Key Concepts and Skills

Lecture 9  Understand the systematic risk principle

 Understand the risk-return trade-off
 Be able to use the Capital Asset Pricing Model
Risk, Return, and Capital Budgeting (CAPM)
 Understand the Security Market Line (SML)

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Topics Covered Risk Definitions – A Review

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 Systematic Risk and Beta p (%)

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Company Specific
 Validity and the Role of the CAPM (Diversifiable) Risk
 The Security Market Line
Total (Stand-Alone) Risk, p
 Company and Project Costs of Capital
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Market Risk

0
10 20 30 40 2,000+

# Stocks in Portfolio

Risk Definitions – A Review Risk Definitions – A Review

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 Market risk is that part of a security’s stand-alone  Rational investors will minimize risk by holding
risk that cannot be eliminated by diversification. portfolios.
 Firm-specific, or diversifiable, risk is that part of a  They bear only market risk, so prices and returns
security’s stand-alone risk that can be eliminated by reflect this lower risk.
diversification.

Total (Stand-Alone) Risk = Market Risk + Diversifiable Risk

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 Measuring Market Risk for Individual
Securities Using a Regression to Estimate Beta
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 Market risk, which is relevant for stocks held in well-  Run a regression with returns on the stock in question
diversified portfolios, is defined as the contribution of plotted on the Y axis and returns on the market
a security to the overall riskiness of the portfolio.
portfolio plotted on the X axis.
 It is measured by a stock’s beta coefficient. For stock
i, its beta is:  The slope of the regression line, which measures
relative volatility, is defined as the stock’s beta
bi = (riM i) / M
coefficient, or b.
 In addition to measuring a stock’s contribution of risk
to a portfolio, beta also measures the sensitivity of
the stock’s returns to fluctuations in returns on the
market.

Using a Regression to Estimate Beta Measuring Beta - Example

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 The market portfolio is the portfolio of all risky  Use the historical stock returns to calculate the beta
investments. for KWE.
 In practice we use a market proxy—a portfolio Year Market KWE
1 25.7% 40.0%
whose return should track the underlying,
2 8.0% -15.0%
unobservable market portfolio. 3 -11.0% -15.0%
 The most common proxy portfolios are market 4 15.0% 35.0%
indexes which report the value of a particular 5 32.5% 10.0%
6 13.7% 30.0%
portfolio (e.g. S&P 500)
7 40.0% 42.0%
8 10.0% -10.0%
9 -10.8% -25.0%
10 -13.1% 25.0%

Measuring Beta - Example How Is Beta Interpreted?

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r KWE  A beta of 1 implies the asset has the same systematic

40% risk as the overall market
 A beta < 1 implies the asset has less systematic risk
20% than the overall market (defensive stocks)
 A beta > 1 implies the asset has more systematic risk
0% rM than the overall market (aggressive stocks)
-40% -20% 0% 20% 40%
-20%

r KWE = 0.83r M + 0.03

-40% 2
R = 0.36

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 Example: Portfolio Weights Risk-Return Trade-Off
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 Consider this example with the following four  Remember that the risk premium = expected return –
securities risk-free rate.
Security Weight Beta  Beta measures risk relative to the market. Thus, the
DCLK .133 2.685 higher the beta, the greater the risk premium should
KO .2 0.195 be.
INTC .267 2.161
KEI .4 2.434 Risk premium = r - rf = β( rm - rf )
 What is the portfolio beta?
 .133(2.685) + .2(.195) + .267(2.161) + .4(2.434) =
1.947

Capital Asset Pricing Model (CAPM) Factors Affecting Expected Return

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 The capital asset pricing model defines the  Pure time value of money: measured by the risk-free
relationship between risk and return. rate
Expected return = risk-free rate + risk premium  Reward for bearing systematic risk: measured by the
market risk premium
r = rf + β( rm - rf )  Amount of systematic risk: measured by beta
 If we know an asset’s systematic risk, we can use the
CAPM to determine its expected return.
 This is true whether we are talking about financial
assets or physical assets.

CAPM - Example The Security Market Line

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 Consider the betas for each of the assets given  The CAPM implies a linear relation between a stock’s
earlier. If the risk-free rate is 4.15% and the market beta and its expected return.
risk premium is 8.5%, what is the expected return for  This line is graphed as a line through the risk-free
each? investment (with a beta of zero) and the market (with
a beta of one); it is called the security market line
Security Beta Expected Return (SML).
DCLK 2.685 4.15 + 2.685(8.5) = 26.97%  The security market line (SML) is the representation of
KO 0.195 4.15 + 0.195(8.5) = 5.81% market equilibrium.
INTC 2.161 4.15 + 2.161(8.5) = 22.52%
KEI 2.434 4.15 + 2.434(8.5) = 24.84%

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 Capital Budgeting and Opportunity
The Security Market Line
Cost of Capital
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Capital Budgeting and Opportunity Web Resources

Cost of Capital
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 Company cost of capital is defined as the expected

return on a portfolio of all the company’s existing
securities. It is used to discount the cash flows on www.finance.yahoo.com

projects that have similar risk to that of the firm as a www.fidelity.com

whole.
 Company cost of capital is not the correct discount
rate if the new projects are more or less risky than the
firm’s existing business.
 Each project should in principle be evaluated at its
own opportunity cost of capital.

End of Lecture

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