Chapter 7 – Risk, Return, and the Capital Asset Pricing Model

7.1 INVESTMENT RETURNS

 The concept of return provides investors with a convenient way to express the financial
performance of an investment
 One way to express an investment return is in dollar terms
Dollar Return = Amount Received – Amount Invested
 Two problems arise when expressing returns in dollars:
o To make a meaningful judgement about the return, you need to know the scale
(size) of the investment
o You also need to know the timing of the return
 The solution is to express investment results as rates of return, or percentage returns
Amount Recieved− Amount Invested
Rate of Return=
Amount Invested

7.2 STAND ALONE RISK

 Risk refers to the chance that some unfavourable event will occur
 An asset risk can be analyzed in two ways
o On a stand-alone basis, where the asset is considered in isolation
o On a portfolio basis, where the asset is held as one of a number of assets in a
portfolio
 An assets stand-alone risk is the risk an investor would face if he or she only held this one
asset
 No investment should be undertaken unless the expected rate of return is high enough to
compensate the investor for the perceived risk of the investment
 Generally, risky assets earn either more or less than was originally expected
 Investment risk is related to the probability of actually earning a low or negative return
o The greater the chance of a low or negative return, the riskier the investment

Probability Distributions
 An events probability is defined as the chance that the event will occur
 If all possible events, or outcomes, are listed, and if a probability is assigned to each
event, the listing is called a probability distribution

Expected Rate of Return

 If we multiple each possible outcome but its probability of occurrence and then sum these
products, we have a weighted average of outcomes
 The weights are the probabilities, and the weighted average is the expected rate of return
n
r^ =∑ Pi r i
i=1
o ri is the return if outcome i occurs
o Pi is the probability that outcome i occurs
o n is the number of possible outcomes
 The tighter, or more peaked, the probability distribution, the more likely it is that the
actual outcome will be close to the expected value, and, consequently, the less likely that
the actual return will end up far below the expected return
  Thus, the tighter the probability distribution, the lower the risk assigned to a stock

Measuring Stand-Alone Risk: The Standard Deviation

 To be most useful, any measure of risk should have a definite value
 Standard deviation ( sigma) is a measure
o The smaller the standard deviation, the tighter the probability distributions, and
accordingly, the less risk the stock
 Steps to calculate standard deviation
1. Calculate the expected rate of return
2. Subtract the expected rate of return from each possible outcome (ri) to obtain a set
of deviations
Deviationi=r i−^r
3. Square each deviation. The multiple the result by the probability of occurrence for
its related outcome, and the sum these products to obtain the variance of the
probability distributions
n
variance=σ =∑ (r ¿¿ i−r^ )2 Pi ¿
2

i=1
4. Find the square root of the variance to obtain the standard deviation
 The standard deviation is essentially a weighted average of the deviations from the
expected value, and it provides an idea of how far above or below the expected value the
actual value is likely to be

Using Historical Data to Measure Risk

 The past realized rate of return in period t is by r bar t
 The average annual return of the last n years is
n

∑ rt
r average = t =1
n
 The standard deviation of a sample of returns can be estimated using this formula

√
n

∑ (r t−r avg )2
t=1
estimated σ =S=
n−1

Measuring Stand-Alone Risk: The Coefficient of Variation

 To choose between two investments if one has a higher expected return but the other has
a lower standard deviation, we use the coefficient of variation (CV)
σ
CV =
r^
 The coefficient of variation shows the risk per unit of return, and it provides a more
meaningful basis for comparison than standard deviation when the expected returns on
two alternatives are not the same

Risk Aversion and Required Returns

  If you choose the less risky investment, you are risk averse. Most investors are risk
averse, and the average investor is risk averse with regard to his/her ‘serious money’
 Other things held constant, the higher a security’s risk, the lower its price and the higher
its required return
 A risk premium, RP, represents the additional compensation investors require for
assuming the additional risk
 A very important principle:
o In a market dominated by risk averse investors, riskier securities must have higher
expected returns, as estimated by the marginal investor, than less risky securities
o If this situation does not exist, buying and selling in the market will force it to
occur

7.3 RISK IN A PORTFOLIO CONTEXT

 An asset held as part of a portfolio is less risky than the same asset held in isolation
 What is important is the return on his/her portfolio, and the portfolio’s risk
 Logically, the risk and return of an individual security should be analyzed in terms of
how that security affects the risk and return of the portfolio in which it is held

Portfolio Returns
 The expected return on a portfolio, is simply the weighted average of the expected returns
on the individual assets in the portfolio, with the weights being the fraction of the total
portfolio invested in each asset
n
r^ P=∑ wi r^ i
i=1
o r hat i are the expected returns on the individual stocks
o wi are the weights
o n are the stocks in the portfolio

Portfolio Risk
 The risk of a portfolio, p, is generally not the weighted average of the standard deviation
of the individual assets in the portfolios
 The tendency of two variables to move together is called correlation, and the correlation
coefficient measures this tendency
 In statistical terms, we say that the returns on Stocks W and M are perfectly negatively
correlated,  = -1.0
o These stocks move opposite from each other
 The opposite of perfect negative correlation is perfect positive correlation,  = 1.0
o The stocks move in the same direction
 The estimate of correlation from a sample of historical data is often called ‘R’
 Diversification does nothing to reduce risk if the portfolio consist of perfectly positively
related stocks
 It is impossible to form completely riskless stocks portfolios
 Combining stocks into portfolios reduces risk but does not completely eliminate it
  As a rule, the risk of a portfolio will decline as the number of stocks in the portfolio
increases

Efficient Portfolios
 One important use of portfolio risk concepts is to select efficient portfolios, defined as
those portfolios that provide the highest expected return for any degree of risk, or the
lowest degree of risk for any expected return
 We must determine the set of attainable portfolios, and then form this attainable set to
select the efficient subset

Diversifiable Risk versus Market Risk

 It is difficult to find stocks whose expected returns are negatively correlated
 Even very large portfolios end up with a substantial amount of risk, but not as much risk
as if all the money were invested in only one stock
 A portfolio consisting of all stocks, which is called the market portfolio, would have a
standard deviation of about 20%
 Thus, almost half of the risk inherent in an average individual stock can be eliminated if
the stock is held in a reasonably well diversified portfolio, which is one containing 40 or
more stocks in a number of different industries
 The part of a stock’s risk that can be eliminated is called diversifiable risk, while the part
that cannot be eliminated is called market risk
 Diversifiable risk is caused by random events such as lawsuits, strikes, successful and
unsuccessful marketing programs, the winning or losing of a major contract, and ither
events that are specific to a particular firm
o Since these events are random, the effect of them can be eliminated by
diversification
 Market risk stems from factors that systemically affect most firms: war, inflation,
recessions, and high interest rates
o Since most stocks are affected by these factors, market risk cannot be eliminated
by diversification
 The Capital Asset Pricing Model is an important tool used to analyze the relationship
between risk and rates of return
o The primary conclusion is: The relevant risk of an individual stock is its
contribution to the risk of a well-diversified portfolio
 A stock might be quite risky if held by itself, but if half of its risk can be eliminated by
diversification, then its relevant risk, which is its contribution to the portfolios risk, is
much smaller than its stand-alone risk
 Different stocks will affect the portfolio differently, so different securities have different
degrees of relevant risk
 All risk except that related to broad market movements can, and presumably will, be
diversified away
 The risk that remains after diversifying is market risk, or the risk that is inherent in the
market, and it can be measured by the degree to which a given stock tends to move up or
down within the market
The Basic Assumptions of the Capital Assets Pricing Model
 Specifies the relationship between risk and required rates of return on assets when they
are held in well-diversified portfolios
 The assumptions are summarized in the following list:
1. All investors focus on a single holding period, and they seek to maximize the
expected utility of their terminal wealth by choosing among alternative portfolios
on the basis of each portfolios expected return and standard deviation
2. All investors can borrow or lend an unlimited amount at a given risk-free rate of
interest, rRF, and there are no restrictions on short sales of any assets
3. All investors have identical estimates of the expected returns, variances, and
covariances among all assets
4. All assets are perfectly divisible and perfectly liquid
5. There are no transactions costs
6. There are no taxes
7. All investors are price takers
8. The quantities of all assets are given and fixed

Contribution to Market Risk: Beta

 The relevant risk of an individual stock, which is called its beta coefficient, is defined
under the CAPM as the amount of risk that the stock contributes to the market portfolio
 In CAPM terminology
o iM is the correlation between the ith stock’s return and the return on the market
o i is the standard deviation of the ith stock’s return
o M is the standard deviation of the market’s return
 The beta coefficient of the ith stock is defined as:
σi
b i= ρ
σM i
 A stock with higher standard deviation will tend to have a higher beta, which means that
it contributes a relatively large amount of risk to a well-diversified portfolio
 A stock with a high correlation with the market will also have a large beta, and hence be
risky
 The covariance between stock I and the market, COViM, is defined as
COV ℑ =ρiσiσ M

Individual Stock Betas

 The tendency of a stock to move up and down with the market is reflected in its beta
coefficient
 An average-risk stock is defined as one with a beta equal to 1.0
 A portfolio of such b=1.0 stocks will move up and down with the bond market indexes,
and it will be just as risky as the indexes
 A portfolio of b=0.5 stock will be half as risky as the market
 A portfolio of b=2.0 stock will be twice as risky as the market
 Beta measures a stock’s volatility relative to the market, which by definition has b=1.0
 If a stock has a positive beta, we expect its return to increase whenever the overall stock
market rises
Portfolio Beta
 The beta of a portfolio is a weighted average of its individual securities’ betas:
n
b ρ=∑ wi bi
i =1
 wi is the fraction of the portfolio invested in the ith stock
 bi is the beta coefficient of the ith stock
 It shows how volatile the portfolio is in relation to the market
 Since a stock’s beta measures it contribution to the risk of a portfolio, beta is the
theoretically correct measure of the stock’s risk

Key Points Related to Beta

1. A stock’s risk consists of two components, market risk and diversifiable risk
2. Diversifiable risk can be eliminated through diversification, and most investors do
diversify, either by holding large portfolios or by purchasing shares in a mutual fund.
Market risk is caused by general movements in the stock market and it reflects the fact
that most stocks are systematically affected by events like war, recession, and inflation.
Market risk is the only risk relevant to a rational, diversified investor because such an
investor would eliminate diversifiable risk
3. Investors must be compensated for bearing risk – the greater the risk of a stock, the
higher its required return. However, compensation is required only for risk that cannot be
eliminated by diversification. If risk premiums existed on stocks due to diversifiable risk,
well-diversified investors would start buying those securities and bidding up their prices.
The stocks’ final expected returns would reflect only non-diversifiable market risk
4. The market risk of a stock is measured by its beta coefficient, which is an index of the
stock’s relative volatility. If b equals 1.0, then the stock is less risky than the market. If
beta is greater than 1.0, the stock is more risky
5. The beta of a portfolio is a weighted average of the individual securities’ betas
6. Since a stock’s beta coefficient determines how the stock affects the risk of a diversified
portfolio, beta is the most relevant measure of any stock’s risk

7.4 THE RELATIONSHIP BETWEEN RISK AND RATES OF RETURN

r^ i=expected rate of return of the i th stock
r i=required rate of returnon the ith stock

 The market risk premium, RPM, shows the premium investors require for bearing the risk
of an average stock, and it depends on the degree of risk aversion that investors on
average have
 The risk premium for the ith stock is
risk premium for stock i=RP i=( RP M )b i
 The relationship between the required return and risk is called the Security Market Line:
SML=r RF +( RP M )b i

The Impact of Changes in Inflation and Interest Rates

 rRF is the price of money to a riskless borrower
  The risk-free rate as measured by the rate on Canadian Government bonds is called the
nominal, or quoted, rate, and it consists of two elements:
o A real inflation-free rate of return, r*
o An inflation premium, IP, equal to the anticipated rate of inflation
 As rRF changes, so may the required return on the market, keeping the market risk
premium stable
 A change in the risk-free rate also causes a change in the required market return, rM,
resulting in a relatively stable market risk premium, rM – rRF

Changes in Risk Aversion

 The slope of the Security Market Line reflects the extent to which investors are averse to
risk
 The steeper the slope of the line, the greater the average investor’s risk aversion
 As risk aversion increases, so does the risk premium, and this causes the SML slope to be
steeper

Changes in a Stock’s Beta Coefficient

 A firm can influence its market risk, hence its beta, through changes in the composition
of its assets and also through its sue of debt
 A company’s beta can also change as a result of external factors such as increased
competition in its industry, the expiration of basic patents, and the like
 When such changes occur, the required rate of return also changes

Current Status of the CAPM

 Doubts of the CAPM begin to arise when one thinks about the assumptions upon which
the model is based, and these doubts are as much reinforced as reduced by the empirical
tests
 Our own views as to the current status of the CAPM are as follows:
1. The CAPM framework, with its focus on market as opposed to stand-alone risk, is
clearly a useful way to think about the risk of assets. Thus, as a conceptual model,
the CAPM is of truly fundamental importance
2. When applied in practice, the CAPM appears to provide neat, precise answers to
important questions about risk and required rates of return. However, the answers
less clear than they seem. The simple truth is that we do not know precisely how
to measure any of the inputs to implement the CAPM. These inputs should all be
ex ante, yet only ex post data are available. Furthermore, historical data varies
greatly depending on the time period studied and the methods used to estimate
them. Thus, although the CAPM appears precise, estimates of ri, found through its
use are subject to potentially large errors
3. Because of the CAPM is logical in the sense that it represents the way risk-averse
people ought to behave, the model is a useful conceptual tool
4. It is appropriate to think about many financial problems in a CAPM framework.
However, it is important to recognize the limitations of the CAPM when using it
in practice.