Topic 6: Risk and Return

6.1 Understanding of Returns

The return received on an investment in stocks and bonds or any other financial investment, comes in
two forms; dividend and capital gain (loss).
Supposing you purchased 100 shares of stock at the beginning of the year at a price of Ksh. 37 per
share. Your total investment, then, would be;
Ksh. 37 x 100 = Ksh. 3,700
Suppose that over the year the stock paid a dividend of Ksh. 1.85 per share. During the year, then, you
would have received an income of;
Div = Ksh. 1.85 x 100 = Ksh. 185
Suppose that at the end of the year the market price of the stock is Ksh. 40.33 per share.
Because the stock increased in price, you have a capital gain of;
Gain = (Ksh. 40.33 – Ksh. 37) x 100 = Ksh. 333
Total return = Dividend income + Capital gain (or loss)
Total return = Ksh. 185 + Ksh.333 = Ksh. 518

6.1.1 Percentage Returns

It is more convenient to summarize the information about returns in percentage terms than in money.
The percentage format gives us the return rate for each shilling invested. Let t stand for the year we
are looking at, let Pt be the price of the stock at the beginning of the year, and let Divt be the dividend
paid on the stock during the year.
6.1.2 Dividend Yield
Divt
Dividend Yield =
pt
1.85
Dividend Yield = = 0.05 = 5%
37
6.1.3 Capital Gain/Loss
Capital gain is the change in the price of the stock divided by the initial price. Let Pt+1 be the price of
the stock at year-end. The capital gain can be computed as;
P − Pt
Capital gain = t +1
Pt
40.33 − 37
Capital gain =
37
3.33
Capital gain = = 0.09 = 9%
37
Combining these two results, we find the total return on the investment, Rt+1.
Divt +1 ( Pt +1 − Pt )
Rt +1 = +
Pt Pt
Rt +1 = 5% + 9%

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 Rt +1 = 14 %
Rt+1 denotes the returns of the stocks at year-end.

6.2 Capital Asset Pricing Model (CAPM)

CAPM is a model that provides a framework to determine the required rate of return on an asset and
indicates the relationship between return and risk of an asset. The required rate of return specified by
CAPM helps in valuing and asset. CAPM allows the analyst to split the total risk into systematic and
unsystematic risk.

Assumptions of CAPM
a) Market efficiency: CAPM assumes that the stock/share prices reflect all the available
information. In addition, individual investors are not able to appreciably affect the prices of
securities. This means that there is a large number of investors holding small amounts of
wealth.
b) Risk aversion and mean variance optimization: Investors are risk averse and they evaluate a
security`s return and risk in terms of expected returns and variance.
c) Homogeneity of expectations: All investors have same expectations about the expected returns
and risks of securities
d) Single time period: All investment decisions are based on a single time period
e) All investors can lend and borrow at a risk-free rate. Therefore the investors form portfolios
from publicly traded shares and bonds.
f) There are no transaction costs or income taxes.

Uses of CAPM

i) Predicting the return of an asset

ii) Determining the rate of return
iii) Using the security market line to determine the cost of equity capital
iv) Using beta factors to estimate the weighted average cost of capital
v) Valuation of securities
vi) Measurement of performance of mutual funds and other managed portfolio.

6.1.1 Expected Return ( R )

This is the return that an individual expects a stock to earn over the next period. Because this is only
an expectation, the actual return may either be higher or lower. There are two ways of arriving at the
expected return for a stock
a) It can be the average return (per period) a security has earned in the past :
1 1 n
R = ( R1 + R2 + ... + Rn ) =  Rt
n n t =1
Example 6.1

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 The following in information relates to HLD Company `s returns over ten years
Year 1 2 3 4 5 6 7 8 9 10
R 149.70 70.54 16.52 22.71 49.52 92.33 36.13 52.64 7.29 12.95
(%)
What’s the expected return?
1
R = (149.70 + 70.54 + 16.52 + 22.71 + 49.52 + 92.33 + 36.13 + 52.64 + 7.29 + 12.95) = 51.03
10
b) It can be based on a detailed analysis of a firm’s prospects, on some computer-based model,
or on special (or inside) information. For instance, there can be probabilities attached to each
of the returns to the security. This may be given by
n
R = R1 P1 + R2 P2 + ... + Rn Pn ) =  Ri Pi
i =1

Where Pi is the probability of occurrence of i

Example 6.2
Suppose the return to a security owned by Woodward Ltd is affected by economic
conditions as shown in the table below. Find R i
State of economy Return (%) Probability n
R =  Ri Pi
i =1

Growth 18.5 0.25 4.63

Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline -6.0 0.25 -1.50
6.00

6.2.2 Variance and Standard Deviation

These measures are used to assess the volatility of a security’s return. Therefore, these measures show
how a security deviates from its expected return.
a) Variance is a measure of the squared deviations of a security’s return from its expected return.
Formally, the variance may be given as
1 n −
2 = 
n − 1 t =1
( Rt − R) 2

In the case of returns that are attached with probabilities, the variance and may be defined
as
n − 2
 2 =  [ Rn − R] Pn
i =1

b) Standard deviation is the square root of the variance

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  = 2

Example 6.3
Using the data in Example 6.1 compute the variance and standard deviation may be given by:
1 n −
2 = 
n − 1 t =1
( Rt − R) 2

1
2 = [(149.70 − 51.03) + (70.54 + 51.03) + (16.52 − 51.03) + (22.71 + 51.03) + (49.52 − 51.03)
10 − 1
+(92.33 − 51.03) + (36.13 − 51.03) + (52.64 + 51.03) + (7.29 − 51.03) + (12.95 + 51.03) = 1.933.80
 = 1.933 .80 = 43 .97

Example 6.4
Using the data in Example 6.2 the variance and standard deviation may be given by:
 2 = [(18.5 − 6) 2 * 0.25] + [(10.5 − 6) 2 * 0.25] + [(1 − 6) 2 * 0.25] + [(−6 − 6) 2 * 0.25] = 86.375
 = 86.375 = 9.29

6.1.2 Portfolio: Two Asset case

A portfolio is a bundle or a combination of individual assets or securities. Under portfolio theory, a
normative approach to how investors make decisions to invest their wealth in assets under risk is
analysed. Portfolio theory analyses investors‟ asset demand given asset returns. It is a theory on how
risk averse investors can construct a portfolio in order to optimize expected returns for given market
risk, with the view that higher risk is an inherent part of higher returns. Portfolio returns assume that
a) Investors hold well-diversified portfolios implying that investors consider the risk and return
of the portfolio rather than the individual assets.
b) The return of assets is normally distributed. What is the implication this?

[Link] Expected returns of a portfolio

The expected returns of a portfolio is equal to a weighted average of the returns of individual assets in
the portfolio with the weights being equal to the proportions of the investment. Consider two assets X
and Y. The expected return may be given as
−
R P = wx R x + w y R y , Where w is the weight for each of the assets.

Example 6.5
The expected returns on two securities (Supertech Ltd and Slowpad Ltd) are 17.5 percent and 5.5
percent, respectively. Assuming a zero correlation coefficient, the expected return on a portfolio of
these two securities alone can be written as:
( R p ) = X Super (17 .5%) + X Slow (5.5%)
Where: X Super is the percentage of the portfolio in Supertech and X Slow is the percentage of the portfolio
in Slowpad.

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If an investor with Ksh.100 invests Ksh60 in Supertech and Ksh. 40 in Slowpad, the expected return
on the portfolio can be written as:
R p = 0.6 X 17 .5% + 0.4 X 5.5% = 12 .7%

6.1.3 Covariance and Correlation

To illustrate portfolio risk, we estimate the variance and standard variation of the portfolio (to be
covered in next subsection). Estimation of this variance depends on the co-movement of returns
between the two assets. Covariance and correlation measures how returns on individual securities are
related to one another. Covariance/Correlation is a statistic measuring the interrelationship between
two securities.

[Link] Covariance
The covariance of returns of assets X and Y is given by
n − _
 xy =  [( Rx − R x )( R y − R y )]Pi
i =1

When the covariance is

Positive: the returns of individual assets (X and Y) are above their average returns at the same time
Negative: the returns of X could be above its average while the return of Y would be below its average
and vice versa.
Zero: the returns of individual assets X and Y show no pattern i.e. there is no relationship.

[Link] Correlation
Correlation is a measure of the linear relationship between two securities. Recall that covariance may
be given as :
Covariance XY= standard deviation X * standard deviation Y * correlation XY
Cov xy =  x y corrxy
Therefore, correlation is given by
Cov xy
Corrxy = where correlation coefficient always ranges between -1 and +1.
 x y
Example 6.6
Consider the following information of assets X and Y. Assume that equal weights on investments in X
and Y
State of economy Prob R (x) R(y)
A 0.10 -8 14
B 0.20 10 -4
C 0.40 8 6
D 0.20 5 15
E 0.10 4 20

Required:
i) Expected value of asset X

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 −
R x = (−8 * 0.1) + (10 * 0.2) + (8 * 0.4) + (5 * 0.2) + (−4 * 0.1) = 5
ii) Expected value of asset Y
−
R y = (14 * 0.1) + (−4 * 0.2) + (6 * 0.4) + (15 * 0.2) + (20 * 0.1) = 8
iii) Expected value of portfolio
−
R p = (0.5 * 5) + (0.5 * 8) = 6.5
iv) Covariance of X and Y
n − _
 xy =  [( Rx − R x )( R y − R y )]Pi
i =1

 xy = 0.1(−8 − 5)(−14 − 8) + 0.2(10 − 5)(−4 − 8) + 0.4(8 − 5)(6 − 8) + 0.2(5 − 5)(15 − 8)

+0.1(−4 − 5)(20 − 8)
= −33.0
6.1.4 Variance and Standard Deviation of a Portfolio
For a two asset case, the variance of a portfolio is given by:
 p2 =  x2 wx2 +  y2 w y2 + 2wx w y xy
Where w is the weight of the individual assets in the portfolio and other parameters as same as
before.
The formula indicates an important point. The variance of a portfolio depends on both the variances of
the individual securities and the covariance between the two securities. The variance of a security
measures the variability of an individual security’s return. Covariance measures the relationship
between the two securities. Given variances of the individual securities, a positive relationship or
covariance between the two securities increases the variance of the entire portfolio. A negative
relationship or covariance between the two securities decreases the variance of the entire portfolio.

Given the variance of a portfolio, we can now determine the standard deviation of the portfolio’s return.
This is given as :  p = SD( portfolio) = Var ( portfolio)

Example 6.6 – Continued

To estimate the variance of the portfolio, we first calculate the variance of individual variances as:
 x2 = 0.1(−8 − 5) 2 + 0.2(10 − 5) 2 + 0.4(8 − 5) 2 + 0.2(5 − 5) 2 + 0.1(−4 − 5) 2 = 33.6
 y2 = 0.1(14 − 8) 2 + 0.2(−4 − 8) 2 + 0.4(6 − 8) 2 + 0.2(15 − 8) 2 + 0.1(20 − 8) 2 = 58.2
Variance of portfolio is now given by:
 p2 = 33.6(0.5) 2 + 58.2(0.5) 2 + 2(0.5)(0.5)(−33.0) = 6.45
This variance provides a basis for choosing an optimum portfolio. The minimum portfolio is
considered the most optimum portfolio – since it reduces the portfolio risk. Since the variance of the
portfolio (6.45) is lower than the variances of individual assets X (33.6) and Y (58.2), investing or
diversifying in a portfolio minimizes the risk.

6.1.5 Risk diversification

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Can diversification reduce all risk? Generally risk has two parts; systematic and unsystematic risk
a) Systematic risk/market risk arises on account of economy-wide uncertainties and the tendency
of the market risk to move together with changes in the market. This part of the risk cannot be
reduced by diversification. Examples include; changes in government policy on interest rates,
deficit financing, inflation, taxation changes
b) Unsystematic risk/ unique risk arises with unique individual uncertainties of individual
securities. This type of risk can be solved by investing in well-diversified portfolios. Examples
include; workers declaring a strike, changes in research and development, entry of a new
competitor, expiration of a contract.

6.2.7. Definition of Risk when Investors Hold the Market Portfolio

Many investors hold diversified portfolios. This has led to economists asking, what is the risk of a
security in the context of a diversified portfolio? Researchers have shown that the best measure of the
risk of a security in a large portfolio is the beta of the security. Beta measures the responsiveness of a
security to movements in the market portfolio.

The formula for beta is:

Cov( Ri , Rm )
i =
 2 ( Rm )
Where:
Cov (Ri, Rm) is the covariance between the return on asset i and the return on the market portfolio and
 2 ( Rm ) is the variance of the market.
When:
B>1 the security is said to be more sensitive to systematic risk than market security and may be called
an aggressive security.
B>1 the security is said to be less sensitive to systematic risk than market security and may be called
a defensive security
B=1, we have a market portfolio
B=0, we have a riskless asset

Expected Return on the Market

Financial economists frequently argue that the expected return on the market can be represented as:
RM = RF + Risk Pr emium
In words, the expected return on the market is the sum of the risk-free rate plus some compensation
for the risk inherent in the market portfolio. Note that the equation refers to the expected return on the
market, not the actual return in a particular month or year. Because stocks have risk, the actual return
on the market over a particular period can, of course, be below RF, or can even be negative. Since
investors want compensation for risk, the risk premium is presumably positive.

6.2.8 Expected Return on Individual Security (Stating the CAPM)

The expected return on the market as a whole has been stated above. What is the expected return on an
individual security?
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The beta of a security is the appropriate measure of risk in a large, diversified portfolio. Since most
investors are diversified, the expected return on a security should be positively related to its beta.
Financial economists posit that, under plausible conditions, the relationship between expected return
and beta can be represented by the following equation:
R = RF +  X ( RM − R F )
 Differencebetween 
 Expected  exp ected returnon 
returnon a  =  Risk − free +  Beta of the  
  rate   Security  X
the market and risk −
 Security     
 
 freerate 
This formula is called the capital-asset-pricing model (CAPM). It implies that the expected return on
a security is linearly related to its beta. Since the average return on the market has been higher than the
average risk-free rate over long periods of time, ( RM − RF ) is presumably positive. Thus, the formula
implies that the expected return on a security is positively related to its beta.

Example 6.7
The stock of Orkwood Enterprises has a beta of 1.5 and that of Zebra Enterprises has a beta of 0.7. The
risk-free rate is 7 percent, and the difference between the expected return on the market and the risk-
free rate is 9.5 percent. Compute the expected returns on the two securities:
Expected Return for Orkwood: 7% + 1.5 x 9.5% = 21.25%
Expected Return for Zebra: 7% + 0.7 x 9.5% = 13.65%

Example 6.8
The following data has been established for Bataking Ltd, a shoe making firm in Kenya.
A B C D E F G H J
Stat RjE(Rm E(Rj Rm – Rj –
Prob Rm ( H )2Pi (G*J)Pi
e ) ) E(Rm) E(Rj)
1 0.1 -0.50 -0.40 -0.05 -0.04 -0.71 0.05041 -0.68 0.04828
2 0.3 0.20 0.20 0.06 0.06 -0.01 3E-05 -0.08 0.00024
3 0.4 0.30 0.40 0.12 0.16 0.09 0.00324 0.12 0.00432
4 0.2 0.40 0.50 0.08 0.1 0.19 0.00722 0.22 0.00836
0.21 0.28 0.0609 0.0612

The risk-free rate is 6%.

Find:
a) The expected market return E ( Rm )
E ( Rm ) =  Pi Rm
= (0.1 * −0.50 ) + (0.3 * 0.20 ) + (0.4 * 0.30 ) + (0.2 * 0.40 ) = 0.21

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 b) The variance of the market return  2 ( Rm )  2 ( Rm ) =
 (R m − E ( Rm )) 2 Pi
=  ( Rm − E ( Rm )) 2 Pi
= 0.0609
c) The expected return for Bataking E ( R j )
E ( R j ) =  Pi R j
= (0.1 * −0.40 ) + (0.3 * 0.20 ) + (0.4 * 0.40 ) + (0.2 * 0.50 )
= 0.28
d) Find the covariance Cov(Rj, Rm)
 jm =  ( Rm − E ( Rm )( R j − E ( R j )) Pi
= 0.0612
e) Find the beta for security of Bataking ( B j )
 jm
Bj =
 ( Rm )
2

0.0612
Bj =
0.0609
B j = 1.0049
f) Using the above information state the CAPM
CAPM = R f + B j [ E ( Rm ) − R f ]
= 0.06 + 1.0049 [0.21 − 0.06 ) =0.2107
g) What is the required return for the company? How does it compare with its expected
return?
Required return = 0.2107 and Expected Return= 0.28. Since the required return is
lower than expected return, prices are expected to rise

6.3 The Arbitrage Pricing Theory (APT)

The CAPM is not always able to account for the differences in asset returns using their betas. This
paved way for the development of the APT.

6.3.1. Stock Returns and Influencing Factors

The return on any stock traded in a financial market consists of two parts.
• First, the normal or expected return from the stock is the part of the return that shareholders in
the market predict or expect. It depends on all of the information shareholders have that affects
the stock, and it uses all understanding of what will influence the stock in the next month.
• The second part is the uncertain or risky return on the stock. This is the portion that comes
from information that will be revealed within the month. The list of such information includes,
a sudden drop in interest rates, sudden outbreak of war in the firm’s markets, discovery that a

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 rival firm has lower quality products, e.t.c. All this incidences might happen within the month
and will affect the stock’s returns
A way to write the return on a stock in the coming month, then, is:
R = R +U
Where:
R = the actual total return in the month,
R = the expected part of the return, and
U = the unexpected part of the return.
The unanticipated part of the return (that portion resulting from surprises) is the true risk of any
investment. This risk can be captured in individual stocks by using the beta coefficient. In this case,
the beta coefficient (β) tells us the response of the stock’s return to a surprise (risk). In CAPM, beta
measures the responsiveness of a security’s return to a specific risk factor, i.e. the return on the market
portfolio.
Because we now consider many types of risks, the APT can be viewed as a generalization of CAPM.

With many risk factors, the stock return can be represented as:
R = R +U
R = R + 1 F1 +  2 F2 +  3 F3 + ... +  n Fn + 
Where:
 = Beta and F = Risk factor

6.3.2 The One Factor Model

In practice, economists frequently use a one-factor model for returns. They do not use all sorts of
economic factors (as used above); instead, they use an index of stock market returns (e.g. the NSE 20
share index) as the single factor. Using the single-factor model we can write returns as:
R = R +  ( RM − RM ) + 
Where:
R = The actual stock return
R = Expected stock return
RM = The actual market return
RM = The expected market return
Where there is only one factor, we do not need to put a subscript on the beta. This factor model can be
slightly modified to create a market model (See the next section).

6.3.3 The Market Portfolio and the Single Factor

In the CAPM, the beta of a security measures the security’s responsiveness to movements in the market
portfolio. In the one-factor model of the APT, the beta of a security measures its responsiveness to the
factor. We now relate the market portfolio to the single factor.

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A large, diversified portfolio has no unsystematic risk because the unsystematic risks of the individual
securities are diversified away. Assuming enough securities so that the market portfolio is fully
diversified and assuming that no security has a disproportionate market share, this portfolio is fully
diversified and contains no unsystematic risk.
With the market portfolio as the factor, our equation of interest becomes:
R = R F +  ( RM − RF )
Where:
R = The expected return for the stock.
RF = Risk free return for the market
RM = The expected return for the market
This equation shows that the expected return on any asset is linearly related to the security’s beta. This
equation is similar to the CAPM equation. It should therefore be noted that if only one factor is
considered in APT, and that the factor is market return, then the APT model is identical to CAPM.
Note
The APT is based on the concept of arbitrage (i.e. the law of one price), which states that any two
identical investments cannot be sold at different prices in different markets. In other words, the theory
states that market forces will adjust to eliminate any arbitrage opportunities.

6.3.4 The Differences between CAPM and APT

Unlike the CAPM, the APT model does not assume that the market risk is the only factor that influences
the return of a portfolio. The APT recognizes that several other factors (or risks) can influence the
return of a portfolio. The APT preserves the linear relationship between risk and return (just like
CAPM) but abandons the single measure of risk by the beta of the portfolio. The APT model is a
multiple factor model. These differences can be illustrated in the table below.

CAPM APT
1 CAPM only considers the risk- APT is a multifactor model as it captures a
return as the only factor that number of industry-specific and macro-economic
affects returns factors that can affect returns other than the risk-
return
2 CAPM which is a single period APT considers multi-periods in assessing the
model when assessing return. returns
3 CAPM Assumes that there is a APT ignores the presence of a market portfolio
market portfolio against which which makes it easier to independently estimate
returns are estimated. the value of a stock
CAPM assumes normal APT does not assume a normal distribution
distribution of returns of stocks hence can measure stocks with different forms of
distribution
5 CAPM assumes that investors APT relaxes the assumption of well-diversified
hold of well-diversified portfolio portfolio

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