PORTFOLIO ANALYSIS

Individual securities, as we have seen, have

risk-return characteristics of their own.
Portfolios, which are combinations of
securities, may or may not take on the
aggregate characteristics of their individual
parts.

Portfolio analysis considers the

determination of future risk and return in
holding various blends (combinations) of
individual securities.
1

PORTFOLIO ANALYSIS
(Cont)
Security analysis recognizes the key
importance of risk and return to the investor.

Most methods recognize return as some

dividend receipt and price appreciation over a
period. But the return for individual securities
is not always over the same common holding
period, nor are the rates of return necessarily
time-adjusted. An analyst may well estimate
future earnings and a P/E to derive future
price. He will surely estimate the dividend.
2

PORTFOLIO ANALYSIS
(Cont)
Given an estimate of return, the analyst is likely
to think of and express risk as the probable
downside price expectation (either by itself or
relative to upside appreciation possibilities).

Each security ends up with some rough measure

of likely return and potential downside risk for
the future.

Why portfolios?
The simple fact that securities carry

differing degrees of expected risk leads

most investors to the notion of holding
more than one security at time, in a
attempt to spread risks by not putting
all their eggs into one basket.

Most investors hope that if they hold

several assets, even if one goes bad,

the others will provide some protection
from an extreme loss.
4

Diversification
Efforts to spread and minimize risk take the form
of diversification

Diversification of ones holdings is intended to

reduce risk in an economy in which every assets
returns are subject to some degree of uncertainty.

Holding one stock each from mining , utility, and

manufacturing groups is superior to holding three
mining stocks.

The best diversification comes through holding

large numbers of securities scattered across
industries.
5

Portfolio Construction
Investment decisions are all about making
choices: Will income be spent or saved?

If you choose to save, you face a second

decision: What should be done with the
savings?

Each saver must decide where to invest

this command over resources (goods and

services). This is an important decision
because these assets are the means by
which investors transfer todays
purchasing power to the future.
6

Portfolio
Construction(cont)
Savings are invested in various assets

that make a portfolio which is a

combination of assets designed to serve
as a store of value.

The investments constitute a portfolio.

Poor management of these assets may

destroy the portfolios value, and the
investor will then not achieve his financial
goals.

The composition of a portfolio depends

on investment goals.

Possible Investment
Goals
There are many reasons for saving and accumulating
assets:

Start a business
Funds to meet emergencies
Funds to finance education expenses
Funds to make a specified purchase (e.g., a home; make
a downpayment on a house)

Funds for retirement

Or accumulate for the sake of accumulating.
For any of these reasons above, people construct

portfolios rather than spend all their current income.

8

Factors affect the

construction of a portfolio
Several factors affect the construction of a
portfolio. These include but not limited to

Goals of the investor

Risks involved in a specific investment
Taxes that will be imposed on any gain
Knowledge of investment alternatives.
The motives for saving should dictate, or at

least affect, the composition of the portfolio.

9

Factors affect the construction of a portfolio

-

goals of the investor

Not all assets are appropriate for all financial

goals.

E.g., savings that are held to meet emergencies,

such as an extended illness or unemployment,

should not be invested in assets whose return
and safety of principal are uncertain. Instead,
emphasis should be placed on safety of principal
and assets that may be readily converted into
cash, such as savings accounts or shares in
money markets. The emphasis should not be on
growth and high returns. However the funds
should not sit idle but should be invested in safe
assets that offer a moderate return.
10

Factors affect the construction of a

portfoliogoals of the

investor (Cont..
Financing a retirement or a childs education,
have a longer and more certain time horizon.
The investor knows approximately when the
funds will be needed and so can construct a
portfolio with a long-term horizon. Bonds that
mature when the funds will be needed or
common stocks that offer the potential for
growth would be more appropriate than
savings accounts or certificates of deposit
with a bank.

The longer time period suggests the

individual can acquire long-term assets that

may offer a higher yield.
11

goals of the
investor (Cont.

portfolio-

In addition to the individuals goals, willingness

to bear the risk plays an important role in

constructing a portfolio. Some individuals are
more able to bear risk. E.g., if the saver wants to
build a retirement fund, he or she can choose
from a variety of possible investments.

Not all investments are equal with regard to risk

and potential return.

Investors who are more willing to accept risk

may construct a portfolio with assets involving

greater risk that may earn higher returns.
12

Factors affect the construction of a

portfolio-

Taxes

Taxes also affect the

composition of an individuals
portfolio. Income such as
interest and realized capital
gains are taxed. Such taxes
and the desire to reduce them
affect the composition of each
investors portfolio.
13

Factors affect the construction

of a portfolio(Cont)
Portfolio decisions are important. They set a general

framework for asset allocation of the portfolio among

various types of investments.

Individuals, however, rarely construct a portfolio all

at once but acquire assets one at a time.

The decision revolves around which specific asset to

purchase: which mutual fund? Which bond? Or which

stock. Security analysis considers the merits of
individual asset. Portfolio management determines
the impact that the specific asset has on the
portfolio.

It is impossible to know an assets effect on the

portfolio without first knowing its characteristics.

14

Factors affect the construction of

a portfolio(Cont)
Stocks and bonds differ with regard to risk, potential
return, and valuation.

Even within a type of asset such as bonds there can

be considerable variation. For example: a corporate
bond is different from a government bond, and a
convertible bond is different from a straight bond
that lacks conversion feature.

Investors need to understand these differences as

well as the relative merits and risks associated with
each of these assets. After understanding how
individual assets are valued, then he/she may then
construct a portfolio that will aid in the realization of
his/her financial goals.
15

Diversification and
Asset Allocation
To achieve diversification, the returns on your

investments must not be highly correlated.

Factors that negatively affect one security must
have a positive impact on others. E.g: higher oil
prices may be good for ExxonMobil but bad for
Delta Airlines. By combining a variety of
disparate assets, an investor achieves
diversification and reduce risk.

Reduction in asset specific risk

Asset allocation refers to a acquiring a wide
spectrum of assets.

16

Diversification and
Asset Allocation(Cont)
Individuals use their finite (limited) resources to
acquire various types of assets. E.g : Allocation of
assets among alternatives such as stocks, bonds,
and precious metals, and real estate.

Even within a class as stocks, the portfolio is

allocated to different sectors or geographical
regions. E.g. an investor may own domestic
stocks and stocks of companies in emerging
nations.

By allocating an investor 'assets over different

types of assets, an investor contributes to the
diversification of the portfolio.
17

Asset
Allocation(Cont)
Asset allocation and diversification are

often used in different contexts. E.g: an

investor may tilt (slope or moving into a
sloping position) his/her allocation
towards energy stocks and away from
airlines if he/she anticipate high gas
prices. The allocation between stocks,
bonds, and other assets remains the
same, but the allocation between two
sectors is altered (changed).

The words diversification and asset

allocation are often used in this context.

18

Asset
Allocation(Cont)
Diversification is important because it
reduces the investor s risk exposure.

Asset allocation is important because it has

a major impact on the return the investors
portfolio earns.

Whenever an investor makes an investment

decision, he/she needs to consider its
impact on the diversification of his portfolio
and the allocation of his/her assets. Both
are crucial components of portfolio
management.

19

Portfolio Assessment
Popular press places emphasis on return.
Higher return requires accepting more risk.
Assessment should consider both the return and
the risk taken to achieve the return.

20

Investment philosophy
Belief that investment decisions are made
in exceedingly competitive financial
markets. Information is disseminated so
rapidly that few investors are able to take
advantage of new information.

Investment philosophy: the philosophy

and strategies of different investors and

portfolio managers may be different.
Some may have a shorter time horizon
and may be less concerned with current
taxes or the cost of buying and selling
securities; others might think differently.
21

Investment
philosophy(Cont)
Understanding yourself and specifying goals
is important when developing an investment
philosophy and making investment
decisions.

Available time to make investment

decisions; develop a continuous contact with
investment, follow daily news and TV
programs talking about investment; have
contact with people who work in the area
and know professionals.
22

The Internet
Major source of information concerning investments:
http://www.investopedia.com ; http://www.TeachMeFinance.com
http://www.bloomberg.com ; http://money.cnn.com;
http://www.fobes.com
http://www.google.com; http://www.marketwatch.com
http://www.morningstar.com ; http://moneycentral.msn.com/investor
http://www.investor.reuters.com ; http://finance.yahoo.com
http://www.cma.org.rw

Much information can be obtained through the internet

free of charge, but some vendors do charge a fee for the

material. However too much information may be
available, or you might obtain contradictory information
from different sites.
23

Portfolio Theory
Portfolio Theory is built around the investor
seeking to construct an efficient portfolio that
offers the highest return for a given level of risk or
the least amount of risk for a given level of return.

Of all the possible efficient portfolios, the

individual investor selects the portfolio that offers
the highest level of satisfaction or utility.

Harry Markowitz is credited with being the first

individual to use the preceding material to
develop a theory of portfolio construction
employing returns and risk as measured by a
portfolios standard deviation.
24

Theory(Cont)
1. A measure of the dispersion of a set of data from its mean. The
more spread apart the data, the higher the deviation. Standard
deviation is calculatedas the square root of variance.

2. In finance, standard deviation is applied to the annual rate of

return of an investment to measure the investment's volatility.
Standard deviation is also known as historical volatility and is used
by investors as a gauge for the amount of expected volatility.
Standard deviation is a statistical measurement that sheds light on
historical volatility. For example,a volatile stock will have a high
standard deviation while thedeviationof a stable blue chip stock
will be lower. A large dispersion tells us how much the return on the
fund is deviating from the expected normal returns.

25

Theory(Cont)
The contribution of Markowitz was a major advance
in finance and led to the development of the
Capital Asset Pricing Model (CAPM) and
subsequently to the arbitrage pricing model,
generally referred to as arbitrage pricing theory
(APT).

CAPM was developed by William F.Sharpe, John

Lintner, and Jan Mossin. It reduces the explanation

of stocks return to two variables:

1. the market return

2. the volatility of the stock in response to two
variables.

26

Portfolio
Theory(Cont)
Arbitrage pricing theory(APT), initially developed by

Stephen A.Ross, seeks to add additional variables to the

explanation of security returns.

Arbitrage is the act of buying a good or a security and

simultaneously selling it in another market at a higher

price (individuals who participate in these transactions
are called arbitrageurs.

E.g, if IBM stock is selling for $50 in New York and $60 in
San Francisco, an opportunity for riskless profit exists.
Arbitrageurs would buy the stock in New York and
simultaneously sell it in San Francisco, thus earning the
$10 profit without bearing any risk.

Arbitage also implies that portfolios with the same risk

generate the same returns.

27

The Markowitz Model

The Markowitz model is premised on a risk-

averse individual constructing a diversified

portfolio that maximizes the individuals
satisfaction (generally referred to as utility by
economists) by maximizing portfolio returns
for a given level of risk.

This process is depicted in Figures 1 through

3, which illustrate the optimal combinations

of risk and return available to investors, the
desire of investors to maximize their utility,
and the determination of the optimal portfolio
that integrates utility maximization within the
constraint of the available portfolios.
28

Figure 1 The Efficient

Frontier

29

Figure 1 The Efficient

Frontier(Cont)
Figure 1 illustrates the determination of the
optimal portfolios available to investors.

The vertical axis measures portfolio expected

returns expressed as a percentage.

The horizontal axis measures the risk

associated with the portfolio, using the
portfolios standard deviation (p).

30

Figure 1 The Efficient

Frontier(Cont)
The shaded area represents possible

portfolios composed of various combinations

of risky securities

This area is generally referred to as the

attainable or feasible set of portfolios. Some

of these portfolios are inefficient because
they offer an inferior return given amount of
risk.

E.g., portfolio A is inefficient since portfolio B

offers a higher return for the same amount
of risk.

31

Figure 1 The Efficient

Frontier(Cont)
Inefficient portfolio is a portfolio whose return is not
maximized given the level of risk.

All portfolios that offer the highest return for a given

amount of risk are referred to as efficient.

The line that connects all these portfolios (XY in Figure

1) defines efficient frontier and is referred to as the
efficient set of portfolios.

Any portfolio that offers the highest return for a given

amount of risk must lie on the efficient frontier.

Any portfolio that offers a lower return is inefficient

and lies below the efficient frontier in the shaded area.
32

Figure 1 The Efficient

Frontier(Cont)
Since inefficient portfolios will not be selected,
the efficient frontier establishes the best set
of portfolios available to investors.

A portfolio such as C that lies above the

efficient frontier offers a superior yield for the

amount of risk. Investors would prefer that
portfolio to portfolio B on the efficient frontier
because C offers a higher return for the same
level of risk.

While the efficient frontier gives all the best

attainable combinations of risk and return, it

does not tell which of the possible
combinations an investor will select.
33

Figure 1 The Efficient

Frontier(Cont)
That selection depends on the individuals
willingness to bear the risk

The combining of the efficient frontier and

the willingness to bear the risk determines

the investors optimal portfolio

This willingness to bear risk may be shown

by the use of indifference curves, which are

often used in economic theory to indicate
levels of an individuals utility (i.e.,
consumer satisfaction) and the impact of
trading one good for another .
34

Figure 1 The Efficient

Frontier(Cont)
When applied to portfolio theory, the economic
theory of consumer behavior develops the
trade-off between risk and return (instead of
trade-off between two goods).

This trade-off between risk and return is also

shown by indifference curves.

A set of these indifference curves is illustrated

in the following Figure 2.

35

Map

36

Figure 2 Indifference
Map(Cont)
Each indifference curve represents a level

of satisfaction, with higher curves indicating

higher levels of satisfaction.

Movements along a given curve indicate

the same level of satisfaction (the individual

is indifferent). E.g., on indifference curve I1,
the investor would be willing to accept a
modest return, such as r1 and bear a
modest amount of risk (p1). The same
investor would also be willing to bear more
risk for a higher return (e.g., r2 and (p2).
37

Figure 2 Indifference
Map(Cont)
The additional return is sufficient to induce bearing
the additional risk, so the investor is indifferent
between the two alternatives.

All the points on the same indifference curve

represent the same level of satisfaction

The indifference curves in Figure 2 are for risk-averse

investor; hence, additional risk requires more return.

Notice that these curves are concave from above;

their slope increases as risk increases. This indicates
that investors require ever-increasing amounts of
additional return for equal increments of risk to
maintain the same level of satisfaction.
38

Figure 2 Indifference
Map(Cont)
Investors would like to earn a higher return without having to
bear additional risk.

A higher return without additional risk increases total

satisfaction.

Higher levels of satisfaction are indicated by indifference

curves I2 and I3, which lie above indifference curve I1.

the investor is indifferent between any combination of risk

and return on I2. All combinations of risk and return on
indifference curve I2 are preferred to all combinations on
indifference curve I1.

All points on indifference curve I3 are preferred to all points on

I2.
39

Figure 2 Indifference
Map(Cont)
The investor seeks to reach the highest level of
satisfaction but is, of course, constrained by what is
available.

The best combinations of risk and return available are

given by the efficient frontier.

Superimposing the indifference curves on the efficient

frontier defines the investors optimal portfolio

This is shown in Figure 3, which combines Figure 1& 2.

The optimal combination of risk and return
represented by point is the investors optimal
combination of risk and return.
40

Figure 3 Determination of the

Optimal Portfolio

41

Figure 3 Determination of
the Optimal
Portfolio(Cont)
If the investor selects any other portfolio with a

different combination of risk and return on the

efficient frontier (e.g., A), that portfolio would not
be the individuals best choice.

While portfolio A is an efficient combination of risk

and return, it is not the optimal choice, as may be
seen using the following logic.

Portfolio B is equal to portfolio A (i.e., the investor

is indifferent between A and B).

B is not efficient and is inferior to portfolio , since

offers a higher level of return for the same
amount of risk.

42

Figure 3 Determination of
the Optimal
Portfolio(Cont)
Portfolio must be preferred to B, and
because A and B are equal, must also
be preferred to A.

Only one portfolio offers the highest level

of satisfaction and lies on the efficient
frontier.

That unique combination of risk and

return is represented by portfolio ,
which occurs at the tangency of the
efficient frontier and indifference curve I2 .
43

Figure 3 Determination of the

Optimal Portfolio(Cont)
If an indifference curve cuts through the efficient
frontier (e.g., I1), it is attainable but inferior, and it
can always be shown that the investor can reach
a higher level of satisfaction by altering the
portfolio.

If an indifference curve lies above the efficient

frontier (e.g., I3), such a level of satisfaction is not
obtainable.

The investor would like to reach that level of

satisfaction, but no combination of assets offers
such a high expected return for that amount of
risk
44

Figure 3 Determination of the

Optimal Portfolio(Cont)
Different investors may have varying indifference
curves.

If the investor is very risk-averse, the curves tend to be

steep, indicating a large amount of additional return is
necessary to induce this individual to bear additional
risk and maintain the same level of satisfaction.

If the curves are relatively flat, the individual is less

risk-averse. Only a modest amount of additional return
is necessary to induce this individual to bear additional
risk and still maintain the same level of satisfaction.

However, both investors are still averse to bearing risk.

The difference is the degree of risk aversion
45

Portfolios Risk and Return

46

The future is uncertain.

Investors do not know with certainty whether the

economy will be growing rapidly or be in recession.

Investors do not know what rate of return their

investments will yield.

Therefore, they base their decisions on their

expectations concerning the future.

The expected rate of return on a stock

represents the mean of a probability distribution of

possible future returns on the stock.

Expected Return
The table below provides a probability distribution for the returns on stocks A

47

and B

State

Probability

Return On
Stock A

Return On
Stock B

20%

5%

50%

30%

10%

30%

30%

15%

10%

20%

20%

-10%

The state represents the state of the economy one period in the future i.e. state
1 could represent a recession and state 2 a growth economy. The probability
reflects how likely it is that the state will occur. The sum of the probabilities
must equal 100%. The last two columns present the returns or outcomes for
stocks A and B that will occur in each of the four states.

Expected Return
48

Given a probability distribution of returns, the

expected return can be calculated using the
following equation:
N

E[R] = (piRi)
i=1

Where:
E[R] = the expected return on the stock
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i.

Expected Return
49

In this example, the expected return

for stock A would be calculated as
follows:

E[R]A = .2(5%) + .3(10%) + .3(15%) + .

2(20%) = 12.5%

Now you try calculating the expected

return for stock B!

Expected Return
50

Did you get 20%? If so, you are correct.

If not, here is how to get the correct answer:
E[R]B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) =
20%

So we see that Stock B offers a higher expected

return than Stock A.

However, that is only part of the story; we haven't

considered risk.

Measures of Risk
51

Risk reflects the chance that the actual

return on an investment may be different

than the expected return.

One way to measure risk is to calculate

the variance and standard deviation of the

distribution of returns.

We will once again use a probability

distribution in our calculations.

The distribution used earlier is provided

again for ease of use.

Measures of Risk
52

Probability Distribution:

State

Probability

Return On
Stock A

Return On
Stock B

20%

5%

50%

30%

10%

30%

30%

15%

10%

20%

20%

-10%

E[R]A = 12.5%
E[R]B = 20%

Measures of Risk
53

Given an asset's expected return, its variance

can be calculated using the following equation:

N

Var(R) = s2 = S pi(Ri E[R])2

i=1

Where:
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i
E[R] = the expected return on the stock

Measures of Risk
54

The standard deviation is calculated as the

positive square root of the variance:

SD(R) = =

2 = (2)1/2 = (2)0.5

Measures of Risk
55

The variance and standard deviation for stock A is

calculated as follows:

2A = 0.2(.05 -.125)2 + 0.3(.1 -.125)2 + 0.3(.15 -.125)2 + 0.2(.2 -.125)2

= .002625

Now you try the variance and standard deviation for stock B!

If you got .042 and 20.49% you are correct.

Measures of Risk
56

If you didnt get the correct answer, here is how to get it:
2B = .2(.50 -.20)2 + .3(.30 -.20)2 + .3(.10 -.20)2 + .2(-.10 - .20)2 = .042

Although Stock B offers a higher expected return than

Stock A, it also is riskier since its variance and standard

deviation are greater than Stock A's.

This, however, is still only part of the picture because most

investors choose to hold securities as part of a diversified
portfolio.

Portfolio Risk and Return

57

Most investors do not hold stocks in isolation.

Instead, they choose to hold a portfolio of several
stocks.

When this is the case, a portion of an individual stock's

risk can be eliminated, i.e., diversified away.

From our previous calculations, we know that:

the expected return on Stock A is 12.5%
the expected return on Stock B is 20%
the variance on Stock A is .00263
the variance on Stock B is .04200
the standard deviation on Stock A is 5.12%
the standard deviation on Stock B is 20.49%

Portfolio Risk and Return

58

The Expected Return on a Portfolio is computed as the

weighted average of the expected returns on the stocks which

comprise the portfolio.

The weights reflect the proportion of the portfolio invested in the

stocks.

This can be expressed as follows:

N

E[Rp] = wiE[Ri]
i=1

Where:

E[Rp] = the expected return on the portfolio

N = the number of stocks in the portfolio
wi = the proportion of the portfolio invested in stock i
E[Ri] = the expected return on stock i

Portfolio Risk and Return

59

For a portfolio consisting of two assets, the

above equation can be expressed as:
E[Rp] = w1E[R1] + w2E[R2]

If we have an equally weighted portfolio of

stock A and stock B (50% in each stock),
then the expected return of the portfolio is:
E[Rp] = .50(.125) + .50(.20) = 16.25%

Portfolio Risk and Return

60

Using either the correlation coefficient or the

covariance, the Variance on a Two-Asset Portfolio

can be calculated as follows:

2p = (wA)22A + (wB)22B + 2wAwBA,B AB

OR
2p = (wA)22A + (wB)22B + 2wAwB A,B

The Standard Deviation of the Portfolio equals

the positive square root of the the variance.

Portfolio Risk and Return

61

The variance/standard deviation of a portfolio reflects not

only the variance/standard deviation of the stocks that
make up the portfolio but also how the returns on the
stocks which comprise the portfolio vary together.

Two measures of how the returns on a pair of stocks vary

together are the covariance and the correlation coefficient.

Covariance is a measure that combines the variance of a
stocks returns with the tendency of those returns to
move up or down at the same time other stocks move up
or down.
Since it is difficult to interpret the magnitude of the
covariance terms, a related statistic, the correlation
coefficient, is often used to measure the degree of comovement between two variables. The correlation
coefficient simply standardizes the covariance.

Portfolio Risk and Return

62

The Covariance between the returns on two stocks can be

calculated as follows:
N

Cov(RA,RB) = sA,B = S pi(RAi - E[RA])(RBi - E[RB])

i=1

Where:
sA,B = the covariance between the returns on stocks A and
B
N = the number of states
pi = the probability of state i
RAi = the return on stock A in state i
E[RA] = the expected return on stock A
RBi = the return on stock B in state i
E[RB] = the expected return on stock B

Portfolio Risk and Return

63

The Correlation Coefficient between the returns on

two stocks can be calculated as follows:

A,B

Cov(RA,RB)

Corr(RA,RB) = A,B = AB = SD(RA)SD(RB)

Where:
A,B=the correlation coefficient between the returns on

stocks A and B
A,B=the covariance between the returns on stocks A and B,
A=the standard deviation on stock A, and
B=the standard deviation on stock B

Portfolio Risk and Return

64

The covariance between stock A and stock B is as follows:

A,B = .2(.05-.125)(.5-.2) + .3(.1-.125)(.3-.2) +

.3(.15-.125)(.1-.2) +.2(.2-.125)(-.1-.2) = -.0105

The correlation coefficient between stock A and stock B is as

follows:

-.0105
A,B =

(.0512)(.2049)

= -1.00

Portfolio Risk and Return

65

Using either the correlation coefficient or the

covariance, the Variance on a Two-Asset
Portfolio can be calculated as follows:

2p = (wA)22A + (wB)22B + 2wAwBA,B AB

OR
2p = (wA)22A + (wB)22B + 2wAwB A,B

The Standard Deviation of the Portfolio equals

the positive square root of the the variance.

Portfolio Risk and Return

66

Lets calculate the variance and standard deviation of a

portfolio comprised of 75% stock A and 25% stock B:

2p =(.75)22+(.25)2(.2049)2+2(.75)(.25)(-1)(.0512)(.2049)= .00016

p = .00016

= .0128 = 1.28%

Notice that the portfolio formed by investing 75% in

Stock A and 25% in Stock B has a lower variance and

standard deviation than either Stocks A or B and the
portfolio has a higher expected return than Stock A.

This is the purpose of diversification; by forming portfolios,

some of the risk in the individual stocks can be eliminated.

Capital Asset Pricing Model

(CAPM)
67

If investors are mainly concerned with the risk of their portfolio

rather than the risk of the individual securities in the portfolio, how
should the risk of an individual stock be measured?

In important tool is the CAPM.

CAPM concludes that the relevant risk of an individual stock is

its contribution to the risk of a well-diversified portfolio.

CAPM specifiesa linear relationship between risk and required

return.
The equation used for CAPM is as follows:
Ki = Krf + bi(Km - Krf)

Where:

Ki = the required return for the individual security

Krf = the risk-free rate of return

bi = the beta of the individual security

Km = the expected return on the market portfolio

(Km - Krf) is called the market risk premium

This equation can be used to find any of the variables listed
above, given the rest of the variables are known.

CAPM Example
68

Find the required return on a stock given that the riskfree rate is 8%, the expected return on the market
portfolio is 12%, and the beta of the stock is 2.

Ki = Krf + bi(Km - Krf)

Ki = 8% + 2(12% - 8%)
Ki = 16%
Note that you can then compare the required rate of

return to the expected rate of return. You would only

invest in stocks where the expected rate of return
exceeded the required rate of return.

Another CAPM Example

69

Find the beta on a stock given that its expected return is

12%, the risk-free rate is 4%, and the expected return on

the market portfolio is 10%.

12% = 4% + bi(10% - 4%)

bi = 12% - 4%
10% - 4%

bi = 1.33
Note that beta measures the stocks volatility (or risk)
relative to the market.