Models of Risk and

Return

Parvesh Aghi
CONCEPT

• Higher Expected Returns Require Taking

Higher Risk
• Most investors are comfortable with the
notion that taking higher levels of risk is
necessary to expect to earn higher returns.
• There are important models that have
been developed to make this relationship
precise. They are
1. CAPITAL ASSET PRICING MODEL
2. ARBITRAGE PRICING MODEL
3. MULTI FACTOR MODEL

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CAPITAL PRICING ASSET MODEL

A model that describes the relationship

between risk and expected return and
that is used in the pricing of risky
securities.
In this model, a security’s expected
(required) return is the risk-free rate
plus a premium based on the systematic
risk of the security

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CAPM MODEL

E(Ri) = Rf + bi(Rm - Rf)

E(Ri) = Expected return of stock i

Rf = Risk free return
bi = Beta relative to market portfolio

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As per CAPM the investors needs to be
compensated in two ways: time value of
money and risk

The time value of money is represented by

the risk-free (Rf ) rate in the formula and
compensates the investors for placing money
in any investment over a period of time

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The other half of the formula represents risk
and calculates the amount of compensation
the investor needs for taking on additional
risk.
This is calculated by taking a risk measure
(beta) that compares the returns of
the asset to the market over a period
of time and to the market premium (Rm-Rf ).

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The CAPM says that the expected return of a
security or a portfolio equals the rate on a
risk-free security plus a risk premium.

If this expected return does not meet or beat

the required return, then the investment
should not be undertaken.
The security market line plots the results of
the CAPM for all different risks (betas).

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Security Market line

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CAPM ASSUMPTIONS

1.Capital markets are efficient.

2. All investor are rational, risk averse and broadly diversified
across a range of investments. They cannot influence prices
and trade without transaction or taxation costs.
3. Risk-free asset return is certain.
4.Market portfolio contains only systematic risk
5. Assume all information is available at the same time to all
investors.
6. Investors have no access to private information
( allowing them to find undervalued or valued stock)

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Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk is the variability of return on stocks or

portfolios associated with changes in return on the
market as a whole.

Unsystematic Risk is the variability of return

on stocks or portfolios not explained by
general market movements.
It is avoidable through diversification

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UNSYSTEMATIC RISK

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SYSTEMATIC RISK

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What is BETA ?

Beta is used in the capital asset pricing model

(CAPM), a model that calculates the expected return of
an asset based on its beta and expected market returns

E(Ri) = Rf + bi(Rm - Rf)

A measure of the volatility, or systematic risk, of a

Security or a portfolio in comparison to the market as
a whole

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Beta is calculated using regression analysis,
and you can think of beta as the tendency
of a security's returns to respond to swings
in the market.
It measures the sensitivity of a stock’s returns to
changes in returns on the market portfolio

The beta for a portfolio is simply a weighted

Average of the individual stock betas in the
portfolio.
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A beta of 1 indicates that the security's price
will move with the market.
A beta of less than 1 means that the security
will be less volatile than the market.
A beta of greater than 1 indicates that the
security's price will be more volatile than
the market.
For example, if a stock's beta
is 1.2, it's theoretically 20% more volatile than
the market.

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BETA FORMULA

Beta : It is the ratio of covariance between

the market return and the security’s
return to the market return variance .

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 Calculating “Beta”
YEARS MARKET RETURN XYZ LTD RETURNS

Rm (%) Rx (%)

1 20 25

2 -18 -32

3 40 55

4 -8 -13

5 36 45
The standard procedure for estimating CAPM beta is to regress stock
Return against market returns
 ESTIMATION OF BETA
YEA MARKET XYZ LTD Market Stock
RS RETURN Rx % Deviation deviation (4) X (5) (Rm-Rm )²
% Rm-Rm Rx -Rx

(1) ( 2) (3) (4) (5) (6) (7)

1 20 25 6 9 54 36

2 -18 -32 -32 -48 1536 1024

3 40 55 26 39 1014 676

4 -8 -13 -22 -29 638 484

5 36 45 22 29 638 484

Rm=14 Rx=16 Sum= Sum=

Mean Mean 3880 2704
Beta Calculation

Multiply deviations of the market returns and

deviations of XYZ Ltd (column 6).
Take the sum and divide by 5 (no of observations) to
get covariance
COV m x = 3880/5 = 776

Calculate the squared deviations of the market returns

(column 7) Take the sum and divide by 5 to find the
variance of market return.
= 2704/5 = 540.8

Divide the covariance of the market and XYZ Ltd by the

Market variance to get beta
Beta = β = 776/ 540.8= 1.434 .
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INTERCEPT

The intercept term is given by the following formula

α = Rx – βxX Rm
Rx= expected return on security x
Rm= is the expected market return
α = return on security on account of unsystematic risk

α = 16 – 1.434 X 14
= 16 – 20.076
= - 4.076 % is the return from unsystematic risk
Thus the characteristic line of XYZ Ltd is :
Rx = -4.076 + 1.434 Rm

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We can plot the observed returns on market and
XYZ ltd and fit a regression line as shown in the
figure . The fitted line is as per the equation is ,
the regression line as per the market model & is called
The characteristics line

Security characteristic line (SCL) is a regression line,

plotting performance of a particular security or
portfolio against that of the market portfolio at every
point in time .The SCL is plotted on a graph where the
Y-axis is the return of the security and the X-axis
is the return of the market in general.

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Security Characteristic line

XYZ LTD RETURN

Rx = -4.076 + 1.434 Rm

Characteristic line

Slope = beta

MARKET RETURN

Characteristic Line
Security Characteristic line

The slope of the line is the security's beta, which is a

measure of systematic risk, determines the
risk-return tradeoff.

According to this metric, the more risk you take on

-as measured by variability in returns - the higher the
returns you can expect to earn.

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The Market Model

There is another proceedure for calculating Beta is the

use of the Market or Index model
In the market model, we regress returns on a security
against returns of the market index

The market model is given by following equation

Where Rx is the expected return on security x , Rm is
the market return. α is intercept , beta is the slope and
e is the error.
R   b R e
x x m x

Return = Unsystematic Risk (α) + Systematic risk (β )

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 Rx    b x Rm  ex
Equation

Rx= expected return on security x

Rm= is the expected market return
α = is intercept ,
β= slope of regression or beta
ex = is the error term

α Is indicates the return on the security when the

market return is zero . It could be interpreted as
return on security on account of unsystematic risk

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The value of β and α in the regression are given
by the following equations

Beta = β = N ∑XY – (∑X) ( ∑Y)

N ∑X² - ( ∑ X)²

X= market deviations
Y = stock’s deviations
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 EXAMPLE
MARKET STOCK
Year RETURN RETURN X Y XY X² Y²
1 20 25 6.00 9.00 54 36 81
2 -18 -32 -32.00 -48.00 1536 1024 2304
3 40 55 26.00 39.00 1014 676 1521
4 -8 -13 -22.00 -29.00 638 484 841
5 36 45 22.00 29.00 638 484 841
14.00 16.00
0 0 3880 2704 5588

∑X=0 ∑y=0 ∑XY=3880 ∑X²=2704

(∑X)²=0 N∑XY= 19400

= 19400- 0 = 19400 = 1.43

5X 2704 13520
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FUNDAMENTAL OF BETA

The beta for a company may be estimated from a

regression but it is dependent on the fundamental
decisions that the company has made on what
business to do, how much operating leverage to
use in the business, and the degree to which the firm
uses financial leverage
So beta of a company is based on three things
-Type of business
-The company’s degree of operational leverage
-The company’s financial leverage

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TYPE OF BUSINESS

Beta measures the risk of a company relative to the

market. That is how sensitive it is to the economic
situation. The more sensitive it is to the economic
Situation higher will be its beta
The cyclical and consumers discretionary company’s
will have higher Beta compared to non cyclical and
consumer staples companies

The company’s in housing , automobile, airlines, hotels

and real estate are very sensitive to economic
conditions, will have higher betas than companies that
are in food processing, pharmaceuticals and tobacco
, which are relatively insensitive to business cycles

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DEGREE OF OPERATIVE LEVERAGE

The degree of operating leverage depends upon the

Cost structure of a company .i.e the proportion of
fixed cost and total cost of a company.

A firm that has high operating leverage i.e. high fixed

cost relative to Total cost will have higher variability
in operating income (EBIT) that would a company
producing a similar product with low operating
leverage
The higher fluctuation in operating income will lead to
higher beta for the company with higher operating
leverage

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DEGREE OF FINANCIAL LEVERAGE

An increase in financial leverage will increase the equity

beta of a firm .The fixed interest payments on debt
Financing will increase EPS in better times and
Reduce it down in worst times
Higher leverage increases the variability of earning per
share and makes the equity investment riskier.
If all of the company’s market risk is borne by the
equity share holders And debt creates a tax benefit
to the company , then
βL = βu [1+ ( 1-t) D/E ]
βL= Levered Beta for equity in the company
βu = Unlevered beta of the company ( beta of company without any debt)

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Intuitively, we expect that as the leverage increases
– as measured by the debt –equity ratio . The equity
investors bear increasing amounts of market risk in
the company leading to higher betas .The tax factor in
the equation captures the benefit created by the
Tax deductibility of interest payments

The unlevered beta of a company is determined by the

types of businesses in which It operates and its
operating leverage

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The unlevered beta is called as asset beta ..because it
is calculated based on the assets owned by the
company

The equity beta is based on both the riskiness of

business and Degree of financial leverage of the
company

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Risk free returns = Rf

A risk-free asset is one where the investor knows

The expected return with certainty.
Therefore an asset is risk free whose actual returns
be equal to the expected return …..

In valuation, the time horizon is generally infinite,

leading to the conclusion that a long-term riskfree
rate will always be preferable to a short term rate, if
you have to pick one.

Ten year G-secs can be considered as Risk free

asset for CAPM

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Risk Premium = (Rm-Rf)

The risk premium in the capital asset pricing model

measures the extra return that would be demanded by
investors for shifting their money from a riskless
investment to an average risk investment
The difference between the expected return on a
market portfolio and the risk-free rate.

Risk premium is the minimum amount of money by

which the expected return on a risky asset must
exceed the known return on a risk-free asset, or the
expected return on a less risky asset, in order to
induce an individual to hold the risky asset rather
than the risk-free asset .
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APT

Arbitrage Pricing Theory

1976, Economist Stephen Ross

assume:
several factors affect E(R)
does not specify factors

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MACRO ECONOMIC FACTORS

Implications
E(R) is a function of several Macro
Economic factors, F each with its
own b .
E( R )  R f  b1F1  b2 F2  b3F3  ....  bN FN

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Arbitrage pricing theory (APT)

APT is a general theory of asset pricing that holds

that the expected return of a financial asset can be
modelled as a linear function of various
macro-economic factors , where sensitivity to changes
in each factor is represented by a factor-specific
beta coefficient.

The model-derived rate of return will then be used to

price the asset correctly - the asset price should
equal the expected end of period price discounted
at the rate implied by the model. If the price
diverges, arbitrage should bring it back into line .

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APT vs. CAPM

APT is more general

many factors
unspecified factors
CAPM is a special case of the APT
•1 factor
•factor is market risk premium
•It captures an assets exposure
to all market risk in one number ..Beta but at
the cost of making restrictive assumptions
•APM relaxes these assumptions.
•It allows for multiple sources of market risk
and asset to have different beta to source of
Market risk

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Multi-Factor Model

A financial model that employs multiple factors

in its computations to explain market phenomena
and/or equilibrium asset prices.
The multi-factor model can be used to explain
either an individual security or a portfolio of
securities.
It will do this by comparing two or more factors
to analyze relationships between variables and
the security's resulting performance.
E(R)= Rf + βGNP (E (RGNP)- Rf ) + βI ( E(RI)-Rf
……………. βƍ( E(Rƍ)- Rf)
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CONCLUSION

The CAPM, with its inherent simplicity, linking

market covariance risk to expected returns.

Its simplicity helps to build intuition around the

concept of modelling return as a function of risk.

The CAPM’s simplicity is also its greatest

shortcoming, as the underlying assumptions limit its
ability to explain and predict actual returns.

APM expands the capabilities of the model by adding

company specific risk factors - These factors in
concert explain most of the returns due to risk expos

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Sensex market return 2002-13 = 15%

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10 year Govt Bond ( 2002-13) = 8%

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»Market risk premium= Rm-Rf = 15% -8% =7%

»-

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THANK YOU

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MCQ SECTION

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Q1 Which of the following is on the horizontal axis
of the Security Market Line?
A. Standard deviation
B. Beta
C. Expected return
D. Required return

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Q2 Financial leverage may increase a
corporation’s risk because
A. operating income may stabilize
B. the firm has fixed obligations to meet
C. more common stock is outstanding
D. dividends must be paid

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Q3 What is the price of a stock estimated to pay a
dividend of $.60 next year, if the dividend growth
rate is 5% and the appropriate discount rate is
8%?
A. $18
B. $19
C. $20
D. $21

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Q4 If you were confident that the price of stock X
would drop dramatically within two months, which
of the following investment transactions would
yield the highest return on your investment?
A. Purchase stock X
B. Sell stock X short
C. Purchase a call on stock X
D. Purchase a put on stock X

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Q 5 Equity does NOT include
A. cash and paid-in capital
B. common stock and paid-in capital
C. paid-in capital and retained earnings
D. common stock, paid-in capital and retained
earnings

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Q 6 The net asset value of a mutual fund investing
in stock rises with
A. higher stock prices
B. lower equity values
C. an increased number of shares
D. increased liabilities

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Q7 The use of financial leverage by a firm may be
measured by the
A. ratio of debt to total assets
B. firm’s beta coefficient
C. firm’s retention of earnings
D. ratio of the price of the firm’s stock price to its
earnings

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Q8 Security returns
A. are based on both macro events and firm-
specific events.
B. are based on firm-specific events only.
C. are usually positively correlated with each
other.
D. A and B.
E. A and C.

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»Q9 . According to the Capital Asset Pricing Model
(CAPM) a well diversified portfolio's rate of return
is a function of
»A) unique risk.
»B) unsystematic risk
»C) market risk
»D) reinvestment risk.
»E) none of the above.

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»Q10. Your personal opinion is that security X has
an expected rate of return of 11%. It has a beta
of 1.5. The risk-free rate is 5% and the market
expected rate of return is 9%. According to the
Capital Asset Pricing Model, this security is
» A) underpriced.
» B) overpriced.
» C) fairly priced.
» D) cannot be determined from data provided.

» E) none of the above.

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»Q11 The risk-free rate is 5 percent. The
expected market rate of return is 11 percent. If
you expect stock X with a beta of 2.1 to offer a
rate of return of 15 percent, you should
»A) buy stock X because it is overpriced.
»B) sell short stock X because it is overpriced.
»C) sell stock short X because it is underpriced.
»D) buy stock X because it is underpriced.
»E) none of the above, as the stock is fairly priced.
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»Q12. The expected return – beta relationship of
the CAPM is graphically represented by
»A) the security market line.
»B) the capital market line.
»C) the capital allocation line.
»D) the efficient frontier with a risk-free asset.
»E) the efficient frontier without a risk-free asset.

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»Q13 .Your opinion is that security C has an
expected rate of return of 0.106. It has a beta of
1.1. The risk-free rate is 0.04 and the market
expected rate of return is 0.10. According to the
Capital Asset Pricing Model, this security is
» A) underpriced.
» B) overpriced.
» C) fairly priced.
» D) cannot be determined from data provided.

» E) none of the above.

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»Q14 Security A has an expected rate of return of
0.10 and a beta of 1.3. The market expected rate
of return is 0.10 and the risk-free rate is 0.04. The
alpha of the stock is
»A) 1.7%.
»B) -1.8%.
»C) 8.3%.
»D) 5.5%.
»E) none of the above
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ANSWER KEY

1.B
2. B
3. C
4. D
5. A
6. A
7. A
8. A
9. C
10 C
11 B
12 A
13 C
14 B

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