Chapter 8

Risk and Return—Capital Market Theory

 Chapter Overview
A key principle explained in this chapter is that with appropriate diversification, an investor can lower
the risk of his/her portfolio without lowering the portfolio’s expected rate of return. The expected return
for a portfolio is the weighted average of the expected rates of return of the individual investments in that
portfolio. However, the risk of a portfolio is not simply the weighted average of the standard deviations
of the individual investments. Rather, diversification—i.e., combining investments which are less than
perfectly positively correlated—can result in a decrease in overall risk.

Risk can be divided into diversifiable and nondiversifiable risk. Investors are assumed to combine
securities into a portfolio in such a way as to diversify away all diversifiable risk. They are left then
with only nondiversifiable risk. The Capital Asset Pricing Model (CAPM) is a major theory in finance.
This theory suggests that beta is the appropriate measure of a stock’s nondiversifiable or systematic risk.
Further, the higher the stock’s beta, the higher rate of return will be for this security.

 Chapter Outline
8.1 Portfolio Returns and Portfolio Risk
A. The expected rate of return for a portfolio of investments is a simple weighted average of the
expected rates of return of the individual investments in the portfolio.
B. Portfolio risk depends on the standard deviation of the returns of the investments in a portfolio
and on the correlation among these investments.
1. Diversification encompasses combining investments into a portfolio that are not perfectly
positively correlated.
2. The correlation coefficient measures the degree to which the returns on two investments are
correlated.
3. The correlation coefficient measures the strength of the linear relationship between two
assets and takes on a range between 1.0 and 1.0.

8.2 Systematic Risk and the Market Portfolio

A. The Capital Asset Pricing Model (CAPM) asserts that investors choose to hold the optimally
diversified portfolio that includes all risky investments—i.e., the market portfolio.
1. Systematic risk measures the component of risk that contributes to the risk of the market.
This is nondiversifiable risk.
2. Unsystematic risk is the element of risk that does not contribute to the risk of the market.
This is diversifiable risk.
3. Beta is the measure of a stock’s systematic risk.

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24  Titman/Keown/Martin  Financial Management, Thirteenth Edition, Global Edition

8.3 The Security Market Line and the CAPM

A. A key insight of the CAPM is that investments with the same beta have the same expected rate
of return.
B. The security market line expresses the relationship between a security’s beta and its required
rate of return: Expected return  rrisk-free  beta (rmarket  rrisk-free).
C. Since systematic risk cannot be eliminated through diversification and must be borne by the
investor, this is the source of risk that is reflected in expected returns.

 Learning Objectives
8-1. Calculate the expected rate of return and volatility for a portfolio of investments and describe how
diversification affects the returns to a portfolio of investments.

8-2. Understand the concept of systematic risk for an individual investment and calculate portfolio
systematic risk (beta).

8-3. Estimate an investor’s required rate of return using the Capital Asset Pricing Model.

 Lecture Tips
1. Often students have difficulty understanding how diversification leads to a reduction in risk without a
change in return. It is helpful to go through an extended two-stock example. Keep the returns,
weights, and standard deviations all constant and vary only the correlation coefficient. This helps
students understand the actual dynamics of diversification.

2. Explain why the beta of the market is 1.0. That is, how beta captures the covariance of a security
relative to the market.

 Questions for Further Class Discussion

1. Discuss some of the limitations of the CAPM.

2. Identify and describe some of the alternatives to the CAPM—e.g., Arbitrage Pricing Model and
the Fama/French Model.

 End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

Simple Average Complex

1, 2, 12, 13, 16, 17 3, 4, 5, 6, 7, 8, 9, 10, 19, 21, 25
11, 14, 15, 18, 20, 22,
23, 24, 26, 27

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 Chapter 8 Risk and Return—Capital Market Theory 25

 Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets
are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login
and password for this Web site, contact your Pearson sales representative.

Problems: 8-1—8-12, 8-15—8-16, 8-19—8-20, 8-22—8-27

 Internet Resources
www.yahoofinance.com
www.moneycentral.com
www.MSN.com

Copyright © 2018 Pearson Education Ltd.