Lecture note 6

Risk and Return

 Risk and Return: Insights from 86
Years of Investor History
• How would $100 have grown if it were placed in
one of the following investments?
– Standard & Poor’s 500: 90 U.S. stocks up to
1957 and 500 after that. Leaders in their
industries and among the largest firms traded
on U.S. markets.
– Small stocks: Securities traded on the NYSE
with market capitalizations in the bottom 20%.
– World Portfolio: International stocks from all
the world’s major stock markets in North
America, Europe, and Asia.
– Corporate Bonds: Long-term, AAA-rated U.S.
corporate bonds with maturities of
approximately 20 years.
– Treasury Bills: An investment in three-month
Treasury bills.
 Value of $100 Invested at the End of
1925

Source: Chicago Center for Research in Security Prices, Standard and Poor’s, MSCI, and Global
Financial Data.
• Small stocks had the highest long-term returns,
while T-Bills had the lowest long-term returns.
• Small stocks had the largest fluctuations in price,
while T-Bills had the lowest.
– Higher risk requires a higher return.
• Few people ever make an investment for 86
years.
• More realistic investment horizons and different
initial investment dates can greatly influence
each investment's risk and return.
Value of $100 Invested for Alternative
Investment Horizons
Common Measures of Risk and Return

• Probability Distributions
– When an investment is risky, there are
different returns it may earn. Each possible
return has some likelihood of occurring. This
information is summarized with a probability
distribution, which assigns a probability, PR ,
that each possible return, R , will occur.
• Assume BFI stock currently trades for $100
per share. In one year, there is a 25%
chance the share price will be $140, a 50%
chance it will be $110, and a 25% chance it
will be $80.
Probability Distribution of Returns for
BFI
 Expected Return

• Expected (Mean) Return

– Calculated as a weighted average of the
possible returns, where the weights
correspond to the probabilities.

Expected Return = E [ R] = å R
PR ´ R

E [ RBFI ] = 25%( - 0.20) + 50%(0.10) + 25%(0.40)

= 10%
 Variance and Standard Deviation

• Variance
– The expected squared deviation from the
mean
Var (R) = E ( R - E [ R ]) ù =
é
å PR ´ ( R - E [ R ])
2 2

ë û R

• Standard Deviation
– The square root of the variance
SD( R) = Var ( R)
• Both are measures of the risk of a probability
distribution
• For BFI, the variance and standard deviation are:
Var [ RBFI ]
= 25% ´ ( - 0.20 - 0.10) + 50% ´ (0.10 - 0.10)
2 2

+ 25% ´ (0.40 - 0.10) 2 = 0.045

SD( R) = Var ( R) = 0.045 = 21.2%
• In finance, the standard deviation of a return is also
referred to as its volatility. The standard deviation is
easier to interpret because it is in the same units as
the returns themselves.
Historical Returns of Stocks and Bonds

• Computing Historical Returns

– Realized Return
• The return that actually occurs over a
particular time period.

𝐷𝑖𝑣! " # + 𝑃! " #

𝑅! " # = − 1
𝑃!
!"#! " # $! " # % $!
= +
$! $!
= Dividend Yield + Capital Gain Rate
• Computing Historical Returns
– If you hold the stock beyond the date of the
first dividend, then to compute your return you
must specify how you invest any dividends
you receive in the interim. Let’s assume that
all dividends are immediately reinvested and
used to purchase additional shares of the
same stock or security.
• Computing Historical Returns
– If a stock pays dividends at the end of each
quarter, with realized returns RQ1, . . . ,RQ4
each quarter, then its annual realized return,
Rannual, is computed as:

1 + Rannual
= (1 + RQ1 )(1 + RQ 2 )(1 + RQ3 )(1 + RQ 4 )
Realized Return for the S&P 500,
Microsoft, and Treasury Bills,
2001–2011
• Computing Historical Returns
– By counting the number of times a realized
return falls within a particular range, we can
estimate the underlying probability
distribution.
– Empirical Distribution
• When the probability distribution is plotted
using historical data
 The Empirical Distribution of Annual
Returns for U.S. Large Stocks (S&P 500), Small Stocks, Corporate
Bonds, and Treasury Bills, 1926–2011
 Average Annual Returns for U.S. Small
Stocks, Large Stocks (S&P 500), Corporate
Bonds, and Treasury Bills, 1926–2011
 Average Annual Return
1 1 T
R =
T
( R1 + R2 +  + RT ) = å
T t =1
Rt

– Where Rt is the realized return of a security in

year t, for the years 1 through T
• Using the data from Table 10.2, the average
annual return for the S&P 500 from 2002 to
2011 is:
1
𝑅8 = (−0.221+ 0.287 + 0.109+0.049 + 0.158
10
+ 0.055 − 0.37 + 0.265+0.151 + 0.021) = 5.04%
 The Variance and Volatility of Returns

• Variance Estimate Using Realized Returns

T
1
å (R - R)
2
Var (R) = t
T - 1 t =1

– The estimate of the standard deviation is the

square root of the variance.
Volatility of U.S. Small Stocks, Large Stocks
(S&P 500), Corporate Bonds, and Treasury
Bills, 1926–2011
Estimation Error: Using Past Returns to
Predict the Future
• We can use a security’s historical average return
to estimate its actual expected return. However,
the average return is just an estimate of the
expected return.
– Standard Error
• A statistical measure of the degree of
estimation error
• Standard Error of the Estimate of the Expected
Return
SD(Average of Independent, Identical Risks)
SD(Individual Risk)
=
Number of Observations

• 95% Confidence Interval

Historical Average Return ± (2 ´ Standard Error)
– For the S&P 500 (1926–2004)
æ 20.36% ö
12.3% ± 2 ç ÷ = 12.3% ± 4.6%
è 79 ø
• Or a range from 7.7% to 19.9%
 The Historical Tradeoff
Between Risk and Return
• The Returns of Large Portfolios
– Excess Returns
• The difference between the average return
for an investment and the average return
for T-Bills
Volatility Versus Excess Return of U.S. Small
Stocks, Large Stocks (S&P 500), Corporate
Bonds, and Treasury Bills, 1926–2011
The Historical Tradeoff Between Risk and Return in
Large Portfolios

Source: CRSP, Morgan Stanley Capital International

 The Returns of Individual Stocks

• Is there a positive relationship between volatility

and average returns for individual stocks?
– As shown on the next slide, there is no
precise relationship between volatility and
average return for individual stocks.
• Larger stocks tend to have lower volatility
than smaller stocks.
• All stocks tend to have higher risk and
lower returns than large portfolios.
Historical Volatility and Return for 500 Individual
Stocks, Ranked Annually by Size
 Common Versus Independent Risk

• Common Risk
– Risk that is perfectly correlated
• Risk that affects all securities
• Independent Risk
– Risk that is uncorrelated
• Risk that affects a particular security
• Diversification
– The averaging out of independent risks in a
large portfolio
 Diversification in Stock Portfolios

• Firm-Specific Versus Systematic Risk

– Firm Specific News
• Good or bad news about an individual
company
– Market-Wide News
• News that affects all stocks, such as news
about the economy
– Independent Risks
• Due to firm-specific news
–Also known as:
»Firm-Specific Risk
»Idiosyncratic Risk
»Unique Risk
»Unsystematic Risk
»Diversifiable Risk
– Common Risks
• Due to market-wide news
–Also known as:
»Systematic Risk
»Undiversifiable Risk
»Market Risk
– When many stocks are combined in a large
portfolio, the firm-specific risks for each stock
will average out and be diversified.
– The systematic risk, however, will affect all
firms and will not be diversified.
– Consider two types of firms:
• Type S firms are affected only by
systematic risk. There is a 50% chance the
economy will be strong and type S stocks
will earn a return of 40%; There is a 50%
change the economy will be weak and their
return will be –20%. Because all these
firms face the same systematic risk, holding
a large portfolio of type S firms will not
diversify the risk.
– Consider two types of firms:
• Type I firms are affected only by firm-
specific risks. Their returns are equally
likely to be 35% or –25%, based on factors
specific to each firm’s local market.
Because these risks are firm specific, if we
hold a portfolio of the stocks of many type I
firms, the risk is diversified.
– Actual firms are affected by both market-wide
risks and firm-specific risks. When firms carry
both types of risk, only the unsystematic risk
will be diversified when many firm’s stocks are
combined into a portfolio. The volatility will
therefore decline until only the systematic risk
remains.
 Volatility of Portfolios
of Type S and I Stocks
 No Arbitrage and the Risk Premium

• The risk premium for diversifiable risk is zero, so

investors are not compensated for holding firm-
specific risk.
– If the diversifiable risk of stocks were
compensated with an additional risk premium,
then investors could buy the stocks, earn the
additional premium, and simultaneously
diversify and eliminate the risk.
– By doing so, investors could earn an
additional premium without taking on
additional risk. This opportunity to earn
something for nothing would quickly be
exploited and eliminated. Because investors
can eliminate firm-specific risk “for free” by
diversifying their portfolios, they will not
require or earn a reward or risk premium for
holding it.
• The risk premium of a security is determined by
its systematic risk and does not depend on its
diversifiable risk.
– This implies that a stock’s volatility, which is a
measure of total risk (that is, systematic risk
plus diversifiable risk), is not especially useful
in determining the risk premium that investors
will earn.
• Standard deviation is not an appropriate
measure of risk for an individual security. There
should be no clear relationship between volatility
and average returns for individual securities.
Consequently, to estimate a security’s expected
return, we need to find a measure of a security’s
systematic risk.
 The Expected Return of a Portfolio

• Portfolio Weights
– The fraction of the total investment in the
portfolio held in each individual investment in
the portfolio
• The portfolio weights must add up to 1.00
or 100%.

Value of investment i
xi =
Total value of portfolio
• Then the return on the portfolio, Rp , is the
weighted average of the returns on the
investments in the portfolio, where the weights
correspond to portfolio weights.

RP = x1R1 + x2 R2 +  + xn Rn
= å xR
i i i
• The expected return of a portfolio is the
weighted average of the expected returns of the
investments within it.

𝐸 𝑅$ = 𝐸 H 𝑥% 𝑅%
%
= ∑! 𝐸 𝑥! 𝑅!
= H 𝑥% 𝐸 𝑅%
%
 The Volatility of a Two-Stock Portfolio

• Combining Risks
Returns for Three Stocks, and Portfolios of Pairs of
Stocks
• Combining Risks
– While the three stocks in the previous table
have the same volatility and average return,
the pattern of their returns differs.
• For example, when the airline stocks
performed well, the oil stock tended to do
poorly, and when the airlines did poorly, the
oil stock tended to do well.
• Combining Risks
– Consider the portfolio which consists of equal
investments in West Air and Tex Oil. The
average return of the portfolio is equal to the
average return of the two stocks
– However, the volatility of 5.1% is much less
than the volatility of the two individual stocks.
• Combining Risks
– By combining stocks into a portfolio, we
reduce risk through diversification.
– The amount of risk that is eliminated in a
portfolio depends on the degree to which the
stocks face common risks and their prices
move together.
 Determining Covariance and
Correlation
• To find the risk of a portfolio, one must
know the degree to which the stocks’ returns
move together.
• Covariance
– The expected product of the deviations of two
returns from their means
– Covariance between Returns Ri and Rj
Cov(Ri ,R j ) = E[(Ri - E[ Ri ]) (R j - E[ R j ])]

– Estimate of the Covariance from Historical

Data
1
Cov(Ri ,R j ) =
T - 1
å t
(Ri ,t - Ri ) (R j ,t - R j )

– If the covariance is positive (negative), the

two returns tend to move together (in opposite
directions).
• Correlation
– A measure of the common risk shared by
stocks that does not depend on their volatility
Cov(Ri ,R j )
Corr (Ri ,R j ) =
SD (Ri ) SD (R j )

• The correlation between two stocks will

always be between –1 and +1.
Correlation
 Computing the Covariance and
Correlation Between Pairs of Stocks
Historical Annual Volatilities and
Correlations for Selected Stocks
 Computing a Portfolio’s Variance
and Volatility
• For a two security portfolio:

Var (RP ) = Cov(RP ,RP )

= Cov(x1 R1 + x2 R2 ,x1 R1 + x2 R2 )
= x1 x1Cov(R1 ,R1 ) + x1 x2Cov(R1 ,R2 )
+ x2 x1Cov(R2 ,R1 ) + x2 x2Cov(R2 ,R2 )
– The Variance of a Two-Stock Portfolio
Var (RP )
= x12Var (R1 ) + x22Var (R2 ) + 2 x1 x2Cov(R1 ,R2 )
 The Volatility of a Large Portfolio

• The variance of a portfolio is equal to the

weighted average covariance of each stock
with the portfolio:
Var (RP ) = Cov(RP ,RP ) = Cov ( å x R ,R )
i i i P

= å x Cov( R ,R
i i i P )
which reduces to:

Var (RP ) = å x Cov( R ,R ) = å x Cov( R ,S x R )

i i i P i i i j j j

= å å x x Cov( R ,R )
i j i j i j
 Diversification with an Equally
Weighted Portfolio
• Equally Weighted Portfolio
– A portfolio in which the same amount is
invested in each stock
• Variance of an Equally Weighted Portfolio
of n Stocks
1
Var ( RP ) = (Average Variance of the Individual Stocks)
n
æ 1ö
+ ç1 - ÷ (Average Covariance between the Stocks)
è nø
Var ( RP )
1
= 2 ´ n ´ (Average Variance of the Individual Stocks)
n
1
+ 2 ´ n ´ ( n - 1) ´ (Average Covariance between the Stocks)
n
1
= ´ (Average Variance of the Individual Stocks)
n
æ 1ö
+ ç1 - ÷ ´ (Average Covariance between the Stocks)
è nø
• The historical volatility of the return of a typical
large firm in the stock market is about 40%.
• The typical correlation between the returns of
large firms is about 25%.
• The volatility of an equally weighted portfolio
of n stocks is:

1 &
1
𝑆𝐷 𝑅$ = (0.4) + 1 − 0.25×0.4×0.4
𝑛 𝑛
 Volatility of an Equally Weighted
Portfolio Versus the Number of Stocks
 Diversification with General Portfolios

• For a portfolio with arbitrary weights, the

standard deviation is calculated as:
– Volatility of a Portfolio with Arbitrary Weights

𝑉𝑎𝑟 𝑅$ = 𝐶𝑜𝑣 𝑅$ , 𝑅$

= 𝐶𝑜𝑣 ∑% 𝑥% 𝑅% , 𝑅$

= ∑% 𝑥% 𝐶𝑜𝑣(𝑅% , 𝑅$ )
𝑉𝑎𝑟(𝑅$ ) = H 𝑥% 𝐶𝑜𝑣(𝑅% , 𝑅$ )
%
𝑆𝐷(𝑅$ )& = H 𝑥% ×𝑆𝐷 𝑅% ×𝑆𝐷 𝑅$ ×𝐶𝑜𝑟𝑟 𝑅% , 𝑅$
%
Security i’s contribution to the
volatility of the portfolio

Þ SD( RP ) = å i
xi ´ SD( Ri ) ´ Corr ( Ri ,R p )
­ ­ ­
Amount Total Fraction of i’s
of i held risk of i risk that is
common to P
• Unless all of the stocks in a portfolio have a
perfect positive correlation of +1 with one
another, the risk of the portfolio will be lower
than the weighted average volatility of the
individual stocks:

SD( RP ) = å x SD( R ) Corr (R ,R )

i i i i p

< å x SD( R )
i i i
 Risk Versus Return:
Choosing an Efficient Portfolio
• Efficient Portfolios with Two Stocks
– Identifying Inefficient Portfolios
• In an inefficient portfolio, it is possible to
find another portfolio that is better in terms
of both expected return and volatility.
– Identifying Efficient Portfolios
• In an efficient portfolio, there is no way to
reduce the volatility of the portfolio without
lowering its expected return.
• Efficient Portfolios with Two Stocks
– Consider a portfolio of Intel and Coca-Cola
Expected Returns and Volatility for Different
Portfolios of Two Stocks
 Volatility Versus Expected Return for
Portfolios of Intel and Coca-Cola Stock
• Efficient Portfolios with Two Stocks
– Consider investing 100% in Coca-Cola stock.
As shown in on the previous slide, other
portfolios—such as the portfolio with 20% in
Intel stock and 80% in Coca-Cola stock—
make the investor better off in two ways: It
has a higher expected return, and it has lower
volatility. As a result, investing solely in Coca-
Cola stock is inefficient.
 The Effect of Correlation

• Correlation has no effect on the expected return

of a portfolio. However, the volatility of the
portfolio will differ depending on the correlation.
• The lower the correlation, the lower the volatility
we can obtain. As the correlation decreases, the
volatility of the portfolio falls.
• The curve showing the portfolios will bend to
the left to a greater degree as shown on the
next slide.
Effect on Volatility and Expected Return of Changing the
Correlation between Intel and Coca-Cola Stock
Var (RP ) = xI ´ 0.5 + (1 - xI ) ´ 0.25
2 2 2 2

- 2 ´ xI ´ (1 - xI ) ´ 0.5 ´ 0.25

(x ´ 0.5 - (1 - xI ) ´ 0.25 )
2
= I

Var (RP ) = 0 Þ xI = 1 / 3
 Short Sales

• Long Position
– A positive investment in a security
• Short Position
– A negative investment in a security
– In a short sale, you sell a stock that you do
not own and then buy that stock back in the
future.
– Short selling is an advantageous strategy if
you expect a stock price to decline in the
future.
Portfolios of Intel and Coca-Cola Allowing
for Short Sales
 Efficient Portfolios with Many Stocks

• Consider adding Bore Industries to the two stock

portfolio:

• Although Bore has a lower return and the same

volatility as Coca-Cola, it still may be beneficial
to add Bore to the portfolio for the diversification
benefits.
Expected Return and Volatility for Selected Portfolios of
Intel, Coca-Cola, and Bore Industries Stocks
The Volatility and Expected Return for All Portfolios of Intel,
Coca-Cola, and Bore Stock
 Risk Versus Return: Many Stocks

• The efficient portfolios, those offering the highest

possible expected return for a given level of
volatility, are those on the northwest edge of the
shaded region, which is called the efficient
frontier for these three stocks.
– In this case none of the stocks, on its own, is
on the efficient frontier, so it would not be
efficient to put all our money in a single stock.
Efficient Frontier with Ten Stocks Versus
Three Stocks
 Risk-Free Saving and Borrowing

• Risk can also be reduced by investing a portion

of a portfolio in a risk-free investment, like T-
Bills. However, doing so will likely reduce the
expected return.
• On the other hand, an aggressive investor who
is seeking high expected returns might decide
to borrow money to invest even more in the
stock market.
 Investing in Risk-Free Securities

• Consider an arbitrary risky portfolio and the

effect on risk and return of putting a fraction of
the money in the portfolio, while leaving the
remaining fraction in risk-free Treasury bills.
– The expected return would be:

E [RxP ] = (1 - x)rf + xE[RP ]

= rf + x (E[RP ] - rf )
 • The standard deviation of the portfolio would be
calculated as:

SD[RxP ] = (1 - x)2Var (rf ) + x 2Var (RP ) + 2(1 - x)xCov(rf ,RP )

= x 2Var (RP ) 0
= xSD(RP )

– Note: The standard deviation is only a fraction

of the volatility of the risky portfolio, based on
the amount invested in the risky portfolio.
 – The expected return of the portfolio is:

𝐸[𝑅'$ ] = (1 − 𝑥)𝑟( + 𝑥𝐸[𝑅$ ]

= 𝑟( + 𝑥(𝐸[𝑅$ ] − 𝑟( )

• The standard deviation of the portfolio is:

𝑆𝐷 𝑅'$ = 𝑥𝑆𝐷 𝑅$
)[+! ]- ."
⟹ 𝐸[𝑅'$ ] = 𝑟( + × 𝑆𝐷 𝑅'$
/0[+! ]
The Risk–Return Combinations from Combining a
Risk-Free Investment and a Risky Portfolio
 Borrowing and Buying Stocks on
Margin
• Buying Stocks on Margin
– Borrowing money to invest in a stock.
– A portfolio that consists of a short position in
the risk-free investment is known as a levered
portfolio. Margin investing is a risky
investment strategy.
 Identifying the Tangent Portfolio

• To earn the highest possible expected return for

any level of volatility we must find the portfolio
that generates the steepest possible line when
combined with the risk-free investment.
The Tangent or Efficient Portfolio
 • Sharpe Ratio
– Measures the ratio of reward-to-volatility
provided by a portfolio
Portfolio Excess Return E[RP ] - rf
Sharpe Ratio = =
Portfolio Volatility SD( RP )
– The portfolio with the highest Sharpe ratio is
the portfolio where the line with the risk-free
investment is tangent to the efficient frontier of
risky investments. The portfolio that generates
this tangent line is known as the tangent
portfolio.
The Tangent or Efficient Portfolio
• Combinations of the risk-free asset and the
tangent portfolio provide the best risk and return
tradeoff available to an investor.
– This means that the tangent portfolio is
efficient and that all efficient portfolios are
combinations of the risk-free investment and
the tangent portfolio. Every investor should
invest in the tangent portfolio independent of
his or her taste for risk.
• An investor’s preferences will determine only
how much to invest in the tangent portfolio
versus the risk-free investment.
– Conservative investors will invest a small
amount in the tangent portfolio.
– Aggressive investors will invest more in the
tangent portfolio.
– Both types of investors will choose to hold the
same portfolio of risky assets, the tangent
portfolio, which is the efficient portfolio.
The Tangent or Efficient Portfolio
 The Efficient Portfolio
and Required Returns
• Portfolio Improvement: Beta and the Required
Return
– Assume there is a portfolio of risky securities,
P. To determine whether P has the highest
possible Sharpe ratio, consider whether its
Sharpe ratio could be raised by adding more
of some investment i to the portfolio.
– The contribution of investment i to the
volatility of the portfolio depends on the risk
that i has in common with the portfolio, which
is measured by i’s volatility multiplied by its
correlation with P.
 Security i’s contribution to the
volatility of the portfolio

SD( RP ) = å i
xi ´ SD( Ri ) ´ Corr ( Ri ,R p )
­ ­ ­
Amount Total Fraction of i’s
of i held risk of i risk that is
common to P

– If you were to purchase more of investment i

by borrowing, you would earn the expected
return of i minus the risk-free return. Thus
adding i to the portfolio P will improve our
Sharpe ratio if:
E[RP ] - rf
E [Ri ] - rf > SD(Ri ) ´ Corr (Ri ,RP ) ´
    SD(RP )
Additional return Incremental volatility 
from investment i from investment i Return per unit of volatilty
available from portfolio P
• Portfolio Improvement: Beta and the Required
Return
– Beta of Investment i with Portfolio P

SD(Ri ) ´ Corr (Ri ,RP )

bP
i =
SD(RP )
• Portfolio Improvement: Beta and the Required
Return
– Increasing the amount invested in i will
increase the Sharpe ratio of portfolio P if its
expected return E[Ri] exceeds the required
return ri , which is given by:

ri = rf + b ´ (E[ RP ] - rf )
P
i
• Portfolio Improvement: Beta and the Required
Return
– Required Return of i
• The expected return that is necessary to
compensate for the risk investment i will
contribute to the portfolio.
 Expected Returns
and the Efficient Portfolio
• Expected Return of a Security

E[ Ri ] = ri º rf + b i
eff
´ (E[ Reff ] - rf )
– A portfolio is efficient if and only if the
expected return of every available security
equals its required return.
(cont'd)
 Sharpe Ratio and Required Return for
Different Investments in the Real Estate
Fund
𝑥+1 = 4%
𝐸 𝑅$ = 15% + 4% 9% − 3% = 15.24%
Var 𝑅$
= 0.04& ×0.35& + 2×0.04×0.1×0.2×0.35 + 0.2&
= 0.040756
SD 𝑅$ = 20.19%
15.24% − 3%
𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = = 0.6063
20.19%
 0.04& ×0.35& + 0.1×0.2×0.35
Corr 𝑅+1 , 𝑅$ =
0.35×0.2019
= 0.1684
$
0.35×0.1684
𝛽+1 = = 0.2919
0.2019
𝑟+1 = 3% + 0.2919 15.24% − 3% = 6.57%
 The Capital Asset Pricing Model

• The Capital Asset Pricing Model (CAPM) allows

us to identify the efficient portfolio of risky assets
without having any knowledge of the expected
return of each security.
• Instead, the CAPM uses the optimal choices
investors make to identify the efficient portfolio
as the market portfolio, the portfolio of all stocks
and securities in the market.
 The CAPM Assumptions

• Three Main Assumptions

– Assumption 1
• Investors can buy and sell all securities at
competitive market prices (without incurring
taxes or transactions costs) and can borrow
and lend at the risk-free interest rate.
• Three Main Assumptions
– Assumption 2
• Investors hold only efficient portfolios of
traded securities—portfolios that yield the
maximum expected return for a given level
of volatility.
• Three Main Assumptions
– Assumption 3
• Investors have homogeneous
expectations regarding the volatilities,
correlations, and expected returns of
securities.
• Homogeneous Expectations
–All investors have the same estimates
concerning future investments and
returns.
Supply, Demand, and the Efficiency of
the Market Portfolio
• Given homogeneous expectations, all investors
will demand the same efficient portfolio of
risky securities.
• The combined portfolio of risky securities of all
investors must equal the efficient portfolio.
• Thus, if all investors demand the efficient
portfolio, and the supply of securities is the
market portfolio, the demand for market portfolio
must equal the supply of the market portfolio.
 Optimal Investing:
The Capital Market Line
• When the CAPM assumptions hold, an optimal
portfolio is a combination of the risk-free
investment and the market portfolio.
– When the tangent line goes through the
market portfolio, it is called the capital
market line (CML).
• The expected return and volatility of a capital
market line portfolio are:
E [RxCML ] = (1 - x)rf + xE[RMkt ]
= rf + x(E [RMkt ] - rf )
SD(RxCML ) = xSD(RMkt )
E [RMkt ] - rf
E [RxCML ] = rf + SD ( RxCML ) ´
SD ( RMkt )
The Capital Market Line
 Determining the Risk Premium

• Market Risk and Beta

– Given an efficient market portfolio, the
expected return of an investment is:

E[Ri ] = ri = rf + b (E[RMkt ] - rf ) i
Mkt
 
Risk premium for security i

– The beta is defined as:

Volatility of i that is common with the market
 
SD(Ri ) ´ Corr (Ri ,RMkt ) Cov(Ri ,RMkt )
b i
Mkt
º bi = =
SD(RMkt ) Var (RMkt )
 The Security Market Line

• There is a linear relationship between a stock’s

beta and its expected return (See figure on next
slide). The security market line (SML) is
graphed as the line through the risk-free
investment and the market.
– According to the CAPM, if the expected return
and beta for individual securities are plotted,
they should all fall along the SML.
The Capital Market Line and the
Security Market Line
The Capital Market Line and the
Security Market Line, panel (a)
The Capital Market Line and the
Security Market Line, panel (b)
• Beta of a Portfolio
– The beta of a portfolio is the weighted
average beta of the securities in the portfolio.

bP =
Cov(RP ,RMkt )
=
(
Cov å i xi Ri ,RMkt )
Var (RMkt ) Var (RMkt )
Cov(Ri ,RMkt )
= å i xi = å xb i i
Var (RMkt ) i
 Summary of the Capital Asset
Pricing Model
• The market portfolio is the efficient portfolio.
• The risk premium for any security is proportional
to its beta with the market.
 The Equity Cost of Capital

• The Capital Asset Pricing Model (CAPM) is a

practical way to estimate.
• The cost of capital of any investment opportunity
equals the expected return of available
investments with the same beta.
• The estimate is provided by the Security Market
Line equation:
ri =rf +b i ´ (E[RMkt ]-rf )
Risk Premium for Security i
 The Market Portfolio

• Constructing the market portfolio

• Market Capitalization
– The total market value of a firm’s outstanding
shares
MVi = (Number of Shares of i Outstanding) ´ (Price of i per Share)
= Ni ´ Pi
• Value-Weighted Portfolio
– A portfolio in which each security is held in
proportion to its market capitalization

Market Value of i
xi =
Total Market Value of All Securities
MVi
=
å j MV j
 Value-Weighted Portfolios

• A value-weighted portfolio is an equal-ownership

portfolio; it contains an equal fraction of the total
number of shares outstanding of each security in
the portfolio.
• Passive Portfolio
– A portfolio that is not rebalanced in response
to price changes.
 Market Indexes

• Report the value of a particular portfolio of

securities.
• Examples:
– S&P 500
• A value-weighted portfolio of the 500
largest U.S. stocks
– Dow Jones Industrial Average (DJIA)
• A price weighted portfolio of 30 large
industrial stocks
• Most practitioners use the S&P 500 as the
market proxy, even though it is not actually the
market portfolio.
 The Market Risk Premium

• Determining the Risk-Free Rate

– The yield on U.S. Treasury securities
– Surveys suggest most practitioners use 10 to
30 year treasuries
• The Historical Risk Premium
– Estimate the risk premium (E[RMkt]-rf) using
the historical average excess return of the
market over the risk-free interest rate
Historical Excess Returns of the S&P 500
Compared to One-Year and Ten-Year U.S.
Treasury Securities
 Beta Estimation

• Estimating Beta from Historical Returns

– Recall, beta is the expected percent change in
the excess return of the security for a 1% change
in the excess return of the market portfolio.
– Consider Cisco Systems stock and how it
changes with the market portfolio.
Monthly Returns for Cisco Stock and for the
S&P 500, 2000-2012
Scatterplot of Monthly Excess Returns for
Cisco Versus the S&P 500, 2000-2012
• Estimating Beta from Historical Returns
– As the scatterplot on the previous slide
shows, Cisco tends to be up when the market
is up, and vice versa.
– We can see that a 10% change in the
market’s return corresponds to about a 16%
change in Cisco’s return.
• Thus, Cisco’s return moves about two for
one with the overall market, so Cisco’s beta
is about 1.6.
• Estimating Beta from Historical Returns
– Beta corresponds to the slope of the best-
fitting line in the plot of the security’s excess
returns versus the market excess return.
 Using Linear Regression
– The statistical technique that identifies the
best-fitting line through a set of points.αi is the
intercept term of the regression.
(Ri - rf ) = a i + bi (RMkt - rf ) + e i
• βi(RMkt – rf) represents the sensitivity of the
stock to market risk. When the market’s
return increases by 1%, the security’s
return increases by βi%.
• εi is the error term and represents the
deviation from the best-fitting line and is
zero on average.
 – Since E[εi] = 0:

E[Ri ] = rf + bi ( E[RMkt ] - rf ) + a
   i
Expected return for i from the SML Distance above / below the SML

• αi represents a risk-adjusted performance

measure for the historical returns.
–If αi is positive, the stock has performed
better than predicted by the CAPM.
–If αi is negative, the stock’s historical
return is below the SML.
– Given data for rf , Ri , and RMkt , statistical
packages for linear regression can estimate
βi.
• A regression for Cisco using the monthly
returns for 1996–2009 indicates the
estimated beta is 1.80.
• The estimate of Cisco’s alpha from the
regression is 1.2%.
 The Debt Cost of Capital

• Debt Yields
– Yield to maturity is the IRR an investor will
earn from holding the bond to maturity and
receiving its promised payments.
– If there is little risk the firm will default, yield to
maturity is a reasonable estimate of investors’
expected rate of return.
– If there is significant risk of default, yield to
maturity will overstate investors’ expected
return.
• Consider a one-year bond with YTM of y. For
each $1 invested in the bond today, the issuer
promises to pay $(1+y) in one year.
• Suppose the bond will default with probability p,
in which case bond holders receive only $(1+y-
L), where L is the expected loss per $1 of debt in
the event of default.
• So the expected return of the bond is:
rd = (1 – p)y + p(y – L)
= y – pL
= Yield to Maturity – Prob(default)
X Expected Loss Rate

• The importance of the adjustment depends on

the riskiness of the bond.
Annual Default Rates by Debt Rating
(1983–2011)
• The average loss rate for unsecured debt is
60%.
• According to Table 12.2, during average times
the annual default rate for B-rated bonds is
5.5%.
• So the expected return to B-rated bondholders
during average times is 0.055X0.60=3.3% below
the bond’s quoted yield.
• Debt Betas
– Alternatively, we can estimate the debt cost of
capital using the CAPM.
– Debt betas are difficult to estimate because
corporate bonds are traded infrequently.
– One approximation is to use estimates of
betas of bond indices by rating category.
Average Debt Betas by Rating and
Maturity
 A Project’s Cost of Capital

• All-equity comparables
– Find an all-equity financed firm in a single line
of business that is comparable to the project.
– Use the comparable firm’s equity beta and
cost of capital as estimates
• Levered firms as comparables
Using a Levered Firm as a Comparable
for a Project’s Risk
• Asset (unlevered) cost of capital
– Expected return required by investors to hold
the firm’s underlying assets.
– Weighted average of the firm’s equity and
debt costs of capital

E D
rU = rE + rD
E+D E+D
• Asset (unlevered) beta

E D
βU = βE + βD
E+D E+D
 Cash and Net Debt

• Some firms maintain high cash balances

• Cash is a risk-free asset that reduces the
average risk of the firm’s assets
• Since the risk of the firm’s enterprise value is
what we’re concerned with, leverage should be
measured in terms of net debt.

Net Debt = Debt – Excess Cash and short-term

investments
 Industry Asset Betas

• We can combine estimates of asset betas for

multiple firms in the same industry
• Doing this will reduce the estimation error of the
estimated beta for the project.
 Industry Asset Betas (2012)

Source: Author calculations based on data from CapitalIQ.

 Project Risk Characteristics and
Financing
• Differences in project risk
– Firm asset betas reflect market risk of the
average project in a firm.
– Individual projects may be more or less
sensitive to market risk.
• For example, 3M has both healthcare and
computer display and graphics divisions.
• 3M’s own asset beta represents an average of
the risk of these and 3M’s other divisions.
• Financial managers in multi-divisional firms
should evaluate projects based on asset betas
of firms in a similar line of business.
 Financing and the Weighted Average
Cost of Capital
• How might the project’s cost of capital change if
the firm uses leverage to finance the project?
• Perfect capital markets
– In perfect capital markets, choice of financing
does not affect cost of capital or project NPV
• Taxes – A Big Imperfection
– When interest payments on debt are tax
deductible, the net cost to the firm is given
by:
– Effective after-tax interest rate = r(1 – τC)
The Weighted Average Cost of Capital

• Weighted Average Cost of Capital (WACC)

E D
rwacc = rE + rD (1 - τC )
E+D E+D
• Given a target leverage ratio:

D
rwacc =rU - τC rD
E+D
• How does rwacc compare with rU?
– Unlevered cost of capital (or pretax WACC) is:
• Expected return investors will earn by
holding the firm’s assets
• In a world with taxes, it can be used to
evaluate an all-equity project with the same
risk as the firm.
– In a world with taxes, WACC is less than the
expected return of the firm’s assets.
• With taxes, WACC can be used to evaluate
a project with the same risk and the same
financing as the firm.
 Final Thoughts on the CAPM

• There are a large number of assumptions made

in the estimation of cost of capital using the
CAPM.
• How reliable are the results?
• The types of approximation are no different from
those made throughout the capital budgeting
process. Errors in cost of capital estimation are
not likely to make a large difference in NPV
estimates.
• CAPM is practical, easy to implement, and
robust.
• CAPM imposes a disciplined approach to cost of
capital estimation that is difficult to manipulate.
• CAPM requires managers to think about risk in
the correct way.