Fin 310 – Introduction to Investments &

Financial Analysis
Lecture 5: Risk & Return; Diversification;
Portfolio Theory ; CAPM;APT
Professor Eric Szabo
Textbook : Investments: An Introduction (13th edition) by Mayo
Relevant Chapters: 5
Lecture 5 (Chapter 5 )
❖Lecture 5 – Chapter 5 (including appendix) – Risk and Return, Diversification, Portfolio Theory;
CAPM; APT
➢ Basic Return Concepts
➢ Risk and Sources of Risk
➢ Measuring Risk and Returns - one asset
➢ Portfolios
❑Measuring Risk and Returns for portfolios
❑Diversification and Risk Reduction
➢ Portfolio Theory
❑Efficient Portfolios and the Efficient Frontier
➢ Capital Market Line
➢ CAPM and Beta
➢ CAPM and SML
➢ Arbitrage Pricing Theory (APT)
➢ STOCK SIMULATOR HW1 demonstration and assignment
2
Basic Return Concepts
❖Return = Income plus capital appreciation
➢Investment returns measure the financial results of an investment
➢Returns may be historical (realized) or prospective (expected) and compared
to what was/is required
❑Expected Return or E(r) – the sum of anticipated income and capital gains
❑Realized Return – the sum of actual income and capital gains. May differ
considerably (in either direction) from the expected return.
❑Required Return – the return required to induce an investor to purchase
an asset. Expected Return >= Required Return to induce investment
▪ Influenced by returns expected on other investments and the amount
of risk

3
Returns Example
❖Returns can be expressed in:
➢Dollar terms.
➢Percentage terms.
❖An investment costs $1,000 and is sold after 1 year for $1,200.
Dollar return:
$ Received - $ Invested
$1,200 - $1,000 = $200.

Percentage return:

$ Return/$ Invested
$200/$1,000 = 0.20 = 20%.

4
Returns Example
❖Dollar Return = Dividend/Income + Change in Market Value

dollar return
percentage return =
beginning market value

dividend + change in market value

=
beginning market value

= dividend yield + capital gains yield

5
Returns Example
❖You are considering three stocks with the following expected dividend yields and
capital gain yields. What is the expected return on each stock

Stock Dividend Yield Capital Gain Yield Expected Rtn E(r)

X 8% 0% ?
Y 2% 8% ?
Z 0% 12% ?

❖Assume you bought 100 shares of IBM one year ago today at $135. Over the last
year, you received $400 in dividends (= $4 per share × 100 shares). At the end of
the year, the stock sells for $150. What is your percentage return?

6
Expected Returns and Discrete Probability
❖Often expected returns are expressed with a qualifier of how likely they are to
occur (how probable) under different economic scenarios
❖Scenarios and Returns for Roscoe’s Tacos Stock Over the Next Year
Scenario Probability Return E(r)= σ𝐧𝐢=𝟏 𝐩𝐢 𝐫𝐢

Worst Case 0.10 −14%

E(r) = 0.10(-14%) + 0.20(-4%) + 0.40(6%)
Poor Case 0.20 −4% + 0.20(16%) + 0.10(26%)
Most Likely 0.40 6% E(r)= 6%
Good Case 0.20 16%
Using Excel SUMPRODUCT Function
Best Case 0.10 26%
1.00

Probabilities always add to one!

7
 Use Excel to Calculate the Expected Return of a
Discrete Distribution
• r̂ = SUMPRODUCT(Probabilities, Returns)
• SUMPRODUCT:
• Multiplies each value in the first array (the range of cells with probabilities) by its
corresponding value in the second array (the range of cells with returns).

• Sums the products.

• This is identical to the formula on the previous slide.

Probabilities of Returns– Practice Examples

Economy Prob. T-Bill Well Sad Market

Weak 0.1 3.0% -28.0% 31.0% -13.0%

Below avg. 0.2 3.0 -2.0 17.0 0.0
Average 0.4 3.0 24.0 0.0 16.0
Above avg. 0.2 3.0 33.0 -8.0 27.0
Strong 0.1 3.0 52.0 -25.0 43.0
1.0

E(r)well = (-28%) x 0.1 + (-2%) x 0.20 + (24%) x 0.40 + (33%) x 0.20 + (52%) x 0.1
= 18.2%

E(r)sad = 2.4%
E(r) t-bill = 3.0% TRY IT with Calculator or Excel!
E(r) market = 14.8%
Expected Returns and Historical Averages
❖Expected returns are also often based on what happened in the past (assumption
is you can use history as a guide to the future).
❖Most analysts use:
➢48 to 60 months of monthly return data, or
➢52 weeks of weekly data, or
➢Shorter period using daily data
❖Use annual returns here for sake of simplicity – but past returns are not always a
good prediction of future returns
A Roscoe’s stock’s realized returns for the past 3yrs Using Excel AVERAGE Function
Year Return
2017 13%
σTt=1 rҧ t
rҧ Avg = 2018 -7%
T 2019 18%

σT തt
t=1 r 13% − 7% +18%
rҧ Avg = T
= 3
= 8%
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Risk and Sources of Risk
What is Risk or Investment Risk
❖What is Risk? The chance that actual outcome ≠ expected outcome
➢Investment risk is exposure to the chance of earning less than expected.
❖The greater the chance of a return far below the expected return, the greater the
risk.
❖Combining Risk and Return = computing your expected outcome and then
understanding how the likelihood of that outcome varies from what you expected
➢In Stock investments this typically translates into looking at average historical
returns and their standard deviations (variability)

12
Sources of Risk
❖Total Risk = the uncertainty of earning the expected return =
➢Diversifiable risk - or Unsystematic Risk or Firm Risk – the risk associated
with the unique/individual events that affect a particular security
(management changes, labor strikes, supply chain issues)
+
➢Non-diversifiable risk – or market risk or systematic risk – the general risk
associated w/ fluctuations in security price (changes in interest rates, wars
inflation, recessions

13
Sources of Risk and Diversification
❖An assets risk can be analyzed in 2 ways
1. On a stand-alone basis – where the asset is considered by itself or
2. On a portfolio basis, where the asset is held as one of a number of assets
❖On a stand- alone basis an assets total risk = both firm specific (or diversifiable/
unsystematic risk) AND market risk (or non-diversifiable/systematic risk)

❖Since most people own assets in a portfolio, the goal is to reduce the firm specific
risk of the assets by accumulating securities in the portfolio w/ different risk profiles
(e.g., different industries, think suntan lotion vs umbrellas or airplanes vs oil). This
process is known as diversification (more later!).
➢Diversification reduces firm specific (or diversifiable/ unsystematic risk)
➢Diversification does not reduce market risk (or non-diversifiable/systematic risk)

14
Sources of Risk and Diversification

= Firm Specific = Diversifiable

= Total Risk

= Market Risk / non-diversifiable

15
Measuring Risk and Returns – one asset
Measuring Risk – Standard Deviation – One Asset
❖Risk is concerned with the uncertainty regarding whether the realized return will equal the expected
return.
➢ Just because an investor expects a return it does not mean they will earn that return.
❖Even though most assets are held in portfolios, it is necessary to understand an asset’s stand-alone
risk to better understand risk on a portfolio basis
❖Recall → Stand-alone risk is the risk of each asset held by itself. This measurement of risk places
emphasis on the extent to which the assets return varies from its average/expected return (also
known as Dispersion)
❖For a single asset: Stand-alone risk = Standard deviation
❖The greater the variation (dispersion) in returns around the average/expected return, the riskier the
investment - this variation is what Standard Deviation helps us measure

17
 Measuring Risk – Standard Deviation – One Asset
Year
1
2
3 Stock A = Less “risky”
4
5
6 Stock B = More “risky”

7
8
9
Average Historical Return %
15% 15% Return %

❖ Although the average return is the same for both stocks, Stock A’s returns are close to the average value, whereas stock
B’s returns are closer to the high and low values.
❖ The returns of stock A cluster around the average return. Because there is less variability in returns, it is the less risky of
the two securities.
❖ Most of stock A’s returns are close to the average return, so the frequency distribution is higher and narrower. The
frequency distribution for stock B’s return is lower and wider, which indicates a greater dispersion in that stock’s
returns. The large dispersion around the average return implies that stock B involves greater risk because the investor
can be less certain of the stock’s return. 18
Consider these return distributions for two investments. Which
riskier? Why?
Frequency of Occurrence of
security returns

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

Return

19
 Standard Deviation Formula for a Sample of T Historical Returns
To measure standard deviation, we first need the expected return – we computed this earlier for Roscoe’s Tacos
A stock’s realized returns for the past 3yrs
Year Return
2017 13% σT തt
t=1 r 13% − 7% + 18%
rҧ Avg = = = 8%
2018 -7% T 3

2019 18%

❖ Then we can compute Variance (σ2) and Standard Deviation (σ) for the Returns. The amount of dispersion
around the expected/average return is measured by standard deviation
2
σT
t=1 𝑟t −ത
rAvg
❖ The Standard Deviation is then = σ = T−1
Using Excel STDEV Function

( R1 − R) 2 + ( R2 − R) 2 +  ( RT − R) 2
SD = VAR =
T −1
(13% − 8%)2 + (−7% − 8%)2 + (18% − 8%)2
= = 𝟏𝟑. 𝟐%
3−1

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Standard Deviation Formula for a Sample of T Historical Returns

Try it!
A stock’s realized returns for the past 3yrs
Year Return
2017 10%
2018 -15%
2019 35%

rҧ Avg = 10%
σ = 25%

21
Understanding the Standard Deviation
❖If the returns are normally distributed:
➢ Using statistics, we know that for a normal distribution with a standard deviation of around
13% and an average expected return of about 8% the return on the stock will be between
-5% and +21% about 68% of the time
❑ 1 std dev ~ 13%, Avg expected return = 8% ± 13% = between -5% and +21%
➢ Also means:
❑ 16% of the time return < −5% = 8% − 13%
❑ 16% of the time return > 21% = 8% + 13%

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Risk and Returns
❖ Risk and return profiles

Security E(r) Risk, s

Well 18.2% 21.6%

Sad 2.4 14.9
T-bills 3.0 0.0
Market Portfolio 14.8 15.2
Std Dev - Useful in Comparing Investments
❖Investments with bigger standard deviations have more risk.
❖Higher risk doesn’t mean you should reject the investment, but:
➢You should know the risk before investing.
➢You should expect a higher return as compensation for bearing the risk.
➢You should compare the risk/return relationship to other investments to get
a relative measure
❑The Coefficient of Variation allows us to do this

24
Coefficient of Variation (CV)
❖CV = Standard deviation / expected return
= σ / E(r) → Measure of the amount of
risk per unit of return

❖CVT-BILLS = 0.0% / 3.0% = 0.0.

❖CVWell = 21.6% / 18.2% = 1.19
❖CVSad = 14.9% / 2.4% = 6.21
❖CVM = 15.2% / 14.8% = 1.03

❖The lower the ratio of standard deviation to expected return, the better
the risk-return trade-off.
Semivariance – “Downside” Risk
Average
Return

Bad Outcomes (Returns BELOW Expected)

Good Outcomes (Returns Above Expected)

❖ The standard deviation does not differentiate between variability that exceeds the average, which presumably
investors want, and variability that is less than the average, which investors do not want.
❖ Investors are primarily concerned with downside risk, the possibility of loss and not the possibility of a large gain.
❖ Downside Risk is a measure of the standard deviation (dispersion) of just those returns that are less than the expected
return (mean/average)
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Semivariance – “Downside” Risk

27
Risk in a Portfolio Context
Portfolio Basics
• The General Investment Process
• Most investments are held as part of a portfolio that call for two wide-ranging
tasks
• Security and Market Analysis – assess the risk and expected return
attributes of possible investments
• Determine the optimal portfolio of the available assets; optimize the risk-
reward tradeoff
• What is a portfolio?
• A collection of investment vehicles assembled to meet an investment goal(s)
• Key Principle - an investor can benefit from diversification; AKA – not putting
all of your eggs in one basket – i.e., combining assets into portfolios will
reduce (but not eliminate) risk

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The Principle of Diversification
❖Combining assets into portfolios will reduce firm specific risk but not eliminate market
risk. Recall
➢The goal is to reduce the firm specific risk of the assets by accumulating securities
w/ different risk profiles (e.g., different industries, think suntan lotion vs umbrellas
or airplanes vs oil). This process is known as diversification.
➢Diversification reduces firm specific (or diversifiable/ unsystematic risk)
➢Diversification does not reduce market risk (or undiversifiable/systematic risk)

❖ As we will see, the key is the correlation among asset returns.

➢Correlation Coefficient ( Greek symbol ρ)
❑Measures the degree of relationship between two variables.
❑Positively correlated stocks have rates of return that generally move in the
same direction. They move in tandem.
❑Negatively correlated stocks have rates of return that generally move in
opposite directions.
The Principle of Diversification

= Firm Specific = Diversifiable

= Total Risk

= Market Risk / non-diversifiable

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 Measuring Risk and Returns - Portfolios
❖Prior slides on measuring risk and return focused on one asset. We can
apply same concepts to a portfolio of assets and start to understand how
diversification works for a portfolio of assets.
Portfolio Returns
❖ The percentage of a portfolio’s value that is invested in Stock i is denoted by the “weight” w i. Notice that the
sum of all the weights must equal 1.
❖ With n stocks in the portfolio, its return each year will be:

N
= E (rp ) =  wi  E ( ri )
i =1

33
Example: 2-Stock Portfolio
❖You have a one stock portfolio of Roscoe’s Tacos – 100% of your money is in it
❖Form a portfolio by selling 25% of the Roscoe stock and investing it in the higher-
risk Traver’s Treats stock.
❖The portfolio return each year will be:
➢rҧ P,t = wR𝑜𝑠𝑐𝑜𝑒 rҧ Roscoe,t + wTravers rҧ Travers,t
➢rҧ P,t = 0.75 rҧ Roscoe,t + 0.25 rҧ Travers,t

34
Historical Data for Stocks and Portfolio Returns

Portfolio of Roscoe and

Year Roscoe Travers Travers

1 26% 47% 31.3% = 26 * 0.75 + 47 * .25

2 15 −54 −2.3

3 −14 15 −6.8

4 −15 7 −9.5

5 2 −28 −5.5

6 −18 40 −3.5

7 42 17 35.8

8 30 −23 16.8

9 −32 −4 −25.0

10 28 75 39.8

35
Portfolio Historical Average and Standard Deviation
❖The portfolio’s average return is the weighted average of the
stocks’ average returns.
❖The portfolio’s standard deviation is less than either stock’s σ!
❖Notice by adding Travers to our portfolio we increased expected
return with NO increase in expected risk -- > What explains this?

Roscoe Travers Portfolio

Average return 6.4% 9.2% 7.1%
Standard deviation 25.2% 38.6% 22.2%
Coefficient of
3.94 4.19 3.13
Variation

36
How closely do the returns follow one
another?
Return ❖Notice that the returns don’t move in
75% Travers perfect lock-step: Sometimes one is
50%
up and the other is down and the
magnitude of the change is vastly
25%
different.
0%

-25%
❖Even though the asset returns
Roscoe
-50% fluctuate, the fluctuations partially
-75% offset each other, so that by
1 2 3 4 5 6 7 8 9 10 combining them in a portfolio risk is
Year reduced with no reduction in return

37
Diversification Principle - Insights
❖ When considering portfolio risk it is necessary to look at both variability (variance and standard deviation) of
returns from each investment and the relationship (covariance and correlation) between returns. This can
lead us to what is known as the “portfolio effect”, where diversification of a portfolio can result in lower
overall risk.
➢ Standard deviation is a statistic used to measure the dispersion (variation) of returns around an asset’s
average or expected return
➢ Correlation is a statistical measure of the relationship between two series of numbers, or in our case
the degree to which asset returns move together or share common risk
❑ Positively Correlated items move in the same direction (+1 correlation = perfectly move
together)
❑ Negatively Correlated items move in opposite directions (-1 correlation = movements perfectly
mirror each other)

38
Correlation Coefficient (ρi,j)
❖Loosely speaking, the correlation (r) coefficient measures the tendency of two
variables to move together.
❖Estimating ρi,j with historical data is tedious
❖Excel is easier

σTt=1 rҧ i,t − rҧ i,Avg rҧ j,t − rҧ j,Avg

2 2
σTt=1 rҧ i,t − rҧ i,Avg σTt=1 rҧ j,t − rҧ j,Avg

Correlation coefficient (ij) = ρij = Cov(ij) / σiσj

39
2-Stock Portfolios
❖r = −1
➢2 stocks can be combined to form a riskless portfolio: σp = 0.
❖r = +1
➢Risk is not “reduced”
➢σp is just the weighted average of the 2 stocks’ standard deviations.
❖−1 < r < +1
➢Risk is reduced but not eliminated.
❖A correlation coefficient of zero suggests that the two variables are not related
to one another; that is, they are independent.

40
Adding Stocks to a Portfolio
❖What would happen to the risk of an average 1-stock portfolio as more randomly
selected stocks were added?
❖sp would decrease because the added stocks would not be perfectly correlated.
◼ That is Diversification reduces risk because it decreases variability of the
portfolio
◼ The lower the positive correlation or the greater the negative correlation
among the stock returns, the greater the risk reduction that can be achieved
by combining the various stocks in a portfolio

41
Diversification in Action – Practice with
Example Returns
❖Portfolio – 75% Roscoe’s, 25% Travers , Correlation, ρ, of returns = .02

Year Roscoe Rtns Travers Rtns

1 26% 47%
2 15% -54%
3 -14% 15%
4 -15% 7%

Average/Expected
= [ 26+ 15 + (-14)+ (-15) ] / 4 = 3.0% ( R1 +  + RT )
Return Roscoe
Average/Expected
R=
Return Travers
= [ 47 + (-54) + 15 + 7 ] / 4 = 3.75% T

Recall from page 40 → The correlation coefficient of 0.02 means that there is nearly no discernible
relationship between Roscoe and Travers over the last 4 years . This should make the total risk of the
portfolio less than the risk of holding either stock by itself.
42
Portfolio Expected Return – 75% Roscoe / 25% Travers

^r = w r^ + (1 – w ) ^r
p R R R T

= 0.75*(3.0) + 0.25*(3.75)

= 3.2%.

43
 Diversification in Action – Example Std Dev
❖Portfolio – 75% Roscoe’s, 25% Travers, Correlation, ρ, of returns = .02
Year Roscoe Rtns Travers Rtns
1 26% 47%
2 15% -54%
3 -14% 15%
4 -15% 7%

Standard Deviation 2 2 2 2
=√ [ (26 - 3.0) + (15 - 3.0) + (-14 - 3.0) + (-15 - 3.0) ] / ( 4 -1) = 20.7%
Roscoe
Standard Deviation
= 42.2%
Travers = √ [ (47 - 3.75)2 + (-54 - 3.75)2 + (15 - 3.75)2 + (7 - 3.75)2 ] / ( 4 -1)

(R1 − R)2 + (R2 − R)2 + (RT − R)2

SD = VAR =
T −1

44
Portfolio Standard Deviation – Example
❖ More complicated. Depends on the co-movement (correlation) of asset returns.

σP = √w2Rσ2R + (1-wR)2σ2T + 2wR(1-wR)ρRTσRσT

= √0.752(0.207)2 + 0.252(0.422)2 + 2(0.75)(0.25)(0.02)(0.207)(0.422)

= 0.189 = 18.9%
Roscoe Travers Portfolio
Average return 3.0% 3.75% 3.2%
Standard deviation 20.7% 42.2% 18.9%
Coefficient of Variation 6.9 11.25 5.9

45
 Portfolio Returns / Standard Deviation –
Alternative Approach
Portfolio of Roscoe and
Year Roscoe Rtns Travers Rtns
Travers

1 26% 47% 31.3% = 26 * 0.75 + 47 * .25

2 15% -54% -2.3%
3 -14% 15% -6.8%
4 -15% 7% -9.5%

( R1 +  + RT )
Average ReturnPorfolio = [ 31.3 + (-2.3) + (-6.8) + (-9.5) ] / 4 = 3.2%
R=
T
Standard Deviation
= √ [ (31.3 - 3.2)2 + (-2.3 - 3.2)2 + (-6.8 - 3.2)2 + (-9.5 - 3.2)2 ] / ( 4 -1) = 18.9%
Portfolio

(R1 − R)2 + (R2 − R)2 + (RT − R)2

SD = VAR =
T −1

46
Portfolio Returns / Standard Deviation – Excel
Approach

47
Conclusions
❖The Diversification Principle contends there are 2 components to risk:
➢ Systematic Risk – market risks that can’t be diversified away
➢ Unsystematic Risk – company or asset specific risks that can be diversified away. It represents
the component of an asset’s return that is not correlated with general market moves.
❖So we can substantially reduce the variability of the returns (the risk) in a portfolio without an
equivalent reduction in expected returns by combining stocks that are negatively correlated or
have a low positive correlation to one another; worse than expected returns from one asset are
offset by better than expected returns from another.
❖That is, we can diversify away the unsystematic risk and be left to deal with just the systematic
risk or the common risk the assets share by combining the securities that have negative (or low-
positive) correlation between each other’s rates of returns.
❖As more stocks are added, each new stock has a smaller risk-reducing impact on the portfolio.

48
Conclusions

49
Portfolio Theory and CML
Portfolio Theory
❖ The main insight from Modern Portfolio Theory (Markowitz) is that a properly constructed portfolio can:
➢ Increase expected return with no increase in expected risk
➢ Reduce expected risk with no reduction in expected return
❖ When considering portfolio risk it is necessary to look at both variability (variance and standard deviation) of returns from each
investment and the relationship (covariance and correlation) between returns. This can lead us to what is known as the “portfolio
effect”, where diversification of a portfolio can result in lower overall risk.
➢ Standard deviation is a statistic used to measure the dispersion (variation) of returns around an asset’s average or expected
return
➢ Correlation is a statistical measure of the relationship between two series of numbers, or in our case the degree to which
asset returns move together or share common risk
❑ Positively Correlated items move in the same direction (+1 correlation = perfectly move together)
❑ Negatively Correlated items move in opposite directions (-1 correlation = movements perfectly mirror each other)
❖ The Ultimate goal is an Efficient Portfolio - Solve the Optimal Portfolio Problem
❑ A portfolio that provides the highest return for a given level of risk or
❑ Has the lowest risk for a given level of return
❑ Meets the investor’s willingness to bear risk

51
Two Stocks – Feasible Portfolios - Risk and
Return Profiles
Feasible Portfolios Risk and Return Profile
0.0575

0.0570

0.0565
Return

0.0560

0.0555

0.0550

0.0545
0.0500 0.0550 0.0600 0.0650 0.0700 0.0750 0.0800 0.0850
Risk = Standard Deviation

52
Efficient vs Inefficient Portfolios

Feasible Portfolios Risk and Return Profile

0.0575
❖Efficient portfolios:
0.0570 ➢Maximize returns for a given level
of risk
➢Minimize risk at specific levels of
0.0565
Return

0.0560 return
0.0555 ❖Inefficient portfolios:
0.0550
➢Returns are not maximized given
the level of risk
0.0545
0.0500 0.0550 0.0600 0.0650 0.0700 0.0750 0.0800 0.0850
Risk = Standard Deviation

53
Efficient vs Inefficient Portfolios

Feasible Portfolios

Stand-alone Assets

54
Efficient Frontier

❖Efficient Frontier = those

possible portfolios that
➢Maximize returns for a given level
of risk
➢Minimize risk at specific levels of
return
➢Investors should prefer those
portfolios on the efficient frontier
than those that are not

55
Efficient Frontier and Investor Preference
❖While the efficient frontier shows us all the
best feasible combinations of risk and return,
it does not tell us which of those portfolios
an individual investor will select
Indifference ❖That selection depends on an individual’s
willingness to accept risk.
curves
❖Indifference curves reflect 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.

56
The Capital Market Line (CML)

B ❖In practical sense, investors

have a choice between
investing in riskless assets like
Treasury bills or in risky assets
z like stocks and bonds or a
combination of all three
A ❖The Capital Market Line
❖Adds a risk-free security (rf)
❖Redefines the efficient frontier

57
The Capital Market Line (CML)

❖ The tangent line (AB) on the efficient frontier curve which

passes through the y-axis at the risk-free rate point is the
B Capital Market Line
To the right of Z = Borrow
money to buy even more ❖ Each point on the line represents a combination of the risk-free
risky securities security (rf) and a portfolio of risky securities. Notice the CML in
effect becomes the new efficient frontier. All portfolios below
Z = Portfolio of
the CML are inferior.
100% risky
securities
z ❖ The investor continues to select the portfolio that:
❖ offers the highest return for a given level of risk
❖ Meets their preference to bear risk

A ❖ Different investors may select different combinations of risk and

return (allocation)
At r(f) invest in just ❖ As investors substitute risky securities (move from rf to point Z
Treasury Bills – earn the and beyond) for the risk-free assets, both expected risk and
risk-free rate of return return increase.
❖ The CML says → to earn a larger return, the investor is required
to take greater risks!

58
CAPM & Beta
RECAP
❖ In prior lectures we focused on the trade-off between risk and return
➢ Estimated risk and return for both individual assets and portfolios
❑ Expected returns
❑ Return Distributions
❑ Standard Deviation
❑ Correlation and diversification
❖ We also explored portfolio theory and the diversification principle, which contends there are 2 components to risk:
➢ Systematic Risk – market risks that can’t be diversified away
➢ Unsystematic Risk – company or asset specific risks that can be diversified away. It represents the component of an
asset’s return that is not correlated with general market moves.
❖ Recall → portfolio theory and diversification propose we can substantially reduce the variability of the returns (the risk) in
a portfolio without an equivalent reduction in expected returns by combining stocks that are negatively correlated or have
a low positive correlation to one another;
➢ Worse than expected returns from one asset are offset by better than expected returns from another.
❖ That is, we can diversify away the unsystematic risk and be left to deal with just the systematic risk, or the common risk
the assets share, by combining securities that have low-positive correlation between their rates of returns.
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Sources of Risk and Diversification

= Firm Specific = Diversifiable

= Total Risk

= Market Risk / non-diversifiable

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Can an investor holding one stock earn a return commensurate
with its risk?
❖In theory →No. Rational investors will minimize risk by holding portfolios and
diversifying away a stocks firm specific/unsystematic risk.
❖Investors bear only market risk, so prices and returns reflect the amount of
market risk an individual stock brings to a portfolio, not the total or stand-alone
risk of individual stock.
❖That is, investors will be rewarded only for systematic/market risk.
➢This ties to another proposition in Finance/Investments

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Market Risk Due to an Individual Stock
❖ In a well-diversified portfolio, the unsystematic risks are diversified away, leaving just market risk as the
relevant risk.
❖ How do you measure the amount of market risk that an individual stock brings to a well-diversified
portfolio?
❖ William Sharpe developed the Capital Asset Pricing Model (CAPM) to help answer this question.
➢ The CAPM describes the relationship between market risk and required rates of return for individual
securities via the Security Market line (“SML”, more later).
➢ Many assumptions – All investors
 Aim to maximize economic utility.
 Are rational and risk-averse.
 Are price takers, i.e., they cannot influence prices.
 Can lend and borrow unlimited under the risk free rate of interest.
 Trade without transaction or taxation costs.
 Deal with securities that are all highly divisible into small parcels.
 Assume all information is at the same time available to all investors.
 Perfect Competitive Markets
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Market Risk as Defined by the CAPM

❖ BETA (bi or Bi) – a measure of systematic/market risk; measures the volatility of a stock (or a portfolio of
stocks) relative to the market
❖ The beta of Stock i (Bi) is defined:
Bi =

➢ Bi =

64
Market Risk and Beta
❖So, Stock i contributes more risk (has a higher beta) to a well-diversified portfolio if
➢ its correlation with the market, 𝛒𝐢,𝐌 , is larger and/or
➢ its standard deviation, 𝛔𝐢 , is larger

65
Interpreting Beta
❖BETA (bi or Bi) – a measure of systematic/market risk; measures the volatility of a stock
(or a portfolio of stocks) relative to the market
❖The market beta is set at 1.00
➢ If a stock has a beta of 1.00, it will tend to move in lock step with the market →
market up 1.0%, stock up about 1% too
➢A beta is greater than 1.00, say 1.30, indicates that a stock’s volatility is greater than
the market
❑With a beta of 1.30, the level of volatility is 30% greater than the market average
→ Market goes up (or down) 10%, the 1.30 beta stock will probably go up
(down) about 13.0%.
➢ A stock with a beta of 0.50 has lower volatility than the market,
❑A rise (fall) of 10% would likely result in a 5% increase (decrease) for the low
beta stock
❖Beta can also vary my industry – Example: HPQ vs Kroger vs United Airlines
66
More on Beta

Firm Value Line Beta Yahoo! Beta Value Line 2012

IBM 1.1 1.21 0.85
McDonald’s 0.95 0.66 0.65

•Your estimate of beta will depend upon your choice of a proxy for the market portfolio
and the time period you use. Analysts estimates of Beta differ and Beta varies with time!
•Beta measures the responsiveness of a security to movements in the market portfolio.
• The Beta of the market portfolio = 1.0 (average of ALL stocks returns)
•Researchers have shown that the best measure of the risk of a security in a large
diversified portfolio is the beta(β) of the security.

67
Calculating Beta in Practice
❖To estimate Beta for a stock a regression of the stock’s return vs the market’s
return can be used
➢Many analysts use the S&P 500 to find the market return.
➢Analysts typically use four or five years of historical monthly returns to
establish the regression line.
➢Some analysts use 52 weeks of weekly returns.
❖ Remember it’s an estimate. There can be a Taleb Turkey Effect (gobble,
gobble).
➢Beta used by investors is usually based off data from the past and then is
assumed to reflect the future

68
Using a Regression to Estimate Beta
❖Run a regression with returns on the stock plotted on the Y-axis and returns on
the market portfolio plotted on the X-axis.
❖The slope of the regression line is equal to the stock’s beta coefficient.

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Excel: Plot Trendline Right on Chart
Roscoe’s
Beta Returns

0.45
y = 0.6027x + 0.0158
R² = 0.2316

0
-0.45 0 0.45

Market
Returns

-0.45

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Portfolio Beta Coefficients

❖The beta of any portfolio of securities is the weighted

average of the individual securities’ betas

 p = w 1 1 + w 2  2 +  + w n  n
N
=  w j j
j=1

71
An Example - Portfolio Beta

❖You have a $100,000 portfolio consisting of 2 stocks, AT&T ($55,000) and

Advanced Micro Devices ($45,000).
❖If the beta of AT&T is 0.70, and the beta of Advanced Micro Devices is 2.30, what
is the beta of the portfolio of AT&T and Advanced Micro Devices?

W1 = 55,000/100,000 = .55
W2 = 45,000/100,000 = .45

0.55(0.70) + 0.45(2.30) = 1.42

❖How do you interpret this?

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Market Risk and Beta - Recap
❖ Definition
➢ Measures a stock’s market risk
➢ Tracks stock’s volatility relative to the market
➢ Shows how risky a stock is if the stock is held in a well-diversified
portfolio
❑ If  = 1.0, average of market portfolio

❑ If  > 1.0, stock’s return is riskier (more volatile) than market portfolio

❑ If  < 1.0, stock’s return is less risky (less volatile) than market portfolio

➢ Most stocks have betas between 0.4 to 1.6

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CAPM & Security Market Line (SML)

74
Required Return and Risk: General Concept

❖Recall CAPM assumes:

➢Investors bear only market risk, so prices and returns reflect the amount of
market risk an individual stock brings to a portfolio, not the total or stand-
alone risk of individual stock. Therefore BETA is the correct measure of a
stock’s relevant risk.
❖Generally, investors require a return for time (for tying their funds up in the
investment – TVM!).
➢RF, the risk-free rate
❖Investors require a return for risk, which is the extra return above the risk-free
rate that investors require to induce them to invest in Stock i.
➢RPi, the risk premium of Stock i.

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Required Return and Risk: The CAPM
❖RPM is the market risk premium. It is the extra return above the risk-free rate that that investors
require to invest in the overall stock market:
➢ RPM = RM − RF
➢ Or said differently – It’s the Risk Free Rate + Market Risk Premium

❖The CAPM defines the risk premium for Stock i as:

➢ RPi = bi (RPM) = bi (RM − RF)

❖Thinking more about the Risk Premium:

➢ The portion of the expected return that can be attributed to an investment’s risk beyond a
riskless investment
➢ The difference between the expected rate of return on a given risky asset (the market) and
that on a less risky asset (the risk free rate)

76
Here are all pieces we have discussed

❖Risk free rate (RF or rf or Rf)

❖RM (or rm); Required/Expected Market return (e.g. S&P 500)
❖RPM = RM – RF; Market Risk Premium
❖. (also shown as “b”) Systematic risk; Stock’s volatility
relative to the market

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Relationship between Risk & Required Return (CAPM)
❖Required Return on the Market:
R M = R F + Market Risk Premium
Market Risk Premium = RPM = RM - RF

❖ Required Return on an individual security:

R i = RF + β i  ( R M − RF )

Market Risk Premium

This applies to individual securities held within well-
diversified portfolios. 78
Example; Betas and CAPM

◼ Risk vs Required Return

3%+1.30(12% - 3%)
Risk Required
Security (Beta) Return

XYZ 1.30 14.7% 3%+0.60(12% - 3%)

ABC 0.60 8.4
T-bills (RF , risk free) 0.00 3.0
S&P500 (RM, market proxy) 1.00 12.0

Try it!
Calculation Help:
Ri = R F +  i [ RM – R F ]
RF= 3% (t-bill), RM = 12%
RPM = [RM – RF ] = 12% - 3% = 9%
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The Security Market Line: Relating Risk and Required
Return
❖The Security Market Line (SML) puts the pieces together in a visual
representation, showing how to determine the return required for
bearing a stock’s risk: RPM= Market Risk Premium

➢SML: Ri = RF + i [RM – RF ]

❖Based on CAPM
❖X-axis; Beta
❖Y-axis; Required return

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The Security Market Line - SML

81
The Security Market Line: Relating Risk and Required Return -
Takeaways
❖Recap - Required Return for a security depends on:
➢The risk-free rate
➢The market risk premium
➢The stocks beta
❖Risk depends on the market risk premium and beta:
➢Market risk premium = extra return above the risk-free rate that investors
require to induce them to invest in well diversified portfolio of riskier stocks
➢ Beta = Systematic risk; Stock’s volatility relative to the market
❖Required return then = ri = RF + (RPM) bi
➢Higher beta = higher required return
❖What happens if the other inputs change?
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Impact on SML and Required Return of an
Increase in Risk-Free Rate
SML: Higher
❖ If the Risk Free Rate 18% Risk-Free Rate
shifts, the SML and 16%
required return shifts as 14%
SML: Base

Required Return
well, for all assets. Case
12%
❖ Market risk premium may 10%
stay the same in this 8%
scenario. 6%
4%
Base Case
Risk-Free Rate
2%
0%

0.0 0.5 1.0 1.5 2.0 2.5

Beta

83
Impact on SML and Required Return of an
Increase in Risk Aversion

SML: Higher
❖ The slope of the SML 25% Market Risk
is the Market Risk Premium
Premium (RM − RF). It 20%

Required Return
reflects the extent to
which investors are 15% SML: Base
averse to risk. Case
10%

❖ An increase in risk 5% Base Case

aversion increases the Risk-Free Rate
risk premium and 0%
increases the slope. 0.0 0.5 1.0 1.5 2.0 2.5
Beta

84
Risk and return: CAPM/SML and Portfolios

85
 Application: CAPM/SML – Portfolio Context
What’s the Beta and Required Rate of Return of a $2mm portfolio split between 2
stocks: $1.4mm in Stock ABC with a Beta of 0.60; $0.6mm in Stock XYZ with a Beta of
1.30.

Also →RF = 4.0% and RM = 9%

1. Calculate the weights for a portfolio with $1.4 million in ABC and $0.6 million in
XYZ.
❖ Find the weights:
➢ wABC = $1.4/($1.4+$0.6) = 70%
➢ wXYZ = $0.6/($1.4+$0.6) = 30%
❖ The portfolio beta is the weighted average of the stocks’ betas:
𝐧

𝐛𝐩 = ෍ 𝐰𝐢 𝐛𝐢
𝐢=𝟏

86
2. Calculate the portfolio beta.

bp = 0.7(bABC) + 0.3(bXYZ)
= 0.7(0.60) + 0.3(1.30)
= 0.81.

87
What is the Required Return on the Portfolio?

(1) Use SML:

Rp = RF + bp (RPM) Remember → RP = R − R (9%-4%)
M M F

= 4.0% + 0.81%(5%) = 8.05%.

88
Arbitrage Pricing Theory: APT

89
CAPM vs Arbitrage Pricing Theory (APT)
❖ In the CAPM
➢ A stock's return depends only on:
❑ The risk-free rate
❑ the market return, and
❑ the volatility of the stock (the beta) relative to the market.
❖ The CAPM/SML helps measure a stock’s required return and how it is related to market risk and is widely used conceptual
tool to estimate the required return on a company’s stock.

❖ However it does have it’s short-comings and we need to recognize these

 Market anomalies
◼ Example – stocks of small companies continually have higher returns than implied by CAPM

 Investors seem to react to market and total risk

 Concepts are based on expectations, but betas calculated using historical data
 Historical data may not reflect investors’ expectations about future risks

❖ APT is an alternative to the Capital Asset Pricing Model.

➢ Arbitrage pricing theory expands the number of variables that may affect an asset's return.
➢ It supposes that other factors besides market risk could play an important role in the explanation a security returns

90
Arbitrage Pricing Theory (APT)
❖APT Explains security returns in terms of
➢The expected return

➢A series of factors that may affect security prices

➢How the individual stock responds to unanticipated changes in those factors

❑Unexpected inflation

❑Unexpected changes in economic activity or unemployment

❑Unanticipated changes in interest rates

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PRACTICE and PREP
❖Chapter 5, Lecture 5 Practice:
➢Work through all the Relationship Problems and the Fundamental Problems
➢Attempt end of chapter problems: 3, 5, 6 and 8a → answers will be posted
under lecture 5 module

❖Upcoming:
❖QUIZ 1 to be Assigned Via Canvas on 9/23 – Due Monday 9/27 by 11:59pm
(more details will be provided during class)

❖STOCK SIMULATOR HW1 demonstration and assignment

❖To be assigned via Canvas week of 9/27 → Due 10/14 by 11:59pm (more details will be
provided during class)

92