1

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Chapter 6

Risk and Return: Past

and Prologue

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Bodie Kane Marcus

Fourth
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Rates of Return: Single Period

P D
P
HPR
P
1

HPR = Holding Period Return

P1 = Ending price
P0 = Beginning price
D1 = Dividend during period one
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Bodie Kane Marcus

Fourth
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Rates of Return: Single Period

Example
Ending Price =
Beginning Price =
Dividend =

24
20
1

HPR = ( 24 - 20 + 1 )/ ( 20) = 25%

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Bodie Kane Marcus

Fourth
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Data from Text Example p. 154

1
1.0
.10

Assets(Beg.)
HPR
TA (Before
Net Flows
1.1
Net Flows
0.1
End Assets
1.2
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2
1.2
.25

3
2.0
(.20)

4
.8
.25

1.5
0.5
2.0

1.6 1.0
(0.8) 0.0
.8 1.0

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Bodie Kane Marcus

Fourth
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Returns Using Arithmetic and

Geometric Averaging
Arithmetic
ra = (r1 + r2 + r3 + ... rn) / n
ra = (.10 + .25 - .20 + .25) / 4
= .10 or 10%
Geometric
rg = {[(1+r1) (1+r2) .... (1+rn)]} 1/n - 1
rg = {[(1.1) (1.25) (.8) (1.25)]}

1/4

-1

= (1.5150) 1/4 -1 = .0829 = 8.29%

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Essentials of Investments

Fourth
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Dollar Weighted Returns

Internal Rate of Return (IRR) - the
discount rate that results present value
of the future cash flows being equal to
the investment amount

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Considers changes in investment

Initial Investment is an outflow
Ending value is considered as an inflow
Additional investment is a negative flow
Reduced investment is a positive flow

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Bodie Kane Marcus

Fourth
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Dollar Weighted Average Using Text

Example
Net CFs
$ (mil)

1 2
- .1 - .5

3
.8

4
1.0

Solving for IRR

1.0 = -.1/(1+r)1 + -.5/(1+r)2 + .8/(1+r)3 +
1.0/(1+r)4
r = .0417 or 4.17%
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Bodie Kane Marcus

Fourth
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Quoting Conventions
APR = annual percentage rate
(periods in year) X (rate for period)
EAR = effective annual rate
( 1+ rate for period)Periods per yr - 1
Example: monthly return of 1%
APR = 1% X 12 = 12%
EAR = (1.01)12 - 1 = 12.68%
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Essentials of Investments

Fourth
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Characteristics of Probability
Distributions
1) Mean: most likely value
2) Variance or standard deviation
3) Skewness
* If a distribution is approximately normal,
the distribution is described by
characteristics 1 and 2

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Bodie Kane Marcus

Fourth
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Normal Distribution

s.d.

s.d.

r
Symmetric distribution
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Bodie Kane Marcus

Fourth
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Skewed Distribution: Large Negative

Returns Possible

Median

Negative

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Positive

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Skewed Distribution: Large Positive

Returns Possible

Median

Negative

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13

Essentials of Investments

Bodie Kane Marcus

Fourth
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Measuring Mean: Scenario or

Subjective Returns
Subjective returns
E(r) = p(s) r(s)
s

p(s) = probability of a state

r(s) = return if a state occurs
1 to s states

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Bodie Kane Marcus

Essentials of Investments

Fourth
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Numerical Example: Subjective or

Scenario Distributions
State
Prob. of State
rin State
1
.1
-.05
2
.2
.05
3
.4
.15
4
.2
.25
5
.1
.35
E(r) = (.1)(-.05) + (.2)(.05)...+ (.1)(.35)
E(r) = .15
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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Measuring Variance or Dispersion of

Returns
Subjective or Scenario

Variance = p(s) [rs - E(r)]

Standard deviation = [variance]1/2

Using Our Example:
Var =[(.1)(-.05-.15)2+(.2)(.05- .15)2...+ .1(.35-.15)2]
Var= .01199
S.D.= [ .01199] 1/2 = .1095
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16

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Real vs. Nominal Rates

Fisher effect: Approximation
nominal rate = real rate + inflation premium
R = r + i or r = R - i

Example r = 3%, i = 6%
R = 9% = 3% + 6% or 3% = 9% - 6%

Fisher effect: Exact

r = (R - i) / (1 + i)
2.83% = (9%-6%) / (1.06)

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Annual Holding Period Returns

From Figure 6.1 of Text
Geom
Series
Mean%
Lg Stk
11.01
Sm Stk 12.46
LT Gov
5.26
T-Bills
3.75
Inflation
3.08
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Arith Stan.
Mean% Dev.%
13.00
20.33
18.77
39.95
5.54
7.99
3.80
3.31
3.18
4.49
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18

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Annual Holding Period Risk

Premiums and Real Returns
Risk
Series
Premiums%
Lg Stk
9.2
Sm Stk
14.97
LT Gov
1.74
T-Bills
--Inflation
--Irwin

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Real
Returns%
9.82
15.59
2.36
0.62
---

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19

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Allocating Capital Between Risky &

Risk-Free Assets
Possible to split investment funds
between safe and risky assets
Risk free asset: proxy; T-bills
Risky asset: stock (or a portfolio)

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Allocating Capital Between Risky &

Risk-Free Assets (cont.)
Issues

Examine risk/ return tradeoff

Demonstrate how different degrees of risk
aversion will affect allocations between
risky and risk free assets

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21

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Example Using the Numbers in

Chapter 6 (pp 171-173)

Irwin

rf = 7%

rf = 0%

E(rp) = 15%

p = 22%

y = % in p

(1-y) = % in rf

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22

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Expected Returns for Combinations

E(rc) = yE(rp) + (1 - y)rf
rc = complete or combined portfolio
For example, y = .75
E(rc) = .75(.15) + .25(.07)
= .13 or 13%
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Essentials of Investments

Bodie Kane Marcus

Possible Combinations
E(r)

E(rp) = 15%

rf = 7%

0
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22%

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24

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Variance on the Possible Combined

Portfolios
Since

r = 0, then
f

c = y p

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Combinations Without Leverage

If y = .75, then

c = .75(.22) = .165 or 16.5%

If y = 1

c = 1(.22) = .22 or 22%

If y = 0
c = 0(.22) = .00 or 0%
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26

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Using Leverage with Capital

Allocation Line
Borrow at the Risk-Free Rate and invest
in stock
Using 50% Leverage
rc = (-.5) (.07) + (1.5) (.15) = .19
c = (1.5) (.22) = .33

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

CAL
(Capital
Allocation
Line)

E(r)

P
E(rp) = 15%
E(rp) - rf = 8%
rf = 7%

0
Irwin

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) S = 8/22
F

P = 22%

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28

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Risk Aversion and Allocation

Greater levels of risk aversion lead to
larger proportions of the risk free rate
Lower levels of risk aversion lead to
larger proportions of the portfolio of
risky assets
Willingness to accept high levels of risk
for high levels of returns would result in
leveraged combinations
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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Quantifying Risk Aversion

E rp rf .005 A p
E(rp) = Expected return on portfolio p
rf = the risk free rate
.005 = Scale factor
A x p = Proportional risk premium

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The larger A is, the larger will be the

added return required for risk

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30

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Quantifying Risk Aversion

Rearranging the equation and solving for A
E ( rp ) rf
A
.005 2p

Many studies have concluded that

investors average risk aversion is
between 2 and 4

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31

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Chapter 7

Efficient
Diversification

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Two-Security Portfolio: Return

rp = W1r1 + W2r2
W1 = Proportion of funds in Security 1
W2 = Proportion of funds in Security 2
r1 = Expected return on Security 1
r2 = Expected return on Security 2
n

Wi = 1
i=1
i=1

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33

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Two-Security Portfolio: Risk

p2 = w12 12 + w22 22 + 2W1W2 Cov(r1r2)
12 = Variance of Security 1
22 = Variance of Security 2
Cov(r1r2) = Covariance of returns for
Security 1 and Security 2
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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Covariance
Cov(r1r2) = 1 2
1,2 = Correlation coefficient of
returns
1 = Standard deviation of
returns for Security 1
2 = Standard deviation of
returns for Security 2
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35

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Correlation Coefficients: Possible

Values
Range of values for 1,2
-1.0 < < 1.0
If = 1.0, the securities would be
perfectly positively correlated
If = - 1.0, the securities would be
perfectly negatively correlated

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Three-Security Portfolio
rp = W1r1 + W2r2 + W3r3
2p = W12 12 + W22 + W32 32
+ 2W1W2 Cov(r1r2)
+ 2W1W3 Cov(r1r3)
+ 2W2W3 Cov(r2r3)
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37

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

In General, For an n-Security

Portfolio:
rp = Weighted average of the
n securities
p2 = (Consider all pair-wise
covariance measures)

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Two-Security Portfolio
E(rp) = W1r1 + W2r2
p2 = w12 12 + w22 22 + 2W1W2 Cov(r1r2)
p = [w12 12 + w22 22 + 2W1W2 Cov(r1r2)]1/2

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39

Essentials of Investments

Bodie Kane Marcus

E(r)

Fourth
Edition

TWO-SECURITY PORTFOLIOS WITH

DIFFERENT CORRELATIONS

13%
= -1
=0
8%

= -1

=1

12%
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= .3

20%

St. Dev

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40

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Portfolio Risk/Return Two Securities:

Correlation Effects
Relationship depends on correlation
coefficient
-1.0 < < +1.0
The smaller the correlation, the greater
the risk reduction potential
If= +1.0, no risk reduction is possible

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41

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Minimum Variance Combination

Sec 1 E(r1) = .10
Sec 2 E(r2) = .14

1 = .15
12 = .2
2 = .20

2 - Cov(r1r2)
2

W1 =

12 + 22 - 2Cov(r1r2)

W2 = (1 - W1)
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42

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Minimum Variance
Combination: = .2
W1 =

(.2)2 - (.2)(.15)(.2)
(.15)2 + (.2)2 - 2(.2)(.15)(.2)

W1 = .6733
W2 = (1 - .6733) = .3267
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43

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Minimum Variance: Return and Risk

with = .2
rp = .6733(.10) + .3267(.14) = .1131

p = [(.6733)2(.15)2 + (.3267)2(.2)2 +
2(.6733)(.3267)(.2)(.15)(.2)]

p= [.0171]
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1/2

1/2

= .1308
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44

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Minimum Variance
Combination: = -.3
W1 =

(.2)2 - (.2)(.15)(.2)
(.15)2 + (.2)2 - 2(.2)(.15)(-.3)

W1 = .6087
W2 = (1 - .6087) = .3913
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45

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Minimum Variance: Return and Risk

with = -.3
rp = .6087(.10) + .3913(.14) = .1157

p = [(.6087)2(.15)2 + (.3913)2(.2)2 +
1/2

2(.6087)(.3913)(.2)(.15)(-.3)]

p= [.0102]
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1/2

= .1009
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46

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Extending Concepts to All Securities

The optimal combinations result in
lowest level of risk for a given return
The optimal trade-off is described as
the efficient frontier
These portfolios are dominant

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47

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

The
minimum-variance
frontier
of
E(r)
risky assets
Efficient
frontier

Global
minimum
variance
portfolio

Individual
assets

Minimum
variance
frontier

St. Dev.
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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Extending to Include Riskless Asset

The optimal combination becomes
linear
A single combination of risky and
riskless assets will dominate

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49

Essentials of Investments

Bodie Kane Marcus

ALTERNATIVE CALS CAL (P)

E(r)

CAL (A)

M
P

P
A

Fourth
Edition

CAL (Global
minimum variance)
A
G

F
P
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P&F M

A&F

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Dominant CAL with a Risk-Free

Investment (F)
CAL(P) dominates other lines -- it has the
best risk/return or the largest slope
Slope = (E(R) - Rf) /
E(RP) - Rf) / PE(RA) - Rf) /
Regardless of risk preferences
combinations of P & F dominate

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51

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Single Factor Model

ri = E(Ri) + iF + e
i = index of a securities particular return
to the factor
F= some macro factor; in this case F is
unanticipated movement; F is commonly
related to security returns
Assumption: a broad market index like the
S&P500 is the common factor
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52

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Single Index Model

r r r r e
i

Risk Prem

Market Risk Prem

or Index Risk Prem
= the stocks expected return if the
i markets excess return is zero (r - r ) = 0
m
f
i(rm - rf) = the component of return due to
movements in the market index
ei = firm specific component, not due to market
movements
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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Risk Premium Format

Let: Ri = (ri - rf)
Rm = (rm - rf)

Risk premium
format

Ri = i + i(Rm) + ei

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Estimating the Index Model

Excess Returns (i)
Security
.
.
.
.
. .
.
.
.
Characteristic
.
. .
Line
.
. ..
. .. . .
.
.
. . . Excess returns
.
on market index
.
.
.
.
.
.
.
.
.
. . . .
.
.
.
.
. . . . . R .= + R + e
i

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Components of Risk
Market or systematic risk: risk related to the
macro economic factor or market index
Unsystematic or firm specific risk: risk not
related to the macro factor or market index
Total risk = Systematic + Unsystematic

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Measuring Components of Risk

i2 = i2 m2 + 2(ei)
where;

i2 = total variance
i2 m2 = systematic variance
2(ei) = unsystematic variance

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Examining Percentage of Variance

Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk/Total Risk = 2
i2 m2 / 2 = 2

Irwin

2
i

m2 / i2 m2 + 2(ei) = 2

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Advantages of the Single Index Model

Reduces the number of inputs for
diversification
Easier for security analysts to specialize

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Chapter 8

Capital Asset Pricing

and Arbitrage
Pricing Theory
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60

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Capital Asset Pricing Model (CAPM)

Equilibrium model that underlies all modern
financial theory
Derived using principles of diversification
with simplified assumptions
Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Assumptions
Individual investors are price takers
Single-period investment horizon
Investments are limited to traded
financial assets
No taxes, and transaction costs

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Assumptions (cont.)
Information is costless and available to
all investors
Investors are rational mean-variance
optimizers
Homogeneous expectations

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Resulting Equilibrium Conditions

All investors will hold the same portfolio
for risky assets market portfolio
Market portfolio contains all securities
and the proportion of each security is its
market value as a percentage of total
market value

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Resulting Equilibrium Conditions

(cont.)
Risk premium on the market depends
on the average risk aversion of all
market participants
Risk premium on an individual security
is a function of its covariance with the
market

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65

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Capital Market Line

E(r)

E(rM)

CML

rf
m
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66

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Slope and Market Risk Premium

M
rf
E(rM) - rf

=
=
=

Market portfolio
Risk free rate
Market risk premium

E(rM) - rf

Market price of risk

Slope of the CAPM

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Expected Return and Risk on

Individual Securities
The risk premium on individual
securities is a function of the individual
securitys contribution to the risk of the
market portfolio
Individual securitys risk premium is a
function of the covariance of returns
with the assets that make up the market
portfolio
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68

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Security Market Line

E(r)
SML
E(rM)
rf
M = 1.0
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69

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

SML Relationships
= [COV(ri,rm)] / m2
Slope SML =

E(rm) - rf

= market risk premium

SML = rf + [E(rm) - rf]

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Sample Calculations for SML

E(rm) - rf = .08 rf = .03
x = 1.25
E(rx) = .03 + 1.25(.08) = .13 or 13%
y = .6
e(ry) = .03 + .6(.08) = .078 or 7.8%
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71

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Graph of Sample Calculations

E(r)
SML
Rx=13%
Rm=11%
Ry=7.8%
3%

.08

.6 1.0 1.25
y m x
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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Disequilibrium Example
E(r)
SML
15%
Rm=11%
rf=3%
1.0 1.25
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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Disequilibrium Example
Suppose a security with a of 1.25 is
offering expected return of 15%
According to SML, it should be 13%
Underpriced: offering too high of a rate
of return for its level of risk

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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Security Characteristic Line

Excess Returns (i)
SCL

.
.
.
.
.
.
. . .
.
.
.
.
.
.
.
.
.
.
.
. .
.
.
Excess returns
.
.
.
on market index
.
.
.
.
.
.
.
.
.
. . . .
.
.
.
.
.
.. . . .
Ri = i + i Rm + e i

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75

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Using the Text Example p. 245, Table

8.5:
Jan.
Feb.
.
.
Dec
Mean
Std Dev
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Excess
GM Ret.

Excess
Mkt. Ret.

5.41
-3.44
.
.
2.43
-.60
4.97

7.24
.93
.
.
3.90
1.75
3.32
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76

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Regression Results:
rGM - rf =

+ (rm - rf)

Estimated coefficient -2.590

Std error of estimate (1.547)
Variance of residuals = 12.601
Std dev of residuals = 3.550
R-SQR = 0.575
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1.1357
(0.309)

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77

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Arbitrage Pricing Theory

Arbitrage - arises if an investor can
construct a zero investment portfolio
with a sure profit
Since no investment is required, an
investor can create large positions to
secure large levels of profit
In efficient markets, profitable arbitrage
opportunities will quickly disappear
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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Arbitrage Example from Text pp. 255257

Current
Stock Price$
A
10
B
10
C
10
D
10

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Expected
Return%
25.0
20.0
32.5
22.5

Standard
Dev.%
29.58
33.91
48.15
8.58

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79

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Arbitrage Portfolio

Portfolio
A,B,C
D

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Mean
Return

Stan.
Dev.

Correlation
Of Returns

25.83

6.40

0.94

22.25

8.58

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80

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Arbitrage Action and Returns

E. Ret.
* P
* D
St.Dev.
Short 3 shares of D and buy 1 of A, B & C to form
P
You earn a higher rate on the investment than
you pay on the short sale
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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

APT and CAPM Compared

APT applies to well diversified portfolios and
not necessarily to individual stocks
With APT it is possible for some individual
stocks to be mispriced - not lie on the SML
APT is more general in that it gets to an
expected return and beta relationship without
the assumption of the market portfolio
APT can be extended to multifactor models

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