CHAPTER 4

RISK AND RETURN THEORIES

Introduction

Firms invest in assets with the expectation that they will achieve adequate returns from their investment.
As a matter of fact, expectation may not be realized. There is uncertainty associated with the cash flow
estimates. This uncertainty is termed as risk. Risk can also be defined as the variability of possible
outcomes from that which was expected. Put another way, it is the surprise element in the actual return,
the other element being the expected outcome.

The development of the theoretical relationship between risk and expected return is built partly on
portfolio theory. Portfolio theory deals with the selection of portfolios that maximize expected returns
consistent with individually acceptable levels of risk. To this end, this chapter discusses how to measure
expected return and risk for individual securities and portfolios, and explain their relationship. In addition
we will see the effect of diversification on risk.

Section 1: Expected Returns and Risk for Individual Securities

Overview

The common stockholders of a corporation are its residual owners; their claim to income and assets
comes after creditors and preferred stockholders have been paid in full. As a result, a common
stockholders' return on investment is less certain than the return to a lender or to a preferred stockholder.
On the other hand, the return to a common stockholder is not bounded on the upside as are returns to the
others. Thus, this section discuses how to measure expected returns for individual securities (common
stock) and the risk for these securities.
1.1. Expected Return on a Stock

Consider a single period of time, say, a year. Suppose that there are two stocks: A and B. Stock A is
expected to return 20% if the state of the economy is boom, 15% if the state of the economy is normal and
-5% if the state of the economy is recession. Stock B is expected to return 24%, 12% and -8% if the state
of the economy is boom, normal and recession respectively.

The probability distribution for the state of the economy is given below:
State of the economy Probability of this state occurring
Boom 0.35
Normal 0.40
Recession 0.25
1.0

The expected return on a stock is simply the weighted average of the possible outcomes, each outcome's
weight being its probability of occurrence. Thus, expected return on a stock can be calculated as:

n
Expected rate of return = P1r1+P2r2+........... + Pnrn = pr
i 1
i i

Where P1, P2... Pn is the probability of the ith outcome

r1,r2... rn is the ith possible outcome

For our example, the expected return on stock A is calculated as:

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Expected rate of return = (0.35x20%) + (0.4x15%)
(Stock A) + (0.25x-5%)
= 11.75%

The expected rate of return for stock B is calculated as:

Expected rate of return = (0.35x24%) + (0.4x12%)
(Stock B) + (0.25x-8%)
= 11.2%

Consider another example. You want to invest in a security whose possible returns next period and
associated probabilities are summarized below:
Possible
Out come Probability
0% 20%
10% 50%
20% 30%
100%
Determine the security's expected rate of return.
Expected rate of return = (0%x0.2) + (10%x0.5) + (20%x0.3)
= 11%
1.2. Risk for an Individual Security

So far we have discussed with the expected return from holding a security. In a world of uncertainty, this
return may not be realized. Risk, therefore, can be defined as the possibility that the actual return from
holding a security will deviate from the expected return. Expected return is simply the ex-ante return-
return before the fact-whereas actual return is the ex-post return-return after the fact. The greater the
magnitude of the deviation of the actual returns from the expected return, the greater the risk of the
security.

We have seen that the expected return on a security ( R ) is calculated as:

n
R   ri pi
i 1
Where ri is the ith possible outcome
Pi is the probability of the ith outcome
N is the total number of outcomes
 is summation of the weighted average of outcomes.

The standard deviation is a measure of total risk and is calculated as:

 r  R 
n
2
 i pi
i l

Where denotes square root

 denotes Standard deviation
The square of standard deviation,  , is known as the variance of the distribution
2

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Suppose we have security L with the distribution of possible returns shown below: (Assume one year
holding period)

Probability Distribution of Possible Returns

Probability of 0.10 0.15 0.05 0.20 0.15 0.20 0.10 0.05
Occurrence
Possible return -8% 0 5% 6% 9% 14% 18% 28%

The expected return R is:

R  (-8%x0.1)+ (0x0.15) + (5%x0.05) + (6%x0.2) + (9%x0.15)
+ (14%x0.2) + (18%x0.10) + (28%x0.05)
= 8%

The Standard deviation is:

Possible
Outcome(ri) ri  R r  R 
i
2 Pi

Pi ri  R 
2

-0.08 -0.16 0.0256 0.1 0.00256

0 -0.08 0.0064 0.15 0.00096
0.05 -0.03 0.0009 0.05 0.000045
0.06 -0.02 0.0004 0.2 0.00008
0.09 0.01 0.0001 0.15 0.000015
0.14 0.06 0.0036 0.2 0.00072
0.18 0.1 0.01 0.1 0.001
0.28 0.2 0.04 0.05 0.002
 2  0.00738
  0.0859
  8.59%
Let's consider another example. Two stocks: L and U have the expected return and standard deviation
shown below:

Stock L Stock U
Expected return 25% 20%
Standard deviation 40% 9%

Which of these stocks would you buy?

When we consider expected return per see, stock L Seems attractive because it offers the higher expected
return of 25% as opposed to stock U, 20%. However, stock L is more risky than stock U as revealed by
its standard deviation. So, we can't really say one is better than the other. It all depends on the preference
of the investor. An aggressive investor may want to assume higher risk with the expectation of higher
return. On the contrary, a risk averse investor may not want to assume a higher risk unless he receives
adequate return for the risk.

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1.2.1. Systematic versus Unsystematic Risk

As we have noticed, standard deviation is a measure of total risk. Total risk can be broken down to
systematic risk and unsystematic risk.

Total risk = Systematic risk + Unsystematic risk

The systematic risk is unavoidable or undiversifiable risk and it is due to the overall market risk- changes
in the nation's economy, tax reform by government or a change in the world energy situation. This risk
affects all securities and not company specific.

The unsystematic risk is avoidable or diversifiable. It is also sometimes called residual risk or company
specific risk. This is the risk that is unique to a company such as a strike or the outcome of unfavorable
litigation or a natural catastrophe. We will discuss more on this topic later in this chapter.
1.3. Relationship Between Expected Return and Risk

We have noticed that the unsystematic risk can be eliminated. For individual securities, therefore the
relevant risk is not the standard deviation of the security itself (total risk) but the systematic risk, as
measured by beta. As the unsystematic risk is relatively easily eliminated, we should not expect the
market to offer investors a risk premium for bearing such risk.

The relationship between an individual security's expected rate of return and its systematic risk, as
measured by beta, will be linear. The relationship is known as the security market line (SML). The
relationship between expected return and unavoidable risk and the valuation of securities that follows, is
the essence of the capital asset pricing model (CAPM).

According to CAPM, the expected return on a risky security is a combination of the risk-free rate plus a
premium for risk. This risk premium is necessary to induce risk-averse investors to buy a risky security.
Frequently, the rate on a Treasury security is used as surrogate for the risk-free rate ( R f ). If the
expected return for the market portfolio is Rm , then the expected return of a security j ( R j ) is :

R j  R f   j (R m  R f )
Where βj is the beta (Systematic risk) of security j.

The greater the beta of a security, the greater the risk and the greater the expected return required. By the
same token, the lower the beta, the lower the risk, the more safe the investment, and the lower the
expected rate of return required. An investor holding only a single security will be exposed to both
systematic and unsystematic risk but the market will reward him for only the systematic risk that is borne.

To illustrate, suppose you want to evaluate the attractiveness of investing in ABC corporation stock.
Assume that the expected return on Treasury securities is 6%, the expected return on the market portfolio
is 11% and the beta of ABC corporation is 1.3. A typical (average) stock has a beta of 1. Thus, ABC has
more systematic risk. Assume further that based on the assessment of the security's future cash flows
(dividend plus capital gain), the stock is expected to return 15%. First, let's determine the expected return
for the stock according to CAPM.

 
Expected return R  Rf   Rm  Rf 
= 6% +1.3(11%-6%)

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 = 12.5%
What does this figure tell us? It all means that, on average, the market expects ABC to show a 12.5%
annual return. This means that a security providing an expected return in excess of that required by the
market for the systematic risk involved would be attractive. In our case, the market expects a return of
12.5% on ABC stock where as based on cash flow analysis the stock is expected to return 15%, as given
in our example. Hence, the sock is attractive as it provides expected return in excess of that required by
the market.
The formula for expected return under CAPM can be expressed in a different way. The beta of a security
is a measure of the responsiveness of its excess returns to those of the market portfolio. Mathematically,
this responsiveness is nothing more than the covariance between possible returns for a security and the
market portfolio divided by the variance of the probability distribution of possible returns for the market
portfolio. Covariance issues will be widely addressed later in this chapter when we discuss portfolio risk.

The beta of security j can, therefore, be expressed as:

rjm j m rjm j
j  
 m2 m
Where rjmjm is the covariance of returns for security j with those of the market, rjm is the expected

correlation between possible returns for security j and the market portfolio, j is the standard deviation

of the probability distribution of possible returns for security j, m is the standard deviation of the
probability distribution of possible returns for the market portfolio.

Accordingly, the expected return on security j can also be calculated as:

R j  Rf 
R m 
 R f r j m j 
m
1.3.1. The Security Market Line and Security Value.

In market equilibrium, an individual security's expected rate of return and its systematic risk will have a
linear relationship. This relationship is depicted below:

SML

Rm Risk Premium
Expected Return

Rf

Risk free rate

1.0
Systematic risk (beta)

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According to CAPM, a security is correctly priced if its expected return lies on the security market line
(SML). If an individual security has an expected return-risk Combination that places it above the security
market line, it will be undervalued in the market. That is, it provides an expected return that is higher than
the rate required by the market for the systematic risk involved. As a result, the security will be attractive
to investors. The price of such securities will rise and the expected return will decline until the security
lies on the SML Since there is increased demand for such stocks.

If an individual security's expected return lies below the security market line, it is said to be overvalued.
This security is not attractive and investors holding it will divest it. The supply for such stocks will
increase, and the price will fall and the expected return of the security will rise until the security lies on
the SML.
Example 1
At present, suppose the risk-free rate is 10 percent and the expected return on the market portfolio is 15
percent. The expected returns for four stocks are listed together with their expected betas.
Stock Expected Return Beta
NIC 17% 1.3
EIC 14.5 0.8
UIC 15.5 1.1
NIBC 18 1.7
Required:
a) Determine the required rate of return according to CAPM
b) Based on the information given and your result in (a), which stocks are overvalued? Which are
undervalued?
c) If the risk-free rate were to rise to 12% and the expected return on the market portfolio rose to 16%,
will the stock of NIC be overvalued or undervalued? (Assume the expected returns and the betas stay
the same)

 
Solution

a) Required return using CAPM = R f   Rm  R f

For NIC Stock:
Required return = 10% + 1.3 (15%-10%)
= 16.5%
For EIC stock:
Required return=10% + 0.8(15%-10%)
=14%
For UIC Stock:
Required return = 10% +1.1(15%-10%)
= 15.5%
For NIBC Stock:
Required return = 10% + 1.7 (15% - 10%)
= 18.5%
b)
Stock Expected Return CAPM based
Required Return Valuation
NIC 17% 16.5% Undervalued
EIC 14.5 14 Undervalued
UIC 15.5 15.5 Correctly priced
NIBC 18 18.5 Overvalued

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c) Required return (NIC stock) = 12%+ 1.3 (16% -12%)
= 17.2%
The expected return for NIC stock was given as 17 percent which is less than that required by the market,
17.2 percent. Thus, NIC's stock is overvalued.

Example 2
ABC enterprise has a beta of 1.45. The risk free rate is 6 percent and the expected return on the market
portfolio is 10 percent. The company presently pays a dividend of Br. 2 a share and investors expect it to
experience a growth in dividends of 7 percent per annum for many years to come.

Required:
a) What is the stock's required rate of return according to CAPM
b) What is the stock's present market price per share if this required return prevails.
Solution

a) Required rate of return = Rf   Rm  Rf 
= 6% +1.45 (10% -6%)
= 11.8%
b) According to the Gordon growth model, Price of a stock (Po) is calculated as :( Valuation of
securities including this model is discussed in financial management I. Hence, you are
advised to refer back)
Do * (1  g )
Po =
Rg
Where Do is dividend at time 0, g is the constant dividend growth rate and R is the
required rate of return.

2 x(1.07)
Po =
0.118  0.07
Price per share = Br. 44.58

1.3.2. The coefficient of variation

Suppose you want to hold only a single security-either security A or B, not both. Security A has expected
return of 12% and standard deviation of 8%. Security B has expected return of 12% and standard
deviation of 5% which security would most people prefer? The answer is simple. Both securities provide
the same expected return but have different standard deviation. So most people would choose security B
which has lower risk while offering the same expected return.

Similarly, given a choice between two investments with the same standard deviations (same risk) but
different expected returns, investors would generally prefer the investment with the higher expected
return. To most investors, this is common sense. Return is good and risk is bad. So everybody wants as
much return and as little risk as possible.

However, if two or more securities have different expected returns and different level of risk (standard
deviation), how do we choose between/among such investment alternatives? For such situations we use
another measure of risk, the coefficient of variation (CV), which is the standard deviation of a security's
return divided by its expected return.

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 
Coefficient of Variation (CV) =
R
The coefficient of variation shows the risk per unit of return. Suppose that you want to determine the
relative risk of two securities: X and Y. Security X provide an expected return of 15 percent and security
Y an expected return of 20 percent. Security X and Y has a standard deviation of 12 percent and 15
percent respectively. Which security is relatively riskier? To determine this, we need to compute the
coefficient of variation of each security.

For security X:
 12
Coefficient of variation =   0.8
R 15
For Security Y
 15
Coefficient of variation =   0.75
R 20

Thus, security X is relatively riskier than security Y despite the fact that security X has lower standard
deviation than security Y.

Example

The following individual securities are available in the market. Arrange the securities in order of risk
(least risky to most risky).
Securities
A B C D E F
Expected return 0.15 0.08 0.14 0.17 0.11 0.11
Standard deviation 0.11 0.03 0.08 0.15 0.05 0.06

Let's first determine the coefficient of variation.

Securities  R CV ( / R )
A 0.11 0.15 0.11/0.15 = 0.733
B 0.03 0.08 0.03/0.08 = 0.375
C 0.08 0.14 0.08/0.14 = 0.571
D 0.15 0.17 0.15/0.17 = 0.882
E 0.05 0.11 0.05/0.11 = 0.455
F 0.06 0.11 0.06/0.11 = 0.545

The securities thus can be arranged from the least risky to most risky as follows:

Securities CV Remark
B 0.375 Least risky
E 0.455 Next least risky
F 0.545 Moderate risk
C 0.571 Moderate risk
A 0.733 Second most risky
D 0.882 Most risky

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Section 2: Portfolios: Risk and Return

Overview

In the previous section, we discussed the expected return and risk concepts and measurement for a single
security (stock). However, most investors actually hold a portfolio of securities. It all means that investors
hold a group of stocks instead of a single stock. Thus, portfolio expected return and risk are of obvious
relevance. Accordingly, this section discusses portfolio expected returns and risk.

Objectives:
After studying this section, you will be able to:
- Compute portfolio expected return and risk
- Create mathematical relationship between expected return and risk for portfolios.

2.1. Portfolios: Expected Return

For a portfolio of securities, the expected return, rp, is

m
rp   R jW j
j 1
Where R j is the expected return for security j, W j is the proportion of funds invested in security j, and m
is the total number of securities in the portfolio, Σ denotes summation of the weighted expected returns
for security 1 through security m.

The formula tells us that the expected return for a portfolio is simply a weighted average of expected
returns for securities making up that portfolio.

To illustrate, consider a two – stock portfolio consisting of stock A and B. Suppose that you have invested
20 percent of your money in security A and 80 percent in security B. The following probability
distribution of possible returns relates to security A and B.

State of Economy Probability of State Rate of return if state occurs

of Economy Security A Security B
Recession 0.50 -20% 30%
Boom 0.50 70% 10%
1.00

What is the expected rate of return for the portfolio?

First, let’s determine the expected return for each security

For Security A:
Expected return = (0.5 x -20%) + (0.5 x70%)
= 25%
For security B:
Expected return = (0.5x30%) +(0.5x10%)
= 20%

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The proportion of money invested in security A and B is 20 percent and 80 percent respectively as given
in our illustration. The expected return for the portfolio is:
rp = (0.2 x25%) + (0.8x20%)
= 21%
The expected return for the portfolio can also be computed in a different way. First, determine the return
for the portfolio for each state of economy (event).

State Probability Return on portfolio

Recession 0.50 (0.2x-20%)+(0.8x30%) =20%
Boom 0.50 (0.2x70%)+I(0.8x10%) = 22%

The expected return on the portfolio is:

rp = (0.5x20%) + (0.5x22%)
= 21%
This result is the same as before.
Portfolios: Risk

Unlike the expected return for a portfolio, the standard deviation of the portfolio is not the weighted
average of the individual standard deviations. Suppose we want to measure the standard deviation for the
portfolio for our previous example.

Possible
Outcome(ri )
Pi ri - R r  R 
i
2

Pi ri  R 
2

Security A
- 0.20 0.5 -0.2-0.25 =-0.45 0.2025 0.10125
0.70 0.5 0.7-0.25=0.45 0.2025 0.10125
 A2  0.2025
 A  0.45  45%
Security B
0.30 0.5 0.30-0.20 = 0.1 0.01 0.005
0.10 0.5 0.10-0.20 =-0.1 0.01 0.005
 B2  0.01
 B  0.10  10%

The weighted average of the individual standard deviations is simply (0.2x45%) + (0.8x10%) = 17%.
However, this is not the standard deviation of the overall portfolio.

The returns for a portfolio consisting of 20% security A and 80% security B are: (shown in our previous
example in this section)

State Probability Return on portfolio

Recession 0.50 20%
Boom 0.50 22%

The expected return for the portfolio was calculated to be 21%. So, the standard deviation of the portfolio
will be:

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 
 p  0.2  0.212 x0.5  0.22  0.212 x0.5 
1
2

=.01
= 1%
We see that the portfolio standard deviation is less than the weighted average of the individual security’s
standard deviations, 17 percent. The reason why the weighted average of the individual standard
deviations fails to give the correct standard deviation of the portfolio is that it ignores the relationship, or
covariance, between the returns of the two securities.

2.2.1. Covariance of returns

Covariance measures how closely security returns move together. The covariance between possible

returns for securities j and k,  jk

 j k = r j k  j k
Where rjk is the expected correlation between possible returns j and k,  j is the standard deviation for
security j and  k is the standard deviation for security K.

If security j and security k are identical, their correlation coefficient is 1.0. The correlation coefficient
always lies in the range -1 to +1. A correlation coefficient of 1.0 indicates that an increase in the return
for one security is always associated with a proportional increase in the return for the other security, and
similarly for decreases. A zero correlation coefficient indicates absence of correlation and a coefficient of
-1 indicates that the returns of the two securities are perfectly negatively related.

The standard deviation of a portfolio (  p ) is:

m m
p  W W 
j 1 k 1
j k jk

Where m is the total number of securities in the portfolio, W j is the proportion invested in security j, Wk is

the proportion of funds invested in security k and  jk is the covariance between possible returns for
securities j and k.

Given the formula for covariance, the standard deviation of the portfolio can also be expressed as:

m m
p   w w r
i 1 k 1
j k jk  jk

To illustrate, suppose that you want to measure the standard deviation of a two-security portfolio: A and
B. Security A and B in the portfolio has a standard deviation of 11 percent and 19 percent respectively.
The expected correlation between the two securities is 0.30. If you invest 20% and 80% of your funds in
security A and B respectively, the standard deviation of the portfolio is:

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 p  W A 2  A 2  WB 2  B 2  2W A WB rAB  A  B 
p  0.2 0.11
2 2 2 2

 0.8 0.19  2 x0.2 x0.8 x0.3x0.11x0.19
= 16%
Expected Return and Risk Related

In the previous section, we have discussed how the expected return and systematic risk of an individual
security are related to one another. Now, let’s see how the expected return on a portfolio is related to its
risk.

As we noticed in section 1 of this chapter, the standard deviation is a measure of total risk. However, the
market doesn’t pay for the unsystematic risk, but for the systematic risk as measured by beta. The beta of
a portfolio is simply a weighted average of the betas of the securities comprising the portfolio.

The CAPM can be applied, like for individual securities, to portfolios to determine their expected returns.
To determine the expected return for a portfolio according to CAPM, we do have two alternatives. The
first is to determine the expected return for individual securities and take their weighted average to get the
portfolio expected return. The second alternative is to determine the weighted average of the betas of the
securities making up the portfolio and insert this portfolio beta in the CAPM formula.

To see how this is so, consider a two security portfolio consisting of securities A and B with betas of 1.3
and 0.7 respectively. Suppose that the expected return on treasury securities is 6 percent and the expected
return on the market portfolio is 12 percent. Assume you invested 30 percent of your fund in security A
and 70 percent of your fund in security B. Let’s now determine the expected return on the portfolio using
two alternatives.

ALTERNATIVE 1:
Here we determine portfolio expected return by taking the weighted average of the expected returns of
the securities comprising the portfolio. As a first step, we need to determine individual securities expected
return.

Expected return for security A = 

Rf   A R m  Rf 
= 6% + 1.3 (12%-6%)
= 13.8%
Expected return for security B = 6%+0.7(12%-6%)
= 10.2%
Thus, the expected return for the portfolio is

rp  W A R A  WB R B
= (0.3x13.8%) + (0.7x10.2%)
= 11.28 percent
ALTERNATIVE 2:
In here, we need to compute the beta of the portfolio first.
n
 p   Wi  i
i 1

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Where p is the beta of the portfolio, Wi is the proportion of funds invested in security i and i is
the beta of security i.  denotes summation of the weighted average of individual security’s beta.

For our example, the beta of the portfolio is

p  W A  A  WB  B
= (0.3x1.3) + (0.7x0.7)
= 0.88
The expected return for the portfolio (rp) is thus:

rp  Rf   P Rm  Rf 
= 6% + 0.88 (12% -6%)
= 11.28 percent
This result is the same as that obtained using ALTERNATIVE 1.

Example
The following information relates to the amount of investment and the beta for six company stocks:

Stock Amount invested Beta

A Br. 10,000 1.40
B 10,000 0.80
C 10,000 0.60
D 10,000 1.80
E 5,000 1.05
F 5,000 0.90
Required:
1. Determine the Beta of the portfolio comprising these six stocks
2. If the risk-free rate is 8 percent and the expected return on the market portfolio is 14 percent,
what will be the portfolio’s expected return?
Solution
1. First we need to determine the proportion of funds invested in each stock.

Stock Amount invested Weights

A Br. 10,000 0.20
B 10,000 0.20
C 10,000 0.20
D 10,000 0.20
E 5,000 0.10
F 5,000 0.10
Total Br. 50,000 1.0
The beta of the portfolio is simply the weighted average of the betas of the stocks in the portfolio. Thus,
 is

 = (0.2x1.4) + (0.2x0.8) + (0.2x0.6)

+ (0.2x1.8) + (0.1x1.05) + (0.1x0.9)
= 1.115

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2. The portfolio’s expected return = Rf  p Rm  Rf  
= 8% +1.115 (14%-8%)
= 14.69%

Section 3: Diversification and portfolio Risk

Overview

We have seen in section 2 that portfolio risk is quite different from the risks of the assets that make up the
portfolio. Often, one hears about portfolio diversification. By this we mean constructing a portfolio in
such a way as to reduce portfolio risk without sacrificing return. This is certainly a goal that investors
should seek. In this section, therefore, we will look more closely at the riskiness of an individual asset
versus the risk of a portfolio of many different assets.

3.1. The Principle of Diversification

Diversification results from combining securities whose returns are less than perfectly correlated in order
to reduce portfolio risk. As noted before, the portfolio expected return is simply a weighted average of the
individual security expected return, no matter the number of securities in the portfolio. Therefore,
diversification will not systematically affect the portfolio return, but it will reduce the variability
(standard deviation) of returns. In general, the less the correlation among security returns, the greater the
impact of diversification on reducing variability. This is true no matter how risky the securities of the
portfolio are when considered in isolation.

To illustrate the concept of diversification, consider the figure below which shows the relationship
between portfolio size and portfolio risk.

50
Diversifiable risk
Standard deviation (%)

24

20

Non-diversifiable risk

20 40 60 80 1000
Number of stocks in portfolio

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The figure shows that when we spread our investment across many different assets, our portfolio risk will
be reduced assuming that the securities returns are less than perfectly correlated. The area that is labeled
“diversifiable risk” is the part that can be eliminated by diversification. As we add more and more
securities in our portfolio, the portfolio risk decreases up to a point. This point is the minimum level of
risk that cannot be eliminated by diversification. This minimum level of risk is labeled “non-diversifiable
risk” in the figure. The lesson from this is that diversification can eliminate some of the risk but not all of
the risk.

3.2. Diversification and Unsystematic Risk

By definition, unsystematic risk is one that is specific to a single asset. Unanticipated law suits, industrial
accidents, strikes, and similar events will tend to decrease future cash flows and thereby reduce share
values.

If we only hold a single stock, the value of our investment will fluctuate because of company-specific
events. However, if we hold a large portfolio, some of the stocks in the portfolio will go up in value
because of positive company specific events and some will go down in value because of negative events.
The net effect on the overall value of the portfolio will be relatively small because these effects will tend
to cancel each other out.

Accordingly, holding a portfolio of assets could eliminate some or all of the unsystematic risk. Put
another way, unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets
has almost no unsystematic risk. In fact, the terms diversifiable risk and unsystematic risk are often used
interchangeably.

3.3. Diversification and systematic Risk

Unlike unsystematic risk, systematic risk cannot be eliminated by diversification. By definition, a

systematic risk affects all assets. As a result, the systematic risk cannot be eliminated regardless of the
number of securities in the portfolio. This is why the terms non-diversifiable risk and systematic risk are
used interchangeably.

Thus, for a well–diversified portfolio, the unsystematic risk is negligible. For such a portfolio, essentially
all of the risk is systematic.
Illustration I
The following information relates to two securities: A and B.
Securities Standard deviation Beta
Security A 35% 0.6
Security B 18% 1.4
Required:
1. Which security has the greater total risk?
2. Which security has more systematic risk?
3. Which security has more unsystematic risk?
Solution
1. From our discussion in this chapter, security A has a greater total risk because its standard
deviation is higher.
2. Security B has more systematic risk since it has the higher beta
3. Security A has a higher total risk but less systematic risk. Thus, security A must have greater
unsystematic risk since total risk is the sum of systematic and unsystematic risk.

Illustration II

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Security A and the market portfolio have the following characteristics:

Standard deviation, Security A ……………………………………………. 0.20

Standard deviation, market portfolio ……………………………………… 0.15
Expected return, market portfolio ……………………………………….. 0.13
Correlation between possible returns for security A and the market portfolio 0.80
Risk-free rate ………………………………………………………………... 0.07
Present dividend per share (security A) …………………………………. Br. 12
Expected constant dividend growth (The growth rate is per annum and applies for
many years to come) …………………………………………… 6 percent
Present market price per share (security A) ……………………………… Br. 100

Required:
1. In the context of the CAPM, What is the expected (required) return of Security A?
2. What is the present market price per share for security A, assuming the required return in (1)

3. What is the expected return for security A, given dividend, growth and price information shown?
4. Is security A correctly priced according to the SML? If not, is it overvalued? Undervalued? Is the
stock attractive?
5. What would happen to the price of the security in the near future?

Solution
(R m  R f )
1. Expected return (Required return) = Rf  rAm A 
m
= 0.07+
0.13  0.07 0.8x0.2
0.15
= 13.4 percent
Do1  g  121.06

2. Present Market price per share = r  g 0.134  0.06
 Br.171.89
Do1  g 
g
3. Expected return = Po

12 x1.06
=  0.06
100
= 18.72 percent
4. Security A is not correctly priced according to the SML
Security A is undervalued and such stocks are attractive.
5. Because there will be higher demand for security A (Since it is undervalued), the price of the
security will rise pushing down its expected returns until it reaches 13.4 percent.

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Illustration III
Securities D, E, and F have the following characteristics with respect to amount invested, expected return,
standard deviation, and the correlation between them:

Amount Correlation Coefficient

Security invested R  D-E D-F E-F
D Br. 30,000 0.08 0.02 0.4 0.6
E 30,000 0.15 0.16 0.4 0.8
F 30,000 0.12 0.08 0.6 0.8

Required:
What is the expected return and standard deviation of a portfolio composed of these three securities?

Solution
In order to determine the expected return of the portfolio, we need to compute the weights for each
security in the portfolio. In our illustration, all the three securities have equal weight since the proportion
of investment in each security is equal. Thus, the weight is 1/3 for each security since we have three
securities. The expected return for the portfolio is, therefore,
rp = 1
3
0.08  13 0.15  13 0.12
= 11.67 percent
The standard deviation of a portfolio consisting of three securities can be computed as:

p  W D 2  D 2  W E 2  E 2  W F 2  F 2  2W DW E  D  E rDE  2W DW F  D  F rDF  2W E W F  E  F rEF  1
2

1

  
2 2 2
p   1 3  0.02   1 3  0.16 13 0.08  2 x 1 3 x 1 3 x0.02 x0.16 x0.4  2 x 1 3 x 1 3 x0.02 x0.08x0.6  2 x 1 3 x 1 3 0.06 x0.08x0.8
2 2 2 2

    
p  0.0798 =7.98 percent

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