Risk, Return, and The Capital Asset Pricing Model

6
chapter 7
Risk, Return, and the
Capital Asset Pricing Model
Topics in Chapter
CH6
CH7
• Basic return concepts

• Basic risk concepts
• Stand-alone risk
• Portfolio (market) risk
• Risk and return Tradeoff:
CAPM/SML & alternative theory
7-2
What are investment returns?
CH6
CH7
• Investment returns measure the

financial results of an investment with
the scale and timing effect.
• Returns may be historical or
prospective (anticipated).
• Returns can be expressed in:
– Dollar terms.
– Percentage terms.
7-3
An investment costs $1,000 and is
sold after 1 year for $1,100
CH6
CH7
Dollar return:
$ Received - $ Invested
$1,100 - $1,000 = $100
Percentage return:
$ Return/$ Invested
$100/$1,000 = 0.10 = 10%
7-4
What is the stand-alone risk?
CH6
CH7
• Typically, investment returns are not

known with certainty.
• An asset’s stand-alone risk pertains to
the probability of earning a return less
than that expected.
• The greater the chance of a return far
below the expected return, the greater
the risk.
7-5
Probability Distribution:
Which stock is riskier? Why?
CH6
CH7
Stock A
Stock B
-30 -15 0 15 30 45 60
Returns (%)
7-6
Probability Distributions
CH6
CH7
• The tighter (i.e. more peaked) the

probability distribution, the more likely it is
that the actual outcome will be close to the
expected value.
• Consequently, the less likely it is that the
actual return will end up far below the
expected return
• The tighter the probability distribution, the
lower the risk assigned to a stock
7-7
Consider the Following
Investment Alternatives
CH6
CH7
State Probability Stock M Stock B

Strong 0.30 100% 40%
Normal 0.40 15% 15%
Weak 0.30 -70% -10%
1.00
7-8
Calculate the expected rate
of return on each alternative
CH6
CH7
^ r = expected rate of return.

n
r = ∑ riPi
^
i=1
^
rM = 0.3(100%)+0.4(15%)+0.3(-70%)
= 15%
r^B = 0.3(40%)+0.4(15%)+0.3(-10%)
= 15%
7-9
What is the standard deviation
of returns for each alternative?
CH6
CH7
σ = Standard deviation
σ = √ Variance = √ σ2
= √ ∑ (ri – ^r)2 Pi
i=1
7-10
Calculating Standard
Deviations for Stocks A & B
CH6
CH7
M = [(100 - 15)2 (0.3) + (15 - 15)2 (0.4)

+ (-70 - 15)2 (0.3)]1/2 = 65.84%
B = [(40 - 15)2 (0.3) + (15 - 15)2 (0.4)

+ (-10 - 15)2 (0.3)]1/2 = 19.36%
7-11
Coefficient of Variation (CV)
CH6
CH7
• CV = Standard deviation / expected

return
• CVM = 65.84% / 15% = 4.39
• CVB = 19.36% / 15% = 1.29
• CV captures the effects of both risk
and return
• A better measure than using SD for
comparison
7-12
Risk Aversion
and Required Return
CH6
CH7
• A risk-averse investor will consider risky

assets or portfolios only if they provide
compensation for risk via a risk premium.
• Risk premium is the excess return on the

risky asset that is the difference between
expected return on risky assets and the
return on risk-free assets.
7-13
Risk in a Portfolio Context
CH6
CH7
• Investors often hold portfolios, not the asset

of only one kind. The smallest portfolio starts
with two assets.
• A particular asset going up or down is
important, but what matters the most is the
return on the portfolio and its risk
• Therefore, risk/return of an asset should be
analyzed in terms of how that asset affects
the overall risk/return of the portfolio it is
held.
7-14
Portfolio Returns
CH6
CH7
• The expected return on a portfolio is

the weighted average of the expected
returns on the individual assets forming
the basket, with the weights being the
fraction of the total portfolio invested in
each asset
7-15
Portfolio Returns
CH6
CH7
Stocks X and Y, each with investments of $25,000,

form a portfolio of $50,000. Their expected returns are
11% and 7%, respectively.
The rate of return on the portfolio is a weighted

average of the returns on X and Y in the portfolio:
E (rP )  rP  wX E (rX )  wY E (rY )

9%  (0.5)  (11%)  (0.5)  (7%)
7-16
Portfolio Risk (σP)
CH6
CH7
• Unlike returns, σP is generally not the

weighted average of the standard deviations
of the individual assets in the basket.
The variance of the rate of return on the two risky assets portfolio is
σ P2  (w X σ X )2  (wY σ Y )2  2(w X σ X )(wY σ Y )ρ XY

where XY is the correlation coefficient between the returns on X and Y.
• Portfolio SD = σP = √σP2
7-17
Portfolio Risk
CH6
CH7
• Two independent assets (i.e. ρAB = 0) A and

B with wA = 0.75, and wB= 1 - wA = 0.25 form
a portfolio. Their standard deviations are σA
= 4%, and σ2B = 10%.2
σ P  (w A σ A )  (wB σ B )  2(w A σ A )(wB σ B )ρ AB
2
2 2
 (0.750.04)  (0.250.10)
 2(0.75  0.04)(0.25  0.10)(0)
 0.001525
• SDP = 0 .001525  0 .039  3 .9 %
7-18
Two-Asset Portfolios with
CH6
CH7
Various Correlations
E(RP)  = -1.0
• -1.0 < ρ < +1.0  = 1.0

 = 0.2
σP
• The smaller the correlation, the greater the risk
reduction potential
– If ρ = –1.0, complete risk reduction is possible
– If ρ = +1.0, no risk reduction is possible
7-19
Efficient Portfolios
CH6
CH7
• Portfolio is a collection of assets

• In a mean-variance (R ^ – σ) space, a set of
portfolios that maximize expected return at
each level of portfolio risk
• Equally, a set of portfolios that minimize risk
for each expected return
• Investors choose along the efficient set for
the best mix of risk and return with their own
risk attitudes
7-20
The Efficient Set for Two-
CH6
CH7
Assets
Portfolo Risk and Return Combinations

Portfolio Return
12.0%
11.0%
10.0%
9.0%
8.0%
7.0%
6.0%
5.0%
0.0% 5.0% 10.0% 15.0% 20.0%
Portfolio Risk (standard deviation)
7-21
Diversification
CH6
CH7
• Diversification can substantially reduce the

variability of returns without an equivalent
reduction in expected returns.
• This reduction in risk arises because worse
than expected returns from one asset are
offset by better than expected returns from
another.
• However, there is a minimum level of risk
that cannot be diversified away, and that is
the systematic portion.
7-22
Diversification (continued)
CH6
CH7
• The risk (variance) of an individual asset’s return

can be broken down into:
– Market risk: economy-wide random events that affect
almost all assets to a certain degree
– Diversifiable risk: random events that affect single
security or small groups of securities
• The Effect of Diversification:

– Unsystematic risk will significantly diminish in large
portfolios
– Systematic risk cannot be eliminated by diversification
since it affects all assets in any large portfolio
7-23
Portfolio Risk as a Function of the
Number of Assets in the Portfolio
CH6
CH7
• In a large portfolio (N ≥ 40) the variance terms are

effectively diversified away, but the covariance terms are
not.
• Thus diversification can eliminate some, but not all of the
P risk of individual securities
Diversifiable Risk; Unsystematic
Risk; Company-specific Risk
Portfolio
Nondiversifiable risk;Risk
Systematic Risk; Market Risk
n
• A large part of the risk of any individual asset can be
removed
7-24
Definition of Risk When Investors
Hold the Market Portfolio
CH6
CH7
• Researchers have shown that the best measure of the risk

of an asset in a large portfolio is the beta (b) of the asset.
• Beta measures the responsiveness of an asset to
movements in the market portfolio.
COViM i
bi    iM 
 M2 M
• In principle, market portfolio includes all risky assets
• Clearly, the estimate of beta will depend upon the choice
of a proxy for the market portfolio.
7-25
Individual Stock Beta (bi )
CH6
CH7
• The tendency of a stock to move up and down

with the market is reflected in its beta
coefficient.
• Estimate beta by running a regression between
the asset’s return and the market return.
• The slope of the regression line (i.e.
characteristic line) is equal to beta showing
how a stock moves in response to a movement
in the general market.
7-26
Beta Coefficients
CH6
CH7
• Average-risk stock(β = 1): returns tend to move up

and down, on average, with the market as measured
by some index such as the S&P/TSX Composite
Index
• Risky-stock (β > 1): returns are more volatile than
the market
• Safe-stock (β < 1): less volatile than market
• Betas are usually positive. Choose a lower beta
stock into a well-diversified portfolio
• Theoretically, it is possible for a stock to have a
negative beta
7-27
Portfolio Beta
CH6
CH7
Beta of a portfolio is a weighted average of its

individual securities’ betas:
bp = w1b1 + w2b2 + … + wnbn
= ∑wibi
Ex: If an investor holds a $100,000 portfolio consisting

of $33,333.33 invested in each of the 3 stocks, and if
beta for stock 1 = beta for stock 2 = 0.7, and beta for
stock 3 = 2
bp = 0.333 (0.7) + 0.333 (0.7) + 0333 (2.0) = 1.13
7-28
Relationship between Risk and Rates of
Return (CAPM)
CH6
CH7
• Expected Return on the Market:

• E(RM) = RF + market risk premium
• Expected return on an individual asset:
• E(Ri) = RF + βi × [E(RM) – RF]
Market Risk Premium
• This applies to individual assets held
within well-diversified portfolios
7-29
Expected Return on an Individual Asset
CH6
CH7
• Capital Asset Pricing Model (CAPM) formula:

• E(Ri) = RF + βi × [RM – RF] = RF + βi × RPM
• Interpretation: expected return on an individual asset =
risk-free rate + risk premium = risk-free rate + (beta of
the asset × market risk premium)
• The CAPM states that the expected return on a security
is positively related to the security’s beta
• Assume bi = 0, then the expected return is risk-free rate
R F.
• Assume bi = 1, then E(Ri) = (RM)
7-30
Relationship Between Risk & Expected
Return (The Security Market Line)
CH6
CH7
Expected
SML : Ri  RRF  ( RPM )  β i
return
E(RM)
R
F
1 b
E(Ri )  Ri  RF  βi [E(RM )  RF ]
7-31
SML: Relationship Between Risk &
Expected Return
CH6
CH7
• Given: βi = 1.5, RRF = 3%, RM = 10%

• Ri = 3% + 1.5 × (10% - 3%) = 13.5%
13.5%
3%
β
1.5
7-32
SML: Impact of Inflation
CH6
CH7
• Given: βi = 1.5, RRF = 3%, RM = 10%

• Ri = 3% + 1.5 × (10% - 3%) = 13.5%
• If RRF = 3% ↑ 5%, Ri = 5% + 1.5×(7%) = 15.5%
SML2
R
15.5% SML1
13.5%
3%
β
1.5
7-33
SML: Changes in Risk Aversion
CH6
CH7
• Given: βi = 1.5, RRF = 3%, RM = 10%

• Ri = 3% + 1.5 × (10% - 3%) = 13.5%
• If RPM = 7% ↑ 8%, Ri = 3% + 1.5×(8%) = 15%
SML2
R
15.0% SML1
13.5%
3%
β
1.5
7-34

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6

• Basic return concepts

• Investment returns measure the

• Typically, investment returns are not

• The tighter (i.e. more peaked) the

State Probability Stock M Stock B

^ r = expected rate of return.

M = [(100 - 15)2 (0.3) + (15 - 15)2 (0.4)

B = [(40 - 15)2 (0.3) + (15 - 15)2 (0.4)

• CV = Standard deviation / expected

• A risk-averse investor will consider risky

• Risk premium is the excess return on the

• Investors often hold portfolios, not the asset

• The expected return on a portfolio is

Stocks X and Y, each with investments of $25,000,

The rate of return on the portfolio is a weighted

E (rP )  rP  wX E (rX )  wY E (rY )

• Unlike returns, σP is generally not the

σ P2  (w X σ X )2  (wY σ Y )2  2(w X σ X )(wY σ Y )ρ XY

• Two independent assets (i.e. ρAB = 0) A and

• -1.0 < ρ < +1.0  = 1.0

• Portfolio is a collection of assets

Portfolo Risk and Return Combinations

Portfolio Risk (standard deviation)

• Diversification can substantially reduce the

• The risk (variance) of an individual asset’s return

• The Effect of Diversification:

• In a large portfolio (N ≥ 40) the variance terms are

• Researchers have shown that the best measure of the risk

• The tendency of a stock to move up and down

• Average-risk stock(β = 1): returns tend to move up

Beta of a portfolio is a weighted average of its

Ex: If an investor holds a $100,000 portfolio consisting

• Expected Return on the Market:

• Capital Asset Pricing Model (CAPM) formula:

• Given: βi = 1.5, RRF = 3%, RM = 10%

• Given: βi = 1.5, RRF = 3%, RM = 10%

• Given: βi = 1.5, RRF = 3%, RM = 10%

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