PORTFOLIO MANAGEMENT Capital Asset Pricing ModelCAPMHARIS*

OverviewPortfolio Returns and Portfolio RiskCalculate the expected rate of return and volatility for a portfolio of investments and describe how diversification affects the returns to a portfolio of investments.The CAPMEstimate an investors required rate of return using capital asset pricing model.

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Portfolio Returns and Portfolio RiskBy investing in many different stocks to form a portfolio, we can lower the risk without lowering the expected return.The effect of lowering risk via appropriate portfolio formulation is called diversification.*

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 economys 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.

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Risk classificationTo understand how an investment contributes to the risk of the portfolio, we categorize the risks of the individual investments into two categories:Systematic risk, andUnsystematic riskThe systematic risk component measures the contribution of the investment to the risk of the market. For example: War, hike in corporate tax rate.The unsystematic risk is the element of risk that does not contribute to the risk of the market. This component is diversified away when the investment is combined with other investments. For example: Product recall, labor strike, change of management.

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Diversification and Systematic RiskAs the number of securities in a portfolio increases, the contribution of the unsystematic or diversifiable risk to the standard deviation of the portfolio declines.Systematic or non-diversifiable risk is not reduced even as we increase the number of stocks in the portfolio.Large portfolios will not be affected by unsystematic risk but will be influenced by systematic risk factors.

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Systematic Risk and BetaSystematic risk is measured by beta coefficient, which estimates the extent to which a particular investments returns vary with the returns on the market portfolio.Beta could be estimated using excel or financial calculator, or readily obtained from various sources on the internet (such as Yahoo Finance and Money Central.com)*

*Utilities companies can be considered less risky because of their lower betas.

Portfolio BetaThe beta of a portfolio measures the systematic risk of the portfolio and is calculated by taking a simple weighted average of the betas for the individual investments contained in the portfolio.Consider a portfolio that is comprised of four investments with betas equal to 1.5, .75, 1.8 and .60. If you invest equal amount in each investment, what will be the beta for the portfolio?Portfolio beta= 1.5*(1/4)+.75*(1/4)+1.8*(1/4)+.6*(1/4) =1.16*

The CAPMCAPM also describes how the betas relate to the expected rates of return that investors require on their investments.The key insight of CAPM is that investors will require a higher rate of return on investments with higher betas. The relation is given by the following linear equation:

Rmarket is the expected return on the market portfolioRf is the risk free rate (return for zero-beta assets).

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Example What will be the expected rate of return on AAPL stock with a beta of 1.49 if the risk-free rate of interest is 2% and if the market risk premium, which is the difference between expected return on the market portfolio and the risk-free rate of return is estimated to be 8%?AAPL expected return = 2% + 1.49*8% = 13.92%.*

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