Principles

Chapter 9
of
Corporate
Finance
Risk and Return

Ninth Edition

Slides by
Matthew Will

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 2

Topics Covered
 Markowitz Portfolio Theory
 The Relationship Between Risk and Return
 Validity and the Role of the CAPM
 Some Alternative Theories

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 3

Markowitz Portfolio Theory

 Combining stocks into portfolios can reduce
standard deviation, below the level obtained
from a simple weighted average calculation.
 Correlation coefficients make this possible.
 The various weighted combinations of
stocks that create this standard deviations
constitute the set of efficient portfolios.
portfolios

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 4

Markowitz Portfolio Theory

Price changes vs. Normal distribution
IBM - Daily % change 1986-2006
6

5
Proportion of Days

0
-6 -5 -5 -4 -3 -2 -1 -1 0 1 2 2 3 4 5 5 6

Daily % Change
McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 5

Markowitz Portfolio Theory

Standard Deviation VS. Expected Return
Investment A
20
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 6

Markowitz Portfolio Theory

Standard Deviation VS. Expected Return
Investment B
20
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 7

Markowitz Portfolio Theory

Standard Deviation VS. Expected Return
Investment C
20
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 8

Markowitz Portfolio Theory

Standard Deviation VS. Expected Return
Investment D
20
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 9

Markowitz Portfolio Theory

 Expected Returns and Standard Deviations vary given
different weighted combinations of the stocks

Expected Return (%)

IBM

40% in IBM

Wal-Mart

Standard Deviation

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 10

Efficient Frontier
4 Efficient Portfolios all from the same 10 stocks

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 11

Efficient Frontier
•Each half egg shell represents the possible weighted combinations for two
stocks.
•The composite of all stock sets constitutes the efficient frontier

Expected Return (%)

Standard Deviation

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 12

Efficient Frontier
•Lending or Borrowing at the risk free rate (rf) allows us to exist outside the
efficient frontier.

Expected Return (%)

S ow
i ng
o rr
B

in g
end
L

rf

T
Standard Deviation

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 13

Efficient Frontier
Previous Example Correlation Coefficient = .4
Stocks  % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%

Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 14

Efficient Frontier
Previous Example Correlation Coefficient = .4
Stocks  % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%

Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%

Let’s Add stock New Corp to the portfolio

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 15

Efficient Frontier
Previous Example Correlation Coefficient = .3
Stocks  % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%

NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 16

Efficient Frontier
Previous Example Correlation Coefficient = .3
Stocks  % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%

NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%

NOTE: Higher return & Lower risk

How did we do that? DIVERSIFICATION
McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 17

Efficient Frontier

Return

Risk
(measured
as )

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 18

Efficient Frontier

Return

B
AB
A

Risk

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 19

Efficient Frontier

Return

B
N
AB
A

Risk

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 20

Efficient Frontier

Return

B
ABN AB N

Risk

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 21

Efficient Frontier
Goal is to move
Return up and left.
WHY?

B
ABN AB N

Risk

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 22

Efficient Frontier

Return

Low Risk High Risk

High Return High Return

Low Risk High Risk

Low Return Low Return

Risk

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 23

Efficient Frontier

Return

Low Risk High Risk

High Return High Return

Low Risk High Risk

Low Return Low Return

Risk

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 24

Efficient Frontier

Return

B
ABN N
AB
A

Risk

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 25

Security Market Line

Return

Market Return = rm .
Risk Free Efficient Portfolio

Return = rf
Risk

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 26

Security Market Line

Return

Market Return = rm .
Risk Free Efficient Portfolio

Return = rf

1.0 BETA

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 27

Security Market Line

Return

.
Risk Free Security Market
Line (SML)
Return = rf

BETA

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 28

Security Market Line

Return

SML

rf
BETA
1.0

SML Equation = rf + B ( rm - rf )
McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 29

Capital Asset Pricing Model

R = rf + B ( r m - rf )

CAPM

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 30

Testing the CAPM

Beta vs. Average Risk Premium
Avg Risk Premium
1931-2005

30
SML

20 Investors

10
Market
Portfolio
0
Portfolio Beta
1.0

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 31

Testing the CAPM

Beta vs. Average Risk Premium
Avg Risk Premium
1931-65 SML
30

20 Investors

10 Market
Portfolio
0
Portfolio Beta
1.0

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 32

Testing the CAPM

Beta vs. Average Risk Premium
Avg Risk Premium
1966-2005

30

20 SML
Investors

10

Market
0 Portfolio
Portfolio Beta
1.0

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 33

Testing the CAPM

Return vs. Book-to-Market
Dollars
(log scale)100

High-minus low book-to-market

10
Small minus big

1976

1986
1926

1936

1946

1956

1966

1996

2006
0.1

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 34

Consumption Betas vs Market Betas

Stocks Stocks
(and other risky assets) (and other risky assets)

Wealth is uncertain

Market risk Standard Consumption

makes wealth Wealth
CAPM CAPM
uncertain.
Consumption is
uncertain

Wealth = market
Consumption
portfolio

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 35

Arbitrage Pricing Theory

Alternative to CAPM

Expected Risk
Premium = r - rf
= Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + …

Return = a + bfactor1(rfactor1) + bf2(rf2) + …

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 36

Arbitrage Pricing Theory

Estimated risk premiums for taking on risk factors
(1978-1990)

Estimated Risk Premium

Factor
(rfactor  rf )
Yield spread 5.10%
Interest rate - .61
Exchange rate - .59
Real GNP .49
Inflation - .83
Mrket 6.36

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 37

Three Factor Model

Steps to Identify Factors

1. Identify a reasonably short list of macroeconomic factors that

could affect stock returns
2. Estimate the expected risk premium on each of these factors ( r
factor 1 − r f , etc.);
3. Measure the sensitivity of each stock to the factors ( b 1 , b 2 ,
etc.).

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 38

Three Factor Model

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
 9- 39

Web Resources
Click to access web sites
Internet connection required

http://finance.yahoo.com

www.duke.edu/~charvey

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french

McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved