Chapter 7- Risk, Return, and the Capital Asset Pricing Model

Percentage Return

Example: Suppose a stock had an initial price of $58 per share, paid a dividend of $1.25 per
share during the year, and had an ending price of $75. Compute the percentage total return.
The percentage total return R = [$1.25 + ($75 - 58)]/$58 = 31.47%
Typically, investment returns are not known with certainty before they are realized, and,
therefore, investment is risky.
• Main principal: Investors like higher return and do not like higher risk!
• Average return = expected value
• Since investment returns are not known with certainty, they are “risky”. What is Risk?
→ An asset’s stand-alone risk is measured by how far, “on average”, the actual return
can differ from the expected return. Usually measured by standard deviation
→ Different kinds of risks (systematic vs. unsystematic)

Probability Distributions
• Probability distributions are used to describe the certainty of returns by listing all
possible returns and their probabilities.
• Graphically, the tighter (i.e., more peaked) the probability distribution, the more likely it
is that the actual returns will be close to the expected value.
• The tighter the probability distribution, the lower the risk assigned to a stock.
• Graphical Presentation of Probability Distributions:

• Quantitative Characteristics of a Probability Distribution:

→ Expected return: The weighted average of outcomes
→ Standard deviation: A measure of the tightness of a probability distribution giving
an idea of how far above or below the expected value the actual value is likely to
be
 Expected Return
M
Calculation:
E(R) = rˆ =  pi Ri where pi is probabilit y of state i and
i =1
M
Ri is return in state i. Don' t forget that  pi = 1
i =1
So, E(RM)= 0.3(100%) + 0.4(15%) + 0.3(-70%) = 15%
and E(RB)= 0.3(40%) + 0.4(15%) + 0.3(-10%) = 15%

Calculation of Standard Deviation (SD) of Returns

M = [(100 – 15)2 (0.3) + (15 – 15)2 (0.4) + (-70 – 15)2 (0.3)]1/2 = 65.84%
B = [(40 – 15)2 (0.3) + (15 – 15)2 (0.4) + (-10 – 15)2 (0.3)]1/2 = 19.36%
• Using Historical Data to Measure Risk

Problem:
Using the following returns, calculate the average returns, the variances, and the standard
deviations for stocks X and Y.

Solution: E[X] = (.18 + .11 - .09 + .13 + .07)/5 = .08

E[Y] = (.28 - .07 - .20 + .33 + .16)/5 = .10
Var(X)=[(.18-.08)2+(.11-.08)2+(-.09 -.08)2+(.13-.08)2+(.07-.08)2]/(5-1)=.0106.
Var(Y)=[(.28-.10)2+(-.07-.10)2+(-.20-.10)2+(.33-.10)2+(.16-.10)2]/(5-1)=.05195.
Standard deviation of X = (.0106)1/2 = 10.30%.
Standard deviation of Y =(.05195)1/2 = 22.79%.
 Expected return = E[R]=p1R1+p2R2+…+pTRT = (-1.25 + 7.50 + 8.75) = 15%
Var (R)=p1(R1 – E[R])2 + . . . pT(RT – E[R])2
The standard deviation = (.02)1/2 = .1414 =14.14%

Coefficient of Variation (CV)

• CV = Standard deviation / expected return
• CVM = 65.84% / 15% = 4.39
• CVB = 19.36% / 15% = 1.29
• CV shows the risk per unit of return and captures the effects of both risk and return.
In Finance we need CV or Sharp Ratios (return/risk) to decide in which assets we want to invest

Risk Aversion and Required Return

• A risk-averse investor will consider risky assets or portfolios only if they provide
compensation for risk via a risk premium.
• Risk premium is the excess return
on the risky asset that is the difference between expected return on risky assets and the
return on risk-free assets.

Risk in a Portfolio Context

• Investors often hold portfolios, not the asset of only one kind.
• A particular asset going up or down is important, but what matters the most is the return
on the portfolio and its risk.
• Therefore, risk/return of an asset should be analyzed in terms of how that asset affects
the overall risk/return of the portfolio in which it is held.
• Saying it differently: only the part of the stand-alone risk that increases the risk of the
portfolio is important!!!

Expected Return and Risk for Portfolios

• A portfolio is a collection of securities, such as stocks and bonds, that are combined and
considered a single investible asset.
• The expected return on a portfolio is the weighted average of the expected returns on
the individual securities in the portfolio,
n
where: (all 3 must equal 1)


ERP = ( wi  ERi )
i =1
• ERP = expected return on the portfolio
• ERi = expected return on the security I
• wi = portfolio weight of security I
 • For a two-security
n portfolio, the above equation becomes:
ERP =  ( wi  ERi ) = ERB + w( ERA − ERB )
i =1

• Example of Calculating Portfolio Returns

Stocks X and Y, each with investments of $25,000, form a portfolio of $50,000. Their
expected returns are 11% and 7%, respectively.
The rate of return on the portfolio is a weighted average of the returns on X and Y in the
portfolio: E (r ) = r = w E (r ) + w E (r )
P P X X Y Y
9% = (0.5)  (11%) + (0.5)  (7%)
Portfolio Risk (ΣP)
• Unlike returns, σP is generally not the weighted average of the standard deviations of the
individual assets in the basket.
The variance of the rate of return on the two risky assets portfolio is

σ P2 = (wX σ X )2 + (wY σY )2 + 2(wX σ X )(wY σY )ρ XY

where XY is the correlation coefficient between the returns on X and Y.
• Portfolio SD = σP

Correlation Coefficient ( )ρ
• Measures the tendency of two variables to move together
• The estimate of correlation from a sample of historical data is often called “R.”
Main lesson:
Expected return on a portfolio is equal to the weighted average of the expected returns
on the individual securities and is between the largest and smallest returns

Variance of a portfolio is less than the weighted average of variances of the individual
securities (unless those securities are perfectly correlated) and may be even smaller then the
smallest of the individual securities variances
σ P2 = (wX σ X )2 + (wY σY )2 + 2(wX σ X )(wY σY )ρ XY
Example of Calculating Portfolio Risk
• Two independent assets (i.e., ρAB = 0) A and B with wA = 0.75, and wB= 1 – wA = 0.25
form a portfolio. Their standard deviations are σA = 4%, and σB =10%.

σ P2 = (wAσ A )2 + (wB σ B )2 + 2(wAσ A )(wB σ B )ρ AB

= (0.5625)(0.0016) + (0.0625)(0.01)
+ 2(0.75)(0.25)(0)(0.04)(0.1)
= 0.001525
• SDP = sqrt(0.001525)= 0.039 = 3.9%

Example: Assume the expected return on stock ABC (denote by x) is 10% with a standard
deviation of 20% and the expected return on XYZ (denoted by “y”) is 15% with a standard
deviation of 30%. The correlation between these stock returns is 0.2. You invest $60 into ABC
and $40 into XYZ. What is the expected return and a standard deviation of your portfolio.

Solution:
Weights: 0.6 into ABC, 0.4 into XYZ
E(0.6x+0.4y)=0.6E(x)+0.4E(y)=0.6*10+0.4*15=12%

Var(0.6x+0.4y)=0.36*Var(x)+0.16*Var(y)+2*0.6*0.4*corr(x,y)*sd(x)*sd(y)
= 0.36*100+0.16*225+2*0.6*0.4*0.2*10*15=86.4

s.d.=sqrt(Var)=sqrt(86.4)=9.3%

Efficient frontier: main idea

• If you have several securities, you can construct several portfolios with the same
expected returns but different standard deviation.
• Your goal: to construct a portfolio with the desired average return and lowest standard
deviation

Efficient Portfolios
• Portfolio is a collection of assets.
• Efficient portfolios are such portfolios that maximize expected return for a given level of
risk (standard deviation).
 • Alternatively, efficient portfolios are such portfolios that minimize the risk for a given
level of expected return
• Investors choose along the efficient set for the best mix of risk and return with their own
risk attitudes.

You can achieve different risk-return combinations by constructing different portfolios.

For each expected return level r the portfolio with the lowest standard deviation (σ) is the
most efficient portfolio.

Diversification
• Diversification can substantially reduce the variability of returns without an equivalent
reduction in expected returns.
• However, there is a minimum level of risk that cannot be diversified away, and that is the
systematic portion.

Diversifiable Risk vs. Market Risk

• The risk (variance) of an individual asset’s return can be broken down into:
→ market risk: Economy-wide random events that affect almost all assets to a
certain degree
→ diversifiable risk: Random events that affect single security or small groups of
securities
• The effect of diversification:
→ Unsystematic (“asset-specific”) risk will significantly diminish in large portfolios.
→ Systematic (“market”) risk cannot be eliminated by diversification since it affects
all assets in any large portfolio.
Portfolio Risk as a Function of the Number of Assets in the Portfolio
• In a large portfolio (N ≥ 40), the unsystematic risk can be eliminated almost completely,
but systematic risk cannot be eliminated regardless of the size of the portfolio
• Thus, diversification can eliminate some, but not all, of the risk of individual securities.

Different types of risks: main lesson

• If an investor holds a number of different stocks, then the stocks’ unsystematic risks may
offset each other. Since unsystematic risk can be diversified away by any investors, there
should be no premium for it. Only systematic risk should affect the expected stock return

-coefficient
• For any asset -coefficient measures the co-movement of the asset with the market. In
particular, for any asset j,
• i= COViM =    i
 M2 M
iM

• -coefficient is asset-specific: different assets may have different betas

• -coefficient is a measure of systematic (i.e., not asset-specific) risk. Since only
systematic risk is priced by the market, -coefficient is important in determining
the expected return on the asset
• Important property: beta of a portfolio is equal to the weighted average of betas of the
individuals securities.

Portfolio Betas
• The beta of a portfolio is a weighted average of its individual securities’ betas:

Return, Risk, and Equilibrium

• What is the relationship between risk and return?
→ Since  is the measure of systematic risk, only this type of risk should affect the
expected stock returns.
 → The fundamental conclusion is that the ratio of the risk premium to beta is the
same for every asset. In other words, the reward-to-risk ratio is constant and
equal to

→ Reward-to-risk ratio is the price of 1 unit of systematic risk

The Relationship Between Risk and Rates of Return: CAPM Graph: SML
Since reward/risk ratio has to be constant we can apply it to any stock i and “market
portfolio” (S&P500). We’ll get E(R i ) - R f E(R M ) - R f Since  = 1and RPM = E(R M ) - R f
= M
we’ll get the SML equation: i M

• SML: A Numerical Example

→ Given: βi = 1.5, rRF = 3%, rM = 10% draw the SML
→ Solution: ri = 3% + 1.5 × (10% - 3%) = 13.5%

• SML: Impact of Inflation

→ Given: βi = 1.5, rRF = 3%, rM = 10%
→ ri = 3% + 1.5 × (10% – 3%) = 13.5%
→ If rRF = 3% ↑ 5%; ri = 5% + 1.5×(7%) = 15.5%
 • SML: Changes in Risk Aversion
→ Given: βi = 1.5, rRF = 3%, rM = 10%
→ ri = 3% + 1.5 × (10% – 3%) = 13.5%
→ If RPM = 7% ↑ 8%; Ri = 3% + 1.5 × (8%) = 15%

• Example: Portfolio Beta Calculations

Example: Portfolio Expected Returns and Betas

• Assume you wish to hold a portfolio consisting of asset A and a riskless asset. Given the
following information, calculate portfolio expected returns and portfolio betas, letting
the proportion of funds invested in asset A range from 0 to 125%.
• Asset A has a beta of 1.2 and an expected return of 18%. The risk-free rate is 7%, and we
assume that βRF=βf= 0. Asset A weights: 0%, 25%, 50%, 75%, 100%, and 125%.
• Solution:
→ e.g., for 25% invested in A, 75% in risk-free asset: βp=0.25×1.2+0.75×0=0.3,
E(Rp)=0.25×0.18+0.75×0.07=0.0975
→ e.g., for 125% invested in A, -25% in risk-free asset: βp=1.25×1.2-0.25×0=1.5,
E(Rp)=1.25×0.18-0.25×0.07=0.2075, see next slide.
Return, Risk, and Equilibrium
Example:
• Asset A has an expected return of 12% and a beta of 1.40. Asset B has an expected return
of 8% and a beta of 0.80. Are these assets valued correctly relative to each other if the
risk-free rate is 5%?
a. For A: (.12 - .05)/1.40 = .05
b. For B: (.08 - .05)/0.80 = .0375
• What would the risk-free rate have to be for these assets to be correctly valued?
(.12 - Rf)/1.40 = (.08 - Rf)/0.80
Rf = .02666

Practice problems
1) Assume stock A has an expected return of 20% and beta = 1.2; the risk-free rate is 4%.
Find the beta of a stock B that has an expected return of 10%
0.2=0.04+1.2(RM-0.04) (1)
0.1=0.04+B(RM-0.04) (2)
from (1): (RM-0.04)=(0.2-0.04)/1.2=0.1333, substituted in (2) it gives:
0.1=0.04+B*0.1333
B=(0.1-0.04)/0.1333=0.45

2) Assume stock A has an expected return of 15% and beta = 0.8. If the risk-free rate is 6%,
what is the market expected rate of return?
0.15=0.06+0.8(RM-0.06)
RM=0.06+(0.15-0.06)/0.8=0.1725 or 17.25%
3) If the market rate of return is 12% and risk-free rate is 4%, what should the beta of a
stock with 10% return be?
0.1=0.04+(0.12-0.04)
=(0.1-0.04)/(0.12-0.04)=0.75