Risk, Return, and The Capital Asset Pricing Model
Risk, Return, and The Capital Asset Pricing Model
1
Topics in Chapter
Basic return concepts
Basic risk concepts
Stand-alone risk
Portfolio (market) risk
Risk and return: CAPM/SML
2
Determinants of Intrinsic Value:
The Cost of Equity
Weighted average
cost of capital
(WACC)
4
An investment costs $1,000 and is
sold after 1 year for $1,100.
Dollar return:
$ Received - $ Invested
$1,100 - $1,000 = $100.
Percentage return:
$ Return/$ Invested
$100/$1,000 = 0.10 = 10%.
5
What is Risk?
Risk is defined as “a hazard; a peril; exposure to
loss or injury.” Thus, risk refers to the chance that
some unfavorable event will occur.
If you go skydiving, you are taking a chance with
your life—skydiving is risky.
If you bet on horse races, you are risking your
money.
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Probability Distribution: Which
stock is riskier? Why?
Stock A
Stock B
-30 -15 0 15 30 45 60
Returns (%)
8
Consider the Following
Investment Alternatives
Econ. Prob. T-Bill Alta Repo Am F. MP
- -
Bust 0.10
8.0% 22.0% 28.0% 10.0% 13.0%
-
Below avg. 0.20 -2.0 1.0
8.0 14.7 10.0
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Alta Inds. and Repo Men vs.
the Economy
Alta Inds. moves with the economy, so
it is positively correlated with the
economy. This is the typical situation.
Repo Men moves counter to the
economy. Such negative correlation is
unusual.
11
Calculate the expected rate of
return on each alternative.
^
r = expected rate of return.
n
^
r = ∑ riPi.
i=1
^r = 0.10(-22%) + 0.20(-2%)
Alta
+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%. 12
Alta has the highest rate of
return. Does that make it best?
^
r
Alta 17.4%
Market 15.0
Am. Foam 13.8
T-bill 8.0
Repo Men 1.7
13
What is the standard deviation
of returns for each alternative?
σ = Standard deviation
σ = √ Variance = √ σ2
√
n
^
∑ (ri – r)2 Pi.
= i=1
14
Standard Deviation of Alta
Industries
15
Standard Deviation of
Alternatives
T-bills = 0.0%.
Alta = 20.0%.
Repo = 13.4%.
Am Foam = 18.8%.
Market = 15.3%.
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Stand-Alone Risk
Standard deviation measures the stand-
alone risk of an investment.
The larger the standard deviation, the
higher the probability that returns will
be far below the expected return.
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Expected Return versus Risk
Expected
Security Return Risk,
Alta Inds. 17.4% 20.0%
Market 15.0 15.3
Am. Foam 13.8 18.8
T-bills 8.0 0.0
Repo Men 1.7 13.4
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Coefficient of Variation (CV)
CV = Standard deviation / Expected
return
CVT-BILLS = 0.0% / 8.0% = 0.0.
CVAlta Inds = 20.0% / 17.4% = 1.1.
CVRepo Men = 13.4% / 1.7% = 7.9.
CVAm. Foam = 18.8% / 13.8% = 1.4.
CVM = 15.3% / 15.0% = 1.0.
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Expected Return versus
Coefficient of Variation
Expected Risk: Risk:
Security Return CV
Alta Inds 17.4% 20.0% 1.1
Market 15.0 15.3 1.0
Am. Foam 13.8 18.8 1.4
T-bills 8.0 0.0 0.0
Repo Men
1.7 13.4 7.9
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Return vs. Risk (Std. Dev.):
Which investment is best?
20.0%
Alta
15.0% Mkt
Am. Foam
Return
10.0%
T-bills
5.0%
Repo
0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Risk (Std. Dev.)
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Portfolio Risk and Return
Calculate ^
rp and p.
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Portfolio Expected Return
^
rp is a weighted average (wi is % of
portfolio in stock i):
n
^
rp = Σ wi ^
ri
i=1
^
rp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.
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Alternative Method: Find portfolio
return in each economic state
Port.=
0.5(Alta)
+
Economy Prob. Alta Repo 0.5(Repo)
Bust 0.10 -22.0% 28.0% 3.0%
Below 0.20 -2.0 14.7 6.4
avg.
Average 0.40 20.0 0.0 10.0
Above 0.20 35.0 -10.0 12.5
avg.
Boom 0.10 50.0 -20.0 15.0
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Use portfolio outcomes to
estimate risk and expected return
^
rp = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40
+ (12.5%)0.20 + (15.0%)0.10 = 9.6%
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s1 stock ≈ 35%
sMany stocks ≈ 20%
1 stock
2 stocks
Many stocks
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Risk vs. Number of Stock in
Portfolio
p
Company Specific
35%
(Diversifiable) Risk
Stand-Alone Risk, p
20%
Market Risk
0
10 20 30 40 2,000 stocks
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Stand-alone risk = Market risk
+ Diversifiable risk
Market risk is that part of a security’s
stand-alone risk that cannot be
eliminated by diversification.
Firm-specific, or diversifiable, risk is that
part of a security’s stand-alone risk that
can be eliminated by diversification.
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Conclusions
As more stocks are added, each new stock
has a smaller risk-reducing impact on the
portfolio.
sp falls very slowly after about 40 stocks are
included. The lower limit for sp is about 20%
= sM .
By forming well-diversified portfolios,
investors can eliminate about half the risk of
owning a single stock.
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Can an investor holding one stock earn a
return commensurate with its risk?
33
How is market risk measured
for individual securities?
Market risk, which is relevant for stocks
held in well-diversified portfolios, is
defined as the contribution of a security
to the overall riskiness of the portfolio.
It is measured by a stock’s beta
coefficient. For stock i, its beta is:
bi = (ri,M si) / sM
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How are betas calculated?
In addition to measuring a stock’s
contribution of risk to a portfolio, beta
also measures the stock’s volatility
relative to the market.
35
Using a Regression to
Estimate Beta
Run a regression with returns on the
stock in question plotted on the Y axis
and returns on the market portfolio
plotted on the X axis.
The slope of the regression line, which
measures relative volatility, is defined
as the stock’s beta coefficient, or b.
36
Use the historical stock returns to
calculate the beta for PQU.
Year Market PQU
1 25.7% 40.0%
2 8.0% -15.0%
3 -11.0% -15.0%
4 15.0% 35.0%
5 32.5% 10.0%
6 13.7% 30.0%
7 40.0% 42.0%
8 10.0% -10.0%
9 -10.8% -25.0%
10 -13.1% 25.0% 37
Calculating Beta for PQU
50%
40%
30%
PQU Return
20%
10%
0%
-10%
-20% rPQU = 0.8308 rM + 0.0256
-30% R2 = 0.3546
-30% -20% -10% 0% 10% 20% 30% 40% 50%
Market Return
38
What is beta for PQU?
The regression line, and hence beta,
can be found using a calculator with a
regression function or a spreadsheet
program. In this example, b = 0.83.
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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.
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How is beta interpreted?
If b = 1.0, stock has average risk.
If b > 1.0, stock is riskier than average.
If b < 1.0, stock is less risky than
average.
Most stocks have betas in the range of
0.5 to 1.5.
Can a stock have a negative beta?
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Other Web Sites for Beta
Go to http://finance.yahoo.com
Enter the ticker symbol for a “Stock
Quote”, such as IBM or Dell, then click
GO.
When the quote comes up, select Key
Statistics from panel on left.
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Expected Return versus Market
Risk: Which investment is best?
Expected
Security Return (%) Risk, b
Alta 17.4 1.29
Market 15.0 1.00
Am. Foam 13.8 0.68
T-bills 8.0 0.00
Repo Men 1.7 -0.86
43
Use the SML to calculate each
alternative’s required return.
The Security Market Line (SML) is part
of the Capital Asset Pricing Model
(CAPM).
44
Required Rates of Return
rAlta = 8.0% + (7%)(1.29) = 17%.
rM = 8.0% + (7%)(1.00) = 15.0%.
rAm. F. = 8.0% + (7%)(0.68) = 12.8%.
rT-bill = 8.0% + (7%)(0.00) = 8.0%.
rRepo = 8.0% + (7%)(-0.86) = 2.0%.
45
Expected versus Required
Returns (%)
Exp. Req.
r r
Alta 17.4 17.0 Undervalued
Market 15.0 15.0 Fairly valued
Am. Foam 13.8 12.8 Undervalued
T-bills 8.0 8.0 Fairly valued
Repo 1.7 2.0 Overvalued
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SML: ri = rRF + (RPM) bi
ri = 8% + (7%) bi
ri (%)
Alta . Market
rM = 15 . .
rRF = 8 . T-bills Am. Foam
Repo
. Risk, bi
-1 0 1 2
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Calculate beta for a portfolio
with 50% Alta and 50% Repo
bp = Weighted average
= 0.5(bAlta) + 0.5(bRepo)
= 0.5(1.29) + 0.5(-0.86)
= 0.22.
48
Required Return on the
Alta/Repo Portfolio?
rp = Weighted average r
= 0.5(17%) + 0.5(2%) = 9.5%.
Or use SML:
rp = rRF + (RPM) bp
= 8.0% + 7%(0.22) = 9.5%.
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Impact of Inflation Change on
SML
r (%)
New SML I = 3%
SML2
18 SML1
15
11 Original situation
8
18 SML1
15 RPM = 3%
8 Original situation
Risk, bi 51
1.0
Has the CAPM been completely
confirmed or refuted?
No. The statistical tests have problems
that make empirical verification or
rejection virtually impossible.
Investors’ required returns are based on
future risk, but betas are calculated with
historical data.
Investors may be concerned about both
stand-alone and market risk.
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