CORPORATE FINANCE

Chapter 11:​ RETURN AND RISK: THE CAPITAL ASSET PRICING MODEL (CAPM)

I. Individual Securities:
- The characteristics of individual securities that are of interest are the:
● Expected Return
● Variance and Standard Deviation
● Covariance and Correlation (to another security or index)
II. Expected return, variance and covariance:
- Expected return: E (R) = ∑(pi x Ri )

- Variance: V ar(δ2 ) = ∑ pi (Ri − E (Ri ))2

- Standard deviation: S D(δ) = √δ2

- Covariance: C ovar(a, b) = ∑ pi [RiA − E (RA )] [RiB − E (RB )]

- Correlation: p = cov (a,b)

δa x δb
( − 1≤p≤1)
III. The Return and Risk for Portfolios:
- Expected return on a portfolio:
E (RP ) = ∑[W i x E(Ri )] ( W i : % investment in a certain asset )

- Standard Deviation of a portfolio of 2 assets:

δ= √δ2 = √W 2A σ2A + W 2B σ2B + 2W A W B ρA,B
Where:
pi : probability of state of economy (recession, normal, boom)
Ri : rate of return at each stage of economy (recession, normal, boom)

E (R) : expected return of an assets

- W A : % investment in asset A
- W B : % investment in asset B
- ρ​A,B​: return correlation between​ A and
​ B
- By creating a portfolio, risk is much reduced. To minimize risk, should choose
asssets with negative correlation.

IV. The Efficient Set for Two Assets:

 - The same return ​→​ lower risk.
- The same risk ​→​ higher return.
V. The Efficient Set for Many Securities:
- The return on any security consists of two parts.
● First, the expected returns
● Second, the unexpected or risky returns
- A way to write the return on a stock in the coming month is:
R= R+U
Where
R : the expected part of the return
U : the unexpected part of the return
- Any announcement can be broken down into two parts, the anticipated (or
expected) part and the surprise (or innovation):
Announcement = Expected part + Surprise.
- The expected part of any announcement is the part of the information the market
uses to form the expectation, ​R,​ of the return on the stock.
- The surprise is the news that influences the unanticipated return on the stock, ​U​.

VI. Diversification and Portfolio Risk:

 - Portfolio Risk and Number of Stocks:

Where:
n: number of shares
- Total risk = systematic risk + unsystematic risk
- A ​systematic risk is any risk that affects a large number of assets, each to a greater
or lesser degree.
- An ​unsystematic risk is a risk that specifically affects a single asset or small group
of assets.
- Unsystematic risk can be diversified away.
- Examples of systematic risk include uncertainty about general economic
conditions, such as GNP, interest rates or inflation.
- On the other hand, announcements specific to a single company are examples of
unsystematic risk.
- The standard deviation of returns is a measure of total risk.
- For well-diversified portfolios, unsystematic risk is very small.
- Consequently, the total risk for a diversified portfolio is essentially equivalent to
the systematic risk.
- Risk free assets (T-bill): R​f​; Standard deviation = 0
- Risky assets (Bond Fund / Stock Fund)
VII. Riskless Borrowing and Lending:

-
With a risk-free asset available and the efficient frontier identified, we choose the
capital allocation line with the steepest slope.
VIII. Market equilibrium:
- Beta measures the responsiveness of a security to movements in the market
portfolio (i.e., systematic risk).
cov (R ,R ) δ(R )
βi = δ2 (Ri )M = p δ(R i )
M M

IX. Relationship between Risk and Expected Return (CAPM):

- Expected Return on the Market: R​M =​ R​f​ + Market risk premium (MRP)
- Expected return on an individual security (CAPM):
R​i​ = R​f +
​ βi x (R​M –​ R​f​)
R​M​ - R​f ​ is market risk premium.
- Assume β i​ = 0, then the expected return is ​R​F.​
- Assume β i​ = 1, then R​i​ = R​M