Financial Management:

Principles & Applications

Thirteenth Edition

Chapter 8
Risk and Return
Capital Market
Theory

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 Learning Objectives
1. Calculate the expected rate of return and volatility
for a portfolio of investments and describe how
diversification affects the returns to a portfolio of
investments.
2. Understand the concept of systematic risk for an
individual investment and calculate portfolio
systematic risk (beta).
3. Estimate an investor’s required rate of return using
the Capital Asset Pricing Model.

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 Principles Applied in This Chapter
• Principle 2: There is a Risk-Return Tradeoff.
• Principle 4: Market Prices Reflect Information.

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8.1 PortfolioReturns and
Portfolio Risk

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 Portfolio Risk and Return
An investment portfolio is any collection or combination
of financial assets.
Portfolio Return ()
The expected return on a portfolio is simply the weighted
average return of the individual assets in the portfolio, the
weights being the fraction of the total funds invested in each
asset:
==
=expected return on each individual asset
=fraction for each respective asset investment
n=number of assets in the portfolio
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 Portfolio Risk and Return
Risk of a Portfolio (sp) is not simply the weighted average
of the standard deviations of the individual assets in the
contribution, for a portfolio’s risk is also dependent on the
correlation coefficients of its assets. The correlation
coefficient () is a measure of the degree to which two
variables ‘‘move’’ together. It has a numerical value that
ranges from -1.0 to 1.0. In a two-asset (X and Y) portfolio,
the portfolio risk is defined as:
= +2

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 Portfolio Risk and Return
Portfolio risk can be minimized by diversification. The
degree to which risk is minimized depends on the
correlation between the assets being combined. The
correlation coefficient can range from −1.0 (perfect
negative correlation), meaning that two variables move in
perfectly opposite directions to +1.0 (perfect positive
correlation). Lower the correlation, greater will be the
diversification benefits.
 The effect of reducing risks by including a large number
of investments in a portfolio is called diversification.

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 Portfolio Risk and Return
• The diversification gains achieved will depend on the
degree of correlation among the investments,
measured by correlation coefficient.
Correlation between Diversification Benefits
investment returns
+1 No benefit

0.0 Substantial benefit

−1 Maximum benefit. Indeed, the risk of

portfolio can be reduced to zero.

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 Portfolio Risk and Return
Example : We have to fill in the third column (Product)
to calculate the weighted average.
Portfolio E(Return) X Weight = Product
Treasury bills 4.0% .25 Blank
EMR stock 8.0% .25 Blank
SBUX stock 12.0% .50 Blank

Solution
==
= 0.25 × 0.04 + 0.25 × 0.08 + 0.50 × 0.12
= 0.09 or 9%

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 Portfolio Risk and Return
Alternatively, we can fill out the following table to get the
same result.
Portfolio E(Return) X Weight = Product
Treasury bills 4.0% .25 1%
EMR stock 8.0% .25 2%
SBUX stock 12.0% .50 6%
Expected Return on Blank Blank 9%
Portfolio

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 Portfolio Risk and Return
Example : Sarah can visualize the expected return,
standard deviation and weights as shown below, with
the need to determine the numbers for the empty
boxes. =0.20
Investment Expected Standard Investment
Fund Return Deviation Weight
S&P500 fund 12% 20% 50%

International 14% 30% 50%

Fund
Portfolio Blank Blank 100%

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 Portfolio Risk and Return
Solution
==
= +2

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 Portfolio Risk and Return
DO IT: The securities of firms A and B have the expected
return and standard deviations given below; the expected
correlation between the two stocks (AB) is 0.1.

Compute the return and risk for each of the following

portfolios:
(a) 60 percent A and 40 percent B
(b) 50 percent A and 50 percent B.

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8.2 Systematic Risk and the
Market Portfolio

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 Capital Asset Pricing Model (CAPM)
Capital Asset pricing model is the linear relationship
between the return required on an investment (whether in
stock market securities or in business operations) and its
systematic risk. The CAPM is an important area of financial
management and also used to price risky assets.
The capital asset pricing model (CAPM) relates the risk
measured by beta to the level of expected or required rate of
return on a security. We categorize the risks of the individual
investments into two categories:
Systematic risk, and
Unsystematic risk
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Systematic Risk and Market Portfolio
The systematic risk (non-controllable risk or Non-
diversifiable risk) component measures the influence
of the investment to the risk of the market portfolio.
For example: War, recession.
The unsystematic risk (Diversifiable risk or
controllable risk) is the element of risk that does not
contribute to the risk of the market and is diversified
away. For example: Product recall, labor strike,
change of management.

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Figure 8.2 Portfolio Risk and the Number
of Investments in the Portfolio

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 Systematic Risk and Beta
Systematic risk is measured by beta coefficient, which
estimates the extent to which a particular investment’s
returns vary with the returns on the market portfolio.
The portfolio beta measures the systematic risk of the
portfolio.
 p   Wi  i

Example : Consider a portfolio that is comprised of four

investments with betas equal to 1.50, 0.75, 1.80 and
0.60 respectively. If you invest equal amount in each
investment, what will be the beta for the portfolio?
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 Systematic Risk and Beta
Solution
 p  W11  W2  2  W33  W4  4
 p 0.25(1.50)  0.25(0.75)  0.25(1.80)  0.25 (0.60)
 p 1.16
DO IT : You are considering a portfolio of three stocks with
30% of your money invested in company X, 45% of your
money invested in company Y, and 25% of your money
invested in company Z. If the betas for each stock are
1.22 for company X, 1.46 for company Y, and 1.03 for
company Z, what is the portfolio beta?
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8.3 The Security Market Line and
the CAPM

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 The Security Market Line and the
CAPM
CAPM describes how the betas relate to the expected
rates of return. The key insight of CAPM is that
investors will require a higher rate of return on
investments with higher betas.
SML is a graphical representation of the CAPM. SML
can be expressed as the following equation, which is
often referred to as the CAPM pricing equation:

ri rf   ( rm  rf )

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 The Security Market Line and the
CAPM
Example : Assume that the risk-free rate of return is 8
percent, the required rate of return on the market is 13
percent, and stock X has a beta coefficient of 1.5. What
is stock X’s required rate of return?
Solution
ri r f   ( rm  r f )
ri 8%  1.5(13%  8%)
ri 15.5

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Chapter 8

The
The End
End

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