FINA 5120

FINA 5120
Corporate Finance
Veronique LAFON-VINAIS
Associate Professor of Business Education, Dept of
Finance
Fall 2022
RISK AND RETURN IN CAPITAL
MARKETS
2
IN THIS CHAPTER…
3
We will learn about:
• Probability Distributions:
– Normal Distribution and Confidence Interval
• Expected Returns
• Variance and Standard Deviation
• Realized Returns
• Types of Risk
– Systematic (common) and firm-specific (independent)
• The efficient (market) portfolio
• Beta
• CAPM
FINA 5120 - Capital Markets and the Pricing of Risk 4
Probability Distributions
• We compare different securities in terms of their
returns (% increase in value of an investment per dollar
invested in the security)
• When an investment is risky, it may earn different
returns.
• 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.
Copyright ©2017 Pearson Education, Inc. All rights reserved.

Application: BFI
• 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.
Table 10.1 Probability Distribution of Returns for BFI

Figure 10.3 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    R
PR  R

Variance and Standard Deviation (Volatility)
• Variance
– The expected squared deviation from the mean – a measure
of how “spread out” the distribution of the return is
Var (R )  E  R  E  R    R  E R 
2 2

   R
PR 
• Standard Deviation
– The square root of the variance – a.k.a “volatility”
SD( R )  Var ( R)
• Both are measures of the risk of a probability
distribution

Application: BFI
• Expected Return:
E  RBFI   25%(  0.20)  50%(0.10)  25%(0.40)  10%
• Variance and Standard Deviation:

Var  RBFI   25%  (  0.20  0.10) 2  50%  (0.10  0.10) 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.
FINA 5120 - Capital Markets and the Pricing of Risk Copyright ©2017 Pearson Education, Inc. All rights reserved.
10
Illustration
• TXU stock has the following probability distribution of
returns:
Probability Return
.25 8%
.55 10%
.20 12%
• What are its expected return and standard deviation?

Solution
– Expected Return Expected Return  E  R    R
PR  R
• E[R] = (0.25)(0.08) + (0.55)(0.10) + (0.20)(0.12)
• E[R] = 0.020 + 0.055 + 0.024 = 0.099 = 9.9%
– Standard Deviation SD ( R )  Var ( R)
Var (R)  E  R  E  R   
 R  E  R 
2 2
   R
PR 
• SD(R) = [(0.25)(0.08 – 0.099)2 + (0.55)(0.10 –

0.099)2 + (0.20)(0.12 – 0.099)2]1/2
• SD(R) = 0.0001791/2 = 0.01338 = 1.34%

Value of $100 Invested at the End of 1925 in U.S. Large
Stocks (S&P 500), Small Stocks, World Stocks, Corporate Bonds, and
Treasury Bills
The
investments
that
performed the
best in the
long run also
had the
greatest
fluctuations
from year to
year.
The CPI is
shown as Small stocks had the highest long-term returns and the largest
fluctuations in price , while T-Bills had the lowest long-term returns and
reference.
the lowest fluctuations in price => Higher risk requires a higher return.
FINA 5120 – Capital Markets and the Pricing of Risk 13
Realized Returns, in %, for Small Stocks, S&P 500, Corporate Bonds, and
Treasury Bills, Year-End 1925–1935
Investors are adverse to fluctuations in the value of their investments so
they demand that riskier investments have higher expected returns: they
don’t like risk so they demand a risk premium to bear it.
1929 Stock
Market
Crash and
ensuing
Great
Depression
Note: Negative returns are in red


Value of $100 Invested in Alternative Investment for Differing
Horizons
Few people
ever make an
investment for
89 years.
More realistic
investment
horizons and
different initial
investment
dates can
greatly
influence each
investment's
risk and
return.
Source: Chicago Center for Research in Security Prices, Standard and Poor’s, MSCI, and Global Financial Data.
Realized Returns
• Realized Return = the total return that actually occurs
over a particular time period
• The Realized Return from your investment in the stock
from t to t+1, assuming you receive a dividend, is:
Divt 1  Pt 1  Pt Divt 1 Pt 1  Pt
Rt 1   
Pt Pt Pt
 Dividend Yield  Capital Gain Yield
• It is the total return as a % of the initial stock price
FINA 5120 – Historical Risks and Returns of Stocks 16

Illustration
• Problem:
• Health Management Associates (HMA) paid a one-time
special dividend of $10.00 on March 2, 2007.
• Suppose you bought HMA stock for $20.33 on
February 15, 2007 and sold it immediately after the
dividend was paid for $10.29.
• What was your realized return from holding the
stock?
FINA 5120 - Historical Risks and Returns of Stocks 17

Solution
• the return from February 15, 2007 until March 2, 2007
is equal to
Div t 1  Pt 1  Pt 10.00  10.29  20.33
R t 1    0.002, or  0.2%
Pt 20.33
• This -0.2% can be broken down into the dividend yield
and the capital gain yield:
Divt 1 10.00
Dividend Yield    0.4919, or 49.19%
Pt 20.33
Pt 1  Pt 10.29  20.33
Capital GainYield    0.4939, or  49.39%
Pt 20.33

Individual Investment Realized Returns
• For quarterly returns (or any four compounding
periods that make up an entire year) the annual
realized return, Rannual, is found by
compounding:
1  Rannual  (1  R1 )(1  R2 )(1  R3 )(1  R4 )
• The assumption is that all dividends are

immediately reinvested and used to purchase
additional shares of the same stock or security

Illustration
• Problem
– What were the realized annual returns for NRG stock in 2012
and in 2016?
Date Price ($) Dividend ($) Return Date Price ($) Dividend ($) Return
12/31/2011 58.69 12/31/2015 6.73 0
1/31/2012 61.44 0.26 5.13% 3/31/2016 5.72 0 -15.01%
4/30/2012 63.94 0.26 4.49% 6/30/2016 4.81 0 -15.91%
7/31/2012 48.5 0.26 -23.74% 9/30/2016 5.2 0 8.11%
10/31/2012 54.88 0.29 13.75% 12/31/2016 2.29 0 -55.96%
12/31/2012 53.31 -2.86%

Solution
– We compute each period’s return. For example, the return
from December 31, 2011, to January 31, 2012, is
61.44  0.26
 1  5.13%
58.69
– We then determine annual returns :
R2012  (1.0513)(1.0449)(0.7626)(1.1375)(0.9714)  1  7.43%
R2016  (0.8499)(0.8409)(1.0811)(0.440)  1  66.0%
2.29
– Note that, since NRG did not pay dividends during
 1  2016,
66.0%the
return can also be computed as follows: 6.73

Realized Return for the S&P 500, Microsoft, and Treasury
Bills, 2002–2014

The Distribution of Annual Returns for U.S. Large
Company Stocks (S&P 500), Small Stocks, Corporate
Bonds, and Treasury Bills, 1926–2012
This histogram plots the

annual returns for each of
the US investments in
Table 10.2.
The height of each bar
represents the number of
years that the annual
returns were in each range
indicated by the x axis.
We notice how much more
variable stock returns are
compared to T Bills

Average Annual Return
• Average Annual Return of a Security = arithmetic average of
an investment’s realized returns for each year
1 1 T
R 
T
 R1   RT 
 R2  ……..  
T t 1
Rt
• Rt = Realized return of a security in year t from years 1

through T
• If we assume that the distribution of possible returns is the
same over time, the average return provides an estimate of
the return we would expect in any given year – the expected
return. Copyright ©2015 Pearson Education, Inc. All rights reserved.

The Variance and Volatility of Returns
• Variance Estimate Using Realized Returns
1 T
 R  R
2
Var (R )  t
T  1 t 1
– The estimate of the standard deviation is the square root of
the variance.

Illustration
• Problem:
– Using the data from Table 10.2, what are the variance and
standard deviation of Microsoft’s returns from 2004 to 2014?

Table 10.2 Realized Return for the S&P 500, Microsoft,
and Treasury Bills, 2002–2014

Solution
– First, we need to calculate the average return for Microsoft’s
over that time period:
1 1 T
R 
T
 R1  R2    RT   
T t 1
Rt
– -0.90%+15.8%+20.8%-44.4%+60.5%-6.5%-4.5%+5.8%
+44.2%+27.5%) = 11.83%

Solution
Next, we calculate the variance:
1 T
 Rt  R 
2
Var (R )  
T  1 t 1
Var(R)= 8.58%
The standard deviation is therefore
SD(R)= = 29.29%

The Normal Distribution
• Normal distribution is a symmetric probability
distribution that is completely characterized by its
average and standard deviation
– About two-thirds of all possible outcomes fall within one
standard deviation above or below the average
– About 95% of all possible outcomes fall within two standard
deviations above and below the average
– 95% Prediction Interval
Average  (2 x standard deviation)

R  (2 x SD  R  )

• This figure shows the
Normal Distribution distribution of returns for
small company stocks.
The height of the line
reflects the likelihood of
each return occurring.
• ~2/3 of all possible
outcomes should lie
within one standard
deviation (38.97%) of
the average return of
59.21% 20.23% 18.74% 57.71% 96.68% 18.74% and about 95%
should lie within two
-38.97% +38.97%
standard deviations i.e.
between -59.21% and
+96.68%

Illustration
• The average return for small stocks from 2005-2009
was 1.71% with a standard deviation of 24.8%.
• What is a 95% confidence interval for 2010’s
return? (assume +/- 2 std)

Solution
• to calculate the 95% confidence interval.
Average  (2 x standard deviation)
R  (2 x SD  R  )
• =1.71%-(2*24.80%) to 1.71%+(2*24.80%)
• = -47.89% to +51.31%

Summary of Tools for Working with Historical
Returns

Common Versus Independent Risk
• Common (Systematic) Risk = risk that is linked across
outcomes (perfectly correlated) => affect all securities.
– For example in earthquake insurance, an earthquake will affect all houses
simultaneously, so the risk is linked across the homes: either all houses are damaged,
or all houses are not damaged
• Independent (Firm-Specific) Risk = risks that bear no relation to
each other (uncorrelated) =>affects a particular security. If risks
are independent, then knowing the outcome of one provides no
information about the other
– For example in theft insurance, whether one house is burglarized has no effect on
another house’s chance of being burglarized.
• Diversification = averaging out of independent risks in a large
portfolio
– The principle of diversification is used routinely in the insurance industry and is
generally used to reduce risk.
FINA 5120 - Historical Tradeoff between Risk and Return 35

Diversification and Risk
• Diversifiable Risk and the Risk Premium
– The risk premium of a stock is not affected by its diversifiable,
unsystematic risk – because we can eliminate unsystematic
risk “for free” by diversifying our portfolio
– The risk premium for diversifiable risk is zero
• Investors are not compensated for holding unsystematic risk
• The Importance of Systematic Risk
– The risk premium of a security is determined by its
systematic risk and does not depend on its diversifiable risk
FINA 5120 - Diversification in Stock Portfolios 36

Systematic Risk Versus Unsystematic Risk
FINA 5120- Diversification in Stock Portfolios 37

The Importance of Systematic Risk
• A stock’s volatility which is a measure of total risk
(=systematic + unsystematic risk) is not useful to
determine the risk premium that investors will earn
• Standard deviation is not an appropriate measure of
risk for an individual security
• There is no relationship between volatility and
average returns for individual securities
• To find a security’s expected return we need to find a
measure of a security’s systematic risk
FINA 5120 - Diversification in Stock Portfolios 38

Measuring Systematic Risk
• To measure the systematic risk of a stock, determine
how much of the variability of its return is due to
systematic risk versus unsystematic risk.
• To determine how sensitive a stock is to systematic
risk, look at the average change in the return for each
1% change in the return of a portfolio that fluctuates
solely due to systematic risk.
• The first step is to find a portfolio that contains only
systematic (common) risk, in other words an efficient
(market) portfolio
FINA 5120 – Systematic Risk 39

Stock Market Indexes as the Market Portfolio
• In practice we use a market proxy — a portfolio whose
return should track the underlying, unobservable market
portfolio
– The most common proxy portfolios are market indexes
– A market index reports the market value of a broad
based portfolio of securities; for example:
• Dow Jones Industrial Average (DJIA): portfolio of 30 large stocks – was
created in 1884 and is one of the oldest stock market indexes
• S&P 500: a value weighted portfolio of 500 of the largest US stocks. The
composition of the index is based on certain criteria determined by the index
provider Standard & Poors. It is one of the most commonly used US indexes.
• https://www.youtube.com/watch?v=RWjrH9KZrHs
FINA 5120 – Measuring Systematic Risk 40

The S&P 500
• Panel (a) shows the
500 firms of the S&P
500 as a fraction of
the approximately
7,000 US public
firms.
• Panel (b) shows the
S&P 500 firms
importance in terms
of market cap –
these 500 firms
represent ~70% of
the total
capitalization of the
7,000 public firms

What about us?
• The Hang Seng Index
https://www.youtube.com/watch?v=Jr2gjIYZRts
• http://www.google.com/finance?ei=QnrnWOH9H8aQ0
ASYn4XgCg&q=Hang+seng+index&
=

Game! Connect the index to its country!
1
2
• A) SSE Composite
• B) Kospi 3
• C) Nifty
• D) Nikkei
4
Index Funds and ETFs
• A good way to invest in a market portfolio is to buy an
index mutual fund
– The index fund replicates the performance of the index by
buying the components of the index in the same proportion as
the index.
– John Boggle, founder of Vanguard, launched the Vanguard
S&P 500 Index Fund in 1976.
http://quote.morningstar.com/fund/chart.aspx?t=VFINX
• Another way is to invest in an ETF (Exchange Traded
Fund) that also replicates the performance of an index
– Two of the better known ETFs are SPDR and iShares

Sensitivity to Systematic Risk: Beta (β)
• We can measure the systematic risk of a security by
calculating the sensitivity of the security’s return to the
return of the market portfolio
• The Beta (β) of a security = the expected % change in the
excess return of a security for a 1% change in the excess
return of the market portfolio.
• Beta differs from volatility.
– Volatility measures total risk (systematic plus unsystematic risk),
while Beta is a measure of only systematic risk.
FINA 5120 – Systematic Risk and Beta 45

Illustration
• If we assume that the market portfolio is efficient, then changes
in the market portfolio represent systematic shocks to the
economy
• Suppose the market portfolio tends to increase by 52%
when the economy is strong and decline by 21% when the
economy is weak.
• What is the beta of a type S firm which is only affected by
systematic risk whose return is 55% on average when
the economy is strong and -24% when the economy is
weak?
• What is the beta of a type U firm that bears only
idiosyncratic, firm-specific risk? Copyright ©2017 Pearson Education, Inc. All rights reserved.
FINA 5120 – Systematic Risk and Beta 46

Solution
• The systematic risk of the strength of the economy
produces a 52% - (-21%) = 73% change in the return
of the market portfolio.
• The type S firm’s return changes by:
55% - (-24%) = 79% on average.
• Thus the type S firm’s beta is
βS = 79%/73% = 1.082.
• That is, each 1% change in the return of the market
portfolio leads to a 1.082% change in the type S firm’s
return on average.
FINA 5120 - Systematic Risk and Beta 47

Solution
• The return of a type U firm has only firm-specific risk,
however, and so is not affected by the strength of the
economy. Its return is affected only by factors specific
to the firm.
• Because it will have the same expected return,
whether the economy is strong or weak,
βI = 0%/72% = 0.

• Market Risk and Beta
– There are many data sources that provide estimates of beta
• Most use 2 to 5 years of weekly or monthly returns
• Most use the S&P 500 as the market portfolio
• http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafil
e/Betas.html
• The beta of the overall market portfolio is 1
• Many industries and companies have betas
higher/lower than 1
– Differences in betas by industry are related to the sensitivity of
each industry’s profits to the general health of the economy

Important Note
• Volatility (standard deviation) and beta are measured in different
units:
– Volatility is expressed in %
– Beta is unitless
• Even though total risk (volatility) is equal to the sum of systematic risk
(measured by beta) and firm-specific risk, our measure of volatility
does not have to be a bigger number than our measure for beta
• Example: Microsoft has total risk of 28% (0.28) and beta of 1.0, which
is greater than 0.28. Because volatility is measured in % and beta is
not, volatility doesn’t have to be greater than beta. So a stock like
Boston Beer can have a higher volatility (standard deviation) than
Microsoft (35%) and a lower beta (0.9). The following Figure 12.6
shows one possible breakdown of risk for Microsoft and Boston Beer
consistent with these data.

Systematic versus Firm-Specific Risk in Boston Beer
and Microsoft
• Beta, measuring systematic risk,
and standard deviation, measuring
total risk, are in different units.
• Even though Microsoft’s total risk
(standard deviation) is 0.28 (28%),
its beta, measuring only systematic
risk, is 1.0.
• In this case, the beta of 1
corresponds to a breakdown in
total risk as depicted in the figure.
• Formally, the portion of Microsoft’s
total risk that is in common with the
market is calculated by multiplying
the correlation between Microsoft
and the market by the standard
deviation of Microsoft.

Illustration
• Suppose that in the coming year, you expect
Rackspace Hosting’s stock to have a standard
deviation of 40% and a beta of 1.4, and SolarWinds’
stock to have a standard deviation of 31% and a beta
of 1.9.
• Which stock carries more total risk?
• Which has more systematic risk?

Solution
Standard Beta (β)
Deviation (Total (Systematic
Risk) Risk)
Rackspace 40% 1.4

SolarWinds 31% 1.9
• Total risk is measured by standard deviation; therefore,

Rackspace Hosting’s stock has more total risk.
• Systematic risk is measured by beta. SolarWinds has a
higher beta, and so has more systematic risk.
• A stock can have high total risk, but if a lot of it is diversifiable, it
can still have low or average systematic risk.
Estimating the Risk Premium
• Market risk premium
– The market risk premium is the reward investors
expect to earn for holding a portfolio with a beta of 1.
Market Risk Premium  E  RMkt   rf

Beta and Cost of Capital - CAPM
• The Capital Asset Pricing Model (CAPM)
– The equation for the expected return of an investment:
Systematic E  R   Risk-Free Interest Rate  Risk Premium
risk premium
of the
investment
 rf    (E  RMkt   rf )
Risk free rate Market risk premium
– 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 is equal to the market risk premium
multiplied by the amount of systematic risk of the investment
FINA 5120 – The CAPM 55

Illustration
• Assume the economy has a 60% chance that the
market return will be 15% next year and a 40% chance
the market return will be 5% next year.
• Assume the risk-free rate is 6%.
• If Microsoft’s beta is 1.18, what is its expected return
next year?

Solution
• First we compute the expected return of the market
• E[RMkt] = (60% × 15%) + (40% × 5%) = 11%
• Then we apply CAPM to calculate Microsoft’s expected
return
• E[R] = rf + β ×(E[RMkt] − rf )
• E[R] = 6% + 1.18 × (11% − 6%)
• E[R] = 6% + 5.9% = 11.9%

Estimating the Cost of Equity
• Two possible ways (there are others)

Your Turn!
• Amazon.com stock prices gave
a realized return of 5%, -5%,
11%, and -11% over four
successive quarters. What is
the annual realized return for
Amazon.com for the year?
A) -1.45%
B) 2.91%
C) 0.00%
D) 1.46%
Answer A
FINA 5120 – Questions 59

Solution to Question 1
1  Rannual  (1  R1 )(1  R2 )(1  R3 )(1  R4 )
Annual realized return

 (1  5%)  (1  5%)  (1  11 %)  (1  11 %)  1
 -1.45%

Your Turn!
• Ford Motor Company had realized
returns of 20%, 30%, 30%, and 20%
over four quarters. What is the
quarterly standard deviation of
returns for Ford calculated from this
sample?
A) 5.77%
B) 5.20%
C) 6.06%
D) 4.62%
Answer A

Solution to Question 2
1
Var  R  
T 1
 ( R1  R )2  ( R2  R ) 2  ...  ( RT  R ) 2 
SD( R )  Var  R 
20%  30%  30%  20%

Average return   25%
4
SD  Var(R) 
20% - 25%2  30% - 25%2  30% - 25%2  20% - 25%2  5.77%
4 -1

Your Turn!
• Many former employees at
AlphaEnergy, an energy trading and
supply company, had a large part of
their portfolio invested in
AlphaEnergy's stock. These
employees were bearing a high
degree of ________ risk.
A) unsystematic
B) systematic
C) market-specific
D) non-diversifiable Answer A

SUMMARY
64
Summary of Tools for Working with Historical
Returns

Systematic Risk Versus Unsystematic Risk
FINA 5120- Diversification in Stock Portfolios 66

Estimating the Cost of Equity
• Two possible ways (there are others)

ADDENDUM
68
• Estimating Beta from Historical Returns
– Beta is the expected percentage change in the excess return
of the security for a 1% change in the excess return of the
market portfolio
• The amount by which risks that affect the overall market are
amplified or dampened in a given stock or investment.
𝐶𝑜𝑣𝑎𝑟 (𝑅A ,𝑅M ) 𝐶𝑜𝑣𝑎𝑟 (𝑅A ,𝑅M )

𝛽𝐴 = = 2
𝑉𝑎𝑟 (𝑅M ) 𝜎𝑀
• Where Ra is the return of stock A and Rm is the return of the

market

Application: Estimating Beta from Historical
Returns
• Apple’s stock for example (Figure 12.7):
– The overall tendency is for Apple to have a high return when
the market is up and a low return when the market is down
– Apple tends to move in the same direction as the market, but
its movements are larger
– The pattern suggests that Apple’s beta is greater than one

Figure 12.7 Monthly Excess Returns for Apple Stock
and for the S&P 500, January 2008-December 2012

Returns
• We can see Apple’s sensitivity to the market even more
clearly by plotting Apple’s returns as a function of S&P
500’s returns, as shown in the next Figure 12.8
• Each point in this figure represents the returns of Apple
and the S&P 500 for one of the months in Figure 12.7.
For example, in May 2009, Apple’s return was 7.9%
and the S&P500’s was 5.3%
• As the scatterplot makes clear, Apple’s returns have a
positive correlation with the market: Apple tends to go
up when the market is up, and vice versa.

Figure 12.8 Scatterplot of Monthly Returns for Apple versus
the S&P 500, January 2008 through December 2012

• In practice, we use linear regression to estimate the
relation
– The output of the linear regression is the best-fitting line that
represents the historical relation between the stock and the
market
– The slope of this line is our estimate of its beta
– The slope tells us how much, on average, the stock’s excess
return changed for a 1% change in the market’s excess return

Returns
• In Fig. 12.8, the best fitting line shows that a 1% change in
the market’s returns corresponds to about a 1.2% change in
Apple’s return.
– So, Apple’s return moves about 1.2 times the overall market’s
movement
– => Apple’s beta is 1.2
• Beta capture the systematic market risk of a security.
• The best fitting line captures the components of a security’s
returns that can be explained by market-risk factors.
• Deviations from the best-fitting line result from risk that is
not related to the market as a whole: that risk is
diversifiable risk that averages out in a large portfolio

Putting It All Together: The Capital Asset Pricing
Model (CAPM)
• The CAPM says that the expected return 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
– The risk premium is equal to the market risk premium times
the amount of systematic risk present in the investment,
measured by its beta (βi)
– When graphed, it is called the security market line (SML)
ഥ = 𝐑 𝐅𝐫𝐞𝐞 + 𝛃 × ሺ𝐑
𝐑 ഥ𝐌𝐚𝐫𝐤𝐞𝐭 − 𝐑 𝐅𝐫𝐞𝐞 ሻ

How to Infer Stock Return from Market Return?
• From the CAPM, we have the Security Market Line,

SML, which links the Expected Return of a security to
the Risk Free Rate, the Beta of the security and the
Expected Market Return
• That is 𝐑ഥ = 𝐑 𝐅𝐫𝐞𝐞 + 𝛃 × ሺ𝐑ഥ𝐌𝐚𝐫𝐤𝐞𝐭 − 𝐑 𝐅𝐫𝐞𝐞 ሻ
• Which for special cases:
– If β = 1 => Rഥ = RഥMarket , i.e. the exposure is to the whole stock market
– If β = 0 => Rഥ = R Free , i.e. no exposure to the stock market
– High beta stocks amplify market return and risks, low beta
stocks amortize them
• The Market-Risk Premium is: ഥMarket − R Free
R

Your Turn!
• Problem:
• Suppose the risk-free return is 5% and you measure
the market risk premium to be 7%.
• Best Buy has a beta of 1.5.
• According to the CAPM, what is its expected
return?

Solution
• We can compute the expected return according to the
CAPM.
• For that equation, we will need the market risk
premium, the risk-free return, and the stock’s beta.
• We have all of these inputs, so we are ready to go.
E[ RBBY ]  rf   BBY ( E[ RMkt ]  rf )  5%  1.5(7%)

 15.5%

The Security Market Line
– The CAPM implies a linear relation between a stock’s beta
and its expected return
– This line is graphed as the line through the risk-free
investment (with a beta of zero) and the market (with a beta of
one); it is called the security
1.6 market line (SML)
– Recall that there is no clear relation between a stock’s

standard deviation (volatility) and its expected return
• The relation between risk and return for individual securities
is only evident when we measure market risk rather than total
risk

Expected Returns, Volatility, and Beta (Panel A)
The graph compares the

standard deviation
(volatility) and expected
(required) returns of stocks
including Apple.
Some of the stocks are
identified.
There is no relation
between total risk and
expected return.
It is clear that we could not
predict Boston Beer’s
expected return using its
total risk.

Expected Returns, Volatility, and Beta (Panel B)
The security market line

(SML) – in green on the
graph – shows the expected
return for Apple and each
of the stocks as a function
of its beta with the market.
According to the CAPM, all
stocks and portfolios -
including the market
portfolio - should lie on the
SML.
Thus, Apple’s expected
return can be determined
by its beta, which measures
its systematic risk.

Your Turn
• Problem:
• Suppose the stock of Ace Marketing & Promotions
(AMKT) has a negative beta of -0.70.
• How does its expected return compare to the risk-
free rate, according to the CAPM?
• Does your result make sense?

Solution
• Plan:
• We can use the CAPM equation to compute the
expected return of this negative beta stock just like we
would a positive beta stock.
• We don’t have the risk-free rate or the market risk
premium, but the problem doesn’t ask us for the exact
expected return, just whether or not it will be more or
less than the risk-free rate.

Solution
• Execute:
• Because the expected return of the market is higher
than the risk-free rate, the equation implies that the
expected return of Ace Marketing & Promotions
(AMKT) will be below the risk-free rate.
• As long as the market risk premium is positive (as
long as people demand a higher return for investing in
the market than for a risk-free investment), then the
second term in the equation will have to be negative if
the beta is negative.

Solution: A Negative Beta Stock
• Execute (cont’d):
• For example, if the risk-free rate is 5% and the market
risk premium is 7%,
– E[RAMKT] = 5% - 0.70(7%) = 0.1%.
– (See Figure 11.9: the SML drops below rf for β < 0.)

• Evaluate:
• This result seems odd—why would investors be willing
to accept a 0.1% expected return on this stock when
they can invest in a safe investment and earn 5%?
• The answer is that a savvy investor will not hold AMKT
alone; instead, the investor will hold it in combination
with other securities as part of a well-diversified
portfolio.
• These other securities will tend to rise and fall with the
market.

• Evaluate (cont’):
• But because AMKT has a negative beta, its correlation
with the market is negative, which means that AMKT
tends to perform well when the rest of the market is
doing poorly.
• Therefore, by holding AMKT, an investor can reduce
the overall market risk of the portfolio.
• In a sense, AMKT is “recession insurance” for a
portfolio, and investors will pay for this insurance by
accepting a lower return.

Putting It All Together: The Capital Asset Pricing
Model (CAPM)
• The CAPM and Portfolios
– We can apply the SML to portfolios as well as individual
securities
• The market portfolio is on the SML, and according to the CAPM,
other portfolios (such as mutual funds) are also on the SML
• Therefore, the expected return of a portfolio should correspond
to the portfolio’s beta
• The beta of a portfolio made up of securities each with weight wi
is:
 P  w11  w2  2  ...  wn  n

Your Turn!
• Problem:
• Suppose Ford (F) has a beta of 2.67, whereas the
beta of Safeway (SWY) is 0.72.
• If the risk free interest rate is 3% and the market risk
premium is 6%, what is the expected return of an
equally weighted portfolio of Ford and Safeway,
according to the CAPM?

Solution: The Expected Return of a Portfolio
• Plan:
• We have the following information:
• rf = 3%,
• E[RMkt] - rf = 6%
• F:
– βF = 2.67,
– wF = 0.50
• SWY:
– βSWY = 0.72,
– wSWY = 0.50

• Plan (cont’d):
• We can compute the expected return of the portfolio
two ways.
• First, we can use the CAPM to compute the expected
return of each stock and then compute the expected
return for the portfolio.
• Or, we could compute the beta of the portfolio and then
use the CAPM to find the portfolio’s expected return.

• Execute:
• Using the first approach, we compute the expected
return for F and SWY:
• E[RF] = rf + βF(E[RMkt] – rf)
• E[RSWY] = rf + βSWY(E[RMkt] – rf)
• E[RF] = 3% + 2.67(6%)=19.02%
• E[RSWY] = 3% + 0.72(6%)=7.32%
• Then the expected return of the equally weighted
portfolio P is:
• E[RP] = 0.5(19.02%) + 0.5(7.32%) = 13.17%

Solution : The Expected Return of a Portfolio
• Execute (cont’d):
• Alternatively, we can compute the beta of the portfolio :
• βP = wFβF + wSWYβSWY
• βP = (0.5)(2.67) + (0.5)(0.72) = 1.695
• We can then find the portfolio’s expected return from
the CAPM:
• E[RP] = rf + βP(E[RMkt] – rf)
• E[RP] = 3% + 1.695(6%) = 13.17%

FINA 5120 - Fall (1) 2022 - Session 6 (With Answers) - Risk and Return CAPM - 26 August22

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FINA 5120 - Fall (1) 2022 - Session 6 (With Answers) - Risk and Return CAPM - 26 August22

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FINA 5120 - Capital Markets and the Pricing of Risk 5

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FINA 5120 - Capital Markets and the Pricing of Risk 6

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FINA 5120 - Capital Markets and the Pricing of Risk 7

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FINA 5120 - Capital Markets and the Pricing of Risk 8

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FINA 5120 - Capital Markets and the Pricing of Risk 9

• Variance and Standard Deviation:

SD( R )  Var ( R )  0.045  21.2%

• In finance, the standard deviation of a return is also referred to as its

• What are its expected return and standard deviation?

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FINA 5120 - Capital Markets and the Pricing of Risk 11

– Standard Deviation SD ( R )  Var ( R)

• SD(R) = [(0.25)(0.08 – 0.099)2 + (0.55)(0.10 –

FINA 5120 - Capital Markets and the Pricing of Risk 12

Note: Negative returns are in red

FINA 5120 - Capital Markets and the Pricing of Risk 14

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FINA 5120 – Historical Risks and Returns of Stocks 16

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FINA 5120 - Historical Risks and Returns of Stocks 17

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FINA 5120 - Historical Risks and Returns of Stocks 18

• The assumption is that all dividends are

FINA 5120 - Historical Risks and Returns of Stocks 19

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FINA 5120 - Historical Risks and Returns of Stocks 20

FINA 5120 - Historical Risks and Returns of Stocks 21

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FINA 5120 - Historical Risks and Returns of Stocks 22

This histogram plots the

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• Rt = Realized return of a security in year t from years 1

FINA 5120 - Historical Risks and Returns of Stocks 24

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FINA 5120 - Historical Risks and Returns of Stocks 25

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FINA 5120 - Historical Risks and Returns of Stocks 26

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FINA 5120 - Historical Risks and Returns of Stocks 27

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FINA 5120 - Historical Risks and Returns of Stocks 28

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FINA 5120 - Historical Risks and Returns of Stocks 29

Average  (2 x standard deviation)

FINA 5120 - Historical Risks and Returns of Stocks 30

FINA 5120 - Historical Risks and Returns of Stocks 31

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FINA 5120 - Historical Risks and Returns of Stocks 32

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FINA 5120 - Historical Risks and Returns of Stocks 34

FINA 5120 - Historical Tradeoff between Risk and Return 35

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FINA 5120 - Diversification in Stock Portfolios 36

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