Topic 3:

Risk and Return: Portfolio Theory and

Capital Asset Pricing Model (CAPM)

Return

2002, Prentice Hall, Inc.

Risk

Learning Objectives
How to measure risk
(variance, standard deviation, beta)
How to reduce risk
(diversification)
How to price risk
(security market line, CAPM)

Returns
Expected Return - the return that an
investor expects to earn on an asset,
given its price, growth potential, etc.
Required Return - the return that an
investor requires on an asset given its
risk and market interest rates.

Expected Return
State of Probability
Return
Economy
(P)
Orl. Utility Orl. Tech
Recession
.20
4%
-10%
Normal
.50
10%
14%
Boom
.30
14%
30%
For each firm, the expected return on the
stock is just a weighted average:
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

Expected Return
State of Probability
Return
Economy
(P)
Orl. Utility Orl. Tech
Recession
.20
4%
-10%
Normal
.50
10%
14%
Boom
.30
14%
30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

Expected Return
State of Probability
Return
Economy
(P)
Orl. Utility Orl. Tech
Recession
.20
4%
-10%
Normal
.50
10%
14%
Boom
.30
14%
30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
k (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

Based only on your

expected return
calculations, which
stock would you
prefer?

Have you considered

RISK?

What is Risk?
The possibility that an actual return
will differ from our expected return.
Uncertainty in the distribution of
possible outcomes.

How do we Measure Risk?

A more scientific approach is to
examine the stocks standard
deviation of returns.
Standard deviation is a measure of
the dispersion of possible outcomes.
The greater the standard deviation,
the greater the uncertainty, and
therefore , the greater the risk.

Standard Deviation

i=1

(ki - k)2 P(ki)

i=1

(ki - k)2 P(ki)

Orlando
Orlando Utility,
Utility, Inc.
Inc.
(( 4%
4% -- 10%)
10%)22 (.2)
(.2) == 0.00072
0.00072
(10%
(10% -- 10%)
10%)22 (.5)
(.5) == 00
(14%
(14% -- 10%)
10%)22 (.3)
(.3) == 0.00048
0.00048
Variance
==
0.0012
Variance
0.0012
Stand.
Stand. dev.
dev. == 0.0012
0.0012 == 3.46%
3.46%

i=1

(ki - k)2 P(ki)

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 0.01152
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) = 0.00768
Variance
=
0.0192
Stand. dev. = 0.0192 = 13.86%

Which stock would you prefer?

How would you decide?

Summary
Orlando
Utility
Expected Return
Standard Deviation

Orlando
Technology

10%

14%

3.46%

13.86%

It depends on your tolerance for risk!

Return

Risk

Remember, theres a tradeoff between

risk and return.

Portfolios
Combining several securities
in a portfolio can actually
reduce overall risk.
How does this work?

Suppose we have stock A and stock B.

The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated).

kA

rate
of
return

time

Suppose we have stock A and stock B.

The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated).

kA

rate
of
return

kB

time

What has happened to the

variability of returns for the
portfolio?

kA
rate
of
return

kB

time

kp

Diversification
Investing in more than one security to
reduce risk.
If two stocks are perfectly positively
correlated, diversification has no
effect on risk.
If two stocks are perfectly negatively
correlated, the portfolio is perfectly
diversified.

 If you owned a share of every stock

traded on the NYSE and NASDAQ,
would you be diversified?
YES!
Would you have eliminated all of
your risk?
NO! Common stock portfolios still
have risk.

Some risk can be diversified

away and some cannot
Market risk (systematic risk) is nondiversifiable. This type of risk
cannot be diversified away.
Company-unique risk (unsystematic
risk) is diversifiable. This type of risk
can be reduced through
diversification.

Market Risk
Unexpected changes in interest rates.
Unexpected changes in cash flows
due to tax rate changes, foreign
competition, and the overall business
cycle.

Company-unique Risk
A companys labor force goes on
strike.
A companys top management dies
in a plane crash.
A huge oil tank bursts and floods a
companys production area.

As you add stocks to your portfolio,

company-unique risk is reduced.
portfolio
risk
companyunique
risk

Market risk
number of stocks

 Note
As we know, the market compensates
investors for accepting risk - but
only for market risk. Companyunique risk can and should be
diversified away.
So - we need to be able to measure
market risk.

This is why we have Beta.

Beta: a measure of market risk.
Specifically, beta is a measure of how
an individual stocks returns vary
with market returns.
Its a measure of the sensitivity of
an individual stocks returns to
changes in the market.

The markets beta is 1

A firm that has a beta = 1 has average market
risk. The stock is no more or less volatile
than the market.
A firm with a beta > 1 is more volatile than
the market.
(ex: technology firms)

A firm with a beta < 1 is less volatile than the

market.
(ex: utilities)

Calculating Beta
XYZ Co. returns
15

S&P 500
returns

-15

.. .

Beta = slope
= 1.20

.
.
.
.
10 . . . .
.. . .
. . 5. .
.. . .
.
.
.
.
-10
5
-5 -5
10
.. . .
. . . . -10
.. . .
. . . -15.

15

Summary:
We know how to measure risk, using
standard deviation for overall risk
and beta for market risk.
We know how to reduce overall risk
to only market risk through
diversification.
We need to know how to price risk so
we will know how much extra return
we should require for accepting extra
risk.

What is the Required Rate of

Return?
The return on an investment
required by an investor given
market interest rates and the
investments risk.

Required
rate of
return

Risk-free
rate of
return

market
risk

Risk
premium

companyunique risk
can be diversified
away

Required
rate of
return

Lets try to graph this

relationship!

Beta

Required
rate of
return

12%

security
market
line
(SML)

Beta

Risk-free
rate of
return
(6%)

This linear relationship between

risk and required return is
known as the Capital Asset
Pricing Model (CAPM).

Required
rate of
return

Is there a riskless
(zero beta) security?

12%

Risk-free
rate of
return
(6%)

SML

Treasury
securities are
as close to riskless
as possible.

Beta

Required
rate of
return

Where does the S&P 500

fall on the SML?

12%

Risk-free
rate of
return
(6%)

SML

The S&P 500 is

a good
approximation
for the market
Beta

Required
rate of
return

SML
Utility
Stocks

12%

Risk-free
rate of
return
(6%)

Beta

Required
rate of
return

High-tech
stocks

SML

12%

Risk-free
rate of
return
(6%)

Beta

The CAPM equation:

kj = krf + j (km - krf )

where:

kj = the required return on security j,

krf = the risk-free rate of interest,
j = the beta of security j, and

km = the return on the market index.

Example:
Suppose the Treasury bond rate is
6%, the average return on the
S&P 500 index is 12%, and Walt
Disney has a beta of 1.2.
According to the CAPM, what
should be the required rate of
return on Disney stock?

kj = krf + (km - krf )

kj = .06 + 1.2 (.12 - .06)
kj = .132 = 13.2%
According to the CAPM, Disney
stock should be priced to give a
13.2% return.

Required
rate of
return

Theoretically, every
security should lie
on the SML

SML

12%

If every stock
is on the SML,
investors are being fully
compensated for risk.

Risk-free
rate of
return
(6%)

Beta

Required
rate of
return

If a security is above
the SML, it is
underpriced.

SML

12%

If a security is
below the SML, it
is overpriced.

Risk-free
rate of
return
(6%)

Beta

Simple Return Calculations

$50

$60

t+1

Pt+1 - Pt
Pt

60 - 50
50

= 20%

Simple Return Calculations

$50

$60

t+1

Pt+1 - Pt
Pt
Pt+1
Pt

-1 =

60 - 50
50
60
50

= 20%

-1 = 20%

The End

Thank You