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Chapter 10: Risk-Return and

Asset Pricing Models


Return

 Percentage form of earnings from an


investment or asset including normal income
and capital gain or loss is called return. Return
may be the following three types:
1. Risk-free rate of return – rate of return can be
earned by making investment in government
securities of a country is known as risk-free
rate of return.
2. Nominal rate of return – rate of return
calculated by ignoring existing level of
inflation is known as nominal rate of return.
3. Real rate of return - rate of return determined
by considering/adjusting existing level of
inflation is known as real rate of return.
Risk
 Risk and uncertainty are terms used to describe situations
where the outcomes of decisions are not known with
complete certainty. Risk is defined as the chance that the
actual outcome will be unequal to the expected outcome. As
a general proposition, the greater the chance of low returns,
the greater the risk of the investment. Actually, the difference
between expected rate of return and actual rate of return is
called risk.
 Classification of risk:
i. Systematic risk – risk that cannot be avoided or minimized and
that is out of control of an individual or a business enterprise.
ii. Unsystematic risk - risk that cannot be avoided but can be
minimized by making intellectual decision based on best
judgment relying on relevant information and that is to some
extent under the control of an individual or a business
enterprise.
iii. Business risk – risk related to overall business activities of a
particular business enterprise that is mostly out of control of
that business enterprise.
iv. Financial risk - risk related to using of fund for forming and
Risk-Return and Asset Pricing Models

Portfolio: To make investment in two or more than two


assets for minimizing level of unsystematic risk is
called portfolio.

Portfolio return and risk: Rate of return calculated by


taking into account the rate of return of specific asset
and proportion of fund allocated in that specific asset is
called portfolio return. Level of risk calculated by
considering level of risk of specific asset, standard
deviation of that specific asset and correlation
coefficient between assets is called portfolio risk.
Example: Mr A has available fund Tk.500000 for making
investment. He is planning to invest Tk.150000 in asset X
and Tk.350000 in asset Y. The information related to these
two assets is given in the following table:
Asset X Asset y Correlation
Curre Exp Prob Divid Curr Expe Prob Interest coefficient
nt ecte abilit end ent cted abilit income between
price d y inco price price y (I1) asset X and
(Po) Y is 0.80
pric (Pi) % me (Po) (P1) (Pi) %
e (D1)
(P1)
120 130 20 15 950 960 35 100
110 35 970 25
115 15 940 40
125 30
Calculation of portfolio return and risk.
Solution:
Asset X:
Return (R) = (P1-P0+D1)/P0
R1 = (130-120+15)/120=0.2083
R2 = (110-120+15)/120=0.0417
R3 = (115-120+15)/120=0.0833
R4 = (125-120+15)/120=0.1667

Expected Return: E(Rx)= ∑ Pi Ri


= P1R1+ P2R2+ P3R3+ P4R4
=0.20*.2083+.35*0.0417+0.15*0.0833+.30*0.1667
= 0.1188=11.88%
Risk:
σx = √ {∑ Pi [ Ri – E(Rx)]2}
= √{ P1 [ R1 – E(Rx)]2 + P2[ R2 – E(Rx)]2 + P3 [ R3 – E(Rx)]2 + P4 [ R4 – E(Rx)]2 }
= √ {0.20 (0.2083-0.1188)2 + 0.35 (0.0417-0.1188)2 + 0.15 (0.0833-
0.1188)2 +
0.30 (0.1667-0.1188)2}
= 0.0675=6.75%
Asset Y:
Return (R) = (P1-P0+I1)/P0
R1 = (960-950+100)/950=0.1158
R2 = (970-950+100)/950=0.1263
R3 = (940-950+100)/950=0.0947

Expected Return: E(Ry)= ∑ Pi Ri


= P 1R 1+ P 2R2+ P 3R3
= 0.35*0.1158+.25*0.1263+0.40*0.0947
= 11%
Risk:
σy = √ {∑ Pi [ Ri – E(Rx)]2}
= √{ P1 [ R1 – E(Ry)]2 + P2[ R2 – E(Ry)]2 + P3 [ R3 – E(Ry)]2
+}
= √ {0.35 (0.1158-0.11)2 + 0.25 (0.1263-0.11)2 + 0.40
(0.0947-0.11)2 }
= 0.0131=1.31%
Portfolio return: E(Rp) = ∑ Wi E(Ri)
= Wx E(Rx)+ Wy E(Ry)
= 0.30*0.1188+0.70*0.11
= 0.1186=11.86%

Portfolio risk for 2 assets:


σp = √ {Wx 2σ x +W
2
y
2 σ y + 2W x W y σ x σ y rx,y}
2

= √ {0.30 2 *0.06752 + 0.70 2 *0.0131 2 +


2*0.30*0.70*.0675 *0.0131*.80} =0.0281=2.81%

Portfolio risk for 3 assets:


σp = √ {Wx 2σ x
2 +W y
2 σ y
2 +W z
2 σ z
2 +2W x W y σ x σ y rx,y +
2W x W z σ x σ z rx,z + 2W y W z σ y σ z ry,z }
Diversification and portfolio
risk:

Level of
risk

Unique
risk/Unsystematic risk

Market risk/systematic risk

No of asset
Markowitz Portfolio Theory:
Markowitz model assumes the followings:
 Investors consider each investment alternative as being
represented by a probability distribution of expected returns
over some holding period.
 Investors maximize one period expected utility and their utility
curves demonstrate diminishing marginal utility of wealth.
 Investors estimate the risk of the portfolio on the basis of the
variability of expected returns.
 Investors base decisions solely on expected return and risk, so
their utility curves are a function of expected return and
expected variance of returns.
 For a given level of risk, investors prefer higher returns to lower
returns and for a given level of expected return investors prefer
less risk to more risk.
Portfolios of two risky assets:
 The lower the correlation between assets, the greater the
gain in efficiency.

 Another consideration for minimizing level of portfolio risk


is proportion of fund allocation. The proportion of fund to
be allocated in each specific asset for getting lowest level of
portfolio risk can be determined by applying the following
formula:

ó 2 E  Cov( rD , rE )
wmin ( D )  2
ó D  ó 2 E  2Cov(rD , rE )
Example: Stock fund offers 12% return with 3.5% risk and debt fund offers 10%
return with 3% risk. Correlation coefficient between stock and debt is 0.40.

3.5 2  3.5 * 3 * 0.40


Wmin ( D )  2
3  3.5 2  2 * 3.5 * 3 * 0.40
 0.63
and WMin (E) = 1 – 0.63 = 0.37

If the correlation coefficient between stock and debt is negative 0.40,


then optimal allocation will be as:
3.5  3.5 * 3 * (0.40)
2
Wmin ( D)  2
3  3.52  2 * 3.5 * 3 * (0.40)
 0.55
and WMin (E) = 1 – 0.55 = 0.45
Calculate the portfolio return and risk for determined
weights and by assuming any other allocation than that
of optimal allocation.
Efficient portfolio: The portfolio provides higher rate of return for
a given level of risk or involves lower level of risk for a given level of
return is known as efficient portfolio. 

Minimum-variance frontier: The frontier (line or curve)


represents the lowest possible variance that can be attained for a
given portfolio expected return is known as minimum-variance
frontier. 

Global minimum-variance portfolio: The portfolio involves the


lowest level of risk out of all portfolios positioned on the frontier is
known as global minimum-variance portfolio. 

Efficient frontier: The part of the frontier lies above the global
minimum-variance portfolio is considered as efficient frontier.
Capital asset pricing model (CAPM):
E(R) = Rf + (Rm – Rf)β,
here
E(R) = Expected rate of return.
Rf = Risk-free rate,
Rm = Market rate,
β = Beta coefficient

Assumptions of CAPM:
1. There are many investors, each with an endowment that is small
compared to the total endowment of all investors and they are price-
takers.
2. All investors plan for one identical holding period.
3. Investments are limited to a universe of publicly traded financial
assets.
4. Investors pay no taxes on returns and no transaction costs.
5. All investors are rational mean-variance optimizers.
6. All investors analyze securities in the same way and share the same
economic view of the world.
 
SML
SML

Security market line


(SML):
The line represents the positive relationship
between expected rate of return and level of
systematic risk for a financial asset is known as
security market line. The graphical presentation is as
follows:
Return
SML

Rf
Systematic risk
Capital market line (CML): The line shows the
positive relationship between expected rate of return
and level of total risk for a financial asset is known as
capital market line. The graphical presentation is as
follows:

Return
CML

Rf
Total risk
Characteristics line (CL): The line represents the
relationship between market rate of return and expected rate
of return of a financial asset is known as characteristics line.
There may be positive, negative, vertical and horizontal
relationship between market rate of return and expected rate
of Security
return of a financial asset. The graphical presentation is as
Return
follows: 

CL1

CL3

CL2

Market return
 Risk Management in Islam
 The broad perspective on risk and its management are embodied in the overall goals of
Islamic law or maqasid al-shariah. Chapra (2008a) quotes al-Ghazali in defining
maqasid as promotion of “the well-being of the people, which lies in safeguarding their
faith (din), their self (nafs), their intellect (aql), their posterity (nasl), and their wealth
(mal)”. The principle of maqasid would imply taking all the precautions to safeguard
present and future wealth. As risk in economics represents the probable loss of wealth,
it is not desirable in itself from an Islamic perspective. While risks are not desirable on
their own, they must be undertaken to create wealth and value. From an Islamic
perspective, economic activities are not judged by their inherent risks, but by whether
they add value and/or create wealth.
 In line with the above discussion, Hassan (2009) identifies three types of risks from the
Islamic perspective. First, is the essential risk that is inherent in all business
transaction. This business risk is necessary and must be undertaken to reap the
associated reward or profit. We find that two legal maxims are associated with returns
to essential risks from the basis of Islamic economic transactions. The first maxim
states “the determinant is as a return for the benefit (al-gjorm bil ghunm)” (Majalla Art
87). This maxim attaches the “entitlement of gain” to the “responsibility of loss”. The
second maxim is derived from the Prophetic saying “al-kharaj bil daman” stating “the
benefit of a thing is a return for the liability for loss from that thing” (Majalla Art.85) The
maxim asserts that the party enjoying the full benefits of an asset or object should
bear the risks of ownership. By putting together these two legal maxims, we can say
that for every investment, the investor must have to take risk in order to get some
return from it. At the same time, with return there comes responsibility, specifically
responsibility to share the loss associated with the investment. So developing the
portfolio, an investor must have to remember these two legal maxims.
 Risk Management in Islam

 The second risk is the prohibited risk in the form of excessive gharar. Gharar is
usually translated as uncertainty, risk or hazard, but it also implies ignorance,
gambling, cheating and fraud. Generally, gharar related to ambiguity and/or
ignorance, gambling, cheating and fraud. Thus a sale can be void due to gharar
– due to risk existence and taking possession of the object of sale on the one
hand, and uncertainty about the quantity, quality, price or time of payment on
the other. While making investment, we have to minimize this uncertainty
factor at certain level so that it does make the whole transaction prohibited.

 The final form of risk identified by Hassan is the permissible risk that does not
fall in the above two categories. For example, operational risks, liquidity risks,
etc. These risks can either be accepted or avoided.
 
 The principles of risk management from an Islamic perspective are to link risk
and causality. There is a need to distinguish between causes and uncertain
outcomes. In uncertain situations, individuals have control over the causal
factors, but not the outcome. There is a Prophetic saying of “tie the camel and
then entrust it to God”, so the Islamic approach to risk management would be
to understand and control the causes of risks and then leave the final outcome
to the will of Allah (s.w.t.).