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11
Return and Risk: The Capital Asset Pricing
Model (CAPM)
Know how to calculate expected returns
Know how to calculate covariances, correlations, and
betas
Understand the impact of diversification
Understand the systematic risk principle
Understand the security market line
Understand the risk-return tradeoff
Be able to use the Capital Asset Pricing Model
11-16
Observe the decrease in risk that diversification offers.
An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than either stocks or bonds held
in isolation. This is not always the case.
100%
= -1.0 stocks
n
= 1.0
100%
= 0.2
bonds
Individual
Assets
P
Consider a world with many risky assets; we can still identify the
opportunity set of risk-return combinations of various portfolios.
Individual Assets
P
rf
100%
bonds
In addition to stocks and bonds, consider a world that also
has risk-free securities like T-bills.
rf
100%
bonds
Now investors can allocate their money across the T-
bills and a balanced mutual fund.
rf
P
rf
P
With the capital allocation line identified, all investors choose a point
along the line—some combination of the risk-free asset and the market
portfolio M. In a world with homogeneous expectations, M is the same
for all investors.
Copyright © 2016 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
11-32
return L
CM 100%
stocks
Balanced
fund
rf
100%
bonds
Where the investor chooses along the Capital Market Line depends
on her risk tolerance. The big point is that all investors have the
same CML.
Copyright © 2016 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
11-33
Researchers have shown that the best measure of the
risk of a security in a large portfolio is the beta () of
the security.
Beta measures the responsiveness of a security to
Ri = i + i Rm + e i
Copyright © 2016 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
11-35
Cov(Ri,RM ) (Ri )
i
(RM )
2
(RM )
R i RF β i ( R M RF )
R i RF i (R M RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
11-38
Expected return
R i RF i (R M RF )
RM
RF
1.0
3%
1.5
i 1.5 RF 3% R M 10%
R i 3 % 1 .5 (10 % 3 %) 13 .5 %
11-40
How do you compute the expected return and
standard deviation for an individual asset? For a
portfolio?
What is the difference between systematic and
unsystematic risk?
What type of risk is relevant for determining the
expected return?
Consider an asset with a beta of 1.2, a risk-free rate of
5%, and a market return of 13%.
◦ What is the expected return on the asset?