University of Kelaniya, Sri Lanka

PMDS Pathiraja
Lecturer (Probationary)
Department of Accountancy
Faculty of Commerce & Management Studies
University of Kelaniya
 Higher Diploma in Business
Accounting
HDAC 12313 – Business Finance
Risk and Return I

Department of Accountancy , University of Kelaniya, Sri Lanka

 Learning Outcomes
End of the session, you should be able to;
▪ Define concepts of risk and return
▪ Measure risk & return of a single asset
▪ Identify types of investors
▪ Identify systematic & unsystematic risk
▪ Define and explain the capital-asset pricing model
(CAPM) & assumptions of the CAPM model
▪ Demonstrate how the Security Market Line (SML) can be
used to describe this relationship between expected rate of
return and systematic risk

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 What is Return?
▪ There is uncertainty associated with
returns on shares.
▪ When you invest in a stock you know that the return
from it can take various possible values.
▪ The probability of an event represents likelihood of
its occurrence.

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 What is Expected Rate of Return (R)
or E(R) ?
▪ If we multiply each possible outcome by its
probability of occurrence and then sum of these
products, then we obtain a weighted average of
outcomes.
▪ The weights are probabilities, and the weighted
average is the expected rate of return.

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 Example 01:
▪ Assume we can assign probabilities to the possible
returns - given the following set of circumstances,
the expected return is;
Example:

Percentage Probability,
Return, Ri Pi n
E (R ) = R P i i
9 0.1 i =1

10 0.2 = (0.09 x 0.1) + (0.10 x 0.2)

11 0.4 + (0.11x 0.4) + (0.12 x 0.2)
+ (0.13 x 0.1)
12 0.2
E (R ) = 11%
13 0.1

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Exercise 01
Prob. Distributions of rate of return on Company A &
B are given below. Calculate the expected rate of
return of each company.
State of the Probability Return of A Return of B
economy
Boom 0.3 16% 40%
Normal 0.5 11% 10%
Recession 0.2 6% (20%)

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What is Risk?
▪ Risk is present whenever investors are not
certain about the outcome an investment will
produce
or
▪ The variability of returns from those that are
expected.
▪ Risk measured by variance - how much a particular
return deviates from an expected return. Use
standard deviation to measure risk.

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 What is Standard Deviation (Risk
Measure)?
▪ Standard Deviation () is a statistical measure of the
variability of a distribution around its mean, which
is simply the square root of the variance.
▪ Standard Deviation (), Variance (2)

n
 =  (Ri − E (R )) Pi
2 2

i =1

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Example 02: How to determine the Expected Return
and Standard Deviation?
▪ Assume that you have given following details of
Stock PQ.
2
Ri Pi (Ri )(Pi ) (Ri - R ) (Pi )
-0.15 .1 -.015 .00576
-.03 .2 -.006 .00288
.09 .4 .036 .00000
.21 .2 .042 .00288
.33 .1 .033 .00576
Sum 1.0 .090 .01728 (2)

Standard Deviation () = Variance (2) = 0.1728

= .1315 or 13.15%
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Example 03: How to determine the Coefficient of
Variation (CV)?

▪ It is a measure of RELATIVE risk.

CV =  / R
Using example 02, we can calculate the CV as;
= .1315/ .09 = 1.46

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 Types of investors
▪ Risk-neutral investor: One whose utility is unaffected
by risk; when chooses to invest, investor focuses only
on expected return.
▪ Risk-averse investor: One who demands compensation
in the form of higher expected returns in order to be
induced into taking on more risk.
▪ Risk-seeking investor: One who derives utility from
being exposed to risk, and hence, may be willing to give
up some expected return in order to be exposed to
additional risk.

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 Systematic & unsystematic risk
▪ We should think of risk as comprising:
Total Risk = Systematic Risk + Unsystematic Risk

▪ Systematic risk: Component of total risk that is due to

economy-wide factors (non-diversifiable risk).
▪ Unsystematic risk: Component of total risk that is unique to
firm and is removed by holding a well-diversified portfolio.

**Systematic risk of a security or portfolio will depend on its

sensitivity to the effects of market-wide or economy-wide factors.

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 Systematic & unsystematic risk

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 Capital Asset Pricing Model (CAPM)

▪ The CAPM was introduced by Jack Treynor (1961,

1962), William F. Sharpe (1964), John Lintner (1965)
and Jan Mossin (1966) independently, building on the earlier
work of Harry Markowitz on diversification and modern
portfolio theory.

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 Capital Asset Pricing Model (CAPM) -
Contd.

▪ CAPM is a model that describes the relationship

between risk and expected (required) return; in this
model, a security’s expected (required) return is the
risk-free rate plus a premium based on the
systematic risk of the security.

RRR = Rf + Beta (Rp)

Rp= Emr- Rf

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 Assumptions of CAPM model

▪ Capital markets are efficient.

▪ Homogeneous investor expectations over a given
period.
▪ Risk-free asset return is certain (use short-to
intermediate-term Treasuries as a proxy).
▪ Market portfolio contains only systematic risk.

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 Risk, Return and the CAPM
▪ The capital market will only reward investors for
bearing risk that cannot be eliminated by
diversification.
▪ Unsystematic risk can be diversified away, so capital
market will not reward investors for taking this type
of firm specific risk.
▪ However, CAPM states the reward for bearing
systematic risk is a higher expected return, consistent
with the idea of higher risk requires higher return.
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 What is Security Market Line (SML)?
▪ The security market line (SML) is a line drawn on
a chart that serves as a graphical representation of
the capital asset pricing model (CAPM), which
shows different levels of systematic, or market,
risk of various marketable securities plotted
against the expected return of the entire market at
a given point in time.

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 What is Security Market Line (SML)?
Cont.

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 What is Security Market Line (SML)?
Cont.

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 What is Risk free rate?

▪ The risk-free rate, or as it is sometimes known,

the risk-free interest rate, is the yield on high
government bonds.
Eg: T/B rate
▪ Why that the T/B rate considered as risk-free rate?
- Because government assurance is always
there.
▪ What is the existing Treasury Bill (T/B) rate of Sri
Lanka?
- 7%
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 Risk free rate (Contd.)

Rf = Real Required Return + Inflation

▪ Real Required Return is; adjusting the
nominal return to inflation or deflation (the actual
return which an investor receive).

▪ Risk free rate should be over and above the

inflation rate. To compensate the investor who has
invested on shares instead of investing on a Fixed
Deposit (because investor has taken the additional
risk already).
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 Risk free rate (Contd.)
Required
Return
(Km) SML 1

SML = Rf + β (Km – Rf)

SML 2

Rf
Changes in the
inflation rate will
cause to shift SML
upward or downward

0 Beta (β)

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 Risk premium
▪ A risk premium is the return in excess of the risk-free
rate of return an investment is expected to yield; an
asset's risk premium is a form of compensation for
investors who tolerate the extra risk, compared to that
of a risk-free asset, in a given investment.

Risk premium = β * (Km – Rf)

Per unit risk

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 Risk premium (Contd.)
Required
Rate of
Return
(Km)
SML
18%

10%
Risk Premium
8%

7%

0.5 1 1.5
0 Conservative Neutral Aggressive Beta (β)
(lower risk) (high risk)
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Common Methods of Measurement
for Investment Risk

• Standard Deviation
• Sharpe Ratio
• Beta
• Value at Risk (VaR)
• Conditional Value at Risk (CVaR)
• R-squared

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 Sharpe Ratio
How do you select funds?

• The most simple approach would be peformance

i.e. returns, right?!

• But is it sufficient to track only returns?

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There is something more …
• The reliability of the scheme too is a critical aspect. Reliability
is nothing but volatility.

• A scheme giving good returns but is extremely volatile or

unreliable may not find favor with a larger number of
investors.

• This calls for a measure of performance which takes into

account both returns as well as volatility / reliability.

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 Understanding Sharpe Ratio
• Sharpe Ratio expresses the relationship between performance
of a scheme and its volatility.
• A higher ratio signifies a relatively less risky scheme.
• Mathematically is can be expressed as:

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 Beta

▪ An index of systematic risk. It measures

the sensitivity of a stock’s returns to
changes in returns on the market portfolio.
▪ The beta for a portfolio is simply a weighted
average of the individual stock betas in the
portfolio.
“Beta measures the extent to which the return on a
financial asset fluctuates with the return on the
market portfolio”.

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 How do you calculate Beta (β)?

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 Value at Risk (VaR)
• VaR is a measure of the minimum loss that would
be expected over a period of time for a pre-specified
small probability
• For example a VaR of $1 million over the next day
at a probability of 0.05 implies that the firm would
expect to lose at least $1 million over the next day 5
percent of the time - one day in twenty
• Or the firm can expect not to lose more than $1m
over the next day 95 percent of the time

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 VaR Cont.
• VaR is a useful device for measuring the
market risk of a portfolio
• It is useful in management reporting
• Three attributes are required when reporting
a VaR:
• A dollar amount
• A level of confidence
• A time horizon or planning horizon

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 VaR - methods of calculation
There are three main approaches to the calculation of
a VaR number for a portfolio
1. The analytical method also called the variance-
covariance method
2. The historical simulation method
3. The Monte Carlo simulation method

Each method has strengths and weaknesses

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 Conditional Value at Risk (CVaR)
• Conditional Value at Risk (CVaR), also known as the
expected shortfall, is a risk assessment measure that
quantifies the amount of tail risk an investment
portfolio has.
• CVaR is derived by taking a weighted average of the
“extreme” losses in the tail of the distribution of
possible returns, beyond the value at risk (VaR) cutoff
point.
• Conditional value at risk is used in portfolio
optimization for effective risk management.

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 Conditional Value at Risk (CVaR)
• Generally speaking, if an investment has shown stability
over time, then the value at risk may be sufficient for risk
management in a portfolio containing that investment.
• However, the less stable the investment, the greater the
chance that VaR will not give a full picture of the risks, as
it is indifferent to anything beyond its own threshold.
• Conditional Value at Risk (CVaR) attempts to address the
shortcomings of the VaR model, which is a statistical
technique used to measure the level of financial risk within
a firm or an investment portfolio over a specific time
frame.
• While VaR represents a worst-case loss associated with a
probability and a time horizon, CVaR is the expected loss if
that worst-case threshold is ever crossed.
• CVaR, in other words, quantifies the expected losses that
occur beyond the VaR breakpoint.
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 Conditional Value at Risk (CVaR)
Formula
• Since CVaR values are derived from the calculation
of VaR itself, the assumptions that VaR is based on,
such as the shape of the distribution of returns, the
cut-off level used, the periodicity of the data, and
the assumptions about stochastic volatility, will all
affect the value of CVaR.
• Calculating CVaR is simple once VaR has been
calculated. It is the average of the values that fall
beyond the VaR:

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Conditional Value at Risk (CVaR)
Formula

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 R-squared
• R-squared is a statistical measure that represents the
percentage of a fund portfolio or a security's
movements that can be explained by movements in
a benchmark index.
• R-squared values range from zero to one and are
commonly stated as a percentage (0% to 100%).
• An R-squared value of 0.9 means 90% of the
analysis accounts for 90% of the variation within
the data.
• Risk models with higher R-squared values indicate
that the independent variables being used within the
model are explaining more of the variation of the
dependent variable.

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The Arbitrage Pricing Theory
• Single-Factor APT Model
• Multi-Factor APT Models
• Arbitrage Opportunities
• Disequilibrium in APT
• Is APT Testable?
• Consistency of APT and CAPM
 Essence of the Arbitrage Pricing
Theory

• Given the impossibility of empirically verifying the

CAPM, an alternative model of asset pricing called
the Arbitrage Pricing Theory (APT) has been
introduced.
• Essence of APT
• A security’s expected return and risk are directly related
to its sensitivities to changes in one or more factors
(e.g., inflation, interest rates, productivity, etc.)
Essence of the Arbitrage Pricing Theory
(Continued)

• In other words, security returns are generated by a

single-index (one factor) model:
rj,t = A j + β1, jI1,t + ε j,t
where:
I1,t = Value of Factor (1) in period (t)
β1, j = beta of security (j) with respect to Factor (1)
• or, by a multi-index (multi-factor) model:

rj,t = A j + β1, jI1,t + β 2, jI 2,t + . . . + βn, jIn,t + ε j,t

 Single-Factor APT Model
(A Comparison With the CAPM)

CAPM (Zero Beta Version) APT (One Factor Version)

Factor = Market Portfolio Factor = “Your Choice”

Actual Returns: Actual Returns:

rj,t = A j + β jrM,t + ε j,t rj,t = A j + β1, jI1,t + ε j,t

Expected Returns: Expected Returns:

E(r j ) = E(r z ) + [E(r M ) − E(r z )] β j E(r j ) = E(r z ) + [E(I 1 ) − E(r z )] β1, j
Market Risk Premium Factor Price *
* Note : In the text, lambda ( ) denotes
factor price.
 Single-Factor APT Model
(A Comparison With the CAPM)
Continued

CAPM (Zero Beta Version) APT (One Factor Version)

Continued Continued
Portfolio Variance: Portfolio Variance:

σ 2 (rp ) = βp2 σ 2 (rM ) + σ 2 (ε p ) σ 2 (rp ) = β1,

2
p σ 2
(I 1 ) + σ 2
(ε p )
m m
where βp = x β
j=1
j j where β1,p = x β
j=1
j 1, j

m m
σ 2 (ε p ) = 
j=1
x 2jσ 2 (ε j ) σ 2 (ε p ) = 
j=1
x 2jσ 2 (ε j )

As suming COV( ε j , ε k ) = 0 As suming COV( ε j , ε k ) = 0

 Multi-Factor APT Models

• One Factor
rj,t = A j + β1, jI1,t + ε j,t
E(r j ) = E(r z ) + [E(I 1 − E(r z )] β1, j

σ 2 (rp ) = β1,
2
p σ 2
(I 1 ) + σ 2
(ε p )
• Two Factors

rj,t = A j + β1, jI1,t + β 2, jI 2,t + ε j,t

E(r j ) = E(r z ) + [E(I 1 ) − E(r z )] β1, j + [E(I 2 ) − E(r z )] β 2, j

σ 2 (rp ) = β1,
2 2
p σ (I 1 ) + β 2 2
2,p σ (I 2 ) + σ 2
(εp )
 The Ideal APT Model

Ideally, you wish to have a model where all of the

covariances between the rates of return to the
securities are attributable to the effects of the
factors. The covariances between the residuals of
the individual securities,
Cov( j,  k), are assumed to be equal to zero.
 APT With an Unlimited Number of
Securities
Given an infinite number of securities, if security
returns are generated by a process equivalent to that
of a linear single-factor or multi-factor model, it is
impossible to construct two different portfolios,
both having zero variance (i.e., zero betas and zero
residual variance) with two different expected rates
of return. In other words, pure riskless arbitrage
opportunities are not available.
 Pure Riskless Arbitrage Opportunities
(An Example)
Note: If two zero variance portfolios could be
constructed with two different expected rates of
return, we could sell short the one with the lower
return, and invest the proceeds in the one with the
higher return, and make a pure riskless profit with
no capital commitment.
Pure Riskless Arbitrage Opportunities
(An Example) - Continued

Expected Return (%)

0.25 D
C

B
E(rZ)1
A
E(rZ)2

0
-0.5 0 0.5 1 1.5

Factor Beta
 “Approximately Linear” APT Equations

• The APT equations are expressed as being

“approximately linear.” That is, the absence of
arbitrage opportunities does not ensure exact linear
pricing. There may be a few securities with expected
returns greater than, or less than, those specified by
the APT equation. However, because their number is
fewer than that required to drive residual variance of
the portfolio to zero, we no longer have a riskless
arbitrage opportunity, and no market pressure forcing
their expected returns to conform to the APT
equation.
 Disequilibrium Situation in APT:
A One Factor Model Example
• Portfolio (P) contains 1/2 of security (B) plus 1/2 of the zero
beta portfolio:
β1,P = .5 β1,B + .5 β1,Z = .5(2.0) + .5(0) = 1.0
• Portfolio (P) dominates security (A). (i.e., it has the same
beta, but more expected return).
Expected Return (%)
B
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P
E(rP)
E(I1) Equilibrium Line
E(rA) A
E(rZ)

0 Beta
0 0.5 1 1.5 2 2.5
 Disequilibrium Situation in APT:
A One Factor Model Example
(Continued)

• Arbitrage: Investors will sell security (A). Price of

security (A) will fall causing E(rA) to rise. Investors
will use proceeds of sale of security (A) to purchase
security (B). Price of security (B) will rise causing
E(rB) to fall. Arbitrage opportunities will no longer
exist when all assets lie on the same straight line.
 Anticipated Versus Unanticipated Events
• Given a Single-Factor Model:
rj,t = A j + β1, jI1,t + ε j,t {Equation #1}
Since E( ε) = 0, we can state that :
E(r j ) = A j + β1, jE(I 1 )
or
A j = E(r j ) − β1, jE(I 1 ) {Equation #2}
• Substituting the right hand side of Equation #2 for Aj in
Equation #1:
rj,t = E(r j ) − β1, jE(I 1 ) + β1, jI1,t + ε j,t
rj,t = E(r j ) + β1, j[I 1,t − E(I 1 )] + ε j,t
Actual Anticipated Un anticipated
Return Return Return
 Anticipated Versus Unanticipated Events
(Continued)
• Note: If the actual factor value (I1,t) is exactly equal
to the expected factor value, E(I1), and the residual
( j,t) equals zero as expected, then all return would
have been anticipated:
rj,t = E(rj)

If (I1,t) is not equal to E(I1), or ( j,t) is not equal to

zero, then some unanticipated return (positive or
negative) will be received.
 Anticipated Versus Unanticipated Events
(A Numerical Example)
• Given:
E(r Z ) = .06 E(I 1 ) = .12 I1,t = .15 ε j,t = .01 β1, j = .5
• Expected Return:
E(r j ) = E(r Z ) + [E(I 1 ) − E(r Z )] β1, j
= .06 + [.12 - .06].5
= .09
• Anticipated Versus Unanticipated Return:
rj,t = E(r j ) + β1, j[I 1,t − E(I 1 )] + ε j,t
= .09 + .5[.15 - .12] + .01
= .09 .015 + .01
Anticipated Unanti cipated
CAPM
Vs. APT
 Questions?

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Department of Accountancy , University of Kelaniya, Sri Lanka
 Thank you.!

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Department of Accountancy , University of Kelaniya, Sri Lanka