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Topic:RiskandReturnandtheCapitalAssetPricingModel
Lecture8:Objectives
MainTopic:TheRisk andtheRequiredReturnonAssets
Knowhowtocalculateexpected(projected)returns
andvolatilityonassetsandportfolioofassets
Distinguishbetweenmarketriskvs.idiosyncraticrisks
Explaintheconceptofdiversification.
Measureandinterpretthebetaofanasset.
Relatethebetaofanassettotherateofreturnthat
themarketexpectstoreceivefromtheasset(The
SecurityMarketLine)
The expecteu (pioject) ietuin on an asset is given by
E(R) = p

n
=1
Where:
p
i
=theprobabilitythatstateicanoccur
R
i
=theexpectedreturnoftheassetifstateIoccurs
n=totalnumberofpossiblestates
Onecomputesexpectedreturnsbasedontheprobabilitiesofpossible
futureoutcomes.
Inthiscontext,expectedmeansaverageiftheprocessisrepeatedmany
times.
Theresultingexpectedreturndoesnothavetobeoneofthepossible
outcomes.
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ComputingExpectedReturns
Supposethatthereare3possiblestatesoftheeconomyfornext
yearwiththefollowingprobabilitiesofrealization Boom(25%),
Neutral(50%),Recession(25%).Historically,stocksAandBhave
yieldedthefollowingaveragereturnsduringeachofthethree
statesoftheeconomy
WhatarestocksAandBsexpectedreturnsfornextyearifyou
believethatthepastisthebestrepresentationofthefuture?
E R
A
= .2S (-2u%)+.S 1S%+.2S SS% = 11.2S%
E R
B
= .2S Su%+.S 1S%+.2S -1u% = 12.S%
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ComputingExpectedReturns Example
States
States Recession Neutral Boom
Prob. .25 .50 .25
Stock A 20% 15% 35%
StockB 30% 15% 10%
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The expecteu ietuin volatility can be computeu as
E|o] = p

- E(R)
2
n
=1
Toestimatefutureinvestmentreturnvolatility,usetheprobabilitiesfor
theentirerangeofpossibilities.
Varianceistheweighted averageofthesquareddeviationsfromthe
projectedreturn
Standarddeviation=squarerootofvariance.
ExampleContd:
o R
A
=
.2S -2u% - 11.2S%
2
+.S 1S% - 11.2S%
2
+.2S SS% - 11.2S%
2
= 19.8u%
o R
B
=
.2S Su% - 12.S%
2
+ .S 1S% - 12.S%
2
+.2S -1u% - 12.S%
2
= 14.S6%
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ComputingExpectedReturnVarianceandStandardDeviation
Aportfolioisacollectionofassets
Aportfoliosriskandreturnareentirelydeterminedbythe
risksandreturnsoftheassetsthatmakeuptheportfolio
TheAllOrds IndexisacollectionofstockstradedontheASX.
Itsalsoaportfolio(offinancialsecurities)!
Afirmisaportfolioofrealassets!
Aportfoliosinvestmentperformancecanbemeasuredbyits
returnsandrisksthesameaswithindividualassets.Soa
portfolioofassetscanbetreatedasanassetjustlikeastock
orabond.
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PortfoliosasAssets
Portfoliohistoricalreturnscanbecalculatedjustlikestockhistorical
returns.Seelastweekslecturenotes.
Theexpectedreturnofaportfolioistheweightedaverageofthe
expectedreturnsforeachassetintheportfolio.
E(R
P
) = w
]
E(R
]
)
m
]=1
where
w
]
=
$ ncstcd n Assct ]
1otuI $ vuIuc o] Pot]oIo
, theportfolioweightonassetj
R
]
=returnofassetj
m = totol numbcr o osscts in tbc portolio
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ComputingPortfolioExpectedReturns
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Youcanalsofindtheexpectedreturnbyfinding
theportfolioreturnineachpossiblestateand
computingtheexpectedvalueaswedidwith
individualsecurities.
E(R
P
) = p

R
P,
n
=1
where
i =particularstateoutofthepossiblenstates
p

=probabilitythatstateiisrealized
R
P,
=returnoftheportfolioinstatei
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ComputingPortfolioExpectedReturns
Supposeyouhave$15000toinvestandyouhavepurchasedstocksinthe
amountsdescribedinthetablebelow.Whatareyourportfolioweightsin
eachsecuritygiventheexpectedreturnsforeachstock,andtheportfolios
expectedreturns?
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ExpectedPortfolioReturns Example
Stock E(r) $Invested %of Portfolio
Value(w)
wxE(r)
Double Click 19.65% $2,000 $2,000
$15,000
= 1S.SS%
2.62%
CocaCola 8.96% $3,000 $3,000
$15,000
=20%
1.79%
Intel 9.67% $4,000 $4,000
$15,000
=26.67%
2.58%
Keithley Ind. 8.13% $6,000 $6,000
$15,000
=40%
3.25%
Total $15,000 100% 10.24%
Portfolioreturnvolatility(orstandarddeviation)isNOT aweighted
averageofthestandarddeviationofthecomponentsecuritiesrisk.
Computetheoverallexpectedportfolioreturnusingthesameformulaas
foranindividualasset.
R
P,
= w
1
R
1,
+w
2
R
2,
++w
m
R
m,
wherem denotestotalnumberofstocksinportfolio,andi denotesa
particularstateoutofnpossiblestates
Thencomputetheportfoliovarianceandstandarddeviationusingthe
sameformulasasforanindividualasset
E R
p
= p

R
P,
m
=1
o(R
p
) = p

R
P,
- E R
p
2

m
=1
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PortfoliosandPortfolioRisk
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Realizedreturnsareingeneralnotequaltoexpectedreturns.
Theunexpectedcomponentofreturns(e
t
)isthedifference
betweenrealizedandexpectedreturns.
R
t
-E
t-1
R
t
= e
t
Theunexpectedcomponentcanbepositiveornegative.
Viewedanotherway,theunexpectedcomponentisa
surprise.
Ifmarketsareefficientandmarketexpectationsarecorrect,
thenexantethesurprisecomponentshouldbezero.
E
t-1
|R
t
- E
t-1
R
t
] = E
t-1
|e
t
] = u
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RealizedReturnsvs.ExpectedReturns
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Totalrisk ofanasset=assetsmarketrisk+assetspecificrisk
Marketrisk: macroeconomicriskthataffectstheoverallstock
market(eachtoagreaterorlesserextent).Alsocalledsystematic
ornondiversifiablerisk.E.g.unexpectedchangesinGDP,
employment,inflation,interestrates
Assetspecificrisk: riskthataffectsanindividualcompanyor
assetonly.Alsocallednonsystematicordiversifiablerisk.E.g.
corporatefraud,laborstrikeataproductionplant,some
loan/debtdefaults
Therisksinassetreturns
Diversification: spreadinginvestmentacrossseveral
assetstoreducesomeoftherisks.
Withmanyassetsinaportfolio,thepositiveand
negativeidiosyncraticsurprisesinassetreturnscan
cancelout,sothereturnvolatilityoftheoverall
portfoliocanbereducedthroughdiversification.
Marketriskaffectsallsecuritiesintheportfoliointhe
samedirection.Thus,nomatterhowmanyassetsare
includesinaportfolio,marketriskcannotbe
eliminated.
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Theriskofassetsandportfoliodiversification
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PortfolioDiversification
Table11.7
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PortfolioDiversification:Agraphicalillustration
Averageannual
standarddeviation
Numberof
stocksinportfolio
1 10 20 30 1,000
17%
23%
Diversifiablerisk
PortfolioMarketRisk
(Nondiversifiablerisk)
Thereisarewardforbearingrisk(Ch 10.,Wk 7)incapital
markets.
Butaportionoftheinvestmentriskcanbeeliminated
throughportfoliodiversification.
Thenrewardforbearingriskshouldberelatedto
systematicriskonly,nottotalinvestmentrisk.
RefinednewversionofRisk/RewardTradeoff:Infinancial
marketsthereisareward forbearingsystematicriskonly.
Assetspecificrisksdonotoffercompensationinformof
higherexpectedreturns.
Logic:Q:Wouldyoupayforsomethingthatisworth
nothing?A:Themarketswont(marketsaresmart)!
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PortfolioDiversificationandSystematicRisk
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MeasuringMarketRiskandBeta
Because of diversification, assetspecific risks do not offer a risk premium.
Q) Then how are the assets riskpremiums related to market risk?
A) The risk premium of an individual asset is tied to the market risk premium
by its beta.
E|r
A
- r
]
]
Assct A
risk prcmium
=
[
A
E|r
M
- r
]
]
Horkct
risk prcmium
Intuitively, [ measures the amount of market risk in an asset relative to the
risk of a perfectly diversified portfolio. The market portfolio by definition has
a [ of 1.
Stocks with > 1 are particularly sensitive to market fluctuations. Stocks
with < 1 are not so sensitive to market fluctuations. The average of all
stocks in the market is 1.
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SomeExamplesofStockBetas Table11.8
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PortfolioBeta: theweightedaverageofthebetasofthe
securitiesintheportfolio.Similartocomputingreturnon
aportfolioofassets.
Examplewith2securities:
Security/PortfolioExpectedReturnsandBetas
$1,uuuinstockA,withE(R
A
) = 1S%, and[
A
= 1.4
$2,uuuinstockB,withE(R
B
) = S%, and[
B
= u.6
E(R
P
) =
1
S
1S% +
2
S
S% = 8.S%
[
P
=
1
S
1.4 +
2
S
u.6 = u.87
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TheCapitalAssetPricingModel(CAPM)
Therelationbetweenanassetsriskpremiumandthe
marketriskpremium:
E R

-R
]
= [

E R
M
-R
]
The CAPM defines the relationship between risk and return
for any asset.
E R

= R
]
+[

E R
M
-R
]
Expectedreturnscomefromtwosources:
(i)compensationforthetimevalueofmoney(R
f
)
(ii)andtheassetsriskpremium
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Example
Investors expect the market rate of return this year to be
14%. A stock with = 0.8 has an expected rate of return
of 12%. If the market return this year turns out to be 10%,
what is your best guess as to the rate of return on the
stock?
Step 1: find R
f
using E(R
i
) = R
f
+
i
[E(R
M
) R
f
]
12% = R
f
+ .8 [14% R
f
]
Solving gives R
f
=4%
Step 2: predict R
i
using the SML
R
i
= 4% + .8 [10%4%]=8.8%
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FortheMarketPortfolio:Agoodproxyforthe
marketportfolioisthevalueweightedportfolioof
allstocks.
InAustralia,agoodproxyistheAllOrds Index.
IntheUSagoodproxyistheNewYorkStock
Exchange(NYSE)IndexortheS&P500.
FortheRiskFreeAsset:asecuritywithnorisk.
Agoodproxyisthe3monthTreasuryBill(TBill).
TwoUsefulBenchmarks
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TheSecurityMarketLine
Asset
expected
return
Asset
beta

M
= 1
R
]
E(R
M
)
E(R
M
) - R
]

M
= 1
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SMLandEfficientMarkets
Asset
expected
return
Asset
beta
Undervaluedstock
Overvaluedstock
E(R
M
)
R
]

M
= 1
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SMLandEfficientMarkets:RewardtoRiskRatio
Therewardtoriskratiosmustbethesameacrossall
assetsastheyareallonthesameSecurityMarketLine
(SML).Equilibriumconditionsandmarketefficiency
ensuresthat
SMLslope=
L(R
i
)-R
]
[
i
=
L(R
]
)-R
]
[
]
=
L(R
k
)-R
]
[
k
Ifassetk isthemarketportfolio,andsince
m
=1,then
E(R

) - R
]
[

=
E(R
]
) - R
]
[
]
= E(R
M
) - R
]
Therefore,inanefficientmarkettherewardtoriskratiois
thesameacrossallassetsinthemarket.
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Whereasweknowfromhistorythattherewasarewardfor
risk,todaywelearnedthattherewardistiedtomarketrisk
andnotjustanyrisk.
Thisisafundamentalconceptthatembodiesalltopicsin
finance,includingvaluationofprojects.
Textbookexercises:
Allcriticalthinkingproblems
QuestionsandProblems:
7,10,11,17,18,24,25,29,31,32,33,34,35,36,37
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Conclusions