CH 12 Risk, Return, and Capital Budgeting

12.1 Measuring market Risk

Market portfolio: portfolio of all assets in economy. A broad stock market
index is used to represent the market
We can evaluate the impact of macro changes by measuring the RofR in a
market portfolio. Market performance reflects only macro changes because
the specific risk is evenly averaged out. The risk of an individual common
stock is then the sensitivity of its returns to fluctuation in returns of the
market portfolio, because risk depends on exposure to macro events.
Beta: sensitivity of a stocks return to the return on the market portfolio
Measuring Beta
1. Observe rates of return (monthly or weekly) for the stock and the
market
2. Plot observations (x-axis is market return)
3. Fit a line showing the average return. The slope of the line is beta. If
slope is more than 1 then the stock is aggressive, if beta is less than 1
the stock is defensive
Diversification can eliminate the risk that is unique to individual stocks but
not the risk of the market as a whole. Some stocks are not very sensitive to
market fluctuations (Defensive) and thus have lower betas (less than 1).
Some stocks are sensible to market fluctuations (Aggressive) and thus have
higher betas (more than 1). It the market goes up, choose aggressive, if it
goes down, choose defensive.
The average beta of all stocks is 1.
Beta is the slope of the line that graphs the stocks return vs. the market
return.
We can break down common stock returns into two parts.

1. Market returns and beta of the firm

2. Specific risk of the firm

Total Risk and Market Risk: some of the most variable stocks have below
average betas and vice versa.
12.2 What can you learn from Beta?
Portfolio beta: average of the betas in the portfolio, weighted by the
investment in each security.
You can also buy shares from mutual funds which portfolios, so the returns on
the portfolios are passed to the shareholders. Its like an investment
cooperative.
Beta can also predict the total risk (standard deviation) of a diversified
portfolio. The volatility of a portfolio returns reduces as more stocks are
added to it. But how much market risk remains? It depends on the beta of
the portfolio.
If the standard deviation of the market is 20%, then a fully diversified
portfolio with betas of 0.5 has a standard deviation of 20 x 0.5 = 10%
A fully diversified portfolio with all the stocks will have the same standard
deviation of the market.
12.3 Risk and Return
The beta of treasury bills is 0 because the return is fixed.
Market Risk premium: return on the market interest rate on Treasury bills
Market risk premium=r mr f
Expected return=r=r f + (r m r f )
Return on portfolio=( %in mkt beta of mkt ) +( Tbills beta of Tbills)

Capital asset pricing model (CAPM): the expected rates of return

demanded by investors depend on two things:

1. Compensation for the TVM (the risk free rate rf)

2. Risk premium, which depends on the beta and market risk premium
The expected RofR of an asset with beta 1 is just the same as the market
return.
Question: How would you construct a portfolio with a beta of 0.25?
You put 25% of the money in the portfolio and the rest in Treasury bills.
The Security Market Line: relationship between expected return and beta
The security market line describes the expected returns and risks from
splitting your overall portfolio between risk-free securities and the market. It
also sets a standard for other investments. Investors will be willing to hold
other securities only if they offer equally good prospects. Thus the required
risk premium for any investment is given by the security market line.
Risk premium oninvestment =beta expected market risk premium
Why CAPM works?
Consider that the market risk premium is 7% and that treasury bills yield at
3%. For a beta of 0.5, that gives a 6.5% expected rate of return. If the stock
offered a lower rate, the demand for it will fall and thus its price, this will be
liked by investors who will then buy it for the low price; the price will fall until
the expected rate of return grows back to 6.5%. Same the RofR was higher,
since there would be a bigger demand which will push up the price and make
the rate go down back to 6.5 %.
Using the CAPM to Estimate Expected Returns: use the same formula,
but take this in consideration:
1.
2.
3.
4.

Betas are estimates, not exact measurements

Very high or low betas tend not to repeat in the future
Its difficult to pin down the expected future market risk premium
The CAPM is widely used in practice, but its not the last word

However, CAPM has two fundamental ideas.

1. Investors require extra return for taking on risk

2. Investors are concerned with the market risk which cannot be

eliminated by diversification
12.4 The CAPM and the OCC
The discount rate for valuing a project should be the OCC. But the CAPM says
that expected rates of return depend on risk, ergo beta. So the OCC for a
project depends on the projects beta.
Project OCC: minimum acceptable expected RofR on a project given its risk.
If the project return lies under the security market line, the project is no
longer attractive.
If the CAPM holds, the security market line defines the OCC, if a projects
expected rate of return plots above the security market line, then it offers a
higher expected RofR than what investors could get on their own at the
same beta.
Company CC: OCC for investment in the firm as a whole. The CCC is the
appropriate discount rate for an average risk investment project undertaken
by the firm.
What determines project risk? What matters is the strength of the
relationship between the firms earnings and the aggregate earnings of all
firms. Cyclical businesses, whose revenues and earnings are strongly
dependent on the state of the economy, tend to have high betas and high
OCC. In contrast, business like food and beverages tend to have lower betas
and OCC.
Dont add Fudge Factors to Discount Rates: expected cash flow
forecasts should already reflect the probabilities of all possible outcomes,
good and bad. If the CF forecasts are prepared well, then, the discount rate
will also reflect the market risk on the project, but no any other risk more.