What is the market risk premium?

Additional return over the risk-free rate needed to compensate investors for assuming an average
amount of risk. Its size depends on the perceived risk of the stock market and investors’ degree of
risk aversion. Varies from year to year, but most estimates suggest that it ranges between 4% and
8% per year.

Expected Vs Required Returns

^r EXPECTED R(REQUIRED)
STOCK A 12.4% 12.1% UNDERVALUE (^r>r)
STOCK B 10.5% 10.5 FAIRLY VALUDED
(^r=r)
STOCK C 9.8% 9.9 OVERVALUED (^r<r)
Illustrating the Security Market Line

An Example: Equally-Weighted Two-Stock Portfolio

Create a portfolio with 50% invested in High Tech and 50% invested in Collections.
The beta of a portfolio is the weighted average of each of the stock’s betas.
bP = wHTbHT + wCollbCollb
P = 0.5(1.32) + 0.5(-0.87)

bP = 0.225

Calculating Portfolio Required Returns

The required return of a portfolio is the weighted average of each of the stock’s required returns.
rP = wHTrHT + wCollrColl

rP = 0.5(12.10%) + 0.5(1.15%)
rP = 6.625%

FACTORS THAT CHANGE THE SML

LEARNINGOBJECTIVE

 Know how to calculate a rate of return; historical rates of return

 Discuss the investment risk; know that our risk measure will be the standard deviation of
returns (no calculations are necessary)
 Know how to calculate expected return, standard deviation and coefficient of variation given
probabilities of each outcome
 Know what is risk aversion and risk premium
 Know how to calculate the portfolio return
 Discuss the diversification effects of a portfolio; the role of correlation and its two signs and
the benefits of diversification
 Know the two sources of risk; market and firm specific
 Briefly discuss what is CAPM and beta
 Know how to calculate required return using SML
 Recommended problems: ST-1, Questions 8-4,8-7,8-8, problems 8-1 to 8-8