Risk Portfolio and CAPM - Case Study Example

Risk Portfolio And CAPM The capability of identifying possible consequences and their probabilities without being certain as to which will occur is called Risk. Risk profile of an individual, also called as the utility function of wealth, consists of three dimensions viz. risk averse, risk neutral and risk seeking. Diminishing return to increasing wealth is called risk averse, constant returns to increase in wealth is said to be risk neutral and increasing returns to increase in wealth is known as risk seeking. Behavioural aspects pertaining to individual’s risk portfolio include the business decision maker’s attitude towards risk as well as the business decision maker’s understanding of the investors’ attitude towards risk. When there is guaranteed return offered with no risk of failure, this is called risk free rate for example the yield on government securities. On the other hand, risk premium involves additional return on investment due to high level of perceived risk. Risk can be measured with the help of probability distribution such as Expected value, Variance, Standard Deviation and Normal Distribution. Expected value refers to the sum of all possible values multiplied by their respective probabilities. It is a weighted average of project expected values. Variance refers to the difference between the possible values and the expected values. Total variance is equal to the value of squared sum of all the variances. Standard Deviation is a statistical measure of dispersion based on the deviations from expected values i.e., the weighted mean value. It is the square root of the variance total. Normal distribution is based on the three important rules viz. about 68% of all possible outcomes fall within one standard deviation of the mean, about 95% of all possible outcomes fall within two standard deviation of the mean and finally about 99% of all possible outcomes fall within three standard deviation of mean. Portfolio theory states that the businesses and investors can avoid the overall risk by applying a portfolio approach to their investment decisions. Portfolio refers to a range of diverse investments. Correlation coefficient refers to any similarity or dissimilarity between two investments, which is a range of values between +1 i.e., perfectly positive correlation and –1 i.e., a perfectly negative correlation. Portfolio risk is gauged with the help of total risk, covariance and the two-asset portfolio. The formula used to measure risk portfolio of two investments is ___________________________________ σp = √ a2 σ2A + (1 – a)2 σ2B +2a(1 – a) COV (RA, RB) Where a is the proportion of the total investment to asset A, (1-a) is the proportion of total investments to asset B, σ2A is the variance of return on asset A, σ2B is the variance of return on asset B and COV (RA, RB) is the covariance of the returns on A and B. An evaluation of all the factors influencing the anticipated outcome of the investment is called risk factor analysis. Total risk can be categorised into diversifiable and non-diversifiable risk. When risk is avoidable and unsystematic such as specific business factors it is known as diversifiable risk for example, competition level and control of legal regulation. This type of risk can be curtailed by means of allocating available funds between a range of investment projects. If is the risk is unavoidable and systematic it is known as non-diversifiable risk and based on general economic and financial factors for example inflation, interest rates and exchange rates etc. This sort of risk is beyond the control of businesses and investors thus it cannot be curtailed and remains common to all investment projects. The Capital Asset Pricing Model is widely used as an investment appraisal. The theory states that investments that are subject to no risk for example government securities require low rates of return known as risk-free rate. It says that additional return rate is required for investments involving high risk known as the risk-premium. The market portfolio rate i.e., M records the required rate for perceived risk. If the risk is non-systematic, it can be reduced with the help of a well-diversified portfolio both at national as well as international level. However if the risk is systematic, it cannot be reduced through diversification. The calculation of CAPM depends mainly on Beta factors. It is crucial to know beta of any asset to know the return the investors expect to have from it. Beta is a statistical measure of the movement in the return on an individual market asset for example an ordinary share in relation to movements on the market as a whole. It also serves as a measure of systematic risk in the investment. The calculation for required return using the beta factor uses the formula as: ke = Rf + β(Rm – Rf) or, ke = Rf + Risk premium ke or rate of return obtained using the beta factor is widely used as a discount factor for investment appraisal. If Beta>1, the security is supposed to be aggressive, which will increase faster than the market in value during a “bull market” and fall faster in value during a “bear market”. If beta1. For Sainsbury plc, the beta factor assigned was 0.8, i.e., β Read More