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Financial
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MARKET LINE
RETURN, RISK, AND THE SECURITY
 LECTURE OBJECTIVES

❑ Calculate the expected return and risk (standard

deviation) of both a single asset and a portfolio.
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❑ Distinguish between systematic and non-

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systematic risk.

❑ Explain the principle of diversification.

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❑ Explain the capital asset pricing model (CAPM).

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 RISK AND RETURN – PRELIMINARIES

Risk: the probability (chance) that an investment’s actual

return will be different than expected return.
How different is different ?
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→ It can be more or less than expected return!!!

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People have different attitudes towards risk:

❑ Risk lover (seeker)
❑ Risk adverse
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❑ Risk neutral
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Always there is risk return tradeoff: The higher the risk, the
higher the return

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- INDIVIDUAL ASSETS
MEASURING RISK AND RETURN
 MEASURING EXPECTED RETURN OF
INDIVIDUAL ASSETS
Expected return—the weighted average of the
distribution of possible returns
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n
E (r ) =  pi ri
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i =1

Where:
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pi : probability of state “i” happening

ri : the return in state “i”
n: number of possible outcomes/states
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 EXAMPLE – MEASURING EXPECTED
RETURN OF INDIVIDUAL ASSETS
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 HOW DO WE MEASURE RISK?

Risk is the variability of returns from

expected return ( how actual return deviates
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from expected return)

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→It is the statistical standard deviation of

possibile returns
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 MEASURING RISK OF INDIVIDUAL ASSETS
Variance is a measure of the variation of possible rates of
return (ri )from the expected return
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( ) =  p r
n
− E (r )
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Variance  2
i i
i =1
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Standard deviation is the square root of the variance

n
StdDev( ) =  p r − E (r )
2
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i i
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i =1

pi: the probability of state ‘”i” happening

E(r): expected return
8 ri : return in state “i”
 INTERPRETING THE STANDARD DEVIATION
From your statistics course:
If we denote standard Deviation for an investment 
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→There is 68.28% probability that a return will fall

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within the expected return (+/-) 1

→95% probability that a return will fall within

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the expected return (+/-) 2

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→99% probability that a return will fall within

the expected return (+/-) 3
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 EXAMPLE – MEASURING STANDARD
DEVIATION OF INDIVIDUAL ASSETS
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How to
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interpret this
14.14%?

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 STANDARD DEVIATION EXAMPLE –
INTERPRETING THE RESULT
How to interpret this 14.14% standard deviation ?
❑ 68.28% probability that a return will fall within
15% (+/-) 14.14% or (0.86%; 29.14%)
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❑ 95% probability that a return will fall within

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15% (+/-) 2*14.14% or (-13.28%; 43.28%)

❑ 99% probability that a return will fall within
15% (+/-) 3*14.14% or (-27.42%; 57.42%)
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Conclusion: StdDev () measures how far each possible

return varies from the mean (expected return)
If small StdDev, then less risk
11 If large StdDev, then more risk
 EXAMPLE 2 – EXPECTED RETURN AND
VARIANCE OF INDIVIDUAL SECURITIES
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Expected Returns:
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 EXAMPLE 2 – EXPECTED RETURN AND
VARIANCE OF INDIVIDUAL SECURITES

Variances:
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Standard deviations
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- TWO OR MORE ASSETS

MEASURING RISK AND RETURN
 PORTFOLIO
❑ A portfolio is a collection of assets held by
an investor.
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What are the possible components of a

portfolio ?
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→ Bond, stock, IOU, COD…

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❑ The risk–return trade-off for a portfolio is

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measured by the portfolio’s expected return

and standard deviation, just as with
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individual assets.
 PORTFOLIO EXPECTED RETURNS
❑ The expected return of a portfolio is the weighted
average of the expected returns for each asset in
the portfolio.
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n
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E(Rp) = ∑ wjE (Rj)

j =1
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Where:
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Wj : the proportion of fund ($) invested in asset j

n : the number of assets in the portfolio
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 EXAMPLE – PORTFOLIO RETURN
and STANDARD DEVIATION
Assume 50 per cent of portfolio in asset A and 50
per cent in asset B.
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What is the portfolio’s expected return?

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What is the portfolio’s StdDev?
 EXAMPLE – PORTFOLIO RETURN
C1: weighted average of the expected return of each asset

E(RA) = 0.3 x 0.4 + (-0.1) x 0.6 = 0.06

E(RB) = -0.05 x 0.4 + 0.25 x 0.6 = 0.13
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→ E(RP) = 0.5x 0.06 + 0.5 x 0.13 = 0.095

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C2: weighted average of the expected return of each state

Return of porfolio in case economy boom:
= 0.3 x 0.5 + (-0.05) x 0.5 = 0.125
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Return of porfolio in case economy bust:

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= -0.1 x 0.5 + 0.25 x 0.5 = 0.075

→ Expected return of porfolio
E(RP) = 0.4 x 0.125 + 0.6 x 0.075 = 0.095
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 EXAMPLE – PORTFOLIO
VARIANCE/STANDARD DEVIATION
❑ Note that Var(Rp)  (0.50 x Var(RA)) + (0.50 x Var(RB))

STATE OF Pi R(P)
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ECONOMY
Boom 0.4 0.125
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Bust 0.6 0.075

E(RP) = 0.095
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Var (RP) = 0.4 x (0.125 – 0.095)2 + 0.6 x (0.075 – 0.095)2 = 0.0006

→StdDev (RP) = 0.0006

19 = 0.0245 or 2.45%
 EXAMPLE – PORTFOLIO VARIANCE/STANDARD
DEVIATION CONCLUSION
❑ Variance of portfolio is not weighted average of
variances of individual assets
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❑ An equally weighted portfolio (50% in stock A and

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50% in stock B) has less risk than stock A or B held

separately.
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❑ By combining assets in a portfolio, the risks faced

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by the investor can significantly DECREASE

(diversification effect).

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 WHY DIVERSIFICATION REDUCES RISK?
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Actual total return differs from Expected Return because

of the unexpected (surprises) that occur.
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 RISK –
SYSTEMATIC AND NON-SYSTEMATIC

❑ Systematic risk: that component of total risk which is

due to economy-wide factors and affects a large
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number of assets.
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ex: uncertainties about GDP, interest rates, inflation…

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❑ Non-systematic risk: that component of total risk

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which is unique to an asset or firm.

ex: strike, death of CEO…
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 SYSTEMATIC OR NON-SYSTEMATIC?
✓ Chinese government depreciate its “Yuan”

✓ Vietnamese government increases energy prices (petrol/gas)

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✓ Dong A Bank and Ocean Bank “incidents” several months ago

✓ Steve Jobs death

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✓ North Korea attacks South Korea

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✓ A strike by Enron’s employees

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 DIVERSIFICATION AND PORTFOLIO RISK
❑ Diversification: The process of spreading
investments across different assets, industries and
countries to reduce risk.
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❑ Come back to our previous example:

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E(RA) = 6% SD (RA) = 19.6%

E(RB) = 13% SD (RB) = 14.7%
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A and B combined in a portfolio (50% A & 50% B):

E(RP) = 9.5%
StdDev (RP) = 2.45%

24 → Diversification significantly reduces risk!!! BUT HOW ???

 DIVERSIFICATION AND NON-SYSTEMATIC
RISK
When stock price increases: new R&D, cost savings
programs
When stock price decreases: strike, CEO death,
lawsuits…
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If we hold only 1 stock, the value of our investment

would fluctuate b/c of company’s specific events

If we hold > 1 stock, some will increase b/c of

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company’s positive events and some will decrease

b/c of negative events → cancel out the risk
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So non-systematic risk is
diversifiable
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 DIVERSIFICATION AND SYSTEMATIC RISK

Systematic risk affects almost all assets to

some degree
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No matter how many assets/securities we

put in a portfolio, systematic risk just
doesn’t go away
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So systematic risk is non-

diversifiable
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 THE PRINCIPLE OF DIVERSIFICATION
❑ Diversification can substantially reduce the variability
of returns without an equivalent reduction in
expected returns.
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❑ This reduction in risk arises because worse than

expected returns from one asset are offset by better
than expected returns from another.
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❑ However, there is a minimum level of risk that cannot

be diversified away - the systematic risk.

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 THE PRINCIPLE OF DIVERSIFICATION
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What’s your
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comment
looking at this
table?
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PORTFOLIO DIVERSIFICATION
 What type(s) of risk would
you be concerned about if
you are a well- diversified
investor?
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Non-systematic?
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✓ Systematic?
 SYSTEMATIC RISK PRINCIPLE
❑ The systematic risk principle states that the
expected return on a risky asset depends only on the
asset’s systematic risk. WHY ?
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- Non-systematic risk is essentially eliminated by

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diversification at no cost.
- Market does not reward risks that are borne
unnecessarily.
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❑ Risk premium: the excess return required from an

investment in a risky asset over that required from a
risk-free asset
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 MEASURING SYSTEMATIC RISK OF AN ASSET
We do not look at the asset in isolation!
Instead we measure the individual asset’s sensitivity
to the fluctuations of the overall market.
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❑ The amount of systematic risk in an asset relative

to an average asset is measured by the beta
coefficient - The expected percent change in the excess
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return of an asset for a 1% change in the excess return of the

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market portfolio

Beta of average asset (market portfolio) = 1

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Beta of risk-free asset = 0
 BETA FACTS
VALUE OF BETA INTERPRETATION
β<0 Asset generally moves in opposite direction with
market
β=0 Movement of the asset is uncorrelated with the
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movement of market
0<β<1 Movement of the asset is generally in the same
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direction as, but less than the movement of

market
β=1 Movement of the asset is generally in the same
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direction as, and about the same amount as the

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movement of market
β>1 Movement of the asset is generally in the same
direction as, but more than the movement of the
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benchmark
 PORTFOLIO BETA
Portfolio Beta: is the weighted average of the
Betas of participating securities.
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 THE CAPITAL ASSET PRICING
MODEL (CAPM)
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How is CAPM originated?

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How to use CAPM?

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 CAPITAL ASSET PRICING MODEL
❑ CAPM decribes the relationship between risk and
return
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❑ CAPM uses
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❑ In calculating the required rate of return for an

investment proposal, which then becomes the
discount rate, or cost of capital for that investment
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❑ Provide a way to calculate the return that market

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is expected to deliver for bearing systematic risk

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 HOW IS CAPM ORIGINATED?
PORTFOLIO CONSISTING OF ASSET A AND A RISK-FREE ASSET

❑ Portfolio P consists of asset A and a risk-free asset.

Calculate portfolio expected returns and portfolio betas,
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letting the proportion of funds invested in asset A to be

0%, 25%; 50%; 75%; 100%; 125%; 150%.
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❑Asset A has a beta of 1.6 and an expected return of 20%

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❑The risk-free rate is 8%

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 HOW IS CAPM ORIGINATED?
PORTFOLIO CONSISTING OF ASSET A AND A RISK-FREE ASSET (CONT’D)
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 HOW IS CAPM ORIGINATED?
PORTFOLIO CONSISTING OF ASSET A AND A RISK-FREE ASSET (CONT’D)
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RF
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βA

“the reward-to-risk ratio” : the slope of the line = { E(RA) – RF}/βA = (20%-8%)/1.6 = 7.5%
39 →This portfolio offers a risk premium of 7.5% per “unit” of systematic risk
 HOW IS CAPM ORIGINATED?
PORTFOLIO CONSISTING OF ASSET B AND A RISK-FREE ASSET

❑ Now consider Asset B. This asset has a Beta of 1.2

and expected return of 16%. Which investment is
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better ? Asset A or asset B? The risk free rate is

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still 8%.
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❑ Calculate different combinations of expected

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returns and Betas for a portfolio of Asset B and a

risk free asset. Percentage of Portfolio in asset B :
0%, 25%; 50%; 75%; 100%; 125%; 150%;
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 HOW IS CAPM ORIGINATED?
PORTFOLIO CONSISTING OF ASSET B AND A RISK-FREE ASSET (CONT’D)
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 HOW IS CAPM ORIGINATED?
PORTFOLIO CONSISTING OF ASSET B AND A RISK-FREE ASSET (CONT’D)
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16%
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RF
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βB
“Reward to risk” ratio of (B&risk-free): = { E(RB) – RF}/ βB = (16%-8%)/1.2 =
42 6.67% < “reward to risk” of (A & risk-free) = 7.5%
 HOW IS CAPM ORIGINATED?
COMBINING 2 PORTFOLIOS IN 1 GRAPH
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 RETURN, RISK, AND EQUILIBRIUM
Conclusions:
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❑ For any given level of systematic risk (measured by Beta),

portfolio (A&risk-free) offers higher return than portfolio
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(B&risk-free)
❑ This would not persist long in a well-organized and active
market, resulting in market equilibrium
→ In an active, competitive market, the reward to risk ratio
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must be the same for all assets

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SECURITY MARKET LINE (SML)

 SECURITY MARKET LINE
❑The security market line (SML) is the
representation of market equilibrium.
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❑The slope of the SML is the reward-to-risk ratio:

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(E(RM) – Rf)/ βM

❑But since the beta for the market is ALWAYS equal

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to one, the slope can be rewritten.

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❑Slope = E(RM) – Rf = market risk premium

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 THE CAPITAL ASSET PRICING MODEL
(CAPM)

E ( Ri ) = RF +  i  E (RM ) − RF 
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❑ What determines an asset’s expected return?

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❑The risk-free rate—the pure time value of money.

❑The market risk premium—the reward for bearing systematic
risk.
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❑The beta coefficient—a measure of the amount of systematic

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risk present in a particular asset.

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 EXAMPLE – ASSET PRICING
❑ Asset A has an expected return of 12 per cent and a beta
of 1.40. Asset B has an expected return of 8 per cent and a
beta of 0.80. Are these two assets valued correctly relative
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to each other if the risk-free rate is 5 per cent?

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❑ Asset B offers insufficient return for its level of risk, relative

to A. B’s price is too high; therefore, it is overvalued (or A
is undervalued).

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CLASS EXERCISE
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CLASS EXERCISE
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CLASS EXERCISE