Risk, Return,

and the Capital Asset Pricing Model

(CAPM)
Topics in Chapter
Basic return concepts
Basic risk concepts
Stand-alone risk / Total risk
Portfolio (market) risk
Risk and return:
CAPM/SML

2
What are investment returns?
Investment returns measure the financial results of an
investment.
Returns may be historical or prospective
(anticipated).
Returns can be expressed in:
Dollar terms.
Percentage terms.

3
Expected (holding period) returns
Expected rate of return on an investment asset can
be calculated as follows:

Expected Return Expected ending value

Cost
Example: if $1,000 is invested and $1,100 is returned after
one year, the rate ofCost for this investment is:
return
($1,100 $1,000)/$1,000 = 10%.

4
What is investment risk?
Typically, investment returns are not known
with certainty (as they depend on an
expected ending value; e.g., price, dividends.)
The greater the chance that the expected
returns will not be realized, the riskier
the investment.
An assets risk can be analyzed in two
ways
On a stand-alone basis (stand-alone risk)
On a portfolio basis (portfolio risk)

5
Probability Distributions: Which stock is
riskier? Why?
A listing of all possible outcomes, and the probability
of each occurrence.
Can be shown graphically (or in tabular form).
Probability

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

6
Investment Alternatives
Economy Prob. T-Bill HT Coll USR Market
Recession 0.1 5.5% -27.0% 27.0% 6.0% -17.0%
Below avg 0.2 5.5% -7.0% 13.0% -14.0% -3.0%

Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0%

Above avg 0.2 5.5% 30.0% -11.0% 41.0% 25.0%

Boom 0.1 5.5% 45.0% -21.0% 26.0% 38.0%

Risk free?

7
Why is the T-bill return independent of the economy?
Do T-bills promise a completely risk-free return?
T-bills will return the promised 5.5%, regardless of
the economy and hence your nominal return is
truly risk free.
But, T-bills do not provide a completely risk-free
return, as they are still exposed to inflation.
Although, very little unexpected inflation is likely
to occur over such a short period of time.
T-bills are also risky in terms of reinvestment
rate risk.
T-bills are risk-free in the default sense of the
word.
8
How do the returns of HT and Coll. behave in
relation to the market?
HT Moves with the economy, and has a
positive correlation. This is typical.
Coll. Is countercyclical with the economy, and has a
negative correlation. This is unusual.

9
Calculating the Expected Return

r = Expected rate of
return

r =
rH
= (-27%)(0.1) + (-7%)(0.2) + (15%)(0.4)
riPi + (30%)(0.2) + (45%)(0.1)
T i=1
= 12.4%

10
Summary of Expected Returns
Expected return
HT 12.4%
Market 10.5%
USR 9.8%
T-bill 5.5%
Coll. 1.0%

HT has the highest expected return, and appears

to be the best investment alternative, but is it
really?
Have we failed to account for risk?
11
Calculating Standard Deviation

i = Standard deviation

i = Variance = 2i

N
i =
(r -
i=1 r)2P
i

12
Standard Deviation for Each Investment
N
i = (r -i i i=1

r)2P

T-bills
2
+ (5.5-5.5)2(0.1)

1/2

T-bills=0.0%
(5.5-5.5) (0.1) + (5.5-5.5) (0.2)
Coll = 13.2%
HT = 20%
= (5.5-5.5)2(0.4) + (5.5-5.5)2(0.2)
USR = 18.8%
M = 15.2%
13
Expected Return and Risk Using
Historical Data
Expected Return = Average (arithmetic)
of
historical returns. N

r i,
ri =
t
t=1

Standard Dev = Square

N root of sum of the
squared deviations of historical individual
returns from the average/expected return.
N

(r
t=1
i, t - r i )2
i =
N-1

An example: Page 228 of the Text.

14
Selected Realized Returns,1926-2007
Average Standard
Return Deviation
Small-company stocks 17.1% 32.6%
Large-company stocks 12.3 20.0
L-T corporate bonds 6.2 8.4
L-T government bonds 5.8 9.2
U.S. Treasury bills 3.8 3.1
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2008
Yearbook (Chicago: Morningstar, Inc., 2008).

15
Comparing Standard Deviations

Prob
. T-bill

USR

HT

0 5.5 9.8 12.4 Rate of Return (%)

16
Comments on Standard Deviation as a
Measure of Risk
Standard deviation (i) measures total, or
stand- alone, risk.
The larger i is, the lower the probability that
actual returns will be closer to expected returns.
Larger i is associated with a wider
probability distribution of returns.

17
Comparing Risk and Return

Security Expected Return, r Risk,

T-bills 5.5% 0.0%
HT 12.4 20.0
Coll* 1.0 13.2
USR* 9.8 18.8
Market 10.5 15.2
*Seems out of place.

18
Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.
Standard deviation i
CV i = Expected return =
i

19
Risk Rankings by Coefficient of Variation
CV
T-bill 0.0
HT 1.6
Coll. 13.2
USR 1.9
Market 1.4

Collections has the highest degree of risk per unit

of return.
HT, despite having the highest standard deviation of
returns, has a relatively average CV.

20
Illustrating the CV as a Measure of Relative
Risk
Prob.

A B

0 Rate of Return (%)

A = B , but A is riskier because of a larger probability

of losses. In other words, the same amount of risk (as
measured by ) for smaller returns.

21
Investor Attitude towards Risk
Risk aversion: Investors are assumed to dislike
risk and require higher rates of return to
encourage them to hold riskier securities.
Risk premium: Difference between the return on
a risky asset and a riskless asset, which serves as
compensation for investors to hold riskier
securities.
Diversification: Shed part of the total (stand-
alone) risk by investing in a portfolio of
assets.
22
Portfolio Construction: Risk and Return

Assume a two-stock portfolio is created with

$50,000 invested in both HT and Collections.
A portfolios expected return is a weighted
average of the returns of the portfolios
component assets.
Standard deviation is a little more tricky and
requires that a new probability distribution for
the portfolio returns be devised.

23
Calculating Portfolio Expected Return

rp
is a weighted average:

N ^

r =
w i ri
p i=1

rp
= 0.5 (12.4%) + 0.5 (1.0%) = 6.7%

24
An Alternative Method for Determining
Portfolio Expected Return
Economy Prob. HT Coll Port.
Recession 0.1 -27.0% 27.0% 0.0%
Below avg 0.2 -7.0% 13.0% 3.0%
Average 0.4 15.0% 0.0% 7.5%
Above avg 0.2 30.0% -11.0% 9.5%
Boom 0.1 45.0% -21.0% 12.0%
= 0.10 (0.0%) + 0.20 (3.0%) + 0.40 (7.5%)
rp + 0.20 (9.5%) + 0.10 (12.0%) = 6.7%

25
Calculating Portfolio Standard Deviation
and CV
1
2
0.10 (0.0 - 6.7) 2

2
+ 0.20 (3.0 - 6.7) = 3.4%
p = + 0.40 (7.5 - 6.7)2

+ 0.20 (9.5 - 6.7)2

+ 0.10 (12.0 - 6.7)
2

3.4%
CVp = 6.7% =
0.51

26
Comments on Portfolio Risk Measures
p = 3.4% is much lower than the i of either
stock (HT = 20.0%; Coll. = 13.2%).
p = 3.4% is lower than the weighted average
of HT and Coll.s (16.6%).
Therefore, the portfolio provides the average
return of component stocks, but lower than
the average risk.
Why? Negative correlation between stocks.

27
General Comments about Risk
35% for an average stock.
Most stocks are positively (though not perfectly)
correlated with the market (i.e., between 0 and 1).
Combining stocks in a portfolio generally lowers
risk.

28
Returns Distribution for Two Perfectly
Negatively Correlated Stocks ( = -1.0)

29
Returns Distribution for Two Perfectly
Positively Correlated Stocks ( = 1.0)
Stock M Stock M Portfolio MM
25 25 25

15 15 15

0 0 0

-10 -10 -10

30
Partial Correlation, = +0.35

31
Creating a Portfolio: Beginning with One Stock
and Adding Randomly Selected Stocks to
Portfolio
decreases as stocks added, because they
p
would not be perfectly correlated with the
existing portfolio.
Expected return of the portfolio would
remain relatively constant.
Eventually the diversification benefits of adding
more stocks dissipates (after about 10 stocks),
and for large stock portfolios, p tends to
converge to 20%.
32
Illustrating Diversification Effects of a
Stock Portfolio

33
Breaking Down Sources of Risk
Stand-alone risk = Market risk + Diversifiable risk

Market risk portion of a securitys stand-

alone risk that cannot be eliminated through
diversification. Measured by beta.
beta = Cov(ri,rM)/Var(rM)
Diversifiable risk portion of a securitys stand-
alone risk that can be eliminated through
proper diversification.

34
Failure to Diversify
If an investor chooses to hold a one-stock portfolio (doesnt
diversify), would the investor be compensated for the extra
risk they bear?
NO!
Stand-alone risk is not important to a well-diversified
investor.
Rational, risk-averse investors are concerned with p,
which is based upon market risk.
There can be only one price (the market return) for
a given security.
No compensation should be earned for holding
unnecessary, diversifiable risk.
35
Capital Asset Pricing Model (CAPM)
Model linking risk and required returns. CAPM
suggests that there is a Security Market Line
(SML) that states that a stocks required return
equals the risk-free return plus a risk premium
that reflects the stocks risk after
diversification.
ri = rRF + (rM rRF)bi
Primary conclusion: The relevant riskiness of a
stock is its contribution to the riskiness of a
well- diversified (market) portfolio, which is
measured by the stocks beta.
36
Beta
Measures a stocks market risk, and shows a
stocks volatility relative to the market.
Indicates how risky a stock is if the stock is held in
a well-diversified portfolio.

37
Beta
beta = Cov(ri,rM)/Var(rM)
Covariance:

Cov(XY) = (X -NX)(Y
-1
- Y)

Variance:

Var(X) = (X - X)
N-1
2

38
Comments on Beta
If beta = 1.0, the security is just as risky
as the average stock.
If beta > 1.0, the security is riskier
than average.
If beta < 1.0, the security is less risky
than average.
Most stocks have betas in the range of
0.5 to 1.5.

39
Can the beta of a security be negative?
Yes, if the correlation between Stock i and
the market is negative (i.e., i,m < 0).
If the correlation is negative, the
regression line would slope downward,
and the beta would be negative.
However, a negative beta is highly unlikely.

40
Calculating Betas
Well-diversified investors are primarily concerned
with how a stock is expected to move relative to
the market in the future.
Without a crystal ball to predict the future,
analysts are forced to rely on historical data. A
typical approach to estimate beta is to run a
regression of the securitys past returns against
the past returns of the market.
The slope of the regression line is defined as
the beta coefficient for the security.

41
Illustrating the Calculation of Beta
ri

.
.
20 Year rM ri
1 15 18
15
2 % %
10 3 -5 -
12 10
5
16
-5 0 5 10 15 20
rM
Regression line:
.
-5
^
r = -2.59 + 1.44 r^
i M
-10

42
Calculation of Beta
The formula for the coefficient or slope in
simple linear regression is:

b= (X - X)(Y - Y)
(X - X)2

The formula for the intercept is:

a = Y - bX

43
Beta Coefficients for HT, Coll, and T-Bills
ri HT: b = 1.32
40

20

T-bills: b = 0

-20 0 20 40
rM

Coll: b = -0.87

-20
44
Calculating Beta in Practice
Many analysts use the S&P 500 to find
the market return.
Analysts typically use four or five years of
monthly returns to establish the regression
line.
Some analysts use 52 weeks of weekly returns.

45
Comparing Expected Returns and
Beta Coefficients
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87

Riskier securities have higher returns, so the rank order

is OK.

46
The Security Market Line (SML):
Calculating Required Rates of Return

SML: ri = rRF + (rM rRF)bi

= rRF + (RPM)bi

Assume that rRF = 5.5% and RPM = 5.0%.

47
What is the market risk premium?
Additional return over the risk-free rate
needed to compensate investors for assuming
an average amount of risk.
Its size depends on the perceived risk of
the stock market and investors degree of
risk aversion.
Varies from year to year, but most estimates
suggest that it ranges between 4% and 8% per
year.
48
Calculating Required Rates of Return
= 5.5% + (5.0%)(1.32)
rHT
= 5.5% + 6.6% = 12.10%
= 5.5% + (5.0%)(1.00) = 10.50%
rM
= 5.5% +(5.0%)(0.88) = 9.90%
rUSR = 5.5% + (5.0)(0.00) = 5.50%
rT-bill = 5.5% + (5.0%)(-0.87) = 1.15%

rColl

49
Expected vs. Required Returns
r
r
HT 12.4% 12.1% Undervalued ( r >r)

Market 10.5 10.5
Fairly valued ( r =r)
USR 9.8 9.9 Overvalued ( < r r)
T-bills 5.5 5.5 Fairly valued ( =
r r)
Coll. 1.0 1.15 Overvalued ( <
r r)

50
Illustrating the Security Market Line
SML: ri = 5.5% + (5.0%)bi
ri (%) SML

rM = 10.5
H T
.
rRF = 5.5 .
. . Risk, bi
USR
T-bills

51
An Example:
Equally-Weighted Two-Stock Portfolio
Create a portfolio with 50% invested in HT
and 50% invested in Collections.
The beta of a portfolio is the weighted average
of each of the stocks betas.
bP = wHTbHT + wCollbColl bP
= 0.5(1.32) + 0.5(-0.87)
bP = 0.225

52
Calculating Portfolio Required Returns
The required return of a portfolio is the
weighted average of each of the stocks required
returns.
rP = wHTrHT + wCollrColl
rP = 0.5(12.10%) + 0.5(1.15%)
rP = 6.625%
Or, using the portfolios beta, CAPM can be
used to solve for expected return.
rP = rRF + (RPM)bP
rP = 5.5% + (5.0%)(0.225)
rP = 6.625%
53
 Factors That Change the SML
What if investors raise inflation expectations
by 3%, what would happen to the SML?
ri (%)
I = 3%
SML2

13.5
10.5 SML1
8.5
5.5

Risk, bi

0 0.5 1.0 1.5

54
 Factors That Change the SML
What if investors risk aversion increased,
causing the market risk premium to increase by
3%, what would happen to the SML?
r (%) i
SML2
RPM = 3%

13.5
10.5
SML1
5.5

Risk, bi

0 0.5 1.0 1.5

55
Verifying the CAPM Empirically
The CAPM has not been verified
completely. Statistical tests have problems
that make verification almost impossible.
Some argue that there are additional risk factors,
other than the market risk premium, that must
be considered.

56
More Thoughts on the CAPM
Investors seem to be concerned with both
market risk and total risk. Therefore, the SML
may not produce a correct estimate of ri.
ri = rRF + (rM rRF)bi + ???

CAPM/SML concepts are based upon

expectations, but betas are calculated using
historical data. A companys historical data may
not reflect investors expectations about future
riskiness.
57