University of Sussex

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University of Sussex

• Finance Course
• Corporate Finance Principles and Practice

Portfolio Theory and CAPM
Heather Stone FCCA
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Measurement of Risk

• Risk is measured as the standard deviation of
  return on a share
• Can be calculated on historical data
• Can be calculated using probability of expected
  future returns

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Examples of relationship between risk and return
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Graph showing distribution of returns of
securities S and T
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Concept of diversification

• Risk can be separated into two types
• Systematic risk non specific, unavoidable,
  market risk
• Unsystematic risk specific, avoidable, specific
  to particular share
• UK Market 34 systematic 66 unsystematic
• Reduce unsystematic risk by diversifying portfolio

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Diagram showing the amount of unsystematic risk
diversification obtained as number of investments
increases
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Investor attitude to risk

• Risk loving
• Preference for high return in exchange for high
  level of risk
• Risk neutral
• Investor indifferent to level of risk
• Risk averse
• preference is for low risk, low return
  investments
• Rational investors will always seek highest
  return for a given level of risk

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Markowitzs Portfolio Theory
F
Expected rate of return
E
A
B
C
R0
D
G
Risk (sd)
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Capital Market Line
N
Expected rate of return
M
Rm
Rf
Risk (sd)
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Using CAPM to value shares

• Assumes linear relationship between risk and
  return
• Equation of Security Market Line
• Rj Rf ßj (Rm Rf)
• Beta can be calculated, usually determined
  graphically and published quarterly

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Meaning of Beta

• Index of responsiveness of changes in returns as
  a result of market changes
• Defensive security
• Beta lt 1
• Aggressive security
• Beta gt 1

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Using CAPM to determine Required Rate if Return

• Rj Rf ßj (Rm Rf)
• Determine market and risk free rates
• Determine Beta for security
• Can calculate required rate of return
• This return takes account of risk involved in
  project

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Projects Hurdle Rate

• Equity Beta total systematic risk
• Asset beta or ungeared beta, excludes risk from
  financial structure of company
• Determine equity beta from company with same risk
  profile as project

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Projects hurdle rate

• Replace with Equity beta representing companys
  actual business risk profile
• Insert regeared beta into CAPM formula
• Gives required rate of return for project
• Companys cost of capital ignore risk of project