Chapter 3

Risk and Return: Part II

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• Portfolio Theory Topics
• Capital Asset Pricing Model (CAPM)
– Efficient Frontier
– Capital Market Line (CML)
– Security Market Line (SML)
– Beta calculation
• Arbitrage pricing theory
• Fama-French 3-factor model
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 Determinants of Intrinsic Value:
The Cost of Equity

Net operating Required investments

−
profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF∞

Value = + + +
(1 + WACC)1 (1 + WACC)2 ... (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

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• Suppose AssetPortfolio Theory
A has an expected return of 10
percent and a standard deviation of 20 percent.
Asset B has an expected return of 16 percent and a
standard deviation of 40 percent. If the correlation
between A and B is 0.35, what are the expected
return and standard deviation for a portfolio
comprised of 30 percent Asset A and 70 percent
Asset B?

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Portfolio Expected Return
^r = w r^ + (1 – w ) r ^
p A A A B

= 0.3(0.1) + 0.7(0.16)

= 0.142 = 14.2%.

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 Portfolio Standard Deviation
σP = √w2Aσ2A + (1-wA)2σ2B + 2wA(1-wA)ρABσAσB

= √0.32(0.22) + 0.72(0.42) + 2(0.3)(0.7)(0.35)(0.2)(0.4)

= 0.306

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Illustrations of Portfolio Return and Risk

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Attainable Portfolios: rAB = 0.35

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Attainable Portfolios: rAB = +1
 AB = +1.0: Attainable Set of Risk/Return
Combinations

20%

15%
Expected return

10%

5%

0%
0% 10% 20% 30% 40%
Risk, p

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Attainable Portfolios: rAB = -1
 AB = -1.0: Attainable Set of Risk/Return
Combinations

20%

15%
Expected return

10%

5%

0%
0% 10% 20% 30% 40%

Risk, s p

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Attainable Portfolios with Risk-Free Asset
(Expected risk-free return = 5%)
Attainable Set of Risk/Return
Combinations with Risk-Free Asset

15%
Expected return

10%

5%

0%
0% 5% 10% 15% 20%
Risk, sp

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Feasible and Efficient Portfolios
Expected Efficient Set
Portfolio D
Return, rp
C Feasible Set
X

Risk, s p
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 Feasible
• The feasible setand Efficient
of portfolios Portfolios
represents all portfolios
that can be constructed from a given set of stocks.
• An efficient portfolio is one that offers:
– the most return for a given amount of risk, or
– the least risk for a give amount of return.
• The collection of efficient portfolios is called the
efficient set or efficient frontier.

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Indifference Curve

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 Optimal Portfolios
IB2 I
B1
Expected
Return, rp
A
B Optimal Portfolio
IA Investor B
2
IA1
Optimal Portfolio
Investor A
15 Risk s p
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 Indifference
• Indifference curves reflect Curves
an investor’s
attitude toward risk as reflected in his or her
risk/return tradeoff function. They differ
among investors because of differences in risk
aversion.
• An investor’s optimal portfolio is defined by
the tangency point between the efficient set
and the investor’s indifference curve.

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• The CAPM What is the CAPM?
is an equilibrium model that
specifies the relationship between risk and
required rate of return for assets held in well-
diversified portfolios.
• It is based on the premise that only one factor
affects risk.
• What is that factor?

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 What are the assumptions
• Investors all think in terms of
of the CAPM?
a single holding period.
• All investors have identical expectations.
• Investors can borrow or lend unlimited
amounts at the risk-free rate.

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• All assets are Assumptions
perfectly divisible.
• There are no taxes and no transactions costs.
• All investors are price takers, that is, investors’
buying and selling won’t influence stock
prices.
• Quantities of all assets are given and fixed.

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 What impact does rRF have on
• When a risk-free asset is added to the feasible
the efficient frontier?
set, investors can create portfolios that
combine this asset with a portfolio of risky
assets.
• The straight line connecting rRF with M, the
tangency point between the line and the old
efficient set, becomes the new efficient
frontier.

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Efficient Set with a Risk-Free Asset
Expected Z
Return, rp

M
. B

^r
M
.
rRF
A . The Capital Market
Line (CML):
New Efficient Set

sM Risk, s p
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• What is the
The Capital Capital
Market Market
Line (CML) Line?
is all linear
combinations of the risk-free asset and
Portfolio M.
• Portfolios below the CML are inferior.
– The CML defines the new efficient set.
– All investors will choose a portfolio on the CML.

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 The CML Equation

^r - r
^r = r + M RF
s p.
p RF
sM

Intercept Slope
Risk
measure
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• TheWhat
expecteddoes the
rate of CML
return tellefficient
on any us?
portfolio is equal to the risk-free rate plus a
risk premium.
• The optimal portfolio for any investor is the
point of tangency between the CML and the
investor’s indifference curves.

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 Capital Market Line
Expected I3 I2 CML
Return, rp I1

^r
^r
R
M

.
R . M

N
R = Optimal
rRF Portfolio

Risk, s p
sR sM 1
•What is the
The CML Security
gives Market
the risk/return Line (SML)?
relationship for
efficient portfolios.
• The Security Market Line (SML), also part of
the CAPM, gives the risk/return relationship
for individual stocks.

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 Theof SML
• The measure Equation
risk used in the SML is the
beta coefficient of company i, bi.

• The SML equation:

ri = rRF + (RPM) bi

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• Run How are betas
a regression calculated?
line of past returns on Stock i
versus returns on the market.
• The regression line is called the characteristic
line.
• The slope coefficient of the characteristic line
is defined as the beta coefficient.

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Illustration of beta calculation
_
.
_ _
ri
.
Year rM ri
15
1 15% 18%
10 2 -5 -10
3 12 16
5
-5 0 5 10 15 20 _
rM
-5
^r = -2.59 + 1.44 r ^
. -10
i M

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 Method
• Analysts of Calculation
use a computer with statistical or
spreadsheet software to perform the
regression.
– At least 3 year’s of monthly returns or 1 year’s of
weekly returns are used.
– Many analysts use 5 years of monthly returns.

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• If beta = 1.0, Interpretation
stock is average risk.
• If beta > 1.0, stock is riskier than average.
• If beta < 1.0, stock is less risky than average.
• Most stocks have betas in the range of 0.5 to
1.5.

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 Interpreting
• The Regression
R2 measures the Results
percent of a stock’s
variance that is explained by the market. The
typical R2 is:
– 0.3 for an individual stock
– over 0.9 for a well diversified portfolio

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 Interpreting
• The 95% confidence Regression
interval showsResults
the range
in which we are 95% sure that the true value
of beta lies. The typical range is:
– from about 0.5 to 1.5 for an individual stock
– from about .92 to 1.08 for a well diversified
portfolio

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What is the relationship between stand-alone,
market, and diversifiable risk?
• s2 = b2 s 2 + s e2.

• s2 = variance
• = stand-alone risk of Stock j.

• b2 s 2 = market risk of Stock j.

• s e2 = variance of error term

• = diversifiable risk of Stock j.

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 What are two potential tests that can be
• Beta stability tests
conducted to verify the CAPM?
• Tests based on the slope of the SML

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 Test of stability of Beta Coefficient
• Betas of individual securities are not good
estimators of future risk.
• Betas of portfolios of 10 or more randomly
selected stocks are reasonably stable.
• Past portfolio betas are good estimates of
future portfolio volatility.

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Tests of the SML

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 Tests oflinear
• A more-or-less the SML indicate:
relationship between
realized returns and market risk.
• Slope is less than predicted.
• CAPM implies that company-specific risk
should not be relevant, yet both kinds of risks
are positively related to security return

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 Are there problems with the
• Yes.
CAPM tests?
– Richard Roll questioned whether it was even
conceptually possible to test the CAPM.
– Roll showed that it is virtually impossible to prove
investors behave in accordance with CAPM theory.
– It should not apply to bonds (they do not plot on
the SML)

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 What are our conclusions
• CAPM is of truly fundamental importance
regarding the CAPM?
• However, when applied in practice, we do not
know how to measure any of the inputs
required to implement CAPM

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 What are our conclusions
• CAPM/SML concepts are based on expectations, yet
regarding
betas are calculated usingthe CAPM?
historical data. A
company’s historical data may not reflect investors’
expectations about future riskiness.
• Other models are being developed that will one day
replace the CAPM, but it still provides a good
framework for thinking about risk and return.

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 What is the difference between the CAPM and
• The CAPM is a single factor model.
the Arbitrage Pricing Theory (APT)?
• The APT proposes that the relationship
between risk and return is more complex and
may be due to multiple factors such as GDP
growth, expected inflation, tax rate changes,
and dividend yield.

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 Required Return for Stock i
under the APT

ri = rRF + (r1 - rRF)bi1 + (r2 - rRF)bi2

+ ... + (rj - rRF)bij.
rj = required rate of return on a portfolio
sensitive only to economic Factor j.
bij = sensitivity of Stock i to economic
Factor j.
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 What
• The is the
APT is being usedstatus
for someof
realthe
worldAPT?
applications.
• Its acceptance has been slow because the model
does not specify what factors influence stock returns.
• More research on risk and return models is needed
to find a model that is theoretically sound,
empirically verified, and easy to use.

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Fama-French 3-Factor Model

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 Fama-French
• Fama 3-Factor
and French propose Model
three factors:
– The excess market return, rM-rRF.
– the return on, S, a portfolio of small firms (where
size is based on the market value of equity) minus
the return on B, a portfolio of big firms. This
return is called rSMB, for S minus B.

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 Fama-French
– the 3-Factor
return on, H, a portfolio of firmsModel
with high
book-to-market ratios (using market equity and
book equity) minus the return on L, a portfolio of
firms with low book-to-market ratios. This return
is called rHML, for H minus L.

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Required Return for Stock i under the Fama-
French 3-Factor Model

ri = rRF + (rM - rRF)bi + (rSMB)ci + (rHMB)di

bi = sensitivity of Stock i to the market return.

cj = sensitivity of Stock i to the size factor.
dj = sensitivity of Stock i to the book-to-market factor.

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 Required Return for Stock i
Inputs: bi=0.9; rRF=6.8%; market risk premium = 6.3%;
ci=-0.5; expected value for the size factor is 4%; di=-0.3;
expected value for the book-to-market factor is 5%.

ri = rRF + (rM - rRF)bi + (rSMB)ci + (rHMB)di

ri = 6.8% + (6.3%)(0.9) + (4%)(-0.5) + (5%)(-0.3)

= 8.97%
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CAPM Required Return for Stock i
CAPM:
ri = rRF + (rM - rRF)bi

ri = 6.8% + (6.3%)(0.9)
= 12.47%

Fama-French (previous slide):

ri = 8.97%