Finance & Financial Management

Risk & Return: The Capital Asset

Pricing Model

Lecture 5

Lecture slides are based on the textbook and accompanying slides of

Hillier, Ross, Westerfield, Jaffe, and Jordan “Corporate Finance”.
European Edition, 3rd Edition, McGraw-Hill, 2016, (Copyright © The
McGraw-Hill Companies 2016)
Risk & Return: The Capital Asset Pricing Model
- Be able to calculate the expected return and risk of individual
securities.
- Know how to extend the efficient frontier analysis of a 2 asset
world to a world with many assets.
- Understand how risk is diversified in a portfolio of many
assets.
-Be familiar with the concept of riskless and risky borrowing and
how the combination of investment in a risk-free asset and risky
portfolio can lead to an optimal investment decision.
- Understand what is meant by systematic risk or beta.
 Individual Securities

Variance and
Expected
Standard
Return
Deviation

Covariance
and
Correlation
 Expected Return and
Variance
What is the expected return and variance of
Slowpoke and Supertech?

Supertech Returns Slowpoke Returns

RAt RBt
Depression -20% 5%
Recession 10 20
Normal 30 -12
Boom 50 9
 Expected Return and
Variance
Expected Return:
Supertech:

-0.20  0.10  0.30  0.50

 0.175  17.5%  RA
4
Slowpoke:

0.05  0.20 - 0.12  0.09

 0.055  5.5%  RB
4
 Expected Return and
Variance
Variance of Supertech:
(1) (2) (3) (4)
State of Rate of Deviation from Squared Value
Economy Return Expected Return of Deviation
Supertech (Expected return =
0.175)

Depression -0.20 -0.375 0.140625

( = -0.20 - 0.175) [ = (-0.375)2]

Recession 0.10 -0.075 0.005625

Normal 0.30 0.125 0.015625
Boom 0.50 0.325 0.105625
0.267500
 Expected Return and
Variance
Variance of Supertech Continued:

-0.20  0.10  0.30  0.50

RA   0.175  17.5%
4
0.2675
Var( RA )   A 
2
 0.066875
4
SD( RA )   A  0.066875  0.2586  25.86%
 Expected Return and
Variance
Variance of Slowpoke:
(1) (2) (3) (4)
State of Rate of Deviation from Squared Value
Economy Return Expected Return of Deviation
Slowpoke (E[r] = 0.055)

Depression 0.05 -0.005 0.000025

( = 0.05 - 0.055) [ = (-0.005)2]

Recession 0.20 0.145 0.021025

-0.12 -0.175 0.030625
Boom 0.09 0.035 0.001225
0.052900
 Expected Return and
Variance
Variance of Slowpoke Continued:

0.05  0.20 - 0.12 - 0.09

RB   0.055  5.5%
4
0.0529
Var( RB )   B   0.013225
2
4
SD( RB )   B  0.013225  0.1150  11.50%
 Covariance and
Correlation
Deviation from
Expected Deviation from
State of Return Expected Return Product of
Economy Supertech Slowpoke Deviations
Depression -0.375 -0.005 0.001875
Recession -0.075 0.145 -0.010875
Normal 0.125 -0.175 - 0.021875
Boom 0.325 0.035 0.011375
- 0.0195
-0.0195
 AB  Cov(RA , RB )   -0.004875
4
Cov(RA , RB ) -0.004875
 AB  Corr(RA , RB )    -0.1639
SD(RA )  SD(RB ) 0.2586  0.1150
 The Return and Risk of
Portfolios

The expected return

on a portfolio is simply
a weighted average of
the expected returns
on the individual
securities.
 The Return and Risk of
Portfolios
• If the investor with £100 invests £60 in
Supertech and £40 in Slowpoke, what is the
expected return on the portfolio?

Expected return on portfolio:

0.6 x 17.5% + 0.4 x 5.5% = 12.7%

X ARA  X B RB  Rp
 The Return and Risk of
Portfolios
The variance of a two asset portfolio:

Var(portfolio)  X A A  2 X A X B A, B  X B B
2 2 2 2

Variance of a portfolio with £60 in Supertech and £40

in Slowpoke:

Var(portfolio)  X SuperSuper  2 X Super X Slow Super,Slow  X Slow Slow

2 2 2 2

0.36 x 0.0668 + 2 x [0.6 x 0.4 x (-0.0049)] + 0.16 x

0.0132
= 0.023851
 The Return and Risk of
Portfolios
Calculating Variance: The Matrix Approach

Calculating Standard Deviation

 p  SD(portfolio)  Var(portfolio)  0.023851

 0.1544  15.44%
 The Risk and Return of
Portfolios: Diversification
Standard Weighted Average of
Deviation of Individual Security
Portfolio Standard Deviations

X SuperSuper  X SlowSlow
 The Risk and Return of
Portfolios: Diversification
As long as Correlation is <
1, the standard deviation
of a portfolio of two
securities is less than the
weighted average of the
standard deviations of the
individual securities.
 The Return and Risk of
Portfolios: Many Securities
Asset Standard Deviation
DJ Euro Stoxx 50 Index 13.10%
Carrefour SA 41.08
Fortis 65.55
Vinci SA 35.17
Intesa SanPaolo 31.53
Saint Gobain 48.80
Telecom Italia 32.22
Arcelormittal 41.07
Credit Agricole 57.92
Adidas 29.47
The Efficient Set of Two
Assets
 The Efficient Set for Two
Assets
10% Slowpoke
90% Supertech

50% Slowpoke
50% Supertech

Minimum Variance
Portfolio

90% Slowpoke
10% Supertech
Efficient Set for Two Assets:
Changing Correlations
Efficient Set for Two Asset Portfolios:
US and Non-US Equities
The Efficient Set for Many
Securities
Two Asset vs Many Asset
Portfolios: Comparison
 Diversification: An
Example

Assumptions
All All
All
securities securities
covariances
possess the are equally
are the
same weighted in
same.
variance the portfolio.
 Diversification: An
Example
What happens as we increase the number
of securities to infinity?

1  1
P
2
   var  1 -  cov
N  N

P
2
 cov
Diversification: An
Example
 Diversification: An
Example
Systematic
Risk

Total Risk

Unsystematic
Risk
 Riskless Borrowing and
Lending
Risk-
Free
Asset

?
Risky
Asset
 Example 3: Riskless
Lending and Portfolio Risk
Ms. Bagwell is considering investing in the equity of
Merville Enterprises and will either borrow or lend at the
risk-free rate.
Equity Risk-Free
of Merville Asset
Expected return 14% 10%
Standard deviation 0.20 0

Suppose Ms. Bagwell chooses to invest a total of £1,000,

£350 of which is to be invested in Merville Enterprises and
£650 placed in the risk-free asset. What is the expected
return and standard deviation of her portfolio?
 Example 3: Riskless
Lending and Portfolio Risk
Ms. Bagwell invests £350 Merville Enterprises and
£650 in the risk-free asset:
Expected return on portfolio
composed of one riskless = 0.114 = (0.35 x 0.14) + (0.65 x 0.10)
and one risky asset

Variance of Portfolio:
2
X Merville 2Merville  2 X Merville X Risk-freeMerville, Risk-free  X Risk-free
2
2Risk-free

 P2  X Merville
2
Merville  0.35 (0.20 )  0.0049
2 2 2

 P  X Merville Merville  0.35(0.20)  0.07

 Example 3: Riskless Borrowing
and Portfolio Risk
Mrs. Bagwell borrows £200 at the risk-free rate
and invests £1,200 in Merville Enterprises

Expected return on portfolio

composed of riskless borrowing = 0.148 = (1.2 x 0.14) + (-0.2 x 0.10)
and one risky asset

Standard deviation of portfolio formed by

 0.24  1.20 x 0.2
borrowing to invest in risky asset
Example 3: Relationship
between Risk and Return
The Optimal Portfolio
 The Separation Principle

• The investor will first estimate the optimal

portfolio

• The investor must then decide how much to

invest in the optimal portfolio and how much
to invest or borrow in the risk free asset
depending on their risk preferences
 Market Equilibrium

Homogeneous Heterogeneous
Expectations Expectations
• All investors • Investors have
have the same different
information and information and
the same ability different abilities
to analyse it to analyse the
information
 Market Equilibrium

In a world with
homogeneous
This portfolio is also
expectations, all
known as the market
investors would hold
portfolio
only one portfolio of
risky assets
 Example 4: Beta

Return on Return on
Type of Market Jelco plc
State Economy (percent) (percent)
I Bull 15 25
II Bull 15 15
III Bear -5 -5
IV Bear -5 -15
 Example 4: Beta
Assume that a bull and bear market are equally likely:

Return on
Type of Market Expected Return on
Economy (percent) Jelco plc (percent)
Bull 15% 1 1
20%  25%   15% 
2 2

Bear -5% 1
-10%  -5%   (-15%) 
1
2 2
Example 4: Beta
 Estimates of Beta for
Selected Companies
Stock Beta
Alcatel-Lucent 1.44
L’Oreal 0.45
SAP 0.56
Siemens 1.51
Daimler 1.25
Philips Electron 0.92
Renault 1.64
Volkswagen 0.40
 A Quiz

Question 1 Question 2

• What sort of investor • What sort of investor

rationally views the rationally views the
variance (or beta of a security as
standard deviation) the security’s proper
of an individual measure of risk?
security’s return as
the security’s proper
measure of risk?
 The Capital Asset Pricing
Model (CAPM)

Expected
Expected
Return on an
Return on the
Individual
Market
Security
 Expected Return on the
Market

RM  RF  Risk Premium
If the risk-free rate, estimated by the current
yield on a one-year Treasury bill, is 1 percent,
and the risk premium is 8.5% the expected
return on the market is:

6.35% = 4.96% + 1.39%

Expected Return on an
Individual Security
 Expected Return on an
Individual Security


E ( Ri )  R f  E( Rm ) - R f i 
This is the Capital Asset Pricing
Model (CAPM)

http://www.investopedia.com/terms/e/emtn.asp
 Example 5: CAPM
The shares of Aardvark Enterprises have a beta of 1.5 and
that of Zebra Enterprises has a beta of 0.7. The risk-free
rate is assumed to be 3 percent, and the difference
between the expected return on the market and the risk-
free rate is assumed to be 8.0 percent. What are the
expected returns on the two securities?

Aardvark
• 15.0% = 3% + 1.5 x 8.0%
Zebra
• 8.6% = 3% + 0.7 x 8.0%
 Criticisms of the CAPM:
Roll’s Critique (1977)
It is practically impossible to construct a
portfolio that contains every single security (i.e.
the true market portfolio), any test of the CAPM
that uses a market proxy (e.g. FT 100, DAX,
CAC 40, etc.) will be testing that specific
portfolio, and not the true market portfolio.
This means that, for all intents and purposes,
the CAPM is empirically untestable because the
underlying market portfolio is unobservable.
Any tests of the CAPM that use market proxies
will be affected by this criticism.