Syndicate
Accept Risks to achieve a higher profitability on investment
If we start from the premise that the investor accepts assuming risks in order to achieve a higher profitability for his investment, we deduce that the difference between the expected profitability (revenue) of the chosen assets in the entire portfolio and the “sans risk asset” yield is the market risk premium. In addition, each of the assets that comprise the portfolio has its own risk premium, and according to this model we establish that the individual premium in each asset is proportional to its beta.
In other words, what we are seeking is to find the expected yield price for the same fact that investing in an asset that carries a risk, considering that this expected revenue should be higher than the “sans risk” asset yield (US Treasury bonds).
Let’s suppose that, as in these moments, the US Treasury bonds are paying a return rate of 4.20 to 4.30% per year (equals the profitability = Rf), and due to their nature of being considered “sans risk”, its standard deviation is zero as well as its beta (it is not affected by market fluctuations at all). If the investor is completely risk adverse, they incest all of their money in this assets, are content with earning a rate which in the best of cases would reach 4.30% per year, sleeps peacefully and is never concerned with this issue. But what happens when we want more profitability (something more than a “plus” over the annual inflation rate) and we are willing to assume risks, although not so much…
What Harry Markowitz, William Sharpe and later their colleagues captured in their studies was that there is a differential between US treasury bonds profitability and more portfolio profitability; but since the portfolio is comprised – partly – of a market risk (non diversifiable), when the investor acquires assets different from the “sans risk” type, they should receive just by assuming that differential, a market risk premium (Rm – RF).
For example, in our American countries, a large part of the “market risk” is given by the country risk itself, and is currently measured by the differential (called spread) there is between the Brady bond price (in each country), and the US Treasury bonds.
Finally, if the market premium is adjusted to each evaluated asset’s beta, we have the asset’s risk premium. If it is a portfolio comprised by several titles, the equation should be done for each of the stocks.
The CAPM formula is:
Example: In order to appreciate this formula’s meaning better, we will take an “i” asset for which we want to calculate the expected profitability (Ri), considering it has a 1.5 b and where Rm – which is the expected profitability over the total portfolio market assets (with a beta = 1.0) – is 9% and the Rf = 4%, that being the “sans risk” asset yield has a b = 0.
Ri= Rf + (bi* (Rm-Rf))
Ri= 4+ (1,5 * (9-4))
Ri= 11,5%