Chapter 13

Return, Risk, and the Security

Market Line

Prepared by Anne Inglis, CFA

© 2016 McGraw-Hill Education Limited

 Key Concepts and Skills
• Know how to calculate expected returns
and standard deviations for individual
securities and portfolios
• Understand the principle of diversification
and the role of correlation
• Understand systematic and unsystematic
risk
• Understand beta as a measure of risk and
the security market line
© 2016 McGraw-Hill Education Limited 13-1
 Chapter Outline
• Expected Returns and Variances
• Portfolios
• Announcements, Surprises, and Expected
Returns
• Risk: Systematic and Unsystematic
• Diversification and Portfolio Risk
• Systematic Risk and Beta
• The Security Market Line
• Arbitrage Pricing Theory and Empirical Models
© 2016 McGraw-Hill Education Limited 13-2
LO1
Expected Returns 13.1
• Expected returns are based on the
probabilities of possible outcomes
• In this context, “expected” means average
if the process is repeated many times
• The “expected” return does not even have
to be a possible return
n
E ( R)   pi Ri
i 1

© 2016 McGraw-Hill Education Limited 13-3

LO1
Expected Returns – Example 1
• Suppose you have predicted the following
returns for stocks C and T in three possible
states of nature. What are the expected returns?
• State Probability C T
• Boom 0.3 0.15 0.25
• Normal 0.5 0.10 0.20
• Recession ??? 0.02 0.01
• RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.9%
• RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%

© 2016 McGraw-Hill Education Limited 13-4

LO1
Expected Returns – Example 1
continued
• This example can also be done in a
spreadsheet
State Probability C T
Boom 0.3 0.15 0.25
Normal 0.5 0.10 0.20
Recession 0.2 0.02 0.01
1.0

Rc = 9.90%
Formula =B$4*C$4+B$5*C$5+B$6*C$6

Rt = 17.70%
Formula =B$4*D$4+B$5*D$5+B$6*D$6
© 2016 McGraw-Hill Education Limited 13-5
LO1
Variance and Standard
Deviation
• Variance and standard deviation still
measure the volatility of returns
• You can use unequal probabilities for the
entire range of possibilities
• Weighted average of squared deviations
n
σ 2   pi ( Ri  E ( R)) 2
i 1

© 2016 McGraw-Hill Education Limited 13-6

LO1 Variance and Standard Deviation – Example 1

• Consider the previous example. What is

the variance and standard deviation for
each stock?
• Stock C
• 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-
.099)2 = .002029
•  = .045
• Stock T
• 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-
.177)2 = .007441
•  = .0863 © 2016 McGraw-Hill Education Limited 13-7
LO1
Variance and Standard Deviation –
Example continued
State Probability C T
Boom 0.3 15% 25%
Normal 0.5 10% 20%
Recession 0.2 2% 1%
1.0

Rc = 9.90%
Formula =B$4*C$4+B$5*C$5+B$6*C$6

Rt = 17.70%
Formula =B$4*D$4+B$5*D$5+B$6*D$6

Variance c 0.002029
Formula =B$4*(C$4-B$9)^2+B$5*(C$5-B$9)^2+B$6*(C$6-B$9)^2
Standard Deviation c 0.04504442
Formula =SQRT(B15)

Variance t 0.007441
Formula =B$4*(D$4-B$12)^2+B$5*(D$5-B$12)^2+B$6*(D$6-B$12)^2
Standard Deviation t 0.08626123
Formula =SQRT(B20)

© 2016 McGraw-Hill Education Limited 13-8

LO1
Quick Quiz I
• Consider the following information:
• State Probability ABC, Inc.
• Boom .25 .15
• Normal .50 .08
• Slowdown .15 .04
• Recession .10 -.03
• What is the expected return?
• What is the variance?
• What is the standard deviation?
© 2016 McGraw-Hill Education Limited 13-9
LO1
Portfolios 13.2
• A portfolio is a collection of assets
• An asset’s risk and return is important in
how it affects the risk and return of the
portfolio
• The risk-return trade-off for a portfolio is
measured by the portfolio expected return
and standard deviation, just as with
individual assets

© 2016 McGraw-Hill Education Limited 13-10

LO1
Example: Portfolio Weights
• Suppose you have $15,000 to invest and
you have purchased securities in the
following amounts. What are your portfolio
weights in each security?
• $2000 of ABC •ABC: 2/15 = .133
• $3000 of DEF •DEF: 3/15 = .2
• $4000 of GHI •GHI: 4/15 = .267
• $6000 of JKL •JKL: 6/15 = .4

© 2016 McGraw-Hill Education Limited 13-11

LO1
Portfolio Expected Returns
• The expected return of a portfolio is the weighted
average of the expected returns for each asset in
the portfolio
m
E ( RP )   w j E ( R j )
j 1

• You can also find the expected return by finding

the portfolio return in each possible state and
computing the expected value as we did with
individual securities

© 2016 McGraw-Hill Education Limited 13-12

LO1
Example: Expected Portfolio
Returns
• Consider the portfolio weights computed
previously. If the individual stocks have the
following expected returns, what is the expected
return for the portfolio?
• ABC: 19.65%
• DEF: 8.96%
• GHI: 9.67%
• JKL: 8.13%
• E(RP) = .133(19.65) + .2(8.96) + .267(9.67) +
.4(8.13) = 10.24%

© 2016 McGraw-Hill Education Limited 13-13

LO1
Example: Expected Portfolio
Returns – continued
Expected
Stock Amount Return Weight
ABC 2000 19.65% 0.133333
DEF 3000 8.96% 0.2
GHI 4000 9.67% 0.266667
JKL 6000 8.13% 0.4
15000

Portfolio Expected Return = 10.24%

Formula = C$4 * D$4 + C$5 * D$5 + C$6 * D$6 + C$7 * D$7

© 2016 McGraw-Hill Education Limited 13-14

LO1
Portfolio Variance
• Compute the portfolio return for each state:
RP = w1R1 + w2R2 + … + wmRm
• Compute the expected portfolio return
using the same formula as for an individual
asset
• Compute the portfolio variance and
standard deviation using the same
formulas as for an individual asset

© 2016 McGraw-Hill Education Limited 13-15

LO1
Example: Portfolio Variance
• Consider the following information
• Invest 60% of your money in Asset A
• State Probability A B
• Boom .5 70% 10%
• Bust .5 -20% 30%
• What is the expected return and standard
deviation for each asset?
• What is the expected return and standard
deviation for the portfolio?

© 2016 McGraw-Hill Education Limited 13-16

LO1
Portfolio Variance Example
continued
State Probability A B Portfolio
Weights 60% 40% 100%
Boom 0.5 70 10 46
Bust 0.5 -20 30 0
25 20 23

Standard
Variance Deviation
A 2025 45.00
B 100 10.00
Portfolio 529 23.00

Formulas:
Portfolio Variance =B5*(E5-E7)^2+B6*(E6-E7)^2
Portfolio Standard Dev. =SQRT(C12)

© 2016 McGraw-Hill Education Limited 13-17

LO1
Another Way to Calculate
Portfolio Variance
• Portfolio variance can also be calculated using
the following formula:
 P2  xL2 L2  xU2  U2  2 xL xU CORR L ,U  L U

Assuming that the correlatio n between A and B is - 1.00, we have

 P2  0.6 2  0.2025  0.4 2  0.01  2  0.6  0.4  -1.00 0.45  0.1

 P2  0.0529

© 2016 McGraw-Hill Education Limited 13-18

LO2
Figure 13.1 – Different Correlation
Coefficients

© 2016 McGraw-Hill Education Limited 13-19

LO2
Figure 13.1 – Different Correlation
Coefficients

© 2016 McGraw-Hill Education Limited 13-20

LO2
Figure 13.1 – Different Correlation
Coefficients

© 2016 McGraw-Hill Education Limited 13-21

 Figure 13.2 – Graphs of Possible
LO2
Relationships Between Two Stocks

© 2016 McGraw-Hill Education Limited 13-22

LO2
Diversification
• There are benefits to diversification
whenever the correlation between two
stocks is less than perfect (p < 1.0)
• If two stocks are perfectly positively
correlated, then there is simply a risk-
return trade-off between the two securities.

© 2016 McGraw-Hill Education Limited 13-23

LO2
Diversification – Figure 13.4

© 2016 McGraw-Hill Education Limited 13-24

LO2
Terminology
• Feasible set (also called the opportunity
set) – the curve that comprises all of the
possible portfolio combinations
• Efficient set – the portion of the feasible set
that only includes the efficient portfolio
(where the maximum return is achieved for
a given level of risk, or where the minimum
risk is accepted for a given level of return)
• Minimum Variance Portfolio – the possible
portfolio with the least amount of risk
© 2016 McGraw-Hill Education Limited 13-25
LO2
Efficient Frontier – Figure 13.5

13-26
LO1
Quick Quiz II
• Consider the following information
• State Probability X Z
• Boom .25 15% 10%
• Normal .60 10% 9%
• Recession .15 5% 10%
• What is the expected return and standard
deviation for a portfolio with an investment
of $6,000 in asset X and $4,000 in asset
Z?
© 2016 McGraw-Hill Education Limited 13-27
LO2
Expected versus Unexpected
Returns 13.3
• Realized returns are generally not equal to
expected returns
• There is the expected component and the
unexpected component
• At any point in time, the unexpected return can
be either positive or negative
• Over time, the average of the unexpected
component is zero

© 2016 McGraw-Hill Education Limited 13-28

LO2
Announcements and News
• Announcements and news contain both an
expected component and a surprise
component
• It is the surprise component that affects a
stock’s price and therefore its return
• This is very obvious when we watch how
stock prices move when an unexpected
announcement is made or earnings are
different than anticipated
© 2016 McGraw-Hill Education Limited 13-29
LO2
Efficient Markets
• Efficient markets are a result of investors
trading on the unexpected portion of
announcements
• The easier it is to trade on surprises, the
more efficient markets should be
• Efficient markets involve random price
changes because we cannot predict
surprises

© 2016 McGraw-Hill Education Limited 13-30

LO3
Systematic Risk 13.4
• Risk factors that affect a large number of
assets
• Also known as non-diversifiable risk or
market risk
• Includes such things as changes in GDP,
inflation, interest rates, etc.

© 2016 McGraw-Hill Education Limited 13-31

LO3
Unsystematic Risk
• Risk factors that affect a limited number of
assets
• Also known as unique risk and asset-
specific risk
• Includes such things as labor strikes,
shortages, etc.

© 2016 McGraw-Hill Education Limited 13-32

LO3
Returns
• Total Return = expected return +
unexpected return
• Unexpected return = systematic portion +
unsystematic portion
• Therefore, total return can be expressed as
follows:
• Total Return = expected return +
systematic portion + unsystematic portion

© 2016 McGraw-Hill Education Limited 13-33

LO2
Diversification 13.5
• Portfolio diversification is the investment in
several different asset classes or sectors
• Diversification is not just holding a lot of
assets
• For example, if you own 50 internet stocks,
you are not diversified
• However, if you own 50 stocks that span
20 different industries, then you are
diversified
© 2016 McGraw-Hill Education Limited 13-34
LO2
Table 13.8 – Portfolio
Diversification

13-35
LO2
& The Principle of Diversification
LO3

• 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
© 2016 McGraw-Hill Education Limited 13-36
LO2
&
Figure 13.6 – Portfolio
LO3 Diversification

© 2016 McGraw-Hill Education Limited 13-37

LO3
Diversifiable (Unsystematic) Risk
• The risk that can be eliminated by
combining assets into a portfolio
• Synonymous with unsystematic, unique or
asset-specific risk
• If we hold only one asset, or assets in the
same industry, then we are exposing
ourselves to risk that we could diversify
away
• The market will not compensate investors
for assuming unnecessary risk
© 2016 McGraw-Hill Education Limited 13-38
LO3
Total Risk
• Total risk = systematic risk + unsystematic
risk
• The standard deviation of returns is a
measure of total risk
• For well diversified portfolios, unsystematic
risk is very small
• Consequently, the total risk for a diversified
portfolio is essentially equivalent to the
systematic risk
© 2016 McGraw-Hill Education Limited 13-39
LO3
Systematic Risk Principle 13.6
• There is a reward for bearing risk
• There is not a reward for bearing risk
unnecessarily
• The expected return on a risky asset
depends only on that asset’s systematic
risk since unsystematic risk can be
diversified away

© 2016 McGraw-Hill Education Limited 13-40

LO3
Measuring Systematic Risk
• How do we measure systematic risk?
• We use the beta coefficient to measure
systematic risk
• What does beta tell us?
• A beta of 1 implies the asset has the same
systematic risk as the overall market
• A beta < 1 implies the asset has less
systematic risk than the overall market
• A beta > 1 implies the asset has more
systematic risk than the overall market
© 2016 McGraw-Hill Education Limited 13-41
LO3
Figure 13.7 – High and Low
Betas

© 2016 McGraw-Hill Education Limited 13-42

LO3
Table 13.10 – Beta Coefficients for
Selected Companies
Companies Beta coefficient
Bank of Nova Scotia 0.81
IGM Financial 0.86
Talisman Energy 1.50
Manulife Financial Corp. 1.53
Rogers Communications 0.36
Teck Resources Ltd. 2.77

© 2016 McGraw-Hill Education Limited 13-43

LO3
Total versus Systematic Risk
• Consider the following information:
Standard Deviation Beta
• Security C 20% 1.25
• Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher
expected return?

© 2016 McGraw-Hill Education Limited 13-44

LO3
Example: Portfolio Betas
• Consider the previous example with the
following four securities
• Security Weight Beta
• ABC .133 3.69
• DEF .2 0.64
• GHI .267 1.64
• JKL .4 1.79
• What is the portfolio beta?
• .133(3.69) + .2(.64) + .267(1.64) + .4(1.79)
= 1.773
© 2016 McGraw-Hill Education Limited 13-45
LO3
Beta and the Risk Premium 13.7
• Remember that the risk premium =
expected return – risk-free rate
• The higher the beta, the greater the risk
premium should be
• Can we define the relationship between
the risk premium and beta so that we can
estimate the expected return?
• YES!

© 2016 McGraw-Hill Education Limited 13-46

LO4
Figure 13.8A – Portfolio Expected
Returns and Betas

Rf

© 2016 McGraw-Hill Education Limited 13-47

 Reward-to-Risk Ratio: Definition
LO4
and Example
• The reward-to-risk ratio is the slope of the
line illustrated in the previous example
• Slope = (E(RA) – Rf) / (A – 0)
• Reward-to-risk ratio for previous example =
(20 – 8) / (1.6 – 0) = 7.5
• What if an asset has a reward-to-risk ratio
of 8 (implying that the asset plots above
the line)?
• What if an asset has a reward-to-risk ratio
of 7 (implying that the asset plots below
the line)?
© 2016 McGraw-Hill Education Limited 13-48
LO4
Market Equilibrium
• In equilibrium, all assets and portfolios
must have the same reward-to-risk ratio
and they all must equal the reward-to-risk
ratio for the market

E ( RA )  R f E ( RM  R f )

A M

© 2016 McGraw-Hill Education Limited 13-49

LO4
Security Market Line
• The security market line (SML) is the
representation of market equilibrium
• The slope of the SML is the reward-to-risk
ratio: (E(RM) – Rf) / M
• But since the beta for the market is
ALWAYS equal to one, the slope can be
rewritten
• Slope = E(RM) – Rf = market risk premium

© 2016 McGraw-Hill Education Limited 13-50

LO4
Figure 13.11 – Security Market
Line

© 2016 McGraw-Hill Education Limited 13-51

LO4
The Capital Asset Pricing Model
(CAPM)
• The capital asset pricing model defines the
relationship between risk and return
• E(RA) = Rf + A(E(RM) – Rf)
• 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

© 2016 McGraw-Hill Education Limited 13-52

LO4
Factors Affecting Expected
Return
• Pure time value of money – measured by
the risk-free rate
• Reward for bearing systematic risk –
measured by the market risk premium
• Amount of systematic risk – measured by
beta

© 2016 McGraw-Hill Education Limited 13-53

LO4
Example - CAPM
• Consider the betas for each of the assets given
earlier. If the risk-free rate is 4.5% and the
market risk premium is 8.5%, what is the
expected return for each?
Security Beta Expected Return
ABC 3.69 4.5 + 3.69(8.5) = 35.865%
DEF .64 4.5 + .64(8.5) = 9.940%
GHI 1.64 4.5 + 1.64(8.5) = 18.440%
JKL 1.79 4.5 + 1.79(8.5) = 19.715%

© 2016 McGraw-Hill Education Limited 13-54

LO1 Arbitrage Pricing Theory (APT) 13.8

• Similar to the CAPM, the APT can handle

multiple factors that the CAPM ignores
• Unexpected return is related to several market
factors
E( R)  RF  E( R1  RF )  1  E( R2  RF )  2  ...  E( RK  RF )   K

© 2016 McGraw-Hill Education Limited 13-55

 Quick Quiz
• What is the difference between systematic and
unsystematic risk?
• What type of risk is relevant for determining the
expected return?
• What is the SML? What is the CAPM? What is
the APT?
• Consider an asset with a beta of 1.2, a risk-free
rate of 5% and a market return of 13%.
• What is the reward-to-risk ratio in equilibrium?
• What is the expected return on the asset?

© 2016 McGraw-Hill Education Limited 13-56

 Summary 13.9
• There is a reward for bearing risk
• Total risk has two parts: systematic risk and
unsystematic risk
• Unsystematic risk can be eliminated through
diversification
• Systematic risk cannot be eliminated and is
rewarded with a risk premium
• Systematic risk is measured by the beta
• The equation for the SML is the CAPM, and it
determines the equilibrium required return for a
given level of risk 13-57
© 2016 McGraw-Hill Education Limited