2 Risk Return VGU SUMMER 2023

2 Risk and Return
Prof. Dr. Leef H. Dierks – Corporate Finance – June/July 2023 © VGU (2023) 108
2.1 Capital Markets and the Pricing of Risk
2.2 Optimal Portfolio Choice and the Capital Asset Pricing Model
2.3 Estimating the Cost of Capital
2.4 Efficient Markets and Behavioural Finance
Common Measures of Risk and Return
§ probability distributions
§ different securities have different initial prices, pay different cash

flows and sell for different future amounts
§ in an attempt to make them comparable, their performance is

expressed in terms of their returns
§ return indicates the percentage increase in the value of an
investment per € initially invested in the security
§ each possible return has some likelihood of occurring which is

summarised with a probability distribution that assigns a
probability PR that each possible return R will occur
§ given the probability distribution of returns the expected return
can be computed
§ the expected (or mean) return is determined as a weighted

average of the possible returns where the weights correspond to
the respective probabilities
expected return = E [ R ] = ∑ pR ⋅ R
R
§ expected return is the return that would be earned on average if
the investment were repeated many times, drawing the return
from the same distribution each time
§ variance and standard deviation (volatility) as two common
measures of the risk of a probability distribution
§ variance is the expected squared deviation from the mean, and

the standard deviation is the square root of the variance
Var ( R) = E !( R − E [ R ]) # = ∑ pR ⋅ ( R − E [ R ])
2 2
" $ R
SD ( R) = Var ( R)
§ in case the return is risk-free and never deviates from its mean,
the variance is zero
§ otherwise, the variance increases with the magnitude of the

deviations from the mean
Historical Returns of Stocks and Bonds
§ of all possible returns, the realised return is the return that
actually occurs over a particular time period
§ to illustrate, the realised return from an investment in a stock is
DIVt+1 + Pt+1 DIVt+1 Pt+1 − Pt

Rt+1 = −1 = +
Pt Pt Pt
§ the realised return thus corresponds to the dividend yield plus

the capital gain rate and is expressed as the total return earned
from dividends and capital gains as a percentage of the initial
stock price
§ average annual return of an investment during some historical
period is simply the average of the realised returns for each year
1 1 T
R = ( R1 + R2 +... + RT ) = ∑ Rt
T T t=1
§ Average annual return is the balancing point of the empirical

distribution, i.e. the probability of a return occurring in a
particular range is measured by the number of times the realised
return falls in that range
§ If the probability distribution of the returns is the same over time,

the average return provides an estimate of the expected return
§ in an attempt to quantify the difference in variability, the
standard deviation of the probability function can be estimated
by means of the the empirical distribution
§ variance is computed by the average squared deviation from the

mean
§ as the mean is actually unknown, the best estimate of the mean is
used instead, i.e. the average realised return
1 T 2
Var ( R) = ∑ Rt − R
T −1 t=1
( )
§ standard deviation (or volatility) is then estimated as the square

root of the variance
§ estimation error: using past returns to predict the future
§ in order to estimate the cost of capital for an investment, the

expected return investors will require to be compensated for the
investment's risk need to be determined
§ in case the distribution of past returns and the distribution of
future returns are the same, the return investors expected to earn
in the past on the same or a similar investment can used to
assume that they will require the same return in the future
Standard Error
§ estimation error of a statistical estimate is measured by its
standard error
§ standard error is the standard deviation of the estimated value of

the mean of the actual distribution around its true value, i.e. the
standard deviation of the average return
§ standard error provides an indication of how far the sample

average might deviate from the expected return
Standard Error
§ assuming that the distribution of a stock’s return is identical each
year, and each year’s return is independent of prior years’
returns, then the standard error of the estimate of the expected
return can be calculated as
SD (individual risk )
SD =
number of observations
Standard Error
§ as the average return will be within two standard errors of the
true expected return approximately 95% of the time, the
standard error can be used to determine a reasonable range for
the true expected value
§ the 95% confidence interval for the expected return corresponds

to the historical average return ± 2 standard errors
Standard Error
§ note that typically, individual stocks tend to be more volatile than
larger portfolios, and, as they have often existed only a few years,
data usable to estimate returns is limited
§ as a result of the relatively large estimation error in this case, the

average return investors earned in the past is not a reliable
estimate of a security's expected return
Trade-Off between Risk and Return
§ generally speaking, investors are risk-averse, i.e. the benefit they
receive from an increase in income is smaller than the personal
cost of an equivalent decrease in income
§ this idea suggests that investors would not choose to hold a

portfolio that is more volatile unless they expected to earn a
higher return
Trade-Off between Risk and Return
§ concept of excess return: excess return is difference between
average return for investment and average return for risk-free
investment (e.g. selected government bonds) and measures
average risk premium investors earned for bearing risk of an
investment
§ historically, investments with higher volatility rewarded investors

with higher average returns
Return of Individual Stocks
§ riskier investment must offer investors higher average returns to
compensate them for the additional risk they are taking on
§ rule of thumb: investments with higher volatility should have a

higher risk premium and therefore higher returns
Common versus Independent Risk
§ the risk of an individual security differs from the risk of a portfolio
composed of similar securities
§ differentiation between a perfectly correlated risk, i.e. common

risk and an uncorrelated risk, the independent risk
§ the averaging out of independent risks with in larger portfolio is

referred to a diversification
§ principle of diversification is routinely used in the insurance

industry, among others, as numbers are relatively predictable in a
larger portfolio
Diversification in Stock Portfolios
§ risk of portfolio depends on whether the individual risks within it
are common or independent
§ independent risks are diversified in a large portfolio whereas

common risks are not
§ over any given time period, the risk of holding a stock is that the
dividends plus the final stock price will be higher or lower than
expected, which makes the realised return risky
Diversification in Stock Portfolios
§ stock prices and dividends typically fluctuate due to two types of
news:
• firm-specific news, i.e. good or bad news about the company
• market-wide news, i.e. news about the economy as a whole
Firm-Specific versus Systematic Risk
§ fluctuations of a stock‘s return that are due to firm-specific news
are independent risks; also known as firm-specific, unique,
idiosyncratic or diversifiable risk
§ fluctuations of a stock‘s return that are due to market-wide news

represent common risk; also known as systematic, undiversifiable,
or market risk
Firm-Specific versus Systematic Risk
§ as soon as many stocks are combined in a larger portfolio, firm-
specific risks for each stock will be averaged out and be
diversified
§ the systematic risk, in contrast, will affect the entire portfolio and
will not be diversified
Diversifiable Risk
§ part of an asset's risk arising from random causes that can be
eliminated through diversification
§ e.g., risk of company losing key account can be diversified away

by investing in competitor that took the account
Nondiversifiable Risk
§ risk attributable to market factors that affect all firms and that
cannot be eliminated through diversification
§ e.g., if there is inflation, all companies experience an increase in

prices of inputs, and generally their profitability will suffer if they
cannot fully pass price increase on to customers
General Principles
§ according to the Law of One Price, as a large portfolio of firms
with (only!) an idiosyncratic risk, the risk-free interest rate must be
earned
§ this no-arbitrage argument suggests the following two, more

general principles:
1. the risk premium for diversifiable risk is zero, so investors are not
compensated for holding firm-specific risks
2. the risk premium of a security is determined by its systematic risk

and does not depend on its diversifiable risk
Measuring Systemic Risk
§ in exchange for bearing systematic risk, investors want to be
compensated for by earning a higher return
§ in order to measure the systemic risk of a stock, the extent to

which the variability of its return is due to systematic, market-
wide risks versus diversifiable, firm-specific risks needs to be
determined
§ in other words, the sensitivity of the stock to systematic shocks

that affect the economy as a whole needs to be determined
§ investors can eliminate the firm-specific risk in their investment
by diversifying their portfolio
§ when evaluating the risk of an investment, an investor must thus

consider the systematic risk, which cannot be eliminated through
diversification
§ in exchange for bearing systematic risk, investors want to be

compensated for by earning a higher return
§ in order to determine the sensitivity of a stock to interest rate
changes, for instance, the change of the return to average
changes for each one per cent change in interest rates needs to
be determined
§ more generally, to determine how sensitive a stock is to

systematic risk, the average change in its return for each one per
cent change in the return of a portfolio that fluctuates solely due
to systematic risk needs to be regarded
Identifying Systemic Risk
§ first step to measuring risk is finding a portfolio that contains only
systemic risk
§ changes in the price of this portfolio will correspond to systemic

shocks to the economy
§ any such portfolio is referred to as an efficient portfolio
Identifying Systemic Risk
§ an efficient portfolio cannot be diversified any further, i.e. there is
no way to reduce the risk of the portfolio without lowering its
expected return
§ natural candidate for an efficient portfolio is the market portfolio,

which is a portfolio of all stocks and securities traded in the
capital markets
Sensitivity to Systemic Risk
§ assuming that the market portfolio is efficient, changes in the
value of the market portfolio represent systemic shocks to the
economy
§ the systematic risk of a security can then be determined by

calculating the sensitivity of the security’s return to the return of
the market portfolio, known as the beta (β) of the security
Sensitivity to Systemic Risk
§ more precisely, the beta of a security is the expected percentage
change in its return given a one per cent change in the return of
the market portfolio
§ the beta can reasonably accurately be determined using past

data, e.g. that of the past five years
Interpreting Betas
§ beta measures the sensitivity of a security to market-wide risk
factors
§ average beta of a stock in the market is about one, i.e. the

average stock price tends to move about one per cent for each
one per cent move in the overall market
Interpreting Betas
§ stocks in cyclical industries, however, in which revenues and
profits vary greatly over the business cycle, are likely to be more
sensitive to systematic risk and have betas that exceed one,
whereas stocks of non-cyclical firms tend to have betas that are
less than one
Estimating the Risk Premium
§ before the risk premium of an individual stock can be deter-
mined, the the investor‘s appetite for risk needs to be assessed
§ size of the risk premium that investors will require to make a risky
investment depends upon their risk aversion
§ rather than attempt to measure this risk aversion directly, it can
be assessed indirectly through determining the risk premium
investors demand for investing in systemic, or market risk
§ market risk premium: risk premium investors earn by holding

market risk is the difference between the market portfolio’s
expected return and the risk-free interest rate:
Market risk premium = E [RMarket] - rf
§ in the same way that the market interest rate reflects investors’
patience and determines the time value of money, the market
risk premium reflects investors’ risk tolerance and determines the
market price of risk in the economy
§ adjusting for beta:

market risk premium is reward investors expect to earn for
holding portfolio with a beta of one – i.e. market portfolio itself
Market Risk Premium
§ consider an investment opportunity with a beta of two, i.e. an
investment that carries twice as much systemic risk as an invest-
ment in the market portfolio
§ for each € invested in the opportunity, twice that amount could

be invested in the market portfolio and be exposed to exactly
the same amount of systematic risk
§ According to the Law of One Price, as it carries exactly twice as

much systemic risk, investors will require twice the risk premium
to invest in an opportunity with a beta of two!
Prof. Dr. Leef H. Dierks – Corporate Finance – June/July 2023 © VGU (2023)
!
150
Market Risk Premium
§ the beta of an investment can be used to determine the scale of
the investment in the market portfolio that carries an equivalent
systematic risk
§ thus, to compensate investors for the time value of their money

as well as the systemic risk that are bearing, the cost of capital rI
for an investment with beta βI should satisfy the following
condition:
rI = risk-free interest rate + βI * market risk premium

= rf + βI * (E [RMarket] – rf)
The Capital Asset Pricing Model
§ above equation for estimating cost of capital, often referred to as
Capital Asset Pricing Model (CAPM), most important method for
estimating cost of capital used in practise
§ so far, focus has been on an intuitive justification of CAPM and its

use of market portfolio as benchmark for systemic risk
§ in the following, we shall provide more complete development of

model and its assumptions as well as portfolio optimisation
process
Expected Return of a Portfolio
§ in order to identify an optimal portfolio, a method to define a
portfolio and analyse its returns needs to be determined
§ a portfolio can be described by its portfolio weights, i,e. the

fraction of the total investment in the portfolio held in each
individual investment in the portfolio
value of investment i
xi =
total value of portfolio
§ portfolio weights always add up to one, thereby representing the

way the money has been divided between the different
individual investments in the portfolio
§ given the portfolio weights, the return on the portfolio can be
calculated
§ assuming that x1, ..., xn are the portfolio weights of the n

investments in a portfolio, and these investments have returns R1,
..., Rn
§ then the return on the portfolio, RP, is the weighted average of

the return on the investments in the portfolio, where the weights
correspond to portfolio weights
RP = x1R1 + x2 R2 +... + xn Rn = ∑ xi Ri
§ the above equation also allows to compute the expected return
of a portfolio
§ remembering that the expectation of a sum is just the sum of the
expectations and that the expectations of a known multiple is
just the multiple of its expectations, the following formula can be
derived
E ( RP ) = E (∑ x R ) = ∑ E(x R ) = ∑ x E(R )
i i i i i i
§ the expected return of a portfolio simply is the weighted average

of the expected return of the investments within it, using the
portfolio weights
Volatility of a Two-Stock Portfolio
§ combining stocks in a portfolio eliminates some of their risk
through diversification
§ amount of risk that will remain depends on degree to which

stocks are exposed to common risks
§ by combining stocks into a portfolio, risk can be reduced through

diversification
§ as prices of the stocks do not move identically, some of the risk is

averaged out in a portfolio
Volatility of a Two-Stock Portfolio
§ as a result, portfolio has a lower risk than individual stocks
§ the amount of risk eliminated in portfolio depends on degree to
which stocks face common risks and on the extent to which their
prices move together
Determining Covariance and Correlation
§ in order to determine the risk of a portfolio, the degree to which
the stocks face common risks and their returns move together
need to be determined
§ in the following, for this purpose, the emphasis shall be put on
covariance and correlation
§ covariance is the expected product of the deviation of two
returns from their means
( (
Cov ( Ri , R j ) = E ( Ri − E ( Ri )) R j − E ( R j ) ))
§ when estimating the covariance from historical data, the
following formula applies
1
Cov ( Ri , R j ) =
T −1
∑( Ri,t − Ri ) ( R j,t − R j )
§ intuitively, if two stocks move together, their returns will tend to
be above or below average at the same time and the covariance
will be positive
§ if the stocks move in opposite directions, one will tend to be

above average and when the other is below average and the
covariance will be negative
§ while the sign of the covariance is easy to interpret, the

magnitude is not
§ in order to control for the volatility of each stock and quantify the
strength of the relationship between them, the correlation
between the return of two stocks can be calculated
Cov ( Ri , R j )
Corr ( Ri , R j ) =
SD ( Ri ) SD ( R j )
§ correlation between two stocks has the same sign as their

covariance, i.e. it has a similar interpretation
§ correlation is an indicator of the degree to which the returns

share common risk and tend to move together
§ for a two-stock portfolio with RP = x1 R1 + x2 R2
Var (RP) = Cov (RP, RP)

= Cov (x1R1 + x2R2, x1R1 + x2R2)
= x1x1 Cov (R1, R1) + x1x2 Cov (R1, R2) + x2x1 Cov (R2, R1) +
x2x2 Cov (R2, R2)
= x21 Var (R1) + x22 Var (R2) + 2 x1x2 Cov (R1, R2)
§ variance of the portfolio depends on the variance of the individual

stocks and on the covariance between them
§ the above equation can thus be rewritten as
Var (RP) = x21 SD (R1)2 + x22 SD (R2)2 + 2 x1 x2 Corr (R1, R2) SD (R1) SD (R2)
§ with a positive amount invested in each stock, the more the stocks
move together, and the higher their covariance or correlation, the
more variable the portfolio will be
§ portfolio will have the greatest variance if the stocks have a perfect
positive correlation of +1
Volatility of a Large Portfolio
§ additional benefits of diversification can be gained by holding
more than two stocks in a portfolio
§ return on a portfolio of n stocks simply is the weighted average

of the returns of the stocks in the portfolio:
RP = x1R1 + x2 R2 +... + xn Rn = ∑ xi Ri
§ using the properties of the covariance, the variance of a portfolio

can be rewritten as follows:
Var(RP ) = Cov(RP , RP ) = Cov(∑ xi Ri , RP ) = ∑ xiCov(Ri , RP )
§ above equation indicates that variance of a portfolio is equal to
weighted average covariance of each stock in portfolio
§ expression further reveals that risk of a portfolio depends on how

each stock’s return moves in relation to it
§ simplification by means of replacing the second RP with a

weighted average leads to
Var(RP ) = ∑ xiCov(Ri , RP ) = ∑ xiCov(Ri , ∑ x j R j ) = ∑∑ xi x j Cov(Ri , R j )
§ according to above formula, variance of portfolio is equal to sum
of covariances of returns of all pairs of stocks in portfolio
multiplied by each of their portfolio weights, i.e. overall variability
of portfolio depends on total co-movement of stocks within it
Diversification Equally Weighted Portfolio
§ the above equation can be used to calculate the variance of an
equally weighted portfolio, i.e. a portfolio in which the same
amount is invested in each stock
§ an equally weighted portfolio consisting of n stocks has portfolio

weights xi = 1 / n
Diversification Equally Weighted Portfolio
§ variance of an equally weighted portfolio of n stocks can can thus
be determined as
Var (RP) = 1 / n (average variance of the individual stocks)
+ (1 – 1 / n) (average covariance between the stocks)
§ equation demonstrates that as the number of stocks, n, grows

large, the variance of the portfolio is determined primarily by the
average covariance among the stocks
Diversification with General Portfolios
§ for a portfolio with arbitrary weights, the above equation can be
rewritten in terms of the correlation as follows
Var(RP ) = ∑ xiCov(Ri , RP ) = ∑ xi SD(Ri ) SD(RP ) Corr(Ri , RP )
§ Dividing both sides of the equation by the standard deviation SD

of the portfolio yields the volatility of a portfolio with arbitrary
weights
SD (RP ) = ∑ xi ⋅ SD(Ri ) ⋅ Corr(Ri , RP )
Diversification with General Portfolios
§ the above equation states that each security contributes to the
volatility of the portfolio according to its volatility, or total risk,
scaled by its correlation with the portfolio, which adjusts for the
fraction of the total risk that is common to the portfolio
§ therefore, when combining stocks into a portfolio that puts

positive weight on each stock, unless all of the stocks have a
perfect positive correlation with the portfolio, the risk of the
portfolio will be lower than the weighted average volatility of the
individual stocks
Choosing an Optimal Portfolio
§ in the following, assume that an investor can choose between
only two stocks which he believes are uncorrelated
§ a portfolio is an inefficient portfolio whenever it is possible to

find another portfolio that is better in terms of both expected
return and volatility
§ inefficient portfolios are not optimal for an investor seeking high

returns and low volatility
Volatility versus Expected Return
Expected Return
30%
efficient portfolios LVMH
20%
10%
inefficient
portfolios EON
Volatility (standard deviation)

0%
0% 10% 20% 30% 40% 50% 60%
Choosing an Efficient Portfolio
§ a portfolio is efficient whenever there is no other portfolio of
stocks that offers a higher expected return with lower volatility
§ whereas inefficient portfolios can be excluded as inferior

investment choices, efficient portfolios cannot be easily ranked
as investors will choose among them based on their own
preferences for return versus risk
Effect of Correlation
§ correlation has no effect on the expected return of a portfolio
§ however, the volatility of a portfolio will differ depending on the

correlation
§ the lower the correlation, the lower the volatility which can be
obtained
The Effect of Correlation
Expected Return
30%
20%
10%
Volatility (standard deviation)

0%
0% 10% 20% 30% 40% 50% 60%
Short Sales
§ so far, only portfolios in which a positive amount in each stock has
been invested have been considered
§ a positive investment in a security is referred to as a long position

in the security
§ yet, it is also possible to invest a negative amount in a stock, i.e. a

short position, by engaging in a short sale, i.e. a transaction in
which a stock which is not owned is being sold with the obligation
to buy it back in the future
Short Sales
§ a short position can be included as part of a portfolio by assigning
that stock a negative portfolio weight
§ short selling is profitable if you expect a stock’s price to decline in

the future
§ short selling can greatly increase the risk of a portfolio
Efficient Portfolios with Many Stocks
§ adding more stocks to a portfolio reduces the risk through
diversification
§ in case of a third stock and allowing for short sales as well,

investors get an entire region of risk and return possibilities
rather than a single curve
§ most of the portfolios are inefficient, however
§ efficient portfolios, i.e. those offering the highest possible

expected return for a given level of volatility, are referred to as
the efficient frontier
Risk-Free Saving and Borrowing
§ so far, risk and return possibilities that result form combining
risky investments into portfolios have been considered
§ by including all risky investments in the construction of the

efficient frontier, a maximum diversification can be achieved
§ another way (besides diversification) to reduce risk that has not

yet been considered, is an investment in a safe, no-risk
investment like German bunds (DBR), for example
Risk-Free Saving and Borrowing
§ this might well reduce the expected return
§ an aggressive investor, in contrast, who is seeking high expected

returns, might decide to borrow money to invest even more in
the stock market
§ ability to choose an amount to invest in risky versus risk-free

securities allows to determine the optimal portfolio of risky
securities for an investor
Investing in Risk-Free Securities
§ consider an arbitrary risky portfolio with returns RP
§ in the following, a fraction x of the money will be put into the
portfolio whereas the remaining fraction (1-x) will be invested in
risk free government bonds with a yield of rf
§ the expected return RxP and the variance of the portfolio can be
determined as
(
E(RxP ) = (1− x ) rf + xE ( R f ) = rf + x E ( R f ) − rf )
SD(RxP ) = (1− x)2 Var(rf ) + x 2Var(RP ) + 2(1− x)x(Cov(rf , RP )
= x 2Var ( RP )
= xSD ( RP )
Identifying the Tangent Portfolio
§ in an attempt to earn the highest possible expected return for
any level of volatility, the portfolio which generates the steepest
possible line when combined with the risk-free investment needs
to be determined
§ the slope of the line through a given portfolio P is often referred

to as the Sharpe ratio of the portfolio
§ Sharpe ratio = Portfolio’s Excess Return / Portfolio Volatility
= (E (RP) – rf) / SD (RP)
§ Sharpe ratio measures the ratio of reward-to-volatility provided

by a portfolio
! § optimal portfolio to combine with the risk-free asset will be the

one with the highest Sharpe ratio
Prof. Dr. Leef H. Dierks – Corporate Finance – June/July 2023

!
© VGU (2023) 183
§ the optimal portfolio of risky investments no longer depends on
how conservative or aggressive the investor is; every investor
should invest in the tangent portfolio independent of his or her
taste for risk
§ investor’s preferences will determine only how much to invest in

the tangent portfolio versus the risk-free investment
§ both types of investors will choose to hold the same portfolio of

risky assets, the tangent portfolio
§ the efficient portfolio is the tangent portfolio, the portfolio with
the highest Sharpe ratio in the economy
§ by combining it with the risk-free investment, an investor will earn
the highest possible expected return for any level of volatility he
or she is willing to bear
Efficient Portfolio and Required Returns
§ the required return is the expected return that is necessary to
compensate for the risk investment i will contribute to the
portfolio
§ the required return for an investment i is equal to the risk-free

interest rate plus the risk premium of the current portfolio, P,
scaled by i’s sensitivity to P, βPi
§ if i’s expected return exceeds the required return, then adding

more of it will improve the performance of the portfolio
Expected Returns and Efficient Portfolios
§ if a security‘s expected return exceeds its required return, then
the performance of a portfolio P can be improved b adding more
of the security
§ as shares of security i are bought, its correlation (and therefore its

beta) with the portfolio will increase, ultimately raising its
required return until E(Ri) = ri
§ at this point, holdings of security i are optimal

§ similarly, if security i’s expected return is less than the required
return ri, holdings of i should be reduced
§ whilst doing so, the correlation and the required return ri will fall
until E(Ri) = ri
§ thus, in the absence of restrictions, trade until E(Ri) = ri for all i
§ as soon as E (Ri) = ri for all i, no trade can possibly improve the
risk-reward ratio of the portfolio, i.e. the portfolio is the optimal,
efficient portfolio
§ in other words, a portfolio is efficient if and only if the expected

return of every available security equals its required return
§ expected return of a security (with Reff as the return of the

efficient portfolio, the portfolio with the highest Sharpe ratio of
!
any portfolio in the economy):
(
E ( Ri ) = ri ≡ rf + βieff ⋅ E ( Reff ) − rf )
Combining Stocks into Portfolios
§ When measured over a short interval, the past rates of return on
any stock conform fairly closely to a normal distribution
§ Normal distributions can be completely defined by two numbers,

the average expected return and the variance (or standard
deviation)
§ due to diversification, a portfolio risk is typically less than the

average of the risks of separate stocks
§ gain from diversification depends on how highly the stocks are

correlated (-1 ≤ ρ ≤ 1)
Capital Asset Pricing Model
§ CAPM is used to determine a theoretically appropriate required
rate of return of an asset, if that asset is to be added to an
already well-diversified portfolio, given that asset's non-
diversifiable risk
§ CAPM takes into account the asset's sensitivity to non-
diversifiable risk (also known as systematic risk or market risk),
often represented by the quantity beta (β), as well as the
expected return of the market and the expected return of a
theoretical risk-free asset
§ CAPM suggests that an investor’s cost of equity capital is

determined by beta
Within the scope of the CAPM, all investors
§ are rational and risk-averse,

§ can lend and borrow unlimited amounts under the risk free rate of
interest,
§ aim to maximize economic utilities (asset quantities are given and
fixed),
§ are broadly diversified across a range of investments,
Within the scope of the CAPM, all investors
§ are price takers, i.e., they cannot influence prices,

§ trade without transaction or taxation costs,
§ deal with securities that are all highly divisible into small parcels (all
assets are perfectly divisible and liquid),
§ have homogeneous expectations and
§ assume all information is available at the same time to all investors
Efficiency of Market Portfolio
§ if investors have homogeneous expectations, then each investor
will identify the same portfolio as having the highest Sharpe ratio
in the economy
§ thus, all investors will demand the same efficient portfolio of risky
securities, i.e. the tangent portfolio, merely adjusting their
investment in risk-free securities to suit their individual appetite
for risk
§ yet, if every investor is holding the tangent portfolio, then the
combined portfolio of risky securities of all investors must also
equal the tangent portfolio
§ further, the sum of all investors’ portfolios must equal the

portfolio of all risky securities available in the market, i.e. the
market portfolio
§ the efficient, tangent portfolio of risky securities (the portfolio

that all investors hold) must equal the market portfolio
The Capital Market Line
§ when the assumptions of the CAPM hold, the market portfolio is
efficient, so the tangent portfolio corresponds to the market
portfolio
§ when the tangent line goes through the market portfolio, it is

referred to as the capital market line
§ according to the CAPM, all investors should choose a portfolio

on the capital market line by means of holding some
combination of the risk-free security and the market portfolio
Determining the Risk Premium
§ under the assumptions of the CAPM, the efficient portfolio can
be identified – it is equal to the market portfolio (!)
§ thus, in case the expected return of a security or the cost of

capital of an investment is unknown, the CAPM can be used to
find it by using the market portfolio as a benchmark
§ CAPM equation for the Expected Return:
E ( Ri ) = ri = rf + βi ⋅ ( E ( RMarket ) − rf )
Security Market Line
§ the above equation implies that there is a linear relationship
between a stock’s beta and its expected return
§ this is typically referred to as the security market line
§ under the assumptions of the CAPM, the security market line is
the line along which all individual securities should lie when
plotted according to their expected return and beta
§ note that in contrast, there is no clear relationship between an
individual stock’s volatility and its expected return
§ relationship between risk and return for individual securities
becomes evident only when market risk rather than total risk is
measured
Beta of Portfolio
§ as the security market line applies to all tradable investment
opportunities, it can be applied to portfolios as well
§ consequently, the expected return of a portfolio depends on the

portfolio‘s beta
β P = ∑ xi β i
i
§ in other words, the beta of a portfolio is the weighted average

beta of the securities in the portfolio
Summary
§ risk of an investment does not arise from the varying cash flows
of the investment - but instead (considering diversification
effects) from their contribution to the overall portfolio risk
§ the CAPM groups all available, risk-carrying financial assets into

the so-called market portfolio
§ the valuation of the risk of individual investment or financing

alternatives will exclusively be based on their individual risk
contributions
Equity Cost of Capital
§ cost of capital is the best expected return available in the market
on investments with similar risk (idea: ‘opportunity costs’)
§ CAPM provides a practical way to identify an investment with

similar risk
§ under CAPM, market portfolio is a well-diversified, efficient

portfolio representing the non-diversifiable risk in the economy
§ investments therefore have similar risk if they have same

sensitivity to market risk as measured by their beta with market
portfolio
Equity Cost of Capital
§ cost of capital of any investment opportunity thus equals the
expected return of available investments with the same beta
§ estimate is provided by Security Market Line of the CAPM
§ in other words, investors will require a risk-premium comparable

to what they would earn taking the same market risk through an
investment in the market portfolio
Market Portfolio
§ in order to apply CAPM, market portfolio needs to be identified
§ as market portfolio is total supply of securities, proportions of

each security should correspond to proportion of total market
that each security represents
§ specifically, investment in each security i is proportional to its

market capitalisation, which is total market value of its out-
standing shares
Market Portfolio
§ portfolio like market portfolio, in which each security is held in
proportion to its market capitalisation, is referred to as value-
weighted portfolio (also known as an equal-ownership portfolio)
§ as little trading is required to maintain value-weighted portfolio,

it is also known as passive portfolio
Market Risk Premium
§ key ingredient of CAPM is market risk premium, i.e. expected
excess return of market portfolio
§ market risk premium provides benchmark by which investor’s
willingness to hold market risk is measured
§ in the following, risk-free interest rate to use in CAPM needs to
be determined
§ typically, risk-free interest rate used in the CAPM corresponds to
interest rate at which investors can both borrow and save
§ generally, risk-free saving rate can be determined using yield on
(risk-free) government bonds (e.g. German bunds)
Historical Risk Premium
§ another approach to estimate the market risk premium is to use
the historical average excess returns of the market over the risk-
free interest rate (i.e. arithmetic average)
§ within the approach, it is important to measure the historical

stock return over the same time horizon as that used for the risk-
free interest rate
§ trade-off as the future market risk premium is of relevance for the

CAPM but as historical data is not necessarily a good indicator
Beta Estimation
§ after identifying a market proxy, the next step in implementing
the CAPM is to determine the security‘s beta, which measures
the sensitivity of the security‘s return to those of the market
§ as beta captures market risk of a security, as opposed to its

diversifiable risk, it is the appropriate measure of risk for a well-
diversified investor
Beta Estimation
§ differences in betas reflect sensitivity of each firm’s profits to
general health of economy
§ generally speaking, beta corresponds to the slope of the best-

fitting line in the plot of the security’s excess return versus the
market’s excess return
§ recall that beta measures the percentage change in the return of

a security for a 1% change in the return of the market portfolio
Debt Cost of Capital
§ having first used the CAPM to estimate the cost of capital of a
firm’s equity, we shall now consider debt cost of capital, i.e. that
cost of capital that firms have to pay on their debt
§ if there is little risk that a firm will default, bond’s yield to maturity
(ytm) can be used as estimate of investors’ expected return
§ if there is significant risk that firm will default on its obligation,

however, yield to maturity of the firm’s debt, i.e. its promised
return, will overstate investors’ expected return
Debt Betas
§ alternatively, debt cost of capital can be estimated using CAPM
§ yet, as bank loans as well as many corporate bonds are traded

infrequently (if at all), it is difficult to obtain reliable data for the
returns of individual debt securities
§ thus, another means of estimating debt betas (approximations) is

needed
All Equity Comparables
§ simplest setting is one in which there is an all equity financed firm
in a single line of business
§ as the firm is all equity, holding the firm’s stock is equivalent to

owning the portfolio of its underlying assets
§ thus, if firm’s average investment has similar market risk to

comparable project, then comparable firm’s equity beta and cost
of capital can be used as estimates for beta and cost of capital of
the project
Levered Firms as Comparables
§ in case the comparable firm has debt, the situation is slightly
more complex as cash flows generated by firm’s assets are used
to pay both debt and equity holders
§ as a result, returns of the firm’s equity alone are not
representative of underlying assets
§ in fact, because of firm’s leverage, equity will often be much
riskier
§ in other words, beta of levered firm’s equity will not be good
estimate of beta of its assets (and thus of a comparable project)
Evaluating CAPM
§ as assumptions of CAPM certainly are not entirely realistic, results
which will be obtained following approach need to be
questioned
§ still, compared to other models, imperfections of CAPM are not

likely to be critical in context of capital budgeting or corporate
finance
Evaluating CAPM
§ further, in addition to being rather practical and straightforward
to implement, CAPM-based approach is very robust
§ CAPM offers very few parameters to actually manipulate
§ finally, despite perhaps not being perfectly accurate, CAPM

might get managers to focus on market as opposed to
diversifiable risk (which investors can diversify themselves)
Arbitrage Pricing Theory
§ originally developed by Stephen Ross (1976)
§ APT does not ask which portfolios are efficient
§ APT instead assumes that each stock‘s return depends partly on

pervasive macroeconomic influences (so-called „factors“) and
partly on „noise“, i.e. events that are unique to that company
Arbitrage Pricing Theory
§ expected return of a financial asset can be modelled as a linear
function of various macro-economic factors, where sensitivity to
changes in each factor is represented by a factor-specific beta
coefficient
§ the model-derived rate of return will then be used to price asset

correctly - asset price should equal expected end of period price
discounted at rate implied by model
§ in case price diverges, arbitrage should c.p. bring it back into line
Comparing CAPM and APT
§ APT differs from the CAPM in that it is less restrictive in its
assumptions
§ APT allows for an explanatory (as opposed to statistical) model of
asset returns
§ APT assumes that each investor will hold a unique portfolio with
its own particular array of betas, as opposed to an identical
"market portfolio“
§ to a certain extent, CAPM can be considered a "special case" of
APT in that securities market line represents a single-factor
model of asset price, where beta is exposed to changes in value
of market
Comparing CAPM and APT
§ APT can further be regarded as "supply side" model, since its
beta coefficients reflect sensitivity of underlying asset to
economic factors
§ factor shocks would cause structural changes in assets' expected
returns, or in the case of stocks, in firms' profitabilities
§ CAPM can be considered "demand side" model
§ CAPM‘s results, although similar to those of the APT, arise from
maximization problem of each investor's utility function, and
from resulting market equilibrium (investors are considered to be
"consumers" of assets)
Competition and Capital Markets
§ if market portfolio is not equal to efficient portfolio, then market
is not in CAPM equilibrium
§ assuming arrival of new information, market portfolio might no

longer be efficient but alternative portfolios might offer higher
expected returns and lower volatility than what can be obtained
by holding market portfolio
§ if market portfolio is inefficient, then stocks will not all lie on

security market line
! A Stock‘s Alpha
§ distance of a stock above or below security market line is referred
to as stock’s alpha
§ market portfolio can be improved upon by buying stocks with

positive alphas and selling those with negative alphas
§ investors who are aware of this fact will alter their investments in
order to make their portfolios efficient
§ whilst doing so, prices will be affected and alphas will shrink
towards zero
A Stock‘s Alpha
§ when market portfolio is efficient, all stocks are on security
market line and have an alpha of zero
§ when stock‘s alpha is not zero, investors can improve upon

performance of market portfolio
§ Sharpe ratio of a portfolio will increase in case stocks whose

expected return exceeds their required return are bought, i.e. if
stocks with positive alphas are bought !
§ similarly, performance of a portfolio can be improved if stocks
with negative alphas are sold
Information and Rational Expectations
§ in order to benefit from buying a positive-alpha stock, there must
be someone willing to sell it
§ under CAPM assumptions of homogeneous expectations, which

states that all investors have the same information, it would seem
that all investors would be aware that stock has positive alpha
and none would be willing to sell
Information and Rational Expectations
§ in reality, however, assumption of homogeneous expectations
might not necessarily be fitting as investors have different
information and spend varying amounts of effort researching
stocks
§ yet, according to CAPM, investors should hold market portfolio;

a conclusion which does not depend on quality of an investor’s
information or respective trading skill
Rational Expectations
§ regardless of how little information an investor has access to,
she/he can guarantee himself average return and earn an alpha
of zero simply by holding market portfolio
§ no investor should thus choose a portfolio with a negative alpha
§ however, as average portfolio of all investors is market portfolio,

the average alpha of all investors is zero
§ if no investor earns a negative alpha, then no investor can earn a

positive alpha, which implies that market portfolio must be
efficient
„Roughly speaking, losses hurt twice as
much as gains make you feel good.“
Richard E. Thaler
§ as a result, CAPM does not depend on assumption of
homogeneous expectations!
§ rather, it requires only that investors have rational expectations,
which means that all investors correctly interpret and use their
own information, as well as information that can be inferred from
market prices or trades of others
§ for investor to earn positive alpha and beat market, some
investors must hold portfolios with negative alphas
§ as these investors could have earned a zero alpha by holding
market portfolio, the following, important conclusion can be
reached:
market portfolio can be inefficient (so it is possible to beat market)
only if a significant number of investors either:
1. do not have rational expectations so that they misinterpret

information and believe they are earning a positive alpha when
they are actually earning a negative alpha, or
2. care about aspects of their portfolios other than expected return

and volatility, and so are willing to hold inefficient portfolios of
securities
Behaviour of Individual Investors
§ by appropriately diversifying their portfolios, investors can
reduce risk without reducing their expected return
§ despite this evidence, empirical findings suggest that individual

investors often fail to diversify their portfolios appropriately
§ among most crucial explanations is the ‘underdiversification’

leading to individual investors choosing sub-optimal portfolios
Behaviour of Individual Investors
§ potential explanations for this behaviour is familiarity bias, i.e. the
fact that investors favour investments in companies they are
familiar with
§ another potential explanation is that investors have relative

wealth concerns and care most about performance of their
portfolio relative to that of their peers (also: fund managers)
Systematic Trading Biases
§ for the behaviour of individual investors to impact market prices,
and thus create a profitable opportunity for more sophisticated
investors, there must be predictable, systematic patterns in the
types of errors individual investors make
§ typically, investors tend to hold on to stocks that have lost value

and sell stocks that have risen in value since the time of purchase
(‘disposition effect’)
§ this possibly arises due to investors’ increased willingness to take

on risk in face of possible losses and may reflect reluctance to
admit a mistake by taking loss
Herd Behaviour
§ so far, common factors that might lead to correlated trading
behaviour by investors have been considered
§ an alternative reason why investors commit similar trading errors

is that they are actively trying to follow each other’s behaviour
§ this phenomenon, in which individuals imitate each other’s

actions, is referred to as herd behaviour
§ typically, there are several reasons why traders might herd in

their portfolio choices
Herd Behaviour
§ first, they might believe others have superior information that
they can take advantage of by copying their trades
§ this behaviour can lead to an informational cascade effect in
which traders ignore their own information hoping to profit from
the information of others
§ second possibility is that, due to relative wealth concerns,
individuals choose to herd in order to avoid the risk of under-
performing their peers
§ third, professional fund managers may face reputational risk if
they stray far from the actions of their peers
§ in order for sophisticated investors to benefit from investor
mistakes, two conditions must hold
1. mistakes must be sufficiently pervasive and persistent to affect

stock prices, i.e. investor behaviour must push prices so that non-
zero alpha trading opportunities become apparent
2. there must be limited competition to exploit these non-zero
alpha opportunities as if competition were too intense,
opportunities would quickly be eliminated before any trader
could take advantage of them in a significant way
§ in the following, it needs to be determined whether there is any

evidence that individual or professional investors can outperform
the market without taking on additional risk
Methods used in Practise
0% 25% 50% 75%
CAPM
74%
Arithmetic Average Historical
40%
Returns
Multifactor Model 33%
Dividend Discount Model 16%
Other 22%
Source: Berk, DeMarzo (2019)

3 Capital Structure

2 Risk Return VGU SUMMER 2023

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2 Risk and Return

§ different securities have different initial prices, pay different cash

§ in an attempt to make them comparable, their performance is

§ each possible return has some likelihood of occurring which is

§ the expected (or mean) return is determined as a weighted

§ variance is the expected squared deviation from the mean, and

§ otherwise, the variance increases with the magnitude of the

DIVt+1 + Pt+1 DIVt+1 Pt+1 − Pt

§ the realised return thus corresponds to the dividend yield plus

§ Average annual return is the balancing point of the empirical

§ If the probability distribution of the returns is the same over time,

§ variance is computed by the average squared deviation from the

§ standard deviation (or volatility) is then estimated as the square

§ in order to estimate the cost of capital for an investment, the

§ standard error is the standard deviation of the estimated value of

§ standard error provides an indication of how far the sample

§ the 95% confidence interval for the expected return corresponds

§ as a result of the relatively large estimation error in this case, the

§ this idea suggests that investors would not choose to hold a

§ historically, investments with higher volatility rewarded investors

§ rule of thumb: investments with higher volatility should have a

§ differentiation between a perfectly correlated risk, i.e. common

§ the averaging out of independent risks with in larger portfolio is

§ principle of diversification is routinely used in the insurance

§ independent risks are diversified in a large portfolio whereas

• firm-specific news, i.e. good or bad news about the company

• market-wide news, i.e. news about the economy as a whole

§ fluctuations of a stock‘s return that are due to market-wide news

§ e.g., risk of company losing key account can be diversified away

§ e.g., if there is inflation, all companies experience an increase in

§ this no-arbitrage argument suggests the following two, more

2. the risk premium of a security is determined by its systematic risk

§ in order to measure the systemic risk of a stock, the extent to

§ in other words, the sensitivity of the stock to systematic shocks

§ when evaluating the risk of an investment, an investor must thus

§ in exchange for bearing systematic risk, investors want to be

§ more generally, to determine how sensitive a stock is to

§ changes in the price of this portfolio will correspond to systemic

§ any such portfolio is referred to as an efficient portfolio

§ natural candidate for an efficient portfolio is the market portfolio,

§ the systematic risk of a security can then be determined by

§ the beta can reasonably accurately be determined using past

§ average beta of a stock in the market is about one, i.e. the

§ market risk premium: risk premium investors earn by holding

Market risk premium = E [RMarket] - rf

§ adjusting for beta:

§ for each € invested in the opportunity, twice that amount could

§ According to the Law of One Price, as it carries exactly twice as

§ thus, to compensate investors for the time value of their money

rI = risk-free interest rate + βI * market risk premium

§ so far, focus has been on an intuitive justification of CAPM and its

§ in the following, we shall provide more complete development of

§ a portfolio can be described by its portfolio weights, i,e. the

§ portfolio weights always add up to one, thereby representing the

§ assuming that x1, ..., xn are the portfolio weights of the n

§ then the return on the portfolio, RP, is the weighted average of

§ the expected return of a portfolio simply is the weighted average

§ amount of risk that will remain depends on degree to which

§ by combining stocks into a portfolio, risk can be reduced through

§ as prices of the stocks do not move identically, some of the risk is

§ as a result, portfolio has a lower risk than individual stocks

§ the amount of risk eliminated in portfolio depends on degree to