Module 6 - Portfolio Management and CAPM

SCHOOL OF ACCOUNTANCY
“Empowerment Solutions For Accountancy Professionals”
2021
(CMAA030)
UNIVERSITY OF LIMPOPO
Management Accounting and Finance III

Portfolio
Module 16
and CAPM
Management
Management Accounting & Finance ll
Portfolio Management and CAPM
Learning Objectives
1. Understand the background of portfolio theory
2. Understand the “efficient frontier”
3. Explain the investor’s attitude to risk
4. Explain the investor’s expected return, required return
and how these are influenced by risk
5. Understand and assess single asset and portfolio risk
and return
6. Explain the effects of diversification on portfolio risk
7. Explain systematic (and beta coefficient) and
unsystematic risk
8. Explain derivation of the CAPM model
SCHOOL OF ACCOUNTANCY Concept of risk and return
• The principal objective of a rational investor is to
maximise the return on an investment or a

portfolio of investments for a given level of risk.
• Return of an individual or a portfolio of
investments includes capital
appreciation/depreciation in value of a portfolio
as well income (e.g Dividends/Interest)
• How can one maximise returns with the lowest
possible risk?
What is Modern Portfolio Theory?
Learning Outcome 1: Portfolio Theory
• Source:https://
www.investopedia.com/terms/m/modernportfoliotheory.asp
• “A theory on how risk-averse investors can construct portfolios
to optimize or maximize expected return based on a given level
of market risk, emphasizing that risk is an inherent part of
higher reward.”
• “According to the theory, it's possible to construct an "efficient
frontier" of optimal portfolios offering the maximum possible
expected return for a given level of risk.”
• This theory was pioneered by Harry Markowitz in his paper
"Portfolio Selection," published in 1952 by the Journal of
Finance. He was later awarded a Nobel prize for developing the
MPT.
Learning Outcome 1: What is efficient frontier
• Different combinations of securities produce

different levels of return.
• The efficient frontier represents the best
combination of these securities i.e those that
produce the maximum expected return for a
given level of risk. The efficient frontier is the
basis for modern portfolio theory
What is efficient frontier
What is efficient frontier
investor
Risk averse
Risk-Pro
Investors’ attitudes to risk
SCHOOL OF ACCOUNTANCY How do we measure risk and expected
“Empowerment Solutions For Accountancy Professionals” return?
• Risk is measured by the portfolio standard
deviation of its expected return.
• Expected return of a portfolio includes
capital appreciation/depreciation in value of
a portfolio as well income (e.g
Dividends/Interest)
Class Example: Expected Return of a single asset
• You own a share that has the following

probability/return characteristics, based on
future scenarios regarding the state of the
economy
State of economy Probability Rate of return
Recession 0.3 -7%
Normal 0.6 13%
Boom 0.1 23%
What is the expected return on the share?

SCHOOL OF ACCOUNTANCY Solution: Expected Return of a single asset
• You own a share that has the following
probability/return characteristics, based on
future scenarios regarding the state of the
economy
State of Probability Rate of return Expected
economy return
Recession 0.3 -7% -2.1%
Normal 0.6 13% 7.8%
Boom 0.1 23% 2.3%
8%
Class Example: Expected return on a two asset
SCHOOL OF ACCOUNTANCY portfolio
The probability distribution of the returns of a
two asset portfolio is as follows

Year Probability Return: Asset A Return: Asset B
1 0.2 5% 50%
2 0.3 10% 30%
3 0.3 15% 10%
4 0.2 20% -10%
There is a 50:50 split between asset A and B in

the portfolio
Calculate the expected return on a two-
asset portfolio
Solution: Expected return on a two asset
portfolio
Year Probability Return: Expected Return: Expected

Asset A Return Asset B return
1 0.2 5% 0.2 x5% 50% 0.2x50%
2 0.3 10% 0.3x10% 30% 0.2x30%
3 0.3 15% 0.3x15% 10% 0.3x10%
4 0.2 20% 0.2x20% -10% 0.2x-10%
12.5% 20%
Therefore expected return (12.5% x50%) +

(16.25%x50%) => 16.25%
Risk of a single asset
The standard deviation measures the dispersion/spread of possible

outcome/data around the mean/expected return, therefore a measure of
risk
Class Example: Standard deviation
• You have obtained the following sample historic data

indicating the return on Memeza Ltd share price:
Year Returns
2018 6%
2017 -10%
2016 4%
2015 23%
2014 12%
• Calculate the average return (mean) of the share over

the past five years
• Calculate the variance and standard deviation of the
share over the past five years
SCHOOL OF ACCOUNTANCY Solution
• You have obtained the following sample historic data
indicating the return on Memeza Ltd share price:

Year Returns Variance Variance ²
2018 6% 6%-7% = -1% 1%
2017 -10% -10%-7% = -17% 289%
2016 4% 4%-7% = -3% 9%
2015 23% 23%-7% = 16% 256%
2014 12% 12%-7% = 5% 2%
Mean 7% Variance =
580%/(5-1) =
145*
• *Note: Sample and not population

• √145 = 12.04
“Empowerment Solutions For Accountancy Professionals” Risk of two stand alone assets/projects
• Coefficient of variation measures the risk per R1 of

return
• When comparing the risk two stand-alone assets/,

standard deviation cannot be used,why?
SCHOOL OF ACCOUNTANCY Class Example: Risk of two stand alone
assets/projects
• A company is considering two independent
investment opportunities as follows:
Project A Project B
Investment Capital R500 000 R500 000
Project Life 1 Year 1 Year
• Estimated cash flows

Probability: A Cash flow: A Probability: B Cash flow: B
0.25 600 000 0.25 200 000
0.5 700 000 0.5 800 000
0.25 800 000 0.25 1000 000
• Which investment would you choose?

SCHOOL OF ACCOUNTANCY Solution: Risk of two stand alone
“Empowerment Solutions For Accountancy Professionals” assets/projects
• Project A
Prob ER ER x Proba ER-Avg ER (ER-Avg
ER)exp2 x P
0.25 600 600 x 0.25 600 – 700 2 500
0.5 700 700 x 0.5 700 – 700 0
0.25 800 800 x 0.15 800 – 700 2 500
700 5 000
• Expected mean =>R700

• Variance = 5 000
• Standard deviation=√5000 = 70.71
• Coefficient of variation 70.71/700 = 0.1
SCHOOL OF ACCOUNTANCY Solution: Risk of two stand alone
“Empowerment Solutions For Accountancy Professionals” assets/projects
• Project B
Prob R R x Proba R-Avg R (R-Avg
R)exp2 x P
0.25 200 200 x 0.25 200 – 700 62 500
0.5 800 800 x 0.5 800 – 700 5 000
0.25 1000 1000 x 0.15 1000 – 700 22 500
700 90 000
• Expected mean =>R700

• Variance = 90 000
• Standard deviation = 300
• Coefficient of variation 300/700 = 0.43
SCHOOL OF ACCOUNTANCY Solution: Risk of two stand alone assets/projects
Note: The two projects have the same risk but different returns,
therefore choose the one with the lowest risk
Note: Two projects with same risk but different returns, choose
highest returns
Variance approach developed by Markowitz in 1952

SCHOOL OF ACCOUNTANCY Real returns from equities and bonds
“Empowerment Solutions For Accountancy Professionals” Returns are after adjusting for inflation
SCHOOL OF ACCOUNTANCY Systematic and unsystematic risk
Market risk( systematic risk) affects all players in the market place.
Changes in economic fundamentals (interest rates, exchange rates,

inflation, consumer demand etc.)
Measured by beta coefficient (A measure of a share’s volatility in relation to

the market as a whole).
The JSE/Market beta benchmark is 1, therefore is a share moves exactly

the same as the JSE All share index, it will have a beta of 1.
Therefore shares/portfolios with beta < 1 are less riskier and beta >1 riskier
than the market.
Firm specific risk (Unsystematic) associated with the basic functions of

organization (human skills, leadership, innovation, financing etc.)
NB. This risk can be avoided through diversification

Systematic/Market risk
SCHOOL OF ACCOUNTANCY Diversification
• Diversification is a strategy designed to reduce exposure to risk by combining, in a
portfolio, a variety of investments such as stocks, bonds, and real estate, which are
unlikely to move in the same direction
SCHOOL OF ACCOUNTANCY Diversification
• Diversification is a strategy designed to reduce exposure to risk by combining, in a
portfolio, a variety of investments such as stocks, bonds, and real estate, which are
unlikely to move in the same direction
Risk-
Risk-Pro
Averse
SCHOOL OF ACCOUNTANCY Capital Asset Pricing Model (CAPM)
CAPM derived from SML – SELF STUDY
R = Rf + B(E(Rm)-Rf)
R = Required rate of return

Rf = Risk free rate of return
B = Systematic risk for security (beta)
E(Rm) = Return on the market portfolio
(E(Rm)-Rf) = The market risk premium
Class Question
Match the risk measures to risk type
Risk Type Risk Measure

Total portfolio risk Beta
Systematic/Market risk Standard deviation
Unsystematic/Residual risk
Thank you!!

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SCHOOL OF ACCOUNTANCY

“Empowerment Solutions For Accountancy Professionals”

Management Accounting and Finance III

maximise the return on an investment or a

• Different combinations of securities produce

• You own a share that has the following

What is the expected return on the share?

two asset portfolio is as follows

There is a 50:50 split between asset A and B in

Year Probability Return: Expected Return: Expected

Therefore expected return (12.5% x50%) +

The standard deviation measures the dispersion/spread of possible

• You have obtained the following sample historic data

• Calculate the average return (mean) of the share over

indicating the return on Memeza Ltd share price:

• *Note: Sample and not population

• Coefficient of variation measures the risk per R1 of

• When comparing the risk two stand-alone assets/,

• Estimated cash flows

• Which investment would you choose?

• Expected mean =>R700

• Expected mean =>R700

Variance approach developed by Markowitz in 1952

Changes in economic fundamentals (interest rates, exchange rates,

Measured by beta coefficient (A measure of a share’s volatility in relation to

The JSE/Market beta benchmark is 1, therefore is a share moves exactly

Firm specific risk (Unsystematic) associated with the basic functions of

NB. This risk can be avoided through diversification

R = Required rate of return

Match the risk measures to risk type

Risk Type Risk Measure

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