Corporate Finance 5E 2020-356-394

C HAP TER
10
Capital Markets
and the Pricing of Risk
NOTATION OVER THE TEN-YEAR PERIOD 2008 THROUGH 2017, INVESTORS IN

pR probability of return R the consumer products firm Procter & Gamble (PG) earned an average return of
6% per year. Within this period, there was some variation, with the annual return
Var (R ) variance of return R
ranging from -14% in 2008 to 24% in 2013. Over the same period, investors
SD (R ) standard deviation of
in the computer networking firm Netgear (NTGR) earned an average return of
return R
14% per year. These investors, however, lost 68% in 2008 and gained over 90%
E [R ] expectation of return R
in 2009. Finally, investors in three-month U.S. Treasury bills earned an average
Divt dividend paid on date t annual return of 0.4% during the period, with a high of 2.0% in 2008 and a low
Pt price on date t of 0.04% in 2014. Clearly, these three investments offered returns that were
very different in terms of their average level and their variability. What accounts
Rt realized or total return
for these differences?
of a security from date
t - 1 to t In this chapter, we will consider why these differences exist. Our goal is to
develop a theory that explains the relationship between average returns and the
R average return
variability of returns and thereby derive the risk premium that investors require to
bs beta of security s hold different securities and investments. We then use this theory to explain how
r cost of capital of an to determine the cost of capital for an investment opportunity.
investment opportunity We begin our investigation of the relationship between risk and return by
examining historical data for publicly traded securities. We will see, for example,
that while stocks are riskier investments than bonds, they have also earned higher
average returns. We can interpret the higher average return on stocks as compen-
sation to investors for the greater risk they are taking.
But we will also find that not all risk needs to be compensated. By holding a
portfolio containing many different investments, investors can eliminate risks that
are specific to individual securities. Only those risks that cannot be eliminated by
holding a large portfolio determine the risk premium required by investors. These
observations will allow us to refine our definition of what risk is, how we can
measure it, and thus, how to determine the cost of capital.
354
10.1 Risk and Return: Insights from 92 Years of Investor History 355
10.1 Risk and Return: Insights from 92 Years

of Investor History
We begin our look at risk and return by illustrating how risk affects investor decisions and
returns. Suppose your great-grandparents invested $100 on your behalf at the end of 1925.
They instructed their broker to reinvest any dividends or interest earned in the account
until the beginning of 2018. How would that $100 have grown if it were placed in one of
the following investments?
1. Standard & Poor’s 500 (S&P 500): A portfolio, constructed by Standard and Poor’s,
comprising 90 U.S. stocks up to 1957 and 500 U.S. stocks after that. The firms rep-
resented are leaders in their respective industries and are among the largest firms, in
terms of market value, traded on U.S. markets.
2. Small Stocks: A portfolio, updated quarterly, of U.S. stocks traded on the NYSE
with market capitalizations in the bottom 20%.
3. World Portfolio: A portfolio of international stocks from all of the world’s major
stock markets in North America, Europe, and Asia.1
4. Corporate Bonds: A portfolio of long-term, AAA-rated U.S. corporate bonds with
maturities of approximately 20 years.2
5. Treasury Bills: An investment in one-month U.S. Treasury bills.
Figure 10.1 shows the result, through the start of 2018, of investing $100 at the end of
1925 in each of these five investment portfolios, ignoring transactions costs. During this
92-year period in the United States, small stocks experienced the highest long-term return,
followed by the large stocks in the S&P 500, the international stocks in the world portfolio,
corporate bonds, and finally Treasury bills. All of the investments grew faster than infla-
tion, as measured by the consumer price index (CPI).
At first glance the graph is striking—had your great-grandparents invested $100 in the
small stock portfolio, the investment would be worth nearly $5.8 million at the beginning of
2018! By contrast, if they had invested in Treasury bills, the investment would be worth only
about $2,000. Given this wide difference, why invest in anything other than small stocks?
But first impressions can be misleading. While over the full horizon stocks (especially
small stocks) did outperform the other investments, they also endured periods of signifi-
cant losses. Had your great-grandparents put the $100 in a small stock portfolio during the
Depression era of the 1930s, it would have grown to $181 in 1928, but then fallen to only
$15 by 1932. Indeed, it would take until World War II for stock investments to outperform
corporate bonds.
Even more importantly, your great-grandparents would have sustained losses at a time
when they likely needed their savings the most––in the depths of the Great Depression.
A similar story held during the 2008 financial crisis: All of the stock portfolios declined by
more than 50%, with the small stock portfolio declining by almost 70% (over $1.5 million!)
from its peak in 2007 to its lowest point in 2009. Again, many investors faced a double
whammy: an increased risk of being unemployed (as firms started laying off employees)
1
Based on a World Market Index constructed by Global Financial Data, with approximate initial weights
of 44% North America, 44% Europe, and 12% Asia, Africa, and Australia.
2
Based on Global Financial Data’s Corporate Bond Index.
356 Chapter 10 Capital Markets and the Pricing of Risk
FIGURE 10.1 Value of $100 Invested in 1925 in Stocks, Bonds, or Bills
$10,000,000
Small Stocks 2007–09: –67%, –51% $5,792,572
S&P 500
2000–02: –26%, –45%
World Portfolio
$1,000,000 Corporate Bonds 1987: –34%, –30% $664,567
Treasury Bills
CPI $248,352
1968–74: –63%, –37%
Value of Investment
$100,000
$22,366
$10,000
$2,063
$1,000 $1,378
1979–81: Inflation, TBill yields peak at 15%

$100
1937–38: –72%, –50%
1928–32: Small stocks –92%, S&P 500 –84%
$10
1925 1935 1945 1955 1965 1975 1985 1995 2005 2015
Year
The chart shows the growth in value of $100 invested in 1925 if it were invested in U.S. large stocks, small stocks,
world stocks, corporate bonds, or Treasury bills, with the level of the consumer price index (CPI) shown as a refer-
ence. Returns were calculated at year-end assuming all dividends and interest are reinvested and excluding transac-
tions costs. Note that while stocks have generally outperformed bonds and bills, they have also endured periods of
significant losses (numbers shown represent peak to trough decline, with the decline in small stocks in red and the
S&P 500 in blue).
Source: Chicago Center for Research in Security Prices, Standard and Poor’s, MSCI, and Global Financial Data
precisely when the value of their savings eroded. Thus, while the stock portfolios had the
best performance over this 92-year period, that performance came at a cost––the risk
of large losses in a downturn. On the other hand, Treasury bills enjoyed steady––albeit
modest––gains each year.
Few people ever make an investment for 92 years, as depicted in Figure 10.1. To gain
additional perspective on the risk and return of these investments, Figure 10.2 shows the
results for more realistic investment horizons and different initial investment dates. Panel
(a), for example, shows the value of each investment after one year and illustrates that if
we rank the investments by the volatility of their annual increases and decreases in value,
we obtain the same ranking we observed with regard to performance: Small stocks had the
most variable returns, followed by the S&P 500, the world portfolio, corporate bonds, and
finally Treasury bills.
Panels (b), (c), and (d) of Figure 10.2 show the results for 5-, 10-, and 20-year invest-
ment horizons, respectively. Note that as the horizon lengthens, the relative performance
of the stock portfolios improves. That said, even with a 10-year horizon there were periods
during which stocks underperformed Treasuries. And while investors in small stocks most
often came out ahead, this was not assured even with a 20-year horizon: For investors in
10.1 Risk and Return: Insights from 92 Years of Investor History 357
FIGURE 10.2 Value of $100 Invested in Alternative Assets for Differing Horizons
Small Stocks S&P 500 Corporate bonds Treasury Bills
(a) Value after 1 Year (b) Value after 5 Years

$300
$1,000
$200
$100
$100
$0 $10
1925 1935 1945 1955 1965 1975 1985 1995 2005 2015 1925 1935 1945 1955 1965 1975 1985 1995 2005
(c) Value after 10 Years (d) Value after 20 Years
$1,000 $10,000
$100 $1,000
$10 $100
1925 1935 1945 1955 1965 1975 1985 1995 2005 1925 1935 1945 1955 1965 1975 1985 1995
Initial Investment Year Initial Investment Year
Each panel shows the result of investing $100, in each investment opportunity, for horizons of 1, 5, 10, or 20 years,
plotted as a function of the year when the investment was initially made. Dividends and interest are reinvested and
transaction costs are excluded. Note that small stocks show the greatest variation in performance at the one-year horizon,
followed by large stocks and then corporate bonds. For longer horizons, the relative performance of stocks improved, but
they remained riskier.
Source Data: Chicago Center for Research in Security Prices, Standard and Poor’s, MSCI, and Global Financial Data
the early 1980s, small stocks did worse than both the S&P 500 and corporate bonds over
the subsequent 20 years. Finally, stock investors with long potential horizons might find
themselves in need of cash in intervening years, and be forced to liquidate at a loss relative
to safer alternatives.
In Chapter 3, we explained why investors are averse to fluctuations in the value of their
investments, and that investments that are more likely to suffer losses in downturns must
compensate investors for this risk with higher expected returns. Figures 10.1 and 10.2 pro-
vide compelling historical evidence of this relationship between risk and return, just as we
should expect in an efficient market. Given this clear evidence that investors do not like
risk and thus demand a risk premium to bear it, our goal in this chapter is to quantify this
relationship. We want to explain how much investors demand (in terms of a higher expected
return) to bear a given level of risk. To do so, we must first develop tools that will allow us
to measure risk and return. That is our objective in the next section.
CONCEPT CHECK 1. For an investment horizon from 1926 to 2017, which of the following investments had the
highest return: the S&P 500, small stocks, world portfolio, corporate bonds, or Treasury
bills? Which had the lowest return?
2. For an investment horizon of just one year, which of these investments was the most
variable? Which was the least variable?
10.2 Common Measures of Risk and Return

When a manager makes an investment decision or an investor purchases a security, they
have some view as to the risk involved and the likely return the investment will earn. Thus,
we begin our discussion by reviewing the standard ways to define and measure risks.
Probability Distributions
Different securities have different initial prices, pay different cash flows, and sell for dif-
ferent future amounts. To make them comparable, we express their performance in terms
of their returns. The return indicates the percentage increase in the value of an investment
per dollar initially invested in the security. When an investment is risky, there are different
returns it may earn. Each possible return has some likelihood of occurring. We summarize
this information with a probability distribution, which assigns a probability, pR , that each
possible return, R , will occur.
Let’s consider a simple example. Suppose BFI stock currently trades for $100 per share.
You believe that in one year there is a 25% chance the share price will be $140, a 50%
chance it will be $110, and a 25% chance it will be $80. BFI pays no dividends, so these pay-
offs correspond to returns of 40%, 10%, and - 20%, respectively. Table 10.1 summarizes
the probability distribution for BFI’s returns.
We can also represent the probability distribution with a histogram, as shown in
Figure 10.3.
Expected Return
Given the probability distribution of returns, we can compute the expected return. We cal-
culate the expected (or mean) return as a weighted average of the possible returns, where
the weights correspond to the probabilities.3
Expected (Mean) Return
Expected Return = E3 R 4 = a pR * R (10.1)
R
TABLE 10.1 Probability Distribution of Returns for BFI
Probability Distribution
Current Stock Price ($) Stock Price in One Year ($) Return, R Probability, pR
140 0.40 25%
100 110 0.10 50%
80 - 0.20 25%
3
The notation Σ R means that we calculate the sum of the expression (in this case, pR * R ) over all
possible returns R.
10.2 Common Measures of Risk and Return 359
FIGURE 10.3
50%
Probability Distribution
of Returns for BFI
The height of a bar in the
Probability
histogram indicates the
25% 25%
likelihood of the associated
outcome.
2.25 2.20 2.15 2.10 2.05 .00 .05 .10 .15 .20 .25 .30 .35 .40 .45
Return
Expected Return
The expected return is the return we would earn on average if we could repeat the in-
vestment many times, drawing the return from the same distribution each time. In terms of
the histogram, the expected return is the “balancing point” of the distribution, if we think
of the probabilities as weights. The expected return for BFI is
E[RBFI ] = 25%( - 0.20) + 50%(0.10) + 25%(0.40) = 10%
This expected return corresponds to the balancing point in Figure 10.3.
Variance and Standard Deviation

Two common measures of the risk of a probability distribution are its variance and standard
deviation. The variance is the expected squared deviation from the mean, and the standard
deviation is the square root of the variance.
Variance and Standard Deviation of the Return Distribution
Var (R ) = E [(R - E [R])2 ] = a pR * (R - E[R ])2
R
SD(R ) = 2Var (R ) (10.2)
If the return is risk-free and never deviates from its mean, the variance is zero.
Otherwise, the variance increases with the magnitude of the deviations from the mean.
Therefore, the variance is a measure of how “spread out” the distribution of the return is.
The variance of BFI’s return is
Var (RBFI ) = 25% * ( - 0.20 - 0.10)2 + 50% * (0.10 - 0.10)2 + 25% * (0.40 - 0.10)2
= 0.045
The standard deviation of the return is the square root of the variance, so for BFI,
SD(R ) = 2Var(R ) = 20.045 = 21.2% (10.3)

In finance, we refer to the standard deviation of a return as its volatility. While the vari-
ance and the standard deviation both measure the variability of the returns, the standard
deviation is easier to interpret because it is in the same units as the returns themselves.4
EXAMPLE 10.1 Calculating the Expected Return and Volatility
Problem
Suppose AMC stock is equally likely to have a 45% return or a - 25% return. What are its
expected return and volatility?
Solution
First, we calculate the expected return by taking the probability-weighted average of the possible
returns:
E[R ] = a pR * R = 50% * 0.45 + 50% * (- 0.25) = 10.0%
R
To compute the volatility, we first determine the variance:
Var (R ) = a pR * (R - E [R ])2 = 50% * (0.45 - 0.10)2 + 50% * (- 0.25 - 0.10)2
R
= 0.1225
Then, the volatility or standard deviation is the square root of the variance:
SD(R ) = 2Var (R ) = 20.1225 = 35%
Note that both AMC and BFI have the same expected return, 10%. However, the re-
turns for AMC are more spread out than those for BFI—the high returns are higher and
the low returns are lower, as shown by the histogram in Figure 10.4. As a result, AMC has
a higher variance and volatility than BFI.
FIGURE 10.4
50% 50% 50%
Probability Distribution BFI

AMC
for BFI and AMC Returns
While both stocks have the
Probability
same expected return, AMC’s 25% 25%

return has a higher variance
and standard deviation.
2.25 2.20 2.15 2.10 2.05 .00 .05 .10 .15 .20 .25 .30 .35 .40 .45
Return
4
While variance and standard deviation are the most common measures of risk, they do not differenti-
ate upside and downside risk. Alternative measures that focus on downside risk include the semivariance
(variance of the losses only) and the expected tail loss (the expected loss in the worst x% of outcomes).
Because they often produce the same ranking (as in Example 10.1, or if returns are normally distributed)
but are more complicated to apply, these alternative measures tend to be used only in special applications.
10.3 Historical Returns of Stocks and Bonds 361
If we could observe the probability distributions that investors anticipate for different
securities, we could compute their expected returns and volatilities and explore the rela-
tionship between them. Of course, in most situations we do not know the explicit prob-
ability distribution, as we did for BFI. Without that information, how can we estimate and
compare risk and return? A popular approach is to extrapolate from historical data, which
is a sensible strategy if we are in a stable environment and believe that the distribution of
future returns should mirror that of past returns. Let’s look at the historical returns of
stocks and bonds, to see what they reveal about the relationship between risk and return.
CONCEPT CHECK 1. How do we calculate the expected return of a stock?

2. What are the two most common measures of risk, and how are they related to each other?
10.3 Historical Returns of Stocks and Bonds

In this section, we explain how to compute average returns and volatilities using historical
stock market data. The distribution of past returns can be helpful when we seek to estimate
the distribution of returns investors may expect in the future. We begin by first explaining
how to compute historical returns.
Computing Historical Returns

Of all the possible returns, the realized return is the return that actually occurs over a par-
ticular time period. How do we measure the realized return for a stock? Suppose you invest
in a stock on date t for price Pt . If the stock pays a dividend, Divt + 1, on date t + 1, and you
sell the stock at that time for price Pt + 1, then the realized return from your investment in
the stock from t to t + 1 is
Divt + 1 + Pt + 1 Divi + 1 Pt + 1 - Pt
Rt + 1 = - 1 = +
Pt Pt Pt
= Dividend Yield + Capital Gain Rate (10.4)
That is, as we discussed in Chapter 9, the realized return, Rt + 1, is the total return we earn
from dividends and capital gains, expressed as a percentage of the initial stock price.5
Calculating Realized Annual Returns. If you hold the stock beyond the date of the
first dividend, then to compute your return you must specify how you invest any divi-
dends you receive in the interim. To focus on the returns of a single security, let’s assume
that you reinvest all dividends immediately and use them to purchase additional shares of the same stock
or security. In this case, we can use Eq. 10.4 to compute the stock’s return between dividend
payments, and then compound the returns from each dividend interval to compute the
return over a longer horizon. For example, if a stock pays dividends at the end of each
quarter, with realized returns RQ1, c , RQ4 each quarter, then its annual realized return,
Rannual, is
1 + Rannual = (1 + RQ1 )(1 + RQ2 )(1 + RQ3 )(1 + RQ4 ) (10.5)
5
We can compute the realized return for any security in the same way, by replacing the dividend payments
with any cash flows paid by the security (e.g., with a bond, coupon payments would replace dividends).
EXAMPLE 10.2 Realized Returns for Microsoft Stock
Problem
What were the realized annual returns for Microsoft ( MSFT ) stock in 2004 and 2008?
Solution
When we compute Microsoft’s annual return, we assume that the proceeds from the dividend
payment were immediately reinvested in Microsoft stock. That way, the return corresponds to
remaining fully invested in Microsoft over the entire period. To do that we look up Microsoft
stock price data at the start and end of the year, as well as at any dividend dates (Yahoo! Finance
is a good source for such data; see also MyLab Finance or www.berkdemarzo.com for addi-
tional sources). From these data, we can construct the following table (prices and dividends
in $/share):
Date Price Dividend Return Date Price Dividend Return

12/31/03 27.37 12/31/07 35.60
8/23/04 27.24 0.08 - 0.18% 2/19/08 28.17 0.11 - 20.56%
11/15/046 27.39 3.08 11.86% 5/13/08 29.78 0.11 6.11%
12/31/04 26.72 - 2.45% 8/19/08 27.32 0.11 - 7.89%
11/18/08 19.62 0.13 - 27.71%
12/31/08 19.44 - 0.92%
The return from December 31, 2003, until August 23, 2004, is equal to
0.08 + 27.24
- 1 = - 0.18%
27.37
The rest of the returns in the table are computed similarly. We then calculate the annual returns
using Eq. 10.5:
R2004 = (0.9982)(1.1186)(0.9755) - 1 = 8.92%
R2008 = (0.7944)(1.0611)(0.9211)(0.7229)(0.9908) - 1 = - 44.39%
Example 10.2 illustrates two features of the returns from holding a stock like Microsoft.
First, both dividends and capital gains contribute to the total realized return—ignoring ei-
ther one would give a very misleading impression of Microsoft’s performance. Second, the
returns are risky. In years like 2004 the returns are positive, but in other years like 2008 they
are negative, meaning Microsoft’s shareholders lost money over the year.
We can compute realized returns in this same way for any investment. We can also com-
pute the realized returns for an entire portfolio, by keeping track of the interest and divi-
dend payments paid by the portfolio during the year, as well as the change in the market
value of the portfolio. For example, the realized returns for the S&P 500 index are shown
in Table 10.2, which for comparison purposes also lists the returns for Microsoft and for
three-month Treasury bills.
6
The large dividend in November 2004 included a $3 special dividend which Microsoft used to reduce its
accumulating cash balance and disburse $32 billion in cash to its investors, in the largest aggregate divi-
dend payment in history.
TABLE 10.2 Realized Return for the S&P 500, Microsoft, and Treasury Bills, 2005–2017
Year End S&P 500 Dividends S&P 500 Realized Microsoft Realized 1-Month T-Bill
Index Paid* Return Return Return
2004 1211.92
2005 1248.29 23.15 4.9% -0.9% 3.0%
2006 1418.30 27.16 15.8% 15.8% 4.8%
2007 1468.36 27.86 5.5% 20.8% 4.7%
2008 903.25 21.85 -37.0% -44.4% 1.5%
2009 1115.10 27.19 26.5% 60.5% 0.1%
2010 1257.64 25.44 15.1% -6.5% 0.1%
2011 1257.61 26.59 2.1% -4.5% 0.0%
2012 1426.19 32.67 16.0% 5.8% 0.1%
2013 1848.36 39.75 32.4% 44.3% 0.0%
2014 2058.90 42.47 13.7% 27.6% 0.0%
2015 2043.94 43.45 1.4% 22.7% 0.0%
2016 2238.83 49.56 12.0% 15.1% 0.2%
2017 2673.61 53.99 21.8% 40.7% 0.8%
* Total dividends paid by the 500 stocks in the portfolio, based on the number of shares of each stock in the index, adjusted until the end of the
year, assuming they were reinvested when paid.
Source: Standard & Poor’s, Microsoft and U.S. Treasury Data
Comparing Realized Annual Returns. Once we have calculated the realized annual re-
turns, we can compare them to see which investments performed better in a given year. From
Table 10.2, we can see that Microsoft stock outperformed the S&P 500 and Treasuries in 2007,
2009, and 2013–2017. On the other hand, Treasury bills performed better than Microsoft stock
in 2005, 2008, and 2010–2011. Note also the overall tendency for Microsoft’s return to move in
the same direction as the S&P 500, which it did in ten out of the thirteen years.
Over any particular period we observe only one draw from the probability distribution
of returns. However, if the probability distribution remains the same, we can observe mul-
tiple draws by observing the realized return over multiple periods. By counting the number
of times the realized return falls within a particular range, we can estimate the underlying
probability distribution. Let’s illustrate this process with the data in Figure 10.1.
Figure 10.5 plots the annual returns for each U.S. investment in Figure 10.1 in a histo-
gram. The height of each bar represents the number of years that the annual returns were
in each range indicated on the x-axis. When we plot the probability distribution in this way
using historical data, we refer to it as the empirical distribution of the returns.
Average Annual Returns

The average annual return of an investment during some historical period is simply the
average of the realized returns for each year. That is, if Rt is the realized return of a security
in year t, then the average annual return for years 1 through T is
Average Annual Return of a Security
R = (R1 + R2 + g + RT ) = a Rt
1 1 T
(10.6)
T Tt =1
Notice that the average annual return is the balancing point of the empirical distribution—in
this case, the probability of a return occurring in a particular range is measured by the num-
ber of times the realized return falls in that range. Therefore, if the probability distribution
FIGURE 10.5
70
60
The Empirical
Distribution of Annual 50
1-month Treasury Bills
Returns for U.S. Large 40 AAA Corporate Bonds
Stocks (S&P 500), Small S&P 500
Frequency (number of years)

30
Small Stocks
Stocks, Corporate 20
Bonds, and Treasury
10
Bills, 1926–2017
The height of each bar rep-
40
resents the number of years
30
that the annual returns were
in each 5% range. Note the 20
greater variability of stock 10

returns (especially small
0
stocks) compared to the re-
turns of corporate bonds or 10
Treasury bills. 0
10
0
260% 240% 220% 0% 20% 40% 60% 80% >100%
Annual Return
of the returns is the same over time, the average return provides an estimate of the expected
return.
Using the data from Table 10.2, the average return for the S&P 500 for the years
2005–2017 is
1
R = (0.049 + 0.158 + 0.055 - 0.37 + 0.265 + 0.151 + 0.021 + 0.160
13
+ 0.324 + 0.137 + 0.014 + 0.120 + 0.218) = 10.0%
The average Treasury bill return from 2005–2017 was 1.2%. Therefore, investors earned
8.8% more on average holding the S&P 500 rather than investing in Treasury bills over
this period. Table 10.3 provides the average returns for different U.S. investments from
1926–2017.
TABLE 10.3 Average Annual Returns for U.S. Small Stocks, Large Stocks
(S&P 500), Corporate Bonds, and Treasury Bills, 1926–2017
Investment Average Annual Return

Small stocks 18.7%
S&P 500 12.0%
Corporate bonds 6.2%
Treasury bills 3.4%
The Variance and Volatility of Returns

Looking at Figure 10.5, we can see that the variability of the returns is very different for
each investment. The distribution of small stocks’ returns shows the widest spread. The
large stocks of the S&P 500 have returns that vary less than those of small stocks, but much
more than the returns of corporate bonds or Treasury bills.
To quantify this difference in variability, we can estimate the standard deviation of the
probability distribution. As before, we will use the empirical distribution to derive this esti-
mate. Using the same logic as we did with the mean, we estimate the variance by comput-
ing the average squared deviation from the mean. We do not actually know the mean, so
instead we use the best estimate of the mean—the average realized return.7
Variance Estimate Using Realized Returns
a
T
1 2
Var (R ) = (R - R ) (10.7)
T - 1t =1 t
We estimate the standard deviation or volatility as the square root of the variance.8
EXAMPLE 10.3 Computing a Historical Volatility
Problem
Using the data from Table 10.2, what are the variance and volatility of the S&P 500’s returns for
the years 2005–2017?
Solution
Earlier, we calculated the average annual return of the S&P 500 during this period to be 10.0%.
Therefore,
T - 1 at t
1 2
Var(R ) = (R - R )
1
= 3(0.049 - 0.100)2 + (0.158 - 0.100)2 + g + (0.218 - 0.100)2 4
13 - 1
= 0.029
The volatility or standard deviation is therefore SD(R ) = 2Var (R ) = 20.029 = 17.0%
We can compute the standard deviation of the returns to quantify the differences in the
variability of the distributions that we observed in Figure 10.5. These results are shown in
Table 10.4.
Comparing the volatilities in Table 10.4 we see that, as expected, small stocks have had
the most variable historical returns, followed by large stocks. The returns of corporate
bonds and Treasury bills are much less variable than stocks, with Treasury bills being the
least volatile investment category.
7
Why do we divide by T - 1 rather than by T here? It is because we do not know the true expected re-
turn, and so must compute deviations from the estimated average return R. But in calculating the average
return from the data, we lose a degree of freedom (in essence, we “use up” one of the data points), so that
effectively we only have T - 1 remaining data points to estimate the variance.
8
If the returns used in Eq. 10.7 are not annual returns, the variance is typically converted to annual terms
by multiplying the number of periods per year. For example, when using monthly returns, we multiply the
variance by 12 and, equivalently, the standard deviation by 212.
TABLE 10.4 Volatility of U.S. Small Stocks, Large Stocks (S&P 500),
Corporate Bonds, and Treasury Bills, 1926–2017
Investment Return Volatility (Standard Deviation)

Small stocks 39.2%
S&P 500 19.8%
Corporate bonds 6.4%
Treasury bills 3.1%
Estimation Error: Using Past Returns to Predict the Future

To estimate the cost of capital for an investment, we need to determine the expected return
that investors will require to compensate them for that investment’s risk. If the distribu-
tion of past returns and the distribution of future returns are the same, we could look at
the return investors expected to earn in the past on the same or similar investments, and
assume they will require the same return in the future. However, there are two difficulties
with this approach. First,
We do not know what investors expected in the past; we can only observe the actual returns
that were realized.
In 2008, for example, investors lost 37% investing in the S&P 500, which is surely not what
they expected at the beginning of the year (or they would have invested in Treasury Bills
instead).
If we believe that investors are neither overly optimistic nor pessimistic on average,
then over time, the average realized return should match investors’ expected return. Armed
with this assumption, we can use a security’s historical average return to infer its expected
return. But now we encounter the second difficulty:
The average return is just an estimate of the true expected return, and is subject to estimation error.
Given the volatility of stock returns, this estimation error can be large even with many
years of data, as we will see next.
Standard Error. We measure the estimation error of a statistical estimate by its standard
error. The standard error is the standard deviation of the estimated value of the mean of
the actual distribution around its true value; that is, it is the standard deviation of the aver-
age return. The standard error provides an indication of how far the sample average might
deviate from the expected return. If the distribution of a stock’s return is identical each
year, and each year’s return is independent of prior years’ returns,9 then we calculate the
standard error of the estimate of the expected return as follows:
Standard Error of the Estimate of the Expected Return
SD (Individual Risk)
SD (Average of Independent, Identical Risks) = (10.8)
2Number of Observations
9
Saying that returns are independent and identically distributed (IID) means that the likelihood that the
return has a given outcome is the same each year and does not depend on past returns (in the same way
that the odds of a coin coming up heads do not depend on past flips). It turns out to be a reasonable first
approximation for stock returns.
Because the average return will be within two standard errors of the true expected return
approximately 95% of the time,10 we can use the standard error to determine a reasonable
range for the true expected value. The 95% confidence interval for the expected return is
Historical Average Return { (2 * Standard Error) (10.9)
For example, from 1926 to 2017 the average return of the S&P 500 was 12.0% with a
volatility of 19.8%. Assuming its returns are drawn from an independent and identical dis-
tribution (IID) each year, the 95% confidence interval for the expected return of the S&P
500 during this period is
19.8%
12.0% { 2 ¢ ≤ = 12.0% { 4.1%
292
or a range from 7.9% to 16.1%. Thus, even with 92 years of data, we cannot estimate the
expected return of the S&P 500 very accurately. If we believe the distribution may have
changed over time and we can use only more recent data to estimate the expected return,
then the estimate will be even less accurate.
Limitations of Expected Return Estimates. Individual stocks tend to be even more vol-
atile than large portfolios, and many have been in existence for only a few years, providing
little data with which to estimate returns. Because of the relatively large estimation error
in such cases, the average return investors earned in the past is not a reliable estimate of
a security’s expected return. Instead, we need to derive a different method to estimate the
expected return that relies on more reliable statistical estimates. In the remainder of this
chapter, we will pursue the following alternative strategy: First we will consider how to
measure a security’s risk, and then we will use the relationship between risk and return—
which we must still determine—to estimate its expected return.
EXAMPLE 10.4 The Accuracy of Expected Return Estimates
Problem
Using the returns for the S&P 500 from 2005–2017 only (see Table 10.2), what is the 95%
confidence interval you would estimate for the S&P 500’s expected return?
Solution
Earlier, we calculated the average return for the S&P 500 during this period to be 10.0%, with a
volatility of 17.0% (see Example 10.3). The standard error of our estimate of the expected return
is 17.0% , 213 = 4.7%, and the 95% confidence interval is 10.0% { (2 * 4.7%), or from
0.6% to 19.4%. As this example shows, with only a few years of data, we cannot reliably estimate
expected returns for stocks!
CONCEPT CHECK 1. How do we estimate the average annual return of an investment?

2. We have 92 years of data on the S&P 500 returns, yet we cannot estimate the expected
return of the S&P 500 very accurately. Why?
10
If returns are independent and from a normal distribution, then the estimated mean will be within two
standard errors of the true mean 95.44% of the time. Even if returns are not normally distributed, this
formula is approximately correct with a sufficient number of independent observations.
Arithmetic Average Returns Versus Compound Annual Returns

We compute average annual returns by calculating an This logic implies that the compound annual return will al-
arithmetic average. An alternative is the compound annual ways be below the average return, and the difference grows
return (also called the compound annual growth rate, or with the volatility of the annual returns. (Typically, the dif-
CAGR), which is computed as the geometric average of the ference is about half of the variance of the returns.)
annual returns R1, c , RT : Which is a better description of an investment’s return?
Compound Annual Return = The compound annual return is a better description of
the long-run historical performance of an investment. It
[(1 + R1) * (1 + R2 ) * c * (1 + RT )]1/T - 1
describes the equivalent risk-free return that would be
It is equivalent to the IRR of the investment over the period: required to duplicate the investment’s performance over the
(Final Value/Initial Investment)1/T - 1 same time period. The ranking of the long-run performance
of different investments coincides with the ranking of their
For example, using the data in Figure 10.1, the com- compound annual returns. Thus, the compound annual
pound annual return of the S&P 500 from 1926–2017 was return is the return that is most often used for comparison
(664,567/100)1/92 - 1 = 10.04% purposes. For example, mutual funds generally report their
That is, investing in the S&P 500 from 1926 to 2018 was compound annual returns over the last five or ten years.
equivalent to earning 10.04% per year over that time period. Conversely, we should use the arithmetic average return
Similarly, the compound annual return for small stocks was when we are trying to estimate an investment’s expected
12.66%, for corporate bonds was 6.06%, and for Treasury return over a future horizon based on its past performance.
bills was 3.3%. If we view past returns as independent draws from the
In each case, the compound annual return is below the same distribution, then the arithmetic average return pro-
average annual return shown in Table 10.3. This difference vides an unbiased estimate of the true expected return.*
reflects the fact that returns are volatile. To see the effect For example, if the investment mentioned above is
of volatility, suppose an investment has annual returns equally likely to have annual returns of + 20% and - 20%
of + 20% one year and - 20% the next year. The average in the future, then if we observe many two-year periods, a
annual return is 12 (20% - 20%) = 0%, but the value of $1 $1 investment will be equally likely to grow to
invested after two years is
(1.20)(1.20) = $1.44,
$1 * (1.20) * (0.80) = $0.96 (1.20)(0.80) = $0.96,
That is, an investor would have lost money. Why? (0.80)(1.20) = $0.96,
Because the 20% gain happens on a $1 investment, whereas or (0.80)(0.80) = $0.64.
the 20% loss happens on a larger investment of $1.20. In
Thus, the average value in two years will be
this case, the compound annual return is
(1.44 + 0.96 + 0.96 + 0.64)>4 = $1, so that the expected
(0.96)1/2 - 1 = - 2.02% annual and two-year returns will both be 0%.
* For this result to hold we must compute the historical returns using the same time interval as the expected return we are estimating; that is, we use
the average of past monthly returns to estimate the future monthly return, or the average of past annual returns to estimate the future annual return.
Because of estimation error the estimate for different time intervals will generally differ from the result one would get by simply compounding the
average annual return. With enough data, however, the results will converge.
10.4 The Historical Tradeoff Between Risk

and Return
In Chapter 3, we discussed the idea that investors are risk averse: The benefit they receive
from an increase in income is smaller than the personal cost of an equivalent decrease in
income. This idea suggests that investors would not choose to hold a portfolio that is more
volatile unless they expected to earn a higher return. In this section, we quantify the histori-
cal relationship between volatility and average returns.
10.4 The Historical Tradeoff Between Risk and Return 369
The Returns of Large Portfolios

In Tables 10.3 and 10.4, we computed the historical average returns and volatilities for several
different types of investments. We combine those data in Table 10.5, which lists the volatility
and excess return for each investment. The excess return is the difference between the average
return for the investment and the average return for Treasury bills, a risk-free investment, and
measures the average risk premium investors earned for bearing the risk of the investment.
In Figure 10.6, we plot the average return versus the volatility of different investments.
In addition to the ones we have already considered, we also include data for a large port-
folio of mid-cap stocks, or stocks of median size in the U.S. market. Note the positive
relationship: The investments with higher volatility have rewarded investors with higher
average returns. Both Table 10.5 and Figure 10.6 are consistent with our view that investors
are risk averse. Riskier investments must offer investors higher average returns to compen-
sate them for the extra risk they are taking on.
TABLE 10.5 Volatility Versus Excess Return of U.S. Small Stocks,

Large Stocks (S&P 500), Corporate Bonds, and Treasury
Bills, 1926–2017
Excess Return
Return Volatility (Average Return in Excess
Investment (Standard Deviation) of Treasury Bills)
Small stocks 39.2% 15.3%
S&P 500 19.8% 8.6%
Corporate bonds 6.4% 2.9%
Treasury bills (30-day) 3.1% 0.0%
FIGURE 10.6
25%
The Historical
Tradeoff Between Small
Risk and Return 20% Stocks
Historical Average Return
in Large Portfolios Mid-Cap

Note the general increas- Stocks
ing relationship between 15%
S&P 500
historical volatility and av-
erage return for these large
portfolios. In addition to the 10% Corporate
portfolios in Figure 10.1, Bonds World 8.6% historical excess return
Portfolio of S&P 500 over TBills
also included is a mid-
cap portfolio composed 5%
of the 10% of U.S. stocks Treasury
Bills
whose size is just above the
median of all U.S. stocks. 0%
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
(Data from 1926–2014.)
Historical Volatility (standard deviation)
Source: CRSP, Morgan Stanley
Capital International
The Returns of Individual Stocks

Figure 10.6 suggests the following simple model of the risk premium: Investments
with higher volatility should have a higher risk premium and therefore higher returns.
Indeed, looking at Figure 10.6 it is tempting to draw a line through the portfolios and
conclude that all investments should lie on or near this line—that is, expected return
should rise proportionately with volatility. This conclusion appears to be approximately
true for the large portfolios we have looked at so far. Is it correct? Does it apply to in-
dividual stocks?
Unfortunately, the answer to both questions is no. Figure 10.7 shows that, if we
look at the volatility and return of individual stocks, we do not see any clear relation-
ship between them.
We can make several important observations from these data. First, there is a re-
lationship between size and risk: Larger stocks have lower volatility overall. Second,
even the largest stocks are typically more volatile than a portfolio of large stocks, the
S&P500. Finally, there is no clear relationship between volatility and return. While the
smallest stocks have a slightly higher average return, many stocks have higher volatility
and lower average returns than other stocks. And all stocks seem to have higher risk and
lower returns than we would have predicted from a simple extrapolation of our data
from large portfolios.
Thus, while volatility is perhaps a reasonable measure of risk when evaluating a large
portfolio, it is not adequate to explain the returns of individual securities. Why wouldn’t
investors demand a higher return from stocks with a higher volatility? And how is it that
the S&P 500—a portfolio of the 500 largest stocks—is so much less risky than all of the
500 stocks individually? To answer these questions, we need to think more carefully about
how to measure risk for an investor.
FIGURE 10.7
Historical Volatility
and Return of the 500 25%
= stocks 1–50
Largest Individual Stocks = stocks 51–400 Small
Each point represents the 20% = stocks 401–500 Stocks
Historical Average Return
volatility and average

Mid-Cap
return of investing in the Stocks
Nth largest stock traded in 15%
the United States (updated S&P 500
annually). Unlike the case
for large portfolios, there 10% Corporate
is no precise relationship Bonds World
between volatility and Portfolio
average return for individual 5%
stocks. Individual stocks Treasury
have higher volatility and Bills
lower average returns than 0%
the relationship shown for 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
large portfolios. (Annual Historical Volatility (standard deviation)
data from 1926–2014.)
Source: CRSP
10.5 Common Versus Independent Risk 371
CONCEPT CHECK 1. What is the excess return?

2. Do expected returns of well-diversified large portfolios of stocks appear to increase with
volatility?
3. Do expected returns for individual stocks appear to increase with volatility?
10.5 Common Versus Independent Risk

In this section, we explain why the risk of an individual security differs from the risk of a port-
folio composed of similar securities. We begin with an example from the insurance industry.
Theft Versus Earthquake Insurance: An Example

Consider two types of home insurance: theft insurance and earthquake insurance. Let us
assume, for the purpose of illustration, that the risk of each of these two hazards is similar
for a given home in the San Francisco area. Each year there is about a 1% chance that the
home will be robbed and a 1% chance that the home will be damaged by an earthquake. So,
the chance the insurance company will pay a claim for a single home is the same for both
types of insurance policies. Suppose an insurance company writes 100,000 policies of each
type for homeowners in San Francisco. We know that the risks of the individual policies
are similar, but are the risks of the portfolios of policies similar?
First, consider theft insurance. Because the chance of a theft in any given home is 1%,
we would expect about 1% of the 100,000 homes to experience a robbery. Thus, the num-
ber of theft claims will be about 1000 per year. The actual number of claims may be a
bit higher or lower each year, but not by much. We can estimate the likelihood that the
insurance company will receive different numbers of claims, assuming that instances of
theft are independent of one another (that is, the fact that one house is robbed does not
change the odds of other houses being robbed). The number of claims will almost always
be between 875 and 1125 (0.875% and 1.125% of the number of policies written). In this
case, if the insurance company holds reserves sufficient to cover 1200 claims, it will almost
certainly have enough to meet its obligations on its theft insurance policies.
Now consider earthquake insurance. Most years, an earthquake will not occur. But be-
cause the homes are in the same city, if an earthquake does occur, all homes are likely to
be affected and the insurance company can expect as many as 100,000 claims. As a result,
the insurance company will have to hold reserves sufficient to cover claims on all 100,000
policies it wrote to meet its obligations if an earthquake occurs.
Thus, although the expected numbers of claims may be the same, earthquake and theft
insurance lead to portfolios with very different risk characteristics. For earthquake insurance,
the number of claims is very risky. It will most likely be zero, but there is a 1% chance that
the insurance company will have to pay claims on all the policies it wrote. In this case, the risk
of the portfolio of insurance policies is no different from the risk of any single policy—it
is still all or nothing. Conversely, for theft insurance, the number of claims in a given year is
quite predictable. Year in and year out, it will be very close to 1% of the total number of poli-
cies, or 1000 claims. The portfolio of theft insurance policies has almost no risk!11
11
In the case of insurance, this difference in risk—and therefore in required reserves—can lead to a sig-
nificant difference in the cost of the insurance. Indeed, earthquake insurance is generally thought to be
much more expensive to purchase, even though the risk to an individual household may be similar to other
risks, such as theft or fire.
Types of Risk. Why are the portfolios of insurance policies so different when the indi-
vidual policies themselves are quite similar? Intuitively, the key difference between them is
that an earthquake affects all houses simultaneously, so the risk is perfectly correlated across
homes. We call risk that is perfectly correlated common risk. In contrast, because thefts in
different houses are not related to each other, the risk of theft is uncorrelated and indepen-
dent across homes. We call risks that share no correlation independent risks. When risks
are independent, some individual homeowners are unlucky and others are lucky, but overall
the number of claims is quite predictable. The averaging out of independent risks in a large
portfolio is called diversification.
The Role of Diversification

We can quantify this difference in terms of the standard deviation of the percentage of
claims. First, consider the standard deviation for an individual homeowner. At the begin-
ning of the year, the homeowner expects a 1% chance of placing a claim for either type of
insurance. But at the end of the year, the homeowner will have filed a claim (100%) or not
(0%). Using Eq. 10.2, the standard deviation is
SD(Claim) = 2Var (Claim)

= 20.99 * (0 - 0.01)2 + 0.01 * (1 - 0.01)2 = 9.95%
For the homeowner, this standard deviation is the same for a loss from earthquake
or theft.
Now consider the standard deviation of the percentage of claims for the insurance
company. In the case of earthquake insurance, because the risk is common, the per-
centage of claims is either 100% or 0%, just as it was for the homeowner. Thus, the
percentage of claims received by the earthquake insurer is also 1% on average, with a
9.95% standard deviation.
While the theft insurer also receives 1% of claims on average, because the risk of theft
is independent across households, the portfolio is much less risky. To quantify this differ-
ence, let’s calculate the standard deviation of the average claim using Eq. 10.8. Recall that
when risks are independent and identical, the standard deviation of the average is known
as the standard error, which declines with the square root of the number of observations.
Therefore,
SD(Individual Claim)
SD(Percentage Theft Claims) =
9.95%
= = 0.03%
2100,000
Thus, there is almost no risk for the theft insurer.

The principle of diversification is used routinely in the insurance industry. In addition to
theft insurance, many other forms of insurance (e.g., life, health, auto) rely on the fact that
the number of claims is relatively predictable in a large portfolio. Even in the case of earth-
quake insurance, insurers can achieve some diversification by selling policies in different
geographical regions or by combining different types of policies. Diversification reduces
risk in many other settings as well. For example, farmers often diversify the types of crops
they plant to reduce the risk from the failure of any individual crop. Similarly, firms may
diversify their supply chains or product lines to reduce the risk from supply disruptions or
demand shocks.
10.6 Diversification in Stock Portfolios 373
EXAMPLE 10.5 Diversification and Gambling
Problem
Roulette wheels are typically marked with the numbers 1 through 36 plus 0 and 00. Each of these
outcomes is equally likely every time the wheel is spun. If you place a bet on any one number
and are correct, the payoff is 35:1; that is, if you bet $1, you will receive $36 if you win ($35 plus
your original $1) and nothing if you lose. Suppose you place a $1 bet on your favorite number.
What is the casino’s expected profit? What is the standard deviation of this profit for a single bet?
Suppose 9 million similar bets are placed throughout the casino in a typical month. What is the
standard deviation of the casino’s average revenues per dollar bet each month?
Solution
Because there are 38 numbers on the wheel, the odds of winning are 1/38. The casino loses $35
if you win, and makes $1 if you lose. Therefore, using Eq. 10.1, the casino’s expected profit is
E [Payoff ] = (1/38) * (- $35) + (37/38) * ($1) = $0.0526
That is, for each dollar bet, the casino earns 5.26 cents on average. For a single bet, we calculate
the standard deviation of this profit using Eq. 10.2 as
SD(Payoff ) = 2(1/38) * (- 35 - 0.0526)2 + (37/38) * (1 - 0.0526)2 = $5.76
This standard deviation is quite large relative to the magnitude of the profits. But if many such
bets are placed, the risk will be diversified. Using Eq. 10.8, the standard deviation of the casino’s
average revenues per dollar bet (i.e., the standard error of their payoff) is only
$5.76
SD(Average Payoff ) = = $0.0019
29,000,000
In other words, by the same logic as Eq. 10.9, there is roughly 95% chance the casino’s profit per
dollar bet will be in the interval $0.0526 { (2 * 0.0019) = $0.0488 to $0.0564. Given $9 million
in bets placed, the casino’s monthly profits will almost always be between $439,000 and $508,000,
which is very little risk. The key assumption, of course, is that each bet is separate so that their
outcomes are independent of each other. If the $9 million were placed in a single bet, the casino’s
risk would be large—sustaining a loss of 35 * $9 million = $315 million if the bet wins. For
this reason, casinos often impose limits on the amount of any individual bet.
CONCEPT CHECK 1. What is the difference between common risk and independent risk?
2. Under what circumstances will risk be diversified in a large portfolio of insurance contracts?
10.6 Diversification in Stock Portfolios

As the insurance example indicates, the risk of a portfolio of insurance contracts depends
on whether the individual risks within it are common or independent. Independent risks
are diversified in a large portfolio, whereas common risks are not. Let’s consider the impli-
cation of this distinction for the risk of stock portfolios.12
12
Harry Markowitz was the first to formalize the role of diversification in forming an optimal stock mar-
ket portfolio. See H. Markowitz, “Portfolio Selection,” Journal of Finance 7 (1952): 77–91.
Firm-Specific Versus Systematic Risk

Over any given time period, the risk of holding a stock is that the dividends plus the final
stock price will be higher or lower than expected, which makes the realized return risky.
What causes dividends or stock prices, and therefore returns, to be higher or lower than we
expect? Usually, stock prices and dividends fluctuate due to two types of news:
1. Firm-specific news is good or bad news about the company itself. For example, a
firm might announce that it has been successful in gaining market share within its
industry.
2. Market-wide news is news about the economy as a whole and therefore affects all
stocks. For instance, the Federal Reserve might announce that it will lower interest
rates to boost the economy.
Fluctuations of a stock’s return that are due to firm-specific news are independent risks.
Like theft across homes, these risks are unrelated across stocks. This type of risk is also
referred to as firm-specific, idiosyncratic, unique, or diversifiable risk.
Fluctuations of a stock’s return that are due to market-wide news represent common
risk. As with earthquakes, all stocks are affected simultaneously by the news. This type of
risk is also called systematic, undiversifiable, or market risk.
When we combine many stocks in a large portfolio, the firm-specific risks for each stock
will average out and be diversified. Good news will affect some stocks, and bad news will
affect others, but the amount of good or bad news overall will be relatively constant. The
systematic risk, however, will affect all firms—and therefore the entire portfolio—and will
not be diversified.
Let’s consider an example. Suppose type S firms are affected only by the strength of the
economy, which has a 50–50 chance of being either strong or weak. If the economy is
strong, type S stocks will earn a return of 40%; if the economy is weak, their return will be
- 20%. Because these firms face systematic risk (the strength of the economy), holding a
large portfolio of type S firms will not diversify the risk. When the economy is strong, the
portfolio will have the same return of 40% as each type S firm; when the economy is weak,
the portfolio will also have a return of - 20%.
Now consider type I firms, which are affected only by idiosyncratic, firm-specific risks.
Their returns are equally likely to be 35% or - 25%, based on factors specific to each firm’s
local market. Because these risks are firm specific, if we hold a portfolio of the stocks of
many type I firms, the risk is diversified. About half of the firms will have returns of 35%,
and half will have returns of - 25%, so that the return of the portfolio will be close to the
average return of 0.5 (35%) + 0.5 ( - 25%) = 5%.
Figure 10.8 illustrates how volatility declines with the size of the portfolio for type S and
I firms. Type S firms have only systematic risk. As with earthquake insurance, the volatility
of the portfolio does not change as the number of firms increases. Type I firms have only
idiosyncratic risk. As with theft insurance, the risk is diversified as the number of firms
increases, and volatility declines. As is evident from Figure 10.8, with a large number of
firms, the risk is essentially eliminated.
Of course, actual firms are not like type S or I firms. Firms are affected by both sys-
tematic, market-wide risks and firm-specific risks. Figure 10.8 also shows how the volatility
changes with the size of a portfolio containing the stocks of typical firms. When firms
carry both types of risk, only the firm-specific risk will be diversified when we combine
many firms’ stocks into a portfolio. The volatility will therefore decline until only the sys-
tematic risk, which affects all firms, remains.
FIGURE 10.8
Volatility of Portfolio (standard deviation)

35%
Volatility of Portfolios of Type Type S

30%
S and I Stocks
Because type S firms have only 25%
systematic risk, the volatility of the
portfolio does not change. Type I 20%
firms have only idiosyncratic risk, Typical Firms
15%
which is diversified and eliminated as
the number of firms in the portfolio
10%
increases. Typical stocks carry a mix
of both types of risk, so that the risk 5%
of the portfolio declines as idiosyn- Type I
cratic risk is diversified away, but 0%
systematic risk still remains. 1 10 100 1000
Number of Stocks
This example explains one of the puzzles shown in Figure 10.7. There we saw that the
S&P 500 had much lower volatility than any of the individual stocks. Now we can see why:
The individual stocks each contain firm-specific risk, which is eliminated when we com-
bine them into a large portfolio. Thus, the portfolio as a whole can have lower volatility
than each of the stocks within it.
EXAMPLE 10.6 Portfolio Volatility
Problem
What is the volatility of the average return of ten type S firms? What is the volatility of the aver-
age return of ten type I firms?
Solution
Type S firms have equally likely returns of 40% or - 20%. Their expected return is
1 1
2 (40%) + 2 (- 20%) = 10%, so
SD(RS ) = 212 (0.40 - 0.10)2 + 12 (- 0.20 - 0.10)2 = 30%

Because all type S firms have high or low returns at the same time, the average return of ten
type S firms is also 40% or - 20%. Thus, it has the same volatility of 30%, as shown in Figure 10.8.
Type I firms have equally likely returns of 35% or - 25%. Their expected return is
1
2 (35%) + 12 (- 25%) = 5%, so
SD( RI ) = 212 (0.35 - 0.05)2 + 12 (- 0.25 - 0.05)2 = 30%
Because the returns of type I firms are independent, using Eq. 10.8, the average return of 10 type
I firms has volatility of 30% , 210 = 9.5%, as shown in Figure 10.8.
No Arbitrage and the Risk Premium

Consider again type I firms, which are affected only by firm-specific risk. Because each in-
dividual type I firm is risky, should investors expect to earn a risk premium when investing
in type I firms?
In a competitive market, the answer is no. To see why, suppose the expected return of
type I firms exceeds the risk-free interest rate. Then, by holding a large portfolio of many
type I firms, investors could diversify the firm-specific risk of these firms and earn a return
above the risk-free interest rate without taking on any significant risk.
The situation just described is very close to an arbitrage opportunity, which investors would
find very attractive. They would borrow money at the risk-free interest rate and invest it in a
large portfolio of type I firms, which offers a higher return with only a tiny amount of risk.13 As
more investors take advantage of this situation and purchase shares of type I firms, the current
share prices for type I firms would rise, lowering their expected return—recall that the current
share price Pt is the denominator when computing the stock’s return as in Eq. 10.4. This trading
would stop only after the return of type I firms equaled the risk-free interest rate. Competition
between investors drives the return of type I firms down to the risk-free return.
The preceding argument is essentially an application of the Law of One Price: Because
a large portfolio of type I firms has no risk, it must earn the risk-free interest rate. This no-
arbitrage argument suggests the following more general principle:
The risk premium for diversifiable risk is zero, so investors are not compensated for holding
firm-specific risk.
We can apply this principle to all stocks and securities. It implies that the risk premium of a
stock is not affected by its diversifiable, firm-specific risk. If the diversifiable risk of stocks
were compensated with an additional risk premium, then investors could buy the stocks,
earn the additional premium, and simultaneously diversify and eliminate the risk. By doing
so, investors could earn an additional premium without taking on additional risk. This op-
portunity to earn something for nothing would quickly be exploited and eliminated.14
Because investors can eliminate firm-specific risk “for free” by diversifying their portfo-
lios, they will not require a reward or risk premium for holding it. However, diversification
does not reduce systematic risk: Even holding a large portfolio, an investor will be exposed
to risks that affect the entire economy and therefore affect all securities. Because investors
are risk averse, they will demand a risk premium to hold systematic risk; otherwise they
would be better off selling their stocks and investing in risk-free bonds. Because investors
can eliminate firm-specific risk for free by diversifying, whereas systematic risk can be elim-
inated only by sacrificing expected returns, it is a security’s systematic risk that determines
the risk premium investors require to hold it. This fact leads to a second key principle:
The risk premium of a security is determined by its systematic risk and does not depend on its
diversifiable risk.
This principle implies that a stock’s volatility, which is a measure of total risk (that is,
systematic risk plus diversifiable risk), is not especially useful in determining the risk pre-
mium that investors will earn. For example, consider again type S and I firms. As calculated
in Example 10.6, the volatility of a single type S or I firm is 30%. Although both types of
firms have the same volatility, type S firms have an expected return of 10% and type I firms
have an expected return of 5%. The difference in expected returns derives from the dif-
ference in the kind of risk each firm bears. Type I firms have only firm-specific risk, which
does not require a risk premium, so the expected return of 5% for type I firms equals the
13
If investors could actually hold a large enough portfolio and completely diversify all the risk, then this
would be a true arbitrage opportunity.
14
The main thrust of this argument can be found in S. Ross, “The Arbitrage Theory of Capital Asset
Pricing,” Journal of Economic Theory 13 (December 1976): 341–360.
GLOBAL FINANCIAL CRISIS Diversification Benefits During Market Crashes

The figure below illustrates the benefits of diversification (i.e., the pink area is about 50% of the total). But as the figure
over the last 45 years. The blue graph shows the historical demonstrates, during the 1987 stock market crash, the 2008
volatility of the S&P 500 portfolio (annualized based on financial crisis, and the recent Eurozone debt crisis, this frac-
daily returns each quarter). The pink graph is the average tion fell dramatically, so that only about 20% of the volatility
volatility of the individual stocks in the portfolio (weighted of individual stocks could be diversified. The combined ef-
according to the size of each stock). Thus, the pink shaded fect of increased volatility and reduced diversification during
area is idiosyncratic risk—risk that has been diversified away the 2008 financial crisis was so severe that the risk that in-
by holding the portfolio. The blue area is market risk which vestors care about—market risk—increased seven-fold, from
cannot be diversified. 10% to 70%, between 2006 and the last quarter of 2008.
Market volatility clearly varies, increasing dramatically dur- Although you are always better off diversifying, it is im-
ing times of crisis. But notice also that the fraction of risk portant to keep in mind that the benefits of diversification
that can be diversified away also varies, and seems to decline depend on economic conditions. In times of extreme crisis,
during times of crisis. For example, since 1970, on average the benefits may go down, making downturns in the market
about 50% of the volatility of individual stocks is diversifiable particularly painful for investors.
2008 Lehman Collapse

Weighted Average Volatility of Individual Stocks
100%
Volatility of S&P 500
90%
1987 Market Crash
80%
Annualized Volatility
70%
2010–11
60%
Euro Crisis
50%
40%
30%
20%
10%
0%
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Year
risk-free interest rate. Type S firms have only systematic risk. Because investors will require
compensation for taking on this risk, the expected return of 10% for type S firms provides
investors with a 5% risk premium above the risk-free interest rate.
We now have an explanation for the second puzzle of Figure 10.7. While volatility might
be a reasonable measure of risk for a well-diversified portfolio, it is not an appropriate met-
ric for an individual security. Thus, there should be no clear relationship between volatility
and average returns for individual securities. Consequently, to estimate a security’s expected
return, we need to find a measure of a security’s systematic risk.
In Chapter 3, we argued that an investment’s risk premium depends on how its returns
move in relation to the overall economy. In particular, risk-averse investors will demand a pre-
mium to invest in securities that will do poorly in bad times (recall, for example, the perfor-
mance of small stocks in Figure 10.1 during the Great Depression). This idea coincides with
the notion of systematic risk we have defined in this chapter. Economy-wide risk—that is,
the risk of recessions and booms—is systematic risk that cannot be diversified. Therefore an
asset that moves with the economy contains systematic risk and so requires a risk premium.
EXAMPLE 10.7 Diversifiable Versus Systematic Risk
Problem
Which of the following risks of a stock are likely to be firm-specific, diversifiable risks, and
which are likely to be systematic risks? Which risks will affect the risk premium that investors
will demand?
a. The risk that the founder and CEO retires
b. The risk that oil prices rise, increasing production costs
c. The risk that a product design is faulty and the product must be recalled
d. The risk that the economy slows, reducing demand for the firm’s products
Solution
Because oil prices and the health of the economy affect all stocks, risks (b) and (d) are systematic
risks. These risks are not diversified in a large portfolio, and so will affect the risk premium that
investors require to invest in a stock. Risks (a) and (c) are firm-specific risks, and so are diversifi-
able. While these risks should be considered when estimating a firm’s future cash flows, they will
not affect the risk premium that investors will require and, therefore, will not affect a firm’s cost
of capital.
COMMON MISTAKE A Fallacy of Long-Run Diversification
We have seen that investors can greatly reduce their risk by would have a little over $2 million. If instead her investment
dividing their investment dollars over many different invest- horizon was 83 years (end of 2008) her portfolio would have
ments, eliminating the diversifiable risk in their portfolios. dropped by over 50% to just $1 million. Again, having a lon-
Does the same logic apply over time? That is, by investing ger horizon did not reduce risk!
for many years, can we also diversify the risk we face during More generally, if returns are independent over time so
any particular year? In the long run, does risk still matter? that future returns are not affected by past returns, then any
Equation 10.8 tells us that if returns each year are inde- change in the value of our portfolio today will translate into
pendent, the volatility of the average annual return declines the same percentage change in the value of our portfolio
with the number of years that we invest. Of course, as long- in the future, and there is no diversification over time. The
term investors, we don’t care about the volatility of our average only way the length of the time horizon can reduce risk is if
return; instead, we care about the volatility of our cumulative a below-average return today implies that returns are more
return over the period. This volatility grows with the investment likely to be above average in the future (and vice versa), a
horizon, as illustrated in the following example. phenomenon sometimes referred to as mean reversion. Mean
In 1925, large U.S. stocks increased in value by about 30%. reversion implies that past low returns can be used to pre-
In fact, a $77 investment at the start of 1925 would have dict future high returns in the stock market.
grown to $77 * 1.30 = $100 by the end of the year. Notice For short horizons of a few years, there is no evidence
from Figure 10.1 that a $100 investment in the S&P 500 of mean reversion in the stock market. For longer horizons,
from 1926 onward would have grown to about $664,567 by there is some evidence of mean reversion historically, but
the start of 2018. But suppose instead stocks had dropped by it is not clear how reliable this evidence is (there are not
35% in 1925. Then, the initial $77 invested would be worth enough decades of accurate stock market data available) or
only $77 * (1 - 35%) = $50 at the beginning of 1926. If whether the pattern will continue. Even if there is long-run
returns from then on were unchanged, the investment would mean reversion in stock returns, a buy-and-hold diversifica-
be worth half as much in 2018, or $332,283. Thus, despite tion strategy is still not optimal: Because mean reversion im-
the long horizon, the difference in the first year’s return still plies that past returns can be used to predict future returns,
has a significant effect on the final payoff. you should invest more in stocks when returns are predicted
The financial crisis in 2008 brought home the reality of to be high, and invest less when they are predicted to be
this fallacy to many investors. Consider for example, a long- low. This strategy is very different from the diversification
term investor who invested $100 in small stocks in 1925. we achieve by holding many stocks, where we cannot predict
If her investment horizon was 81 years (end of 2006), she which stocks will have good or bad firm-specific shocks.
10.7 Measuring Systematic Risk 379
CONCEPT CHECK 1. Explain why the risk premium of diversifiable risk is zero.
2. Why is the risk premium of a security determined only by its systematic risk?
10.7 Measuring Systematic Risk

As we have discussed, investors can eliminate the firm-specific risk in their investments by
diversifying their portfolio. Thus, when evaluating the risk of an investment, an investor
will care about its systematic risk, which cannot be eliminated through diversification. In
exchange for bearing systematic risk, investors want to be compensated by earning a higher
return. So, to determine the additional return, or risk premium, investors will require to
undertake an investment, we first need to measure the investment’s systematic risk.
Identifying Systematic Risk: The Market Portfolio

To measure the systematic risk of a stock, we must determine how much of the variability
of its return is due to systematic, market-wide risks versus diversifiable, firm-specific risks.
That is, we would like to know how sensitive the stock is to systematic shocks that affect
the economy as a whole.
To determine how sensitive a stock’s return is to interest rate changes, for example, we
would look at how much the return tends to change on average for each 1% change in in-
terest rates. Similarly, to determine how sensitive a stock’s return is to oil prices, we would
examine the average change in the return for each 1% change in oil prices. In the same way,
to determine how sensitive a stock is to systematic risk, we can look at the average change in
its return for each 1% change in the return of a portfolio that fluctuates solely due to systematic risk.
Thus, the first step to measuring systematic risk is finding a portfolio that contains only
systematic risk. Changes in the price of this portfolio will correspond to systematic shocks
to the economy. We call such a portfolio an efficient portfolio. An efficient portfolio
cannot be diversified further—that is, there is no way to reduce the risk of the portfolio
without lowering its expected return. How can we identify such a portfolio?
As we will see over the next few chapters, the best way to identify an efficient portfolio
is one of the key questions in modern finance. Because diversification improves with the
number of stocks held in a portfolio, an efficient portfolio should be a large portfolio
containing many different stocks. Thus, a natural candidate for an efficient portfolio is
the market portfolio, which is a portfolio of all stocks and securities traded in the capital
markets. Because it is difficult to find data for the returns of many bonds and small stocks,
it is common in practice to use the S&P 500 portfolio as an approximation for the market
portfolio, under the assumption that the S&P 500 is large enough to be essentially fully
diversified.
Sensitivity to Systematic Risk: Beta

If we assume that the market portfolio (or the S&P 500) is efficient, then changes in the
value of the market portfolio represent systematic shocks to the economy. We can then
measure the systematic risk of a security by calculating the sensitivity of the security’s re-
turn to the return of the market portfolio, known as the beta (b) of the security. More
precisely,
The beta of a security is the expected % change in its return given a 1% change in the return of the
market portfolio.
EXAMPLE 10.8 Estimating Beta
Problem
Suppose the market portfolio tends to increase by 47% when the economy is strong and decline
by 25% when the economy is weak. What is the beta of a type S firm whose return is 40% on
average when the economy is strong and - 20% when the economy is weak? What is the beta of
a type I firm that bears only idiosyncratic, firm-specific risk?
Solution
The systematic risk of the strength of the economy produces a 47% - (- 25%) = 72% change
in the return of the market portfolio. The type S firm’s return changes by 40% - (- 20%) = 60%
on average. Thus the firm’s beta is bS = 60%/72% = 0.833. That is, each 1% change in the
return of the market portfolio leads to a 0.833% change in the type S firm’s return on average.
The return of a type I firm has only firm-specific risk, however, and so is not affected by the
strength of the economy. Its return is affected only by factors specific to the firm. Because it will
have the same expected return, whether the economy is strong or weak, bI = 0%/72% = 0.
Real-Firm Betas. We will look at statistical techniques for estimating beta from historical
stock returns in Chapter 12. There we will see that we can estimate beta reasonably accu-
rately using just a few years of data (which was not the case for expected returns, as we saw
in Example 10.4). Using the S&P 500 to represent the market’s return, Table 10.6 shows
the betas of several stocks during 2013–2018. As shown in the table, each 1% change in the
return of the market during this period led, on average, to a 1.24% change in the return for
Apple but only a 0.73% change in the return for Coca-Cola.
Interpreting Betas. Beta measures the sensitivity of a security to market-wide risk fac-
tors. For a stock, this value is related to how sensitive its underlying revenues and cash
flows are to general economic conditions. The average beta of a stock in the market is
about 1; that is, the average stock price tends to move about 1% for each 1% move in the
overall market. Stocks in cyclical industries, in which revenues and profits vary greatly over
the business cycle, are likely to be more sensitive to systematic risk and have betas that ex-
ceed 1, whereas stocks of non-cyclical firms tend to have betas that are less than 1.
For example, notice the relatively low betas of Edison International (a utility company),
Johnson & Johnson (pharmaceuticals), Tyson Foods and Hershey (food processing), and
Procter & Gamble (household products). Utilities tend to be stable and highly regulated,
and thus are insensitive to fluctuations in the overall market. Drug and food companies are
also insensitive—the demand for their products appears to be unrelated to the booms and
busts of the economy as a whole.
At the other extreme, technology stocks tend to have higher betas; consider Hewlett-
Packard, Netgear, Autodesk, and Advanced Micro Devices. Shocks in the economy have
an amplified impact on these stocks: When the market as a whole is up, Advanced Micro
Devices’ (AMD)’s stock tends to rise nearly three times as much; but when the market
stumbles, it tends to fall nearly three times as far. Note also the high beta of furniture and
luxury retailers Ethan Allen and Tiffany & Co., compared with the much lower beta of
Walmart; presumably their sales respond very differently to economic booms and busts.
Finally, we see that highly levered firms in cyclical industries, such as General Motors and
Nucor, tend to have high betas reflecting their sensitivity to economic conditions.
CONCEPT CHECK 1. What is the market portfolio?

2. Define the beta of a security.
10.7 Measuring Systematic Risk 381
TABLE 10.6 Betas with Respect to the S&P 500 for Individual Stocks (based on monthly data
for 2013–2018)
Company Ticker Industry Equity Beta
Edison International EIX Utilities 0.15
Tyson Foods TSN Packaged Foods 0.19
Newmont Mining NEM Gold 0.31
The Hershey Company HSY Packaged Foods 0.33
Clorox CLX Household Products 0.34
Walmart WMT Superstores 0.55
Procter & Gamble PG Household Products 0.55
McDonald's MCD Restaurants 0.63
Nike NKE Footwear 0.64
Pepsico PEP Soft Drinks 0.68
Williams-Sonoma WSM Home Furnishing Retail 0.71
Coca-Cola KO Soft Drinks 0.73
Johnson & Johnson JNJ Pharmaceuticals 0.73
Macy's M Department Stores 0.75
Molson Coors Brewing TAP Brewers 0.78
Starbucks SBUX Restaurants 0.80
Foot Locker FL Apparel Retail 0.83
Harley-Davidson HOG Motorcycle Manufacturers 0.88
Pfizer PFE Pharmaceuticals 0.89
Sprouts Farmers Market SFM Food Retail 0.89
Philip Morris PM Tobacco 0.89
Intel INTC Semiconductors 0.93
Netflix NFLX Internet Retail 0.98
Kroger KR Food Retail 1.04
Microsoft MSFT Systems Software 1.04
Alphabet GOOGL Internet Software and Services 1.06
eBay EBAY Internet Software and Services 1.11
Cisco Systems CSCO Communications Equipment 1.14
Southwest Airlines LUV Airlines 1.15
Apple AAPL Computer Hardware 1.24
salesforce.com CRM Application Software 1.25
Walt Disney DIS Movies and Entertainment 1.29
Marriott International MAR Hotels and Resorts 1.32
Amgen AMGN Biotechnology 1.37
Toll Brothers TOL Homebuilding 1.37
Wynn Resorts Ltd. WYNN Casinos and Gaming 1.38
Parker-Hannifin PH Industrial Machinery 1.43
Prudential Financial PRU Insurance 1.51
Nucor NUE Steel 1.57
Amazon.com AMZN Internet Retail 1.62
General Motors GM Automobile Manufacturers 1.64
Autodesk ADSK Application Software 1.72
Hewlett-Packard HPQ Computer Hardware 1.77
Tiffany & Co. TIF Apparel and Luxury Goods 1.77
Brunswick BC Leisure Products 1.84
Chesapeake Energy CHK Oil and Gas Exploration 1.85
Netgear NTGR Communications Equipment 1.94
Ethan Allen Interiors ETH Home Furnishings 2.04
Trimble TRMB Electronic Equipment 2.44
Advanced Micro Devices AMD Semiconductors 2.83
Source : CapitalIQ
10.8 Beta and the Cost of Capital

Throughout this text, we have emphasized that financial managers should evaluate an
investment opportunity based on its cost of capital, which is the expected return avail-
able on alternative investments in the market with comparable risk and term. For risky
investments, this cost of capital corresponds to the risk-free interest rate, plus an ap-
propriate risk premium. Now that we can measure the systematic risk of an investment
according to its beta, we are in a position to estimate the risk premium investors will
require.
Estimating the Risk Premium

Before we can estimate the risk premium of an individual stock, we need a way to assess
investors’ appetite for risk. The size of the risk premium investors will require to make a
risky investment depends upon their risk aversion. Rather than attempt to measure this risk
aversion directly, we can measure it indirectly by looking at the risk premium investors’
demand for investing in systematic, or market, risk.
The Market Risk Premium. We can calibrate investors’ appetite for market risk from the
market portfolio. The risk premium investors earn by holding market risk is the difference
between the market portfolio’s expected return and the risk-free interest rate:
Market Risk Premium = E[RMkt ] - rf (10.10)
For example, if the risk-free rate is 5% and the expected return of the market portfolio
is 11%, the market risk premium is 6%. In the same way that the market interest rate
reflects investors’ patience and determines the time value of money, the market risk
premium reflects investors’ risk tolerance and determines the market price of risk in the
economy.
Adjusting for Beta. The market risk premium is the reward investors expect to earn
for holding a portfolio with a beta of 1—the market portfolio itself. Consider an in-
vestment opportunity with a beta of 2. This investment carries twice as much system-
atic risk as an investment in the market portfolio. That is, for each dollar we invest
in the opportunity, we could invest twice that amount in the market portfolio and be
exposed to exactly the same amount of systematic risk. Because it has twice as much
systematic risk, investors will require twice the risk premium to invest in an opportunity
with a beta of 2.
COMMON MISTAKE Beta Versus Volatility

Recall that beta differs from volatility. Volatility measures total drug companies face a great deal of risk related to the devel-
risk—that is, both market and firm-specific risks—so that opment and approval of new drugs, this risk is unrelated to
there is no necessary relationship between volatility and beta. the rest of the economy. And though healthcare expenditures
For example, from 2013 to 2018, the stocks of pharmaceuti- do vary a little with the state of the economy, they vary much
cal firm The Medicines Company and semiconductor maker less than expenditures on technology. Thus, while their vola-
and networking equipment maker Belden had similar volatility tilities are similar, much more of the risk of The Medicines
(about 11% per month). The Medicines Company, however, Company’s stock is diversifiable risk, whereas Belden’s stock
had a much lower beta (0.6 versus about 2.4 for Belden). While has a much greater proportion of systematic risk.
10.8 Beta and the Cost of Capital 383
To summarize, we can use the beta of the investment to determine the scale of the
investment in the market portfolio that has equivalent systematic risk. Thus, to compen-
sate investors for the time value of their money as well as the systematic risk they are
bearing, the cost of capital rI for an investment with beta bI should satisfy the following
formula:
Estimating the Cost of Capital of an Investment from Its Beta
rI = Risk@Free Interest Rate + bI * Market Risk Premium
= rf + bI * (E3 RMkt 4 - rf ) (10.11)
As an example, let’s consider Netgear (NTGR) and Procter & Gamble (PG) stocks,
using the beta estimates in Table 10.6. According to Eq. 10.11, if the market risk pre-
mium is 5% and the risk-free interest rate is 4%, the equity cost of capital for each of
these firms is
rNTGR = 4% + 1.94 * 5% = 13.7%
rPG = 4% + 0.55 * 5% = 6.75%
Thus, the difference in the average returns of these two stocks that we reported in the in-
troduction of this chapter is not so surprising. Investors in Netgear require a much higher
return on average to compensate them for Netgear’s much higher systematic risk.
EXAMPLE 10.9 Expected Returns and Beta
Problem
Suppose the risk-free rate is 5% and the economy is equally likely to be strong or weak. Use Eq.
10.11 to determine the cost of capital for the type S firms considered in Example 10.8. How does
this cost of capital compare with the expected return for these firms?
Solution
If the economy is equally likely to be strong or weak, the expected return of the market is
E [RMkt ] = 12 (0.47) + 12 (- 0.25) = 11%, and the market risk premium is E [RMkt ] - rf =
11% - 5% = 6%. Given the beta of 0.833 for type S firms that we calculated in Example 10.8, the
estimate of the cost of capital for type S firms from Eq. 10.11 is
rs = rf + bs * (E [RMkt ] - rf ) = 5% + 0.833 * (11% - 5%) = 10%
This matches their expected return: 12 (40%) + 12 (- 20%) = 10%. Thus, investors who hold
these stocks can expect a return that appropriately compensates them for the systematic risk they
are bearing by holding them (as we should expect in a competitive market).
What happens if a stock has a negative beta? According to Eq. 10.11, such a stock
would have a negative risk premium—it would have an expected return below the risk-free
rate. While this might seem unreasonable at first, note that stock with a negative beta will
tend to do well when times are bad, so owning it will provide insurance against the system-
atic risk of other stocks in the portfolio. (For an example of such a security, see Example
3A.1 in Chapter 3.) Risk-averse investors are willing to pay for this insurance by accepting
a return below the risk-free interest rate.
The Capital Asset Pricing Model

Equation 10.11, for estimating the cost of capital, is often referred to as the Capital Asset
Pricing Model (CAPM),15 the most important method for estimating the cost of capital
that is used in practice. In this chapter, we have provided an intuitive justification of the
CAPM, and its use of the market portfolio as the benchmark for systematic risk. We pro-
vide a more complete development of the model and its assumptions in Chapter 11, where
we also detail the portfolio optimization process used by professional fund managers.
Then, in Chapter 12, we look at the practicalities of implementing the CAPM, and develop
statistical tools for estimating the betas of individual stocks, together with methods for
estimating the beta and cost of capital of projects within these firms. Finally, in Chapter 13
we look at the empirical evidence for (and against) the CAPM, both as a model of investor
behavior and as forecast of expected returns, and introduce some proposed extensions to
the CAPM.
CONCEPT CHECK 1. How can you use a security’s beta to estimate its cost of capital?
2. If a risky investment has a beta of zero, what should its cost of capital be according to the
CAPM? How can you justify this?
Here is what you should know after reading this chapter. MyLab Finance will
MyLab Finance help you identify what you know and where to go when you need to practice.
10.1 Risk and Return: Insights from 92 Years of Investor History

■■ Historically, over long horizons, investments in stocks have outperformed investments in bonds.
■■ Investing in stocks has also been much riskier than investing in bonds historically. Even over
a horizon of 5 years, there have been many occasions in the past that stocks have substantially
underperformed bonds.
10.2 Common Measures of Risk and Return

■■ A probability distribution summarizes information about possible different returns and their
likelihood of occurring.
■■ The expected, or mean, return is the return we expect to earn on average:
Expected Return = E [R ] = a pR * R (10.1)

R
■■ The variance or standard deviation measures the variability of the returns:
Var (R ) = E [(R - E [R ] )2 ] = a pR * (R - E [R ])2
R
SD (R ) = 2Var (R ) (10.2)
■■ The standard deviation of a return is also called its volatility.
15
The CAPM was first developed independently by William Sharpe, Jack Treynor, John Lintner, and Jan
Mossin. See J. Lintner “The Valuation of Risk Assets and the Selection of Risky Investments in Stock
Portfolios and Capital Budgets,” Review of Economics and Statistics 47 (1965): 13–37; W. Sharpe, “Capital
Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk,” Journal of Finance 19 (1964):
425–442; J. Treynor, “Toward a Theory of the Market Value of Risky Assets” (1961); and J. Mossin
“Equilibrium in a Capital Asset Market,” Econometrica, 34 (1966): 768–783.
MyLab Finance 385
10.3 Historical Returns of Stocks and Bonds

■■ The realized or total return for an investment is the total of the dividend yield and the capital
gain rate.
■■ Using the empirical distribution of realized returns, we can estimate the expected return and
variance of the distribution of returns by calculating the average annual return and variance
of realized returns:
(R1 + R2 + g + RT ) = a Rt
1 1 T
R = (10.6)
T Tt =1
a
T
1
Var (R ) = (R - R )2 (10.7)
T - 1t =1 t
■■ The square root of the estimated variance is an estimate of the volatility of returns.
■■ Because a security’s historical average return is only an estimate of its true expected return,
we use the standard error of the estimate to gauge the amount of estimation error:
SD(Individual Risk)
SD(Average of Independent, Identical Risks) = (10.8)
10.4 The Historical Tradeoff Between Risk and Return

■■ Comparing historical data for large portfolios, small stocks have had higher volatility and higher
average returns than large stocks, which have had higher volatility and higher average returns
than bonds.
■■ There is no clear relationship between the volatility and return of individual stocks.
■■ Larger stocks tend to have lower overall volatility, but even the largest stocks are typically
more risky than a portfolio of large stocks.

■■ All stocks seem to have higher risk and lower returns than would be predicted based on
extrapolation of data for large portfolios.
10.5 Common Versus Independent Risk

■■ The total risk of a security represents both idiosyncratic risk and systematic risk.
■■ Variation in a stock’s return due to firm-specific news is called idiosyncratic risk. This type
of risk is also called firm-specific, unique, or diversifiable risk. It is risk that is independent
of other shocks in the economy.
■■ Systematic risk, also called market or undiversifiable risk, is risk due to market-wide news
that affects all stocks simultaneously. It is risk that is common to all stocks.
10.6 Diversification in Stock Portfolios

■■ Diversification eliminates idiosyncratic risk but does not eliminate systematic risk.
■■ Because investors can eliminate idiosyncratic risk, they do not require a risk premium for
taking it on.
■■ Because investors cannot eliminate systematic risk, they must be compensated for holding
it. As a consequence, the risk premium for a stock depends on the amount of its systematic
risk rather than its total risk.
10.7 Measuring Systematic Risk

■■ An efficient portfolio contains only systematic risk and cannot be diversified further—that is,
there is no way to reduce the risk of the portfolio without lowering its expected return.
■■ The market portfolio contains all shares of all stocks and securities in the market. The market
portfolio is often assumed to be efficient.
■■ If the market portfolio is efficient, we can measure the systematic risk of a security by its beta (b).
The beta of a security is the sensitivity of the security’s return to the return of the overall market.
10.8 Beta and the Cost of Capital

■■ The market risk premium is the expected excess return of the market portfolio:
Market Risk Premium = E [RMkt ] - rf (10.10)
It reflects investors’ overall risk tolerance and represents the market price of risk in the economy.
■■ The cost of capital for a risky investment equals the risk-free rate plus a risk premium. The
Capital Asset Pricing Model (CAPM) states that the risk premium equals the investment’s beta
times the market risk premium:
rI = rf + bI * (E [R Mkt ] - rf ) (10.11)
Key Terms 95% confidence interval p. 367 independent risk p. 372

average annual return p. 363 market portfolio p. 379
beta (b ) p. 379 probability distribution p. 358
Capital Asset Pricing Model (CAPM) p. 384 realized return p. 361
common risk p. 372 standard deviation p. 359
diversification p. 372 standard error p. 366
efficient portfolio p. 379 systematic, undiversifiable, or market
empirical distribution p. 363 risk p. 374
excess return p. 369 variance p. 359
expected (mean) return p. 358 volatility p. 360
firm-specific, idiosyncratic, unique, or
diversifiable risk p. 374
Further The original work on diversification was developed in the following papers: H. Markowitz, “Portfo-
lio Selection,” Journal of Finance 7 (1952): 77–91; A. Roy, “Safety First and the Holding of Assets,”
Reading Econometrica 20 (1952): 431–449; and, in the context of insurance, B. de Finetti, “Il problema de
pieni,” Giornale dell’Instituto Italiano degli Attuari, 11 (1940): 1–88.
For information on historical returns of different types of assets, see: E. Dimson, P. Marsh, and
M. Staunton, Triumph of the Optimist: 101 Years of Global Equity Returns (Princeton University Press,
2002); and Ibbotson Associates, Inc., Stocks, Bonds, Bills, and Inflation (Ibbotson Associates, 2009).
For an analysis of the poor historical performance of individual stocks in comparison with diversi-
fied portfolios, see H. Bessembinder, “Do Stocks Outperform Treasury Bills?,” Journal of Financial
Economics 129 (2018): 440–457.
Many books address the topics of this chapter in more depth: E. Elton, M. Gruber, S. Brown, and
W. Goetzmann, Modern Portfolio Theory and Investment Analysis ( John Wiley & Sons, 2006); J. Francis,
Investments: Analysis and Management (McGraw-Hill, 1991); R. Radcliffe, Investment: Concepts, Analysis,
and Strategy (Harper-Collins, 1994); F. Reilly and K. Brown, Investment Analysis and Portfolio Management
(Dryden Press, 1996); and Z. Bodie, A. Kane, and A. Marcus, Investments (McGraw-Hill/Irwin, 2008).
Problems All problems are available in MyLab Finance. The icon indicates Excel Projects problems available in
MyLab Finance.
Common Measures of Risk and Return

1. The figure on page 357 shows the one-year return distribution for RCS stock. Calculate
a. The expected return.
b. The standard deviation of the return.
Problems 387
35
30
Probability (%)
25
20
15
10
5
0
A B C D E
Return
2. The following table shows the one-year return distribution of Startup, Inc. Calculate
a. The expected return.
b. The standard deviation of the return.
Probability 40% 20% 20% 10% 10%
Return - 120% - 85% - 40% - 30% 1000%
3. Characterize the difference between the two stocks in Problems 1 and 2. What tradeoffs would
you face in choosing one to hold?
Historical Returns of Stocks and Bonds

4. You bought a stock one year ago for $50 per share and sold it today for $55 per share. It paid a
$1 per share dividend today.
a. What was your realized return?
b. How much of the return came from dividend yield and how much came from capital gain?
5. Repeat Problem 4 assuming that the stock fell $5 to $45 instead.
a. Is your capital gain different? Why or why not?
b. Is your dividend yield different? Why or why not?
6. Using the data in the following table, calculate the return for investing in Boeing stock (BA)
from January 2, 2008, to January 2, 2009, and also from January 3, 2011, to January 3, 2012,
assuming all dividends are reinvested in the stock immediately.
Historical Stock and Dividend Data for Boeing

Date Price Dividend Date Price Dividend
1/2/2008 86.62 1/3/2011 66.40
2/6/2008 79.91 0.40 2/9/2011 72.63 0.42
5/7/2008 84.55 0.40 5/11/2011 79.08 0.42
8/6/2008 65.40 0.40 8/10/2011 57.41 0.42
11/5/2008 49.55 0.40 11/8/2011 66.65 0.42
1/2/2009 45.25 1/3/2012 74.22
7. The last four years of returns for a stock are as follows:
Year 1 2 3 4
Return - 4.4% + 27.8% + 11.6% + 3.9%
a. What is the average annual return?

b. What is the variance of the stock’s returns?
c. What is the standard deviation of the stock’s returns?
8. Assume that historical returns and future returns are independently and identically distributed
and drawn from the same distribution.
a. Calculate the 95% confidence intervals for the expected annual return of four different in-
vestments included in Tables 10.3 and 10.4 (the dates are inclusive, so the time period spans
92 years).
b. Assume that the values in Tables 10.3 and 10.4 are the true expected return and volatility
(i.e., estimated without error) and that these returns are normally distributed. For each in-
vestment, calculate the probability that an investor will not lose more than 5% in the next
year. (Hint: you can use the function normdist (x,mean,volatility,1) in Excel to compute
the probability that a normally distributed variable with a given mean and volatility will
fall below x.)
c. Do all the probabilities you calculated in part (b) make sense? If so, explain. If not, can you
identify the reason?
9. Using the data in Table 10.2,
a. What was the average annual return of Microsoft stock from 2005–2017?
b. What was the annual volatility for Microsoft stock from 2005–2017?
10. Using the data in Table 10.2,
a. What was the average dividend yield for the SP500 from 2005–2017?
b. What was the volatility of the dividend yield?
c. What was the average annual return of the SP500 from 2005–2017 excluding dividends (i.e.,
from capital gains only)?
d. What was the volatility of the S&P 500 returns from capital gains?
e. Were dividends or capital gains a more important component of the S&P 500’s average re-
turns during this period? Which were the more important source of volatility?
11. Consider an investment with the following returns over four years:
Year 1 2 3 4
Return 6% 13% - 5% 13%
a. What is the compound annual growth rate (CAGR) for this investment over the four years?
b. What is the average annual return of the investment over the four years?
c. Which is a better measure of the investment’s past performance?
d. If the investment’s returns are independent and identically distributed, which is a better mea-
sure of the investment’s expected return next year?
12. Download the spreadsheet from MyLab Finance that contains historical monthly prices and
dividends (paid at the end of the month) for Ford Motor Company stock (Ticker: F) from
August 1994 to August 1998. Calculate the realized return over this period, expressing your
answer in percent per month (i.e., what monthly return would have led to the same cumulative
performance as an investment in Ford stock over this period).
13. Using the same data as in Problem 12, compute the
a. Average monthly return over this period.
b. Monthly volatility (or standard deviation) over this period.
14. Explain the difference between the average return you calculated in Problem 13(a) and the real-
ized return you calculated in Problem 12. Are both numbers useful? If so, explain why.
15. Compute the 95% confidence interval of the estimate of the average monthly return you cal-
culated in Problem 13(a).
The Historical Tradeoff Between Risk and Return

16. How does the relationship between the average return and the historical volatility of individual
stocks differ from the relationship between the average return and the historical volatility of
large, well-diversified portfolios?
Problems 389
17. Download the spreadsheet from MyLab Finance containing the data for Figure 10.1.
a. Compute the average return for each of the assets from 1929 to 1940 (The Great Depression).
b. Compute the variance and standard deviation for each of the assets from 1929 to 1940.
c. Which asset was riskiest during the Great Depression? How does that fit with your intuition?
18. Using the data from Problem 17, repeat your analysis over the 1990s.
a. Which asset was riskiest?
b. Compare the standard deviations of the assets in the 1990s to their standard deviations in
the Great Depression. Which had the greatest difference between the two periods?
c. If you only had information about the 1990s, what would you conclude about the relative
risk of investing in small stocks?
19. What if the last two and a half decades had been “normal”? Download the spreadsheet from
MyLab Finance containing the data for Figure 10.1.
a. Calculate the arithmetic average return on the S&P 500 from 1926 to 1989.
b. Assuming that the S&P 500 had simply continued to earn the average return from
(a), calculate the amount that $100 invested at the end of 1925 would have grown to by
the end of 2017.
c. Do the same for small stocks.
Common Versus Independent Risk

20. Consider two local banks. Bank A has 100 loans outstanding, each for $1 million, that it expects
will be repaid today. Each loan has a 5% probability of default, in which case the bank is not
repaid anything. The chance of default is independent across all the loans. Bank B has only one
loan of $100 million outstanding, which it also expects will be repaid today. It also has a 5%
probability of not being repaid. Explain the difference between the type of risk each bank faces.
Which bank faces less risk? Why?
21. Using the data in Problem 20, calculate
a. The expected overall payoff of each bank.
b. The standard deviation of the overall payoff of each bank.
Diversification in Stock Portfolios

22. Consider the following two, completely separate, economies. The expected return and volatility
of all stocks in both economies is the same. In the first economy, all stocks move together—in
good times all prices rise together and in bad times they all fall together. In the second economy,
stock returns are independent—one stock increasing in price has no effect on the prices of
other stocks. Assuming you are risk-averse and you could choose one of the two economies in
which to invest, which one would you choose? Explain.
23. Consider an economy with two types of firms, S and I. S firms all move together. I firms move
independently. For both types of firms, there is a 60% probability that the firms will have a
15% return and a 40% probability that the firms will have a - 10% return. What is the volatility
(standard deviation) of a portfolio that consists of an equal investment in 20 firms of (a) type
S, and (b) type I?
24. Using the data in Problem 23, plot the volatility as a function of the number of firms in the two
portfolios.
25. Explain why the risk premium of a stock does not depend on its diversifiable risk.
26. Identify each of the following risks as most likely to be systematic risk or diversifiable risk:
a. The risk that your main production plant is shut down due to a tornado.
b. The risk that the economy slows, decreasing demand for your firm’s products.
c. The risk that your best employees will be hired away.
d. The risk that the new product you expect your R&D division to produce will not materialize.
27. Suppose the risk-free interest rate is 6%, and the stock market will return either 25% or - 20%
each year, with each outcome equally likely. Compare the following two investment strategies:
(1) invest for one year in the risk-free investment, and one year in the market, or (2) invest for
both years in the market.
a. Which strategy has the highest expected final payoff ?
b. Which strategy has the highest standard deviation for the final payoff ?
c. Does holding stocks for a longer period decrease your risk?
28. Download the spreadsheet from MyLab Finance containing the realized return of the S&P
500 from 1929–2008. Starting in 1929, divide the sample into four periods of 20 years each. For
each 20-year period, calculate the final amount an investor would have earned given a $1000
initial investment. Also express your answer as an annualized return. If risk were eliminated
by holding stocks for 20 years, what would you expect to find? What can you conclude about
long-run diversification?
Measuring Systematic Risk

29. What is an efficient portfolio?
30. What does the beta of a stock measure?
31. You turn on the news and find out the stock market has gone up 10%. Based on the data in
Table 10.6, by how much do you expect each of the following stocks to have gone up or down:
(1) Starbucks, (2) Tiffany & Co., (3) Hershey, and (4) McDonald’s.
32. Based on the data in Table 10.6, estimate which of the following investments you expect to lose
the most in the event of a severe market down turn: (1) A $2000 investment in Hershey, (2) a
$1500 investment in Macy’s, or (3) a $1000 investment in Amazon.
33. Suppose the market portfolio is equally likely to increase by 30% or decrease by 10%.
a. Calculate the beta of a firm that goes up on average by 43% when the market goes up and
goes down by 17% when the market goes down.
b. Calculate the beta of a firm that goes up on average by 18% when the market goes down and
goes down by 22% when the market goes up.
c. Calculate the beta of a firm that is expected to go up by 4% independently of the market.
Beta and the Cost of Capital

34. Suppose the risk-free interest rate is 4%.
a. i. Use the beta you calculated for the stock in Problem 33(a) to estimate its expected return.
ii. How does this compare with the stock’s actual expected return?
b. i. Use the beta you calculated for the stock in Problem 33(b) to estimate its expected return.
ii. How does this compare with the stock’s actual expected return?
35. Suppose the market risk premium is 5% and the risk-free interest rate is 4%. Using the data in
Table 10.6, calculate the expected return of investing in
a. Starbucks’ stock.
b. Hershey’s stock.
c. Autodesk’s stock.
36. Given the results to Problem 35, why don’t all investors hold Autodesk’s stock rather than
Hershey’s stock?
37. Suppose the market risk premium is 6.2% and the risk-free interest rate is 5.5%. Calculate the
cost of capital of investing in a project with a beta of 1.1.
38. State whether each of the following is inconsistent with an efficient capital market, the CAPM,
or both:
a. A security with only diversifiable risk has an expected return that exceeds the risk-free inter-
est rate.
Data Case 391
b. A security with a beta of 1 had a return last year of 15% when the market had a return
of 9%.
c. Small stocks with a beta of 1.5 tend to have higher returns on average than large stocks with
a beta of 1.5.
Data Case Today is March 30, 2018, and you have just started your new job with a financial planning firm. In
addition to studying for all your license exams, you have been asked to review a portion of a client’s
stock portfolio to determine the risk/return profiles of 12 stocks in the portfolio. Unfortunately,
your small firm cannot afford the expensive databases that would provide all this information with a
few simple keystrokes, but that’s why they hired you. Specifically, you have been asked to determine
the monthly average returns and standard deviations for the 12 stocks for the past five years. In the
following chapters, you will be asked to do more extensive analyses on these same stocks.
The stocks (with their symbols in parentheses) are:
Archer Daniels Midland (ADM) International Business Machines

Boeing (BA) Corporation ( IBM )
Caterpillar (CAT) JPMorgan Chase & Co. ( JPM )
Deere & Co. (DE) Microsoft ( MSFT )
General Mills, Inc. (GIS) Procter and Gamble (PG)
eBay (EBAY) Walmart ( WMT )
Hershey (HSY)
1. Collect price information for each stock from Yahoo! Finance (finance.yahoo.com) as follows:
a. Enter the stock symbol. On the page for that stock, click “Historical Prices” on the left side
of the page.
b. Enter the “start date” as March 1, 2013 and the “end date” as March 30, 2018 to cover the
five-year period. Make sure you click “monthly” next to the date; the closing prices reported
by Yahoo! will then be for the last day of each month.
c. After hitting “Get Prices,” scroll to the bottom of the first page and click “Download to
Spreadsheet.” If you are asked if you want to open or save the file, click open.
d. Copy the entire spreadsheet, open Excel, and paste the Web data into a spreadsheet. Delete all
the columns except the date and the adjusted close (the first and last columns).
e. Keep the Excel file open and go back to the Yahoo! Finance Web page and hit the back button.
If you are asked if you want to save the data, click no.
f. When you return to the prices page, enter the next stock symbol and hit “Get Prices” again.
Do not change the dates or frequency, but make sure you have the same dates for all the stocks
you will download. Again, click “Download to Spreadsheet” and then open the file. Copy the
last column, “Adj. Close,” paste it into the Excel file and change “Adj. Close” to the stock sym-
bol. Make sure that the first and last prices are in the same rows as the first stock.
g. Repeat these steps for the remaining 10 stocks, pasting each closing price right next to the other
stocks, again making sure that the correct prices on the correct dates all appear on the same rows.
2. Convert these prices to monthly returns as the percentage change in the monthly adjusted prices.16
(Hint: Create a separate worksheet within the Excel file.) Note that to compute a return for each
month, you need a beginning and ending price, so you will not be able to compute the return for
the first month.
3. Compute the mean monthly returns and standard deviations for the monthly returns of each of
the stocks. Convert the monthly statistics to annual statistics for easier interpretation (multiply the
mean monthly return by 12, and multiply the monthly standard deviation by 212).
16
In Eq. 10.4, we showed how to compute returns with stock price and dividend data. The “adjusted
close” series from Yahoo! Finance is already adjusted for dividends and splits, so we may compute returns
based on the percentage change in monthly adjusted prices.
4. Add a column in your Excel worksheet with the average return across stocks for each month.
This is the monthly return to an equally weighted portfolio of these 12 stocks. Compute the mean
and standard deviation of monthly returns for the equally weighted portfolio. Double check that
the average return on this equally weighted portfolio is equal to the average return of all of the
individual stocks. Convert these monthly statistics to annual statistics (as described in Step 3) for
interpretation.
5. Using the annual statistics, create an Excel plot with standard deviation (volatility) on the x-axis
and average return on the y-axis as follows:
a. Create three columns on your spreadsheet with the statistics you created in Questions 3 and 4
for each of the individual stocks and the equally weighted portfolio. The first column will have
the ticker, the second will have annual standard deviation, and the third will have the annual
mean return.
b. Highlight the data in the last two columns (standard deviation and mean), choose Insert>
Chart >XY Scatter Plot. Complete the chart wizard to finish the plot.
6. What do you notice about the average of the volatilities of the individual stocks, compared to the
volatility of the equally weighted portfolio?
Note: Updates to this data case may be found at www.berkdemarzo.com.

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C HAP TER

NOTATION OVER THE TEN-YEAR PERIOD 2008 THROUGH 2017, INVESTORS IN

10.1 Risk and Return: Insights from 92 Years

FIGURE 10.1 Value of $100 Invested in 1925 in Stocks, Bonds, or Bills

1979–81: Inflation, TBill yields peak at 15%

Small Stocks S&P 500 Corporate bonds Treasury Bills

(a) Value after 1 Year (b) Value after 5 Years

(c) Value after 10 Years (d) Value after 20 Years

10.2 Common Measures of Risk and Return

TABLE 10.1 Probability Distribution of Returns for BFI

Variance and Standard Deviation

SD(R ) = 2Var (R ) (10.2)

SD(R ) = 2Var(R ) = 20.045 = 21.2% (10.3)

EXAMPLE 10.1 Calculating the Expected Return and Volatility

Probability Distribution BFI

same expected return, AMC’s 25% 25%

CONCEPT CHECK 1. How do we calculate the expected return of a stock?

10.3 Historical Returns of Stocks and Bonds

Computing Historical Returns

EXAMPLE 10.2 Realized Returns for Microsoft Stock

Date Price Dividend Return Date Price Dividend Return

Average Annual Returns

Frequency (number of years)

greater variability of stock 10

Investment Average Annual Return

The Variance and Volatility of Returns

EXAMPLE 10.3 Computing a Historical Volatility

Investment Return Volatility (Standard Deviation)

Estimation Error: Using Past Returns to Predict the Future

EXAMPLE 10.4 The Accuracy of Expected Return Estimates

CONCEPT CHECK 1. How do we estimate the average annual return of an investment?

Arithmetic Average Returns Versus Compound Annual Returns

10.4 The Historical Tradeoff Between Risk

The Returns of Large Portfolios

TABLE 10.5 Volatility Versus Excess Return of U.S. Small Stocks,

in Large Portfolios Mid-Cap

The Returns of Individual Stocks

volatility and average

CONCEPT CHECK 1. What is the excess return?

10.5 Common Versus Independent Risk

Theft Versus Earthquake Insurance: An Example

The Role of Diversification

SD(Claim) = 2Var (Claim)

Thus, there is almost no risk for the theft insurer.

EXAMPLE 10.5 Diversification and Gambling

10.6 Diversification in Stock Portfolios

Firm-Specific Versus Systematic Risk

Volatility of Portfolio (standard deviation)

Volatility of Portfolios of Type Type S

EXAMPLE 10.6 Portfolio Volatility

SD(RS ) = 212 (0.40 - 0.10)2 + 12 (- 0.20 - 0.10)2 = 30%

No Arbitrage and the Risk Premium

GLOBAL FINANCIAL CRISIS Diversification Benefits During Market Crashes

2008 Lehman Collapse

EXAMPLE 10.7 Diversifiable Versus Systematic Risk

COMMON MISTAKE A Fallacy of Long-Run Diversification

10.7 Measuring Systematic Risk

Identifying Systematic Risk: The Market Portfolio