Return, Risk, and The Capital Asset Pricing Model

Chapter 11
Return, Risk, and the Capital Asset Pricing Model
Copyright © 2019 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Key Concepts and Skills
 Know how to calculate expected returns
 Know how to calculate covariances, correlations, and
betas
 Understand the impact of diversification
 Understand the systematic risk principle
 Understand the security market line
 Understand the risk-return tradeoff
 Be able to use the Capital Asset Pricing Model

11-2
Chapter Outline
11.1 Individual Securities

11.2 Expected Return, Variance, and Covariance
11.3 The Return and Risk for Portfolios
11.4 The Efficient Set for Two Assets
11.5 The Efficient Set for Many Securities
11.6 Diversification
11.7 Riskless Borrowing and Lending
11.8 Market Equilibrium
11.9 Relationship between Risk and Expected Return
(CAPM)
11-3
11.1 Individual Securities
 The characteristics of individual securities that are of
interest are the:
◦ Expected Return
◦ Variance and Standard Deviation
◦ Covariance and Correlation (to another security or index)

11-4
11.2 Expected Return, Variance, and
Covariance
Consider the following two risky asset world. There is
a 1/3 chance of each state of the economy, and the only
assets are a stock fund and a bond fund.
Rate of Return
Scenario Probability Stock Fund Bond Fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

11-5
Expected Return – I
Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

11-6
Expected Return – II
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Variance 0.0205 0.0067
E(rS )  1 3  (7%)  1 3  (12%)  1 3  (28%)

E(rS )  11%
11-7
Variance – I
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Variance 0.0205 0.0067
(7% 11%)  .0324 2

11-8
Variance – II
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Variance 0.0205 0.0067
1
.0205  (.0324  .0001 .0289)
3
11-9
Standard Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Variance 0.0205 0.0067
14.3%  0.0205
11-10
Covariance
Stock Bond
Scenario Deviation Deviation Product Weighted
Recession -18% 10% -0.0180 -0.0060
Normal 1% 0% 0.0000 0.0000
Boom 17% -10% -0.0170 -0.0057
Sum -0.0117
Covariance -0.0117
“Deviation” compares return in each state to the expected return.

“Weighted” takes the product of the deviations multiplied by the
probability of that state.

11-11
Correlation
Cov(a,b)

 a b
.0117
  0.998
(.143)(.082)

11-12
11.3 The Return and Risk for Portfolios
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Variance 0.0205 0.0067
Note that stocks have a higher expected return than bonds and
higher risk. Let us turn now to the risk-return tradeoff of a
portfolio that is 50% invested in bonds and 50% invested in
stocks.
11-13
Portfolios – I
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012
Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The rate of return on the portfolio is a weighted average of the

returns on the stocks and bonds in the portfolio:
rP  w B rB  w S rS
5 %  50 %  (  7 %)  50 %  (17 % )
11-14
Portfolios – II
Rate of Return
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Variance 0.0205 0.0067 0.0010
The expected rate of return on the portfolio is a weighted average

of the expected returns on the securities in the portfolio.
E (rP )  w B E (rB )  w S E (rS )
9%  50%  (11%)  50%  (7%)
11-15
Portfolios – III
Rate of Return
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Variance 0.0205 0.0067 0.0010
The variance of the rate of return on the two risky assets portfolio
is
+ 2)
where BS is the correlation coefficient between the returns on the

stock and bond funds.
11-16
Portfolios – IV
Rate of Return
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Variance 0.0205 0.0067 0.0010
Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50% in bonds)
has less risk than either stocks or bonds held in isolation. This is
not always the case.

11-17
11.4 The Efficient Set for Two Assets – I
Portfolio R eturn
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2% Portfolio Risk and Return Combinations
10% 5.9% 7.4%
15% 4.8% 7.6% 100%
12.0%
20% 3.7% 7.8% 11.0% stocks
10.0%
25% 2.6% 8.0% 9.0%
30% 1.4% 8.2% 8.0%
35% 0.4% 8.4%

7.0% 100%
6.0%
40% 0.9% 8.6% 5.0% bonds

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
45% 2.0% 8.8%
50.00% 3.08% 9.00% Portfolio Risk (standard deviation)
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70%
75%
7.6%
8.7%
9.8%
10.0%
We can consider other portfolio
80% 9.8% 10.2% weights besides 50% in stocks and
85% 10.9% 10.4%
90% 12.1% 10.6% 50% in bonds.
95% 13.2% 10.8%
100% 14.3% 11.0%

11-18
The Efficient Set for Two Assets – II
Portfolio R eturn
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2% Portfolio Risk and Return Combinations
10% 5.9% 7.4%
15% 4.8% 7.6%
12.0%
20% 3.7% 7.8% 11.0% 100%
25% 2.6% 8.0% 10.0%
30% 1.4% 8.2% 9.0% stocks

8.0%
35% 0.4% 8.4% 7.0%
40% 0.9% 8.6% 6.0%

100%
5.0%
45% 2.0% 8.8% 0.0% 2.0% 4.0% 6.0% 8.0%
bonds
10.0% 12.0% 14.0% 16.0%
50% 3.1% 9.0%

55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2% Note that some portfolios are
85% 10.9% 10.4%
90% 12.1% 10.6% “better” than others. They have
95%
100%
13.2%
14.3%
10.8%
11.0%
higher returns for the same level
of risk or less.
11-19
Portfolios with Various Correlations
return 100%
 = -1.0 stocks
 = 1.0
100%  = 0.2
bonds

 Relationship depends on correlation coefficient.
-1.0 < r < +1.0
 If r = +1.0, no risk reduction is possible.
 If r = –1.0, complete risk reduction is possible.

11-20
11.5 The Efficient Set for Many
Securities - I
return
Individual
Assets
P
Consider a world with many risky assets; we can still identify the
opportunity set of risk-return combinations of various portfolios.

11-21
The Efficient Set for Many Securities – II
return t fro
n t ier
i e n
c
effi
minimum
variance
portfolio
Individual Assets
P
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.

11-22
Announcements, Surprises, and
Expected Returns – I

The return on any security consists of two parts.
◦ First, the expected returns
◦ Second, the unexpected or risky returns
 A way to write the return on a stock in the coming
month is:
R  R U
where
R is the expected part of the return
U is the unexpected part of the return
11-23
Announcements, Surprises, and
Expected Returns – II
 Any announcement can be broken down into two
parts, the anticipated (or expected) part and the
surprise (or innovation):
◦ Announcement = Expected part + Surprise.
 The expected part of any announcement is the part of the

information the market uses to form the expectation, R, of the
return on the stock.
 The surprise is the news that influences the unanticipated
return on the stock, U.

11-24
Diversification and Portfolio Risk
 Diversification can substantially reduce the
variability of returns without an equivalent reduction
in expected returns.
 This reduction in risk arises because worse than
expected returns from one asset are offset by better

than expected returns from another.
 However, there is a minimum level of risk that cannot
be diversified away, and that is the systematic

portion.

11-25
Portfolio Risk and Number of Stocks
In a large portfolio the variance terms are
 effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
11-26
Risk: Systematic and Unsystematic
 A systematic risk is any risk that affects a large
number of assets, each to a greater or lesser degree.
 An unsystematic risk is a risk that specifically affects
a single asset or small group of assets.
 Unsystematic risk can be diversified away.
 Examples of systematic risk include uncertainty
about general economic conditions, such as GNP,
interest rates or inflation.
 On the other hand, announcements specific to a
single company are examples of unsystematic risk.

11-27
Total Risk
 Total risk = systematic risk + unsystematic risk
 The standard deviation of returns is a measure of total
risk.
 For well-diversified portfolios, unsystematic risk is
very small.
 Consequently, the total risk for a diversified portfolio
is essentially equivalent to the systematic risk.

11-28
Optimal Portfolio with a Risk-Free Asset
return 100%
stocks
rf
100%
bonds

In addition to stocks and bonds, consider a world that
also has risk-free securities like T-bills.

11-29
11.7 Riskless Borrowing and Lending – I
L
return CM 100%
stocks
Balanced
fund
rf
100%
bonds

Now investors can allocate their money across the T-

bills and a balanced mutual fund.

11-30
Riskless Borrowing and Lending – II
return
L
CM efficient frontier
rf
P
With a risk-free asset available and the efficient frontier

identified, we choose the capital allocation line with
the steepest slope.
11-31
11.8 Market Equilibrium – I
return
L
CM efficient frontier
rf
P
With the capital allocation line identified, all investors choose a point
along the line—some combination of the risk-free asset and the market
portfolio M. In a world with homogeneous expectations, M is the same
for all investors.
11-32
Market Equilibrium – II
L
return CM 100%
stocks
Balanced
fund
rf
100%
bonds

Where the investor chooses along the Capital Market
Line depends on her risk tolerance. The big point is
that all investors have the same CML.
11-33
Risk When Holding the Market
Portfolio
 Researchers have shown that the best measure of the
risk of a security in a large portfolio is the beta (b) of
the security.
 Beta measures the responsiveness of a security to
movements in the market portfolio (i.e., systematic

risk).
Cov(Ri,RM )
i 
 (RM )
2

11-34
Estimating b with Regression
Security Returns
i ne
t i cL
ri s
c te
ara
Ch Slope = bi
Return on
market %
Ri = a i + biRm + ei
11-35
The Formula for Beta
Cov(Ri,RM )  (Ri )
i  
 (RM )
2
 (RM )
Clearly, your estimate of beta will depend upon your
choice of a proxy for the market portfolio.


11-36
11.9 Relationship Between Risk and
Expected Return (CAPM)
 Expected Return on the Market:
R M  RF  Market Risk Premium

 Expected 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.
11-37
Expected Return on a Security
 This formula is called the Capital Asset Pricing
Model (CAPM):
R i  RF  i  (R M  RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
◦ Assume bi = 0, then the expected return is RF.
◦ Assume bi = 1, then

11-38
Relationship Between Risk & Return - I
Expected return
R i  RF  i  (R M  RF )
RM
 RF
1.0 b

11-39
Relationship Between Risk & Return – II
Expected return
13.5%
3%
 1.5 b
i  1.5 RF  3% R M  10%
 R i  3 %  1 . 5  (10 %  3 %)  13 . 5 %
11-40
Quick Quiz
 How do you compute the expected return and
standard deviation for an individual asset? For a
portfolio?
 What is the difference between systematic and
unsystematic risk?
 What type of risk is relevant for determining the
expected return?
 Consider an asset with a beta of 1.2, a risk-free rate
of 5%, and a market return of 13%.

◦ What is the expected return on the asset?
11-41

Return, Risk, and The Capital Asset Pricing Model

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Chapter 11

Return, Risk, and the Capital Asset Pricing Model

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

11.1 Individual Securities

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

E(rS )  1 3  (7%)  1 3  (12%)  1 3  (28%)

(7% 11%)  .0324 2

Copyright © 2019 McGraw-Hill Education. All rights reserved.

“Deviation” compares return in each state to the expected return.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Expected return 11.00% 7.00% 9.0%

The rate of return on the portfolio is a weighted average of the

Expected return 11.00% 7.00% 9.0%

The expected rate of return on the portfolio is a weighted average

Expected return 11.00% 7.00% 9.0%

where BS is the correlation coefficient between the returns on the

Expected return 11.00% 7.00% 9.0%

Observe the decrease in risk that diversification offers.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

30% 1.4% 8.2% 8.0%

35% 0.4% 8.4%

40% 0.9% 8.6% 5.0% bonds

Copyright © 2019 McGraw-Hill Education. All rights reserved.

30% 1.4% 8.2% 9.0% stocks

40% 0.9% 8.6% 6.0%

50% 3.1% 9.0%

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

 The expected part of any announcement is the part of the

Copyright © 2019 McGraw-Hill Education. All rights reserved.

expected returns from one asset are offset by better

be diversified away, and that is the systematic

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

is essentially equivalent to the systematic risk.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Now investors can allocate their money across the T-

Copyright © 2019 McGraw-Hill Education. All rights reserved.

With a risk-free asset available and the efficient frontier

movements in the market portfolio (i.e., systematic

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

R M  RF  Market Risk Premium

Market Risk Premium

This applies to individual securities held within

Copyright © 2019 McGraw-Hill Education. All rights reserved.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

of 5%, and a market return of 13%.

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