Financial Systems

and Markets: Stock

Valuation and Risk

IPM – Term IV, September 2023

Dr. Landis Conrad Felix Michel

 • The presence of risk means that more than one
1. Risk and outcome is possible. Suppose that a certain initial
wealth is placed at risk, and there are only two

Risk Aversion possible outcomes.

• Take as an example initial wealth W=100.000$ and assume
two possible results. With probability p=0.6, the favor
outcome will occur, leading to a final wealth
W1=150.000$.Otherwise, with probability 1-p=0.4, a less
favorable outcome, W2=80.000, will occur.
• Suppose an investor is offered an investment portfolio with a payoff in one year described by a
simple Concept as above. How can we evaluate the portfolio?

• First we will summarize its descriptive statistics :

a. the mean, or expected end-of-year wealth, denoted by E(W), is

E(W)=pW1+ (1-p)W2=0.6*150.000+0.4*80.000=122.000

The expected profit on the 100.000 investment portfolio is 22.000.

b. The variance, σ2, of the portfolio’s payoff is calculated as the:

σ2 = E[W-E(W)]2=p[W1-E(W)]2+(1-p) [W2-E(W)]2 =
= 0.6*(150.000-122.000)2+0.4(80.000-122.000)2 =
= 1.176.000.000

The standard deviation, σ, which is the square root of the variance, is therefore, 34.292,86.
• The standard deviation of the payoff is large, much larger than the expected profit of 22.000.
Whether the expected profit is large enough to justify such risk depends on the alternative portfolios.

• Let us suppose that Treasury bills (bonds) are one alternative to the risky portfolio. Suppose that at
the time of the decision, a one-year T-bill offers a rate of return of 5%; 100.000 can be invested to
yield a sure profit of 5.000. We can now draw the decision tree.
• Earlier we showed the expected profit on the prospect to be 22.000. Therefore, the expected marginal,
or incremental, profit of the risky portfolio over investing in safe T-bills is 22.000-5.000=17.000,
meaning that one can earn a risk premium of 17.000 as compensation for the risk of the investment.

• Speculation is the assumption of considerable business risk in obtaining commensurate gain.

Commensurate gain is a positive risk premium, that is, an expected profit greater than the risk free
alternative. By considerable risk we mean that the risk is sufficient to affect the decision.
• Risk averse investors are willing to consider only risk-free or speculative prospects with positive risk
premia.
• Risk-neutral investors judge risk prospects solely by their expected rates of return. They don’t take
into account the risk.
• Risk lovers adjust the expected return upward to take into account the “fun” of confronting the
prospect’s risk.
• We assume that each investor can assign a utility score to competing investment portfolios based on
the expected return and risk of these portfolios.
• The utility score may be viewed as a means of ranking portfolios. Higher utility values are assigned to
portfolios with more attractive risk-return profile.
• One reasonable function assigns a portfolio with expected return E(r) and variance of returns σ2 the
following utility score:

U=E(r) – 0.005A σ2

Where U is the utility value and A is an index of the investor’s risk aversion. The factor of 0.005 is a
scaling convention that allows us to express the expected return and standard deviation, as percentages
rather than decimals.
• For example, recall the earlier investment problem, choosing between portfolio with an expected return
of 22% and a standard deviation 34% and T-bill providing a risk-free return of 5%.
• Even for A=3, a moderate risk-aversion parameter, the risky portfolio’s utility value is U=E(r) – 0.005A
σ2=22-0.005*3*342=4.66% which is slightly lower than the 5% of the T-bill.
• In this case one would reject the portfolio in favor of T-bill. If the investor where less risk averse, for
example A=2, then U= U=E(r) – 0.005A σ2=22-0.005*2*342=10.44%, higher than the risk-free rate,
leading her to adopt the prospect.
• We can depict the individual’s trade-off between risk and return by plotting the characteristics of
potential investment portfolios.
• Portfolio P with expected return E(rp) and standard deviation σp, is preferred by any risk-averse investor
to any portfolio in quadrant IV because it has an expected return equal to or greater than any portfolio in
that quadrant and a standard deviation equal to or smaller than any portfolio in that quadrant.
Conversely, any portfolio in quadrant I is preferable to portfolio P because its expected return is equal to
or greater than P’s and its standard deviation is equal to or smaller than P’s.
• This is the mean-standard deviation, or equivalently, the Mean-Variance (M-V) criterion.
It can be stated as:
A dominates B if
E(rA)≥ E(rB)
σ A≤ σ B
and at least one inequality is strict.
2.1 Market The Opportunity Set with N Risky Assets

Equilibrium:
CAPM

When considering portfolios with many assets, we can discover

the opportunity set and efficient set if we know the expected
returns and the variances of individual assets as well as the
covariances between each pair of assets.
The efficient set with one risk-free and many risky assets
• Assume Borrowing rate equals the
Lending rate then we can draw a straight
line between any risky asset and risk-free
asset.
• Points along the line represent portfolios
consisting of combinations of the risk-free
and risky assets. Several possibilities are
graphed
• Portfolios along any of the lines are
possible, but only one line dominates.
• All investors will prefer combinations of
the risk-free asset and portfolio M on the
efficient set.
• These combinations lie along the
positively sloped portion of line NMRfO.
• Therefore the efficient set (which is represented by line segment RfMN) is linear in the presence of a risk-
free asset.
• All an investor needs to know is the combination of assets that makes up portfolio M as well
as the risk-free asset.
• This is true for any investor, regardless of his or her degree of risk aversion (Indifference Curves – Utility
Score Functions for different levels of risk aversion A>0 ( I, II and III).
• Investor III is the most risk averse of the three
and will choose to invest nearly all of his or her
portfolio in the risk-free asset.
• Investor I, who is the least risk averse, will
borrow (at the risk-free rate) to invest more than
100% of his or her portfolio in the risky
portfolio M.
• However, no investor will choose to invest in
any other risky portfolio except portfolio M.
For example, all three could attain the minimum
variance portfolio at point B, but none will
choose this alternative because all do better
with some combination of the risk-free asset
and portfolio M.
The CAPM (Capital Asset Pricing Model) is developed in a hypothetical world where the following
assumptions are made about investors and the opportunity set.

1. Investors are risk-averse individuals who maximize the expected utility of their wealth.

2. Investors are price takers and have homogeneous expectations about asset returns that have a
joint normal distribution.

3. There exists a risk-free asset such that investors may borrow or lend unlimited amounts at a risk-
free rate.

4. The quantities of assets are fixed. Also, all assets are marketable and perfectly divisible.

5. Asset markets are frictionless, and information is costless and simultaneously available to all
investors. All Assets are divisible and tradable.

6. There are no market imperfections such as taxes, regulations, or restrictions on short selling.
Implications :

Since markets are frictionless, the borrowing rate equals the lending rate (=risk free rate), and we are
able to develop a linear efficient set.

Since investors have homogeneous beliefs. They all make decisions based on an identical opportunity
set (IMI’). In other words, no one can be fooled because everyone has the same information at the same
time.

Since all investors maximize the expected utility of their end-of-period wealth, the model is implicitly
a one-period model.
Two-fund separation Theorem and Capital market line (CML):
• If investors have homogeneous beliefs, then they all have the same linear efficient set called the
capital market line (CML)

• Therefore, they will try to hold some

combination of the risk-free asset and
the portfolio M, which under CAPM is
called the Market Portfolio.
(Two-Fund Separation Theorem)

• In equilibrium, the market portfolio will

consist of all marketable assets held in
proportion to their weight values (wi).

• The equilibrium proportion of each asset in the market portfolio must be

Market Value of individual asset

wi =
Market value of all assets
Market Equilibrium and CAPM
• Consider a portfolio consisting of a% invested in risky asset I and (1-a)% in the market
portfolio will have the following mean and standard deviation:

෪𝑝)=aE(𝑅
E(𝑅 ෪𝑖 )+(1-a)E(𝑅෪
𝑚) (eq. 1)

෪𝑝) = [a2σ2i + (1−a) 2 σ2m + 2a(1−a)σim]

σ(𝑅 (eq. 2)

where σ2i = the variance of risky asset I

σ2m = the variance of the market portfolio
σim = the covariance between asset I and the market portfolio
Market Equilibrium and CAPM
• The market portfolio already contains asset I held according to its market value weight. The
opportunity set provided by various combinations of the risky asset and the market portfolio is the
line IMI’.

• The change in the mean and standard deviation with respect

to the percentage of the portfolio, a, invested in asset I is
determined as follows:

(eq. 3)

(eq. 4)
• In equilibrium, the market portfolio already has the value weight, wi percent, invested in the risky asset I.

• Therefore, the percentage a in the above equations 3 and 4 is the excess demand for an individual risky
asset. But we know that in equilibrium the excess demand for any risky asset must be zero. Prices will
adjust until all assets are held by someone. Then, in the above equations if we set a=0 we can determine
the equilibrium price relationships at point M.

(eq. 5)

(eq. 6)
• The slope of the risk-free trade-off evaluated at point M, in market equilibrium, is :

(eq. 7)

• The final insight is to realize that the slope of the opportunity set IMI’ provided by the
relationship between the risk asset and the market portfolio at point M must also be equal to the
slope of the capital market line, Rf M.

• For the Capital Market Line (CML):

෪𝑝)=aE(𝑅෪
E(𝑅 ෪
𝑚 )+(1-a)E(𝑅𝑓 ) (eq. 8)

෪𝑝) = aσm
σ(𝑅 (eq. 9)
• The slope of the capital market line is :

(eq. 10)

• Equating the slope at point M from both equations 7 and 10 , we have :

(eq. 11)

෪𝑖 ) we have :
• And solving for E(𝑅

(eq. 12)

• This equation is known as the Capital Asset Pricing Model (CAPM)

• CAPM is also called the security market line (SML) :

• The required rate of return on any asset,

E(Ri), is equal to the risk-free rate of return
plus a risk premium.
• The risk premium is the price of risk
multiplied by the quantity of risk.
• The price of the risk is the slope of the SML
line, the difference between the expected
rate of return on the market portfolio and
the risk-free rate of return.
• The quantity of risk is often called beta, βi.
 i = im2 =
COV(R ,Rm)
i
Beta  m VAR(Rm)
• It is the covariance between returns on the risky asset I, and the market portfolio M, divided
by the variance of the market portfolio.
• The risk-free asset has a beta of zero because its covariance with the market portfolio is zero.
• The market portfolio has a beta of one because the covariance of the market with itself is the
variance of the market portfolio.
2.2 Properties of the CAPM
• In equilibrium, every asset must be priced so that its risk-adjusted required rate of return falls
exactly on the security market line.

• Investors can always diversify away all risk except the covariance of an asset with the market
portfolio. In other words, they can diversify away all risk except the risk of the economy as a
whole, which is inescapable (undiversifiable).

• Consequently, the only risk that investors will pay a premium to avoid is covariance risk.

• The total risk of individual asset can be partitioned into two parts-systematic risk, which is a
measure of how the asset covaries with the economy, and unsystematic risk, which is
independent of the economy:

Total risk=systematic risk + unsystematic risk

 (eq. 13)

The variance of this relationship is :

 2j =b2j  m2 + 2 (eq. 14)

The variance is total risk: it can be partitioned into systematic risk: b2j  m2
and unsystematic risk :  2

It turns out that bj in the simple linear relationship between individual asset return and
market return is exactly the same as βj in the CAPM.
• One cannot compare the variance of return on a single asset with the variance for a well
diversified portfolio.
• The variance of the portfolio will almost always be smaller.
• The appropriate measure of risk for a single asset is beta, its covariance with the market divided
by the variance of the market. This risk is non-diversifiable, and is linearly related to the rate of
return of the asset required in equilibrium.

• The second property is that the measure of risk for individual assets is linearly additive when the
assets are combined into portfolios.

• If we put a% of our wealth into asset X and b% of our wealth into asset Y, then the beta of the
resulting portfolio is simply the weighted average of the betas of the individual securities:

βp = aβX + bβY (eq. 15)

• The correct definition of an individual asset’s risk is its contribution to portfolio risk. We know that
the variance of returns for a portfolio of assets is :

N N N N N
Var(Rp)= w w  =w (w  )=w COV(R ,R )
i j ij i j ij i i p (eq. 16)
i =1 j =1 i =1 j =1 i =1

• We can interpret the following term : wiCOV(Ri,Rp)

as the risk of security i in portfolio j. However, at the margin, the change in the contribution
of asset I to portfolio risk is simply : COV(Ri,Rp)

• Therefore, covariance risk is the appropriate definition of risk since it measures the change in
portfolio risk as we change the weighting of an individual asset in the portfolio
Example
Suppose you are the manager of an investment fund in a two-parameter economy. Given
that E(Rm)=0.16, Rf=0.08, and σm=0.20, would you recommend investment in a security
with an expected Rate of Return E(RJ)=0.12 and σjm=0.01?
Solutions – A

• The required rate of return on a security with cov(E(Rj), E(Rm)) = .01 is

E(R j ) = R f + [E(R m ) − R f ] j
= .08 + (.16 − .08).25
E(R j ) = .10
where
 jm .01
j = = = .25
2m (.2) 2

• Since the expected rate of return is greater than the required rate of return, investment in
the security would be advisable.
 • Because it provides a quantifiable measure of risk for
individual assets, the CAPM is an extremely
2.3 Use of useful tool for valuing risky assets.
• We assume that we are dealing with a
CAPM for single time period. This assumption was built into the
derivation of the CAPM.

Evaluation • We want to value an asset, j, that has a risky payoff at the

෪e
end of the period, call this 𝑃
• The risky return for asset j, is then :

(eq. 17)

• It could represent the capital gain plus a dividend, on a

common stock or on a bond, it is the repayment of the
principal plus the interest on the bond.
• The expected return on an investment in the risky asset
is determined by the price we are willing to pay at the
beginning of the time period for the right to the risky
end-of-period payoff
Risk-Adjusted Rate of Return Valuation Formula
• The CAPM can be used to determine what the current value of the asset, P0 , should be.
The CAPM is (using equation 12) :

• Which can be rewritten as :

E(R j )= R f + jm (eq. 18)

• Where, λ can be described as the market price per unit risk :

 =[E(Rm)− R f ] 12
m (eq. 19)
• Substituting equation 17 into equation 19 we get :

(E(Pe )−P0 )/ P0 =R f + jm (eq. 19)

• We can now interpret P0 as the equilibrium price of the risky asset. Rearranging the above
expression, we get :

E(Pe )
P0 =
1+ R f + jm (eq. 20)

• Which is often referred to as the risk-adjusted rate of return valuation formula. For assets with


positive systematic risk, a risk premium =  jm (eq. 21)

jm

is added to the risk-free rate so that the discount rate is adjusted.

 2.4 Empirical Tests of the CAPM
• The first step to empirically test the theoretical CAPM is to transform it from expectations or ex
ante form (expectations cannot be measured) into a form that uses observed data.

• For that purpose we assume that the realized rate of return on any asset is equal to the expected rate
of return.

• The CAPM is then usually written in the following form:

ERpt = β0 + β1 γ+εpt (eq. 33)

Where the excess return of the market is γ=Rmt-Rft

the excess return on portfolio p, ERpt = (Rpt-Rft).
• We can use Ordinary Least Squares Regressions to estimate beta in equation 33.

• We can Estimate the Empirical Market Line by the following

regression :

(eq. 34)

The predictions should meet the following criteria:

1. The intercept term di should not be significantly different from zero.
2. When the equation is estimated over very long periods of time, the rate of return on the market
portfolio should be greater than the risk-free rate.
3. Beta should be the only factor that explains the rate of return on a risky asset.
4. The relationship should be linear in beta. Gamma in equation 34 should be positive and
statistically significant.
Empirical Sample
Testing the Theory
Collecting – Handling Data:
• Collect Prices for Stocks Listed in the National Stock Exchange of India
• Collect a Benchmark for the Market (INDIA-DS Banks, INDIA-DS Market)
• Collect a Benchmark for the risk free rate (INDIA Government Bond – Tbill Rate – 3month)

• Prices should be adjusted for all capital actions having an impact on the “raw” price in the
exchange – Some Examples are:
• Stock Splits
• Reverse Stock Splits
• Dividends
• Returns need to reflect the total return obtained from investors adjusting for all possible
capital actions and dividends (Usually this price is referred as a Total Return Index)
References:
• Jeff Madura, Financial Markets and Institutions, 12th edition, Cengage (JM), Chapter 11