Shirley Pat
BSc (Hons)
MBA in Financial Management
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You ask me why I dwell in the green mountain;
I smile and make no reply for my heart is free of care.
As the peach-blossom flows down stream and is gone into the unknown,
I have a world apart that is not among men.
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I built my cottage among the habitations of men,
And yet there is no clamor of carriages and horses.
You ask: "Sir, how can this be done?"
"A heart that is distant creates its own solitude."
I pluck chrysanthemums under the eastern hedge,
Then gaze afar towards the southern hills.
The mountain air is fresh at the dusk of day;
The flying birds in flocks return.
In these things there lies a deep meaning;
I want to tell it, but have forgotten the words.
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Investment
In the capital market, Portfolio managers use a variety of investment techniques to invest other people’s money. A good portfolio manager should be the one who use the proper investment techniques to achieve the highest returns. Capital Asset Pricing Model is one of the techniques used by managers to access the expected return of a individual security as well as their portfolio. It tells the manager the relationship between risk and expected return for individual securities and portfolios.
Capital Asset Pricing Model: a measure of risk and expected return
CAPM can be expressed in the following formula:
R = Rf + b ( Rm - Rf )
Expected return on a security = Risk-free rate + Beta of the security x Difference between expected return on market and risk-free rate
According to CAPM, there are only two type of risks of any security: inherent systematic risk (the market risk) which cannot be diversified, such as economic recession; and the unsystematic risk (the unique risk or company-specific risk) which can be diversified away through holding a portfolio. Since systematic risk is unavoidable, it will be rewarded by a return which is higher than the return on a risk-free investment. As a result, the expected return on a security is equal to its level of systematic risk, beta. The expected return increases as beta increases. Safe investments, such as treasury bills, have a beta of zero. Riskier investments will earn a premium over the risk-free rate which increases with beta. Those whose risks equal to the market’s will earn the market return and thus have a beta of one.
By using CAPM, a portfolio manager can calculate the expected return of individual securities and their contribution to the expected return of a portfolio. The critical issue for is to measure and control the risk of the portfolio. This can be done through the control of beta. A portfolio manager can measure the contribution of a security to the risk of a portfolio. Suppose he is considering two securities A & B. A has a beta of 0.5, this means when the market rises or falls by 10%, the return of stock A tends to rise or fall by 5%. So its risk premium is only half that of the market. B has a beta of 2 means when the market rises or falls by 10%, the return of the B tends to rise or fall by 20% which is twice that of the market, so it must earn a higher return to cover the 3higher risk. Thus, by selecting different securities, a portfolio manager can control the beta of the portfolio and further control the expected return. Up to 28 February 1998, there are 661 companies and 1,434 securities listed in Hong Kong Stock Exchange (HKSE) that can be chosen for portfolio managers. The average P/E ratio is 12.05 and market capitalisation is HK$3,266,841million (=US$418,826 million). Through build up a well-diversified portfolio, a portfolio manager can eliminate the unsystematic risk, for example, they can select the stocks which across many industries and areas in order to eliminate company-specific risk.
The implication of the CAPM for investment decision-making is that it assumes a portfolio manger will simply select securities on the basis of the risk and expected return predicted by the CAPM and he will expect a reasonable return for the risk of their portfolio.
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