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Risk and Return

Capital Asset Pricing Model



Celso Brunetti
Johns Hopkins University

Based on: Corporate Finance by Smart, Megginson, and Gitman (2006). South-
Western College Publications, 2nd Edition.
Introduction to Risk and Return
Valuing risky assets - a task fundamental to
financial management
Three-step procedure for valuing a risky asset:
1. Determine the assets expected cash flows.
2. Choose discount rate that reflects assets risk.
3. Calculate present value (PV cash inflows - PV
outflows).
The three-step procedure is called
discounted cash flow (DCF) analysis.
Historical vs. Expected Returns
Decisions Must Be Based On Expected Returns
There Are Many Ways to Estimate Expected Returns
Assume that Expected Return Going Forward
Equals the Average Return in the Past.
Simple Way to Estimate Expected Return
Risk and Return Fundamentals
Equity risk premium: the difference in equity
returns and returns on safe investments
implies that stocks are riskier than bonds or bills
trade-off always arises between expected risk
and expected return
Risk and Return
The return earned on investments represents
the marginal benefit of investing.
Risk represents the marginal cost of investing.
Standard Deviation of Stocks, Bonds,
and Bills for Different Holding Periods

Risk Aversion

Risk Neutral

Investors seek the highest return without
regard to risk.

Risk Seeking

Investors have a taste for risk and will
take risk even if they cannot expect a
reward for doing so.

Risk Averse

Investors do not like risk and must be
compensated for taking it.
Historical returns on financial assets are consistent with
a population of risk-averse investors.
Value of $1 Invested in Equities,
Treasury Bonds & Bills, 1900-2003
Year
$15,579
$148
$61
$22
10,000
100,000
1,000
100
10
1
Equities Bonds

Bills Inflation
1900 1920 1940 1960 1980 2000 2003
Percentage Returns on Bills, Bonds, and
Stocks, 1900 - 2003
Difference between average return of stocks and bills = 7.6%
Difference between average return of stocks and bonds = 6.5%
Risk premium: the difference in returns offered by a
risky asset relative to the risk-free return available
Nominal (%) Real (%)
Asset Class Average Best Year Worst Year Average Best Year Worst Year
Bills 4.1 14.7 0.0 1.1 19.7 -15.1
Bonds 5.2 40.4 -9.2 2.3 35.1 -19.4
Stocks 11.7 57.6 -43.9 8.5 56.8 -38
Two Assets with Same Expected Return
But Different Distributions
Risk of a Single Asset
How Do We Measure Risk?
One Approach Volatility of Assets Returns
Variance (o
2
) - the expected value of squared
deviations from the mean
Units of Variance (%-squared) - hard to interpret, so
calculate standard deviation, square root of o
2
2
2
2
1
2
2
% 4 . 4 ......
35
%) 838 . 0 % 34 . 22 (
35
%) 838 . 0 % 96 . 26 (
1
) (
= +

+

=

=
N
R R
N
t
i
it
o
An example
Immucell Corp.

Monthly Returns for
Jan 2000 Dec 2002

Average Return =
0.838%
Return on an Asset
t
t t t
t
P
C P P
R
1 1
1
+ +
+
+
=
Return - the total gain or loss experienced on
an investment over a given period of time
An example...

Investor Bought Utilyco
for $60/share

Dividend = $6/share

Sold for $66/share

+ -
=
R
util
% 20
60 $
12 $
60 $
6 $ 60 $ 66 $
= =
Arithmetic vs. Geometric Returns
Arithmetic return is the simple average of annual
returns: best estimate of expected return each year.
Geometric average return is the compound annual
return to an investor who bought and held a stock t
years.
Geometric avg return =
(1+R
1
)(1+R
2
)(1+R
3
).(1+R
t
)]
1/t
1
The difference between arithmetic returns and geometric returns
increases the more volatile the returns are.
Arithmetic vs. Geometric Returns
The difference between arithmetic returns and geometric returns
increases the more volatile the returns are.
AAR = 6.25%
GAR = 5.78%
An example ...

Year Return

2000 -10%

2001 +12%

2002 +15%

2003 + 8%
Probability Distribution
Probability distribution tells us what
outcomes are possible and associates a
probability with each outcome.
Normal distribution
Distribution of Historical Stock Returns,
1900 - 2003
Histogram of Nominal Returns on Equities
1900-2003
<-30 -30 to -20 to -10 to 0 to 10 to 20 to 30 to 40 to >50
-20 -10 0 10 20 30 40 50
Percent return in a given year
Probability distribution for future stock returns is
unknown. We can approximate the unknown distribution
by assuming a normal distribution.
Variance
A reasonable way to define risk is to focus on the
dispersion of returns:
Most common measure of dispersion used as a
proxy for risk in finance is variance, or its square
root, the standard deviation.
Distributions variance equals the expected
value of squared deviations from the mean.
Expected Return for a Portfolio
Most investors hold multiple asset
portfolios.
Key insight of Portfolio Theory: Asset
return adds linearly, but risk is (almost
always) reduced in a portfolio.
)
N
E(R
N
w ... )
3
E(R
3
w )
2
E(R
2
w )
1
E(R
1
w )
p
E(R + + + + =
Two-Asset Portfolio Standard Deviation
2 1 12 2 1
2
2
2
2
2
1
2
1
2
2 o o o o o w w w w
p
+ + =
2
Deviation Standard
p
o =
Correlation between stocks
influences portfolio volatility.
Covariance & Correlation
( )( )
( )( ) ( )
1 1
1
1
1
1
+ s s
=
=

=
=
XY
Y X
XY
XY
n
i
i i XY
n
i
i i XY
XY P Y Y X X
Y Y X X
n

o o
o

o
o
Correlation Coefficients and
Risk Reduction for Two-Asset Portfolios
10%
15%
20%
25%
0% 5% 10% 15% 20% 25%
Standard Deviation of Portfolio Returns
E
x
p
e
c
t
e
d

R
e
t
u
r
n

o
n

t
h
e

P
o
r
t
f
o
l
i
o


is +1.0
-1.0 < <1.0


is -1.0
Portfolios with More than Two Assets
Five-Asset Portfolio
) ( ) (
) ( ) ( ) ( ) (
5 5 4 4
3 3 2 2 1 1
R E w R E w
R E w R E w R E w R E
p
+ +
+ + =
Expected return of portfolio is still the average of
expected returns of the two stocks.
How is the variance of the portfolio influenced by the number of
assets in the portfolio?
5
4
3
2
1
5 4 3 2 1 Asset
The covariance terms determine to a large extent
the variance of the portfolio.
Asset 1 2 3 4 5
1
2
3
4
5 5
4
3
2
1
5 4 3 2 1 Asset
Variance of individual assets account for only 1/25
th
of the
portfolio variance.
Variance Covariance Matrix
2
1
2
5
1
o |
.
|

\
|
12
2
5
1
o
|
.
|

\
|
13
2
5
1
o
|
.
|

\
|
14
2
5
1
o
|
.
|

\
|
15
2
5
1
o
|
.
|

\
|
21
2
5
1
o
|
.
|

\
|
2
2
2
5
1
o
|
.
|

\
|
23
2
5
1
o
|
.
|

\
|
24
2
5
1
o
|
.
|

\
|
25
2
5
1
o
|
.
|

\
|
31
2
5
1
o
|
.
|

\
|
32
2
5
1
o
|
.
|

\
|
2
3
2
5
1
o
|
.
|

\
|
34
2
5
1
o
|
.
|

\
|
35
2
5
1
o
|
.
|

\
|
41
2
5
1
o
|
.
|

\
|
42
2
5
1
o
|
.
|

\
|
43
2
5
1
o
|
.
|

\
|
2
4
2
5
1
o
|
.
|

\
|
45
2
5
1
o
|
.
|

\
|
51
2
5
1
o
|
.
|

\
|
52
2
5
1
o
|
.
|

\
|
53
2
5
1
o
|
.
|

\
|
54
2
5
1
o
|
.
|

\
|
2
5
2
5
1
o
|
.
|

\
|
Effect of Diversification on
Portfolio Variance

Portfolio Risk
Variance cannot fall below the average
covariance of securities in the portfolio:
Undiversifiable risk (systematic risk, market
risk)
Only systematic risk is priced in the market.
Beta is one way to measure the systematic risk
of an asset.
Diversifiable risk (unsystematic risk,
idiosyncratic risk, or unique risk)
What is a Stocks Beta?
Beta is a measure of systematic risk.
m
im
i
=
What if
beta >1 or
beta <1?
The stock moves more than 1% on average
when the market moves 1% (beta >1).
The stock moves less than 1% on average
when the market moves 1% (beta <1).
What if
beta = 1?
The stock moves 1% on average when the
market moves 1%.
An average level of risk
Diversifiable And Non-Diversifiable Risk
As the number of assets increases,
diversification reduces the importance of
a stocks own variance:
Diversifiable risk, unsystematic risk
Only an assets covariance with all other
assets contributes measurably to overall
portfolio return variance:
Non-diversifiable risk, systematic risk

How Risky is an Individual Asset?
First Approach Assets variance or
standard deviation
What really matters is systematic risk . How an
asset covaries with everything else.

Use assets beta.
The Impact of Additional Assets
on the Risk of a Portfolio
Number of Securities (Assets) in Portfolio
P
o
r
t
f
o
l
i
o

R
i
s
k
,

o
k
p

Nondiversifiable Risk
Diversifiable Risk
Total risk
1 5 10 15 20 25
Capital Asset Pricing Model
(CAPM)


A portfolio is a collection of assets.


An efficient portfolio is a collection of assets
managed to either maximize return for a given
level of risk or minimize risk for a given level of
return.


Correlation, Diversification, Risk and Return

A. In general, the lower the correlation between asset returns, the
greater the potential diversification of risk.

B. Only in the case of perfect negative correlation can risk be
reduced to zero.

C. The amount of risk reduction achieved through diversification is
also dependent upon the proportions in which the assets are
combined.

D. There is potentially an infinite number of asset combinations
possible in a given portfolio of assets.

E. While diversification can alter the risk of a portfolio, the
portfolio's expected return will always range between the
highest and lowest expected returns of the assets within the
portfolio if held in isolation.
Efficient Risky Portfolios
Variance of return - a poor measure of
risk
Investors can only expect compensation
for systematic risk.
Asset pricing models aim to define and
quantify systematic risk.
Begin developing pricing model by asking:
Are some portfolios better than others?
CAPM - Assumptions
Perfect competition

Single period investment horizon

No taxes or transaction costs

Investors are rational mean variance
optimizers

Homogeneous expectations
E(R
P
)
o
P

Expanding the Feasible Set on
the Efficient Frontier
EF including domestic
& foreign assets
EF including domestic
stocks, bonds, and
real estate
EF for portfolios of
domestic stocks
Two Asset Portfolios
E(R
P
)
o
P

Stock A


Stock B
MVP (75%A, 25%B)
C (50%A, 50%B)
inefficient portfolios
efficient portfolios


Are Some Portfolios Better
Than Others?
efficient portfolios

MVP
D
F


E













N Asset Portfolios
Efficient portfolios achieve the highest possible return for any level of volatility.
What happens when we add a risk-free asset to the picture?
Expected Return (per month) and
Standard Deviation for Various Portfolios

Riskless Borrowing and Lending
Return: 6%
Risk-free
asset Y
Buying asset Y = Lending
money at 6% interest
How would a portfolio with $100 (50%) in asset X and $100
(50%) in asset Y perform?
Portfolio has lower return but also less volatility than 100% in X.
Portfolio has higher return and higher volatility than 100% in risk-free.
Three possible returns:
-10%; 10%; 30%
Risky asset X
Expected return =
10%
Standard
deviation=16.3%
$100 Asset X

$100 Asset Y
Three possible returns:
-2%; 8%; 18%
Expected return =
8%
Standard
deviation=8.16%
Riskless Borrowing and Lending (contd)
What if we sell short asset Y instead of buying it?
Borrow $100 at 6%
Must repay $106
Invest $300 in X
Original $200 investment plus $100 in borrowed funds
% 18
$200
$200 - $106 - $270
Investment $200 on Return Net = =
When X Pays 10%

% 12
$200
$200 - $106 - $330
Investment $200 on Return Net = =
When X Pays 10%

% 42
$200
$200 - $106 - $390
Investment $200 on Return Net = =
When X Pays 30%

Expected return on the portfolio is 12%. Higher expected return
comes at the expense of greater volatility.
Riskless Borrowing and Lending (contd)
Portfolio
Expected
Return
Standard
Deviation
50% risky, 50% risk-free 8% 8.16%
100% risky, 0% risk free 10% 16.33%
150% risky, -50% risk free 12% 24.49%
The more we invest in X, the higher the expected return.
The expected return is higher, but so is the volatility.
This relationship is linear.
Portfolios of Risky & Risk-Free Assets




R
F
=6%
0 30% 52%
12%
16.5%
E(R
P
)
o
P

9%
15%
A
MF
B
New Efficient Frontier
The Market Portfolio
Only one risky portfolio is efficient.
Equilibrium requires this to be the market portfolio.
Suppose investors agree on which portfolio is efficient.
Market Portfolio: value-weighted portfolio of all
available risky assets
The line connecting R
f
to the market portfolio is called
the Capital Market Line.

Finding the Optimal Risky Portfolio
If investors can borrow and lend at the risk-free
rate, then from the entire feasible set of risky
portfolios, one portfolio will emerge that
maximizes the return investors can expect for a
given standard deviation.
To determine the composition of the optimal
portfolio, you need to know the expected return
and standard deviation for every risky asset, as
well as the covariance between every pair of
assets.

Finding the Optimal Portfolio
The Capital Market Line
The line connecting R
f
to the market portfolio is
called the Capital Market Line (CML).
CML quantifies the relationship between the
expected return and standard deviation for
portfolios consisting of the risk-free asset and
the market portfolio, using:

Capital Asset Pricing Model (CAPM)
Only beta changes from one security to the next.
For that reason, analysts classify the CAPM as a
single-factor model, meaning that just one
variable explains differences in returns across
securities.
The Security Market Line
Plots the relationship between expected
return and betas
In equilibrium, all assets lie on this line
If stock lies above the line:
Expected return is too high.
Investors bid up price until expected return
falls.
If stock lies below the line:
Expected return is too low.
Investors sell stock, driving down price until
expected return rises.
The Security Market Line
|
i

E(R
P
)
R
F

SML
Slope = E(R
m
) - R
F
= Market
Risk Premium (MRP)

A - Undervalued



R
M

| =1.0

B

A

B - Overvalued
Beta
2
m
im
i
=
The numerator is the covariance of the stock
with the market.
The denominator is the markets variance.
In the CAPM, a stocks systematic risk is captured by beta.
The higher the beta, the higher the expected return on the stock.
Beta And Expected Return
Beta measures a stocks exposure to market risk
The market risk premium is the reward for bearing
market risk:
R
m
- R
f
E(R
i
) = R
f
+ [E(R
m
) R
f
]
Return for
bearing no
market risk
Stocks
exposure to
market risk
Reward for
bearing
market risk
Calculating Expected Returns
E(R
i
) = R
f
+ [E(R
m
) R
f
]
Assume
Riskfree rate = 2%
Expected return on the market = 8%
If Stocks Beta Is Then Expected Return Is
0 2%
0.5 5%
1 8%
2 14%
When beta = 0, the return equals the risk-free return.
When beta = 1, the return equals the expected market return.
Scatterplot for Returns on
Sharper Image and S&P500
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
-0.3 -0.2 -0.1 0 0.1 0.2 0.3
S&P500 Weekly Return
S
h
a
r
p
e
r

I
m
a
g
e

W
e
e
k
l
y

R
e
t
u
r
n
Slope = Bet a = 1.44
R-square = 0.19
Scatterplot for Returns on
ConAgra and S&P500
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
-0.15 -0.1 -0.05 0 0.05 0.1 0.15
S&P500 Weekly Return
C
o
n
A
g
r
a

W
e
e
k
l
y

R
e
t
u
r
n
beta = 0.11
R-square = 0.003
Scatterplot for Returns on
Citigroup and S&P500
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
0.2
-0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2
S&P500 Weekly Return
C
i
t
i
g
r
o
u
p

W
e
e
k
l
y

R
e
t
u
r
n beta = 1.20
R-square = 0.50
r%
|
12.4%
10
5
R
f
= 2%
1 2 GE P&G
SML
6.8%
Using the Security Market Line (SML)
15

slope = E(R
m
) R
F
=
MRP = 10% - 2% = 8%
= AY AX
The SML and where P&G and GE place on it
r%
|
11.1%
10
5
R
f
= 2%
1 2 GE P&G
SML
1
6.2%
Shifts in the SML Due to a Shift in
Required Market Return
15
Shift due to change in
market risk premium
from 8% to 7%


SML
2
r%
|
14.4%
10
5
R
f
= 4%
1 2 GE P&G
SML
1

8.8%
Shifts in the SML Due to a Shift in the
Risk-Free Rate
15

Shift due to change in
risk-free rate from 2% to
4%, with market risk
premium remaining at
8%. Note all returns
increase by 2%.
SML
2
Alternatives to CAPM
Arbitrage Pricing Theory


Fama-French Model
( ) ( ) ( )
low high 3 big small 2 1
R R R R R R R R
i i f m i f i
+ + + = | | | o
Betas represent sensitivities to each source of
risk. Terms in parentheses are the rewards for
bearing each type of risk.
The Current State of APT
Investors demand compensation for taking
risk because they are risk averse.
There is widespread agreement that
systematic risk drives returns.
You can measure systematic risk in several
different ways depending on the asset
pricing model you choose.
The CAPM is still widely used in practice in
both corporate finance and investment-
oriented professions.

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