CHAPTER 6

Risk, Return, and the Capital

Asset Pricing Model

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Topics in Chapter
 Basic return concepts
 Basic risk concept
 Calculating Expected Return
 Calculating Expected Risk
 Risk and return: CAPM/SML

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What are investment returns?
 Investment returns measure the
financial results of an investment.
 Returns may be historical or expected
(anticipated for future with
probabilities).
 Returns can be expressed in:
 Dollar terms.
 Percentage terms.
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 An investment costs $1,000 and is
sold after 1 year for $1,100.

Dollar return:
$ Received - $ Invested
$1,100 - $1,000 = $100.
Percentage return:
$ Return/$ Invested
$100/$1,000 = 0.10 = 10%.
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What is risk?
 Risk is any unexpected change in
expected return.
 There is a positive relationship between
return & risk.
 The greater the chance of a high return
from investment, the greater the risk.

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Probability Distribution: Which
stock is riskier? Why?

Stock A
Stock B

-30 -15 0 15 30 45 60
Returns (%)

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Types of Risk
 There are 2 types of Risk
 Systematic risk or Market Risk or Non-
Diversifiable Risk.
 Unsystematic Risk or Company Specific
Risk or Diversifiable Risk.
Types of Risk
 Systematic risk or Market risk of Non-
Diversifiable risk: this is the type of risk
that cannot be controlled by an investor
by increasing the investment in many
different stocks in the market.
 It is the type of risk that affects the
market as a whole.
Types of risk
 Examples of systematic or market risk
are inflation rate risk, political risk,
economic risk etc…
 Market risk could never be eliminated,
but it could be decreased only through
international investment.
Types of Risk
 Unsystematic risk or Company Specific
risk or Diversifiable risk: this is the type
or risk that can be controlled or
decreased by an investor by increasing
investment in many different stocks in
the market.
 It is the type of risk that affects a
specific company, not the whole
market!
Unsystematic Risk
 Examples of unsystematic risk include:
bad management, liquidity risk,
profitability risk etc…
 Company specific risk could be
completely eliminated by creating
efficient portfolios (increasing
investments in many different stocks
from many different companies in the
market).
 Risk vs. Number of Stocks in a
Portfolio
p
Company Specific
35%
(Diversifiable) Risk

20%
Market Risk

0
10 20 30 40 2,000 stocks
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 Consider the Following
Investment Alternatives
Econ. Prob. T-Bill Alta Repo Am F. Market
- -
Recession 0.10
8.0% 22.0% 28.0% 10.0% 13.0%
-
Below avg. 0.20 -2.0 1.0
8.0 14.7 10.0

Avg. 0.40 20.0 0.0 7.0

8.0 15.0
-
Above avg. 0.20 35.0
8.0 10.0 45.0 29.0
-
Boom 0.10 50.0
8.0 20.0 30.0 43.0
1.00 13
Alta Inds. and Repo Men vs.
the Economy
 Alta Inds. moves with the economy, so
it is positively correlated with the
economy. This is the typical situation.
 Repo Men moves counter to the
economy. Such negative correlation is
unusual.

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Calculate the expected rate of
return on each alternative.

^
r = expected rate of return.

^
r = ∑ rP.

^r = (0.10×-22) + (0.20×-2)
Alta
+ (0.40×20) + (0.20×35)
+ (0.10×50) = 17.4%. 15
Alta has the highest rate of
return. Does that make it best?
^
r
Alta 17.4%
Market 15.0
Am. Foam 13.8
T-bill 8.0
Repo Men 1.7
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What is the risk (standard
deviation) of returns for each
alternative?
σ = Standard deviation

σ = √ Variance = √ σ2

= √ ∑ ^
(r – r)2 P.

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Risk (Standard Deviation) of
Alta Industries

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Risk (Standard Deviation) of
all Investment Alternatives
T-bills = 0.0%.
 Alta = 20.0%.
 Repo = 13.4%.
 Am Foam = 18.8%.
Market = 15.3%.

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Expected Return versus Risk
Expected
Security Return Risk, 
Alta Inds. 17.4% 20.0%
Market 15.0 15.3
Am. Foam 13.8 18.8
T-bills 8.0 0.0
Repo Men 1.7 13.4

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Which Stock is the best for
investment?
 Investors are looking for the highest
return
 Investors are also looking for the lowest
risk
 Calculate Coefficient of Variation (C.V.):
this determines the amount of risk an
investor is willing to take for every 1%
of return. The stock giving the lowest
CV is the best for investment.
Coefficient of Variation (CV)

 CVT-BILLS = 0.0% / 8.0% = 0.0.

 CVAlta Inds = 20.0% / 17.4% = 1.1.
 CVRepo Men = 13.4% / 1.7% = 7.9.
 CVAm. Foam = 18.8% / 13.8% = 1.4.
 CVM = 15.3% / 15.0% = 1.0.
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Expected Return versus
Coefficient of Variation
Expected Risk: Risk:
Security Return  CV
Alta Inds 17.4% 20.0% 1.1
Market 15.0 15.3 1.0
Am. Foam 13.8 18.8 1.4
T-bills 8.0 0.0 0.0
Repo Men
1.7 13.4 7.9
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Expected Return versus & Risk given
Historical Data
 Example

Return of ABC Company Past Years

10% 2008
15% 2009
12% 2011
0% 2012
6% 2013
8% 2014

a) Calculate expected return for ABC company

b) Calculate expected risk for ABC company
c) Is ABC company better or XYZ company better, given that XYZ company
Has an expected return of 10% and risk of 6.9%.
Solution (a)
Solution (b)
 Solution (c)

Investment in ABC company is better than XYZ company, because

Investors will incur more risk for every 1% return received from
Investment in XYZ company when compared to ABC company.
Stand-alone risk = Market risk
+ Company Specific risk
 Market risk is that part of a security’s
stand-alone risk that cannot be
eliminated by diversification.
 Firm-specific, or diversifiable, risk is that
part of a security’s stand-alone risk that
can be eliminated by diversification.

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Stand-alone risk = Market risk
+ Company Specific risk
 By creating efficient portfolios, investors
could eliminate all company specific
risk.
 The only risk present in efficient
portfolios will be market risk or
systematic risk &this risk is measured
by beta (β).

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How is market risk measured
for individual securities?
 Market risk, which is relevant for stocks
held in well-diversified portfolios,
determines the relationship between a
company’s stock & the market (the
stock market index)
 It shows whether the stock is moving
with the market, moving less than the
market (stock less risky), or moving
more than the market (stock more
risky) 31
How is beta interpreted?
 If b = 1.0, stock has average risk (like
the market).
 If b > 1.0, stock is riskier than the
market.
 If b < 1.0, stock is less risky than the
market.
 Most stocks have betas in the range of
0.5 to 1.5.
 Can a stock have a negative beta? 32
Expected Return versus Market
Risk: Which investment is best?
Expected
Security Return (%) Risk, b
Alta 17.4 1.29
Market 15.0 1.00
Am. Foam 13.8 0.68
T-bills 8.0 0.00
Repo Men 1.7 -0.86

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Use the CAPM model to
calculate each alternative’s
required return (RRR).
 The Security Market Line (SML) is part
of the Capital Asset Pricing Model
(CAPM).

 SML or CAPM: RRR = rRF + (RPM)bi .

 Assume rRF = 8%; rM = 15%.
 RPM = (rM - rRF) = 15% - 8% = 7%.

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Required Rates of Return
 rAlta = 8.0% + (7%)(1.29) = 17%.
 rM = 8.0% + (7%)(1.00) = 15.0%.
 rAm. F. = 8.0% + (7%)(0.68) = 12.8%.
 rT-bill = 8.0% + (7%)(0.00) = 8.0%.
 rRepo = 8.0% + (7%)(-0.86) = 2.0%.

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 Expected versus Required
Returns (%)
Exp. Req.
r r
Alta 17.4 17.0 Undervalued
Market 15.0 15.0 Fairly valued
Am. Foam 13.8 12.8 Undervalued
T-bills 8.0 8.0 Fairly valued
Repo 1.7 2.0 Overvalued
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Impact of Inflation Change on
SML
r (%)

New SML  I = 3%
SML2

18 SML1
15
11 Original situation
8

0 0.5 1.0 1.5 Risk, bi

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 Impact of Risk Aversion
Change
r (%)
SML2
After change

18 SML1
15  RPM = 3%

8 Original situation

Risk, bi 38
1.0
Has the CAPM been completely
confirmed or refuted?
 No. The statistical tests have problems
that make empirical verification or
rejection virtually impossible.
 Investors’ required returns are based on
future risk, but betas are calculated with
historical data.
 Investors may be concerned about both
stand-alone and market risk.

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