Name: Randrianantenaina Solohery Mampionona Aime

NIM: 041924353041

Chapter 11: Return, Risk, and the Capital Asset Pricing Model

11.1 Individual securities

1. Expected return: the profit or loss an investor anticipates on an investment that has known or
anticipated rates of return

2. Variance and standard deviation: a common way to assess the volatility of a security’s return

3. Covariance and correlation: a statistic way to measure the interrelationship between two
securities

11.2 Expected Return, Variance, and Covariance

Expected return and variance

Example of return predictions:

Supertech Returns Rsuper Slowpoke returns Rslow

Depression -20% 5%
Recession 10 20
Normal 30 -12
Boom 50 9
There are 4 steps to calculate the variance:

1.Calculate the expected return

−0.20+0.10+ 0.30+ 0.50

E (Rsuper)= = 0.175, or 17.5%
4
0.05+0.20−0.12+ 0.09
E (RSlow)= =0.055, or 5.5%
4
2.For each company, calculate the average squared deviation, which is the variance:

Table 11.1 Calculating Variance and Standard Deviation

(1)State of Economy (2) Rate of return (3) Deviation from (4) Squared value of
expected return deviation
Supertech (expected return= 0.175)
Rsuper Rsuper-E(Rsuper) [Rsuper-E(Rsuper)]2
Depression -0.20 -0.375(=-0.20-0.175) 0.140625 (= −.3752)
Recession 0.10 -0.075 0.005625
Normal 0.30 0.125 0.015625
Boom 0.50 0.325 0.105625
Slowpoke (Expected return=0.055)
Rslow Rslow-E(Rslow) [Rslow-E(Rslow)]2
Depression 0.05 −0.005 (= 0.05 − 0.000025 (= −0.0052)
0.055)
Recession 0.20 0.145 0.021025
Normal -0.12 -0.175 0.030625
Boom 0.09 0.035 0.001225
So the variance of Supertech is:
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

0 .140625+ 0.005625+0.015625+0.105625
σ 2Super= =0.066875
4
and the variance of slowpoke is

0 .000025+ 0.021025+0.030625+0.001225
σ 2Slow= = 0.013225
4
3. Calculation of standard deviation

σ Super= √ 0.066875= 0.2586, or 25.86%

σ Slow= √ 0.013225= 0.1150, or 11.50%

2
Var (R)=σ 2= ∑ [ R−E ( R ) ] E(R): the security’s expected return ; R: the actual return

COVARIANCE AND CORRELATION

Covariance and correlation measure how two random variables are related.

Covariance Correlation
Formula σ SuperSlow=Cov(RsuperRslow)= ρSuperSlow= Corr(RSuperRSlow)=
∑ { [ Rsuper −E ( Rsuper ) ] × [ R slow−E ( R slow ) ] } Cov(R Super , RSlow )
σ super × σ Slow

Calculation σ SuperSlow= −0.004875

ρSuperSlow=
0.001875−0.010875−0.021875+0.011375 0.2586 ×0.1150
4 = -0.1639
= - 0.004875

11.3 The return and risk for portofolios

The expected return on a portfolio is a weighted average of the expected returns on the individual
securities.

E(Rp)= XSuperE(RSuper)+ XSlowE(RSlow) XSuper, XSlow: the proportions of the total portfolio in the assets
Supertech and Slowpoke

E.g: An investor with $100 invests $60 in Supertech and $40 in Slowpoke, so the expected return on
the portfolio is:

E(Rp)=0.6x0.175+0.4x0.055= 0.127 or 12.7%

Variance and standard deviation of a portfolio

σ 2P= X 2Super σ 2Super +2 X Super X Slow σ SuperSlow + X 2Slow σ 2Slow

σ 2P=0.36x0.066875+2x[0.6x0.4x(-0.004875)]+0.16x0.13225= 0.023851
σ P=√ Var ( portfolio)= √ 0.023851= 0.1544 or 15.44%
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

Interpretation: A return of −2.74 percent (= 12.7% − 15.44%) is one standard deviation below the
mean, and a return of 28.14 percent (= 12.7% + 15.44%) is one standard deviation above the mean.
If the return on the portfolio is normally distributed, a return between −2.74 percent and +28.14
percent occurs about 68 percent of the time.

Weighted average of St.dev= Xsuperσ Super +XSlowσ Slow= 0.6x0.2586+0.4x0.115= 0.2012

How high must the positive correlation be before all diversification benefits vanish?

to answer that:

σ SuperSlow =ρSuperSlow σ Super σ Slow

2 2 2 2 2
So, σ P= X Super σ Super +2 X Super X Slow ρ SuperSlow σ Super σ Slow + X Slow σ Slow

σ 2P=0.036 × 0.066575+2×[0.6 × 0.4 ×(−0.1639)× 0.2586 ×0.115 ]+0.16 ×0.013225 =

0.023851

Suppose the correlation (not covariance) ρ SuperSlow=1

2
σ P=0.036 × 0.066575+2×[0.6 × 0.4 ×1 ×0.2586 × 0.115]+0.16 × 0.013225= 0.0404466

the st. dev σ P=√ 0. 0404466= 0.2012 or 20.12%

Note that St. dev and Weighted average of St.dev are equals

 As long as ρ < 1, the standard deviation of a portfolio of two securities is less than the
weighted average of the standard deviations of the individual securities.

11.4 Diversification

THE ANTICIPATED AND UNANTICIPATED COMPONENTS OF NEWS

The return on any stock consists of two parts: the normal or expected and the uncertain or risky
part.

R=E(R)+U R: the actual total return in the year

E(R): the expected part of the return
U: the unexpected part of the return
RISK: SYSTEMATIC AND UNSYSTEMATIC

1. systematic risk (m) is any risk that affects a large number of assets, each to a greater or
lesser degree.
2. unsystematic risk (Ɛ) is a risk that specifically affects a single asset or a small group of assets.

R=E(R)+U= E(R)+m+ Ɛ

A well-diversified portfolio is essential for moderating investment risk and it s very helpful for
achieving a certain financial goals. The principle of diversification tells us that spreading an
investment across many assets will eliminate some of the risk.

11.5 Riskless Borrowing and Lending

supposition Ms Bagwell invest (1000$) in a risky asset (350$) and in a risk free asset (650$), showed
with the following table
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

Common stock of Merville Risk-free asset

Expected return 14% 10%
Standart deviation 20 0
so the expected return on the total investment is:

E(Rp)=0.35 × 0.14 + 0.65 × 0.10 = 0.114, or 11.4%

using the equation for variance which is

σ 2P= X 2Merville σ 2Merville +2 X Merville X Riskfree ρMervilleRiskfree σ Merville σ Riskfree + X 2Riskfree σ 2Riskfree
because the risk-free asset has no variability (St.Dev=0), so that expression is reduced to:

σ 2P= X 2Merville σ 2Merville =0.352x0.202=0.0049

and the st.Dev is σ P=√ 0. 0049= 0.07

Suppose that Ms. Bagwell borrows $200 at the risk-free rate. So in total, her invetement in Merville
is 1000$+200$=1200$. so the expected return is

E(Rp)= 1.20 × 0.14 + ( − 0.2 × 0.10) = 0.148, or 14.8%

Here, she invests 120 percent of her original investment of $1,000 by borrowing 20 percent of her
original investment. The return of 14.8%>14% expected return on Merville because Merville has an
expected return greater that at Riskfree asset.

So the St.dev σ P= 1.20 × .2 = .24, or 24% which is greater than the st.dev 20% of the Merville
investment. Borrowing increases the variability of the investment.

Figure 11.9 Relationship between Expected Return and Standard Deviation for an Investment in a
Combination of Risky Securities and the Riskless Asse

In this figure, we got shares and all of them have a risk measured by the st. dev. Now we have
another asset called risk free rate (Rf) which means it doesn’t have risk at all, so st.dev=0. The risk
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

free asset can be combined with the portfolio which gives us the capital market line. The CML is
tangent to the efficient frontier at one point which is the point A, or the market portfolio. This means
we have a separation theory which is very essential to the mark of its portfolio theory which means
that first of all we compute the point A (market portfolio); and the 2 nd dependant on the utility
function/investor either decides on lending or on borrowing depending on his utility function.

11.6 Market equilibrium

Definition of risk when investors hold the market portfolio

There is a way to measure (beta) the risk of an individual security from the point of view of
diversified investor. Or Beta measures the responsiveness of a security to movements in the market
portfolio.

βi= Cov ( Ri R M ): covariance between the return on Asset i and the return on the
Cov (Ri R M ) market portfolio
σ 2 (R¿¿ M )¿ σ 2(R ¿¿ M ) ¿: variance of the market.

N
useful property: ∑ X i β i=1 where X is the proportion of Security i’s market value to that of the
i
i=1
entire market and N is the number of securities in the market.

11.7 Relationship between Risk and Expected Return (CAPM)

E(RM)= RF + Risk premium

The CAPM states that E(R)= RF+β×[E(RM)−RF] where the last bracket stand for the difference between
expected return on market and riskfree rate.

The CML is a line that is used to show the rates of return, which depends on risk-free rates of return
and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical
representation of the market’s risk and return at a given time. One of the differences between CML
and SML, is how the risk factors are measured. While standard deviation is the measure of risk for
CML, Beta coefficient determines the risk factors of the SML.