Risk, Return, and The Capital Asset Pricing Model: Muhammad Abubakr Naeem
Risk, Return, and The Capital Asset Pricing Model: Muhammad Abubakr Naeem
Risk, Return, and The Capital Asset Pricing Model: Muhammad Abubakr Naeem
Capital
Asset Pricing Model
Muhammad Abubakr Naeem
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5-3
What is Risk?
Risk refers to the chance that some unfavorable
event will occur.
The greater the chance of lower than expected or
negative returns, the riskier the investment.
Two types of investment risk
Stand-alone risk
An assets stand-alone risk is the risk an investor
would face if she held only this one asset.
Portfolio risk
Portfolio is a combined holding of more than one
asset.
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Probability Distributions
An events probability is defined as the chance that the
event will occur.
Probability Distribution A list of all the possible
outcomes of a future event together with the
probability (chance of occurrence) for each outcome.
You can calculate the mean (expected value), the
standard deviation, and the variance of a probability
distribution.
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Pri (ki )
i 1
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i 1
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Stddev
CV
^
Mean
k
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Diversification
Definition - An investment strategy designed to
reduce risk by spreading the funds across many
investments.
It is holding a broad portfolio of investments so as not
to have all your eggs in one basket.
Since people hold diversified portfolios of securities,
they are not very concerned about the risk and return
of a single security. They are more concerned about
the risk and return of their entire portfolio.
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w
i 1
1.00
k p w1k1 w2 k 2 wN k N
N
k p wi ki
i 1
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Portfolio Variance p2 wi i 2 wi w j ij
2
i 1
i 1 j 1
wi i 2 wi w j ij i j
2
p
i 1
i 1 j 1
Correlation Coefficient
The Correlation Coefficient is a measure of the
extent that two variables move or vary together.
It ranges between 1.0 and +1.0
Positive correlation: a high value on one variable is
likely to be associated with a high value on the other.
Negative correlation: a high value on one variable is
likely to be associated with a low value on the other.
No correlation: values of each are independent of the
other
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Correlation Coefficient-Contd
It is denoted by the Greek letter, rho:
If = +1.0, perfect positive correlation
If = -1.0, perfect negative correlation
If = 0, uncorrelated or independent
ij = the correlation coefficient for returns of
stock i and stock j
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Stdev
12.00% 30.00%
11.20% 22.27%
10.40% 15.62%
13.00%
12.00%
11.00% Global Minimum Variance
10.00%
9.60% 12.00%
9.00%
8.80% 14.00%
8.00%
8.00% 20.00%
7.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
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Correlatio
n
30.000%
Standard
deviation
25.000%
24.00%
20.000%
0.5
20.78%
15.000%
16.97%
10.000%
-0.5
12.00%
5.000%
-1
0.00%
-1.5
-1
-0.5
0.000%
0
0.5
1.5
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im
Bi 2
m
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ki = kRF + Bi ( kM - kRF )
CAPM
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kRF
BETA
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An example:
Equally-weighted two-stock portfolio
Create a portfolio with 50% invested in HT and 50%
invested in Collections.
The beta of a portfolio is the weighted average of each
of the stocks betas.
P = wHT HT + wColl Coll
P = 0.5 (1.30) + 0.5 (-0.87)
P = 0.215
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I = 3%
18
15
SML2
SML1
11
8
Risk, i
0
0.5
1.0
1.5
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RPM = 3%
SML2
SML1
18
15
11
8
Risk, i
0
0.5
1.0
1.5
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