CHAPTER TWO

2. RISK, RETURN AND PORTFOLIO THEORY

Discussion Points:
 Expected Return
 Risk
 Portfolio Expected Return and Risk
 Systematic and Unsystematic Risk
 Portfolio Theory and Risk Diversification
 Capital Asset Pricing Model (CAPM)
Introduction
 Risk and return are most important concepts in
finance. In fact, they are the foundation of the modern
finance theory. What is risk? How is it measured?
What is return? How is it measured?
 Risk in general is the quantifiable likelihood of loss or
less-than expected returns.
 Many definitions of risk depend on specific application
and situational contexts. Frequently, risk is considered
as an indicator of threat. It can be assessed
qualitatively or quantitatively.
…Cont’d
 Qualitatively, risk is considered proportional to the
expected losses which can be caused by an event and
to the probability of this event. The harsher the loss
and the more likely the event, the greater the overall
risk.
 Measuring risk is often difficult; the probability is
assessed by the frequency of past similar events, but
rare failures are hard to estimate, and loss of human
life is generally considered beyond estimation.
 Examples of risk include: credit risk, inflation risk,
liquidity risk, market risk, interest-rate risk, etc.
…Cont’d
Risk in Finance
In finance, risk is the probability that an
investment’s actual return will be different than
expected. This includes the possibility of losing
some or all of the original investment.
Risk is usually measured by calculating the
standard deviation of the historical returns or
average returns of a specific investment.
…Cont’d
Risk Vs. Return
A fundamental concept in finance is the relationship
between risk and return.
The compensation required by investors to invest in
ventures where returns are not certain is over and
above the compensation they require for the pure time
value of their money.
Thus, the greater the amount of risk that an investor
is willing to take on, the greater the potential return.
The reason for this is that investors need to be
compensated for taking on additional risk.
…Cont’d
 In general, investors require a rate of return that
reflects at least:
a) their time value of money, and
b) their risk taking
c) the purchasing power loss (due to inflation)
 For example, a government Treasury Bond is considered to be
one of the safest investments and, when compared to a
corporate bond, provides a lower rate of return. The reason
for this is that a corporation is much more likely to go bankrupt
than the government.
 Because the risk of investing in a corporate bond is higher,
investors are offered a higher rate of return.
…Cont’d
 From the perspective of the possible variability in the
expected outcomes, for example, a government
bond that guarantees its holder Birr 100 interest
after 30 days has no risk, since there is no variability
associated with the return. However, an investment
in a firm’s common stock that may earn over the
same period from Birr 0 to Birr 200 is very risky due
to the variability of the expected return. The more
certain the return expected from an asset, the less
the variability, and therefore the lower the risk.
…Cont’d
Measuring Risk
Risk is measured with probability, which is
merely number that represents the chances of
occurrence of different possible outcomes.
Probabilities give hints about the intensity of
risk involved in investments.
Probability Distributions
Probability distribution describes the
outcomes and their associated probabilities.
…Cont’d
Example:
ABC Company is considering investing Birr 100,000 in
short term investment. Let’s call this investment,
Investment X. Based on some research, we believe that
the rate of return to be earned on investment X is
directly related to how the Ethiopian economy
performs in the near future. The table below shows
possible rates of return on the short-term investment
the firm planned to make and probabilities for the
possible performance of the national economy.
…Cont’d
State of Economy Probability Rate of Return on
Investment X (%)

Good 0.2 20

Average 0.6 10

Bad 0.2 0
…Cont’d
Measures of Central Tendency
A probability distribution may be summarized by measures of
central tendency. Central tendency refers to the value that the
outcomes tend to cluster around.
There are several measures of central tendency but finance usually
emphasizes the importance of the expected value.
Expected Value E(X) – is the probability weighted average of the
possible outcomes.
 …Cont’d
 In general,
n
Expected Value of X = E(X) = Ẍ = ∑PiXi
i=1
where, n = the number of possible outcomes
i = the ith possible outcome
P = probability of the occurrence of i

 From the data given in the table, we can calculate the expected rate of
return for investment X as follows:
E(X) = [(0.2x0.2) + (0.6x0.1) + (0.2x0)] = 0.1

NB: An investment with a higher expected value will be considered

better and one with lower expected value is bad.
 …Cont’d

Measures of Dispersion
Dispersion refers to the spreading or scattering
of the possible outcomes in the probability
distribution.
In other words, dispersion measures how likely it
is that an outcome will vary from the central
tendency.
Two of the widely used measures of dispersion
are variance and standard deviation.
 …Cont’d

Variance
Variance indicates the weighted dispersion of outcomes
around the expected value, with probabilities serving as
weights.
For a random variable X with values X1, X2, X3,…,Xn, and
corresponding probabilities P1, P2, P3,…, Pn, the variance is:

Variance of x = σx2 = ∑pi (xi-ẍ)2

i=1
 …Cont’d

 For investment X, the variance of the possible return rate is:

σx2 = 0.2(0.2-0.1)2 + 0.6(0.1-0.1)2 + 0.2(0-0.1)2

= 0.004

 Variance shows the likelihood that the actual value of X will

vary from the expected value, and to what degree. The lower
the variance, the more likely it is for the actual and the
expected values to be similar.
…Cont’d
…Cont’d
 …Cont’d

Example
To illustrate the use of the coefficient of variation, let us add
another investment venture, investment Y, to our investment X
based on our earlier assumption under the three different
investment climates.
State of Economy Probability Rate of Return on
Investment Y
Good 0.2 0.4
Average 0.6 0.1
Bad 0.2 -0.1
…Cont’d
…Cont’d
 In the example above, a comparison of investment X with
investment Y reveals that Y has a higher expected return rate,
but also has a higher associated risk.
 If only one of X or Y has to be selected, the coefficient of
variation would serve the purpose.
 Since X has a lower risk per unit of return (CVx = 0.63) unlike
that of Y (CVy = 1.33), investment X should be preferred.
 The one with the lowest coefficient of variation (the lowest
risk per unit of return) is the better.
Risk and Return: Financial Asset Portfolios …Cont’d
So far we have concerned on individual assets considered
separately. However, most investors actually hold a portfolio of assets.
Portfolio refers to a bundle or group of assets or securities such as
stocks and bonds held by an investor.
If the investor holds a well-diversified portfolio, then his concern
should be the expected return and risk of the portfolio rather than
individual assets or securities.
Another assumption of the portfolio theory is that the returns of
securities are normally distributed. This means that the mean (the
expected value) and variance (or standard deviation) analysis is the
foundation of the portfolio decisions.
…Cont’d
Example: Portfolio Return
To illustrate assume a simple portfolio composed of the two
investments, X and Y, already discussed in the foregoing
sections. Assume further that the portfolio of X and y is
composed of 50% investment in each. Thus, the weight, w, given
for each is 0.5. That is, wx = 0.5, and wy = 0.5. Weights of
investments in portfolios should sum to 1.0. It is possible now to
calculate the expected portfolio return.
…Cont’d
…Cont’d
Measuring Portfolio Risk
Like in the case of individual assets or securities, the risk
of a portfolio could be measured in terms of its variance
or standard deviation.
However, the variance or standard deviation of a
portfolio is not simply the weighted average of variances
(or standard deviations) of individual securities.
The portfolio variance (or standard deviation) is affected
by the association of movement of returns of the two
securities.
Covariance of two securities measures their co-
movement.
…Cont’d
Measures of Co-movement
The co-movement concept is very important in
developing the concept of risk.
Co-movement refers to the association of movement
between two variables.
There are two measures of co-movement:
correlation and covariance.
…Cont’d
…Cont’d
 …Cont’d

 How is the portfolio variance affected by the correlation

coefficient? Let’s take an example.
Example:
Securities A and B are equally risky, but they have different
expected returns:
___________________________________________________
E(Ra) = 0.16 E(Rb) = 0.24
Wa = 0.50 Wb = 0.50
σa2 = 0.04 σb2 = 0.04
σa = 0.20 σb = 0.20
__________________________________________________
 What is the portfolio variance if (a) Corrab = +1.0, (b) Corrab = - 1.0, (c) Corrab =
+0.10, and (d) Corrab = - 0.10?
 …Cont’d

 Corrab = +1.0, i.e., perfect positive correlation: the returns of the

two securities A and B are perfectly positively correlated, the
portfolio variance will be:

σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(1.0)(0.2)(0.2)

= 0.01+0.01+0.02 = 0.04

 As can be seen above, the portfolio variance is just equal to the

variance of individual securities. Thus, the combination of securities
A and B is as risky as the individual securities.
 …Cont’d

 Corrab = - 1.0, i.e., perfect negative correlation: If the returns of

securities A and B are perfectly negatively correlated, the portfolio
variance is:

σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(-1.0)(0.2)(0.2)

= 0.01+0.01 – 0.02 = 0

 As can be shown above, the portfolio variance is zero. It means

that the combination of securities A and B completely reduces the
risk.
 …Cont’d

 Weak positive correlation (Corrab = +0.10): the portfolio variance

under weakly positive correlation is computed below:

σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(0.1)(0.2)(0.2)

= 0.01+0.01+0.002 = 0.022

 As can be evident above, the portfolio variance is less than the

variance of individual securities, hence reduces the risk.
 …Cont’d

 Weak negative correlation (Corrab = - 0.10): the portfolio variance under

weakly negative correlated returns of two securities A and B is:

σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(- 0.10)(0.2)(0.2)

= 0.01+0.10 – 0.002 = 0.018

 The above calculation revealed that the portfolio variance has reduced
more than when returns were weakly positively correlated.
 It is clearly indicated in the above example that a total reduction of risk is
possible if the returns of the two securities are perfectly negatively
correlated, though, such a perfect negative correlation will not generally
be found in practice. Securities do have a tendency of moving together to
some extent, and therefore, risk may not be totally eliminated.
 …Cont’d

Covariance
Covariance shows how the two variables co-vary.
Covariance states not only how well two variables ‘track’ with each
other but also how likely each variable is to vary from the track.
How is co-variance calculated? Three steps are involved in the
calculation of covariance between two securities.
Step 1. Determine the expected returns for the securities.
2. Determine the deviation of possible returns from
the expected return for each security.
3. Determine the sum of the product of each
deviation of returns of two securities and probability.
…Cont’d
…Cont’d
…Cont’d
 …Cont’d
 As σp increases, the riskiness of a portfolio of assets
increases.
 With the portfolio composed of 50% investment in asset X
and 50% investment in Y, the expected rate of return is 11%
and the portfolio standard deviation of rate of return (risk) is
11.14%.
 Choosing different values for Wx and Wy leads to different
risk-return results.
 Note that in the foregoing computation of the expected value,
variance, standard deviation, covariance and correlation, we
have dealt with future probabilistic data. But when we want
to compute these statistics from historical data, we use the
number of data used in the computation (N) instead of
probability to weigh the values.
 …Cont’d
Diversification and Portfolio Risk
The Principle of Diversification
The process of spreading an investment across several assets
(and thereby forming a portfolio) is called diversification.
The principle of diversification tells us that spreading an
investment across many assets (diversifying) will help in
minimizing, even in eliminating some of the risk. However,
diversification cannot eliminate all risk.
There is a minimum level of risk that cannot be eliminated
simply by diversifying. Thus, diversification reduces risk, but up to a
point. Put another way, some risk is diversifiable and some is not.
 …Cont’d
Types of Risk
The total risk of a security can be viewed as consisting of two
parts:
Total Security Risk = Diversifiable Risk + Nondiversifiable Risk

Diversifiable Risk
Diversifiable risk represents the portion of an asset’s risk that is associated
with random causes that can be eliminated through diversification.
It is attributable to firm-specific events such as strikes, lawsuits, regulatory
actions and loss of a key account.
Diversifiable risk is also called unsystematic risk. It is also referred to as
unique risk, or asset-specific risk.
 …Cont’d
 Examples of unsystematic risk are:
 workers declare strike in a company
 a formidable competitor enters the market
 the company loses a big contract in a bid
 the government increases custom duty on the material
used by the company
 the company is not able to get adequate quantity of
raw materials from the suppliers
 The company experts leave to another company
 …Cont’d
Nondiversifiable Risk
This part of the risk arises on account of the
economy-wide uncertainties and the tendency of
individual securities to move together with changes in
the market.
This part of the risk cannot be reduced through
diversification, and it is called systematic, or markets,
risk.
Investors are exposed to market risk even when they
hold well-diversified portfolios of securities.
 …Cont’d
The examples of systematic risk are:
 the government changes the interest rate
policy
 the corporate tax rate is increased
 the government resorts to massive resource
financing
 the inflation rate increases
 the NBE promulgates a restrictive credit policy
 …Cont’d
 The unsystematic risk can be reduced as more and more
securities are added to a portfolio. How many securities
should be held by an investor to eliminate unsystematic risk?
 In USA, it has been found that unsystematic risk can be
eliminated by holding about 15 securities (Evans et al.,
Diversification and the reduction of Dispersion, Journal of
Finance, Dec. 1968, pp. 761–69).
 In Indian context, a portfolio of about 40 shares can almost
totally reduce the systematic risk (Gupta, L. C., Rates of Return
on Equities: The Indian Experience, 1981 pp. 30–35) .
 …Cont’d
Can no diversifiable (systematic) risk be
eliminated through diversification? The
answer is no, because, the systematic risk
affects almost all assets to some degree.
Hence, no matter how many securities
investors put into a portfolio, systematic risk
cannot be eliminated or reduced.
 …Cont’d
Measuring Nondiversifiable (Systematic) Risk
Since the systematic risk is the most important determinant
factor of an asset’s expected return, we need some way of
measuring the level of systematic risk for different investments.
The specific measure that we will use is called the beta
coefficient, denoted by the Greek letter β.
A beta coefficient, or beta for short, tells us how much
systematic risk a particular security has relative to an average
assets.
By definition, an average asset has a beta of 1.0 relative to
itself.
 …Cont’d
 The beta coefficient, β, is used to measure nondiversifiable
(systematic) risk.
 It is an index of the degree of movement of an asset’s return
in response to a change in the market return.
 The beta coefficient for an asset can be found by examining
the asset’s historical returns relative to the returns for the
market.
 The market return is the return on the market portfolio of all
traded securities.
…Cont’d
 …Cont’d

Obtaining and Interpreting Betas

Beta coefficients can be obtained for actively traded securities
from published sources.
The beta coefficient for the market is to be equal to 1.0; all
other betas are viewed in relation to this value.
Asset betas may take on values that are either positive or
negative, but positive betas are the norm.
The majority of beta coefficients fall between 0.5 and 2.0.
 …Cont’d

 Some selected beta coefficients and their associated

interpretations are presented in the table below:
Beta Comment Interpretation
2 Move in same Twice as responsive, or risky, as the market
1 Direction as Same response or risk as the market
0.5 market Only half as responsive, or risky, as the market
0 Unaffected by market movement
-0.5 Move in opposite Only half as responsive, or risky, as the market
-1 Direction as Same response or risk as the market
-2 market Twice as responsive, or risky, as the market

NB: a stock that is twice as responsive as the market is expected to experience a 2%

change in its return for each 1% change in the return of the market portfolio, whereas
the return of a stock that is half as responsive as the market is expected to change by
half of 1% for each 1% change in the return of the market portfolio.
 …Cont’d
Portfolio Betas
Given the beta of each asset comprising the portfolio, the
beta of a portfolio can be easily estimated by using the betas of
the individual assets it includes.
Let wi represent the proportion of the portfolio’s total Birr
value represented by asset i and βi equal the beta of asset i.
Then portfolio beta, βp, is given by the following equation:
n
βp = (w1* β1) + (w2* β2) + … + (wn* βn) = ∑ (wi* βi)
i=1
 …Cont’d
 Portfolio betas are interpreted in exactly the same way as
individual asset betas.
 They indicate the degree of responsiveness of the portfolio’s
return to changes in the market return.
 For example, when the market return increases by 10%, a
portfolio with a beta of 0.75 will experience a 7.5% increase in
its return (.75*10%) whereas a portfolio with a beta of 1.25
will experience a 12.5% increase in its return (1.25*10%).
Portfolio A Proportion =10% beta A= 0.75 (0.10* 0.75) = 0.075
Portfolio B Proportion =10 % beta B= 1.25 (0.10*1.25) = 0.125
 Low-beta portfolios are less responsive and therefore less
risky than high-beta portfolios. (Low-beta portfolio’s ---less
risky)
 …Cont’d

Illustration
Ghibe Corporation wishes to assess the risk of two portfolios:
portfolio A and portfolio B. Both portfolios contain five assets,
with the proportions and betas shown below.
Required: Compute the beta of each of the two portfolios
 …Cont’d

Portfolio A Portfolio B
Asset Proportion Beta Proportion Beta
01 0.1 1.65 0.1 0.8
02 0.3 1.0 0.1 1.0
03 0.2 1.3 0.2 0.65
04 0.2 1.1 0.1 0.75
05 0.2 1.25 0.5 1.05
Totals 1.00 1.00

βA = (0.10*1.65) + (.3*1.0) + (0.2*1.3) + (0.2*1.1) + (0.2*1.25) = 1.20

βB = (0.10*0.8) + (0.10*1.0) + (0.2*0.65) + (0.1*0.75) + (0.5*1.05) = 0.91
 …Cont’d

Risk & Required Rate of Return

How can we relate risk and the required rate of return?
Provided that an investor has measured the level of systematic
risk prevalent in an asset, then how can s/he determine the rate
of return that is commensurate with the asset’s risk?
The issue of relating risk with the required rate of return can
be addressed using a model called capital asset pricing model
(CAPM).
 …Cont’d
The Capital Asset Pricing Model (CAPM)
The basic theory that links together risk and return for all assets is
commonly called the capital asset pricing model (CAPM).
Using the beta coefficient, β, to measure nondiversifiable risk, the
CAPM is given by the following equation:
Kj = RF + [(Km – RF) βj]
where,
Kj = required rate of return
RF = risk-free rate of return, commonly measured by the
return on the government treasury bill
βj = beta coefficient or index of nondiversifiable risk for
asset j
Km = market return; the return on market portfolio of assets
 …Cont’d
Example:
IBX Company wishes to determine the required rate of return on
an asset – Asset X – that has a beta, βx, of 1.45. The risk free rate
of return is found to be 7.5%; the return on the market portfolio
of assets is 11%.
Required: Calculate the required rate of return, Kx.
Kx = RF + [(Km – RF) βx]
Kx = 7.5% + [(11% - 7.5%)1.45]
Kx = 7.5% + [(3.5%)1.45]
= 7.5% + 5.075
Therefore, Kx = 12.575%
 …Cont’d

 The 3.5% (11% - 7.5%) is the market risk premium, i.e., the
premium paid by the average assets in the market.
 When this market risk premium is adjusted for the asset’s
index of risk (beta) of 1.45, we get the asset’s risk premium of
5.075 (1.45*3.5%).
 Finally, when the asset’s risk premium (5.075%) is added to
the 7.5% risk-free rate, we will get a 12.575% required rate of
return.
 …Cont’d
 Other things being equal, the higher the beta (the extent of
systematic risk), the higher the riskiness of an asset, and the
greater the return required by investors; and the lower the
beta (the level of systematic risk), the lower the risk, and the
lower the required return. This is what is known as the risk-
return trade-off.
 High return investments are associated with those that have
high systematic risk, and assets with low systematic risk have
low return potential.
 …Cont’d

Assumptions of CAPM
CAPM is based on a number of assumptions. Some of the important
assumptions are here under:
1)Market efficiency: the capital markets are assumed to be efficient.
Efficiency implies that share markets reflect all available information.
2)Risk aversion: Investors are assumed to be risk averse. They
evaluate a security’s return and risk in terms of the expected return
and standard deviation respectively. They prefer the highest expected
returns for a given level of risk.
 …Cont’d

3) Homogeneous expectations: All investors are assumed to

have the same expectations about the expected return and risk of
securities.
4) Single time period: All investors’ decisions are based on single
time period.
5) Risk-free rate: All investors can lend or borrow at a risk-free
rate of interest.
 …Cont’d
The Security Market Line
When the capital asset pricing model is depicted graphically, it
is called the security market line (SML).
The SML, which is a straight line, reflects the required return
in the market place for each level of nondiversifiable risk.
In the graph below, risk as measured by beta, β, is plotted on
the x-axis, and rrr, k, are plotted on the y-axis. The risk-return
trade-off is clearly represented by the SML.
 …Cont’d

14.0 SML
Expected
Return (%) 12.0

10.0 Expected Market

Return = 8%
8.0

6.0
Market
Risk
4.0 Premium
= 5%
0.2.0
02 Risk-free return
= 3%
0
0
0 0.5 1 1.5 2 2.5 X
Nondiversifiable
0
Risk, β,
Fig. 2.1 The Security Market Line (SML) with Anthony Co.’s asset Z data shown.
 …Cont’d
Implications and Relevance of CAPM
CAPM has the following implications:
a)Investors will always combine a risk-free asset with a market
portfolio of risky assets.
b)They will invest in risky assets in proportion to their value.
c) Investors will be compensated only for that risk which they cannot
diversify. Beta is the most appropriate measure of an asset’s
risk.
d) Investors can expect returns from their investment according to
the risk. This implies a linear relationship between the asset’s
expected return and its beta.
 …Cont’d
 In general, the concepts of risk and return as developed under
CAPM have intuitive appeal and they are quite simple to
understand.
 Financial managers use these concepts in a number of financial
decision making such as valuation of securities, cost of capital
measurement, investment risk analysis, etc. However, despite
its intuitive appeal and simplicity, CAPM suffers from a number
of practical problems.
 …Cont’d
Limitations of CAPM
a)It is based on unrealistic assumptions: CAPM is based on a number
of assumptions that are far from the reality. For example, it is very
difficult to find a risk-free security. A short-term highly liquid
government security is considered as a risk-free security. It is unlikely
that the government will default, but inflation causes uncertainty
about the real rate of return.
The assumption of the equality of the borrowing and lending rates
is not correct. In practice, these rates differ. Further investors
may not hold highly diversified portfolios. Under these
circumstances, CAPM may not accurately explain the investment
behavior of investors and beta may fail to capture the risk of
investment.
 …Cont’d

b) It is difficult to test the validity of beta:

c) Stability of data: Beta is a measure of a security’s future risk. But
investors do not have future data to estimate beta. What they have
are past date about the share price and the market portfolio. Thus,
they can only estimate beta based on historical data. Investors can use
historical data as the measure of future risk only if it is stable over
time.
 …Cont’d
The Arbitrage Pricing Model
The CAPM is not always able to account for the difference in
assets’ returns using their betas. This paved the way for the
development of an alternative approach, called the arbitrage
pricing model (APM), for estimating the assets’ expected
returns.
APM, unlike CAPM, does not assume that investors employ
mean-variance analysis for their investment decisions. However,
like CAPM, APM is founded on the notion that investors are
rewarded for assuming nondiversifiable (systematic) risk;
diversifiable (unsystematic) risk is not compensated.
 …Cont’d

 Beta is considered as the most important single factor in

CAPM that captures the systematic risk of an asset. In APM,
there may be one or more macro-economic factors that may
measure the systematic risk of an asset.
 The fundamental logic of APM is that investors always indulge
in arbitrage whenever they find differences in the returns of
assets with similar risk characteristics.
 …Cont’d

Concept of Return Under APM

In APM, the return of an asset is assumed to have two
components: predictable and unpredictable return. Thus, return
on asset j will be:
Kj = Kf + UR
where,
Kj = return on an asset j
Kf = the predictable return (risk-free return on a
zero-beta),and
UR = the unanticipated part of the return
 …Cont’d
 What are the sources of the unexpected return? Like in CAPM, there
are two sources for the unexpected return: the firm-specific and the
market-related.
 The firm-specific factors are special to the firm and affect only the firm.
 The market related factors affect all assets and they comprise macro-
economic factors. Thus, we can rewrite the above equation as follows:
Kj = Kf + URs + URm
where,
URs = the unexpected component of return arising from the specific factors
related to the firm, and
URm = that component of the unexpected return that arises from the
economy wide, market related factors.
 …Cont’d
Concept of Risk Under APM
In CAPM, market risk primarily arises from the sensitivity of an
asset’s return to the market returns and this is reflected by the
asset’s beta. On the other hand, APM assumes that market risk
can be caused by economic factors such as changes in GDP, price
level, the structure of interest rates, etc.
The sensitivity of the asset’s return to each factor is estimated.
Hence, there will be as many betas as the number of factors.
 …Cont’d
The above equation can be expressed as follows:
Kj = Kf + (β1F1 + β2F2 + β3F3 + . . . + βnFn) + URs
Like in CAPM, in APM also there is no compensation for the risk arising
from firm-specific factors (URs).
The portfolio under APM will be weighted average of expected return
and market related unexpected return:
The APM equation for the expected return of asset j can be
generalized as follows:
K j = K f + ∑ β i Yi
where,
Kj = the expected return on asset j
Kf = the expected return on a risk-free (zero-beta) asset
βi = the sensitivity of asset j to factor i, and
Yi = the risk premium for factor i
 …Cont’d
Example
An investor is considering to make an investment in the share of
Bishoftu Co. The following are the attributes of five economic forces
that influence the return of Bishoftu’s share:

Factor Beta Expected Value Actual Value

GNP 1.95 6.00% 6.50%
Inflation 0.85 5.00% 5.75%
Interest Rate 1.20 7.00% 8.00%
Stock Market Index 2.50 9.50% 11.50%
Industrial Production 2.20 9.00% 10.00%
 …Cont’d

Assume that the risk-free (expected) rate of return on Bishoftu’s share

is 9%. How much is the total return on the share? The total return will
consist of anticipated (risk-free) return and unanticipated return:
Kj = Kf + (β1F1 + β2F2 + β3F3 + . . . + βnFn) + URs
= 9% + [(6.5% - 6%)1.95 + (5.75% - 5%)0.85 + (8% - 7%)1.20 +
(11.5% - 9.5%)2.50 + (10% - 9%)2.20]
= 9% + 10%
= 19%
 …Cont’d

 What factors are important in explaining the expected return? How

are they identified?
 APM does not indicate the factors that explain the asset’s return.
The factors are empirically derived from the available data.
Different assets will be affected differently by the factors. For
example, the following factors have been identified in a research
study in the USA:
 Industrial production
 Changes in default premium
 Changes in the structure of interest rate
 Inflation rate
 Changes in the real rate of return
 …Cont’d
Risk Preferences
Different managers or firms might possibly have different risk
preferences. The three basic risk preference behaviors are risk-
averse, risk-indifferent, and risk-seeking behaviors.
The risk-indifferent manager does not require an increase in
required return as risk increases. That is, the manager is indifferent to
the increment in risk.
For the risk seeking manager, the required return decreases for an
increase in risk. Theoretically, because such managers enjoy risk, they
are willing to give up some return to take more risk. Such an individual
would willingly assume all risk in the economy and hence not likely to
exist.
 …Cont’d

 On the other hand, a risk-averse manager requires an increase in

required return for every increase in risk. Because such managers
shy away from risk, they need a higher return if they are to accept a
given level of risk.
 Generally, managers tend to be risk-averse, and such risk-averse
manager has been assumed in our discussions in this chapter. The
SML is positively sloped for risk-averse managers only.