Expected return, beta and

CAPM
Expected return

There are at least 3 methods for developing an

expectation of future returns:
1. Based on historical returns: Requires relying on
the assumption that the future will be the same
as the past. Not a realistic assumption in a
constantly changing world.
2. Probabilistic approach: Uses probability
distributions and estimates of returns in
various scenarios to determine an overall
expected return.
3. The risk-based approach: Uses the Security
Market Line (SML), which describes the
relationship between risk and return predicted
by the Capital Asset Pricing Model (CAPM).
Probabilistic approach

Economic Probability of Estimated rate of

scenarios occurrence return on Stock X
Boom 0.1 60%
Normal growth 0.7 15%
Recession 0.2 -35% Outcome Probability Return
Recession 10% 60%
Expansion 70% 15%
To estimate the expected rate of return:
n Boom 20% -35%
ˆr  p r
i=1
i i
Expected return
Standard deviation
9.5%
25.9%
ˆrX  0.1(60%)  0.7(15%)  0.2(-35%)  9.5%

To estimate standard deviation as a measure of expected

stand-alone risk:
σ  X   60 - 9.5  2
0.1   15 - 9.5  2
0.7   - 35 - 9.5  2
0.2  25.93%
Risk-based approach

This approach to requires:

(1) measuring the risk of an asset and then
(2) estimating the expected return commensurate
with that risk.
Recall that there is no risk premium (extra return)
for bearing unsystematic risk because it can be
removed by diversification.
Therefore, diversified investors are only interested
in how much systematic risk an individual asset
will add to their portfolio.
Therefore, for this approach, we need a measure of
systematic risk.
A measure of systematic risk:
Beta
Beta measures relative systematic risk and
describes how an asset's returns tend to move
with changes in the market return.
Beta is estimated by regressing an asset’s returns
against the market’s returns. A market index is
used as a proxy for the ‘market’ portfolio (the
portfolio of all risky investments available, held in
proportion to their market value).
You don’t have to estimate beta but do need to
interpret it. Estimates of beta can be found in the
S&P Capital IQ database.
Interpreting beta

An asset’s beta is the percentage change in its

return that we expect for each 1% change in the
market’s return.
If the absolute value of beta:
• Equals 0, the asset has no market risk.
• Equals 1, the asset has the same market risk as the
market portfolio – ‘average’ market risk.
• < 1, the asset has less market risk than average.
• > 1, the asset has more market risk than average.
If the sign of beta is:
• Positive, returns on the asset tend to move with the
market.
• Negative, returns on the asset tend to move in the
Total risk vs systematic risk

Standard deviation measures total, or stand-alone,

risk.
Beta measures systematic, or market, risk.
Which stock carries more total risk? Which has more
Standard Beta
systematic risk?
deviation
Stock L 40% 0.9
Stock M 30% 1.1

Stock L has greater total risk but lower systematic

risk than Stock M. Therefore L is riskier than M when
held alone but less risky when held in a diversified
portfolio.
M will have a higher risk premium.
Portfolio beta

Calculated by taking a weighted average of the beta

of each investment in the portfolio. The weights are
the proportion of the portfolio’s value invested in
the asset
Amount Portfolio
Share Invested Weights Beta
(1) (2 (3) (4) (3) x(4)
)
L $6 000 50% 0.90 0.450
M 4 000 33% 1.10 0.367
N 2 000 17% 1.30 0.217

Portfolio $12 000 100 1.034

%
Risk-based approach cont’d

This approach to requires:

(1) measuring the risk of an asset and then
(2) estimating the expected return commensurate
with that risk.
We measure systematic risk using beta (step 1)
but how can we use it to estimate expected return
(step 2)?
The answer lies in one of the enduring theories of
finance, the Capital Asset Pricing Model (CAPM)
and its Security Market Line (SML).
CAPM

 Predicts that an asset’s expected return () equals

the risk-free rate of return () plus a risk premium
that depends on the asset’s systematic risk () and
the expected risk premium on the market portfolio
():

The market portfolio includes every risky asset and

so has beta = 1. The expected risk premium on the
market portfolio is known as the market risk
premium and often symbolised by .
 
The term is the asset’s risk premium over the risk-
free rate and is often symbolised by .
SML

The security market line (SML) shows the

relationship between risk and return predicted by
CAPM.
Expected return (%)  
E(ri) = 22

E(rm) = 15 Market portfolio

E.g. If a share has a beta of 2.0 (twice
rf = 8 as risky as the market), its expected
return = 8% + 2 x 7% = 8% +14% = 22%

-1 0 1 2 Risk, bi
SML

The SML will change if the risk-free rate changes.

Example:
Inflation expectations increase by 3
percentage points.
Risk-free rate will increase from 8% to 11%.
Expected return on the market portfolio
will increase from 15% to 18%.
SML

The SML will change if average risk aversion

changes.

Example:
Investors’ risk aversion increases such that
RPM increases by 3 percentage points.
Risk-free rate will stay the same.
The expected return on the market (b=1)
would increase from 15% to 18%.
Expected return and required
return
An asset’s value is all its future cash flows
discounted at the market’s required return, which
compensates for the asset’s risk.
Investors will not invest in an asset unless they
expect to make at least the required return.
If expected return > required return, the security
is a “bargain” – it offers more potential return than
required for its level of risk. Buy orders will exceed
sell orders, bidding up the market price. This will
drive down expected return until it equals required
return.
The opposite would occur if expected return <
required return.
In an active and competitive market, expected
EMH

One of the key assumptions of CAPM is that

securities markets are very competitive and
efficient and all relevant information is quickly
absorbed into security prices.
This is the Efficient Markets Hypothesis (EMH).
The EMH asserts that when new information
arrives, prices move to a new equilibrium very
quickly because:
• There are many analysts looking for mispriced
securities.
• New information is available to most professional
traders almost instantly.
• When mispricing occurs (due to new info or inefficient
markets), analysts have billions of dollars to use in
Market equilibrium and EMH

The implications of the EMH are:

• Stocks are normally in equilibrium, so expected
return = required return.
• One cannot consistently “beat the market” by
earning a return higher than is justified by a
stock’s risk.
While bubbles do occur infrequently, for most
stocks, most of the time, it is generally safe to
assume that the market is reasonably efficient.
Many investors have given up trying to beat the
market, which helps explain the popularity of index
funds.
The big picture

The CAPM provides a model of how investors in

capital markets trade-off risk and return, providing
a powerful and widely used tool to quantify the
return that should accompany a particular amount
of market risk.
The return predicted by the CAPM can be used as:
• a benchmark for making investment decisions. If
an investment’s expected return is less than
that predicted by CAPM, it may be an investment
that does not adequately compensate risk.
• an input to estimating a cost of capital (discount
rate) for evaluating investment projects and
valuing companies with the same level of
systematic risk.