Session 2: Return, Risk, and The Security Market Line

Session 2:
RETURN, RISK, AND THE SECURITY

MARKET LINE
1
Expected Returns
• Expected returns are based on the
probabilities of possible outcomes
• In this context, “expected” means average

if the process is repeated many times
• The “expected” return does not even have

to be a possible return
n
E (R)  
i 1
piRi
13-2
Copyright © 2016 by McGraw-Hill Education. All rights reserved
Example: Expected Returns
• 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 C T___
Boom 0.3 0.15 0.25
Normal 0.5 0.10 0.20
Recession ??? 0.02 0.01
• RC = .3(15) + .5(10) + .2(2) = 9.9%

• RT = .3(25) + .5(20) + .2(1) = 17.7%
13-3
Variance and Standard Deviation
• Variance and standard deviation measure the

volatility of returns
• Using unequal probabilities for the entire range

of possibilities
• Weighted average of squared deviations

n
σ 
2

i 1
p i ( R i  E ( R )) 2
13-4
Example: Variance and Standard
Deviation
• Consider the previous example. What are the
variance and standard deviation for each stock?
• Stock C
 2 = .3(0.15-0.099)2 + .5(0.10-0.099)2 + .2(0.02-
0.099)2 = 0.002029
  = 4.50%
• Stock T
 2 = .3(0.25-0.177)2 + .5(0.20-0.177)2 + .2(0.01-
0.177)2 = 0.007441
  = 8.63%
13-5
Another Example
• Consider the following information:
State Probability ABC, Inc. Return
Boom .25 0.15
Normal .50 0.08
Slowdown .15 0.04
Recession .10 -0.03
• What is the expected return?
• What is the variance?
• What is the standard deviation?
13-6
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
13-7
Example: Portfolio Weights
• Suppose you have $15,000 to invest and you

have purchased securities in the following
amounts. What are your portfolio weights in
each security?
 $2000 of C
 C: 2/15 = .133
 $3000 of KO
 $4000 of INTC  KO: 3/15 = .2
 $6000 of BP  INTC: 4/15 = .267
 BP: 6/15 = .4
13-8
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)
• You can also find the expected return by finding the portfolio
return in each possible state and computing the expected
value as we did with individual securities
13-9
Example: Expected Portfolio Returns
• Consider the portfolio weights computed

previously. If the individual stocks have the
following expected returns, what is the expected
return for the portfolio?
 C: 19.69%
 KO: 5.25%
 INTC: 16.65%
 BP: 18.24%
• E(RP) = .133(19.69%) + .2(5.25%)+ .267(16.65%) + .

4(18.24%) = 15.41%
13-10
Portfolio Variance
• 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
• Example 13.4 page 452
13-11
BD- The Volatility of a Portfolio
• Investors in a company care not only about the

return, but also about the risk of their portfolios.
• When we combine shares in a portfolio, some of
their risk is eliminated through diversification.
• The volatility of a portfolio is the total risk,
measured as standard deviation, of the portfolio.
• In this section we describe the tools to quantify

the degree to which two shares share risk and to
determine the volatility of a portfolio.
12
• Diversifying Risks
• Let’s begin with a simple example of how risk changes
when shares are combined in a portfolio.
• Table 11.2 shows returns for three hypothetical shares,
along with their average returns and volatilities.
• Note that while the three shares have the same
volatility and average return, the pattern of returns
differs.
• In years when the airline shares performed well, the oil
shares tended to do poorly (see 2004–05), and when
the airlines did poorly, the oil shares tended to do well
(2007–08).
13
BD- Returns for Three Shares and Portfolios of Pairs of Shares
14
• Table 11.2 also shows the returns for two portfolios of the
shares.
• The first portfolio is an equal investment in the two airlines,
North Air and West Air.
• The second portfolio is an equal investment in West Air and
Tassie Oil—bottom rows display the average return and
volatility for each share and portfolio of shares.
• Note that the 10% average return of both portfolios is equal to
the 10% average return of the shares.
• However, as Table11.2 illustrates, their volatilities (standard
deviations)—12.1% for portfolio 1 and 5.1% for portfolio 2—are
very different from the 13.4% volatility for the individual
shares and from each other.
15
BD- Volatility of Airline and Oil
Portfolios
16
• Diversifying risks
• This example demonstrates two important things:
• First, by combining shares into a portfolio, we

reduce risk through diversification.
• Because the shares do not move identically, some
of the risk is averaged out in a portfolio.
• As a result, both portfolios have lower risk than the
individual shares.
• Second, the amount of risk that is eliminated in a
portfolio depends upon the degree to which the
shares face common risks and move together.
17
• Measuring co-movement: Correlation
• Correlation: a barometer of the degree to which
the returns share common risk, calculated as the
covariance of the returns divided by the standard
deviation of each return.
• The closer the correlation is to +1, the more the
returns tend to move together as a result of
common risk.
• When the correlation equals 0, the returns are
uncorrelated (no tendency to move together or
opposite of one another).
• Finally, the closer the correlation is to –1, the more
the returns tend to move in opposite directions.
18
BD- Figure 11.2 Correlation
19
• When will share returns be highly correlated

with each other?
• Share returns will tend to move together if they
are affected similarly by economic events.
• Thus, shares in the same industry tend to have
more highly correlated returns than shares in
different industries.
• This tendency is illustrated in Table 12.3, which
shows the volatility (standard deviation) of
individual share returns and the correlation
between them for several common shares.
20
BD- The volatility of a portfolio
BD- Computing portfolio’s variance and
standard deviation
• The formula for the variance of a two stock
portfolio is:
• Look at example 12.3 AND 12.4 page 400 (BD)

Expected vs. Unexpected Returns
• Realized returns are generally not equal to

expected returns
• There is the expected component and the

unexpected component
 At any point in time, the unexpected return
can be either positive or negative
 Over time, the average of the unexpected

component is zero
13-23
Announcements and News
• Announcements and news contain both an
expected component and a surprise component
• It is the surprise component that affects a

stock’s price and therefore its return
• This is very obvious when we watch how stock

prices move when an unexpected announcement
is made or earnings are different than
anticipated
13-24
Efficient Markets
• Efficient markets are a result of investors

trading on the unexpected portion of
announcements
• The easier it is to trade on surprises, the more

efficient markets should be
• Efficient markets involve random price changes

because we cannot predict surprises
13-25
Systematic Risk
• Risk factors that affect a large number of assets
• Also known as non-diversifiable risk or market

risk
• Includes such things as changes in GDP,

inflation, interest rates, etc.
13-26
Unsystematic Risk
• Risk factors that affect a limited number of

assets
• Also known as unique risk and asset-specific risk
• Includes such things as labor strikes, part

shortages, etc.
13-27
Diversifiable Risk
• The risk that can be eliminated by combining

assets into a portfolio
• Often considered the same as unsystematic,

unique or asset-specific risk
• If we hold only one asset, or assets in the same

industry, then we are exposing ourselves to risk
that we could diversify away
13-28
Total Risk
• Total risk = systematic risk + 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
13-29
Systematic Risk Principle
• There is a reward for bearing risk
• There is not a reward for bearing risk

unnecessarily
• The expected return on a risky asset depends

only on that asset’s systematic risk since
unsystematic risk can be diversified away
13-30
Measuring Systematic Risk
• How do we measure systematic risk?
 We use the beta coefficient
• What does beta tell us?

 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
13-31
BD- Measuring Systematic Risk
• Role of the market portfolio

• Because every security is owned by someone, the sum
of all investors’ portfolios must equal the portfolio of
all risky securities available in the market.
• But everyone wants to hold the most diversified
portfolio, so for supply and demand to balance,
everyone must hold the market portfolio.
• The market portfolio is the portfolio of all risky
investments, held in proportion to their value.
• In Indonesia we have IHSG as the stock market index
which used as the market portfolio
32
BD- Measuring Systematic Risk
• Market risk and beta

• We can measure a share’s systematic risk by
estimating the share’s sensitivity to the market
portfolio (or how sensitive the stock with
systematic risk), which we refer to as its beta
(β):
• A share’s beta (β) is the percentage change in its
return that we expect for each 1% change in the
market’s return.
• There are many data sources that provide
estimates of beta based on historical data.
33
BD- Total Risk versus Systematic Risk
Problem:
• Suppose that, in the coming year, you expect
Qantas shares to have a standard deviation of
30% and a beta of 1.2, and Woolworths’ shares
to have a standard deviation of 41% and a beta
of 0.6.
• Which share carries more total risk? Which has
more systematic risk?
34
BD- Total Risk versus Systematic Risk
Execute:
• Total risk is measured by standard
deviation, therefore, Woolworths’ shares
have more total risk.
• Systematic risk is measured by beta.
• Qantas has a higher beta, and so has more
systematic risk.
Evaluate:
• A share can have high total risk, but if a
lot of it is diversifiable, it can still have
low or average systematic risk.
35
Total vs. Systematic Risk
• Consider the following information:
Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher expected

return?
13-36
Example: Portfolio Betas
• Consider the previous example with the
following four securities
Security Weight Beta
C .133 2.685
KO .2 0.195
INTC .267 2.161
BP .4 2.434
• What is the portfolio beta?
• .133(2.685) + .2(.195) + .267(2.161) + .

4(2.434) = 1.947
13-37
Beta and the Risk Premium
• Remember that the risk premium = expected

return – risk-free rate
• The higher the beta, the greater the risk

premium should be
• Can we define the relationship between the risk

premium and beta so that we can estimate the
expected return?
 YES!
13-38
Security Market Line
• The security market line (SML) is the

representation of market equilibrium
• The slope of the SML is the reward-to-risk ratio:

(E(RM) – Rf) / M
• But since the beta for the market is always

equal to one, the slope can be rewritten
• Slope = E(RM) – Rf = market risk premium
13-39
Example: Portfolio Expected Returns
and Betas
30%
25% E(RA)
Expected Return
20%
15%
10%
Rf
5%
0%
0 0.5 1 1.5 A 2 2.5 3
Beta
13-40
Reward-to-Risk Ratio: Definition
and Example
• The reward-to-risk ratio is the slope of the line
illustrated in the previous example
 Slope = (E(RA) – Rf) / (A – 0)
 Reward-to-risk ratio for previous example =

(20 – 8) / (1.6 – 0) = 7.5
• What if an asset has a reward-to-risk ratio of 8

(implying that the asset plots above the line)?
• What if an asset has a reward-to-risk ratio of 7

(implying that the asset plots below the line)?
13-41
Market Equilibrium
• In equilibrium, 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
13-42
The Capital Asset Pricing Model (CAPM)
• The capital asset pricing model defines the

relationship between risk and return
• E(RA) = Rf + A(E(RM) – Rf)
• If we know an asset’s systematic risk, we can

use the CAPM to determine its expected
return
• This is true whether we are talking about

financial assets or physical assets
13-43
BD- Putting It All Together: The Capital
Asset Pricing Model
• The CAPM simply says that the return we should
expect on any investment is equal to the risk-free
rate of return plus a risk premium proportional to
the amount of systematic risk in the investment.
• Specifically, the risk premium of an investment is
equal to the market risk premium multiplied by the
amount of systematic (market) risk present in the
investment, measured by its beta with the market
(βi).
• Because investors will not invest in this security
unless they can expect at least the return given in
Eq. 11.6, we also call this return the investment’s
required return. 44
BD- Calculating the Expected Return for a Share
Problem:
• Suppose the risk-free return is 5% and you
measure the market risk premium to be
7%.
• Qantas has a beta of 1.33.
• According to the CAPM, what is its
expected return?
45
BD- Example 11.5 Calculating the Expected
Return for a Share (p.356)
Evaluate:
• Because of Qantas’ beta of 1.33, investors
will require a risk premium of 9.31% over
the risk-free rate for investments in its
shares to compensate for the systematic
risk of Qantas shares.
• This leads to a total expected return of
14.31%.
46
Example - CAPM
• 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%, what
is the expected return for each?
Security Beta Expected Return
C 2.685 4.15 + 2.685(8.5) = 26.97%
KO 0.195 4.15 + 0.195(8.5) = 5.81%
INTC 2.161 4.15 + 2.161(8.5) = 22.52%
BP 2.434 4.15 + 2.434(8.5) = 24.84%
13-47
Figure 13.4
13-48
11.4 Putting It All Together: The Capital Asset
Pricing Model
• The CAPM and portfolios

• We can apply CAPM to portfolios as well.
• Therefore, the expected return of a portfolio
should correspond to the portfolio’s beta.
• We calculate the beta of a portfolio made up of
securities each with weight wi as follows:
• That is, the beta of a portfolio is the weighted

average beta of the securities in the portfolio.
49

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Session 2:

RETURN, RISK, AND THE SECURITY

• In this context, “expected” means average

• The “expected” return does not even have

• RC = .3(15) + .5(10) + .2(2) = 9.9%

• Variance and standard deviation measure the

• Using unequal probabilities for the entire range

• Weighted average of squared deviations

• What is the expected return?

• What is the variance?

• What is the standard deviation?

• A portfolio is a collection of assets

• An asset’s risk and return are important in how

• The risk-return trade-off for a portfolio is

• Suppose you have $15,000 to invest and you

• The expected return of a portfolio is the weighted average of

• Consider the portfolio weights computed

• E(RP) = .133(19.69%) + .2(5.25%)+ .267(16.65%) + .

• Compute the expected portfolio return using the

• Compute the portfolio variance and standard

• Investors in a company care not only about the

• In this section we describe the tools to quantify

• First, by combining shares into a portfolio, we

• When will share returns be highly correlated

• Look at example 12.3 AND 12.4 page 400 (BD)

• Realized returns are generally not equal to

• There is the expected component and the

 Over time, the average of the unexpected

• It is the surprise component that affects a

• This is very obvious when we watch how stock

• Efficient markets are a result of investors

• The easier it is to trade on surprises, the more

• Efficient markets involve random price changes

• Risk factors that affect a large number of assets

• Also known as non-diversifiable risk or market

• Includes such things as changes in GDP,

• Risk factors that affect a limited number of

• Also known as unique risk and asset-specific risk

• Includes such things as labor strikes, part

• The risk that can be eliminated by combining

• Often considered the same as unsystematic,

• If we hold only one asset, or assets in the same

• The standard deviation of returns is a measure of

• For well-diversified portfolios, unsystematic risk

• Consequently, the total risk for a diversified

• There is a reward for bearing risk

• There is not a reward for bearing risk

• The expected return on a risky asset depends

• What does beta tell us?

 A beta < 1 implies the asset has less systematic

 A beta > 1 implies the asset has more

• Role of the market portfolio

• Market risk and beta

• Which security has more total risk?

• Which security has more systematic risk?

• Which security should have the higher expected

• What is the portfolio beta?

• .133(2.685) + .2(.195) + .267(2.161) + .

• Remember that the risk premium = expected

• The higher the beta, the greater the risk

• Can we define the relationship between the risk

• The security market line (SML) is the

• The slope of the SML is the reward-to-risk ratio: