Recap of Chapter 10

• Risk and return trade-off: investors are compensated

with more return for more risk they have to bear.
• Risks are different: some are unique or unsystematic,
reflecting perils specific to a particular
company/industry; other are market-wide or systematic,
affecting all securities/businesses in the market.
• Investors can avoid unsystematic risk by constructing a
well-diversified portfolio, so they won’t be compensated
for bearing the unique risk.
• Investors cannot diversify away systematic risk, so they
need to be compensated for the non-diversifiable risk.
1
 Chapter 11

• Portfolio Return and Risk

• Risk and Diversification
• Measuring Market Risk
• CAPM and SML
• Capital Budgeting

2
 Portfolio Return and Risk
• Example (contd.)
– Below we see the return table expanded to include the
portfolio (75% auto and 25% gold):
Rate of Return
Scenario Probability Auto Stock Gold Stock Portfolio
Recession 1/3 -8.0% 20.0% -1.0%
Normal 1/3 5.0% 3.0% 4.5%
Boom 1/3 18.0% -20.0% 8.5%

Expected Return 5.0% 1.0% 4.0%

Standard Deviation 10.6% 16.4% 3.9%

3
 Portfolio Return and Risk

• Portfolio Return and Risk

– The portfolio return will be the weighted average of the
returns on the individual assets.
• The weight will be equal to the proportion of the
portfolio invested in each asset.
E ( RP ) = w1  E ( R1 ) + w2  E ( R2 ) + L + wN  E ( RN )

– However, the portfolio standard deviation will not be

the weighted average of the standard deviations on
the individual assets.

4
 Portfolio Return and Risk
• Portfolio Return
– Weighted average of the returns on the individual
assets:
5% x 0.75 + 1% x 0.25 = 4%

• Portfolio Risk
– However, the portfolio standard deviation is not a
weighted average of individual standard deviations
10.6% x 0.75 + 16.4% x 0.25 = 12.05% x
𝜎𝑝 = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝝆𝟏𝟐 𝜎1 𝜎2
√
5
 Risk and Diversification

• Diversification
– Diversification reduces risk in a portfolio because the
assets in the portfolio do not move in exact lock step
with each other.
– When one stock is doing poorly, the other is doing well,
helping to offset the negative impact on return of the
stock with the poorer performance.
– The correlation coefficient, “rho” (), quantifies the
degree to which two assets move together.

6
 Risk and Diversification

• Correlation Coefficient, “rho” ()

– A measure of how closely two variables move together.
– The correlation coefficient is always a number between
-1 and +1.
• If  > 0, positively correlated; move in the same
direction;
• If  < 0, negatively correlated; move in the opposite
direction;
• If  = 0, uncorrelated; no relationship between the
movement of one variable and the other.
7
 Risk and Diversification

• Standard Deviation
– In the previous Auto and Gold stock example

𝜎𝑝 = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝝆𝟏𝟐 𝜎1 𝜎2

0.0392 = 0.752 x 0.1062 +0.252 x 0.1642

+ 2x0.75x0.25x 12 x0.106x0.164
12 = -0.994
– The closer 12 is to -1, the greater the benefit from
diversification, and the lower the risk of the portfolio.

8
 Risk and Diversification


• Implications
– As long as the returns of the two
0.2 securities are not perfectly
12 = −1 2 positively correlated (𝜌 < 1),
there will be diversification
12 = 0
benefits in term of risk-return
0.1
12 = 1 trade-off.
1
– If the returns of two securities
12 = −1 are perfectly negatively
correlated (𝜌 = −1), , a risk-free
0 0.1 0.2 0.3 0.4 0.5  portfolio can be formed by
allocating investment funds
between the two securities in a
specific way. 9
 Risk and Diversification

• Exercise 1
Mr. Anderson holds the following portfolio:
Dollar Expected Return Return
Stock
amount return SD correlation
AAA $40,000 8% 15%
0.5
BBB $60,000 12% 20%

1) What is the expected return for his portfolio?

2) What is the portfolio’s standard deviation?

10
 Measuring Market Risk

• Total Risk
– Standard deviation or variance measures total risk.
– Since we can eliminate firm specific risk through
diversification we will not be rewarded for it (no risk
premium).
– As we will not be rewarded for total risk, standard
deviation is not a relevant risk variable.
– We need to find a way to measure market risk, it is
the only risk we will be rewarded for; the only risk for
which we receive a risk premium.

11
 Measuring Market Risk

• Systematic Risk
– Market risk is measured by something we call Beta β.
– We can measure a stock’s beta and use it to estimate
the required return of the stock.
– Beta is defined as the sensitivity of a stock’s return
to the return of the market.
– A stock’s beta (β) is the percentage change in its
return that we expect for each 1% change in the
market’s return.

12
 Measuring Market Risk

• The Market Portfolio

– In theory, the market portfolio should contain all the
assets in the world economy.
• Not just stocks, but bonds, foreign securities, real
estate, etc.
– In reality, financial analysts use indices of the stock
market,
• S&P/TSX Composite Index as proxies for the
market portfolio in Canada.
• S&P 500 as proxies in the United States
– The market portfolio is used as a benchmark to
measure the systematic risk of individual stocks.
13
 Measuring Market Risk

• Estimating Beta
Return to stock j vs
return to market
Calculating Beta
1.5
Stock Return (%)

1 = slope of
0.5 line = 0.804

-1.5 -1 -0.5 0.5 1 1.5

-0.5

-1
Market Return (%) 14
 Measuring Market Risk

• Mathematically, the beta of an asset is given by

SD( Ri )
i = Corr ( Ri , RM ) 
SD( RM )
• It depends on:
1. The correlation of the asset with the market portfolio
2. The return standard deviation of the asset relative to
the market portfolio
• The beta of any investment portfolio is the
weighted average of the betas for each asset in
it
 P = w1  1 + w2   2 + L + wN   N
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 Measuring Market Risk

• Example
– If the weights will be 50% of Inco and 50% of Royal
Bank in your portfolio.
– The beta of Inco is 1.47.
– The beta of Royal Bank is 0.49.
– What is the Beta of the portfolio?
 p = w11 + w2  2
 p = 0.5 1.47 + 0.5  0.49 = 0.98

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 Measuring Market Risk

• What does beta tell us?

– A beta of 1 implies the asset
has the same systematic risk
as the overall market
– A beta < 1 implies the asset
has less systematic risk than
the overall market
– A beta > 1 implies the asset
has more systematic risk
than the overall market

17
 Measuring Market Risk
• Beta Coefficients for Selected Industries and Companies

18
 CAPM and SML

• Market Risk Premium

– Risk premium of market portfolio.
– Difference between market return and return on risk-
free Treasury bills.
– Unit reward of bearing the systematic risk
• Benchmark Betas
– Since the return on a t-bill is fixed and unaffected by
what happens in the market; the beta of the risk-free
asset is zero.
– By definition, the beta of the market portfolio is one.

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 CAPM and SML

• Capital Asset Pricing Model (CAPM)

– Theory of the relationship between risk and return
which states that the expected risk premium on any
security equals its beta times the market risk
premium.
E (ri ) = R f +  i ( E (rm ) − R f )

We measure the risk premium by this

expression when we calculate the
expected/required return of a stock (later a
capital budgeting project).
– Proposed by William Sharpe, a Nobel Laureate
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 CAPM and SML

• Factors affecting expected return

– Pure time value of money – measured by the risk-free
rate
– Reward for bearing systematic risk – measured by the
market risk premium
– Amount of systematic risk – measured by beta

E (ri ) = R f +  i ( E (rm ) − R f )

21
 CAPM and SML

• Example
– What is the expected return/required return for this
investment:
• Beta of 0.5
• A t-bill returns 4%
• The market returns 11%

E (ri ) = R f +  i ( E (rm ) − R f )
E (ri ) = 4% + 0.5(11% − 4%)
E (ri ) = 7.5%

22
 CAPM and SML

• Exercise 2
– The risk-free rate is 4.5% and the market risk
premium is 8.5%. You are interested in the following
two stocks, Innovate Pharmaceutical and Kostco Inc.
Their beta estimates are 1.3 and 0.8, respectively.
1. What are the expected returns of these two
firms?
2. What would be the beta and expected return for
a portfolio consisting of 40% of Innovate
Pharmaceutical and 60% of Kostco Inc?

23
 CAPM and SML

• Exercise 3
– If the market is correctly pricing assets following the
CAPM, what is the beta and expected return for this
portfolio?
Asset Amount Beta E(R)
Risk-free asset $30,000 ? 4%
IKKEA Inc. $20,000 0.8 12%
Market index fund $50,000 ? ?__

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CAPM and SML

Security Market Line

25
 CAPM and SML

• Security Market Line (SML)

– The graph showing the relationship between the
market risk of the security and its expected return is
called the Security Market Line (SML).
– According to the CAPM, expected rates of return for all
securities and all portfolios lie on the SML.
– In equilibrium, all securities and portfolios must have
the same reward-to-risk ratio and they all must equal
the reward-to-risk ratio for the market.
E (ri ) − R f E (rm ) − R f
=
i m
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 CAPM and SML

• Example
– For example, you are looking at investing in security
with a beta of 2.3 and at the same time a Bay Street
analyst says you would get 16%. A t-bill returns 4%
and the market returns 11%.
– Should you buy the stock?

• Answer
– Expected return = 4% + 2.3 x (11% - 4%) = 20.1%.
– An asset with a beta of 2.3 should yield 20.1%.
– According to the analyst, this security is yielding only
16%.
27
 CAPM and SML

25.0%
Expected Return (%)

20.0%
15.0%
10.0%
5.0% Proposed Holding
0.0%
0 0.5 1 1.5 2 2.3
Beta of Asset
28
 CAPM and SML

• Answer (contd.)
– Is this asset underpriced or overpriced?
• It is overpriced.
• (When the actual return is below the SML, it is
overpriced, and vice versa.)

– Should you buy the stock?

• No one would buy it because the expected return is
insufficient for the risk.

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 CAPM and SML

• How Well Does the CAPM Work?

– Studies have found the CAPM is too simple to capture
exactly how stock markets work.
– However :
• Investors require extra return for taking on risk.
• Investors appear to be concerned primarily with the
market risk they cannot eliminate by diversification.
– Thus the CAPM is a good rule of thumb for pricing
assets.
– Alternative pricing models include Arbitrage Pricing
Theory, Fama-French 3-factor Model, etc.
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 Capital Budgeting

• Using the CAPM to Estimate Project Returns

– You can use the CAPM to estimate the discount rate
for new capital projects or any equity investments.
– For example, Firm BBB has a beta of 1.25. A t-bill
returns 4% and the market returns 11%.
Expected Return = 4% + 1.25x(11% - 4%) = 12.75%
– The CAPM is the most common approach for
estimating the cost of equity capital.
– In Chapter 12, you will further learn how to estimate
the cost of debt and finally the WACC.
31
 Review Exercises
1. A firm purchases a Class 8 equipment for $1,000,000 (CCA Rate
20%) for a 10-year project. What will be the CCA tax shield in year
4? The tax rate is 35%. The half-year rule is in effect. ($40,320)
2. You decide to take out a 25-year mortgage for $375,000 at 5%
APR, compounded semi-annually. You will make monthly
payments at the end of each month. What will your monthly
payments? ($2,181.02)
3. Heavy Metal Corporation is expected to generate free cash flows
of $53 million, $68 million, $78 million, $75 million, $82 million from
Year 1 to Year 5, respectively. Thereafter, the FCFs are expected
to grow at the industry average of 4% per year. Use the discounted
free cash flow model and a WACC of 14% to estimate:
1) The enterprise value of Heavy Metal ($681.37 million)
2) Heavy Metal’s share price if the company has no excess cash,
debt of $300 million, and 40 million shares outstanding. ($9.53)
32