Managerial Finance:

Chapter 13—Return, Risk & the

Security Market Line

OVU-ADVANCE
Notes prepared by D. B. Hamm
Updated January 2006
Expected Return (1)

Most investments carry some degree of risk.

Generally only U.S. securities (specifically T-

bills) are considered risk free [Rf] because the
Federal government can raise taxes or borrow as
necessary to avoid default.
Expected Return (2):
Suppose Investment A has probable returns as
follows:
• In the previous "go-go" market, it had earned 12%.
• In the recent market slump, it earned only 4%.
• If we project a 60% probability of renewed boom
and a 40% probability of bust, then the expected
return of A [ E(RA) ] is as follows:
 
E(RA) = (.60 x .12) + (.40 x .04)
= .072 + .016
= .088 or 8.8%
Risk Premium:
Risk Premium is the difference between the
expected return on the proposed investment and
the risk free rate.

If U.S. security G is earning 4% then the risk

premium for investment A (from previous slide,
E(R) = 8.8%) is:
 
RiskA = E(RA) - Rf
= .088 - .04 = .048 or 4.8%
Variance & Standard Deviation
The Variance, or squared deviations from the expected
return gives us a measurement of how much risk movement
is in an investment. For Investment A:

2A = [prob1 x (return1 - E(RA)2] + [prob2 x (return2 - E(RA)2]

2A = [.60 x (.12 - .088)2] + [.40 x (.04 - .088)2]
= [.60 x .001024 ] + [.40 x .002304 ]
= [.00036864] + [.0009216]
= .00129024
 
The Standard deviation is the square root of the variance.
For A:
A = SQRT of .00129024 =+-0.03592 = + or - 3.59%
 
This gives some idea of the potential movement in Investment A
Investment Portfolios
A portfolio of investments enables us to
diversify and therefore minimize the
portion of risk that relates to "surprises"
or unexpected movement in individual
securities.

A portfolio won't remove risk related to

the market as a whole ("market risk").
Portfolio Illustration
Suppose we mix a portfolio of 40% in Investment A
(previous) + 40% in Investment B, which may earn only
7% in a good market but booms to 14% in a recession, and
we put the other 20% in government investment G earning
4%. Portfolio Expected Return for Portfolio "P" :
 
E(RP) = [.40 x E(RA)] + [.40 x E(RB)] + [.20 x E(RG)]
 
Where E(RA) =8.8% , E(RB) =9.8% , and E(RG) = 4%
(the risk-free rate)
 
E(RP) = ( .40 x .088) + (.40 x .098) + (.20 x .04)
E(RP) = .0824 or 8.24%
 
Portfolio Illustration (continued):
Note: The percentage weights are based on the total
dollars invested in each security. If we invested $100,000
as follows: $40,000 in A, $40,000 in B, and $20,000 in G,
then we would have the 40%-40%-20% mix above.
 
 
The variance of this portfolio is 0.00000434062 and the
standard deviation is .0020736 or about + or - 2/10 of 1%.
In other words, diversifying eliminated almost all of the
diversification risk or unexpected return.
 
Risk & Beta (1):
Total risk of any investment = both
• the market risk (which can't be diversified) and
• the diversifiable risk, which can be minimized or
eliminated by diversification in a portfolio.

•The market risk is called systematic and the

diversifiable risk is called unsystematic.
 
Total risk = Systematic risk + Unsystematic risk
(market risk) (diversifiable risk)
Risk & Beta (2):
Total risk = Systematic risk + Unsystematic risk
  (market) (diversifiable)
The unsystematic risk is asset-specific and relates to
individual investments which can be minimized through
diversification. The systematic risk, or market risk, can
affect all market investments. A recession or a war, for
example, might impact all investments in a portfolio.
Since we can usually eliminate the unsystematic risk, we
focus primarily on the systematic risk.
 
Expected return of any asset , or E(Rasset), depends
only on the asset's systematic risk. We measure the
systematic risk by the beta coefficient, or .
Risk & Beta (3):
The Beta of an asset = Covariance of asset returns with
The market index portfolio
Variance with the market portfolio
 
I don't want to figure that out--do you? There are people on this
planet who live for this stuff and do that for most publicly traded
assets. (Your facilitator is NOT one of them!) Therefore we will
assume the Beta is given for any investment we work with.

The general rule for  is as follows:

If  = 1.0 then the investment has "normal" market risk
If  < 1.0 then the investment has below normal market risk
(for example U.S. securities'  = 0 or zero risk)
If  > 1.0 then the investment has a greater than normal

market risk (higher risk)

Some Sample Betas (as of 1/31/07)
 Ford Motor Co (recent financial concerns, stock has
dipped from $13.17 to $8.08/share over 2 yrs) = 1.83
 Wal-Mart (solid, $47.19/sh)= 0.17
 GE (also solid, $36.11/sh) = 0.51
 CVS Corp. (near mkt average, $33.31/sh)= 0.94
 Microsoft (solid, but rolling out Windows Vista,
$30.41/sh) = 0.71
 Trump Entertainment Resorts (considerable
fluctuation, $17.57/sh) = 1.96
 NutriSystem, Inc. (also wildly fluctuates, $45.83/sh)=
2.06 (stock has recently endured a 12% drop)
Portfolio Beta:
If we have the Beta coefficient for each of the individual
investments in our portfolio, we can evaluate the overall risk
in our entire portfolio. Using the earlier example, let's make
the following assumptions:
40% + 40% + 20% = Portfolio P
Investment A Investment B Investment G
A = 1.40 B = .90 G = 0 (risk free)
 
P = (.40 x 1.40) + (.40 x .90) + (.20 x 0)
= .56 + .36 + 0
= .92 (slightly below normal systematic risk)

(As we calculated earlier, the expected return E(R) on

portfolio P: E(RP) = 8.24%. Since the portfolio Beta is
slightly < 1, we assume its E(R) to be slightly < the market
The Security Market Line (SML)
When we mix a portfolio of assets, we find a
linear ( positive correlation) relationship
between the individual assets' expected returns
and their Betas.

Assets with a higher Beta generally have a

higher expected return to compensate for the
higher systematic (market) risk. (General
concept of risk vs. return--the higher the
potential return, the higher the potential risk.)
 
The Security Market Line (SML) (2)
 

This linear relationship between expected return

and Beta is called the Security Market Line (SML).
The slope of the SML is as follows:
 
E(RA) - Rf
Slope of SML for Asset A = A

Or the difference between expected return and risk

free return divided by the beta coefficient.
Security Market Line (SML) (3)
E(RA) - Rf
Slope of SML for Asset A = A

.088 - .04
For our Investment A = 1.40 = .0343 or 3.4%
 
For our Investment B = .098 - .04
.90 = .0644 or 6.4%
 
This is the reward-to-risk ratio. Here investment B is
more attractive, although neither is particularly high in a
“bull” market ( remember B was better in a “bear”
market).
Security Market Line (SML) (4)
In an organized market, this difference in reward-
to-risk would not persist because buyers and
sellers would bid up investment B over
investment A which would lower B's return and
increase A's return.
 
We therefore assume the reward to risk ratio is
the same for all assets in the market and can
therefore be plotted on the SML.
 
Market Risk Premium
If we create a theoretical portfolio of all
securities in the market, which would
therefore have a Beta of the market average
M = 1.0 we can evaluate the entire market
risk premium as
 
Market Risk Premium = E(RM) - Rf
Risk premium = Expected market return – risk free rate
Example: If the “going” market rate were 11.5%
and the T-bill (risk free) rate were 4%, then the
market risk premium is the difference of 7.5%
Capital Asset Pricing Model
(CAPM)
If we select any asset "i" in this market and
assume that trading in the market's assets
has "normalized" the expected return so that
it equals the same reward to risk, then the
equation for the SML of any asset "i" in the
market is

Expected return = risk free rate + (risk premium x Beta)

E(Ri) = Rf + [E(RM) - Rf] x i.
 
This is called the Capital Asset Pricing
Model or CAPM.
CAPM Illustration (1):
If the Rf = 4% and the E(RM)=11.5%
Suppose we select an asset "i" with a i = .7
The expected return on this asset is therefore
(using CAPM)
 
E(Ri)= Rf + [E(RM) - Rf] x i
= .04 + [.115 - .04] x .7
= .04 + (.075 x .7)
= .04 + .0525
= .0925 or 9.25%
 Because the Beta is low risk (less than market), the
expected return is less than the market rate.
CAPM Illustration (2):
Expected Return = risk free rate + (risk premium) x Beta
E(Ri)= Rf + [E(RM) - Rf] x I

(Where Rf= 4%, E(RM)= 11.5%)

If the  = 1.0 then the expected return = 11.5%

(the market rate)
If the  = 1.5 then the expected return = 15.25 %
If the  = 2.0 then the expected return = 19%
(this is double the market risk!)
If the  = .5 then the expected return = 7.75%
If the  = 0 then the expected return = 4%
(the risk-free rate)
CAPM (3):
 As long as we have the following variables:
– The risk free rate
– The current market rate
– The asset’s Beta
 Then we can estimate the expected return for any
asset (investment).
 If we have the E(R) of an asset and any two of the
above, we can work backward and find the
missing variable. Example-if we knew the return on an
asset over time, we could estimate what its Beta should be.
CAPM (conclusion):
Assumptions of the Capital Asset Pricing Model
(CAPM)
 The pure time value of money This is the risk- free
rate, or the rate you could expect to earn over time if you
accepted no (zero) risk (govt. securities)
 The reward for bearing systematic risk, or the risk
premium (asset rate in excess of the risk free rate)
 The amount of systematic risk in the market, or the
Beta value
Cartoon
Pause here for class case before
going to chapter 15