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CH 67 SP 06
CH 67 SP 06
Chapter 7
Risk, Return, and the
CAPM
1
Today’s Chapter 6 & 7 Topics
2
Risk and Return
Valuing risky assets - a task fundamental to
financial management
5
Percentage Returns on Bills, Bonds,
and Stocks, 1900 - 2003
Nominal (%) Real (%)
Asset Class Average Best Year Worst Year Average Best Year Worst Year
6
Variability of Stock Returns
( R R)
t
2
Variance 2 t 1
N 1
Units of variance (%-squared) - hard to interpret, so
calculate standard deviation, a measure of volatility
equal to square root of 2 7
Volatility of Asset Returns
Stocks
Bills Bonds
E(R) = Pi Ri
i=1
10
Probabilistic Standard Deviation
11
Example: Exp. Return and
State of Contrary
Economy Probability MAD Inc. Co. (CON)
Boom 0.25 80% -6%
Normal 0.60 30% 10%
Recession 0.15 -30% 20%
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Example: Standard Deviation
13
Portfolio Risk and Return
14
Risk and Diversification
Portfolio rate
of return (
=
in first asset )(
fraction of portfolio
x
rate of return
on first asset)
(
+
in second asset )(
fraction of portfolio
x
rate of return
on second asset
)
E(rp) = wiE(ri) = .7(33.5%) + .3(7.5%) =
25.7%
15
Portfolio Risk
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Example 70% MAD, 30% CON
Portfolio
State of Contrary MAD-CON
Economy Probability MAD Inc. Co. (CON) Portfolio
Boom 0.25 80% -6% 54.2%
Normal 0.60 30% 10% 24.0%
Recession 0.15 -30% 20% -15.0%
17
Average Return and St. Dev. for
Individual Securities, 1994-2003
Wal-Mart
Anheuser-Busch
American Airlines
Archer Daniels Midland
AMD
AMD + American Airlines
AMD + American Airlines + Wal-Mart
Systematic Risk
1 2 3 11
Number of Stocks
21
Systematic and Unsystematic Risk
Diversification reduces portfolio volatility, but only
up to a point. Portfolio of all stocks still has a
volatility of 21%.
23