 rq = 24 = rf + 5.26 × 1.24
= 10% − 10.8% = 20.8% rf = 24 − 6.5 = 17.5%
PROBLEM 5.5 An aggressive mutual fund promises Similarly, rp = 22 = 17.5 + (rm − 17.5) . 86
an expected return of 16 per cent with a possible volatility
= 22 = 17.5 + .86 rm − 15.1
(standard deviation) of 20 per cent. On the other hand,
a conservative mutual fund promises an expected return rm = (22 − 17.5 + 15.1) / .86
of 13 per cent and volatility of 15 per cent. (a) Which = 22.8%
fund would you like to invest in? (b) Would you like to Similarly, rq = 24 = 17.5 + (rm − 17.5) 1.24
invest in both if you have money? (c) Assuming you can
borrow money from your provident fund at an opportunity = 24 = 17.5 + 1.24 rm − 21.7
cost of 10 per cent, which fund you would invest your rm = (24 − 17.5 + 21.7) / 1.24
money in? (d) Would you consider both funds if you = 22.8%
could lend or borrow money at 10 per cent?
(d) β pq = β p × w p × β q × w q
= 0.86 × 0.7 + 1.24 × 0.3 = 0.974
114 Financial Management

REVIEW QUESTIONS

1. Illustrate the computation of the expected rate of return of an asset.

2. What is risk? How can risk of a security be calculated? Explain your answer with the help of an example.
3. What is a portfolio? How is the portfolio return and risk calculated for a two-security portfolio?
4. Does diversification reduce the risk of investment? Explain with an example.
5. Define systematic and unsystematic risks. Give examples of both.
6. Explain the principle of dominance. Define the efficient portfolio and efficient frontier.
7. What is the portfolio theory? Explain the assumptions and principles underlying the portfolio theory?
8. What is the capital asset pricing model? Explain its assumptions and implications.
9. Explain the security market line (SML) with the help of a figure. How does it differ from the capital market line?
10. What is beta? How is it measured? How do you calculate the expected rate of return of a security?
11. Explain the logic of the arbitrage-pricing theory (APT)? How does it compare and contrast with CAPM?
12. Explain the meaning and significance of the Fama-French three-factor model. How does it differ from CAPM
and APT?

QUIZ EXERCISES

1. You hold your investment in two assets—X and Y—in proportions of 60 per cent and 40 per cent respectively.
You expect a return of 12 per cent from X and 14 per cent from Y. What is your return from the portfolio
of X and Y?
2. Your return on HUL’s share may either yield a return of 24 per cent with 75 per cent chance or 7 per cent
with 25 per cent chance. What is your expected return?
3. You have investments in assets A and B. You have equal chances of earning either 24 per cent or 12 per
cent or 6 per cent on A and either 33 per cent or 9 per cent or –6 per cent on B under three different
economic situations. Calculate (i) expected return and variance of the expected return for A and B; (ii)
covariance of the expected returns of A and B.
4. The correlation between the returns of assets L and M is 0.60. The standard deviations of returns of L and
M are respectively 8 and 12. Calculate covariance of returns of L and M.
5. The covariance between the returns of assets P and Q is –33. The standard deviations of returns of P and
Q are respectively 5.8 and 7.6. Calculate correlation of returns of P and Q.
6. Security C has expected return of 20 per cent and standard deviation of 25 per cent. On the other hand,
security D has expected return of 24 per cent and standard deviation of 25 per cent. Both securities have
equal weights in the portfolio. Calculate the portfolio variance if the correlation is (i) 0.00; (ii) 0.20; (iii)
0.80 and (iv) –0.20. What inferences do you make from the calculations?
7. The risk-free rate of return is 6 per cent. The market rate of return is 12 per cent with a standard deviation
of 8 per cent. If you desire to earn a rate of return of 10 per cent, in what proportion should you hold
market portfolio and the risk-free asset?

PROBLEMS

1. An asset has the following possible returns with Security X Security Y

associated probabilities: Return Probability Return Probability
Possible returns 20% 18% 8% 0 –6% 30% 0.10 –20% 0.05
Probability 0.10 0.45 0.30 0.05 0.10 20% 0.20 10% 0.25
10% 0.40 20% 0.30
Calculate the expected rate of return and the
5% 0.20 30% 0.30
standard deviation of the rate of return.
–10% 0.10 40% 0.10
2. Securities X and Y have the following
characteristics: You are required to calculate (a) the expected return
and standard deviation of return for each security
 Portfolio Theory and Assets Pricing Models 115
(b) the expected return and standard deviation of You are required (a) to determine the expected
the return for the portfolio of X and Y, combined covariance of returns and (b) the correlation
with equal weights. of returns between the Sunrise and Sunset
3. The distribution of returns for share P and the companies.
market portfolio M is given below: 7. Two shares, P and Q, have the following expected
returns, standard deviation and correlation:
Returns (%)
Probability P M E(rP) = 18% E(rQ) = 15%
0.30 30 –10 σP = 23% σQ = 19%
0.40 20 20 Cor σPQ = 0
0.30 0 30
(a) Determine the minimum risk combination
You are required to calculate the expected for a portfolio of P and Q.
returns of security P and the market portfolio, (b) If the correlation of returns of P and Q is
the covariance between the market portfolio and –1.0, then what is the minimum risk portfolio
security P and beta for the security. of P and Q ?
4. The standard deviation of return of security Y 8. The following information relates to two securities:
is 20 per cent and of market portfolio is 15 per X and Y:
cent. Calculate beta of Y if
X Y
(a) Cory, m = 0.70,
(b) Cory,m = + 0.40, and (c) Cory, m = – 0.25. Expected return (%) 20 25
5. An investor holds a portfolio, which is expected Standard deviation (%) 30 40
to yield a rate of return of 18 per cent with Beta 0.85 1.20
a standard deviation of return of 25 per cent.
The correlation between the returns of two
The investor is considering of buying a new
securities is 0.75. The standard deviation of the
share (investment being 5 per cent of the total
market return is 20 per cent.
investment in the new portfolio). The new share
(a) Calculate the expected returns and standard
has the following distribution of return:
deviation of the portfolio of X and Y if you
Return Probability invest 40 per cent in X and 60 per cent in Y.
(b) How much is risk-free rate and how much
40% 0.3
is the market rate of return?
30% 0.4
(c) Calculate the portfolio (X and Y) beta if you
–10% 0.3 invest 60 per cent in X and 40 per cent in Y.
If the correlation coefficient between the returns of (d) Calcualte the slope of CML.
the new portfolio and the new security is +0.25, 9. A study shows that the factors that influence the
calculate the portfolio return and the standard stock return include GDP growth, inflation, interest
deviation of return of the new portfolio. rate, stock market index and industrial growth. Global
6. The Sunrise and Sunset companies have the Ltd has the following information about its stock:
following probability distribution of returns: Beta Expected Actual
Returns (%) value (%) value (%)

Economic GDP growth 1.8 8.5 6.7

conditions Probability Sunrise Sunset Inflation 1.4 7.0 9.0
Interest rate 0.8 9.5 10.0
High growth 0.1 32 30
Normal growth 0.2 20 17 Stock market index 2.10 10.0 12.5
Slow growth 0.4 14 6 Industrial growth 1.95 11.0 8.5
Stagnation 0.2 –5 –12 Assume risk-free return is 8.5 per cent. Calculate
Decline 0.1 –10 –16 total return of the company’s stock.

PRACTICAL PROJECT

Collect data on monthly closing share prices of State Bank covariance of the share returns of two companies. How
of India and ICICI Bank for past two years. Calculate much is the correlation between the returns of the two
the returns as change in the closing share prices. Now companies? Explain your calculations.
calculate the average returns, standard deviations and