RISK IN A PORTFOLIO CONTEXT: THE CAPITAL ASSET PRICING MODEL

(CAPM)

This section introduces the Capital Asset Pricing Model (CAPM) against the backdrop of
criticisms against Professor Markowitz’s assumptions in portfolio theory. We discuss the
risks of stock when they are held in portfolios rather than stand alone assets.

Criticisms against Professor Markowitz

1. An average investor will not do all the calculations. The mathematics is too complex
for a decision.

2. Rational behaviour for an investor – an investor may not be risk averse but he could
take more risk to earn higher returns.

3. Why should the standard deviation be a measure of risk? Couldn’t there be something
else suitable.

The CAPM is based on a comparison of the systematic risk of individual investments with
the risks of all shares in the market.

Key Assumptions in the CAPM:

i) Although there maybe exceptions, most investors are risk averse in that they will
prefer the smaller variance at comparable levels of return and greater return at comparable
levels of variance.

ii) Investors seek to control risk via diversification of their holdings.

iii) Investors as a group view risk/return relationships over similar periods (i.e. they have
similar investment horizons).

iv) Investors hold similar views as to the variance though not necessarily the mean of
future returns available on different assets.

v) Investors are able to borrow or lend readily at the prevailing risk free rate (e.g. 90 day
T.B. rate) and can sell short without restriction.

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 vi) Securities are divisible, and an investor is able to commit virtually any desired amount
of funds without affecting the price or rate of return associated with each and any
investment.

vii) There are no taxes, no transaction costs, no inflation and no interest rate charges.
These assumptions here remove market imperfections.

Systematic and Unsystematic Risk

The risk involved in holding securities (shares) divides into risk specific to the company
(unsystematic) and risk due to variations in market activity (systematic).

Whenever an investor invests in some shares, or a company invests in a new project, there
will be some risk involved. The actual return on the investment might be better or worse than
that hoped for. To some extent, risk is unavoidable (unless the investor settles for risk free
securities).

Provided that the investor diversifies his investment in a suitably wide portfolio, the
investments which perform well and those that perform badly should tend to cancel each
other out, and much risk can be diversified away. In the same way, a company which invests
in a number of projects will find that some do well and others badly, but taking the whole
portfolio of investments, average returns should turn out much as expected.

Risks that can be diversified away are referred to as unsystematic risk (or diversifiable risk or
idiosyncratic risk). But there is another sort of risk – some investments are by their very
nature more risky than others. This has nothing to do with chance variations up or down in
actual returns compared with what an investor should expect. This inherent risk – the
systematic risk or market risk or non-diversifiable risk - cannot be diversified away. This risk
affects the market as a whole and cannot be diversified away. This risk includes interest rates,
inflation and foreign exchange rate risks.

While unsystematic risk applies to a single investment or a class of investments and can be
reduced or eliminated by diversification, systematic risk cannot be diversified away.

In return for accepting systematic risk, a risk averse investor will expect to earn a return
which is higher than the return on a risk free investment. The amount of systematic risk in an
investment varies between different types of investments.

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Systematic Risk and the CAPM

The Capital Asset Pricing Model (CAPM) is mainly concerned with how systematic risk is
measured, and how systematic risk affects required returns and share prices. Systematic risk
is measured using beta factors.

Beta factor is the measure of the systematic risk of a security relative to the market portfolio.
If a share price were to rise or fall at double the market rate, it would have a beta factor of
2.0. Conversely, if the share price moved at half the market rate, the beta factor would be 0.5.

CAPM theory includes the following propositions:

a) Investors in shares require a return in excess of the risk free rate to compensate them
for systematic risk.

b) Investors should not require a premium for unsystematic risk because this can be
diversified away by holding a wide portfolio of investments.

c) Because systematic risk varies between companies, investors will require a higher
return from shares in those companies where the systematic risk is bigger.

The same propositions can be applied to capital investments by companies:

a) Companies will want a return on a project to exceed the risk free rate to compensate
them for systematic risk.

b) Unsystematic risk can be diversified away, and so a premium for unsystematic risk
should not be required.

c) Companies should want a bigger return on projects where systematic risk is greater.

Market Risk and Returns

Market risk (systematic risk) is the average risk of the market as a whole. Taking all the
shares on a stock market together, the total expected returns from the market will vary
because of systematic risk. The market as a whole might do well or it might do badly.

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Risk and Returns from an Individual Security

In the same way, an individual security may offer prospects of a return of x%, but with some
risk (business risk and financial risk) attached. The return (the x%) that investors will require
from the individual security will be higher or lower than the market return, depending on
whether the security’s systematic risk is greater or less than the market average. A major
assumption in CAPM is that there is a linear relationship between the return obtained from an
individual security and the average return from all securities in the market.

The Equity Risk Premium

The equity risk premium (or market risk premium), [E(rm - rf)], represents the excess of
market returns over those associated with investing in risk free assets. In other words, the
equity risk premium is the difference between the expected rate of return on a market
portfolio and the risk free rate of return over the same period.

The CAPM makes use of the principle that returns on shares in the market as a whole are
expected to be higher than returns on risk free investments. The difference between market
returns and risk free returns is called an excess return. For example, if the return on
government stocks is 9% and market returns are 13%, the excess return on the market’s
shares as a whole is 4%.

The difference between the risk free return and the expected return on an individual security
can be measured as the excess return for the market as a whole multiplied by the security’s
beta factor.

The CAPM formula

The CAPM is statement of the principles explained above. It can be stated as follows:

E(ri) = Rf + βi [E(rm) – Rf]

Where: E(ri) is the expected rate of return from the security (or the cost of equity capital)

Rf is the risk free rate of return

E(rm) is the return from the market as whole

βi is the beta factor of the individual security

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Example:

(a) Shares in Dango company have a beta of 0.9. The expected returns to the market are 10%
and the risk free rate of return is 4%. What is the expected rate of return (or the cost of
equity) from Dango company?

(b) Investors have an expected rate of return of 8% from ordinary shares in Alpha Ltd, which
have a beta of 1.2. The expected returns to the market are 7%.

What will be the expected rate of return from ordinary shares in Omega Ltd, which have
a beta of 1.8?

(c) If the risk free rate of return is 7% and the average market return is 11%;

(i) What will be the return expected from a share whose beta factor is 0.9?

(ii) What would be the share’s expected value if it is expected to earn an annual
dividend of 5.3c with no capital growth?

Calculation of beta factors

The beta factor for an individual asset is calculated as follows:

βA =

Example:

Year RA RA - ERA RM RM - ERM (RA-ERA)(RM-ERM) (RM-ERM)(RM-ERM)

Therefore, beta for asset A (βA) = 0.109/0.26 = 0.419

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The beta for a portfolio is the weighted average of the individual securities betas, i.e.:

βp =

The line that shows the relationship between risk as measured by beta and the required rate of
return for individual securities is called the security market line (SML).

Beta of security

The SML relates the security return to beta. Note that on the horizontal axis, beta appears as
opposed to standard deviation in a capital market line (CML). SML holds for both individual
securities and all possible portfolios while CML holds only for efficient portfolios.

Problems with applying the CAPM in practice

i) The need to determine the excess return, [E(rm) - Rf], Expected rather than historical
returns should be used, although historical returns are often used in practice.
ii) The need to determine the risk free rate. A risk free investment might be a government
security. However, interest rates vary with the term of the lending.
iii) Errors in the statistical analysis used to calculate beta values. Betas may also change
over time.
iv) The CAPM is also unable to forecast accurately returns for companies with low
price/earnings ratios and to take account of the seasonal ‘month-of-the-year’ effects
and ‘day-of-the-week’ effects that appear to influence returns on shares.

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The CAPM was also criticised because it is a one factor model i.e. the beta affecting the
expected return. There are other factors that might affect the risk and return relationship
e.g. inflation, interest rates, etc.

Arbitrage Pricing Model (APT)

APT is a multifactor model that takes into account all other factors that can affect the
risk-return relationship:

Ri = Rf + (ERm – Rf) β1 + (ERm2 – Rf) β2 + e

Arbitrage refers to finding two investments that are essentially the same (i.e. they are
equally desirable but one is over-priced and the other underpriced) and buying the
cheaper one and selling the more expensive one.