Lecture 5 Question of the Week

Instead of investing in bonds, you are considering investing in stocks.

The information for three stocks, Stock A, B and C are given below. The
returns on the three stocks are positively correlated, but they are not
perfectly correlated (i.e., that means each of the correlation coefficient
is between 0 and 1).
Stock Expected Standard Beta
Return Deviation
A 9.00% 15% 0.7
B 11.50% 15% 1.2
C 14.50% 15% 1.8

Portfolio ABC has one-third of its funds invested in each of the three
stocks. The risk-free rate is 5.5%, and the market is in equilibrium.
a) What is the market risk premium (rM – rRF)?
b) What is the beta of Portfolio ABC?
c) What is the required return of Portfolio ABC?
d) Would you expect the standard deviation of Portfolio ABC to be
less than 15%, equal to 15%, or greater than 15%? Why?
By the end of the lecture, you should be able to answer the above questions.
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Lecture 5: Risk and Rate of Return
Learning Objectives
• Explain the difference between stand-alone risk and portfolio risk
• Understand how risk aversion affects a stock’s required rate of return
• Calculate the expected return and risk when holding an individual
stock
• Calculate the coefficient of variation
• Discuss the difference between diversifiable risk and market risk, and
explain how each type of risk affects well-diversified investors
• Understand what the capital asset pricing model (CAPM) is and how
it is used to estimate a stock’s required rate of return
• Calculate a portfolio’s expected return and its risk
• Determine if a stock is undervalued or overvalued
• Explain how expected inflation and investors’ risk aversion can affect
the security market line (SML)
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https://sg.finance.yahoo.com/quote/MSFT/history?p=MSFT

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https://sg.finance.yahoo.com/quote/AMZN/chart?p=AMZN
 AB1201:
Financial Management

Lecture 5: Risk and Rates of Return

By: Chanika Charoenwong

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Which Investment would You Choose?

• Both investments cost $100 now

– Investment A: 100% chance of getting $150 in
one year’s time
– Investment B: 50% chance of getting $200 and
50% of getting $100 in one year’s time

4
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Risk and Rates of Return

• Stand-alone risk/Total risk

• Portfolio risk
• Risk and Return: CAPM

5
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Investors’ Attitude towards Risk

• Most investors are risk averse
– Risk-averse investors dislike risk and require higher
rates of return to encourage them to hold riskier
securities.
• Risk premium—the difference between the
return on a risky asset and a riskless asset
– Serves as compensation for investors to hold
riskier securities.
• Implication:
– Higher risk  Higher required return
6
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Investment Returns
• Calculating the rate of return on an investment:

Return 
Ending value  Amount Invested 
Amount Invested

• If $1,000 is invested and $1,100 is returned after one

year, the annual rate of return is:
(1100–1000)/1000=10%
• A stock is selling for $30 and you expect the stock
price to be $39 in one year’s time. The stock is also
expected to pay a dividend of $3 at the end of the
year. The annual rate of return is: (39+3-30)/30 = 40%

7
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

What is Investment Risk?

• Investment risk is related to the probability of
earning a return that is different from
expected.
– The greater the chance
of earning a return different Investment
risk
from expected, the riskier
the investment.

Stand-alone
risk Portfolio risk
(Total risk)

8
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Holding an Individual Stock

• Calculation of expected returns and risk

– Stand-alone risk/Total risk

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Probability Distributions
• A listing of all possible outcomes, and the
probability of each occurrence.
• Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

10
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Investment Alternatives
Economy Prob. T-Bill MP HT Coll
Recession 0.1 5.5% -17.0% -27.0% 27.0%

Below avg 0.2 5.5% -3.0% -7.0% 13.0%

Average 0.4 5.5% 10.0% 15.0% 0.0%

Above avg 0.2 5.5% 25.0% 30.0% -11.0%

Boom 0.1 5.5% 38.0% 45.0% -21.0%

11
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Expected Return for Each Investment

N
Expected return  rˆ   ri Pi
i 1

rˆHT  ( 27)(0.1)  ( 7)(0.2)  (15)(0.4)  (30)(0.2)  (45)(0.1)

rˆHT  12.4%

rˆTBills  5.5% rˆM  10.5%

rˆColl  1.0%??

12
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Measuring Stand-alone Risk:

Standard Deviation for Each Investment
N
  i Pi
( r
i 1
 r̂ ) 2

1/ 2
( 27  12.4) (0.1)  ( 7  12.4) (0.2)
2 2

 
 HT   (15  12.4)2 (0.4)  (30  12.4) 2 (0.2) 
  ( 45  12 . 4 ) 2
( 0 . 1) 
 
 HT  20.0%
??
σTBills = 0.0%
σColl = 13.2%
σM = 15.2%
13
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Coefficient of Variation (CV)

• A standardised measure of dispersion about
the expected value that shows the risk per
unit of return.
• Especially useful when comparing
investments with different expected returns.
Standard deviation σ
CV  
Expected return r̂

CVTBills = 0.0 CVColl = 13.2

CVM = 1.4 CVHT = 1.6

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Lessons Learnt 1
• Most investors are risk averse and require higher rates
of return to encourage them to hold riskier securities.
• Two types of investment risk—stand-alone risk and
portfolio risk
• When holding individual investment,
 N
r   ri Pi
1

• Standard deviation is used to measure stand-alone

risk
• Coefficient of variation measures risk per unit of return
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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Holding Stocks in a Portfolio

• Calculation of expected returns and risk

of a portfolio
– Portfolio risk

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Portfolio Construction: Risk and return

• Assume a two-stock portfolio created with

$50,000 is invested in both HT and
Collections.
• Calculate the expected return and
standard deviation of the portfolio.

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Calculating a Portfolio’s Expected Return

Method 1
• A portfolio’s expected return is a weighted
average of the returns of the portfolio’s
component assets.

rˆp is a weighted average :

N ^
rˆp =  w i r i
i=1

rˆp = 0.5 (12.4%) + 0.5 (1.0%) = 6.7%

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Alternative Method
Economy Prob. HT Coll Port.
Recession 0.1 -27.0% 27.0% 0.0%
Below avg 0.2 -7.0% 13.0% 3.0%
Average 0.4 15.0% 0.0% 7.5%
Above avg 0.2 30.0% -11.0% 9.5%
Boom 0.1 45.0% -21.0% 12.0%

rˆp  0.10 (0.0%)  0.20 (3.0%)  0.40 (7.5%)

 0.20 (9.5%)  0.10 (12.0%)  6.7%
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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Calculating a Portfolio’s Standard

Deviation
1
 0.10 (0.0 - 6.7)  2 2

 2 
 0.20 (3.0 - 6.7) 
 p   0.40 (7.5 - 6.7) 2   3.4%
 0.20 (9.5 - 6.7) 2 
 
 0.10 (12.0 - 6.7) 
2

lower than the weighted average of

HT and Coll.’s σ:
(0.5*20% + 0.5*13.2% = 16.6%!!)
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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Comments on the Portfolio’s Risk Measures

• Some risk is diversified away:
– σp = 3.4% is much lower than the σi of either stock
(σHT = 20.0%; σColl. = 13.2%).
– σp = 3.4% is lower than the weighted average of
HT and Coll.’s σ (16.6%).
• Will there always be diversification benefits
when combining stocks?
– Depends on the correlation coefficient between
the stocks Recall: ρ (“rho”) measures how
the returns of two stocks move
with one another
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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Returns Distribution for Two Perfectly

Negatively Correlated Stocks (ρ = -1.0)

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Returns Distribution for Two Perfectly

Positively Correlated Stocks (ρ = 1.0)

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Partial Correlation, ρ = +0.35

Diversification benefits
exist as long as stocks are
not perfectly positively
correlated i.e. ρ ≠ +1

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

General Comments about Diversification

Most stocks are positively (though not perfectly)

correlated with the market (i.e. ρ between 0 and 1).

Combining stocks in a portfolio generally lowers

risk.

Eventually the diversification benefits of adding more

stocks dissipates (after about 10 stocks), and for large
stock portfolios, σp tends to converge to 20%.

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

For Figure 8.6 in the textbook, ignore the statements below

“Effects of Portfolio Size on Risk for a Portfolio of Randomly Selected Stocks” from Essentials of
Financial Management, by Brigham, Houston, Hsu, Kong, and Bany-Ariffin, 2018, Singapore:
Cengage Learning.
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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Breaking Down the Sources of Risk

• Stand-alone risk can be decomposed into
diversifiable risk and market risk
• Diversifiable risk—portion of a security’s stand-alone
risk that can be eliminated through proper
diversification.
– Caused by idiosyncratic events of a company
• Market risk—portion of a security’s stand-alone risk
that cannot be eliminated through diversification.
Measured by beta.
– Caused by market-wide risk factors that affect all
stocks
27
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

• If an investor chooses to hold a one-stock

portfolio (and does not diversify), would the
investor be compensated for the extra risk
he bears?
1. Yes
2. No

28
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Lessons Learnt 2
• A portfolio’s expected return is a weighted average of the
returns of the portfolio’s component assets.
• A portfolio’s standard deviation is NOT a weighted
average of the standard deviation of the portfolio’s
component assets.
• Adding more stocks to a portfolio may reduce the
portfolio’s risk. However diversification benefits exist as
long as stocks are not perfectly positively correlated (i.e. ρ
= +1).
• Stand-alone risk can be decomposed into two
components:
– Diversifiable risk—can be diversified through proper diversification
– Market risk—cannot be eliminated through diversification.
29
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Capital Asset Pricing Model (CAPM)

• Model linking risk and required returns.
CAPM suggests that a stock’s required return
equals the risk-free return plus a risk premium
that reflects the stock’s risk after
diversification.
ri = rRF + (rM – rRF)bi
• Primary conclusion: The relevant riskiness of
a stock is its market risk as measured by
beta.

30
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

What is the Market Risk Premium (rM – rRF)?

• Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
• Its size depends on the perceived risk of the
stock market and the investors’ degree of
risk aversion.
• Varies from year to year, but most estimates
suggest that it ranges between 4% and 8%
per year.
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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Beta
• Measures a stock’s market risk, and shows a
stock’s volatility relative to the market.
– How sensitive is the stock to market-wide risk
factors?
– A stock’s beta is the expected change in its
return given a 1% change in the return of the
market portfolio.
Why market portfolio? Changes in the
value of market portfolio are due
solely to market-wide events 
Market portfolio returns is a good
proxy for market-wide events

32
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Calculating Betas
• Well-diversified investors are primarily
concerned with how a stock is expected to
move relative to the market in the future.
– Without a crystal ball to
predict the future, analysts are
forced to rely on historical data.

• A typical approach to estimating beta is to

run a regression of the security’s past returns
against the past returns of the market.
– The slope of the regression line is defined as the
beta coefficient for the security.
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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Illustrating the Calculation of Beta

_ Historical returns
ri

.
.
20 Year rM ri
1 15% 18%
15
2 -5 -10
10 3 12 16
5

-5 0 5 10 15 20
rM
Regression line:

.
-5 ^ ^
ri = -2.59 + 1.44 rM Estimated Beta
-10
of Stock i
Go back 34
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Comments on Beta
• If beta = 1.0, the security is just as risky as the
average stock.
• If beta > 1.0, the security is riskier than
average.
• If beta < 1.0, the security is less risky than
average.
• Most stocks have betas in the range of 0.5 to
1.5.
• Can a stock have negative beta?
35
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Beta Coefficients for High Tech,

Collections, and T-Bills
ri HT: b = 1.32
40

Why is Coll’s beta

negative?
20

T‐bills: b = 0

‐20               0                 20                40
rM

Coll: b = ‐0.87

‐20
36
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

The Security Market Line (SML):

Calculating Required Rates of Return
ri (%)
SML: ri = rRF + (rM – rRF)bi
ri = rRF + (RPM)bi
Risk, bi
• Assume the yield curve is flat and that rRF = 5.5% and
RPM = 5.0% and the below beta
Security Beta
HT 1.32
Market 1.00
T-Bills 0.00
Coll. -0.87
37
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Calculating Required Rates of Return

• rHT = 5.5% + (5.0%)(1.32) = 12.1%

• rM = 5.5% + (5.0%)(1.00) = 10.5%

• rTBILL= 5.5% + (5.0%)(0.00) = 5.5%

??
• rCOLL= 5.5% + (5.0%)(-0.87) = 1.15%

38
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Expected versus Required Returns

Expected returns based on
current stock price and
future cash flows Required returns based
^ on market risk
r r
^
HT 12.4% 12.1% Undervalued ( r  r)
^
Market 10.5 10.5 Fairly valued ( r  r)
^
T - bills 5.5 5.5 Fairly valued ( r  r)
^
Coll. 1.0 1.15 Overvalued ( r  r)
39
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Illustrating the Security Market Line

SML: ri = 5.5% + (5.0%)bi

ri (%)
SML

rM
12.4
= 10.5 . . HT

rRF = 5.5
. T-bills

-1
.
Coll. 0 1 1.32 2
Risk, bi

40
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Example: Calculating Beta and the

Required Returns of a Portfolio
• Create a portfolio with 50% invested in HT
and 50% invested in Collections.
• The beta of a portfolio is the weighted
average of each of the stock’s betas.
bP = wHTbHT + wCollbColl
= 0.5(1.32) + 0.5(-0.87)
= 0.225

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Calculating a Portfolio’s Required Returns

• 1st Method: Use the portfolio’s beta. CAPM can be
used to solve for required return.
rP = rRF + (RPM)bP
= 5.5% + (5.0%)(0.225)
= 6.625%

• 2nd Method: The required return of a portfolio is the

weighted average of each of the stock’s required
returns.
rP = wHTrHT + wCollrColl
= 0.5(12.10%) + 0.5(1.15%)
= 6.625%

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Lessons Learnt 3
• CAPM is a model linking risk and required returns.
ri = rRF + (rM – rRF)bi

• The primary concern of well-diversified investors is

market risk which is measured by beta.
• To determine beta, the security’s past returns are
regressed against the past returns of the market.
– The slope of the regression line is defined as the beta
coefficient for the security.
– If beta = 1.0, the security is just as risky as the average
stock. If beta > 1.0, the security is riskier than average. If
beta < 1.0, the security is less risky than average.
• The beta of a portfolio is the weighted average of
each of the stock’s beta.
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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

How would the Following Affect the Security

Market Line (SML) and Required Returns?

• Expectations about future inflation

• Investors’ risk aversion

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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Factors that Change the SML

• What if the investors raised inflation expectations
by 3%, what would happen to the SML?

ri (%)
∆I = 3% SML2
13.5 SML1
10.5
8.5

5.5

Risk, bi
0 0.5 1.0 1.5
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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Factors that Change the SML

• What would happen to the SML if the investors’
aversion to risk increased, causing the market risk
premium to increase by 3%?

ri (%) SML2
∆RPM = 3%

13.5 SML1
10.5

5.5
Risk, bi
0 0.5 1.0 1.5  
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Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Realised, Expected and Required Returns

• Required returns: Returns an investor requires given
the riskiness of the stock and returns available on
other investments
• Expected returns: Returns an investor who buys the
stock expects to get in the future
– Only buy the stock when expected returns > required returns
– In equilibrium, expected and required returns should be equal
• Realised returns: Returns you actually get
– Expected and required returns are forward-looking, while
realised returns are historical
• When the realised returns are not equal to required
returns, it does not mean that the CAPM does not work
– What you require and what you ultimately get
47
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Lessons Learnt 4
• A change in the expected inflation affects
the nominal risk free rate and market rate of
return
– The higher the expected inflation, the higher the
intercept of the SML
– The slope of SML does not change
• A change in the investors’ risk aversion
causes market risk premium to change
– The intercept of SML does not change
– The greater the investors’ risk aversion, the
steeper the slope of the SML
48
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion

Where do We Stand?
• Stock returns can be summarised by probability
distribution
– Expected returns
– Total risk is measured by the standard deviation
– Compare alternative assets using CV
• Total risk can be decomposed into market risk and
diversifiable risk
• CAPM:
– Only market risk is being compensated
– Market risk is measured by beta
– ri = rRF + (rM – rRF) bi
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Lecture 5 Revisiting Question of the Week
Instead of investing in bonds, you are considering investing in stocks.
The information for three stocks, Stock A, B and C are given below. The
returns on the three stocks are positively correlated, but they are not
perfectly correlated (i.e., that means each of the correlation coefficient
is between 0 and 1).
Stock Expected Standard Beta
Return Deviation
A 9.00% 15% 0.7
B 11.50% 15% 1.2
C 14.50% 15% 1.8

Portfolio ABC has one-third of its funds invested in each of the three
stocks. The risk-free rate is 5.5%, and the market is in equilibrium.
a) What is the market risk premium (rM – rRF)?
b) What is the beta of Portfolio ABC?
c) What is the required return of Portfolio ABC?
d) Would you expect the standard deviation of Portfolio ABC to be
less than 15%, equal to 15%, or greater than 15%? Why?

50
Lecture 5 Revisiting Questions of the Week
a) What is the market risk premium (rM – rRF)?
Using CAPM and information of Stock A, (or any stock):

b) What is the beta of Portfolio ABC?

51
Lecture 5 Revisiting Questions of the Week

c) What is the required return of Portfolio ABC?

d) Would you expect the standard deviation of Portfolio ABC

to be less than 15%, equal to 15%, or greater than 15%?
Why?

Since the returns on the 3 stocks included in the Portfolio

ABC are not perfectly positively correlated, one would
expect the standard deviation of the portfolio to be less
than 15%.

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