Handout - Chapter 1213 - Some Lessons Risk, Return, SML - 2023

CORPORATE FINANCE 2
 Credit :3
 Program : FinTech Program
1-1
Lecturer’s Information
 Full name: Phan, Hong Mai

 Tittle: PhD
 Address: Room 921 –Building A1
 Email: hongmai@neu.edu.vn
 Institute: School of Banking and Finance
 National Economics University
1-2
Required Textbook
Ross et al. (2019), Fundamentals of Corporate Finance,

The 12th Edition, The McGraw-Hill/Irwin.
1-3
Course Schedule
Session Chapter Number of period

(75 minutes/period)
Theory Practice
1 Review module 1 2 0
2,3 & 4 Chapter 12 & 13 4 2
5,6 & 7 Chapter 14 & 16 4 2
8 1st Exam 2
9 Chapter 17 2 0
10,11 & 12 Chapter 18,19 & 20 4 2
1-4
Course Schedule
Session Chapter Number of period

(75 minutes/period)
Theory Homework,
Practice
13 Chapter 26 2 0
14 2nd Exam 2
15 Review module 2 2 0
Total 24 6
Grading policy: Total point
= 10%.Participation + 20%.1stexam + 20%.2ndexam + 50%.Final exam
1-5
Chapter 12 & 13
Some lessons from
capital market history
Risk, Return, Stock market line
 PhD, Phan Hong Mai

 School of Banking and Finance
 National Economics University
 hongmaiktqd@yahoo.com 12-6
Chapter Outline
12.1 Returns
12.2 Some Lessons from Capital Market History
12.3 Arithmetic versus Geometric Averages
12.4 Efficient Capital Markets
12.5 Expected Returns and Variances
12.6 Portfolios
12.7 Expected and Unexpected Returns
12.8 Diversification
12.9 The Security Market Line
12-7
12.1 Returns
Dollar Returns:
 Your gain (or loss) from an asset is called the
return on your investment.
 Total dollar return = income from investment +
capital gain (loss) due to change in price
12-8
12.1 Returns
Dollar Returns:
 You bought a bond for $950 one year ago. You have
received two coupons of $30 each. You can sell the
bond for $975 today. What is your total dollar
return?
12-9
12.1 Returns
Percentage Returns:
 It is generally more convenient to summarize
information about returns in percentage terms
because of the independence from the amount of
investment.
12-10
12.1 Returns
Percentage Returns:
Dividend yield = Dt+1/Pt
Capital gains yield = (Pt+1 – Pt)/Pt
Total percentage return = dividend yield + capital
gains yield
 Dt+1 : Dividend paid on stock during the year
 Pt : The price of stock at the beginning of the year
 Pt+1 : The price of stock at the ending of the year
12-11
12.1 Returns
Percentage Returns:
 You bought a bond for $950 one year ago. You have
received two coupons of $30 each. You can sell the
bond for $975 today. What is your total percentage
return?
12-12
Concept Questions 12.1
 What are the two parts of total return?

 What is the different between a dollar return
and a percentage return? Why are percentage
returns more convenient?
12-13
12.2 Some Lessons from
Capital Market History
The Importance of Financial Markets:

 Financial markets allow companies, governments
and individuals to increase their utility:
 Savers have the ability to invest in financial assets so
that they can defer consumption and earn a return to
compensate them for doing so
 Borrowers have better access to the capital that is
available so that they can invest in productive assets
12-14
The Importance of Financial Markets:

 Financial markets also provide us with information
about the returns that are required for various
levels of risk.
 We can examine returns in the financial markets to
help us determine the appropriate returns on non-
financial assets.
12-15
Lessons from capital market history:

 There is a reward for bearing risk
 The greater the potential reward, the greater the risk
 This is called the risk-return trade-off
12-16
 Treasury bills are considered to be risk-free

because the government can always raise
taxes to pay its bills.
 The “excess” return is the additional return
we can earn by moving from a relatively risk-
free investment to a risky one. -> It is also
called “the risk premium”, which can be
interpreted as a reward for bearing risk.
12-17
 Variance measures the average squared difference

between the actual returns and the average return.
Historical variance = sum of squared deviations
from the mean / (number of observations – 1)
Var(R) 
1*
T -1
2
  
R1  R  ...  RT  R 
2
* Using historical data

12-18
 Standard deviation is the square root of the

variance.
-> The bigger these numbers are, the more the

actual returns tend to differ from the average
return.
12-19
 Suppose a particular investment had returns of

15%, 9%, 6% and 12% over the last four years.
What is the historical variance and standard
deviation of this investment?
12-20
 What do we mean by risk premium?

 How do we calculate a variance? A standard
deviation?
 What are lessons from capital market history?
12-21
 Arithmetic average – return earned in an average

period over multiple periods.
 Geometric average – average compound return
per period over multiple periods.
 The geometric average will be less than the
arithmetic average unless all the returns are equal.
12-22
 What is the arithmetic and geometric average for

the following returns?
 Year 1 5%
 Year 2 -3%
 Year 3 12%
12-23
Arithmetic vs. Geometric mean, Which is better?

 The arithmetic average is overly optimistic for long
horizons. The geometric average is overly pessimistic
for short horizons
 So, the answer depends on the planning period under
consideration
 15 – 20 years or less: use the arithmetic
 20 – 40 years or so: split the difference between them
 40 + years: use the geometric
12-24
 If you wanted to forecast what the stock market

is going to do over the next year, should you use
an arithmetic or geometric average?
 If you wanted to forecast what the stock market
is going to do over the next century, should you
use an arithmetic or geometric average?
12-25
Definition:
 Efficient capital market is a market in which
security prices reflect available information. So
there is no reason to believe that the current
price is too high or too low.
 Efficient market hypothesis asserts that well-
organized markets are efficient markets.
12-26
If a market is efficient:
 All investments in that market are zero-NPV
investments because the difference between
market value of an investment and its cost is
zero.
 Investors get exactly what they pay for when
they buy securities.
 The firms receive exactly what their stocks and
bonds are worth when they sell them.
12-27
Common Misconceptions about Efficient market

hypothesis:
 Efficient markets do not mean that you can’t make
money. On average, you will earn a return that is
appropriate for the risk undertaken.
 However, there is not a bias in prices that can be
exploited to earn “excess returns”.
 Market efficiency will not protect you from wrong
choices if you do not diversify.
12-28
Strong Form Efficiency:

 Prices reflect all information, including public and
private.
 If the market is strong form efficient, then
investors could not earn abnormal returns
regardless of the information they possessed.
 Empirical evidence indicates that markets are NOT
strong form efficient and that insiders could earn
abnormal returns.
12-29
Semi-strong Form Efficiency:

 Prices reflect all publicly available information
including trading information, annual reports,
press releases, etc.
 If the market is semi-strong form efficient, then
investors cannot earn abnormal returns by trading
on public information.
 Implies that fundamental analysis will not lead to
abnormal returns.
12-30
Weak Form Efficiency:

 Prices reflect all past market information such as
price and volume.
 If the market is weak form efficient, then investors
cannot earn abnormal returns by trading on
market information.
 Implies that technical analysis will not lead to
abnormal returns.
 Empirical evidence indicates that markets are
generally weak form efficient.
12-31
 What is an efficient market?

 What are the forms of market efficiency?
12-32
Expected returns:
 Expected return is the return on a risky asset
expected in the future.
 Expected return is simply equal to the sum of the
possible returns multiplied by their probabilities.
n
E ( R )   pi Ri
i 1
12-33
 Suppose you have predicted the following returns

for stocks C and T in three possible states of the
economy. What are the expected returns?
State Probability Stock C Stock T

Boom 0.3 15% 25%
Normal 0.5 10% 20%
Recession 0.2 2% -5%
12-34
Steps to compute variance and standard

deviation - using future information:
 Determine the squared deviations from the
expected return.
 Multiply each possible squared deviation by its
probability.
n
 Add them up. σ   pi ( Ri  E ( R ))
2 2
i 1
12-35
 Suppose you have predicted the following returns

for stocks C and T in three possible states of the
economy. What are the variance and standard
deviation for each stock?
State Probability Stock C Stock T

Boom 0.3 15% 25%
Normal 0.5 10% 20%
Recession 0.2 2% -5%
12-36
 How do we calculate the expected return on a

security?
 In words, how do we calculate the variance of
the expected return?
12-37
12.6 Portfolios
 A portfolio is a collection of assets

 An asset’s risk and return are important in how
they affect the risk and return of the portfolio
 The risk-return trade-off for a portfolio is
measured by the portfolio expected return and
standard deviation, just as with individual
assets
12-38
12.6 Portfolios
Portfolio Weights:
 Portfolio weight is the percentage of a portfolio’s
total value that is invested in a particular asset.
12-39
12.6 Portfolios
Portfolio Weights:
 Suppose you have $15,000 to invest and you have
purchased securities in the following amounts.
 $2000 of A
 $3000 of B
 $4000 of C
 $6000 of D
 What are your portfolio weights in each security?
12-40
12.6 Portfolios
Portfolio Expected Returns:

 The expected return of a portfolio is the weighted
average of the expected returns of the respective
assets in the portfolio m
E ( RP )  w
j 1
j E(R j )
 The expected return can be also found by finding

the portfolio return in each possible state and
computing the expected value as we did with
individual securities.
12-41
12.6 Portfolios
Portfolio expected returns:

 Suppose you have $15,000 to invest. You have
purchased some stocks with the following amounts of
money and expected returns.
Stock Amount of money Expected return
A $2,000 19.69%
B $3,000 5.25%
C $4,000 16.65%
D $6,000 18.24%
 What is the expected return for the portfolio?

12-42
12.6 Portfolios
 Invest your money in following equally weighted

portfolio:
State Probability A B_____
Boom 0.4 30% -5%
Bust 0.6 -10% 25%
 What is the expected return for the portfolio?
12-43
12.6 Portfolios
Portfolio Variance and Deviation:

 Compute the portfolio return for each state:
RP = w1R1 + w2R2 + … + wmRm
 Compute the expected portfolio return using the
same formula as for an individual asset.
 Compute the portfolio variance and standard
deviation using the same formulas as for an
individual asset.
12-44
12.6 Portfolios
 Invest your money in following equally weighted

portfolio:
State Probability A B
Boom 0.4 30% -5%
Bust 0.6 -10% 25%
 What are the variance and standard deviation for
each stock?
 What are the variance and standard deviation for
the portfolio?
12-45
 What is a portfolio weight?

 How do we calculate the expected return on a
portfolio?
 Is there a simple relationship between the
standard deviation on a portfolio and the
standard deviation of the assets in the portfolio?
12-46
 Announcements and news contain both an expected

component and a surprise component.
 The market uses the anticipated part of information
to form the expected the return on the stock, E(R).
 The surprise part of information influences the
unexpected return on the stock, U.
 Actual return or Total return = E(R) + U
P(R)
Predictable Return
12-47
 If we always receive what we expect, the

investment is perfectly predictable -> it is risk free.
 The risk of owning an asset comes from surprise
events.
 The systematic risk is a risk that influences a large
number of assets (such as changes in GDP, inflation,
interest rates...).
 The unsystematic risk is a risk that affects a limited
number of assets (labor strikes, part shortages…).
12-48
 The distinction between two types of risk allows us

to break down the surprise portion of the return
(U) into two part: systematic portion (m) and
unsystematic portion (ɛ).
 Actual return or Total return = E(R) + U
= E(R) + m + ɛ
= P(R) + m + ɛ
12-49
 What are the two basic types of risk?

 What is the distinction between the two types of
risk?
12-50
 Diversification is the process of spreading an

investment across assets (and thereby forming a
portfolio).
 The principle of diversification tells us that
spreading an investment across a number of
assets will eliminate some, but not all, of the risk.
12-51
The standard deviation declines as the numbers of stock is increased
 Diversification can substantially reduce the

variability of returns without an equivalent
reduction in expected returns.
 This reduction in risk arises because worse than
expected returns from one asset are offset by
better than expected returns from another.
 However, there is a minimum level of risk that
cannot be diversified away and that is the
systematic portion.
12-53
13-53
= Unsystematic risk which can be
eliminated by combining assets
12-54
 Total risk = Systematic risk + Unsystematic 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.
 And the expected return on a risky asset depends
only on that asset’s systematic risk since
unsystematic risk can be diversified away.
 Actual return = P(R) + m + ɛ
-> Expected Return E(R) = P(R) + m
12-55
13-55
 What happens to the standard deviation or the

return for a portfolio if we increase the number
of securities in the portfolio?
 What is the principle of diversification?
 Why is some risk diversifiable? Why is some risk
not diversifiable?
 True of False: The expected return on a risky
asset depends on that asset’s total risk. Explain.
12-56
 Systematic risk can be measured by the beta

coefficient.
 The beta coefficient tells us how much systematic risk
a particular asset has relative to an average asset (or
overall market).
 A beta of 1 implies the asset has the same
systematic risk as the overall market.
 A beta < 1 implies the asset has less systematic
risk than the overall market.
 A beta > 1 implies the asset has more systematic
risk than the overall market.
12-57
Insert Table 13.8 here
Assets with larger betas have greater systematic risks, so

they will have greater expected return <- E(R) = P(R) + m
12-58
 A portfolio beta is calculated like a portfolio expected

return.
 Multiply each asset’s beta by its portfolio weight.
 Add the results to get the portfolio beta.
12-59
 Consider the previous example with the following

four securities
Stock Weight Beta
A 13.3% 2.685
B 20.0% 0.195
C 26.7% 2.161
D 40.0% 2.434
 What is the portfolio beta?
12-60
 If the investment is perfectly predictable -> it is risk

free -> P(R) = Risk-free rate = Rf
-> E(R) = P(R) + m = Rf + m
-> m = E(R) – Rf = risk premium
 The risk premium = expected return – risk-free rate.
So the higher the beta, the greater the risk premium
should be.
 If we can define the relationship between the risk
premium and beta, we can estimate the expected
return.
12-61
 Suppose that Asset A has an expected return of

E(RA) = 20% and a beta of A = 1.6. A risk-free
asset has risk-free rate of Rf = 8% and a beta of
zero. Consider a portfolio made up of asset A and
a risk-free asset.
 So we can calculate some following different
possible portfolio expected returns and betas by
varying the percentage invested in these two
assets.
12-62
 E(RA) = 20%, A = 1.6. Rf = 8%, f = 0.
Percentage of portfolio Portfolio Portfolio

in asset A expected return beta
0% 8% 0.0
25% 11% 0.4
50% 14% 0.8
75% 17% 1.2
100% 20% 1.6
11% = 0.25 x 20% + (1 – 0.25) x 8%
0.4 = 0.25 x 1.6 + (1 – 0.25) x 0

a linear relationship between
E(R) 30% beta and expected return
25%
E(RA)
Expected Return
20%
15%
Risk Premium
Rf =
10% Slope = tang α
α
8%
5%
A
0%
0 0.5 1 1.5 2 2.5 3
Beta
 The reward-to-risk ratio is the slope of the line

which displays the relationship between expected
return and beta.
Slope = [E(RA) – Rf ] / A
 Reward-to-risk ratio for previous example =
(20% – 8%) / 1.6 = 7.5%
-> Asset A has a risk premium of 7.5% per “unit” of
systematic risk.
12-65
 In equilibrium, in a active, competitive, well-

organized market, all assets and portfolios
must have the same reward-to-risk ratio, and
they all must equal the reward-to-risk ratio for
the market
E ( RA )  R f E ( RM )  R f

A M
12-66
 The security market line (SML) is a positive sloped

straight line displaying the relationship between
expected return and beta.
 The slope of the SML is the reward-to-risk ratio:
[E(RM) – Rf ] / M
 Because M =1 -> Slope = E(RM) – Rf
= Market risk premium
12-67
 If we let E(Ri) and i stand for the expected

return and beta on any asset in the market, its
reward-to-risk ratio is the same as the overall
market’s.
E ( Ri )  R f
 E ( RM )  Rf
i
12-68
 If we rearrange this, we can get the equation for

the SML or Capital asset pricing model (CAPM)
E ( R i)  R f  [ E ( R M )  R f ) ] x  i
 Or
RP = Risk Premium
E(Ri) = Rf + m = Rf + RPi
RPi / i = RPM / M
-> M = 1 -> RPi = RPM x i
-> E(Ri) = Rf + RPM x i
12-69
 The CAPM shows that the expected return for a

particular asset depends on:
 The pure time value of money: measured by the
risk-free rate, Rf.
 The reward for bearing systematic risk: measured
by the market risk premium, E(RM) – Rf
 The amount of systematic risk: measured by beta, 
12-70
 Consider the betas for each of the assets given

earlier. If the risk-free rate is 4.15% and the market
risk premium is 8.5%.
Stock Beta_____
A 2.685
B 0.195
C 2.161
D 2.434
 What is the expected return for each?
12-71
 What does a beta coefficient measure?

 How do we calculate a portfolio beta?
 What is the fundamental relationship between risk
and return in well-functioning market?
 What is the security market line? Why must all
assets plot directly on it in a well-functioning
market?
 What is the capital asset pricing model? What does
it tell us about the required return on a risky
investment?
12-72
Summary and Conclusions
 Risky assets, on average, earn a risk premium.

There is a reward for bearing risk.
 In an efficient market, prices adjust quickly and
correctly to new information. So, asset prices are
rarely too high or too low.
 The total risk associated with an asset has two
parts: systematic risk and unsystematic risk. Only
systematic risk is rewarded so the risk premium on
an asset is given by its beta multiplied by the
market risk premium, [E(RM) – Rf ] x i
12-73
HOMEWORKS
Concepts review:
Chapter 12: 1, 2, 3, 4, 5, 6, 7.
Chapter 13: 1, 2, 3, 5, 6, 8.
Question and Problems:

Chapter 12: 1, 2, 5, 7, 9, 15.
Chapter 13: 1, 2, 5, 7, 10, 11, 13, 19, 20.
7-74

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CORPORATE FINANCE 2

 Full name: Phan, Hong Mai

Ross et al. (2019), Fundamentals of Corporate Finance,

Session Chapter Number of period

Session Chapter Number of period

 PhD, Phan Hong Mai

 What are the two parts of total return?

The Importance of Financial Markets:

The Importance of Financial Markets:

Lessons from capital market history:

 Treasury bills are considered to be risk-free

 Variance measures the average squared difference

* Using historical data

 Standard deviation is the square root of the

-> The bigger these numbers are, the more the

 Suppose a particular investment had returns of

 What do we mean by risk premium?

 Arithmetic average – return earned in an average

 What is the arithmetic and geometric average for

Arithmetic vs. Geometric mean, Which is better?

 If you wanted to forecast what the stock market

Common Misconceptions about Efficient market

Strong Form Efficiency:

Semi-strong Form Efficiency:

Weak Form Efficiency:

 What is an efficient market?

 Suppose you have predicted the following returns

State Probability Stock C Stock T

Steps to compute variance and standard

 Suppose you have predicted the following returns

State Probability Stock C Stock T

 How do we calculate the expected return on a

 A portfolio is a collection of assets

Portfolio Expected Returns:

 The expected return can be also found by finding

Portfolio expected returns:

 What is the expected return for the portfolio?

 Invest your money in following equally weighted

Portfolio Variance and Deviation:

 Invest your money in following equally weighted

 What is a portfolio weight?

 Announcements and news contain both an expected

 If we always receive what we expect, the

 The distinction between two types of risk allows us

 What are the two basic types of risk?

 Diversification is the process of spreading an

 Diversification can substantially reduce the

 Total risk = Systematic risk + Unsystematic risk

 What happens to the standard deviation or the

 Systematic risk can be measured by the beta

Assets with larger betas have greater systematic risks, so

 A portfolio beta is calculated like a portfolio expected

 Consider the previous example with the following

 If the investment is perfectly predictable -> it is risk

 Suppose that Asset A has an expected return of

Percentage of portfolio Portfolio Portfolio

11% = 0.25 x 20% + (1 – 0.25) x 8%

0.4 = 0.25 x 1.6 + (1 – 0.25) x 0

 The reward-to-risk ratio is the slope of the line

 In equilibrium, in a active, competitive, well-

 The security market line (SML) is a positive sloped

 If we let E(Ri) and i stand for the expected