Risk, Return

and CAPM
Week 6

Presentation by:
Anirudh Dhawan
 Realised Return

Return for equity holders (cost of equity for company) stems from
stock price rise (capital gains) and dividends

Realised return (historical) = capital gains yield + dividend yield

Eg. Stock price of X rose from $18 to $20 in 2016, and it paid an interim
dividend of $0.50/share and a final dividend of the same value. What is
the annual realised return for shareholders?

Ans. Realised return = cap. gains yield + dividend yield = $20 - $18 +
$0.5 + $0.5 = 16.67%
$18 $18
 Risk

Total risk of investment = volatility of returns = Standard Deviation

Standard Deviation () measures how much historical returns deviate

from the mean return

Assuming returns are normally distributed (symmetrical bell-shaped

curve), it can be stated with 95% confidence that a given return will lie
within 2 SDs of the mean
 Total Risk

Total risk of stock (Standard Deviation) = Unsystematic risk +

Systematic risk

Unsystematic risk caused by individual firm specific factors, like

court cases etc., and doesnt exist uniformly in the market. Hence, it
can be eliminated by diversification, or by holding other stocks which
are independent of this stock. Also, investors dont need a risk
premium for this risk since it can be diversified in their portfolio.

Systematic risk caused by market-wide factors such as inflation,

exchange rate fluctuations etc. Since this risk affects all stocks in the
market to some extent, it cant be eliminated via diversification. This
risk determines the companys risk premium.
 Covariance & Correlation

The covariance measure tells us the direction of movement of one security with
respect to another.
2 securities that have positive covariance move in the same direction
2 securities that have negative covariance move in opposite directions

The correlation coefficient () tells us the direction of co-movement of 2

securities, as well as the magnitude of the association
If 0<<=+1, then the securities are positively correlated, with an increasing
degree of co-movement as moves to +1.
If -1<<0, then the securities are negatively correlated, with a decreasing
degree of co-movement as moves to -1.

SD of a portfolio is not the weighted SD of the assets in the portfolio, since all
assets dont move together, and thus some degree of portfolio volatility is
reduced due to diversification.
 Capital Asset Pricing Model (CAPM)
Since a securitys risk premium is only determined by its systematic risk, we
only need to consider that in pricing the asset. Hence, SD (total risk measure)
would not be appropriate.
So, another risk measure called beta () is used, which measures only the
systematic risk.
measures the sensitivity of a stock return to the return of a market
portfolio, and is calculated using historical stock and market returns
For a given 1% change in market return, the average change in stock return
is given by its , hence, firms with a higher face higher market
(systematic) risk, and should intuitively be priced higher (high sys. Risk
higher risk premium higher price).

As per CAPM theory, the return of a stock is given by the return on a risk free
asset (=0), and a risk premium for the systematic risk of the stock.
 CAPM & Security Market Line (cont.)
When the CAPM relationship is plotted on a graph with expected return on the y
axis and beta on the x axis, we get a straight line plot which has a slope equal
to the market risk premium, and an intercept equal to the risk free return.
 CAPM & Security Market Line
This straight line is called the Security Market Line (SML), and as per the CAPM
theory, all fairly priced assets must lie on the SML.

However, in practice, all securities might not lie on the SML. To determine where
the security lies, we must compare its realised return (historical return) with its
required return (predicted by CAPM)
If realised return > required return. Stock is performing better than
expected, hence it is underpriced and we would buy/hold it. These stocks lie
above the SML, since they earn a higher return than predicted by CAPM for
the same .
If realised return < required return. Stock isnt performing well, it is
overpriced and we would sell it. These stocks lie below the SML, since they
earn a lower return than predicted by CAPM for the same .