Chapter 10: Risk-Return and Asset

Pricing Models
 Return

Percentage form of earnings from an investment or asset

including normal income and capital gain or loss is called
return. Return may be the following three types:
1. Risk-free rate of return rate of return can be earned by
making investment in government securities of a country
is known as risk-free rate of return.
2. Nominal rate of return rate of return calculated by
ignoring existing level of inflation is known as nominal
rate of return.
3. Real rate of return - rate of return determined by
considering/adjusting existing level of inflation is known as
real rate of return.
 Risk
Risk and uncertainty are terms used to describe situations where the
outcomes of decisions are not known with complete certainty. Risk is
defined as the chance that the actual outcome will be unequal to the
expected outcome. As a general proposition, the greater the chance of low
returns, the greater the risk of the investment. Actually, the difference
between expected rate of return and actual rate of return is called risk.
Classification of risk:
i. Systematic risk risk that cannot be avoided or minimized and that is out of
control of an individual or a business enterprise.
ii. Unsystematic risk - risk that cannot be avoided but can be minimized by
making intellectual decision based on best judgment relying on relevant
information and that is to some extent under the control of an individual or
a business enterprise.
iii. Business risk risk related to overall business activities of a particular
business enterprise that is mostly out of control of that business enterprise.
iv. Financial risk - risk related to using of fund for forming and running business
operations or making investments by a particular party that is under the
control of that party.
Risk-Return and Asset Pricing Models

Portfolio: To make investment in two or more than two

assets for minimizing level of unsystematic risk is
called portfolio.

Portfolio return and risk: Rate of return calculated by

taking into account the rate of return of specific asset
and proportion of fund allocated in that specific asset is
called portfolio return. Level of risk calculated by
considering level of risk of specific asset, standard
deviation of that specific asset and correlation
coefficient between assets is called portfolio risk.
Example: Mr A has available fund Tk.500000 for making investment. He is
planning to invest Tk.150000 in asset X and Tk.350000 in asset Y. The
information related to these two assets is given in the following table:

Asset X Asset y Correlation

coefficient
Curre Expe Proba Divide Curre Expect Proba Interest
nt between
cted bility nd nt ed bility income
price( price (Pi) % incom price( price (Pi) % (I1) asset X and
Po) Y is 0.80
(P1) e (D1) Po) (P1)

120 130 20 15 950 960 35 100

110 35 970 25
115 15 940 40
125 30
Calculation of portfolio return and risk.
Solution:
Asset X:
Return (R) = (P1-P0+D1)/P0
R1 = (130-120+15)/120=0.2083
R2 = (110-120+15)/120=0.0417
R3 = (115-120+15)/120=0.0833
R4 = (125-120+15)/120=0.1667

Expected Return: E(Rx)= Pi Ri

= P1R1+ P2R2+ P3R3+ P4R4
=0.20*.2083+.35*0.0417+0.15*0.0833+.30*0.1667
= 0.1188=11.88%
Risk:
x = { Pi [ Ri E(Rx)]2}
= { P1 [ R1 E(Rx)]2 + P2[ R2 E(Rx)]2 + P3 [ R3 E(Rx)]2 + P4 [ R4 E(Rx)]2 }
= {0.20 (0.2083-0.1188)2 + 0.35 (0.0417-0.1188)2 + 0.15 (0.0833-0.1188)2 +
0.30 (0.1667-0.1188)2}
= 0.0675=6.75%
Asset Y:
Return (R) = (P1-P0+I1)/P0
R1 = (960-950+100)/950=0.1158
R2 = (970-950+100)/950=0.1263
R3 = (940-950+100)/950=0.0947

Expected Return: E(Ry)= Pi Ri

= P1R1+ P2R2+ P3R3
= 0.35*0.1158+.25*0.1263+0.40*0.0947
= 11%
Risk:
y = { Pi [ Ri E(Rx)]2}
= { P1 [ R1 E(Rx)]2 + P2[ R2 E(Rx)]2 + P3 [ R3 E(Rx)]2 +}
= {0.35 (0.1158-0.11)2 + 0.25 (0.1263-0.11)2 + 0.40 (0.0947-0.11)2 }
= 0.0131=1.31%
 Portfolio return: E(Rp) = Wi E(Ri)
= Wx E(Rx)+ Wy E(Ry)
= 0.30*0.1188+0.70*0.11
= 0.1186=11.86%

Portfolio risk for 2 assets:

p = {Wx 2 x 2+ W y 2 y 2+ 2W x W y x y rx,y}
= {0.30 2 *0.06752 + 0.70 2 *0.0131 2 + 2*0.30*0.70*.0675 *0.0131*.80}
=0.0281=2.81%

Portfolio risk for 3 assets:

p = {Wx 2 x 2+ W y 2 y 2+ W z 2 z 2 +2W x W y x y rx,y +
2W x W z x z rx,z + 2W y W z y z ry,z }
Diversification and portfolio risk:

Level of risk

Unique risk/Unsystematic
risk

Market risk/systematic risk

No of asset
 Markowitz Portfolio Theory:
Markowitz model assumes the followings:
Investors consider each investment alternative as being
represented by a probability distribution of expected returns
over some holding period.
Investors maximize one period expected utility and their utility
curves demonstrate diminishing marginal utility of wealth.
Investors estimate the risk of the portfolio on the basis of the
variability of expected returns.
Investors base decisions solely on expected return and risk, so
their utility curves are a function of expected return and
expected variance of returns.
For a given level of risk, investors prefer higher returns to lower
returns and for a given level of expected return investors prefer
less risk to more risk.
 Portfolios of two risky assets:
The lower the correlation between assets, the greater the gain in
efficiency.

Another consideration for minimizing level of portfolio risk is

proportion of fund allocation. The proportion of fund to be allocated in
each specific asset for getting lowest level of portfolio risk can be
determined by applying the following formula:

2 E Cov(rD , rE )
wmin ( D) 2
D 2 E 2Cov(rD , rE )
 Example: Stock fund offers 12% return with 3.5% risk and debt fund offers 10% return
with 3% risk. Correlation coefficient between stock and debt is 0.40.

3.5 2 3.5 * 3 * 0.40

Wmin ( D) 2
3 3.5 2 2 * 3.5 * 3 * 0.40
0.63
and WMin (E) = 1 0.63 = 0.37

If the correlation coefficient between stock and debt is negative 0.40, then
optimal allocation will be as:
3.52 3.5 * 3 * (0.40)
Wmin ( D) 2
3 3.52 2 * 3.5 * 3 * (0.40)
0.55
and WMin (E) = 1 0.55 = 0.45
Calculate the portfolio return and risk for determined weights
and by assuming any other allocation than that of optimal
allocation.
 Asset allocation with stocks, bonds and bills
(The optimal risky portfolio with two risky assets and a risk-
free asset):
The proportion of fund to be allocated in each specific risky asset and risk-
free asset for getting lowest level of portfolio risk can be determined by
applying the following formulae:
E (rp ) rF )
Wmin ( D)
0.01A 2 p
And
[E(rD ) - rF ] 2 E [E(rE ) rF ] Cov(rD , rE )
Wmin ( D ) [E(r ) - r ] 2E [E(r ) r ] 2D [E(r ) r E(r ) r ] Cov(r , r )
D F E F D F E F D E

E ( rp ) r f
Wmin ( M )
0.01A 2 p

where M is the portfolio of risky assets, A is risk aversion factor or coefficient.

 Example, expected return from investment in debt is 8% with standard deviation of 12%,
expected return from investment in equity is 13% with standard deviation of 20%. Risk-free
rate from asset Y is 5%. Covariance between debt and equity is 72 and correlation coefficient
is 0.30. Riskm aversion factor is 4. Find out the portfolio return and risk for an optimal risky
portfolio.
(8 - 5) * 20 - (13 5) *12 * 20 * 0.30
2
Wmin ( D)
(8 - 5) * 20 2 (13 5) *12 2 (8 5 13 5) *12 * 20 * 0.30

WMin (E) = 1.00 0.40 = 0.60

It means 40% of fund allocated is to be invested in debt instrument and 60% fund is to be
invested in equity instrument out of fund allocation in two risky assets. Now proportion of
fund is to be allocated in risky and risk-free portfolio is:

Portfolio return: E(Rp) = Wi E(Ri) = WD E(RD)+ WE E(RE) = 0.40*8+0.60*13= 11%

Portfolio risk for 2 assets: p = {WD 2 D 2+ W E 2 E 2+ 2W D W E D E rD,E}
= {0.402*122 +0.602*202 +2*0.40*0.60*12*20*0.30} =
14.20%

E (rp ) rF ) 11 5
Wmin (M ) 0.7439
0.01A 2 p .01* 4 *14.2 2
 WMin (Y) = 1.00 0.7439 = 25.61%
WMin (D) = 0.7439*0.40 = 29.76%
WMin (E) = 0.7439*0.60 = 44.63%

Return for optimal risky portfolio: E(rp) = 0.2561*0.05 +

0.2976*0.08 + 0.4463*0.13 = 9.46%
Risk for optimal risky portfolio:
p={(0.2976*0.12)2+(0.4463*0.20)2+2*0.2976*.4463*0.12
*0.20*0.30} = 10.56%
 Efficient portfolio: The portfolio provides higher rate of return for a given level of
risk or involves lower level of risk for a given level of return is known as efficient
portfolio.

Minimum-variance frontier: The frontier (line or curve) represents the lowest

possible variance that can be attained for a given portfolio expected return is known
as minimum-variance frontier.

Global minimum-variance portfolio: The portfolio involves the lowest level of risk
out of all portfolios positioned on the frontier is known as global minimum-variance
portfolio.

Efficient frontier: The part of the frontier lies above the global minimum-variance
portfolio is considered as efficient frontier.
 Capital asset pricing model (CAPM):
E(R) = Rf + (Rm Rf),
here
E(R) = Expected rate of return.
Rf = Risk-free rate,
Rm = Market rate,
= Beta coefficient

Assumptions of CAPM:
1. There are many investors, each with an endowment that is small compared
to the total endowment of all investors and they are price-takers.
2.All investors plan for one identical holding period.
3. Investments are limited to a universe of publicly traded financial assets.
4. Investors pay no taxes on returns and no transaction costs.
5.All investors are rational mean-variance optimizers.
6. All investors analyze securities in the same way and share the same
economic view of the world.
 SML
SML

Security market line (SML):

The line represents the positive relationship between expected
rate of return and level of systematic risk for a financial asset is
known as security market line. The graphical presentation is as
follows:

Return
SML

Rf
Systematic risk
 Capital market line (CML): The line shows the positive
relationship between expected rate of return and level of total risk
for a financial asset is known as capital market line. The graphical
presentation is as follows:

Return
CML

Rf
Total risk
 Characteristics line (CL): The line represents the relationship between
market rate of return and expected rate of return of a financial asset is
known as characteristics line. There may be positive, negative, vertical and
horizontal relationship between market rate of return and expected rate of
return of a financial asset.The graphical presentation is as follows:
Security Return

CL1

CL3

CL2

Market return
 Risk Management in Islam
The broad perspective on risk and its management are embodied in the overall goals
of Islamic law or maqasid al-shariah. Chapra (2008a) quotes al-Ghazali in defining
maqasid as promotion of the well-being of the people, which lies in safeguarding their
faith (din), their self (nafs), their intellect (aql), their posterity (nasl), and their wealth
(mal). The principle of maqasid would imply taking all the precautions to safeguard
present and future wealth. As risk in economics represents the probable loss of wealth,
it is not desirable in itself from an Islamic perspective. While risks are not desirable on
their own, they must be undertaken to create wealth and value. From an Islamic
perspective, economic activities are not judged by their inherent risks, but by whether
they add value and/or create wealth.
In line with the above discussion, Hassan (2009) identifies three types of risks from the
Islamic perspective. First, is the essential risk that is inherent in all business transaction.
This business risk is necessary and must be undertaken to reap the associated reward
or profit. We find that two legal maxims are associated with returns to essential risks
from the basis of Islamic economic transactions. The first maxim states the
determinant is as a return for the benefit (al-gjorm bil ghunm) (Majalla Art 87). This
maxim attaches the entitlement of gain to the responsibility of loss. The second
maxim is derived from the Prophetic saying al-kharaj bil daman stating the benefit of
a thing is a return for the liability for loss from that thing (Majalla Art.85) The maxim
asserts that the party enjoying the full benefits of an asset or object should bear the
risks of ownership. By putting together these two legal maxims, we can say that for
every investment, the investor must have to take risk in order to get some return
from it. At the same time, with return there comes responsibility, specifically
responsibility to share the loss associated with the investment. So developing the
portfolio, an investor must have to remember these two legal maxims.
 Risk Management in Islam

The second risk is the prohibited risk in the form of excessive gharar. Gharar is usually
translated as uncertainty, risk or hazard, but it also implies ignorance, gambling,
cheating and fraud. Generally, gharar related to ambiguity and/or ignorance, gambling,
cheating and fraud. Thus a sale can be void due to gharar due to risk existence and
taking possession of the object of sale on the one hand, and uncertainty about the
quantity, quality, price or time of payment on the other. While making investment, we
have to minimize this uncertainty factor at certain level so that it does make the
whole transaction prohibited.

The final form of risk identified by Hassan is the permissible risk that does not fall in
the above two categories. For example, operational risks, liquidity risks, etc. These risks
can either be accepted or avoided.

The principles of risk management from an Islamic perspective are to link risk and
causality. There is a need to distinguish between causes and uncertain outcomes. In
uncertain situations, individuals have control over the causal factors, but not the
outcome. There is a Prophetic saying of tie the camel and then entrust it to God, so
the Islamic approach to risk management would be to understand and control the
causes of risks and then leave the final outcome to the will of Allah (s.w.t.).