Risk & Return Example

The Alpha Value

If the CAPM is a realistic model (that is, it correctly reflects the risk-
return relationship) and the stock market is efficient (at least weak
and semi-strong), then the alpha values reflect a temporary abnormal
return. In an efficient market, the expected and required returns are
equal, ie a zero alpha. Investors are exactly compensated for the level
of perceived systematic risk in an investment, ie shares are fairly
priced. Arbitrage profit taking would ensure that any existing alpha
values would be on a journey towards zero.
 Oriel plc
Oriel plc is considering investing in one of two short-term portfolios of four
short-term financial investments. The correlation between the returns of the
individual investments is believed to be negligible (zero/independent/no
correlation). See Portfolio 1 and Portfolio 2. The market return is estimated to
be 15%, and the risk free rate 5%

Source
https://www.accaglobal.com/in/en/student/exam-support-resources/professional-exams-study-resources/p4/technical-articles/risk-return.html
 Required:
Estimate the risk and return of the two portfolios.
10 Key Points To Remember
1. The beta is a relative measure of systematic risk. It indicates the sensitivity of the return on a share
with the return on the market. If the market moves by 1% and a share has a beta of two, then the return on
the share would move by 2%.
2. We may have to calculate the beta from basic data using the following two different formulae:

3. The value of beta is normally between 0 and 2.5.

4. Ensure that you know how to calculate the required return using the CAPM formula:
RA = RF + (RM - RF) bA
as this is examined in every paper.
5. Be able to prepare an alpha table and to give investment advice based on alpha values:
Decision advice based on alpha values
Alpha            Have shares               Don’t have shares
+                   Hold                           Buy
-                    Sell                            Don’t buy
6. If CAPM is a realistic model and the market is efficient, an alpha value (a temporary abnormal return)
is on a journey towards zero.
7. Ensure that you are able to list the problems associated with CAPM.
8. APM suggests that a number of factors affect the risk-return relationship and in time, this model may
replace CAPM when more developments take place to improve its practical application.
9. Remember that the formula for a multi-asset portfolio with no correlation between the returns is:

10. The basic exam technique required for portfolio theory is the preparation of a summary table to aid
identification of the most efficient portfolio. Similarly, the key to applying CAPM is the preparation of
an alpha table to help identify the largest positive alpha value.