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Risk, Return, & The Capital Asset Pricing Model

The document discusses key concepts related to risk, return, and the Capital Asset Pricing Model (CAPM). It defines investment return, risk, and different types of risk including stand-alone risk and market risk. Market risk cannot be eliminated through diversification, while diversification can reduce firm-specific or diversifiable risk. The CAPM holds that the expected return of an asset is determined by its beta, or level of non-diversifiable market risk. It also introduces the security market line which portrays the relationship between risk and required return in the CAPM.

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Elyza Bartolome
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54 views

Risk, Return, & The Capital Asset Pricing Model

The document discusses key concepts related to risk, return, and the Capital Asset Pricing Model (CAPM). It defines investment return, risk, and different types of risk including stand-alone risk and market risk. Market risk cannot be eliminated through diversification, while diversification can reduce firm-specific or diversifiable risk. The CAPM holds that the expected return of an asset is determined by its beta, or level of non-diversifiable market risk. It also introduces the security market line which portrays the relationship between risk and required return in the CAPM.

Uploaded by

Elyza Bartolome
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 19

Risk, Return, & 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
What are investment returns?
 Investment returns measure financial results
of an investment.
 Returns may be historical or prospective
(anticipated).
 Returns can be expressed in:
 (P) Peso terms.
 (%) percentage terms.

3
Basic Formula for Return
Fixed Returns
Lesser risk since the return is fixed
. An investment costs P1,000 and is
sold after 1 year for P1,100

Peso return:
Received - Invested
P1,100 - P1,000 = P100
Percentage return:
Return/Invested
P100/P1,000 = 0.10 = 10%
6
Variable Income (series of
time)
 Return is computed by getting the
average return
Variable Income (Probabililty
based)

 Normal 40% Return 20%


 Bad 30% Return 5%
 Good 30% Return 35%
WedTech Co

 Normal 40% Return 20% = .08


 Bad 30% Return 5% = .015
 Good 30% Return 35% = .105
 =Expected ave return = 20%
Notes
 Expected Rate of Return- return that
expected to realize.
 Required rate of Return – Minimum
Rate of return acceptable by the
investor
 Actual Rate of Return- Return
actually earned
 Market Equillibrium- Required rate
of return is equal to expected return
What is investment risk?

 Typically, investment returns are not known


with certainty.

 Investment risk pertains to the probability of


earning a return less than expected.

 Greater the chance of a return far below the


expected return, greater the risk.
11
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.

12
Standard deviation
Risk Aversion and Risk
Premium
 Risk Aversion – the higher the risk the
higher the return.

 Risk Premium –difference between


expected return against Required rate
of Return
Porfolio
 Collection of assets or securities that a
particular firm has for it investor.
> Risk, > Return, (both + & -)

Stand – Alone Risk Risk in Portfolio Context


 a. Diversifiable

 b. Market Risk
 Quantified by Beta & used in
 CAPM: Capital Asset Pricing Model
 Relationship b/w market risk &
required return as depicted in SML

 Req’d return =
 Risk-free return + Mrkt risk Prem(Beta)
 SML: ri = rRF + (RM - rRF )bi
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.

17
Conclusions
 As more stocks are added, each new stock
has a smaller risk-reducing impact on the
portfolio.
 By forming well-diversified portfolios,
investors can eliminate about half the risk of
owning a single stock.

18
Capital Asset Pricing Model
 R=Rf +Beta (Rm-Rf)

 Beta- The measure of the riskiness of


the security

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