Lecture 8

Risk and Return

Managerial Finance
FINA 6335
Ronald F. Singer
Topics Covered
 Markowitz Portfolio Theory
 Risk and Return Relationship
 Testing the CAPM
 CAPM Alternatives

8-2
Markowitz Portfolio Theory
 Combining stocks into portfolios can
reduce standard deviation below the level
obtained from a simple weighted average
calculation.
 Correlation coefficients make this possible.
 The various weighted combinations of
stocks that create this standard deviations
constitute the set of efficient portfolios.
portfolios

8-3
Markowitz Portfolio Theory
Price changes vs. Normal distribution
Microsoft - Daily % change 1986-1997
600

500
(frequency)
# of Days

400

300

200

100

0
-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%

Daily % Change 8-4

Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment C
20
18
16
probability

14
12
10
%

8
6
4
2
0
-50 0 50

% return 8-5
Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment D
20
18
16
probability

14
12
10
%

8
6
4
2
0
-50 0 50

% return 8-6
 Markowitz Portfolio Theory
Expected Returns and Standard Deviations vary given
different weighted combinations of the stocks.

Expected Return (%)

McDonald’s

45% McDonald’s

Bristol-Myers Squibb
8-7
Standard Deviation
 Efficient Frontier
Each half egg shell represents the possible weighted
combinations for two stocks.
The composite of all stock sets constitutes the efficient frontier.
Expected Return (%)

Standard Deviation 8-8

 Efficient Frontier
Lending or Borrowing at the risk free rate (rf) allows us to exist
outside the efficient frontier.
Expected Return (%)
T o wing
rr
Bo

d ing
n
Le

rf

S
Standard Deviation 8-9
Efficient Frontier
Correlation Coefficient = 0.4
Stocks  % of Portfolio Avg. Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%

Standard Deviation = weighted avg. = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg. = Portfolio = 17.4%

Let’s Add stock New Corp to the portfolio

Efficient Frontier
Correlation Coefficient = .3
Stocks  % of Portfolio Avg. Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%

NEW Standard Deviation = weighted avg. = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg. = Portfolio = 18.20%

NOTE: Higher return & Lower risk

How did we do that? DIVERSIFICATION
Efficient Frontier

Return

B
AB
A
Risk
(measured
as )
Efficient Frontier
Return

B
N
AB
A

Risk
Efficient Frontier
Return

B
ABN AB N

Risk
Efficient Frontier
Goal is to move
Return up and left.
WHY?

B
ABN AB N

Risk
Efficient Frontier
Return

Low Risk High Risk

High Return High Return

Low Risk High Risk

Low Return Low Return

Risk
Efficient Frontier
Return

B
ABN AB N

Risk
Security Market Line
Return

.
Efficient Portfolio
Risk Free
Return = rf
Risk
 Security Market Line
Return

Market Return = rm .
Efficient Portfolio
Risk Free
Return = rf
Risk
 Security Market Line
Return

Market Return = rm .
Efficient Portfolio
Risk Free
Return = rf
Risk
 Security Market Line
Return

Market Return = rm .
Efficient Portfolio
Risk Free
Return = rf
BETA
1.0
 Security Market Line
Return

Market Return = rm

Security Market
Risk Free Line (SML)
Return = rf
BETA
1.0
 Security Market Line
Return

SML

SML Equation = rf + B ( rm - rf )
rf
BETA
1.0
Capital Asset Pricing Model

R = rf + B ( rm - rf )

CAPM
Testing the CAPM
Beta vs. Average Risk Premium
Avg. Risk
Premium 1931-65 SML
30

20 Investors

10 Market
Portfolio
0
Portfolio Beta
1.0
Testing the CAPM
Beta vs. Average Risk Premium
Avg. Risk Premium
1966-91

30

20 SML
Investors

10

Market
0 Portfolio
Portfolio Beta
1.0
Testing the CAPM
Company Size vs. Average Return
Average Return (%)
25

20

15

10

Company size
0
Smallest Largest
 Testing the CAPM
Book-Market vs. Average Return
Average Return (%)
25

20

15

10

5 Book-Market Ratio

0
Highest Lowest
Consumption Betas Vs. Market Betas
Stocks Stocks
(and other risky assets) (and other risky assets)

Wealth is uncertain

Market risk Standard Consumption

makes wealth Wealth
CAPM CAPM
uncertain.
Consumption is
uncertain

Wealth = market
Consumption
portfolio
8-29
 Arbitrage Pricing Theory
Alternative to CAPM

Expected Risk
Premium = r - rf
= Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + …

Return = a + bfactor1(rfactor1) + bf2(rf2) + …

Arbitrage Pricing Theory
Estimated risk premiums for taking on risk factors
(1978-1990)
EstimatedRisk
Estimated RiskPrem
Premium
ium
Factor
Factor
(r(rfactor rrf))
factor  f
Yieldspread
Yield spread 5.10%
5.10%
Interestrate
Interest rate --.61
.61
Exchangerate
Exchange rate --.59
.59
RealGNP
Real GNP .49
.49
Inflation
Inflation --.83
.83
Mrket
Mrket 6.36
6.36