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Risk, Return, and the Capital Asset Pricing Model

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Topics in Chapter

Basic return concepts Basic risk concepts Stand-alone risk Portfolio (market) risk Risk and return: CAPM/SML

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Determinants of Intrinsic Value:

**The Cost of Equity
**

Net operating profit after taxes − Required investments in operating capital =

Free cash flow (FCF)

Value =

FCF1 FCF2 FCF∞ ... + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average cost of capital (WACC)

**Market interest rates
**

Market risk aversion

Cost of debt

**Firm’s debt/equity mix
**

Firm’s business risk

Cost of equity

**What are investment returns?
**

Investment returns measure the financial results of an investment. Returns may be historical or prospective (anticipated). Returns can be expressed in:

**Dollar terms. Percentage terms.
**

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**An investment costs $1,000 and is sold after 1 year for $1,100.
**

Dollar return: $ Received - $ Invested $1,100 - $1,000

= $100.

Percentage return: $ Return/$ Invested $100/$1,000

= 0.10 = 10%.

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Investment risk pertains to the probability of earning a return less than that expected. investment returns are not known with certainty. the greater the risk. The greater the chance of a return far below the expected return.What is investment risk? Typically. 6 .

Probability Distribution: Which stock is riskier? Why? Stock A Stock B -30 -15 0 15 Returns (%) 30 45 60 7 .

00 50.0 45.0 15.0 Boom 0.0 30.0 20. Above avg.10 8.0 35.0 1.20 8.0 -20. T-Bill Alta Repo Am F.0% -22.20 8.7 0.0 -2.0 0. 0.0% -13.Consider the Following Investment Alternatives Econ.0% 0. Avg.0 -10.0 1.10 8.0 10.40 8.0 7.0% 14. Prob. MP Bust Below avg.0% -10.0 0.0 29.0 43.0 28.0 8 .

Is the T-bill riskless? Explain.What is unique about the Tbill return? The T-bill will return 8% regardless of the state of the economy. 9 .

moves with the economy. This is the typical situation. the Economy Alta Inds.Alta Inds. Repo Men moves counter to the economy. so it is positively correlated with the economy. and Repo Men vs. Such negative correlation is unusual. 10 .

4%.10(50%) = 17.20(35%) + 0.Calculate the expected rate of return on each alternative.40(20%) + 0. i=1 n ^ rAlta = 0.10(-22%) + 0.20(-2%) + 0. ^ r = ∑ riPi. ^ r = expected rate of return. 11 .

0 13.7 12 .0 1. Does that make it best? ^ r Alta Market Am.8 8.4% 15. Foam T-bill Repo Men 17.Alta has the highest rate of return.

What is the standard deviation of returns for each alternative? σ = Standard deviation σ = √ Variance = √ σ2 = √ ∑ i=1 n (ri – r)2 Pi. 13 ^ .

20 + (20 .Standard Deviation of Alta Industries = [(-22 . 14 .17.4)20.4)20.17.20 + (50 .0%.4)20.17.17.10]1/2 = 20.4)20.40 + (35 .4)20.10 + (-2 .17.

3%. = 13.8%.4%. 15 .0%.0%. Am Foam = 18.Standard Deviation of Alternatives T-bills Alta Repo Market = 0. = 20. = 15.

Stand-Alone Risk Standard deviation measures the standalone risk of an investment. The larger the standard deviation. the higher the probability that returns will be far below the expected return. 16 .

3 18.7 Risk.4% 15.8 0.4 17 .Expected Return versus Risk Security Alta Inds.0% 15.0 13. Market Am.0 1. Foam T-bills Repo Men Expected Return 17.8 8.0 13. 20.

CVAlta Inds = 20.9. CVRepo Men = 13.0% = 0. Foam = 18.0.4% = 1. 18 .0.8% = 1.7% = 7.4% / 1.3% / 15. CVAm.0% / 8.0% = 1.4. CVM = 15.Coefficient of Variation (CV) CV = Standard deviation / Expected return CVT-BILLS = 0.1.0% / 17.8% / 13.

0 1.Expected Return versus Coefficient of Variation Security Alta Inds Market Am.0 1.0 13.0 13.1 1.3 18.8 Risk: CV 1.9 19 .4 T-bills Repo Men 8.0% 15.7 0.8 Risk: 20.4 0. Foam Expected Return 17.4% 15.0 7.

0% 0.0% Repo 0.0% Alta 15.0% T-bills 5.): Which investment is best? 20.0% 20.0% 5.Return vs. Risk (Std. Dev.0% Mkt Am.) 20 .0% 15. Dev. Foam Return 10.0% 10.0% 25.0% Risk (Std.

and $50. 21 .000 in Alta Inds.000 in Repo Men.Portfolio Risk and Return Assume a two-stock portfolio with $50. Calculate ^ rp and p.

4%) + 0.5(1.7%) = 9.Portfolio Expected Return ^ rp is a weighted average (wi is % of portfolio in stock i): ^ rp = Σ wi ^ ri i=1 n ^ rp = 0.5(17.6%. 22 .

0 23 .10 0.20 Alta -22. 0.5(Repo) 3.40 0.7 0.10 50. Boom Prob.5 Economy Bust Below avg.0% -2.0 Repo 28.20 0. Average Above avg.0 0.0% 6.0 -10.0 20.0 12.4 10.0 15.0 -20.= 0.0 35.5(Alta) + 0.Alternative Method: Find portfolio return in each economic state Port.0% 14.

5%)0.0%)0.10)1/2 = 3.10 + (6.6)20.20 + (15.9.9.9.3% CVp = 3.3%/9.34 24 .10 + (6.20 + (10.0%)0.6)20.6% p = ((3.20 +(10.6)20.10 = 9.5 .Use portfolio outcomes to estimate risk and expected return ^ rp = (3.6)20.0%)0.6% = .40 + (12.40 + (12.9.4 .0 .6)20.20 + (15.0 .0 .9.4%)0.

Its Components Portfolio expected return (9. Portfolio standard deviation is much lower than: either stock (20% and 13.4%) and Repo (1.7%) returns. 25 . The reason is due to negative correlation (r) between Alta and Repo returns.Portfolio vs. average of Alta and Repo (16.7%).6%) is between Alta (17.4%).

In general. so risk is lowered but not eliminated.35. stocks have r ≈ 0. What happens when r = 0? 26 .0. Investors typically hold many stocks.0.Two-Stock Portfolios Two stocks can be combined to form a riskless portfolio if r = -1. Risk is not reduced at all if the two stocks have r = +1.

Adding Stocks to a Portfolio What would happen to the risk of an average 1-stock portfolio as more randomly selected stocks were added? p would decrease because the added stocks would not be perfectly correlated. 27 . but the expected portfolio return would remain relatively constant.

1 stock ≈ 35% Many stocks ≈ 20% 1 stock 2 stocks Many stocks -75 -60 -45 -30 -15 0 15 30 45 60 75 90 10 5 Returns (%) 28 .

Risk vs. p 20% Market Risk 0 10 20 30 40 2.000 stocks 29 . Number of Stock in Portfolio p 35% Company Specific (Diversifiable) Risk Stand-Alone Risk.

risk is that part of a security’s stand-alone risk that can be eliminated by diversification.Stand-alone risk = Market risk + Diversifiable risk Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification. or diversifiable. 30 . Firm-specific.

p falls very slowly after about 40 stocks are included. The lower limit for p is about 20% = M . 31 . By forming well-diversified portfolios.Conclusions As more stocks are added. investors can eliminate about half the risk of owning a single stock. each new stock has a smaller risk-reducing impact on the portfolio.

They bear only market risk. Rational investors will minimize risk by holding portfolios. so the return is less than that required by the risk. so prices and returns reflect this lower risk. The one-stock investor bears higher (stand-alone) risk. 32 .Can an investor holding one stock earn a return commensurate with its risk? No.

For stock i.M i) / M 33 .How is market risk measured for individual securities? Market risk. its beta is: bi = (ri. which is relevant for stocks held in well-diversified portfolios. is defined as the contribution of a security to the overall riskiness of the portfolio. It is measured by a stock’s beta coefficient.

beta also measures the stock’s volatility relative to the market.How are betas calculated? In addition to measuring a stock’s contribution of risk to a portfolio. 34 .

35 . or b. The slope of the regression line. is defined as the stock’s beta coefficient. which measures relative volatility.Using a Regression to Estimate Beta Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis.

0% 10.7% 40.0% -15.0% -11.0% 36 .0% 15.0% 32.0% 42.5% 13.0% 10.0% 35. Year 1 2 3 4 5 6 7 8 9 10 Market 25.0% -15.7% 8.1% PQU 40.0% -25.0% -10.0% -10.Use the historical stock returns to calculate the beta for PQU.8% -13.0% 30.0% 25.

Calculating Beta for PQU 50% 40% 30% 20% 10% 0% -10% -20% -30% -30% -20% -10% 0% 10% PQU Return rPQU = 0.8308 rM + 0.3546 20% 30% 40% 50% 2 Market Return 37 .0256 R = 0.

can be found using a calculator with a regression function or a spreadsheet program. 38 .83. In this example. and hence beta.What is beta for PQU? The regression line. b = 0.

39 . Some analysts use 52 weeks of weekly returns. Analysts typically use four or five years’ of monthly returns to establish the regression line.Calculating Beta in Practice Many analysts use the S&P 500 to find the market return.

5 to 1. stock has average risk.0. If b < 1.5. Can a stock have a negative beta? 40 . Most stocks have betas in the range of 0.0. stock is less risky than average.How is beta interpreted? If b = 1.0. stock is riskier than average. If b > 1.

Other Web Sites for Beta Go to http://finance. When the quote comes up. then click GO. select Key Statistics from panel on left.yahoo.com Enter the ticker symbol for a “Stock Quote”. such as IBM or Dell. 41 .

29 1.00 0.0 13.4 15.00 -0.0 1. b 1.7 Risk. Foam T-bills Repo Men Expected Return (%) 17.86 42 .Expected Return versus Market Risk: Which investment is best? Security Alta Market Am.68 0.8 8.

8% = 7%. SML: ri = rRF + (RPM)bi . The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM). RPM = (rM . Assume rRF = 8%. rM = rM = 15%. 43 .Use the SML to calculate each alternative’s required return.rRF) = 15% .

0% + (7%)(0.0%.00) = 8. rT-bill = 8. rRepo = 8. rAm.29) = 17%.0% + (7%)(-0. 44 .8%. F.0% + (7%)(0. rM = 8.68) = 12.00) = 15.Required Rates of Return rAlta = 8.0%. = 8.0% + (7%)(1.86) = 2.0%.0% + (7%)(1.

8 8. Foam T-bills Repo Undervalued Fairly valued Undervalued Fairly valued Overvalued 45 .0 2.Expected versus Required Returns (%) Exp.4 15. r 17.0 15.0 1.0 12.8 8.0 Alta Market Am. r 17.0 13.7 Req.

Alta . Market Am.SML: ri = rRF + (RPM) bi ri = 8% + (7%) bi ri (%) rM = 15 rRF = 8 Repo -1 . Foam 0 1 2 Risk. . . bi 46 . T-bills .

5(-0.Calculate beta for a portfolio with 50% Alta and 50% Repo bp = = = = Weighted average 0.22. 47 .5(bAlta) + 0.86) 0.5(1.29) + 0.5(bRepo) 0.

22) = 9. 48 .Required Return on the Alta/Repo Portfolio? rp = Weighted average r = 0.0% + 7%(0.5%.5%. Or use SML: rp = rRF + (RPM) bp = 8.5(2%) = 9.5(17%) + 0.

0 1. bi 49 .5 1.5 Risk.Impact of Inflation Change on SML r (%) New SML 18 15 11 8 I = 3% SML2 SML1 Original situation 0 0.

Impact of Risk Aversion Change r (%) SML2 After change 18 15 SML1 RPM = 3% 8 Original situation 1. bi 50 .0 Risk.

Has the CAPM been completely confirmed or refuted? No. The statistical tests have problems that make empirical verification or rejection virtually impossible. 51 . Investors’ required returns are based on future risk. Investors may be concerned about both stand-alone and market risk. but betas are calculated with historical data.

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