Chapter 3

Risk and Return: Part II

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 Topics in Chapter
 Portfolio Theory
 Capital Asset Pricing Model (CAPM)
 Efficient Frontier
 Capital Market Line (CML)
 Security Market Line (SML)
 Beta calculation
 Arbitrage pricing theory
 Fama-French 3-factor model
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 Efficient Portfolio
 Provide highest expected return for any
degree of risk
or
 Provide the lowest degree of risk for
any expected return

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 Portfolio Theory – 2 Asset Portfolio
 Suppose Asset A has an expected return of
10 percent and a standard deviation of 20
percent. Asset B has an expected return of
16 percent and a standard deviation of 40
percent. If the correlation between A and B
is 0.35, what are the expected return and
standard deviation for a portfolio with 30
percent invested in Asset A?

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 Portfolio Expected Return

^r = w r^ + (1 – w ) r^
p A A A B

= 0.3(0.1) + 0.7(0.16)

= 0.142 = 14.2%.

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 Portfolio Standard Deviation

σP = √w2Aσ2A + (1-wA)2σ2B + 2wA(1-wA)ρABσAσB

= √0.32(0.22) + 0.72(0.42) + 2(0.3)(0.7)(0.35)(0.2)(0.4)

= 0.306

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 Attainable Portfolios: rAB = 0.35
r AB = +0.35: Attainable Set of
Risk/Return Combinations

20%
Expected return

15%

10%

5%

0%
0% 10% 20% 30% 40%
Risk, s p

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 Attainable Portfolios: rAB = +1
 AB = +1.0: Attainable Set of Risk/Return
Combinations

20%
Expected return

15%

10%

5%

0%
0% 10% 20% 30% 40%

Risk, p

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 Attainable Portfolios: rAB = -1
r AB = -1.0: Attainable Set of Risk/Return
Combinations

20%
Expected return

15%

10%

5%

0%
0% 10% 20% 30% 40%

Risk, s p

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 Attainable Portfolios with Risk-Free Asset
(Expected risk-free return = 5%)

Attainable Set of Risk/Return

Combinations with Risk-Free Asset

15%
Expected return

10%

5%

0%
0% 5% 10% 15% 20%
Risk, p
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 Minimum Risk Portfolio
 

wA =

 
wA =
=

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 Feasible and Efficient
Portfolios

Expected Efficient Set

E
Portfolio
Return, rp
G
Feasible Set
H

Risk, p 12
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 Feasible and Efficient
Portfolios
 The feasible set of portfolios represents all
portfolios that can be constructed from a
given set of stocks.
 An efficient portfolio is one that offers:
 the most return for a given amount of risk, or
 the least risk for a given amount of return.
 The collection of efficient portfolios is called
the efficient set or efficient frontier.

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 Optimal Portfolios
IB I
2 B
1
Expected
Return, rp

Optimal
IA 2 Portfolio
IA 1 Investor B

Optimal Portfolio
Investor A

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Risk p 14
 Indifference Curves
 Indifference curves reflect an investor’s
attitude toward risk as reflected in his
or her risk/return tradeoff function.
They differ among investors because of
differences in risk aversion.
 An investor’s optimal portfolio is defined
by the tangency point between the
efficient set and the investor’s
indifference curve.
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 What is the CAPM?
 The CAPM is an equilibrium model that
specifies the relationship between risk
and required rate of return for assets
held in well-diversified portfolios.
 It is based on the premise that only one
factor affects risk.
 What is that factor?

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 What impact does rRF have on
the efficient frontier?
 When a risk-free asset is added to the
feasible set, investors can create
portfolios that combine this asset with a
portfolio of risky assets.
 The straight line connecting rRF with M,
the tangency point between the line
and the old efficient set, becomes the
new efficient frontier.
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 Efficient Set with a Risk-Free
Asset
Expected Z
Return, rp
. B

^r
M
M
.
rRF
A . The Capital Market
Line (CML):
New Efficient Set

M Risk, p
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 What is the Capital Market
Line?
 The Capital Market Line (CML) is all
linear combinations of the risk-free
asset and a risky asset.
 Portfolios below the CML are inferior.
 The CML defines the new efficient set.
 All investors will choose a portfolio on the
CML.

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 The CML Equation

^
^ rM - rRF
rp = rRF + p.
M

Intercept Slope
Risk
measure
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 Capital Market Line
Expected I2
I1 CML
Return, rp

^r
^r
M

R .R
. M

R = Optimal
rRF Portfolio

Risk, p
R M
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 What is the Security Market
Line (SML)?
 The CML gives the risk/return
relationship for efficient portfolios.
 The Security Market Line (SML), also
part of the CAPM, gives the risk/return
relationship for individual stocks.

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 The SML Equation
 The measure of risk used in the SML is
the beta coefficient of company i, bi.

 The SML equation:

ri = rRF + (RPM) bi

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 Beta Review
 If beta = 1.0, stock is average risk.
 If beta > 1.0, stock is riskier than
average.
 If beta < 1.0, stock is less risky than
average.
 Most stocks have betas in the range of
0.5 to 1.5.

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 What are our conclusions
regarding the CAPM?
 Recent studies have questioned its
validity.
 Investors seem to be concerned with
both market risk and stand-alone risk.
Therefore, the SML may not produce a
correct estimate of ri.

(More...)
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 What are our conclusions
regarding the CAPM?
 CAPM/SML concepts are based on
expectations, yet betas are calculated using
historical data. A company’s historical data
may not reflect investors’ expectations about
future riskiness.
 Other models are being developed that will
one day replace the CAPM, but it still provides
a good framework for thinking about risk and
return.

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 Arbitrage Pricing Theory (APT)

 The CAPM is a single factor model.

 The APT proposes that the relationship
between risk and return is more
complex and may be due to multiple
factors such as GDP growth, expected
inflation, tax rate changes, and dividend
yield.

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 Required Return for Stock i
under the APT

ri = rRF + (r1 - rRF)bi1 + (r2 - rRF)bi2

+ ... + (rj - rRF)bij.

rj = required rate of return on a portfolio

sensitive only to economic Factor j.
bij = sensitivity of Stock i to economic
Factor j.
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 What is the status of the APT?
 The APT is being used for some real world
applications.
 Its acceptance has been slow because the
model does not specify what factors influence
stock returns.
 More research on risk and return models is
needed to find a model that is theoretically
sound, empirically verified, and easy to use.

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 Fama-French 3-Factor Model
 Fama and French propose three factors:
 The excess market return, rM-rRF.
 the return on, S, a portfolio of small firms
(where size is based on the market value
of equity) minus the return on B, a
portfolio of big firms.
 This return is called rSMB, for S minus B.

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 Fama-French 3-Factor Model
(Continued)
 the return on, H, a portfolio of firms with
high book-to-market ratios (using market
equity and book equity) minus the return
on L, a portfolio of firms with low book-to-
market ratios.
 This return is called rHML, for H minus L.

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 Required Return for Stock i under the
Fama-French 3-Factor Model

ri = rRF + (rM - rRF)bi + (rSMB)ci + (rHML)di

bi = sensitivity of Stock i to the market

return.
ci = sensitivity of Stock i to the size
factor.
di = sensitivity of Stock i to the book-
to-market factor. 32
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 Required Return for Stock i
Inputs: bi=0.9; rRF=6.8%; market risk premium =
6.3%; ci=-0.5; expected value for the size factor is
4%; di=-0.3; expected value for the book-to-
market factor is 5%.
ri = rRF + (rM - rRF)bi + (rSMB)ci + (rHMl)di

ri = 6.8% + (6.3%)(0.9) + (4%)(-0.5) + (5%)(-0.3)

= 8.97%
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 CAPM Required Return for
Stock i

CAPM:
ri = rRF + (rM - rRF)bi
ri = 6.8% + (6.3%)(0.9)
= 12.47%
Fama-French (previous slide):
ri = 8.97%
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