RISK AND RETURN

INTRODUCTION
What is an investment?
Investment is current commitment of dollars for a period of time in order to derive
future payment that will compensate the investor for:
1. the time funds are committed
2. the expected rate of inflation
3. the uncertainty of the future payments
What are investment returns?
Investment returns measure the financial results of an investment.
Returns may be historical or prospective (anticipated).
Calculating the rate of return

Amount invested

Amount received Amount invested

Rate of return=

Example: (Tool Kit 2.1)

Suppose you pay $500 for an investment that returns $600 in one year. What is the
annual rate of return?
Amount invested
Amount received in one
year

$500

Dollar return

$100

Rate of return

20%

$600

If you have a known amount

dividend (D1) and realized or
security is not exceeding one
securities can be calculated as

of the initial market price (P0), realized or planned

planned selling price (P1), and a holding period of
year, then the rate of return on investment in this
follows:

Rate of return=

D 1+( P1P0 )
P1

So, this formula can be used to determine the historical rate of return for the
holding period of one year (based on the historical data) as the expected rate of

return for the holding period of one year (based on expected future dividends and
prices).
For holding periods longer than one year we have to calculated internal rate of
return, which is consistent with the principles of time value of money.
The term in brackets is called a capital gain or loss during the period.
Examples:
1. Suppose you buy 10 shares of a stock for $ 1,000. The stock pays no dividends,
but at the end of 1 year, you sell the stock for $ 1,100. What is the return on your $
1,000 investment?
P0=1,000 $
P1=1,100 $
D1=0 $
n=1

Rate of return=

1,1001,000
=0.1=10
1,000

2. At the begin of the year, the investor has bought a share of BH Telecom on the
Sarajevo Stock Exchange at a price of 25 KM. BH Telecom paid during the year a
dividend in the amount of 0.90 KM. The investor sold the share at the end of the
year for 39 KM. What is the rate of return on this investment?
P0=25 KM
D1=0,90 KM
P1=39 KM
R=?
First way: since the holding period is one year we can use the above mentioned
formula

R=

0,9+(3925)
=0.596 59.6
25

Second way: we calculate the internal rate of return or we discount all cash flows
from investments

P 0=

D1
P
+ 1
1+k 1+ k

25=

0.9 39
+
1+k 1+ k

25=

39.9
1+ k
1+k=39.9/25
1+k=1.596
k=0.596 59.6%

3. Another invester has also bought a share of BH Telecom at a price of 25 KM. He

kept the share for two years and sold it after two years for 55 KM. BH Telecom paid
during the first year a dividend in the amount of 0.90 KM and during the second
year a dividend in the amount of 1.60 KM. What is the rate of return on this
investment?
P0=25 KM
P2=55 KM
D1=0.90 KM
D2=1.6 KM
k=?

P 0=

D1
D2
P2
+
+
2
1+k (1+k ) (1+ k)2

25=

0.9
1.6
55
+
+
2
1+k (1+k ) ( 1+ k )2

25=

0.9
56.6
+
1+k (1+k )2

By introducing the following replacement (1+ k) = t we have

25=

0.9 56.6
+ 2
t
t

After multiplying the equation with t2 we have:

25t2=0.9t + 56.6
25t2-0.9t-56.6=0

t1 =

b+ b 24 ac
2a

t1 =

0.9+ 0.81+5,660 0.9+75.238355

=
=1.522767 1.52
50
50
3

1+k=t k=1.52-1=0.52 52%

What is investment risk?
For all securities, except for the risk free securities, the return expected may differ
from the return realized. So, we defined the risk as the chance that some
unfavorable event will occur. An event's probability is defined as the chance that
the event will occur. If all possible events, or outcomes, are listed, and if a
probability is assigned to each event, the listing is called a probability
distribution. The probabilities must sum to 1,0 or 100%. For risky securities the
actual rate of return can be viewed as a random variable that has a probability
distribution.
The risk of an assets cash flow can be considered:

a) on a stand-alone basis (each asset by itself) Stand alone Risk

b) in a portfolio context, where the investment is combined with other assets and
its risk is reduced through diversification

Riska portfolio context

INVESTMENT IN ONE ASSET

r^

Expected rate of return (

n

r^i=P1 r 1 + P2 r 2+ + Pn r n= Pi r i
i=1

r^i

= the expected rate of return on the ith stock

r i=

the ith possible outcome

Pi= the probability of the ith outcome

n=

the number of possible outcomes

The tighter the probability distribution, the more likely is that the actual outcome
will be close to the expected value and consequently, the less likely it is that the
actual return will end up far below the expected return. Thus, the tighter the
probability distribution of expected return, the smaller the risk of a given
investment.
The measure of tightness of the probability distribution is the standard deviation,
which we calculate as follows:
2

Variance (

r i^r

=
2

i=1

Standard deviation (

r i^r

i=1

=
The smaller the standard deviation, the tighter the probability distribution and
accordingly, the less risky the stock. The standard deviation provides an idea how
far above or below the expected value the actual value is likely to be.

Stock A

-30

-15

Stock B

15

30

45

60

Returns (%)

If a probability distribution is a normal distribution1, then we can apply six-sigma

rule:
-

the actual return will be within

1 standard deviation of the expected

2 standard deviation of the expected

3 standard deviation of the expected

return 68.26% of the time

p [ r^ X r^ + ] 68.26
-

the actual return will be within

return 9.,46% of the time

p [ r^ 2 X r^ + 2 ] 95.46
-

the actual return will be within

return 99.74% of the time

p [ r^ 3 X r^ +3 ] 99.74
Example: (Tool Kit 2.2)
An investment has a 30% chance of producing a 25% return, a 40% chance of
producing a 10% return, and a 30% chance of producing a -15% return. What is its
expected return? What is its standard deviation?
Probabilit
y

30%
40%
30%

Return
25%
10%
-15%

r^i=P1 r 1 + P2 r 2+ P3 r 3=( 0.3 0.25 ) + ( 0.4 0.1 )+ ( 0.3 (0.15 ) ) =0.07 7

= (0.250.07)2 0.30+(0.100.07)2 0.40+(0.150.07)2 0.30=0.157 15.7

2=2.46
Note:
Standard deviation can be used as an absolute measure of risk meaning that if the
standard deviation is larger, the uncertainty of the actual outcome is greater and
consequently. So if a choice has to be made between two investments that have the
same expected returns but different standard deviations, most people would choose
the one with lower standard deviation and therefore the lower risk.
1 Rate of return is continuous variable, we have large number of iterations and
because of that we will take approximation with normal distribution.
6

In order to perform comparisons of alternative investments with different expected

rates of return, you cannot use the standard deviation. In that case we use another
measure of risk called the coefficient of variation (CV) which shows the risk per unit
of return.
Coefficient of variation ( CV

CV =

r^

Example: (Tool Kit 2.2)

An investment has an expected return of 15% and a standard deviation of 30%.
What is its coefficient of variation?

CV =

30
=2
15

Using Historical data

We described the procedure for finding mean and standard deviation when data are
in the form of a known probability distribution.
But in case that we have available only data on returns realized in some past period
(

rt available we use following formula:

Annual return (

r Avg

rt

r Avg = t =1
n

Estimated

S=

( S)

(r tr Avg )2
t=1

n1

Example: (Tool Kit 2.2)

A stock's returns for past 3 years are 10%, -15% and 35%. What is the historical
average return? What is the historical sample standard deviation?

r Avg =

S=

10 + (15 ) +35
=10
3

(10 10 ) +(15 10 ) +( 35 10 )
=25
31

Exercise:
A stock's return has the following distributions:
Demand for the
Probability of This Demand
Rate of Return if This
Company's Products
Occurring
Demand Occurs (%)
Weak
0.1
50
Below average
0.2
5
Average
0.4
16
Above average
0.2
25
Strong
0.1
60
1.0

Calculate the stock's expected return, standard deviation and coefficient of

variation.
Solution:

= (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)(60%) =

11.40%.
2 = (-50% - 11.40%)2(0.1) + (-5% - 11.40%)2(0.2) + (16% - 11.40%)2(0.4) +
(25% - 11.40%)2(0.2) + (60% - 11.40%)2(0.1) = 712.44; = 26.69%

CV =

26.69%
11.40%

= 2.34

The average investor is risk averse, which means that he or she must be
compensated for holding risky assets. Therefore, riskier assets have higher required
returns than less risky assets.

INVESTMENT IN THE PORTFOLIO

Portfolio is a combination of two or more securities, currencies, real estate or other
assets held by individuals or companies. The goal of creating a portfolio is to
minimize risk through diversification.
So, portfolio of securities consists of two and / or more securities in which the
investor invests money in specific ratios to reduce the risk. Diversification of risk
8

is achieved by the successful combination of securities. The successful combination

of securities is done by selecting the securities that are each weakly correlated with
each, and whose yields move inversely. So we can use the benefits of diversification
in terms of risk reduction until the securities are not perfectly positively correlated

( 1) .
Expected return on a portfolio (

r^p

The expected return on a portfolio is weighted mean of the expected returns of

individual investments that make up the portfolio, where weights are the shares of
the money invested in each security.
n

r^p=w1 r^1 + w2 r^2 ++ wn r^n= w i r^i

i=1

r^p

= the expected return on a portfolio

r^i=

the expected returns on the individual stocks

w i= the weights
n= the number of stocks in the portfolio
Standard deviation of a portfolio (

The risk of the portfolio is as with the individual securities expressed by the
variance and standard deviation of returns. However, the risk of the portfolio is not
simply the weighted mean of individual securities standard deviations, because the
risk of a portfolio depends not only on the riskiness of the securities that make up
the portfolio, but also the relationships that exist between these securities.

p=

i=1 j=1

wi w j COV ij

w i=

share of total funds invested in security j

w j=

share of total funds invested in security i

COV ij =

covariance between the yield of the i-th and j-th security

Covariance between stock i and the stock j (

COV ij

This is a statistical measure that indicates the degree to which two variables, in this
case securities' rates of return, are moving together. Positive value means that, on
average, they are moving in the same direction.
m

COV ij = Pi ( r i ,t r^i ) ( r j ,t r^j )

t=1

( r i ,t r^i ) ( r j , t r^j )

COV ij = t =1

COV ij =ij i j
where we work with m-period sample.
Correlation coefficient (

ij

This is a standardized statistical measure of linear relationship between two

variables. The correlation coefficient (

ij

can range from +1,0, denoting that two

variables move up and down in perfect synchronization (perfect positive

correlation), to -1,0, denoting that the variables always move in exactly opposite
directions (perfect negative correlation). A correlation coefficient of zero indicates
that two variables are not related to each other.

ij =

COV ij
i j

Thus, the risk of the portfolio or portfolios or standard deviation of a portfolio (

depends on:

- variances of individual securities and the

- covariance between different pairs of securities (which are crucial for large
portfolios)
The goal of a successful diversification is the combination of securities which are
each slightly with each dependent (as measured by covariance and correlations)
and whose rates of returns move inversely.
The effect of diversification is present when the
maximum effect of diversification when

ij 1, and we have the

ij =-1.

10

TWO-STOCK PORTFOLIOS
Expected return on a portfolio (

r^p

r^p=w1 r^1 + w2 r^2

Standard deviation of a portfolio (

P= w 21 21+ 2w 1 ( 1w1 ) Cov 1,2+(1w1 ) 22

Covariance between stock 1 and the stock 1 (

COV 1,2

COV 12=12 1 2
Exercise:
Stocks A and B have the following historical returns:
Year

rA

2005
2006
2007
2008
2009

18.00
33.00
15.00
-0.50
27.00

(%)

rB

(%)

-14.50
21.80
30.50
-7.60
26.30

a) Calculate the average rate of return for each stock during the 5-year period
b) Assume that someone held a portfolio consisting of 50% of Stock A and 50% of
Stock B. What would have been the realized rate of return on the portfolio in each
year? What would have been the average return on the portfolio during this period?
c) Calculate the standard deviation of returns for each stock and for the portfolio
d) Calculate the coefficient of variation for each stock and for the portfolio.
e) If you are a risk-averse investor, would you prefer to hold Stock A, Stock B, or the
portfolio? Why?

11

The answers to a, b, c, and d are given below:

A
2005

Mean

(18.00%)
2006

33.00

2007

15.00

Portfolio

(14.50%)

(16.25%)

21.80
30.50

27.40
22.75

2008

(0.50)

(7.60)

(4.05)

2009

27.00

26.30

26.65

11.30

Std Dev

20.79

CV

1.84

11.30

11.30

20.78

20.13

1.84

1.78

e. A risk-averse investor would choose the portfolio over either Stock A or Stock B
alone, since the portfolio offers the same expected return but with less risk. This
result occurs because returns on A and B are not perfectly positively correlated ( AB
= 0.88).
Exercise:
The market and Stock J have the following probability distributions:
Probability
rM
rj
0,3
15 %
20%
0,4
9%
5%
0,3
18%
12%
a) Calculate the expected rates of return for the market and Stock J
b) Calculate the standard deviations for the market and Stock J
c) Calculate the coefficients of variation for the market and Stock J

12

a.
r

= (0.3)(15%) + (0.4)(9%) + (0.3)(18%) = 13.5%

r
J

= (0.3)(20%) + (0.4)(5%) + (0.3)(12%) = 11.6%

b.
M

= [(0.3)(15% - 13.5%)2 + (0.4)(9% - 13.5%)2 + (0.3)(18% -13.5%)2]1/2

14.85%
=
J

= 3.85%

= [(0.3)(20% - 11.6%)2 + (0.4)(5% - 11.6%)2 + (0.3)(12% - 11.6%)2]1/2

38.64%
=

c.

= 6.22%

CVM =

3.85%
13.5%

= 0.29

6.22%
11.6%

CVJ =

= 0.54

REQUIRED RATE OF RETURN

The average investor is risk averse, which means that he or she must be
compensated for holding risky assets, in a form of a minimum rate of return which is
called the required rate of return. Therefore, riskier assets have higher required
returns than less risky assets.
An asset's risk consists of diversifiable risk (unsystematic risk or companyspecific risk), which can be eliminated by diversification, plus market risk
(systematic risk), which cannot be eliminated by diversification.
Diversifiable risk is caused by such random events as lawsuits, strikes, winning or
losing a major contract, successful and unsuccessful marketing programs and other
events that are unique to a particular firm. Because the events are random, their
effects on a portfolio can be eliminated by diversification-bad events in one firm will
be offset by good events in another.
Market risk, on the other hand, stems from factors that systematically affect most
firms: war, inflation, recession, and high interest rates. Since most stocks are
negatively affected by these factors, market risk cannot be eliminated by
diversification.
A stock's beta coefficient, b, is a measure of its market risk. Beta measures the
extent to which the stock's returns move relative to the market. Since a stock's beta
13

coefficient determines how stock affects the risk of a diversified portfolio, beta is the
most relevant measure of any stock's risk. If b equal 1.0 then the stock is about as
risky as the market, if held in a diversified portfolio. If b is less than 1.0, the stock is
less risky than the market. If beta is greater than 1.0, the stock is more risky than a
market. The beta of a portfolio is a weighted average of the betas of the individual
securities in the portfolio.
Since market risk cannot be eliminated by diversification, investors must be
compensated for bearing it. So, the relevant risk of an individual asset is its
contribution to the risk of a well diversified portfolio, which is the asset's market
risk. That logic is explained by the Capital Asset Pricing Model (CAPM).
CAPM gives us the answer to the question of the size of the required rate of return
on risky asset. On the other hand, if we have assessed the expected rate of return,
then comparing the expected and the required rate of return implied by CAPM we
can determine whether a property is undervalued, overvalued or fair valued.
Assuming that the unsystematic risk is completely remove by diversification, the
required rate of return on a stock i is equal to risk-free rate plus the stock's
beta times the market risk premium:

r i=r RF +b i (RP m )
where

RP m=r M r RF

bi =

COV
i
= 2
M
M = slope of regression (SML)

( )

COV = i M

r i= the required return on a stock i

r M =the required return on stock market (or on a portfolio consisting of all stocks,
which is called the market portfolio)

bi

= the beta of stock i

r RF = the risk-free rate

RP m = the market risk premium
COV =the

covariance between stock i and the market

Exercise:
14

Assume that the risk-free rate is 6% and the expected return on the market is 13%.
What is the required rate of return on a stock that has a beta of 0.7?
rRF = 6%;
rM = 13%;
b = 0.7;
rs = ?

r M r RF
=6 +0.7 ( 13 6 )=10.9

r i=r RF + bi
Exercise:
Assume that the risk-free rate is 6% and the market risk premium is 6%.
a) What is the required rate of return for the overall stock market?
b) What is the required rate of return on a stock that has a beta of 1.2?
rRF = 5%;
RPM = 6%;
rM = ?

a) rM = 5% + (6%)1 = 11%.
b) rs = 5% + 6%(1.2) = 12.2%.
Exercise:
Suppose rRF=5%, rM=10% and rA=12%
a) Calculate Stock A's beta
b) If Stock A's beta were 2.0, what would be A's new required rate of return?
a) rA = rRF + (rM - rRF)bA
12% = 5% + (10% - 5%)bA
12% = 5% + 5%(bA)
7% = 5%(bA)
1.4 = bA
b) rA = 5% + 5%bA

15

rA = 5% + 5%(2)
rA = 15%
Exercise:
Suppose rRF=9%, rM=14% and bi=1.3
a) What is ri, the required rate of return on Stock i?
b) Now suppose
b.1. rRF increases to 10%
b.2. rRF decreases to 8%
The slope of the SML remains constant.
How would this affect rM and ri?
c) Now assume rRF remains 9% but
c.1. rM increases to 16% or
c.2. rM falls to 13%
The slope of the SML doe not remains constant.
How would these changes affect ri?
a.ri = rRF + (rM - rRF)bi = 9% + (14% - 9%)1.3 = 15.5%.
b.1.rRF increases to 10%:
rM increases by 1 percentage point, from 14% to 15%.
ri = rRF + (rM - rRF)bi = 10% + (15% - 10%)1.3 = 16.5%
b.2.rRF decreases to 8%:
rM decreases by 1%, from 14% to 13%.
ri = rRF + (rM - rRF)bi = 8% + (13% - 8%)1.3 = 14.5%
c.1.rM increases to 16%:
ri = rRF + (rM - rRF)bi = 9% + (16% - 9%)1.3 = 18.1%
c.2.rM decreases to 13%:
ri = rRF + (rM - rRF)bi = 9% + (13% - 9%)1.3 = 14.2%
Exercise:
Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of return on
an average stock is 1.3% and the risk-free rate of return is 7%. By how much does
the required return on the riskier stock exceeds the required return on the less risky
stock?
We know that bR = 1.50, bS = 0.75, rM = 13%, rRF = 7%
ri = rRF + (rM - rRF)bi = 7% + (13% - 7%)bi
rR = 7% + 6%(1.50) = 16.0%
16

rS = 7% + 6%(0.75) = 11.5
4.5%
The required rate of return on a portfolio due to the CAPM would be:

r p=r RF +b p ( RP m )
Where
n

b p = w i bi
i=1

Exercise:
An individual has $ 35,000 invested in a stock which has a beta of 0.8 and $ 40,000
invested in a stock with beta of 1.4. If these are the only two investments in her
portfolio, what is her portfolio's beta?
Investment

Total

Beta

$35,000

0.8

40,000

1.4

$75,000

b p =w1 b1 +w2 b2=

($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) =

1.12
Exercise: (Tool Kit 2.3)
An investor has a 3-stock portfolio with $25,000 invested in Dell, $50,000 invested
in Ford, and $25,000 invested in Wal-Mart. Dells beta is estimated to be 1.20,
Fords beta is estimated to be 0.80, and Wal-Marts beta is estimated to be 1.0.
What is the estimated beta of the investors portfolio?

b p =w1 b1 +w2 b2 +w 3 b3=

=($25,000/$100,000)(1.2)+($50,000/$100,000)(0.8)+($25,000/$100,000)(1.0)
= 0.95
Exercise:
Suppose you hold a diversified portfolio consisting of a $7,500 investment in each of
20 different common stocks. The portfolio beta is equal to 1.12. Now, suppose you
have decided to sell one of the stock in your portfolio with a beta equal to 1.0 for
$7,500 and to use these proceeds to buy another stock for your portfolio. Assume
the new stock's beta is equal 1.75. Calculate your portfolio's new beta.
17

$142,500
$150,000

Old portfolio beta =

$7,500
$150,000

(b) +
(1.00)
1.12 = 0.95b + 0.05
1.07 = 0.95b
1.13 = b

New portfolio beta = 0.95(1.13) + 0.05(1.75) = 1.16

Alternative Solutions:
1.Old portfolio beta = 1.12 = (0.05)b1 + (0.05)b2 +...+ (0.05)b20
1.12 = (bi)(0.05)
bi = 1.12/0.05 = 22.4
New portfolio beta = (22.4 - 1.0 + 1.75)(0.05) = 1.1575 = 1.16
2.bi excluding the stock with the beta equal to 1.0 is (22.4 - 1.0) = 21.4, so the
beta of the portfolio excluding this stock is b = 21.4/19 = 1.1263. The beta of the
new portfolio is:
1.1263(0.95) + 1.75(0.05) = 1.1575 = 1.16
Example:
Suppose you are the money manager of a $4 million investment fund. The fund
consists of four stocks with the following investments and betas:
Stock
Investment ($)
Beta
A
400,000
1.50
B
600,000
-0.50
C
1,000,000
1.25
D
2,000,000
0.75
If the marker required rate of return is 14% and the risk-free rate is 6%, what is the
fund's required rate of return?

Portfolio beta =
$2, 000, 000

$4, 000, 000

(0.75)=

$400, 000

$4, 000, 000

(1.50) +

$600, 000

$4, 000, 000

(-0.50) +

$1, 000, 000

$4, 000, 000

(1.25) +

= (0.1)(1.5) + (0.15)(-0.50) + (0.25)(1.25) + (0.5)(0.75)

= 0.15 - 0.075 + 0.3125 + 0.375 = 0.7625
rp= rRF + (rM - rRF)(bp) = 6% + (14% - 6%)(0.7625) = 12.1%.

18

Alternative solution: First compute the return for each stock using the CAPM
equation [rRF + (rM - rRF)(bp)], and then compute the weighted average of these
returns.
rRF = 6% and (rM - rRF )= 8%.
Stock
A
B
C
D
Total

Investment
$ 400,000
600,000
1,000,000
2,000,000
$4,000,000

Beta
1.50
(0.50)
1.25
0.75

r = rRF + (rM - rRF)b

18%
2
16
12

Weight
0.10
0.15
0.25
0.50
1.00

rp = 18%(0.10) + 2%(0.15) + 16%(0.25) + 12%(0.50) = 12.1%

Exercise:
You have a $2 million portfolio consisting of a $100,000 investment in each of 20
different stocks. The portfolio has a beta equal to 1.1. You are considering selling $
100,000 worth of one stock that has a beta equal to 0.9 and using the proceeds to
purchase another stock that has a beta equal to 1.4. What will be the new beta of
your portfolio following this transaction?
First, calculate the beta of what remains after selling the stock:
bp = 1.1 = ($100,000/$2,000,000)0.9 + ($1,900,000/$2,000,000)bR
1.1 = 0.045 + (0.95)bR
bR = 1.1105
bN = (0.95)1.1105 + (0.05)1.4 = 1.125
Example:
You have observed the following returns over time:
Year
Stock X (%)
Stock Y (%)
Market (%)
2005
14
13
12
2006
19
7
10
2007
-16
-5
-12
2008
3
1
1
2009
20
11
15
Assume that the risk-free rate is 6% and the market risk-premium is 5%
a) What are the betas of Stocks X and Y?
b) What are the required rates of return for Stocks X and Y?
c) What is the required rate of return for a portfolio consisting of 80% of Stock X and
20% of Stock Y?
d) If Stock X's expected return is 22%, is Stock X under-or overvalued?
a.

bX = 1.3471; bY = 0.6508. These can be calculated with a spreadsheet.

b.

rX = 6% + (5%)1.3471 = 12.7355%
rY = 6% + (5%)0.6508 = 9.2540%
19

c.

bp = 0.8(1.3471) + 0.2(0.6508) = 1.2078

rp = 6% + (5%)1.2078 = 12.04%
Alternatively,
rp = 0.8(12.7355%) + 0.2(9.254%) = 12.04%

d. Stock X is undervalued, because its expected return exceeds its required rate of
return.
Security Market Line (SML)
Security Market Line is a line that in a state of market equilibrium shows the
relationship between the required rate of return on individual securities and
systematic risk expressed by beta.
The line that reflects the combination of risk and return availabe on alternative
investments is referred as the security market line (SML). The SML refelcts the riskreturn combinations available for all risky assest in the capital market at a given
time. Investors would select investmnet that are consistent with their risk
prefercences: some would consider only low-risk investments, whereas other
welcome high-risk inevstments.
The SML intersects the ordinate, which shows the expected rate of return, at the

level of risk-free rate of return

=NRFR), because the beta of risk-free securities

is zero.

Expected
Return
Security
Low
RiskAverage
Risk High
Risk Market Line
The slope
returnindicates
per unit the
of risk
NRFR required
Risk
(business risk, etc., or systematic risk-beta)

SML line and its changes

Beginning with an initial SML, three changes can occur
20

1. Movement along the SML

A movement along the SML demonstrate a change in the risk characteristics of a
specific investment, such as a change in its business risk, its financial risk, or its
systematic risk (its beta).
This change affects only the individual investment.
2. Changes in the Slope of the SML
A change on the slope of the SML occurs in response to a change in the attitudes of
inevstors toward risk. Such a change demonstrates that investors want either
higher or lower rate of return for the same risk. This is also described as a change in
the market risk premium(

RP m .

A changes in the market risk premim will affecst all risky investments.

Expected Return
R m
Rm
NRFR

New SML
Original SML
Risk

3. Changes in Capital Market Conditions or Expected Inflation

A shift in the SML reflects a change in expeced real growth, a change in market
conditins (such as ease or tughtness of money), or a change in the expected rate of
inflation.
Such a change will affect all investments.

21

Expected Return

New SML
Original SML

NRFR'
NRFR

Risk

Example: Tool Kit (Chapter)

We want to predict stock i's required return using SML if we know:
rRF
rM
bi

6%
11%
0.5

<< Varies over time, but is constant for all companies at any given time.
<< Varies over time, but is constant for all companies at any given time.
<< Varies over time, and varies by company.

rp = rRF + bp (RPM)
rp= rRF + (rM - rRF)(bp) rp= 6% + 0.5 (11% - 6%)=8.5
The SML shows the relationship between the stock's beta and its required return, as
predicted by the CAPM.
With the data about different levels for beta and appropriate levels of required
return (according to previous model), we can generate a Security Market Line that
will be flexible enough to allow for changes in:

Beta
0.00
0.50
1.00
1.50
2.00

Required
Return
rRF + (rM rRF)(bp)
6.0%
8.5%
11.0%
13.5%
16.0%

The Security Market Line shows the projected changes in expected return, due to
changes in the beta coefficient. We will use graph to present this relationship:

22

Security Market Line

18%
12%
Required Return

6%
0%
0.00

0.50

1.00

1.50

2.00

2.50

Beta

However, we can also look at the potential changes in the required return due to
variation of other factors, namely the market return and risk-free rate. In other
words, we can see how required returns can be influenced by changing inflation and
risk aversion. The level of investor risk aversion is measured by the market risk
premium (rM-rRF), which is also the slope of the SML. Hence, an increase in the
market return results in an increase in the maturity risk premium, other things held
constant.
We will look at two potential conditions as shown in the following columns:
rp= rRF + (rM - rRF)(bp)
Scenario 1. Inflation Increases:
Risk-free Rate
Change in inflation
Old Market Return
New Market
Return
Beta

6%
2%
11%
13%

0,50

Required Return

Scenario 2. Investors become more risk

averse:
Risk-free Rate
6%
Old Market Return
11%
Increase in MRP
2,5%
New Market
Return
13,5%
Beta

10,5%

0,50

Required Return

9,75%

Now, we can see how these two factors can affect a Security Market Line, by
creating a data table for the required return with different beta coefficients.

Beta
0,00
0,50
1,00
1,50
2,00

Original Situation
6,00%
8,50%
11,00%
13,50%
16,00%

Inflation increases
8,00%
10,50%
13,00%
15,50%
18,00%

Risk aversion
increases
6,00%
9,75%
13,50%
17,25%
21,00%

Or graphically:

23

The SML Under Different Conditions

25%
20%
15%
Required Returns Original
10%

Inflation up

Risk aversion up

5%
0%
0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

Beta

The graph shows that as risk as measured by beta increases, so does the required
rate of return on securities. However, the required return for any given beta varies
depending on the position and slope of the SML.

24

CALCULATING BETA COEFFICIENT

Homework 1:
Calculate beta for an actual company.
Apply all three methods presented in the example below:
1. I way Excel function
2. II way Regression
3. III way Scatter plot

Example: Tool Kit (Chapter)

Acquire data
We downloaded stock prices and dividends from http://finance.yahoo.com for General
Electric, using its ticker symbol GE. We also downloaded data for the S&P 500 Index
(^SPX), which contains 500 actively traded large stocks. For example, to download the
GE data, enter its ticker symbol and click Go. Then select Historical Prices from the left
side of the page. After the daily prices come up, get monthly prices by entering the
start date and the end date. Yahoo provides monthly prices as of the first trading day of
the month. Note that these prices are "adjusted" to reflect any dividends or stock
splits.
Date
February 2008
January 2008
December 2007
November 2007
October 2007
September 2007
August 2007
July 2007
June 2007
May 2007
April 2007
March 2007
February 2007
January 2007
December 2006
November 2006
October 2006
September 2006
August 2006
July 2006
June 2006
May 2006
April 2006
March 2006
February 2006

Market Level
(S&P 500 Index)
1330,63
1378,55
1468,36
1481,14
1549,38
1526,75
1473,99
1455,27
1503,35
1530,62
1482,37
1420,86
1406,82
1438,24
1418,3
1400,63
1377,94
1335,85
1303,82
1276,66
1270,2
1270,09
1310,61
1294,87
1280,66

Market Return (rM)

-3,5%
-6,1%
-0,9%
-4,4%
1,5%
3,6%
1,3%
-3,2%
-1,8%
3,3%
4,3%
1,0%
-2,2%
1,4%
1,3%
1,6%
3,2%
2,5%
2,1%
0,5%
0,0%
-3,1%
1,2%
1,1%
0,0%

GE Adjusted Stock
Price
33,14
35,04
36,74
37,62
40,44
40,68
37,94
37,83
37,36
36,41
35,72
34,26
33,83
34,66
35,78
33,67
33,51
33,69
32,27
30,98
31,23
32,22
32,53
32,71
30,92

GE Return (rp)
-5,4%
-4,6%
-2,3%
-7,0%
-0,6%
7,2%
0,3%
1,3%
2,6%
1,9%
4,3%
1,3%
-2,4%
-3,1%
6,3%
0,5%
-0,5%
4,4%
4,2%
-0,8%
-3,1%
-1,0%
-0,6%
5,8%
1,1%

25

January 2006
December 2005
November 2005
October 2005
September 2005
August 2005
July 2005
June 2005
May 2005
April 2005
March 2005
February 2005
January 2005
December 2004
November 2004
October 2004
September 2004
August 2004
July 2004
June 2004
May 2004
April 2004
March 2004
February 2004

1280,08
1248,29
1249,48
1207,01
1228,81
1220,33
1234,18
1191,33
1191,5
1156,85
1180,59
1203,6
1181,27
1211,92
1173,82
1130,2
1114,58
1104,24
1101,72
1140,84
1120,68
1107,3
1126,21
1144,94

2,5%
-0,1%
3,5%
-1,8%
0,7%
-1,1%
3,6%
0,0%
3,0%
-2,0%
-1,9%
1,9%
-2,5%
3,2%
3,9%
1,4%
0,9%
0,2%
-3,4%
1,8%
1,2%
-1,7%
-1,6%
NA

30,57
32,72
33,11
31,43
31,21
30,95
31,77
31,91
33,39
33,13
33
32,21
32,86
33,2
31,97
30,85
30,36
29,47
29,88
29,12
27,8
26,76
27,27
29,05

-6,6%
-1,2%
5,3%
0,7%
0,8%
-2,6%
-0,4%
-4,4%
0,8%
0,4%
2,5%
-2,0%
-1,0%
3,8%
3,6%
1,6%
3,0%
-1,4%
2,6%
4,7%
3,9%
-1,9%
-6,1%
NA

Beta is slope for regression line where Market Return is independent variable and
GE Return is dependent variable.
a) I way Excel function

26

27

Beta for this case is 0.7.

b) II way Regression
Excel Data Data Analysis

28

SUMMARY OUTPUT
Regression Statistics
0,5030009
Multiple R
9
R Square
0,25301
Adjusted R
0,2367710
Square
9
0,0302065
Standard Error
1
Observations
48
ANOVA
df
Regression

SS
0,01421
6

MS
0,014216144

F
15,5804
8

Significance
F
0,000268704

29

Residual

46

Total

47

0,04197
2
0,05618
8

Coefficient
s
0,0008980
9
0,7099301
7

Standar
d Error
0,00440
3
0,17985
6

Intercept
X Variable 1

0,000912433

t Stat
0,203953489
3,947211209

P-value
0,83928
9
0,00026
9

Lower 95%
-0,007965494
0,347898542

Upper
95%
0,00976
2
1,07196
2

Well, beta for this case is 0.7.

c) III way Scaterrplot (tool kits)

30

#REF!
12
10
8

#REF!

6
4
2
0
0

10

12

With right mouse we will click on points on graph and:

31

32

rp
0.08
0.06
0.04
f(x) = 0.71x +0.02
0
R = 0.25
0
-0.08 -0.06 -0.04 -0.02
0
-0.02

rp
Linear (rp)
0.02

0.04

0.06

-0.04
-0.06
-0.08

Therefore, beta for this case is 0.7.

33