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Advanced Financial Management

MAF - 581

Abraham G. (Assistant Professor)

 Chapter One
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Risk, Return, and Asset Pricing

Models

 Required readings:
 Ehrhardt, M.C. Brigham, E. F. (2011), Financial Management: Theory
and Practice, 13th Ed., South-Western Cengage Learning. (Chapter 6, 24)
 Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan (2013),
Fundamentals of Corporate Finance, 10 th ed. McGraw-Hill. (Chapter 13)
 Return on Investments
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 Investment is the current commitment of resources

for a period of time in expectation of receiving future
resources greater than the current outlay.
 In order to part with their money, investors require
compensation for:
 The time resources committed
 The expected rate of inflation
 The uncertainty of the future payments

 The gain (or loss) from the investment is return on

investment .
 Cont’d……….
4

 Return on investment usually have two components.

 Cash collection while owning the investment - the

income component of return.

 The value of the asset (or investment) will often

change. In this case, there is a capital gain or

capital loss on the investment.
 Thus, return is measured by taking the income plus

the price change.

Rate of return = (Income + Capital gains)/Purchase
price
 Cont’d………
5

 The expected rate of return E(r) on investment is

the statistical measure of return; the sum of all
possible rates of returns for the same investment
weighted by probabilities:
n
E(r) =Σ pi × ri where; pi - probability of rate of return;
i=1 ri - rate of return.
 The decision of investment is based on the estimated
expected rate of return.
 Stand-Alone Risk
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 Risk is a chance that the actual outcome from an

investment will differ from the expected outcome.
 The more variable the possible outcomes that can
occur, the greater the risk.
 Stand-alone risk is the risk an investor would face if
s/he held only one asset.
 Risk of investments can be measured with the
common absolute measures used in statistics;
 Variance and Standard deviation
 Cont’d………
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Variance and Standard Deviation

 Measure the “spread” in returns

 The potential average deviation of each possible

investment rate of return from the expected rate of
return:
 How far the actual return deviates from the
average in a typical year?

 The greater the volatility, the greater the

uncertainty/risk
 Cont’d……..
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 Variance of actual returns=sum of squared

deviations from the mean/(number of observations –
1)
V = (Σ(ri – E(r))2/(N – 1)
 Standard deviation of expected returns = positive
square root of the expected variance
δ2 = Σ pi × [ ri - E(r) ]2
i=1
 They are similar measures of risk and can be used for
the same purposes in investment analysis; however,
standard deviation is used more often in practice.
 Cont’d……..
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Year Actual Average Deviation from the Squared

Return Return Mean (Average) Deviation
1 -.20 .175 -.375 .140625
2 .50 .175 .325 .105625
3 .30 .175 .125 .015625

4 .10 .175 -.075 .005625

Totals .70 / 4 = . .000 .267500

175
Variance = sum of squared deviations from the mean / (number of observations –
1)
= .26750 / (4-1) = .0892
 Cont’d……….
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 The larger the variance, the more the actual returns

tend to differ from the average return.
 The larger the variance or standard deviation, the
more spread out the returns will be.
 Cont’d………..
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Historical average returns, standard deviations, and

frequency distributions: 1926 – 2011.
Average Standard
Series Return Deviation Distribution
Large-company
stocks 11.7% 20.3
Small-company *

stocks 18.7 39.2

Long-term
corporate bonds 6.6 7.0
Long-term
government Bonds 5.5 9.3
Intermediate-term
government Bonds 5.4 5.8
U.S. Treasury
bills 3.6 3.1
Inflation 3.2 4.5
-90% 0% 90%
 Cont’d………..
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NB:
 The 1933 small-company stock total return was

142.9 percent.
 The standard deviation for small-stock portfolio is

more than 10 times larger than the T-bill portfolio’s

standard deviation.
 Risk Premium
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 Risk premium is the excess return required from an

investment in a risky asset over that required from a
risk-free investment.
 The “extra” return earned for taking a risk
 Treasury bills are considered as a risk-free

investment.
 Cont’d………
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Coefficient of Variation (CV)

 If a choice has to be made between two investments

that have the same expected returns but different

standard deviations, choose the one with the lower
standard deviation.
 Given a choice between two investments with the

same risk but different expected returns, investors

generally prefer the investment with the higher
expected return.
 But, how do we choose between two investments if

one has a higher expected return and the other a

 Cont’d………
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 Use the coefficient of variation (CV) to measure the

degree of risk,
CV = σ/r
 The coefficient of variation shows the risk per unit of
return, and it provides a more meaningful basis for
comparison than σ when the expected returns on two
alternatives are different.
 Return on Portfolio
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 Portfolio is a collection of investment vehicles

assembled to meet one or more investment goals.
 Growth-Oriented Portfolio: primary objective is

long-term price appreciation
 Income-Oriented Portfolio: primary objective is

current dividend and interest income

 Capital preserving Portfolio: primary objective is

getting marginal income without depleting capital

 Return on Portfolio is the weighted average of
returns on the individual assets in the portfolio.
 Cont’d……….
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Rp = w1r1 + w2r2 + w3r3 + w4r4

n
E R P    w
i1
i  E R i  

Where: E(RP) = expected portfolio return

wi = portfolio weight in portfolio asset i
E(Ri) = expected return for portfolio asset i

 Assume that a security analyst estimated the coming

year’s returns on the stocks of four large companies.
The investment is $1 million, divided among the
stocks.
 Cont’d……….
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 30% in Co. A (expected return of 15%), 10% in Co.

B (expected return of 12%), 20% in Co. C (expected
return of 10%), and 40% in Co. D (expected return
of 9%). The expected portfolio return is:
Rp = w1r1 + w2r2 + w3r3 + w4r4
= 0.3(15%) + 0.1(12%) + 0.2(10%) + 0.4(9%)

=11.3%
 Risk in a Portfolio
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 Portfolio risk is the risk an investor would face if s/he

held many assets.
 Standard Deviation (σ) of a portfolio return is
calculated using all individual assets in the portfolio.
 Unlike returns, the risk of a portfolio, σp, is generally
not the weighted average of the standard deviations
of the individual assets in the portfolio.
 σp will be smaller than the assets’ weighted σ , and it
is theoretically possible to combine stocks that are
individually quite risky as measured by their σ and
form a portfolio that is completely riskless, with σp =
 Cont’d……….
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 The reason assets can be combined to form a riskless

portfolio is that their returns move countercyclically
to each other when asset one returns fall, those of
other rise, and vice versa.
 The tendency of two variables to move together is
called correlation, and the correlation coefficient
measures this tendency.
 The symbol for the correlation coefficient is the

Greek letter rho, ρ (pronounced roe).

 Cont’d………
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 In statistical terms, the returns on Stocks A and B are;

 Perfectly negatively correlated, with ρ = −1.0.
 Perfectly positively correlated, with ρ = 1.0.
 Uncorrelated, with ρ = 0

 The correlation coefficient, ρ, can range from +1.0,

denoting that the two variables move up and down in
perfect synchronization, to –1.0, denoting that the
variables always move in exactly opposite directions.
 Cont’d……….
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n
p   (r
t 1
i ,t  ri , Avg )( r j , t  r j , Avg )

 n

  ri , t  ri , Avg  2  n

   r j , t  r j , Avg  2 

 t 1   tt 
 Returns on two perfectly positively correlated stocks
move up and down together, and a portfolio
consisting of two such stocks would be exactly as
risky as each individual stock.
 Thus, diversification does nothing to reduce risk if
the portfolio consists of perfectly positively
correlated stocks.
 Cont’d………..
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 When stocks are perfectly negatively correlated, all

risk can be diversified away.
 Cont’d………
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 In reality, almost all stocks are positively correlated,

but not perfectly so.
 Studies have estimated on average, the correlation
coefficient for the monthly returns on two randomly
selected stocks is in the range of 0.28 to 0.35.
 Under this condition, combining stocks into
portfolios reduces but does not completely eliminate
risk.
 Thus, diversification can reduce risk but not

eliminate it.
 A portfolio that provides the highest return for a
 Cont’d………
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 The risk of a portfolio declines as the number of

stocks in the portfolio increases.
 In general, there are higher correlations
 Between the returns on two companies in the same

industry than for two companies in different

industries.
 Among similar “style” companies, such as large

versus small, and growth versus value.

 Thus, to minimize risk, portfolios should be
diversified across industries and styles.
 Cont’d……..
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 Financial data shows,

 σ of a one-stock portfolio (or an average stock), is
1
approximately 35%.
 However, a portfolio consisting of all stocks,

which is called the market portfolio, have a σM of

20%.
 Thus, almost half of the risk inherent in an average
individual stock can be eliminated if the stock is held
in a reasonably well-diversified portfolio.
 The risk that can be eliminated is called diversifiable
risk, while the part that cannot be eliminated is called
 Cont’d………
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 Diversifiable risk is caused by random events like

lawsuits, strikes, unsuccessful marketing programs,
losing a major contract, and others that are unique to
a particular firm.
 Their effects on a portfolio can be eliminated by

diversification; bad events in one firm will be

offset by good events in another.
 Market risk stems from factors that are systematically
affects most firms and cannot be eliminated by
diversification: war, inflation, recessions, and high
interest rates.
 Cont’d………..
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 Diversifiable risk is also known as company-specific,

or unsystematic risk.
 Market risk is also known as non-diversifiable,
systematic; it is the risk that remains after
diversification.
 Cont’d…………
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 Cont’d………
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 2
p   A2  A2   B2  B2  2 A  B  A B CORR ( R A R B )

 Where: wA = portfolio weight of asset A

wB = portfolio weight of asset B
wA + wB = 1
 Cont’d……….
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 The other important measurement of relationships

between two assets in portfolio creation is
covariance.
 Covariance is the expected product of the deviations
of two returns from their means.
 The covariance between expected Ri and Rj is:
Cov (Ri, Rj) = E [(Ri - E [Ri])(Rj - E [Rj])]
 Covariance from Historical Data:
Cov (Ri, Rj) = ∑t (Ri,t - Ri)(Rj,t - Rj)
2 2 2 2 2 T – 1
        2  COV ( A, B )
p A A B B A B
 Cont’d……….
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Example
 The returns and risk of Johnson & Johnson (JNJ),

International Business Machines Corp. (IBM), and

Boeing Co. (BA), for April 2001 to April 2010 are;
 Cont’d……….
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 The weights are 20.87% in JNJ, 46.93% in IBM, and

32.2% in BA company.
 The return on this portfolio is:
R p   0.2087   0.0080   0.4693  0.0050    0.3220  0.0113
 0.76%
 The risk on portfolio:
 p2   0.2087  0.0025   0.4693  0.0071   0.3220  0.0083
2 2 2

 2 0.2087  0.4693  0.0007  2 0.2087  0.3220  0.0007  2 0.4693  0.3220  0.0006

 0.00302

σp = 5.495%
 Market Risk
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Market risk of a stock is measured by beta

coefficient.
 It measures a stock’s tendency to move up and

down with the market.

bi = (σi/σM)ρiM
Where; bi - beta coefficient of Stock i
ρiM - correlation between Stock i’s R and the market
R
σi - standard deviation of Stock i’s return
σM - standard deviation of the market’s return.
 Cont’d……….
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 If beta of a given stock equals 1.0, the stock is as

risky as the market, assuming it is held in a
diversified portfolio.
 If beta is less than 1.0 then the stock is less risky

than the market;

 If beta is greater than 1.0, the stock is more risky

than the market.

 Most stocks have betas in the range of 0.50 to 1.50.
 The beta of a portfolio is a weighted average of the
individual securities’ betas.
bp = w1b1 + w2b2 +…+ wnbn
 Risk and Return Relationships
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 Have positive relationship between them. The higher

the risk the higher the return.
 The market risk premium, RPM, is the premium that
investors require for bearing the risk of an average
stock, and it depends on the degree of risk aversion
that investors on average have.
 The reward for bearing risk depends only on the
systematic risk of an investment since unsystematic
risk can be diversified away.
RPM = RMkt − RRF
 Capital Asset Pricing Model
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 It specifies the relationship between a risk and

required rates of return on well-diversified portfolios.
 CAPM was developed by Harry Markowitz in 1959.
 The assumptions underlying the CAPM’s
development;
 All investors focus on a single holding period, and

they seek to maximize the expected utility.

 All investors can borrow or lend an unlimited

amount at a given risk-free rate of interest.

 All investors have identical estimates of the

expected returns, variances, and covariances

 Cont’d………..
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 All assets are perfectly divisible and perfectly

liquid.
 There are no transaction costs.
 There are no taxes.
 All investors are price takers (assume their own
buying and selling activity will not affect stock
prices).
 The quantities of all assets are given and fixed.
 Cont’d………
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 The CML specifies the relationship between risk and

return for an efficient portfolio, but investors and
managers are more concerned about the relationship
between risk and return of individual assets.
 SML specifies the relationship between risk and
return of individual assets.
ri = rRF + (rM – rRF)bi
= rRF + (RPM)bi
 SML is the representation of the CAPM. It displays
the expected rate of return of an individual security
as a function of systematic risk.
 Cont’d………
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 Cont’d……….
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 Unlike the CML for a well-diversified portfolio, the

SML indicates that the σi of an individual stock
should not be used to measure its risk, because some
of the risk as reflected by σi can be eliminated by
diversification.
 Beta reflects risk after taking diversification benefits
into account and so beta, rather than σi, is used to
measure individual stocks’ risks to investors.
 Cont’d………
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 Suppose the risk-free rate is 4%, the market risk

premium is 8.6%, and a stock has a beta of 1.3.
Based on the CAPM, what is the expected return on
this stock? What would the expected return be if the
beta were to double?
ri = rRF + bi(rM – rRF)
= 4% + 1.3*8.6%
= 15.18%
ri = rRF + bi(rM – rRF)
= 4% + 2.6*8.6%
= 26.36%
 Arbitrage Pricing Theory (APT)
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 CAPM is a single factor model that specifies risk as a

function of only one factor, the security’s beta.

 The risk–return relationship is more complex, with a

stock’s required return a function of more than one
factor.
 Ross (1976) has developed APT that includes a
number of risk factors, so the required return be a
function of two, three, four, or more factors.
 Cont’d……..
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 APT model
ri = rRF + (r1 – rRF)bi1 + . . . + (rj – rRF)bij
ri = required rate of return on Stock i:
bi = sensitive only to economic Factor:
Example
 Assume that all stocks’ returns depend on inflation,

industrial production, and the aggregate degree of

risk aversion (the cost of bearing risk, which we
assume is reflected in the spread between the yields
on Treasury and low-grade bonds).
 Cont’d………
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 The risk-free rate is 8.0%;

 The required rate of return is 13% on a portfolio with
unit sensitivity to inflation;
 The required return is 10% on a portfolio with unit
sensitivity to industrial production;
 The required return is 6% on a portfolio with unit
sensitivity to the degree of risk aversion.
 Assume that Stock i has factor sensitivities (betas) of
0.9 to inflation portfolio, 1.2 to industrial production
portfolio, and −0.7 to the risk-bearing portfolio.
 Cont’d……….
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 Stock i’s required rate of return, according to APT

would be;
ri = 8% + (13% − 8%)0.9 + (10% − 8%)1.2 + (6% −
8%)(−0.7)
= 16.3%
 If the required rate of return on the market were

15.0% and if Stock i had a CAPM beta of 1.1, then

its required rate of return, according to the SML,
would be;
ri = 8% + (15% − 8%)1.1
= 15.7%
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The End!

Thank You!