Topic 8 - Risk And Return (CAPM)

This article is a topic within the subject Business Finance.

Required Reading

Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 330-366.

Computing Expected Returns

Computing Return Variance & Standard Deviation

Variation & standard deviation are measures of dispersion & volatility.

Portfolios as Assets

A portfolio is a collection of assets & its returns & risks are derived from the returns & risks of the underlying assets within the portfolio. The ASX is a collection/portfolio of stocks on the ASX. Hence, a portfolio of is an asset like a stock or bond.

Portfolio Returns

Portfolio Risk

Realised Returns vs. Expected Returns

Realised returns are usually not equal to expected returns. This difference is the realised return less the expected return.

The unexpected component is made up of systematic & unsystematic portions.

The Risk Of A Security And Diversification

Risk is the volatility of the returns of an asset.

• Total Risk of an Asset = Asset Market Risk + Asset Specific Risk

  • Market Risk is the macroeconomic risk that affects the overall stock market. It is often termed as systematic or non diversifiable risk e.g. unexpected changes in GDP
  • Asset Specific Risk is the risk that affects an individual company or asset. Often termed as unsystematic or diversifiable risk e.g. corporate fraud

• Diversification involves spreading investments across several assets to reduce asset specific risk (unsystematic). Systematic risk cannot be diversified. (positive/negative company specific announcements will tend to cancel each other out)

  • Thus reward for bearing risk is only related to systematic risk. Asset specific risks do not compensate investors as it can be diversified away at no costs (market does not reward risks borne unneccessarily).
  • Expected return on an asset depends only on that asset’s systematic risk

Measuring Market Risk And Beta

In diversified portfolio’s asset specific risk is irrelevant. Hence, we are interested how the asset is related to market risk. We want to relate asset risk premiums to the market risk premium. Beta, measures the amount of market risk in an asset relative to the risk of a perfectly diversified portfolio. Portfolio Beta is the weighted average of the betas of the securities within the portfolio.

Capital Asset Pricing Model (CAPM)

CAPM states that the expected risk premium on any asset is equal to the beta multiplied by the expected market risk premium (defines the relationship between risk & returns for any asset).

Expected Risk Premium = β × Expected Market Risk Premium

Expected returns depend on:

• Risk Free Rate = Time Value of Money
• Risk Premium = Depends on Beta (amount of systematic risk) & the Market Risk Premium (reward for bearing systematic risk) (Beta × (E(R_m) – Rf))

Example

Expected market rate of return = 14%, beta = 0.8 with expected rate of return of 12%, actual market return was 10%. What was the rate of return on the stock?

The Security Market Line

Assuming EMH, the risk reward ratio of all assets must be the same as they lie on the security market line.

End

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References

Textbook refers to Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010.