Big Picture D

Week 8-9: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to:
a. Quantify risk and analyze risk-return relationship.
b. Apply Capital Asset Pricing Model (CAPM) concepts in evaluating
investments.

Big Picture in Focus: ULOb. Apply Capital Asset Pricing Model

(CAPM) concepts in evaluating investments.

Metalanguage
For you to demonstrate ULOa, you will need operational understanding of the terms
enumerated below.
1. Capital Asset Pricing Model (CAPM) is a model based on the proposition that
any stocks required rate of return is equal to the risk-free rate of return plus a
risk premium that reflects only the risk remaining after diversification.

2. Diversifiable risk also called unsystematic risk or company risk, is a type of

risk can be diversified away.

3. Undiversifiable risk also called systematic or market risk, is a type of risk

cannot be eliminated by diversification.

4. Beta coefficient (or beta) is the measure of risk when assets are held in a
portfolio.

5. Risk-free rate is the rate of return that an investor would require in a riskless
investment. This is composed of the real rate and inflation premium.

6. Market rate of return is the expected rate of return of the market as a whole.

7. Market risk premium (or price per unit of risk) is the difference between the
market rate of return and the risk-free rate; computed as: (rm – rf).

8. Risk premium is the return required as compensation to investors for taking

risk; computed as: [(rm – rf)(bi)]

9. Security Market Line (SML) a graphical presentation of CAPM.

Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the 6th and 7th
weeks of the course, you need to fully understand the following essential
knowledge laid down in the succeeding pages. Please note that you are not limited
to exclusively refer to these resources. Thus, you are expected to utilize other
books, research articles and other resources that are available in the university’s
library e.g. ebrary, search.proquest.com etc., and even online tutorial websites.
1. The previous sections focused only on the riskiness of stand-alone assets which
is generally appropriate for small businesses, many real estate investments, and
capital budgeting projects. However, the same may not be applicable for banks,
insurance companies, pension funds and other financial institutions as they are
required by law to hold diversified portfolio. It is believed that the risk of a stock
held in portfolio is typically lower than the stock’s risk when it is held alone. Since
most investors dislike risk, they are inclined to hold portfolio to reduce risk. The
next discussion is an attempt to explain how risk should be considered when
stocks are held in a portfolio using the Capital Asset Pricing Model (CAPM).

Capital Asset Pricing Model (CAPM) is a model based on the proposition that
any stocks required rate of return is equal to the risk-free rate of return plus a risk
premium that reflects only the risk remaining after diversification. It provides a
general framework for analyzing risk-return relationships for all types of assets.
CAPM uses only one part of the total risk called the systematic risk, in evaluating
the risk-return relationship.

The total risk (previously measured by standard deviation) can be separated into
two major components:

• Diversifiable risk – also called unsystematic risk or company risk. This is

the part of the security’s risk caused by factors unique to a particular firm.
This type of risk can be diversified away because it represents essentially
random events. Sources of diversifiable or unsystematic risk include
lawsuits, strikes, company management, marketing strategies and research
and development programs, operating and financial leverage and other
events that are unique to a particular firm. Because these events are
random, their effects on a portfolio can be eliminated by diversification.

• Undiversifiable risk – also called systematic or market risk. This is the part
of a security’s risk caused by factors affecting the market as a whole. This
type of risk cannot be eliminated by diversification because it affects all firms
simultaneously. Some companies are sensitive than others to factors that
1affect systematic risk. Hence, systematic risk is the only relevant risk and
is affected by such factors as wars, inflation, interest rates, business cycles,
fiscal and monetary policies and therefore cannot be eliminated by
diversification.
Effect of Diversification on Systematic and Unsystematic Risk
The effect of diversification can be shown on the figure below:

Figure 8. Effect of diversification

It can be observed that as the number of stocks held in a portfolio increases,

the diversifying effect of each additional stock on unsystematic risk
diminishes. However, one should be careful in selecting stocks to be included
in the portfolio taking into consideration their correlations with one another. If
the investor chooses stocks with correlations with one another and with low
stand-alone risk, the portfolio’s risk will decline faster rather than if stocks will
be randomly added.

If increasing the number of stocks held in a portfolio, then is it advisable for an

investor to just hold a portfolio consisting all stocks? Probably not, because of
the following reasons:

❖ It entails high administrative costs and commissions would be more

than offset the income for individual investors.
❖ Index fund can be used for diversification and many individuals can
and do get broad diversification through these funds.
❖ Some people believe that they can pick stocks that will “beat the
market” so they buy them rather than the broad market.
❖ Some people can, through superior analysis, beat the market; so they
find and buy undervalued stocks and sell overvalued ones.
 Capital Asset Pricing Model Illustrated

The CAPM uses beta as a measure of risk. It is a model developed to help

determine a share’s required rate of return for a given level of risk. It can be
computed as:

Required rate of return = risk-free rate + risk premium

If an investor chooses to invest his money, then he must postpone

consumption. Then at what rate of return will an investor be persuaded to
postpone consumption and invest his money instead? If the investor takes no
risk whatsoever, but merely postpones consumption, he wanted to be
compensated for the wait plus an additional return for any inflationary
pressures (an inflation premium).
If the investor demands a 3% return to postpone consumption, and another
2% to cover the expected rate of inflation, he will require 5% rate of return
which is a risk-free rate. In actual market scenario, we can consider treasury
securities as a good proxy or benchmark for a riskless asset because there is
no default risk. At this point we can say that, risk-free rate is composed of:
• real rate that excludes any inflationary expectations; and
• inflation premium that equals the expected inflationary rate.
To continue the illustration, an investor would get to move from a risk-free
asset if he will be given an additional compensation that he requires for
investing in a risky asset. The additional compensation required referred as
risk premium can be computed as follows:

Risk Premium = (Price per unit of Risk) (Beta)

The price per unit of risk is the difference between return on the market and
the risk-free rate, that is:

Price per unit of risk = Return on the Market – Risk-free Rate

Therefore, the formula to compute for the required rate of return under CAPM,
can be expressed as follows:
ri = rf + (rm – rf) (bi)
Where:
ri = required (or expected) return on security, i
rf = expected risk-free rate of return
rm = expected return on the market portfolio
bi = beta coefficient of security, i
Illustration 1. Suppose a particular stock has a risk-free rate of 5%, a rate of return
on the market of 12% and a beta coefficient (quantity of risk) of 1.5. What would be
the investor’s required rate of return?
Solution: ri = rf + (rm – rf) (bi)
ri = 5% + (12% - 5%) (1.5)
ri = 5% + 10.5%
ri = 15.5%

The investor would require a risk premium of 10.5%. Thus, the required rate of
return is 15.5%.

Illustration 2. Using the same illustration, except that the beta coefficient is 2.0,
what would be the required rate of return?
Solution: ri = rf + (rm – rf) (bi)
ri = 5% + (12% - 5%) (2)
ri = 5% + 14%
ri = 19%

The investor would demand for a greater rate of return because of the increase in
risk. The additional compensation (risk premium) required is 14%. Thus, the
required rate of return is 19%. As can be observed, the higher the risk, the greater
would be the required rate of return.
The Beta Coefficient Concept
The risk of a stock when it is held by itself can be measured using the standard
deviation of its expected returns. However, this is not applicable if stocks are held in
a portfolio. Hence, the systematic risk can be measured by a stock’s beta
coefficient.
Beta is a measure of the sensitivity of a security’s return relative to the returns of a
broad-based market portfolio securities. It measures the co-movement between a
stock and the market portfolio. The tendency of the stock to move with the market is
reflected in its beta coefficient (b), which is the measure of the stock’s volatility
relative to an average stock.
An average-risk stock is defined as one that tends to move up and down in step
with the general market as measured by some index, such as PSE Index, Dow
Jones Industrials, the S&P 500 or the New York Stock Exchange Index.
An average stock generally has a beta (b) of 1.0 which means that is the market
moves up by 10%, the stock will also move up by 10%; on the other hand, if the
market falls by 10%, the stock will likewise fall by 10%. Hence, a portfolio of stocks
with beta of 1.0, will move up and down with the broad market averages, and it will
be just as risky as the averages.
If the beta is equal to 0.50, the stock is only half as volatile as the market – it will
rise and fall only half as much – and a portfolio of such stocks will be half as risky
as a portfolio of stocks with beta of 1.0.
If the beta is equal to 2.0, the stock is twice as volatile as an average stock, so a
portfolio of such stocks will be twice as risky as an average portfolio. The value of
such portfolio could double – or halve – in a short time; hence, very risky.
Figure 9. Relative Volatility of Stocks A, B and C

Figure 9 presents the relative volatility of three stocks. The data below the graph
assume that in 2009 the market, defined as the portfolio consisting of all stocks,
had a total return (dividend yield plus capital gains yield) of k m = 10%, and stocks A,
B and C (for High, Average and Low risk) also had returns of 10%. In 2013, the
market went up sharply, and the return on the market portfolio was k m = 20%.
Returns on the three stocks also went up: A soared to 30%; B went to 20%, the
same as the market; and C only went up to 15%. Now suppose that the market
dropped in 2014, and the market return was km = -10%. The three stocks’ return
also fell, A plunging to -30%; B falling to -10% while C reported 0%. Thus, the three
stocks all moved in the same direction as the market, but A was by far the most
volatile; B was a volatile as the market; and C was less volatile.
If a higher-beta-than-average stock is added to an average-beta portfolio, then the
beta and consequently, the riskiness of the portfolio will increase. Conversely, if a
lower-beta-than-average stock is added to an average-risk portfolio, the portfolio’s
beta and risk will decline.
To summarize, the market risk of a stock is measured by its beta coefficient, which
is an index of the stock’s volatility. Some benchmark betas follow:
b = 0.5 : Stock is only half as volatile, or risky, as the average stock.
 b = 1.0 : Stock is of average risk.
b = 2.0 : Stock is twice as risky as the average stock.

Portfolio Beta Coefficient

Portfolio beta coefficient can be computed as the weighted average of the individual
securities’ betas. The beta of the portfolio reflects how volatile the portfolio is in
relation to the market.

For example, if an investor holds P1,500,000 portfolio consisting of P500,000

invested in each of 3 stocks and each of the stock has a beta of 0.8, then the
portfolio’s beta will be:
bp = (1/3)(0.8) + (1/3)(0.8) + (1/3)(0.8)
= .8

Since the portfolio beta is lower than 1, we can safely say that this portfolio is less
risky than the market. Hence, it should experience relatively narrow price swings
and have relatively small rate of return fluctuations.

Suppose one of the existing stocks is sold and replaced by a stock with b1 = 2, what
will happen to the portfolio beta? In this case, since, one of the stocks has
increased its beta, we can expect that the portfolio beta will also increase as
computed as follows:

bp = (1/3)(0.8) + (1/3)(0.8) + (1/3)(2)

= 1.2

Hence, from a portfolio beta of 0.80, it increased to 1.2 as a stock with higher beta
was added in the portfolio.

Another illustration. Calculation of Portfolio Beta

An investor decided to invest his P350,000 as follows:

Amount % Allocation Beta

Diversified Stocks P200,000 57.1% 1.00
Bonds 100,000 28.6% 0.18
Treasury bills 50,000 14.3% 0.00
Total P350,000 100.0%

The beta for this portfolio can be computed as follows:

b = (0.571)(1) + (.286)(0.18) + (.143)(0)
b = .62
With a portfolio beta of .62, a market return of 11% and a risk-free rate of 5%, an
investor can expect a return of:

ri = rf + (rm – rf) (bi)

= 5% + (11%-5%)(.62)
= 8.7%

Security Market Line (SML)

The CAPM is expressed graphically by the security market line (SML). The security
market line represents the linear relationship between a security’s required rate of
return and its risks as measured by beta.

Figure 10. The Security Market Line (SML)

Figure 10 shows the SML and the risk-return tradeoff of Stock 1 and Stock 2. As can
be gleaned, the risk-free rate is 8% whereas the market rate of return is 14%;
therefore, the market risk premium is 6% (14%-8%). Stock 1 with a beta coefficient
of 2 would require a high risk premium of 12%; hence, its required rate of return is
20%. On the other hand, Stock 2 with a beta coefficient of 0.5 would require a low
risk premium of 3%, hence, its required rate of return is 11%.

The required rate of return computed under CAPM can also be used as a market-
based hurdle rate for the purpose of evaluating investments. A hurdle rate is the
minimum rate of return required for a project to be accepted. Hence, if an assets’
expected rate of return equals or exceeds the required return (falls on or above the
SML), as computed by CAPM, the asset is accepted; otherwise, it is rejected.
Illustration on Investment Decision based on SML

Based on the previous illustration, Stock 1 and Stock 2 have required rates of return
of 20% and 11%, respectively. Assume that the expected return for Stock 1 is 18%
and for Stock 2 is 15%. Should the investments be acquired based on the SML?

Figure 11 shows that Stock 2’s expected return of 15% is above the SML and
therefore should be acquired because it is higher than the required rate of return
(hurdle rate) of 11%. On the other hand, Stock 1 is rejected because it is expected
return is only 18% which is lower than the required rate of return of 20%. Also, based
on the graph, the expected return of Stock 1 of 18% is under the SML; hence, should
be rejected.

Figure 11. Using Security Market Line (SML) to Select Securities

Concerns About CAPM

The CAPM is based on restrictive assumptions about investor behavior and the
securities market.
❖ Assumptions about investor behavior include:
• Investors are risk-averse and expect to be rewarded for taking risks;
• Investors act rationally and prefer a security with the highest return for a given
level of risk, or the lowest risk for a given level of return;
• Investors make their decisions based on a single time horizon; and
• Investors share the same expectations about the risk and return
characteristics of securities.
2. Assumptions about the securities market include:
• All investors can borrow or lend in unlimited amounts at the risk-free rate;
• Financial markets are frictionless in that there are no taxes or transaction
costs;
• All assets are perfectly divisible and perfectly liquid and
• Information is freely available to all investors.

CAPM’s limitation lies on the fact that some of its assumptions do not all reflect
reality. There is also greater possibility that we may not be able to determine the
average return on market portfolio since they could be many possible bases and we
may not be able to determine which is most representative of the market. Another
concern is related to beta estimation because the applicability and relevance of a
company’s beta will depend on the future plans of the firm.

With these limitations, finance researchers have introduced other asset pricing
models which considers other risk factors to the predictive relationship of risk and
return other than the market risk. These factors such as firm size and book-to-market
ratio are used along with beta as measure of market risk.

Self-Help: You can also refer to the sources below to help you
further understand the lesson.

Cabrera, M. B. (2015). Financial management principles and applications volume 2.

Manila: GIC Enterprises & Co., Inc.

Saunders, A., & Cornett, M. M. (2019). Financial markets and institutions (7th ed.).
New York: McGraw Hill Education.

Let’s Check

Activity 1: Classify the following events whether they can be distinguished as

systematic or unsystematic.

_________________ 1. Short-term interest rates increase unexpectedly.

_________________ 2.The interest rate a company pays on its short-term debt
borrowing is increased by its bank.
_________________ 3. Oil prices unexpectedly declined.
_________________ 4. An oil tanker ruptures, creating a large oil spill.
_________________ 5. A manufacturer loses a multimillion-peso product liability
suit.
_________________ 6. A Supreme Court decision substantially broadens producer
liability for injuries suffered by product users.
_________________ 7. A company suffered losses due to employees strike.
_________________ 8. Companies reported losses due to Covid-19 Pandemic.
_________________ 9. Inflation rate increased sharply.
_________________ 10. The stock price of a company declined due to reported
losses.
Activity 2: Apply CAPM concepts in answering the problems below.

Problem 1. Assume that the risk-free rate is 8%. The expected return on the market
is 16%. If a particular stock has a beta of .7, what is the expected return based on
the CAPM?

Problem 2. The ordinary equity share of Cebu Air, Inc. (CEB) has an estimated
beta of 1.2. The risk-free rate is 7% and the expected return on the market is 12%.

Show your computations in answering the following:

2.1. What is the market risk premium?

2.2. What is the required rate of return using CAPM?

2.3. Assume that the risk-free rate of 7% includes an inflation premium of 4%. What
would happen to the required rate of return if the inflationary expectations of
investors will increase to 6%?

Activity 3. Computation of Portfolio Beta

An investor owns an equity share portfolio invested in the following manner:

% Allocation Beta
Stock A 25% 0.84
Stock B 20% 1.17
Stock C 15% 1.11
Stock D 40% 1.36

What is the portfolio beta?

Let’s Analyze

Activity 1. Investment Evaluation using Beta Coefficient

Joel Securities plans to purchase equal amount of four of the following equity
shares for one of its clients. The client already holds a highly diversified portfolio.
The risk-free rate of return is estimated at 8% and the expected market return at
14%. The beta coefficients of the equity shares are as follows:

Equity Share 1 2 3 4 5 6
Betai 1.5 1.0 0.8 2.0 0.3 1.2

Questions:

1. What is the required rate of return of each security?

Stock 1: ______________________________________________________
Stock 2: ______________________________________________________
Stock 3: ______________________________________________________
Stock 4: ______________________________________________________
Stock 5: ______________________________________________________
Stock 6: ______________________________________________________

2. If the client wants to have the lowest risk portfolio, what four (4) equity shares
should be selected?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

3. What is the required rate of return of the four-equity shares portfolio selected?
Assume an equal investment in each equity share.

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________
Activity 2. Investment Evaluation using Security Market Line

The following information pertains to Stock A, B and C:

Stock A Stock B Stock C

Beta 0.5 1.0 1.2
Expected return 11% 12% 20%
Risk-free rate 5%
Expected return on market 15%

The following information is plotted in the following graph and draws a

security market line:

1. What does the SML represent?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

2. How can you use this graph to select securities?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

3. How much is the required rate of return of Stocks A, B and C?

 Stock A: ______________________________________________________

Stock B: ______________________________________________________

Stock C: ______________________________________________________

4. Which of the stocks should be selected? Explain your answer.

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

In a Nutshell

Based on the concepts presented, answer the following questions.

1. Distinguish between systematic risk and unsystematic risk?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

2. What the significance of Capital Asset Pricing Model (CAPM)?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

3. What will happen to the required rate of return when beta coefficient increases?

_____________________________________________________________
 _____________________________________________________________

_____________________________________________________________

_____________________________________________________________

4. How do you make investment decisions using CAPM?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

5. How do you make investment decisions using Security Market Line (SML)?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

Q&A List
Do you have any question for clarification? Write them here.

Questions/Issues Answers

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5.
Keyword Index
Beta coefficient (or beta) Risk-free rate
Capital Asset Pricing Model (CAPM) Risk premium
Diversifiable risk Security Market Line (SML)
Market rate of return Undiversifiable risk
Market risk premium