BF Lecture Notes Topic 5 Part 2

Topic 5
Risk & Return

Part 2
Risk-Free Asset
Risk-Free Asset
A risk-free asset (Rf) is usually considered to be a central government security.
Generally, we assume the risk-free asset is a central government bond.
When introducing the risk-free asset we make a number of assumptions:
1. Asset markets are perfect - there are no taxes, no transaction costs, etc.
2. Quantities of assets are fixed and all assets are marketable (can be sold at any
time) and divisible (can be sold in any quantity).
. The introduction of a risk-free asset allows investors to borrow and lend at the riskfree rate.
. Once the risk-free asset is introduced we now have a new efficient frontier with our
opportunity set. The new efficient frontier is called the Capital Market Line (CML).
BAFI1008 Business Finance
Risk-Free Asset
The New Efficient Frontier rontier
Expected
Return
Portfolio (M)
Rm
New efficient frontier is called the
Capital Market Line (CML)
Rf
m
Risk
Risk-Free Asset
When a risk-free asset (Rf) is introduced investors can create portfolios that combine
this risk-free asset with a portfolio of risky assets (where the risky asset is M the
Market Portfolio).
The risk attached to the risk-free asset is equal to zero.
The straight line connecting Rf with M, the tangency point between Rf and the old
Efficient Frontier, becomes the new Efficient Frontier called the Capital Market Line
(CML).
Risk-Free Asset
CML
Efficient Frontier And Investor Preference

Higher return for same level of risk
High
Expected Return
M
B
RB
RA Rc
Rf
A
C
Low
Low
C
A
B
High
Risk (i)
Risk-Free Asset
Introducing a risk-free asset enlarges the opportunity set - many more risk/return
combinations are possible.
The risk-free asset increases the return for each level of risk or, alternatively expressed,
it reduces the risk for every given level of return
The Capital Market Line (CML) is all linear combinations of the risk-free asset (R f ) and
the market portfolio (M)
With the CML all investors will hold some combination of the risk-free asset and the
market portfolio M. All investors will choose a portfolio on the CML where on the CML
will depend on their risk preferences, i.e. on their attitude towards risk.
Risk-Free Asset
Efficient Frontier And Investors Risk Preference
CML
B
High
B high expected
return & high risk
Expected Return
M
A
A low
risk & low
expected
return
Rf
Low
Low
Risk
High
Market Portfolio
The point of tangency can be shown to be the market portfolio, denoted by the letter
M, and represents the most diversified portfolio in the economy.
Each asset weight in the portfolio will reflect its relative importance in the economy
as a whole. Example if the retail sector makes up 60% of the national economy,
retail sector assets will make up 60% of the market portfolio M.
The market portfolio is considered as being one asset.
Borrowing & Lending At Rf

Borrowing And Lending At The Risk-Free Rate
The introduction of the risk-free asset allows investors to borrow and lend at the riskfree rate of interest (Rf)
Expected
Return
M
Rf
RO
R
BO
NG
I
W
CML
ING
D
N
LE
To the right of M - Borrowing
To the left of M - Lending
Borrowing & Lending At Rf

Borrowing And Lending At The Risk-Free Rate
The equation for the CML is:
Rp =
Rf + (Rm - Rf)p/M
i.e. Portfolio Return = Risk-Free Return + ((Market Risk Premium) x Measure of Relative Risk)
Where:
Rp
= Portfolio Return
Rf
= Risk-Free Return
Rm
= Market Return
(Rm - Rf)
= Market Risk Premium
= Market Risk
= Portfolio Risk
p/M = Measure of Relative Risk
10
Capital Market Line

The Capital Market Line (CML) reflects:
1.A positive relationship between risk and expected return, i.e. higher risk leads to a
higher expected return, and vice-versa; and
2.Risk premium is proportionate to the risk of the market (as reflected in the measure of
relative risk - p/M)
.If investors want less risk than the risk of the market, they can satisfy their preference
by investing in a combination of Rf and M and lending at Rf (and they will have a lower
expected return than the expected return on the market portfolio M).
.If investors want a higher return than the return on the market, they can satisfy their
preference by investing in a combination of Rf and M and borrowing at Rf (and they
will have higher risk than the risk of the market portfolio).
.Investors risk/return preferences are now satisfied by borrowing and lending.
11
Lending At Rf
Example: Lending Portfolio Investor wants less risk than the market portfolio.
Rf = 10%, Rm = 12%, m = 8%, p = 6%
What will be the investors expected return?
CML Expected Return = Rp = Rf + (Rm Rf)p/m
Rp = 0.10 + (0.12 0.10)0.06/0.08
Rp = 0.10 + (0.02)0.75 = 0.10 + 0.015 = 0.115 = 11.50%
It makes sense that the expected return of the investor (11.50%) is less than the
expected return on the market portfolio (12%) because the investor wishes to have less
risk in his/her portfolio (p = 6%) than the risk of the market portfolio (m = 8%).
Remember, there is a positive relationship between risk and expected return.
Therefore, lower risk leads to lower expected return.
12
Lending At Rf
Example: Lending Portfolio
The question can now be asked: What proportion of the investment should be in the riskfree asset Rf and in the risky asset Rm so that the investor can achieve his/her desired
level of risk of p = 6%?
The investor can tolerate less risk than the market risk, i.e. 6% / 8% = 0.75 times the risk
of the market, so wishes to invest only 75% of his/her funds in the market.
Investor always has exactly 100% of funds to invest so assuming the investor has $100
to invest:
$75 of funds will be invested in the market portfolio M (the risky asset); and
$25 of funds will be invested in the risk-free asset R f (i.e. the investor will buy $25 worth
of central government bonds, which means, in effect, the investor would be lending $25
to the central government).
By transferring some of his/her funds to the risk-free asset (and away from the risky
asset M) the investor is able to bring down the average risk of his/her portfolio.
In this example the investor transfers $25 of his/her funds to the risk-free asset, which
has a standard deviation of zero, and this brings down the average standard
deviation/risk of his/her portfolio.
13
Borrowing At Rf
Example: Borrowing Portfolio Investor wants a higher return than the market
portfolio.
Rf = 10%, Rm = 12%, m = 8%, p = 14%
What will be the investors expected return?
CML Expected Return = Rp = Rf + (Rm Rf)p/m
Rp = 0.10 + (0.12 0.10)0.14/0.08
Rp = 0.10 + (0.02)1.75 = 0.10 + 0.035 = 0.135 = 13.50%
It makes sense that the expected return of the investor (13.50%) is higher than the
expected return on the market portfolio (12%) because the investor is prepared to have
more risk in his/her portfolio (p = 14%) than the risk of the market portfolio (m = 8%).
Remember, there is a positive relationship between risk and expected return.
Therefore, higher risk leads to higher expected return.
14
Borrowing At Rf
Example: Borrowing Portfolio
The question can now be asked: What proportion of the investment should be in the risk-free
asset Rf and in the risky asset Rm so that the investor can achieve his/her desired return of R p =
13.50%?
The investor can tolerate more risk than the market risk, i.e. 14% / 8% = 1.75 times the risk of
the market, so wishes to invest 175% of his/her funds in the market.
Investor always has exactly 100% of funds to invest so assuming the investor has $100 to
invest:
$100 of the investors funds will be invested in the market portfolio M (the risky asset); and
$75 will be borrowed by the investor and also invested in the market portfolio R m.
In total the investor will invest $175 in the market portfolio R m.
By borrowing funds the investor increases the risk on his/her portfolio and is able to increase
the expected return on the portfolio to 13.50%.
In this example the investor borrows 75% of the required funds and invests the total funds in
the market portfolio Rm and this increases the total risk on the investors portfolio p by 75%
above that of the market portfolio m i.e. increases the standard deviation on the investors
portfolio p = m x 1.75 = 0.08 x 1.75 = 0.14 = 14%.
15
Total Return & Risk

Components of Total Return
Actual Return (Ri) = expected return + unexpected return
The unexpected part of the return is the true risk of any investment because it
results in uncertainty and variability of returns (returns might be < or > than
expected).
Two Types of Risk
1.Systematic Risk affects a large number of securities, i.e. it affects the whole
system.
2.Non-Systematic Risk - affects a single firm/asset or a small number of
firms/assets.
16
Capital Asset Pricing Model (CAPM)

We know from the Lecture for Part 1 of Risk & Return that the process of
diversification - spreading investments across different assets, industries and
countries can reduce risk.
We also know that the gain from diversification is closely related to the correlation
coefficient of each pair of assets in a portfolio.
Portfolio risk is reduced by combining assets that are less than perfectly positively
correlated (i.e. where x,y < +1) - there is a reduction in the variability of cashflows due to the prices of the assets not moving up and down identically.
17

However, not all risk can be eliminated.
Total risk = systematic risk + unsystematic risk
Examples of systematic risk factors:
Government tax cuts
Interest rate rises
These factors affect the whole economic system
Examples non-systematic risk factors:

A firms technical wizard leaves
A competitor enters a firms product market.
These factors affect only a small part of the economic system
Non-systematic risk can be eliminated by diversification

Systematic risk affects all assets and cannot be diversified away
Total risk =
systematic
market risk
+
+
non-systematic
non-market risk
non-diversifiable risk +
diversifiable risk
18

Systematic risk principle states that the expected return on a risky asset depends only
on the assets systematic risk, i.e. investors will not be rewarded for having nonsystematic risk in their portfolio.
The amount of systematic risk in an asset relative to the average risky asset (where the
average risky asset is the market portfolio) is measured by the eta coefficient.
Example
Std Dev
eta
Security A
30%
0.60
Security B
10%
1.20
Security A has greater total risk (as it has a higher standard deviation) but less
systematic risk than Security B (because Security A has a lower eta).
19

eta (i) - A measure of the sensitivity of an assets return relative to changes in
the market return:
i = 0
the assets returns are independent of the market
i = 0.5
the assets returns are half as responsive as the market
i= 1.0
the assets returns will move exactly with the market
i= 1.5
the assets returns will increase by 50% more than the market for any
given increase in the market returns.
i = -1.5 the assets returns will decrease by 50% more than the market for
any given increase in the market returns.
The higher the degree of systematic risk (i), the higher the return expected by
investors.
20

Australian Company etas
ASX Company
eta Coefficient
Amcor
1.11
Amcor is 11% more risk than the market.
BHP-Billiton
0.99
BHP-Billiton moves with the market
Boral
0.84
Coca-Cola Amatil (CCA)
1.05
CSR
0.90
Mayne Nickless
0.80
NAB
1.09
Mayne Nickless is 20% less risk than the market
21

Because a fully diversified portfolio will eliminate non-systematic risk, there is no
reward to investors for having any non-systematic risk in their portfolio.
Investors are only rewarded for their exposure to systematic risk.
Market Risk Premium And Beta
Investors require a risk premium for holding risky assets.
Market Risk Premium = (Rm - Rf).
How much market risk premium an investor receives depends on the extent of their
systematic risk exposure (as measured by i).
22

The CAPM is an equilibrium model of the relationship between risk and return.
What determines an assets expected return with the CAPM?
The risk-free rate of return reflects the time value of money.
The market risk premium - the reward for bearing systematic risk.
The eta coefficient - a measure of the amount of systematic risk present in a
particular asset.
Required Rate of Return With CAPM:
R i R f R M R f i
Market Risk Premium
Total Risk Premium
23

R i is the required rate of return on Asset i based upon its systematic risk.
The actual rate of return on an asset will at equilibrium be equal to the required
rate of return.
R i can also be referred to as the equilibrium rate of return.
R i is the return that the asset needs to yield in order for it to be willingly held
given its systematic risk
Example
Given a risk free rate (Rf) of 5% and an expected market return (R m) of 10%, what
is the required return ( R i ) for Share Z with a beta of 1.5?
R Z 0.05 [ 0.10 - 0.05 ] 1.5

R Z 0.05 0.051.5
R Z 0.05 0.075
R Z 0.125 12.5%
24
CAPM & The Security Market Line (SML)

Security Market Line
The Security Market Line (SML) is the positively sloped straight line displaying the
relationship between required return and beta.
CAPM is the equation that describes the relationship between required return and beta.
CAPM is the equation of the SML:
SML is the graphical representation of the CAPM.
The Capital Market Line (CML), which we covered earlier, gives the risk return
relationship for portfolios consisting of some combination of the market portfolio
and the risk free asset, where risk is total risk (as measured by standard deviation
p).
The Security Market Line (SML) is used for working out the risk and return
relationship for individual assets and portfolios other than those comprised of a
combination of the market portfolio and the risk free asset, and where risk is
measured only by systematic risk (eta i).
25
CAPM & eta

Individual Asset eta
i is the measure of systematic risk for an individual asset.
i ,m i m cov i ,m
i
2
m
m2
where:
i,m = correlation coefficient between the return on the Asset i and the market return;
i = standard deviation of returns on Asset i;
m = standard deviation of returns on the market;
m2 = variance of returns on the market.
Note: The eta of the market (m) is always equal to 1.
Portfolio eta
The eta of a portfolio (p) is equal to the weighted average eta of the individual assets
being held in the portfolio:
p = W1 1 + W2 2 + W3 3 + ... + W n n
26
CAPM & Equilibrium

CAPM - based on market in equilibrium;
- model of how share prices are formed;
- price and return are inversely related;
If the actual/expected/forecast return on an asset is greater than its required
rate of return the asset is under-priced. Investors will buy the asset - demand
will force the price up.
If the actual/expected/forecast return on an asset is less than its required rate
of return the asset is over-priced. Investors will sell the asset - the price will be
forced down.
Buying and selling will continue until a state of equilibrium is achieved, i.e.
actual/expected/forecast return equals required return.
27
CAPM & Equilibrium

Example
Market analysts have forecast that Share X will return 7% by year end, Share Y will
return 12.5% and Share Z will return 14%.
Given a risk free rate Rf of 5% and an expected market return Rm of 10%, what is the
required rate of return for Share X with a beta of 0.8, Share Y with a beta of 1.2 and
Share Z with a beta of 1.8? Are these shares fairly priced?
R i R f ( RM R f ) i
R x 0.05 (0.10 0.05)0.8 0.09 9%
R y 0.05 (0.10 0.05)1.2 0.11 11%
R z 0.05 (0.10 0.05)1.8 0.14 14%
28
CAPM & Equilibrium
SML
% R
14
RM
11
10
9
5
Z FZ
FY
X
FX
FX = actual/forecast return on Asset X (7%)
X = required return on Asset A (9%)

FY = actual/forecast return on Asset Y (12.5%)
Y = required return on Asset Y (11%)
FZ = actual/forecast return on Asset Z (14%)
Z = required return on Asset Z (14%)
2
1.
0
1.
0.
8
1.8
M
29
CAPM & Equilibrium

X Share X is overpriced. The share is forecast to generate an actual return (7%) that is
lower than the required/equilibrium return predicted by CAPM (9%).
X Investors will sell Share X causing its price to fall until the actual return increases to
equal the required return.
Y Share Y is underpriced. The share is forecast to generate an actual return (12.5%) that
is higher than the required/equilibrium return predicted by CAPM (11%).
Y Investors will buy Share Y causing its price to rise until the actual return decreases to
equal the required return.
Z Share Z is fairly priced (actual return 14% equals required return 14%).
30
Efficient Market Hypothesis

Efficient Market Hypothesis (EMH) Are financial markets efficient?
Types of Market Efficiency
1. Operational Efficiency: Are financial services produced at minimum cost?
2. Allocative Efficiency: Are funds allocated to those investments that provide the
highest return for a given level of risk?
3. Dynamic Efficiency: Is the market able to adapt to changing needs and generate
innovations in financial services?
4. Informational Efficiency: Do market prices reflect all information regarding assets
and adjust fully and quickly to any new information concerning those assets?
.. The type of market efficiency we are most interested in (and what you may be
examined on) is Informational Efficiency.
31

Informational Efficiency
What we are interested in is Informational Efficiency - where market prices of financial
assets reflect all available information and adjust fully and quickly to new information.
Individual traders process the information available to them and trade in securities in
response to that information.
Market prices aggregate this diverse information and reflect all available information.
Requirements For Capital Market Informational Effciency
1. A large number of well-informed investors/analysts who continually evaluate the
available information regarding any particular asset. And,
2. Large, well functioning security markets with significant competition between
participants that results in securities being fairly and accurately priced.
32

Informational Efficiency
Speed - instantaneous adjustment of prices so that investors cannot trade at old price
and earn an abnormal profit when price adjusts.
Type - information sets are used to categorise all relevant information the type of
efficiency is related to the information set specified.
If a financial market is efficient an investor cannot consistently earn abnormal profits
because prices of securities adjust instantaneously to fully reflect all relevant
information.
Consistently - other than by chance.
Abnormal profits - a return greater than a risk-adjusted return (as estimated using
CAPM).
33

Information Sets
Eugene Fama (a University of Chicago finance academic most famous for his random
walk hypothesis (1965)) in 1976 specified three levels of market efficiency by
considering three different types of information sets:
1. Weak Form
2. Semi-Strong Form
3. Strong Form
. Each form builds on and incorporates the previous form.
34

Weak-Form Informational Efficiency
Asserts that prices fully reflect the information contained in the historical sequence of prices.
Implication: Investors cannot devise an investment strategy to yield abnormal profits on the basis of an analysis of past
price patterns, i.e. using technical analysis, because any new information from such an analysis will already be
factored into current market prices.
Weak-Form informational efficiency is associated with the Random Walk Hypothesis - price changes represent
random departures from previous price changes (i.e. there is no pattern in price changes).
Investopedia*1 Says:
One of the different degrees of efficient market hypothesis (EMH) that claims all past prices of a stock are reflected in
today's stock price. Therefore, technical analysis *2 cannot be used to predict and beat a market.
Theoretical in nature, weak form efficiency advocates assert that fundamental analysis can be used to identify stocks
that are undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by
researching financial statements.
Technical Analysis: Also known as Charting, is the study of historical chart patterns and trends of publicly traded
stocks using tools such as bar or candlestick charts and trading volumes to determine the future behaviour of a stock.
Much of this practice involves discovering the overall trend line of a stock's movement.
*2
*1 http://www.investopedia.com/terms/w/weakform.asp, 19/09/13.
*2
http://www.investopedia.com/terms/t/technical-analysis-of-stocks-and-trends.asp, 19/09/13.
35

Semi-Strong Form Informational Efficiency
Asserts that current market share prices reflect not only historical price data but also all
publicly available information relevant to a company's securities.
Implication: Analysis of all publicly available information e.g. balance sheets, profit and
loss statements, media reports, etc., will not consistently yield abnormal profits, i.e.
fundamental analysis will not lead to consistently abnormal profits.
36

Strong-Form Informational Efficiency
Asserts that all information that is known to any market participant about a company is fully reflected
in market information
Implication: All analysis is useless in trying to achieve abnormal profits - not even insider trading can
consistently yield abnormal profits.
Implication of Strong-Form Informational Efficiency For Investment Strategy
The market cannot be beaten by analysis of information.
The optimal investment strategy is to invest in a well-diversified portfolio.
Investopedia*1 Says:
Strongform informational efficiency is the strongest version of market efficiency. It states all
information in a market, whether public or private, is accounted for in a stock price. Not even insider
information could give an investor the advantage.
This degree of market efficiency implies that profits exceeding normal returns cannot be made,
regardless of the amount of research or information investors have access to.
*1
http://www.investopedia.com/terms/s/strongform.aspardless of the amount of research or information investors have access to., 19/09/13.
37

Regarding the EMH, Investopedia*1 says:
[If markets are strong-form efficient] This would naturally imply, as many market experts often maintain, that the
absolute best investment strategy is simply to place all of one's investment funds into an index fund, which would
increase or decrease according to the overall level of corporate profitability or losses. Then:
There are, however, many examples of investors who have consistently beaten the market - you need look no
further than Warren Buffet*2 to find an example of someone who's managed to beat the averages year after year.
Also: It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater efficiency to
occur, the following criteria must be met:
1.
Universal access to high-speed and advanced systems of pricing analysis,
2.
A universally accepted analysis system of pricing stocks,
3.
An absolute absence of human emotion in investment decision-making,
4.
The willingness of all investors to accept that their returns or losses will be exactly identical to all other market
participants. It is hard to imagine even one of these criteria of market efficiency ever being met.
*1
http://www.investopedia.com/articles/basics/04/022004.asp, 19/09/13.
*2
Warren Buffet: Known as "the Oracle of Omaha", Buffett is Chairman of Berkshire Hathaway and arguably the greatest investor of all time. His wealth fluctuates with the
performance of the market but as of 2008 his net worth was estimated at $62 billion, making him the richest man in the world. Buffett is a value investor. His company Berkshire
Hathaway is basically a holding company for his investments. Major holdings he has had at some point include Coca-Cola, American Express and Gillette. Critics predicted an end
to his success when his conservative investing style meant missing out on the dotcom bull market. Of course, he had the last laugh after the dotcom crash because, once again,
Buffett's time tested strategy proved successful. http://www.investopedia.com/terms/w/warrenbuffet.asp, 19/09/13.
38

Empirical (Real-World) Evidence On The EMH
Extensively tested hypothesis Event Study Methodology.
There is considerable evidence which suggests that markets perform well in
reflecting available information and respond quickly to new information
(Peirson et. al, Business Finance, 10th Edition, p. 521, McGraw-Hill, 2009*1).
Australian Market is considered to be at least semi-strong form efficient.
However, there is evidence that market anomolies mean markets may not be
efficient.
*1 For those interested in learning more about the EMH and empirical evidence on its validity the
Peirson et. al textbook has a good summary (note: current (prescribed text) edition is Ed. 11).
39

Market Anomolies
Examples of market anomolies include:
Tuesday effect (in Australia share prices tend to fall on Tuesdays)
January effect (share prices generally rise more in January);
Turn-of-the-month effect (share prices generally rise at the beginning of a month);
Small-firm effect (returns on the shares of small companies are generally higher);
If these effects are true they imply markets are not even weak-form efficient and, therefore,
this information can be used to earn abnormal returns over an extended period of time.
Does Insider Trading Beat the Market?
There is evidence from both Australian and overseas markets that some market
professionals (e.g. stockbrokers, dealing-room traders, fund managers) who may have
access to private information earn abnormal above-average returns (Bishop et. al, Corporate
Finance, Edition 5, Pearson-Prentice Hall, 2004, p. 84).
Question is this because they are insider-traders or because they are better skilled
traders?
40

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Topic 5

Risk & Return

BAFI1008 Business Finance

BAFI1008 Business Finance

Efficient Frontier And Investor Preference

BAFI1008 Business Finance

BAFI1008 Business Finance

BAFI1008 Business Finance

BAFI1008 Business Finance

Borrowing & Lending At Rf

To the left of M - Lending

BAFI1008 Business Finance

Borrowing & Lending At Rf

= Market Risk Premium

p/M = Measure of Relative Risk

BAFI1008 Business Finance

Capital Market Line

BAFI1008 Business Finance

BAFI1008 Business Finance

BAFI1008 Business Finance

BAFI1008 Business Finance

BAFI1008 Business Finance

Total Return & Risk

BAFI1008 Business Finance

Capital Asset Pricing Model (CAPM)

BAFI1008 Business Finance

Capital Asset Pricing Model (CAPM)

These factors affect the whole economic system

Examples non-systematic risk factors:

These factors affect only a small part of the economic system

Non-systematic risk can be eliminated by diversification

BAFI1008 Business Finance

Capital Asset Pricing Model (CAPM)

BAFI1008 Business Finance

Capital Asset Pricing Model (CAPM)

the assets returns are independent of the market

the assets returns are half as responsive as the market

the assets returns will move exactly with the market

BAFI1008 Business Finance

Capital Asset Pricing Model (CAPM)

Amcor is 11% more risk than the market.

BHP-Billiton moves with the market

Coca-Cola Amatil (CCA)

BAFI1008 Business Finance

Mayne Nickless is 20% less risk than the market

Capital Asset Pricing Model (CAPM)

BAFI1008 Business Finance

Capital Asset Pricing Model (CAPM)

Total Risk Premium

BAFI1008 Business Finance

Capital Asset Pricing Model (CAPM)

R Z 0.05 [ 0.10 - 0.05 ] 1.5

CAPM & The Security Market Line (SML)

BAFI1008 Business Finance

CAPM & eta

CAPM & Equilibrium

BAFI1008 Business Finance

CAPM & Equilibrium

BAFI1008 Business Finance

CAPM & Equilibrium

FX = actual/forecast return on Asset X (7%)

X = required return on Asset A (9%)

CAPM & Equilibrium