RISK-RETURN NEXUS:

EMPIRICAL EVIDENCE
FROM THE CAPM
Title and Content Layout with List

 Concept of Risk
 Concept of Return
 Financial Decision
 Risk Portfolio Diversification and Indifference Curve
 What is risk?
 Risk is the potential for divergence between the actual
outcome and what is expected.
 In finance, risk is usually related to whether expected cash
flows will materialize, whether security prices will fluctuate
unexpectedly, or whether returns will be as expected.
 Risk is a measure of the uncertainty surrounding the return
that an investment will earn or, more formally, the variability
of returns associated with a given asset.
 Types of Risk
Systematic Risk Unsystematic Risk
• Risk factors that affect a • Risk factors that affect a
large number of assets limited number of assets
• Also known as non- • Also known as unique risk
diversifiable risk or market and asset-specific risk
risk • Includes such things as labor
• Includes such things as strikes, part shortages, etc.
changes in GDP, inflation,
interest rates, etc.
 Total Risk
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure of
total risk
For well-diversified portfolios, unsystematic risk is
very small
Consequently, the total risk for a diversified portfolio
is essentially equivalent to the systematic risk
Total Risk = Systematic Risk + Unsystematic Risk
 Systematic Risk Principle
There is a reward for bearing risk
There is not a reward for bearing risk unnecessarily
The expected return on a risky asset depends only on
that asset’s systematic risk since unsystematic risk
can be diversified away
 What is Return?
Income received on an investment plus any
change in market price, usually expressed as a
percent of the beginning (average) market price
of the investment.

𝐷𝑡 + 𝑃𝑡 −𝑃𝑡−1
𝑅𝑡 = 𝑃𝑡−1
 Returns
Total Return = expected return + unexpected return
Unexpected return = systematic portion +
unsystematic portion
Therefore, total return can be expressed as follows:
Total Return = expected return + systematic portion +
unsystematic portion
 The risk premium
The risk premium is the return on a risky security
minus the return on a risk-free security (often T-bills
are used as the risk-free security)
 Another name for a security’s risk premium is the excess
return of the risky security.
The market risk premium is the return on the market
(as a whole) minus the risk-free rate of return.
We may talk about this much later in this study.
 Keynote
Thus, effective risk pooling strategy that will guarantee
optimal returns associated with uncorrelated risk
portfolios. That is, a diversified risk portfolio
commands higher risk-returns tradeoff mix. This may
also warrant the need for risk sharing (the spreading of
risk between insurers according to percentage
retention capacity). On the whole, risk pooling and
sharing in insurance allows individuals underwriters to
deal many risks at affordable premiums.
 Financial Decision and Risk Portfolio Diversification

Financial Decisions is a comprehensive financial planning and

wealth management firm that helps high-net-worth individuals
and businesses achieve their financial objectives.
Types of Financial Decisions
1. Investment decision (Capital Budgeting Decision)
2. Financing decision (Sources of Funding Decision)
3. Dividend decision
4. Liquidity Decision
 Financial Decision
Financing Dividend Liquidity
Investment Decision Sources of Decision Decision
Decision Funding (Owner
Cash Flow Earnings Solvency Margin
or Borrowed
Funds)

Cost of Capital Stability of

Return on
(Interest and Earnings Reserves
Investment
Exchange rates)

Financial Risk
Cash Flow Risk on Current
(Inflation &
Risk Involved Position Assets
Business
Investment
Volatilities)

Investment Profitability
Criteria Margin
Avenues for Diversification
Diversify
with asset
classes

Diversify
Buy
with index
insurance
funds

Diversify
Evaluate
among
assets
countries
 Risk Portfolio Diversification and Indifference Curve

In economics, the analysis of consumer behavior

is performed using the indifference curve
approach. The indifference curve shows
consumption bundles that give the consumer the
same level of satisfaction. That is, the risk
appetite of an insurer on risk portfolios that
guarantees the highest risk premium in insurance.
 Standard Behaviors towards Risk

INDIVIDUAL INSURANCE BUSINESS INVESTMENT A PRIORI BETA

RISK APPETITE EXPECTATIONS
DECISION DECISION RESULTS

Invest more and

β > 1.0 =
Risk-Averse Favorable Outcomes May buy underwrite major risk
Aggressive
exposures

Indeterminate speculative
Risk-Neutral Indifferent Undecided risk underwriting and β =1.0 Neutral
investment

Invest little and

β < 1.0 =
Risk-Lover All Outcomes Won’t buy underwrite minor risk
Defensive
exposures
Utility Theory
Expected return Variance or risk

1
U  E (r )  A 2

Utility of an investment Measure of risk tolerance

or risk aversion
Risk Preferences
Risk Reduction
 Capital Asset Pricing Model (CAPM)

CAPM is a model that describes the relationship between risk

and expected (required) return; in this model, a security’s
expected (required) return is the risk-free rate plus a premium
based on the systematic risk of the security.
Under various assumptions about investors’ behavior, the
CAPM asserts that the market portfolio is mean variance
efficient, that is, it gives maximum expected return for a
given variance (level of risk).
 The Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model or the CAPM provides a

relatively simple measure of risk.
CAPM assumes that investors choose to hold the
optimally diversified portfolio that includes all risky
investments. This optimally diversified portfolio that
includes all of the economy’s assets is referred to as the
market portfolio.
According to the CAPM, the relevant risk of an investment
relates to how the investment contributes to the risk of
this market portfolio. 26
 The Capital Asset Pricing Model (CAPM)

The capital asset pricing model defines the

relationship between risk and return
If we know an asset’s systematic risk, we can
use the CAPM to determine its expected return
This is true whether we are talking about
financial assets or physical assets
 Security Market Line

𝑅𝑗 = 𝑅𝑓 + 𝛽𝑗 𝑅𝑀 − 𝑅𝑓

Market Risk
premium
Investors
required Risk-free
rate of investment Expected
return for Beta, return for
rate of
stock j measures market
return
systematic portfolio
risk of stock j
CAPM = SML
Security Market Line cont.
What is Beta?

An index of systematic risk.

It measures the sensitivity of a stock’s
returns to changes in returns on the
market portfolio.
The beta for a portfolio is simply a
weighted average of the individual stock
betas in the portfolio.
RISK – RETURN EMPIRICAL TOOLS
 Probability Distribution
 A listing of the various outcomes and the probability of
each outcome occurring
 Expected return
 A weighted average of the different outcomes multiplied
by their respective probability
n
E ( R)   pi Ri
i 1
 Variance and Standard Deviation

Variance and standard deviation measure the

volatility of returns
Weighted average of squared deviations

n
σ   pi ( Ri  E ( R))
2 2

i 1
 Portfolio Expected Returns

 The expected return of a portfolio is the weighted average of the

expected returns for each asset in the portfolio

m
E ( RP )   w j E ( R j )
j 1
 You can also find the expected return by finding the portfolio return
in each possible state and computing the expected value as we did
with individual securities
 ECONOMETRIC ANALYSIS (CAPM)

To analyze the market risk premium model, we restate the CAPM as:
𝐋 𝐢 = 𝛄 𝐢 + 𝛃 𝐋 𝐦 − 𝛄 𝐢 + 𝛍𝐢
The CAPM shall be analyzed using regression analysis.
The data used were derived from www.finance.yahoo.com, for the
period 2010-2017, on monthly basis.

Data information
• S&P 500 Stock Index, to proxy market return/portfolio
• Vanguard Government Short Term Bond, to proxy risk-free return
• JP Morgan Emerging Market Bond for LDCs, to proxy risk-free return
• Trust 20 year Treasury Bond, to proxy risk-free return
 Analysis and Interpretation
Variable Beta-value Standard Error t Stat P-value

Alpha (0.01) 0.02 (0.28) 0.78

VGST BOND (41.28) 2.63 (15.69) 0.00

JP MORGAN EMB 6.09 0.71 8.57 0.00

TRUST 20YR T-BOND 36.12 2.14 16.85 0.00

The P-value results indicate that the portfolio assets analyzed are uncorrelated
and statistically significant at 0.95 levels.
Dependent Variable: S&P500 STOCK INDEX PORTFOLIO
 Regression Statistics
Multiple R 1.00
R Square 1.00
Adjusted R Square 1.00
Standard Error 0.17
Observations 88.00
 VGST BOND Line Fit Plot
2,000.00

1,500.00 S&P500 STOCK INDEX

S&P500 STOCK INDEX

1,000.00
Predicted S&P500 STOCK
INDEX
500.00
2 per. Mov. Avg.
- (Predicted S&P500
(20.00) - 20.00 40.00 60.00 80.00 STOCK INDEX)
(500.00)
VGST BOND
 JP MORGAN EMB Line Fit Plot
2,000.00

S&P500 STOCK INDEX

S&P500 STOCK INDEX

1,500.00

1,000.00 Predicted S&P500

STOCK INDEX
500.00 Linear (S&P500 STOCK
INDEX)
- Linear (Predicted
(50.00) - 50.00 100.00 S&P500 STOCK INDEX)
(500.00)
JP MORGAN EMB
 TRUST 20YR T-BOND Line Fit Plot
2,000.00

S&P500 STOCK INDEX

S&P500 STOCK INDEX

1,500.00

1,000.00 Predicted S&P500

STOCK INDEX
500.00 Linear (S&P500 STOCK
INDEX)
- Linear (Predicted
(50.00) - 50.00 100.00 150.00 S&P500 STOCK INDEX)
(500.00)
TRUST 20YR T-BOND
BRAVO!