In the article on portfolio theory, we saw that the motivation behind the establishment of a portfolio is that risk (the

bad) can be reduced without a consequential reduction in return (the good). This was mathematically evident when
the portfolios' expected return was equal to the weighted average of the expected returns on the individual
investments, while the portfolio risk was normally less than the weighted average of the risk of the individual
investments.

The portfolio's total risk (as measured by the standard deviation of returns) consists of unsystematic and systematic
risk. We saw the dramatic risk reduction effect of diversification (see Example 1). If an investor invests in just 15
companies in different sectors (a well-diversified portfolio), it is possible to virtually eliminate unsystematic risk. The
only risk affecting a well-diversified portfolio is therefore systematic. As a result, an investor who holds a well-
diversified portfolio will only require a return for systematic risk. In this article, we explain how to measure an
investment's systematic risk.

Learning Objectives
By the end of this article you should be able to:
calculate beta from basic data using two different formulae
calculate the required return using the CAPM formula
understand the meaning of beta
prepare an alpha table and understand the nature of the alpha value
explain the problems with CAPM
briefly explain the arbitrage pricing model (APM)
calculate the portfolio risk of a multi-asset portfolio when there is no correlation between the return of the
investments.

Risk reduction effect of diversification example image

The measurement of systematic risk
You may recall from the previous article on portfolio theory that the formula of the variance of a large portfolio (where
we invest equal amounts in each investment) is:

The first term is the average variance of the individual investments (unsystematic risk). As N becomes very large, the
first term tends towards zero. Thus, unsystematic risk can be diversified away.

The second term is the covariance term and it measures systematic risk. As N becomes large, the second term will
approach the average covariance. The risk contributed by the covariance (the systematic risk) cannot be diversified
away.
Systematic risk reflects market-wide factors such as the country's rate of economic growth, corporate tax rates,
interest rates etc. Since these market-wide factors generally cause returns to move in the same direction they cannot
cancel out.

Therefore, systematic risk remains present in all portfolios. Some investments will be more sensitive to market factors
than others and will therefore have a higher systematic risk.

Remember that investors who hold well-diversified portfolios will find that the risk affecting the portfolio is wholly
systematic. Unsystematic risk has been diversified away. These investors may want to measure the systematic risk of
each individual investment within their portfolio, or of a potential new investment to be added to the portfolio. A single
investment is affected by both systematic and unsystematic risk but if an investor owns a well-diversified portfolio then
only the systematic risk of that investment would be relevant. If a single investment becomes part of a well-diversified
portfolio the unsystematic risk can be ignored.

The systematic risk of an investment is measured by the covariance of an investment's return with the returns of the
market. Once the systematic risk of an investment is calculated, it is then divided by the market risk, to calculate a
relative measure of systematic risk. This relative measure of risk is called the beta' and is usually represented by the
symbol b. If an investment has twice as much systematic risk as the market, it would have a beta of two. There are
two different formulae for beta. The first is:

You must commit both formulae to memory, as they are not given on the exam formulae sheet. The formula that you
need to use in the exam will be determined by the information given in the question. If you are given the covariance,
use the first formula or if you are given the correlation coefficient, use the second formula.

Example 2
You are considering investing in Y plc. The covariance between the company's returns and the return on the market is
30%. The standard deviation of the returns on the market is 5%.
Calculate the beta value:
be =
30% = 1.2
52%

Example 3
You are considering investing in Z plc. The correlation coefficient between the company's returns and the return on
the market is 0.7. The standard deviation of the returns for the company and the market are 8% and 5% respectively.
Calculate the beta value:

be =
0.7 x 8% = 1.12
5%

Investors make investment decisions about the future. Therefore, it is necessary to calculate the future beta.
Obviously, the future cannot be foreseen. As a result, it is difficult to obtain an estimate of the likely future co-
movements of the returns on a share and the market. However, in the real world the most popular method is to
observe the historical relationships between the returns and then assume that this covariance will continue into the
future. You will not be required to calculate the beta value using this approach in the exam.

The CAPM Formula

The capital asset pricing model (CAPM) provides the required return based on the perceived level of systematic risk
of an investment:

The calculation of the required return

The required return on a share will depend on the systematic risk of the share. What is the required return on the
following shares if the return on the market is 11% and the risk free rate is 6%?
The shares in B plc have a beta value of 0.5
Answer: 6% + (11% - 6%) 0.5 = 8.5%

The shares in C plc have a beta value of 1.0

Answer: 6% + (11% - 6%) 1.0 = 11%
The shares in D plc have a beta value of 2.0
Answer: 6% + (11% - 6%) 2.0 = 16%.

Obviously, with hindsight there was no need to calculate the required return for C plc as it has a beta of one and
therefore the same level of risk as the market and will require the same level of return as the market, ie the RM of
11%. The systematic risk-return relationship is graphically demonstrated by the security market line. See Example 4.

Example 4
The CAPM contends that the systematic risk-return relationship is positive (the higher the risk the higher the return)
and linear.

If we use our common sense, we probably agree that the risk-return relationship should be positive. However, it is
hard to accept that in our complex and dynamic world that the relationship will neatly conform to a linear pattern.
Indeed, there have been doubts raised about the accuracy of the CAPM.

The meaning of beta

The CAPM contends that shares co-move with the market. If the market moves by 1% and a share has a beta of two,
then the return on the share would move by 2%. The beta indicates the sensitivity of the return on shares with the
return on the market. Some companies' activities are more sensitive to changes in the market - eg luxury car
manufacturers - have high betas, while those relating to goods and services likely to be in demand irrespective of the
economic cycle - eg food manufacturers - have lower betas. The beta value of 1.0 is the benchmark against which all
share betas are measured.
Beta > 1 - aggressive shares
These shares tend to go up faster then the market in a rising(bull) market and fall more than the market in a
declining (bear) market.
Beta < 1 - defensive shares
These shares will generally experience smaller than average gains in a rising market and smaller than average
falls in a declining market.
Beta = 1 - neutral shares
These shares are expected to follow the market.
The beta value of a share is normally between 0 and 2.5. A risk-free investment (a treasury bill) has a b = 0 (no risk).
The most risky shares like some of the more questionable penny share investments would have a beta value closer to
2.5. Therefore, if you are in the exam and you calculate a beta of 11 you know that you have made a mistake.

Basic exam application of CAPM

1. Capital investment decisions
The calculation of Ke in the WACC calculation to enable an NPV calculation
A shareholder's required return on a project will depend on the project's perceived level of systematic risk. Different
projects generally have different levels of systematic risk and therefore shareholders have a different required return
for each project. A shareholder's required return is the minimum return the company must earn on the project in order
to compensate the shareholder. It therefore becomes the company's cost of equity.
Example 5
E plc is evaluating a project which has a beta value of 1.5. The return on the FTSE All-Share Index is 15%. The return
on treasury bills is 5%.
Required:
What is the cost of equity?
Answer:
5% + (15% - 5%) 1.5 = 20%
2. Stock market investment decisions
When we read the financial section of newspapers, it is commonplace to see analysts advising us that it is a good
time to buy, sell, or hold certain shares. The CAPM is one method that may employed by analysts to help them reach
their conclusions. An analyst would calculate the expected return and required return for each share. They then
subtract the required return from the expected return for each share, ie they calculate the alpha value (or abnormal
return) for each share. They would then construct an alpha table to present their findings.
Example 6
We are considering investing in F plc or G plc. Their beta values and expected returns are as follows:
Beta values Expected returns
F plc 1.5 18%
G plc 1.1 18%
The market return is 15% and the risk-free return is 5%.

Required:
What investment advice would you give us?
Answer:
Alpha table
Expected returns Required returns Alpha values F plc 18% 5% + (15% - 5%) -2%
1.5 = 20%
G plc 18% 5% + (15% - 5%) +2%
1.1 = 16%
Sell shares in F plc as the expected return does not compensate the investors for its perceived level of systematic
risk, it has a negative alpha. Buy shares in G plc as the expected return more than compensates the investors for its
perceived level of systematic risk, ie it has a positive alpha.

3. The preparation of an alpha table for a portfolio

The portfolio beta is a weighted average
A common exam-style question is a combined portfolio theory and CAPM question. A good example of this is the
Oriel plc question at the end of this article where you are asked to calculate the alpha table for a portfolio.
The expected return of the portfolio is calculated as normal (a weighted average) and goes in the first column in the
alpha table. We then have to calculate the required return of the portfolio. To do this we must first calculate the
portfolio beta, which is the weighted average of the individual betas. Then we can calculate the required return of the
portfolio using the CAPM formula.

Example 7
The expected return of the portfolio A + B is 20%. The return on the market is 15% and the risk-free rate is 6%. 80%
of your funds are invested in A plc and the balance is invested in B plc. The beta of A is 1.6 and the beta of B is 1.1.
Required:
Prepare the alpha table for the Portfolio
(A + B)
Answer:
b(A + B) = (1.6 .80) + (1.1 .20)
= 1.5

R portfolio (A + B) = 6% + (15% - 6%) 1.5 = 19.50%

Alpha table
Expected return Required return Alpha value
Portfolio (A + B) 20% 19.50% 0.50%
The Alpha Value
If the CAPM is a realistic model (that is, it correctly reflects the risk-return relationship) and the stock market is efficient
(at least weak and semi-strong), then the alpha values reflect a temporary abnormal return. In an efficient market, the
expected and required returns are equal, ie a zero alpha. Investors are exactly compensated for the level of perceived
systematic risk in an investment, ie shares are fairly priced. Arbitrage profit taking would ensure that any existing
alpha values would be on a journey towards zero.
Remember in Example 6 that the shares in G plc had a positive alpha of 2%. This would encourage investors to buy
these shares. As a result of the increased demand, the current share price would increase (which if you recall from
the portfolio theory article is the denominator in the expected return calculation) thus the expected return would fall.
The expected return would keep falling until it reaches 16%, the level of the required return and the alpha becomes
zero.

The opposite is true for shares with a negative alpha. This would encourage investors to sell these shares. As a result
of the increased supply, the current share price would decrease thus the expected return would increase until it
reaches the level of the required return and the alpha value becomes zero.

It is worth noting that when the share price changes, the expected return changes and thus the alpha value changes.
Therefore, we can say that alpha values are as dynamic as the share price. Of course, alpha values may exist
because CAPM does not perfectly capture the risk-return relationship due to the various problems with the model.

Problems with CAPM

Investors hold well-diversified portfolios
CAPM assumes that all the company's shareholders hold well-diversified portfolios and therefore need only consider
systematic risk. However, a considerable number of private investors in the UK do not hold well-diversified portfolios.
One period model
CAPM is a one period model, while most investment projects tend to be over a number of years.
Assumes the stock market is a perfect capital market
This is based on the following unrealistic assumptions:
no individual dominates the market
all investors are rational and risk-averse
investors have perfect information
all investors can borrow or lend at the risk-free rate
no transaction costs.
Evidence
CAPM does not correctly express the risk-return relationship in some circumstances. To cite a number of these
circumstances they are, for small companies, high and low beta companies, low PE companies, and certain days of
the week or months of the year.
Estimation of future b based on past b
A scatter diagram is prepared of the share's historical risk premium plotted against the historical market risk premium
usually over the last five years. The slope of the resulting line of best fit will be the b value. The difficulty of using
historic data is that it assumes that historic relationships will continue into the future. This is questionable, as betas
tend to be unstable over time.
Data input problems
Richard Roll (1977) criticised CAPM as untestable, because the FTSE All-Share Index is a poor substitute for the true
market, ie all the risky investments worldwide. How can the risk and return of the market be established as a whole?
What is the appropriate risk-free rate? However, despite the problems with CAPM, it provides a simple and reasonably
accurate way of expressing the risk-return relationship. Quite simply, CAPM is not perfect but it is the best model that
we have at the moment.
Additionally, some critics believe that the relationship between risk and return is more complex than the simple linear
relationship defined by CAPM. Another model may possibly replace CAPM in the future. The most likely potential
successor to CAPM is the arbitrage pricing model (APM).

The Arbitrage Pricing Model - APM

The CAPM contends that the only reason the return of a share moves is because the return on the market moves.
The magnitude of a share's co-movement with the market is measured by its beta. If a share has a beta of two and
the market increases by 1%, we would expect the share's return to increase by 2%. If the market increases by 5% we
would expect the share's return to increase by 10%. Remember that the market only gives a return for systematic risk.
Therefore, any changes in the market return are due to a large number of macro-economic factors.
The model
The arbitrage pricing model, developed by Stephen Ross in 1976, attempts to identify all of the macro-economic
factors and then specifies how each factor would affect the return of a particular share. The APM is therefore more
sophisticated than CAPM in that it attempts to identify the specific macro-economic factors that influence the return of
a particular share. Commonly invoked factors are:
inflation
industrial production
market risk premiums
interest rates
oil prices.
Each share will have a different set of factors and a different degree of sensitivity (beta) to each of the factors. To
construct the APM for a share we require the risk premiums and the betas for each of the relevant factors.

Return on a share = RF + Risk premium F1.b1 + Risk premium F2.b2 + Risk premium F3.b3 + . . .

Example 8
beta 1 = the effect of changes in interest rates on the returns from a share
beta 2 = the effect of oil prices on the returns from a share
A share in a retail furniture company may have a high beta 1 and a low beta 2 whereas a share in a haulage company
may have a low beta 1 and a high beta 2. Under the APM, these differences can be taken into account. However,
despite its theoretical merits, APM scores poorly on practical application. The main problem is that it is extremely
difficult to identify the relevant individual factors and the appropriate sensitivities of such factors for an individual
share. This has meant that APM has not been widely adopted in the investment community as a practical decision-
making tool despite its intuitive appeal.

Before we conclude the articles on the risk-return relationship, it is essential that we see the practical application of
both portfolio theory and CAPM in an exam-style question. Indeed, it is quite common to have both topics examined in
the same question as demonstrated in Oriel plc below.

Exam Style Question (including the multi-asset portfolio exam trick)

Oriel plc
Oriel plc is considering investing in one of two short-term portfolios of four short-term financial investments. The
correlation between the returns of the individual investments is believed to be negligible (zero/independent/no
correlation). See Portfolio 1 and Portfolio 2. The market return is estimated to be 15%, and the risk free rate 5%

Portfolio 1
 Amounts invested Expected Total
Investment million return risk Beta

a 10 20% 8 0.7

b 40 22% 10 1.2

c 30 24% 11 1.3

d 20 26% 9 1.4

Portfolio 2

Amounts invested Expected Total

Investment million return risk Beta

a 20 18% 7 0.8

b 40 20% 9 1.1

c 20 22% 12 1.2

d 20 16% 13 1.4

Required:
Estimate the risk and return of the two portfolios using the principles of both portfolio theory and CAPM and decide
which one should be selected.
How would you alter your calculations for the summary table if you were told: The correlation between the returns of
the individual investments is perfectly positively correlated'.
Solution to Oriel plc

Answer to part (a)

The CAPM calculations - the application of CAPM principles in the exam means the preparation of the alpha table to
find the portfolio with the largest positive alpha. See Portfolio 1 Solution and Portfolio 2 Solution.

Portfilio 1
Solution

Portfolio
Investment Expected expected Portfolio
Investment weightings return (%) return (%) Beta beta

a .1 20 2.00 0.7 .07

 b .4 22 8.80 1.2 .48

c .3 24 7.20 1.3 .39

d .2 26 5.20 1.4 .28

23.20 1.22

The required
return: 5 + (15 -
5) 1.12=16.20%

Portfolio 2
Solution

Portfolio
Investment Expected expected Portfolio
Investment weightings return (%) return (%) Beta beta

a .2 18 3.60 0.8 .16

b .4 20 8.00 1.1 .44

c .2 22 4.40 1.2 .24

d .2 16 3.20 1.4 .28

19.20 1.12

The required
return: 5 + (15 -
5) 1.12 = 16.20%

Alpha table
Expected returns Required returns Alpha values
Portfolio 1 23.20% 17.20% 6.00%
Portfolio 2 19.20% 16.20% 3.00%
Portfolio 1 is chosen because it has the largest positive alpha.

Portfolio theory calculations

The application of the portfolio theory principles in the exam requires the preparation of a summary table to help
identify the efficient portfolio. However, in this question we are dealing with more than a two-asset portfolio, in fact
there are four assets in each portfolio. This is known as the multi-asset portfolio exam trick. This was examined in
Rodfin (December 1995) and Maltec (June 2001). Both times you were told there is no correlation between the
returns of the individual investments. Therefore, the correlation coefficient is zero and the third term disappears from
the portfolio risk equation.

Therefore, the formula for a multi-asset portfolio with no correlation between the returns is:

Summary table
Expected returns Portfolio risk
Portfolio 1 23.20% 5.55%
Portfolio 2 19.20% 5.24%
The portfolio with the highest return also has the highest level of risk. Therefore, neither portfolio can be said to be
more efficient than the other. An objective answer cannot be reached. As the company is making decisions on behalf
of its shareholders the correct way to evaluate the investments is by looking at the effect they have on a shareholders
existing/enlarged portfolios.

Thus, the portfolio theory decision rule will probably break down if different shareholders experience different levels of
total risk or they may have different attitudes to risk. Therefore, some shareholders would prefer portfolio 1 and other
shareholders portfolio 2.

If the majority of Oriel's shareholders are institutional shareholders, I would recommend the use of CAPM to make the
decision, as they would hold well-diversified portfolios and only be subject to systematic risk. This would be a
reasonable assumption as institutional investors like pension companies and unit trust companies hold approximately
75% of all the shares that are quoted on the London stock market.

Answer to part (b)

If the correlation coefficient identifies perfect positive correlation, there is no reduction in risk at all. Therefore, the
portfolio's total risk is simply a weighted average of the total risk (as measured by the standard deviation) of the
individual investments of the portfolio.
sport1 = 8 0.1 + 10 0.4 + 11 0.3 + 9 0.2 = 9.9

sport2 = 7 0.2 + 9 0.4 + 12 0.2 + 13 0.2 = 10

Summary table
Expected returns Portfolio risk
Portfolio 1 23.20% 9.9%
Portfolio 2 19.20% 10.0%
Portfolio 1 is the most efficient portfolio as it gives us the highest return for the lowest level of risk.

10 Key Points To Remember

1. The beta is a relative measure of systematic risk. It indicates the sensitivity of the return on a share with the return
on the market. If the market moves by 1% and a share has a beta of two, then the return on the share would move by
2%.

2. We may have to calculate the beta from basic data using the following two different formulae:

3. The value of beta is normally between 0 and 2.5.

4. Ensure that you know how to calculate the required return using the CAPM formula:
RA = RF + (RM - RF) bA
as this is examined in every paper.

5. Be able to prepare an alpha table and to give investment advice based on alpha values:

Decision advice based on alpha values

Alpha Have shares Dont have shares
+ Hold Buy
- Sell Dont buy
6. If CAPM is a realistic model and the market is efficient, an alpha value (a temporary abnormal return) is on a
journey towards zero.

7. Ensure that you are able to list the problems associated with CAPM.

8. APM suggests that a number of factors affect the risk-return relationship and in time, this model may replace CAPM
when more developments take place to improve its practical application.

9. Remember that the formula for a multi-asset portfolio with no correlation between the returns is:

10. The basic exam technique required for portfolio theory is the preparation of a summary table to aid identification
of the most efficient portfolio. Similarly, the key to applying CAPM is the preparation of an alpha table to help identify
the largest positive alpha value.