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,

and the Capital Asset Pricing Model

(CAPM)

Topics in Chapter

Basic return concepts

Basic risk concepts

Stand-alone risk / Total risk

Portfolio (market) risk

Risk and return:

CAPM/SML

2

**What are investment returns?
**

Investment returns measure the financial results of an

investment.

Returns may be historical or prospective

(anticipated).

Returns can be expressed in:

Dollar terms.

Percentage terms.

3

**Expected (holding period) returns
**

Expected rate of return on an investment asset can

be calculated as follows:

**Expected Return Expected ending value
**

Cost

Example: if $1,000 is invested and $1,100 is returned after

one year, the rate ofCost for this investment is:

return

($1,100 – $1,000)/$1,000 = 10%.

4

**What is investment risk?
**

Typically, investment returns are not known

with certainty (as they depend on an

expected ending value; e.g., price, dividends.)

The greater the chance that the expected

returns will not be realized, the riskier

the investment.

An asset’s risk can be analyzed in two

ways

On a stand-alone basis (stand-alone risk)

On a portfolio basis (portfolio risk)

5

Probability Firm X Firm Y Rate of -70 0 15 100 Return (%) Expected Rate of Return 6 .Probability Distributions: Which stock is riskier? Why? A listing of all possible outcomes. Can be shown graphically (or in tabular form). and the probability of each occurrence.

2 5.0% -3.1 5.0% -21.0% 25.0% 13.0% -11. T-Bill HT Coll USR Market Recession 0.0% Risk free? 7 .0% 38.0% Above avg 0.0% 41.0% Below avg 0.2 5.0% -17.0% -14.0% 0.0% 10.5% 30.0% 6.0% 27.5% 15.4 5.5% -7.0% Boom 0.0% 26.Investment Alternatives Economy Prob.0% Average 0.1 5.0% 3.5% 45.5% -27.

very little unexpected inflation is likely to occur over such a short period of time.Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return? T-bills will return the promised 5. regardless of the economy and hence your nominal return is truly risk free. 8 . as they are still exposed to inflation. T-bills are also risky in terms of reinvestment rate risk.5%. T-bills are risk-free in the default sense of the word. But. Although. T-bills do not provide a completely risk-free return.

and has a negative correlation. behave in relation to the market? HT – Moves with the economy. and has a positive correlation. Coll. – Is countercyclical with the economy. This is unusual. This is typical. 9 .How do the returns of HT and Coll.

4) riPi + (30%)(0.Calculating the Expected Return ˆr = Expected rate of return N ˆr = ˆrH = (-27%)(0.2) + (45%)(0.1) + (-7%)(0.4% 10 .2) + (15%)(0.1) T i=1 = 12.

4% Market 10. but is it really? Have we failed to account for risk? 11 . and appears to be the best investment alternative.Summary of Expected Returns Expected return HT 12.5% USR 9.0% HT has the highest expected return.5% Coll. 1.8% T-bill 5.

Calculating Standard Deviation σi = Standard deviation σi = Variance = σ 2i N σi = (r - i=1 rˆ)2P i i 12 .

5) (0.5)2(0.5) (0.8% σM = 15.Standard Deviation for Each Investment N σi = (r -i i i=1 ˆr)2P 2 T-bills 2 + (5.5)2(0.2% σHT = 20% σ = (5.5-5.5-5.5-5.4) + (5.5-5.5-5.1) + (5.2% 13 .5)2(0.1) 1/2 σT-bills=0.0% (5.2) σColl = 13.2) σUSR = 18.

r i )2 σi = N-1 An example: Page 228 of the Text.Expected Return and Risk Using Historical Data Expected Return = Average (arithmetic) of historical returns. t . N (r t=1 i. N r i. 14 . ri = t t=1 Standard Dev = Square N root of sum of the squared deviations of historical individual returns from the average/expected return.

0 L-T corporate bonds 6.3 20.2 8.2 U. Bills. 15 . 2008).4 L-T government bonds 5.1 Source: Based on Stocks.S.8 3. and Inflation: (Valuation Edition) 2008 Yearbook (Chicago: Morningstar.8 9.1926-2007 Average Standard Return Deviation Small-company stocks 17. Treasury bills 3.1% 32. Inc..Selected Realized Returns.6% Large-company stocks 12. Bonds.

T-bill USR HT 0 5.4 Rate of Return (%) 16 .5 9.8 12.Comparing Standard Deviations Prob .

17 .alone. The larger σi is. risk. or stand. Larger σi is associated with a wider probability distribution of returns. the lower the probability that actual returns will be closer to expected returns.Comments on Standard Deviation as a Measure of Risk Standard deviation (σi) measures total.

8 Market 10. 18 .0 Coll* 1.0 13.2 USR* 9.5 15. ˆr Risk.0% HT 12.2 *Seems out of place.4 20.5% 0.Comparing Risk and Return Security Expected Return.8 18. T-bills 5.

that shows the risk per unit of return.Coefficient of Variation (CV) A standardized measure of dispersion about the expected value. Standard deviation σi CV i = Expected return = ˆ i r 19 .

2 USR 1. has a relatively average CV.6 Coll. despite having the highest standard deviation of returns.0 HT 1.Risk Rankings by Coefficient of Variation CV T-bill 0. 13.4 Collections has the highest degree of risk per unit of return. HT. 20 .9 Market 1.

A B 0 Rate of Return (%) σA = σB . but A is riskier because of a larger probability of losses. the same amount of risk (as measured by σ) for smaller returns. 21 .Illustrating the CV as a Measure of Relative Risk Prob. In other words.

which serves as compensation for investors to hold riskier securities. Diversification: Shed part of the total (stand- alone) risk by investing in a portfolio of assets. Risk premium: Difference between the return on a risky asset and a riskless asset.Investor Attitude towards Risk Risk aversion: Investors are assumed to dislike risk and require higher rates of return to encourage them to hold riskier securities. 22 .

Portfolio Construction: Risk and Return Assume a two-stock portfolio is created with $50. A portfolio’s expected return is a weighted average of the returns of the portfolio’s component assets. 23 . Standard deviation is a little more tricky and requires that a new probability distribution for the portfolio returns be devised.000 invested in both HT and Collections.

Calculating Portfolio Expected Return rp is a weighted average: ˆ N ^ r = w i ri ˆp i=1 rp = 0.7% ˆ 24 .5 (12.0%) = 6.5 (1.4%) + 0.

4 15.0% 0.0%) + 0.10 (12.0% -21.40 (7.2 -7.0% 3.1 -27.0% Average 0.An Alternative Method for Determining Portfolio Expected Return Economy Prob.0% Below avg 0.20 (9. Recession 0.20 (3.0% 7.0% 12.0% ˆ = 0.2 30.0% 27. HT Coll Port.0% 13.0% 0.5% Above avg 0.0%) = 6.10 (0.0%) + 0.5%) rp + 0.0% -11.5% Boom 0.5%) + 0.7% 25 .0% 9.1 45.

6.6.Calculating Portfolio Standard Deviation and CV 1 2 0.4% σ p = + 0.7) 2 3.20 (3.5 .51 26 .40 (7.10 (12.7)2 + 0.5 .10 (0.4% CVp = 6.0 .20 (9.7) 2 2 + 0.7)2 + 0.7) = 3.7% = 0.0 .6.0 .6.6.

σColl.0%.2%). Why? Negative correlation between stocks.4% is much lower than the σi of either stock (σHT = 20. σp = 3. = 13.’s σ (16. but lower than the average risk. Therefore.6%). 27 .4% is lower than the weighted average of HT and Coll.Comments on Portfolio Risk Measures σp = 3. the portfolio provides the average return of component stocks.

Most stocks are positively (though not perfectly) correlated with the market (i. 28 .. Combining stocks in a portfolio generally lowers risk. ρ between 0 and 1).General Comments about Risk σ 35% for an average stock.e.

0) 29 .Returns Distribution for Two Perfectly Negatively Correlated Stocks (ρ = -1.

Returns Distribution for Two Perfectly Positively Correlated Stocks (ρ = 1.0) Stock M Stock M’ Portfolio MM’ 25 25 25 15 15 15 0 0 0 -10 -10 -10 30 .

Partial Correlation.35 31 . ρ = +0.

Eventually the diversification benefits of adding more stocks dissipates (after about 10 stocks). σp tends to converge to 20%. 32 . Expected return of the portfolio would remain relatively constant.Creating a Portfolio: Beginning with One Stock and Adding Randomly Selected Stocks to Portfolio σ decreases as stocks added. because they p would not be perfectly correlated with the existing portfolio. and for large stock portfolios.

Illustrating Diversification Effects of a Stock Portfolio 33 .

rM)/Var(rM) Diversifiable risk – portion of a security’s stand- alone risk that can be eliminated through proper diversification.Breaking Down Sources of Risk Stand-alone risk = Market risk + Diversifiable risk Market risk – portion of a security’s stand- alone risk that cannot be eliminated through diversification. Measured by beta. beta = Cov(ri. 34 .

diversifiable risk. which is based upon market risk. There can be only one price (the market return) for a given security. No compensation should be earned for holding unnecessary.Failure to Diversify If an investor chooses to hold a one-stock portfolio (doesn’t diversify). risk-averse investors are concerned with σp. would the investor be compensated for the extra risk they bear? NO! Stand-alone risk is not important to a well-diversified investor. 35 . Rational.

diversified (market) portfolio. 36 .Capital Asset Pricing Model (CAPM) Model linking risk and required returns. CAPM suggests that there is a Security Market Line (SML) that states that a stock’s required return equals the risk-free return plus a risk premium that reflects the stock’s risk after diversification. which is measured by the stock’s beta. ri = rRF + (rM – rRF)bi Primary conclusion: The relevant riskiness of a stock is its contribution to the riskiness of a well.

Beta Measures a stock’s market risk. 37 . and shows a stock’s volatility relative to the market. Indicates how risky a stock is if the stock is held in a well-diversified portfolio.

X) N-1 2 38 .Beta beta = Cov(ri.Y) Variance: Var(X) = (X .rM)/Var(rM) Covariance: Cov(XY) = (X -NX)(Y -1 .

39 .0. If beta < 1.5.5 to 1.0. the security is riskier than average.0. the security is just as risky as the average stock. Most stocks have betas in the range of 0. the security is less risky than average.Comments on Beta If beta = 1. If beta > 1.

a negative beta is highly unlikely.e.Can the beta of a security be negative? Yes. However. ρi..m < 0). if the correlation between Stock i and the market is negative (i. If the correlation is negative. the regression line would slope downward. and the beta would be negative. 40 .

The slope of the regression line is defined as the beta coefficient for the security. A typical approach to estimate beta is to run a regression of the security’s past returns against the past returns of the market. analysts are forced to rely on historical data. 41 . Without a crystal ball to predict the future.Calculating Betas Well-diversified investors are primarily concerned with how a stock is expected to move relative to the market in the future.

. -5 ^ r = -2. 20 Year rM ri 1 15 18 15 2 % % 10 3 -5 - 12 10 5 16 -5 0 5 10 15 20 rM Regression line: .59 + 1.44 r^ i M -10 42 .Illustrating the Calculation of Beta ri .

X)(Y .X)2 The formula for the intercept is: a = Y .Y) (X .Calculation of Beta The formula for the coefficient or slope in simple linear regression is: b= (X .bX 43 .

87 -20 44 .32 40 20 T-bills: b = 0 -20 0 20 40 rM Coll: b = -0. Coll. and T-Bills ri HT: b = 1.Beta Coefficients for HT.

Analysts typically use four or five years’ of monthly returns to establish the regression line. 45 .Calculating Beta in Practice Many analysts use the S&P 500 to find the market return. Some analysts use 52 weeks of weekly returns.

5 1. so the rank order is OK. 46 .4% 1.32 Market 10.Comparing Expected Returns and Beta Coefficients Security Expected Return Beta HT 12.87 Riskier securities have higher returns.8 0.00 USR 9. 1.00 Coll.5 0.88 T-Bills 5.0 -0.

0%.5% and RPM = 5. 47 .The Security Market Line (SML): Calculating Required Rates of Return SML: ri = rRF + (rM – rRF)bi = rRF + (RPM)bi Assume that rRF = 5.

What is the market risk premium? Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. 48 . but most estimates suggest that it ranges between 4% and 8% per year. Its size depends on the perceived risk of the stock market and investors’ degree of risk aversion. Varies from year to year.

00) = 5.5% + (5.88) = 9.0%)(1.50% rM = 5.5% + (5.00) = 10.0%)(1.50% rT-bill = 5.0)(0.15% rColl 49 .0%)(0.Calculating Required Rates of Return = 5.5% + (5.5% + 6.5% +(5.90% rUSR = 5.6% = 12.5% + (5.87) = 1.32) rHT = 5.10% = 5.0%)(-0.

5 5.1% Undervalued ( r >r) ˆ Market 10.5 10.4% 12.8 9.5 Fairly valued ( ˆ= r r) Coll.Expected vs.5 Fairly valued ( ˆr =r) USR 9. 1. Required Returns r ˆr HT 12.0 1.9 Overvalued ( ˆ< r r) T-bills 5.15 Overvalued ( ˆ< r r) 50 .

rRF = 5. bi USR T-bills 51 . . Risk.0%)bi ri (%) SML rM = 10.Illustrating the Security Market Line SML: ri = 5.5 .5 H T . .5% + (5.

bP = wHTbHT + wCollbColl bP = 0.5(1.32) + 0.225 52 .An Example: Equally-Weighted Two-Stock Portfolio Create a portfolio with 50% invested in HT and 50% invested in Collections.87) bP = 0. The beta of a portfolio is the weighted average of each of the stock’s betas.5(-0.

625% 53 . CAPM can be used to solve for expected return.5(12. using the portfolio’s beta.0%)(0.Calculating Portfolio Required Returns The required return of a portfolio is the weighted average of each of the stock’s required returns.625% Or. rP = rRF + (RPM)bP rP = 5.225) rP = 6.5% + (5.5(1.10%) + 0. rP = wHTrHT + wCollrColl rP = 0.15%) rP = 6.

Factors That Change the SML What if investors raise inflation expectations by 3%. bi 0 0.5 54 .5 10.0 1. what would happen to the SML? ri (%) ΔI = 3% SML2 13.5 5.5 1.5 Risk.5 SML1 8.

5 1. what would happen to the SML? r (%) i SML2 ΔRPM = 3% 13.5 55 .0 1. causing the market risk premium to increase by 3%.5 SML1 5. Factors That Change the SML What if investors’ risk aversion increased. bi 0 0.5 Risk.5 10.

56 . Statistical tests have problems that make verification almost impossible. other than the market risk premium.Verifying the CAPM Empirically The CAPM has not been verified completely. Some argue that there are additional risk factors. that must be considered.

the SML may not produce a correct estimate of ri. ri = rRF + (rM – rRF)bi + ??? CAPM/SML concepts are based upon expectations. 57 . Therefore.More Thoughts on the CAPM Investors seem to be concerned with both market risk and total risk. A company’s historical data may not reflect investors’ expectations about future riskiness. but betas are calculated using historical data.

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