Financial Management:: Risk and Return - Capital Market Theory

Financial Management:
Principles & Applications

Fourteenth Global Edition
Chapter 8
Risk and Return—
Capital Market
Theory
Copyright ©
Copyright © 2021
2021 Pearson
Pearson Education
Education Ltd.
Ltd.
Learning Objectives
1. Calculate the expected rate of return and
volatility for a portfolio of investments and
describe how diversification affects the returns to
a portfolio of investments.
2. Understand the concept of systematic risk for an
individual investment and calculate portfolio
systematic risk (beta).
3. Estimate an investor’s required rate of return
using the Capital Asset Pricing Model.
Copyright © 2021 Pearson Education Ltd.

Principles Applied in This Chapter
• Principle 2: There is a Risk-Return Tradeoff.
• Principle 4: Market Prices Reflect Information.

8.1 PORTFOLIO RETURNS AND PORTFOLIO RISK

Portfolio Returns and Portfolio Risk
• With appropriate diversification, you can lower the
risk of your portfolio without lowering it’s expected
rate of return.
• Those risks that can be eliminated by
diversification are not necessarily rewarded in the
financial marketplace.

Calculating the Expected Return of a
Portfolio (1 of 2)
• To calculate a portfolio’s expected rate of return,
we weight each individual investment’s expected
rate of return using the fraction of the portfolio that
is invested in each investment.

Calculating the Expected Return of a
Portfolio (2 of 2)
Portfolio Expected Rate of Return

E (rportfolio )  [W1  E (r1 )]  [W2  E (r2 )]  [W3  E (r3 )]    [Wn  E (rn )]
E(rportfolio) = the expected rate of return on a portfolio

of n assets.
Wi = the portfolio weight for asset i.
E(ri ) = the expected rate of return earned by asset i.
W1 × E(r1) = the contribution of asset 1 to the
portfolio expected return.
CHECKPOINT 8.1: CHECK YOURSELF
Calculating a Portfolio’s Expected Rate of Return
Evaluate the expected return for Penny’s portfolio where she places a quarter of her
money in Treasury bills, half in Starbucks stock, and the remainder in Emerson Electric
stock.

Step 1: Picture the Problem

Step 2: Decide on a Solution Strategy (1 of 2)
• The portfolio expected rate of return is simply a
weighted average of the expected rates of return
of the investments in the portfolio.
• We can use equation 8-1 to calculate the
expected rate of return for Penny’s portfolio.

Step 2: Decide on a Solution Strategy (2 of 2)
• We have to fill in the third column (Product) to
calculate the weighted average.
Portfolio E(Return) X Weight = Product
Treasury bills 4.0% .25 Blank
EMR stock 8.0% .25 Blank
SBUX stock 12.0% .50 Blank
• We can also use equation 8-1 to solve the

problem.

Step 3: Solve (1 of 2)

E(rportfolio) = .25 × .04 + .25 × .08 + .50 × .12

= .09 or 9%

Alternatively, we can fill out the following table from
step 2 to get the same result.
Portfolio E(Return) X Weight = Product
Treasury bills 4.0% .25 1%
EMR stock 8.0% .25 2%
SBUX stock 12.0% .50 6%
Expected Return on Portfolio Blank Blank 9%

Step 4: Analyze
• The expected return is 9% for a portfolio
composed of 25% each in treasury bills and
Emerson Electric stock and 50% in Starbucks.
• If we change the percentage invested in each
asset, it will result in a change in the expected
return for the portfolio.

Evaluating Portfolio Risk: Portfolio
Diversification
• The effect of reducing risks by including a large
number of investments in a portfolio is called
diversification.
• The diversification gains achieved will depend on
the degree of correlation among the
investments, measured by correlation
coefficient.

Portfolio Diversification
The correlation coefficient can range from −1.0
(perfect negative correlation), meaning that two
variables move in perfectly opposite directions to
+1.0 (perfect positive correlation). Lower the
correlation, greater will be the diversification
benefits.

Diversification Lessons
1. A portfolio can be less risky than the average
risk of its individual investments.
2. The key to reducing risk through diversification is
to combine investments whose returns are not
perfectly positively correlated.

Calculating the Standard Deviation of a
Portfolio’s Returns
 portfolio  W12 12  W22 22  2W1W2 1,2 1 2
Important Definitions and Concepts:
• Portfolio = the standard deviation in portfolio returns.
• W1, W2, and W3 = the proportions of the portfolio that are invested in assets 1, 2, and 3, respectively.
• 1,  2, and  3 = the standard deviations in the rates of return earned by assets 1, 2, and 3, respectively.
• i, j = the correlation between the rates of return earned by assets i and j. The symbol 1, 2 (pronounced
“rho”) represents correlation between the rates of return for asset 1 and asset 2.

Figure 8-1 Diversification and the Correlation Coefficient—
Apple and Coca—Cola (1 of 2)

Figure 8-1 Diversification and the Correlation Coefficient—
Apple and Coca—Cola (2 of 2)
Legend:
Correlation Expected Return Standard Deviation
−1.00 0.14 0%
−0.80 0.14 6%
−0.60 0.14 9%
−0.40 0.14 11%
−0.20 0.14 13%
0.0 0.14 14%
0.20 0.14 15%
0.40 0.14 17%
0.60 0.14 18%
0.80 0.14 19%
1.00 0.14 20%
All portfolios are comprised of equal investments in Apple and Coca-Cola shares.

The Impact of Correlation Coefficient on
the Risk of the Portfolio
We observe (from figure 8.1) that lower the
correlation, greater is the benefit of diversification.
Correlation between investment returns Diversification Benefits
+1 No benefit
0.0 Substantial benefit
−1 Maximum benefit. Indeed, the risk of portfolio

can be reduced to zero.

Evaluating a Portfolio’s Risk and Return
Evaluate the expected return and standard deviation of the portfolio of the S&P500
index fund and the international fund where the correlation is estimated to be .20 and
Sarah still places half of her money in each of the funds.

Step 1: Picture the Problem
Sarah can visualize the expected return, standard
deviation and weights as shown below, with the
need to determine the numbers for the empty
boxes.
Investment Fund Expected Return Standard Deviation Investment Weight
S&P500 fund 12% 20% 50%
International Fund 14% 30% 50%
Portfolio Blank Blank 100%

Step 2: Decide on a Solution Strategy
• The portfolio expected return is a simple weighted
average of the expected rates of return of the two
investments given by equation 8-1.
• The standard deviation of the portfolio can be
calculated using equation 8-2. We are given the
correlation to be equal to 0.20.


E(rportfolio)
= WS&P500 E(rS&P500) + WInternational E(rInternational)
= .5 (12) + .5(14)
= 13%

 portfolio  W12 12  W22 22  2W1W2 1,2 1 2
Standard deviation of Portfolio

= √ { (.52x.22)+(.52x.32)+(2x.5x.5x.20x.2x.3)}
= √ {.0385}
= .1962 or 19.62%

Step 4: Analyze
• A simple weighted average of the standard
deviation of the two funds would have resulted in
a standard deviation of 25% (20 x .5 + 30 x .5) for
the portfolio.
• However, the standard deviation of the portfolio is
less than 25% (19.62%) because of the
diversification benefits (with correlation being less
than 1).

8.2 SYSTEMATIC RISK AND THE
MARKET PORTFOLIO

Systematic Risk and Market Portfolio (1 of 3)
CAPM theory assumes that investors chose to hold
the optimally diversified portfolio that includes all of
the economy’s assets (referred to as the market
portfolio). According to the CAPM, the relevant risk
of an investment is determined by how it contributes
to the risk of this market portfolio.

To understand how an investment contributes to the
risk of the portfolio, we categorize the risks of the
individual investments into two categories:
– Systematic risk, and
– Unsystematic risk

• The systematic risk component measures the
contribution of the investment to the risk of the
market portfolio. For example: War, recession.
• The unsystematic risk is the element of risk that
does not contribute to the risk of the market and is
diversified away. For example: Product recall,
labor strike, change of management.

Diversification and Unsystematic Risk
Figure 8-2 illustrates that, as the number of
securities in a portfolio increases, the contribution of
the unsystematic risk to the standard deviation of
the portfolio declines while the systematic risk is not
reduced. Thus large portfolios will not be affected by
unsystematic risk.

Figure 8.2 Portfolio Risk and the Number of Investments in
the Portfolio

Systematic Risk and Beta
Systematic risk is measured by beta coefficient,
which estimates the extent to which a particular
investment’s returns vary with the returns on the
market portfolio. In practice, it is estimated as the
slope of a straight line (see figure 8-3).

Figure 8.3 Estimating Home Depot’s (HD) Beta Coefficient
(1 of 2)

Figure 8.3 Estimating Home Depot’s (HD) Beta Coefficient
(2 of 2)
Observation Date S&P 500 Return Home Depot Stock Return
1 Nov-10 −0.23% −1.47%
2 Dec-10 6.53% 16.05%
3 Jan-11 2.26% 4.88%
4 Feb-11 3.90% 1.90%
5 Mar-11 −0.10% −0.43%
6 Apr-11 2.85% 0.24%
7 May-12 −1.35% −2.34%
8 Jun-12 −1.83% 0.52%
9 Jul-12 −2.15% −3.56%
10 Aug-12 −5.68% −3.72%
11 Sep-12 −7.18% −1.53%
12 Oct-12 10.77% 8.91%

Table 8.1 Beta Coefficients for Selected Companies
Company Yahoo Finance Microsoft Money

(Yahoo.com) Central (MSN.com)
Computers and Software Blank Blank
Apple Inc. (AAPL) 2.90 2.58
Hewlett Packard (HPQ) 1.27 1.47
Utilities Blank Blank
American Electric Power Co. (AEP) 0.74 0.73
Duke Energy Corp. (DUK) 0.40 0.56
Centerpoint Energy (CNP) 0.82 0.91

Beta
Table 8-1 illustrates the wide variation in Betas for
various companies. Utilities companies can be
considered less risky because of their lower betas.
For example, based on the beta estimates, a 1%
drop in market could lead to a .74% drop in AEP but
a much greater 2.9% drop in AAPL.

Calculating Portfolio Beta (1 of 2)
The portfolio beta measures the systematic risk of
the portfolio.
 Proportion of Beta for   Proportion of Beta for   Proportion of Beta for 

Portfolio      
  Portfolio Invested  Asset 1    Portfolio Invested  Asset 2      Portfolio Invested  Asset n 
Beta  in Asset 1 (W )
 1 ( 1 )   in Asset 2 (W2 ) ( 2 )   in Asset n (W )
 n (  n ) 

Calculating Portfolio Beta (2 of 2)
Example Consider a portfolio that is comprised of
four investments with betas equal to 1.50, 0.75,
1.80 and 0.60 respectively. If you invest equal
amount in each investment, what will be the beta for
the portfolio?
= .25(1.50) + .25(0.75) + .25(1.80) + .25 (0.60)
= 1.16

8.3 THE SECURITY MARKET LINE AND THE CAPM

The Security Market Line and the CAPM
(1 of 3)
• CAPM describes how the betas relate to the

expected rates of return. The key insight of CAPM
is that investors will require a higher rate of return
on investments with higher betas.
• Figure 8-4 provides the expected returns and
betas for portfolios comprised of market portfolio
and risk-free asset.

Figure 8.4 Risk and Return for Portfolios Containing the
Market and the Risk—Free Security (1 of 2)

Figure 8.4 Risk and Return for Portfolios Containing the
Market and the Risk—Free Security (2 of 2)
Legend: Blank Blank Blank
% Market Portfolio, % Risk-Free Portfolio Beta, Expected Portfolio

WM Asset, Wrf βPortfolio Return, E(rPortfolio)
0% 100% 0.0 6.0%
20% 80% 0.2 7.0%
40% 60% 0.4 8.0%
60% 40% 0.6 9.0%
80% 20% 0.8 10.0%
100% 0% 1.0 11.0%
120% −20% 1.2 12.0%

(2 of 3)
• CAPM describes how the betas relate to the

expected rates of return. The key insight of CAPM
is that investors will require a higher rate of return
on investments with higher betas.
• Figure 8-4 provides the expected returns and
betas for portfolios comprised of market portfolio
and risk-free asset.

(3 of 3)
SML is a graphical representation of the CAPM.

SML can be expressed as the following equation,
which is often referred to as the CAPM pricing
equation:
E (rAsset j )  rf   Asset j [E (rMarket )  rf ]

Using the CAPM to Estimate the Expected
Rate of Return
Equation 8-6 implies that higher the systematic risk
of an investment, other things remaining the same,
the higher will be the expected rate of return an
investor would require to invest in the asset.

Estimating the Expected Rate of Return Using the CAPM
Estimate the expected rates of return for the three utility companies, found in Table 8-
1, using the 4.5% risk-free rate and market risk premium of 6%.

Step 1: Picture the Problem (1 of 2)

Step 1: Picture the Problem (2 of 2)
The graph shows that as beta increases, the
expected return also increases. When beta = 0, the
expected return is equal to the risk free rate of
4.5%.

Step 2: Decide on a Solution Strategy
We can determine the required rate of return by
using CAPM equation 8-6. The betas for the three
utilities companies (Yahoo Finance estimates) are:
AEP = 0.74, DUK = 0.40, CNP = 0.82

E (rAsset j )  rf   Asset j [E (rMarket )  rf ]
• Beta (AEP) = 4.5% + 0.74(6) = 8.94%

• Beta (DUK) = 4.5% + 0.40(6) = 6.9%
• Beta (CNP) = 4.5% + 0.82(6) = 9.42%

Blank Beta Yahoo MSN E(r ) Yahoo MSN
Apple Inc. (APPL) 2.90 2.58 21.90% 19.98%
Hewlett Packard (HPQ) 1.27 1.47 12.12% 13.32%

Step 4: Analyze
The expected rates of return on the stocks vary
depending on their beta. Higher the beta, higher is
the expected return.

Key Terms (1 of 2)
• Beta coefficient
• Capital asset pricing model (CAPM)
• Correlation coefficient
• Diversification
• Diversifiable risk
• Market portfolio
• Market risk premium

Key Terms (2 of 2)
• Non-diversifiable risk
• Portfolio beta
• Security market line
• Systematic risk
• Unsystematic risk

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Financial Management:

Principles & Applications

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

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Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Portfolio Expected Rate of Return

E(rportfolio) = the expected rate of return on a portfolio

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Portfolio E(Return) X Weight = Product

Treasury bills 4.0% .25 Blank

EMR stock 8.0% .25 Blank

SBUX stock 12.0% .50 Blank

• We can also use equation 8-1 to solve the

Copyright © 2021 Pearson Education Ltd.

Portfolio Expected Rate of Return

E(rportfolio) = .25 × .04 + .25 × .08 + .50 × .12

Copyright © 2021 Pearson Education Ltd.

Portfolio E(Return) X Weight = Product

Treasury bills 4.0% .25 1%

EMR stock 8.0% .25 2%

SBUX stock 12.0% .50 6%

Expected Return on Portfolio Blank Blank 9%

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

 portfolio  W12 12  W22 22  2W1W2 1,2 1 2

Important Definitions and Concepts:

• Portfolio = the standard deviation in portfolio returns.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Correlation between investment returns Diversification Benefits

0.0 Substantial benefit

−1 Maximum benefit. Indeed, the risk of portfolio

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

S&P500 fund 12% 20% 50%

International Fund 14% 30% 50%

Portfolio Blank Blank 100%

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Portfolio Expected Rate of Return

Copyright © 2021 Pearson Education Ltd.

 portfolio  W12 12  W22 22  2W1W2 1,2 1 2

Standard deviation of Portfolio

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

1 Nov-10 −0.23% −1.47%

2 Dec-10 6.53% 16.05%