Lecture 7

Risk and Return: Asset Pricing

Models

Learning Objectives
Understand the probability and statistics concepts:
mean, variance, covariance and correlation coefficient
Understand the different return concepts: Required rate
of return, expected rate of return and realized rate of
return.
Explain why diversification is beneficial.
Describe the efficient frontier and the Capital Market
Line.
Demonstrate choice of an investment position on the
Capital Market Line (CML).
Understand the Capital Asset Pricing Model (CAPM) and
its uses


Probability and Statistics
Random variable
Something whose value in the future is subject to
uncertainty.
Probability
The relative likelihood of each possible outcome
(or value) of a random variable.
Probabilities of individual outcomes cannot be
negative nor greater than 1.0.
Sum of the probabilities of all possible outcomes
must equal 1.0.
Probability Concepts
Mean
The long run average of the random variable.
Equals the expected value of the random variable.
Variance (and Standard Deviation)
Measure the dispersion in the possible outcomes.
Standard deviation is the square-root of the variance.
Higher variance implies greater dispersion in the
possible outcomes.
Probability Concepts
Covariance
Measures how two random variables vary
together (or co-vary).
Covariance can be negative, positive or zero.
Its magnitude has no bounds.
Correlation Coefficient
A standardized measure of co-variation
between two random variables.
Always lies between -1.0 and +1.0.
Probability Concepts
Positive Covariance (or correlation)
When one random variables outcome is above the
mean, the other is also likely to be above its mean.
Negative Covariance (or correlation)
When one random variables outcome is above the
mean, the other is likely to be below its mean.
Zero Covariance (or correlation)
There is no relationship between the outcomes of the
two random variables.
Required Rate of Return
It is the return a person requires to be
willing to make the investment.
The required rate of return is the return
that exactly reflects the risk of the
expected future cash flows.
It reflects the opportunity cost of the
investment.
It is determined by market conditions.
Expected Rate of Return
The return an investor expects to earn from
the investment.
For conventional investments:
If it equals the required return, the NPV is
zero.
If it exceeds the required return, the NPV is
positive.
If its less than the required return, the NPV is
negative.


Expected Rate of Return
State of the
Market
Probability that
State Occurs
XYZ Return
Stable 0.3 -5%
Slow growth 0.5 18
Rapid growth 0.20 3
Expected Rate of Return of XYZ
= 0.3*(-5%) + 0.5*18% + 0.2*3%=10.5%
Realized Rate of Return
The return actually earned on the
investment during a given time period.
It can only be observed after the fact.
It is disconnected from the expected (and
required) returns by the risk of the cash
flows.
Realized Rates of Return
Compute Peters realized return from
his investment in Iomega common
shares.
Three months ago, Peter Lynch purchased 100
shares of Iomega Corp. at $50 per share. Last
month, he received dividends of $0.25 per
share from Iomega. These shares are worth
$56 each today.
Dollar Returns
Total amount invested
$50(100) = $5,000
Total dividends received
$0.25(100) = $25
Total proceeds from sale of stock
$56 (100) = $5,600
Capital gain
$5,600 $5,000 = $600
Dollar Returns
Total Dollar Return =
Dividends + Capital Gain (or Loss)
= $25 + $600 = $625
Capital gain is part of the total dollar return
even if it is not yet realized.
Holding Period Return
The Holding Period is defined as the
length of time over which the assets
percentage return is computed.
In Peter Lynchs case, the holding period
is 3 months long.
Holding Period Return
The Holding Period Return (HPR) is
defined as:
where P
t
is the price at the end of period t,
P
t

1
is the price at the end of period t 1,
and D
t
is the dividend received during period t.
HPR
P D P
P
t
t t t
t
=
+

-
-
1
1
Holding Period Return
In Peter Lynchs case,
P
t

1
= $50
P
t
= $56
D
t
= $0.25
or
=
+ -
=
25
0 125 12 50%
$56 $0 . $50
$50
. .
HPR
P D P
P
t
t t t
t
=
+

-
-
1
1
Holding Period Return
The total return of 12.50% consists of:
Dividend Yield
and
Capital Gains Yield
= =
=
-
=
$0 .
$50
.
$56 $50
$50
.
25
0 50%
12 00%
Asset Pricing Models
These models provide a relationship
between an assets required rate of return
and its risk.
The required return can be used for:
computing the NPV of an asset.
valuing an asset.
The Capital Asset Pricing Model
(CAPM)
Asset pricing models provide a relationship between an
assets required rate of return and its risk.
The CAPM can be developed from the Capital Market
Line (CML).
CML represents the collection of the best portfolio ( highest
possible expected return for any level of volatility).
Individual securities might not lie on the CML. CAPM
allows us to determine the required rate of return for an
individual security.
When applied to financial securities, the relationship in
the CAPM between risk and return for an individual asset
is referred to as the Security Market Line (SML).
Efficient Portfolios
A portfolio is an efficient portfolio if
no other portfolio with the same expected
return has lower risk, or
no other portfolio with the same risk has a
higher expected return.
The collection of efficient portfolio is called
an efficient frontier.
Portfolio Expected Return and Risk
The expected return of the portfolio depends on:
The expected return r of the securities in the
portfolio.
The portfolio weights w.
The risk of the portfolio depends on:
The risk of the securities in the portfolio.
The portfolio weights w.
The correlation coefficient of the returns on
the securities.
Perfect Positive Correlation
(two-asset portfolio)
o
o
1
o
2

2
r
1
r
2 1 1 1
) 1 ( o o o w w
p
+ =
Perfect Negative Correlation
(two-asset portfolio)
o
o
1
o
2

2
r
1
r
0 ) 1 ( 2 ) 1 (
2 1 1 1
2
2
2
1
2
1
2
1
= + o o o o w w w w
2 1
1
*
1
o o
o
+
= w
Various Correlations
(two-asset portfolio)
o
o
x
o
y

2
r
1
r
= 1 = 0
= 1
The Efficient Frontier
(multi-asset portfolio)
F
E
1
N
E
2
E
e
x
p
e
c
t
e
d

r
e
t
u
r
n

o
Choosing the Best Risky Asset
Investors prefer efficient portfolios over
inefficient ones.
Which one of the efficient portfolios is best?
We can answer this by introducing a riskless
asset.
There is no uncertainty about the future value of this
asset (i.e. the standard deviation of returns is zero).
Let the return on this asset be r
f
.
For practical purposes, 90-day U.S. Treasury Bills are
(almost) risk-free.
The Best Risky Asset
M

e
x
p
e
c
t
e
d

r
e
t
u
r
n

o
r
f

The Capital Market Line
Assume investors can lend and borrow at the
risk- free rate of interest.
Borrowing entails a negative investment in the
riskless asset.
Because every investor holds a part of the best
risky asset M, portfolio M is the market portfolio.
The market portfolio consists of all risky assets.
Each assets weight is proportional to its
market value.
The slope of CML is the amount of
expected return per unit of risk.
The Capital Market Line (CML)
r
f
r

(
e
x
p
e
c
t
e
d

r
i
s
k
)


o (risk)
F
E
M
Lend
borrow
M f
M
r r
CML Slope
o

=
The Capital Market Line with
different borrowing and lending rate
e
x
p
e
c
t
e
d

r
e
t
u
r
n

o
r
f

M
The Capital Market Line
When there are different saving and borrowing
rates, the market portfolio is not the unique
efficient portfolio of risky investments. Investors
with different risk preferences will choose
different portfolios of risky securities.
The market portfolio will be inefficient only if a
significant number of investors either
systematically misinterpret information or
care about aspects of their portfolio rather than
expected return and volatility, and so are willing to
hold inefficient portfolios of securities
Assumptions of the CAPM
Investors can borrow and lend at the
risk-free rate
Investors hold only efficient portfolios
Investors have homogeneous
expectations
Diversifiable and Nondiversifiable
Risk
A securitys specific risk is the sum of two parts:

Specific risk = Diversifiable risk + Nondiversifiable risk

Diversifiable risk (unsystematic risk) is risk that
can be eliminated by diversification.
Nondiversifiable risk (systematic risk) is risk that
cannot be eliminated by diversification. Also
called market risk.

Diversifiable and Nondiversifiable
Risk
0
5 10 15
Number of Securities
P
o
r
t
f
o
l
i
o

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n
Nondiversifiable risk
Diversifiable
risk
Nondiversifiable (Systematic) Risk
Nondiversifiable risk is the part of a
securitys standard deviation that
correlates with the market portfolio
Nondiversifiable risk of security j = [Corr(j,M)]
j
The risk premium is
Security js risk premium = (Nondiversifiable risk)(CML
slope)
=

[ ( , )]
M f
j
M
r r
Corr j M o
o

| |
|
\ .
Risk Premium a Function of
Beta
Security js risk premium =

=

Beta can be expressed in terms of the
correlation or the covariance:
[ ( , )]
M f
j
M
r r
Corr j M o
o

| |
|
\ .
( , )
[ ]( ) ( )
j
M f j M f
M
Corr j M
r r r r
o
|
o
=
2
( , ) ( , )
( , )
j j M
j
M M M M
Corr j M Corr j M
Cov j M
o o o
|
o o o o
= = =
Capital Asset Pricing Model
) (
f M i f i
r R r r + = |
Graphical Representation of the
Security Market Line
|
M
1.0
r
f
M
r
) (
f M i f i
r R r r + = |
Riskless
return
Market
Risk
Premium
Risk
Premium
for a stock
twice as
risky as
the market
2.0
) ( 2
f M f i
r R r r + =
Risk Premium for a
stock half as risky
as the market
0.5
) (
2
1
f M f i
r R r r + =