Chapter 11:

Risk, Return, and the

Capital Asset Pricing Model
 Systematic Risk and Asset Pricing
• Investors can only expect compensation
for systematic risk:
 Contribution of an asset’s risk to a diversified
portfolio
 Measured by beta
• The capital asset pricing model
(CAPM) relates an asset’s return to its
systematic risk.
 Assumes that rational, risk-averse investors
select efficient portfolios
 Correlation Coefficients and Risk
Reduction for Two-Asset Portfolios
Expected Return on the Portfolio 25%
1.0 <  < 1.0
20%  12
Correlatio n Coeffient  12 
 1 2

15%  = +1.0
 = 1.0
10%

0% 5% 10% 15% 20% 25%

Standard Deviation of Portfolio Returns

3
The Efficient Frontier with Two Assets

Lower return and lower

variance portfolio
The Efficient Frontier with Many Assets
Efficient portfolios achieve the highest possible return for any level of volatility.
Expanding the Feasible Set on the
Efficient Frontier
1
Higher return and lower risk

E Lower return and Higher risk

2

The broader the range of investments in the feasible set,

the greater the risk reduction achievable through diversification.
 Efficient Frontier

Low Risk High Risk

Return

High Return High Return

Low Risk High Risk

Low Return Low Return

Risk
 Efficient Frontier
The ratio of the risk premium to Goal is to move
the standard deviation is called up and left.
the Sharpe ratio: WHY?

rp  r f
Sharpe ratio 
p
Example: Efficient Frontier with
Many Assets
Efficient Frontier with Many Assets
Expected Return (per month) and
Standard Deviation for Various Portfolios
 Portfolios of Risky and Risk-Free Assets

Expected Standard
Portfolio
Return Deviation

A: 50% risky, 50% risk-free 9% 15%

MF: 100% risky 12% 30%

B: Borrowing to invest over 100% 16.5% 52.5%

Figure 6.5 Portfolios of Risky and Risk-Free
Assets
Additional Example: Risk-Free
Borrowing and Lending
Expected return
Three possible returns: 10%
Risky asset X
-10%; 10%; 30% Standard deviation
16.3%

Risk-free Buying asset Y = Lending

Return: 6%
asset Y money at 6% interest

How would a portfolio with $100 (50%) in asset X

and $100 (50%) in asset Y perform?
Expected return
$100 Asset X Three possible returns: 8%
$100 Asset Y -2%; 8%; 18% Standard deviation
8.16%

Portfolio return and volatility are exactly halfway between

those of the risky asset and the risk-free asset.
 Risk-Free Borrowing and Lending
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

$270 - $106 - $200

When X Pays –10% Net Return on $200 Investment   18%
$200

$330 - $106 - $200

When X Pays 10% Net Return on $200 Investment   12%
$200

$390 - $106 - $200

When X Pays 30% Net Return on $200 Investment   42%
$200

Expected return on the portfolio is 12%.

Higher expected return comes at the expense of greater volatility.
 Risk-Free Borrowing And Lending

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.

Expected Standard
Portfolio
Return Deviation
50% risky, 50% risk-free 8% 8.16%
100% risky, 0% risk free 10% 16.33%
150% risky, -50% risk free 12% 24.50%
 Portfolios of Risky and
Risk-Free Assets

E(RP)

12%
•B
10%
•X
8%
•A
Rf=6% •

0 8.16% 16.33% 24.50% P

Figure 6.6 A New Efficient Frontier
Line L3
defines a new
efficient frontier
Figure 6.7 Finding the Optimal Portfolio
 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.
 The Market Portfolio
Only one risky portfolio is efficient.

Suppose investors agree on which portfolio is

efficient.

Equilibrium requires this to be the market portfolio.

Market portfolio: Value weighted portfolio of all

available risky assets

The line connecting Rf to the market portfolio is

called the Capital Market Line
Figure 6.6 A New Efficient Frontier: The
Capital Market Line (CML)
The Capital
Market Line
(CML)

The market
portfolio
 The Capital Market Line
• The line connecting Rf to the market portfolio is
called the Capital Market Line (CML).
• The CML quantifies the relationship between the
expected return and standard deviation for
combinations of the risk-free asset and the
market portfolio: risk premium
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.
 Figure 6.8 The Security Market
Line
E(Ri)
A: Undervalued SML
•

•
A Slope of SML = R  R =
m f
Rm • B • Market Risk Premium (MRP)
•
Rf
• B: Overvalued
•
 =1.0 i
Example: Expected Return
 Beta
 im
i  2
m
• The numerator is the covariance of the
stock with the market.
• The denominator is the market’s variance.

A stock’s 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 stock’s exposure to market risk.

The market risk premium is the reward for bearing

market risk:
• Rm  Rf

E(Ri) = Rf +  [E(Rm) – Rf]

• Return for • Stock’s • Reward for

bearing no exposure to bearing
market risk market risk market risk
Calculating Expected Returns
E(Ri) = Rf +  [E(Rm) – Rf]
• Assume
• Risk-free rate = 2%
• Expected return on the market = 8%
If stock’s beta is… Then expected return is…
0 2%
0.5 5%
1 8%
2 14%

When  = 0, the return equals the risk-free rate.

When  = 1, the return equals the expected market return.
Estimating Beta by Regression
Coach Inc.:
• Beta of 1.61 is above average, indicating relatively high market risk.
• The general tendency is for Coach shares to perform very well (poorly) when
the overall stock market is up (down).
 Estimating Beta by Regression
ConAgra:
• Beta of 0.11 indicates a very low level of market risk.
• This sample period, ConAgra stock moved more or less independently of the
overall market.
 Estimating Beta by Regression
Citigroup:
• Beta of 1.20 indicates a level of market risk between Coach and ConAgra
and is somewhat high.
• The regression R-squared shows that systematic risk represents a larger
proportion of total risk for Citigroup than for either of the other two firms.
Though the beta (not the R-squared) determines a stock’s expected return,
the R-squared value provides useful information about statistical fit.
 Criticisms of the CAPM
• Model is based on expected returns, which
are unobservable.
• CAPM is a one-period model and does not
account for changing expectations.
• Because even Treasury bonds are not free of
all types of risk, Rf is not known precisely.
• Market indices (such as the S&P 500) are an
imperfect proxy for the true market portfolio.
• The relationship between stock returns and
estimated betas is flatter than predicted and
not stable over time.
What Companies Do Globally: CFO Survey
Evidence
 The Fama-French Model
Ri  R f     i1 Rm  R f    i 2 Rsmall  Rbig    i 3 Rhigh  Rlow 

• In the Fama-French model, asset returns are affected

by three factors:
– The market risk premium
– A “size effect” measured by the return on a portfolio of small
stocks, minus the return on a portfolio of large stocks
– A “value effect” measured by the return on a portfolio of
stocks with high book-to-market ratios, minus the return on
a portfolio of stocks with low book-to-market ratios

Betas represent sensitivities to each source of risk.

Terms in parentheses are the rewards for bearing
each type of risk.
 The Current State of Asset Pricing Theory

• 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.