Chapter

Thirteen

Return, Risk, and the

Security Market Line

© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
• Expected Returns and Variances
• Portfolios
• Announcements, Surprises, and Expected Returns
• Risk: Systematic and Unsystematic
• Diversification and Portfolio Risk
• Systematic Risk and Beta
• The Security Market Line
• The SML and the Cost of Capital: A Preview
Expected Returns

• Expected returns are based on the probabilities

of possible outcomes
• In this context, “expected” means average if
the process is repeated many times
• The “expected” return does not even have to
be a possible return

n
E ( R )   pi Ri
i 1
Example: Expected Returns
• Suppose you have predicted the following
returns for stocks C and T in three possible
states of nature. What are the expected
returns?
– State Probability C T
– Boom 0.3 0.15 0.25
– Normal 0.5 0.10 0.20
– Recession ??? 0.02 0.01
• RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99%
• RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%
Variance and Standard Deviation

• Variance and standard deviation still measure

the volatility of returns
• Using unequal probabilities for the entire
range of possibilities
• Weighted average of squared deviations

n
σ 2   pi ( Ri  E ( R)) 2
i 1
Example: Variance and Standard Deviation
• Consider the previous example. What are the
variance and standard deviation for each stock?
• Stock C
 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2
= .002029
  = .045
• Stock T
 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2
= .007441
  = .0863
Another Example

• Consider the following information:

– State Probability ABC, Inc.
– Boom .25 .15
– Normal .50 .08
– Slowdown .15 .04
– Recession .10 -.03
• What is the expected return?
• What is the variance?
• What is the standard deviation?
Another Example
• Consider the following information:
– State Probability ABC, Inc.
– Boom .25 .15
– Normal . 50 .08
– Slowdown .15 .04
– Recession .10 -.03
• What is the expected return?
– E(R) = .25(.15) + .5(.08) + .15(.04) + .1(-.03) = .0805
• What is the variance?
– Variance = .25(.15-.0805)2 + .5(.08-.0805)2 + .15(.04-.0805)2
+ .1(-.03-.0805)2 = .00267475
• What is the standard deviation?
– Standard Deviation = .051717985
Portfolios

• A portfolio is a collection of assets

• An asset’s risk and return is important in how
it affects the risk and return of the portfolio
• The risk-return trade-off for a portfolio is
measured by the portfolio expected return and
standard deviation, just as with individual
assets
Portfolio Expected Returns
• The expected return of a portfolio is the weighted
average of the expected returns for each asset in the
portfolio
m
E ( RP )   w j E ( R j )
j 1

• You can also find the expected return by finding the

portfolio return in each possible state and computing
the expected value as we did with individual
securities
Portfolio Variance

• Compute the portfolio return for each state:

RP = w1R1 + w2R2 + … + wmRm
• Compute the expected portfolio return using
the same formula as for an individual asset
• Compute the portfolio variance and standard
deviation using the same formulas as for an
individual asset
Example: Portfolio Variance
• Consider the following information
– Invest 50% of your money in Asset A
– State Probability A B Portfolio
– Boom .4 30% -5% 12.5%
– Bust .6 -10% 25% 7.5%
• What is the expected return and standard
deviation for each asset?
• What is the expected return and standard
deviation for the portfolio?
 Detailed Solution
• Portfolio return in boom = .5(30) + .5(-5) = 12.5
• Portfolio return in bust = .5(-10) + .5(25) = 7.5
• Expected return = .4(12.5) + .6(7.5) = 9.5 or
• Expected return = .5(6) + .5(13) = 9.5
• Variance of portfolio = .4(12.5-9.5)2 + .6(7.5-9.5)2 = 6
• Standard deviation = 2.45%
• Note that the variance is NOT equal to .5(384) + .5(216) =
300 and
• Standard deviation is NOT equal to .5(19.6) + .5(14.7)
= 17.17%

• What would the expected return and standard deviation for the
portfolio be if we invested 3/7 of our money in A and 4/7 in
B? Portfolio return = 10% and standard deviation = 0
Another Example

• Consider the following information

– State Probability X Z
– Boom .25 15% 10%
– Normal .60 10% 9%
– Recession .15 5% 10%
• What is the expected return and standard
deviation for a portfolio with an investment of
$6000 in asset X and $4000 in asset Y?
 Detailed Solution
• Portfolio return in Boom: .6(15) + .4(10) = 13%
• Portfolio return in Normal: .6(10) + .4(9) = 9.6%
• Portfolio return in Recession: .6(5) + .4(10) = 7%

• Expected return = .25(13) + .6(9.6) + .15(7) = 10.06%

• Variance = .25(13-10.06)2 + .6(9.6-10.06)2 + .15(7-10.06)2 =
3.6924
• Standard deviation = 1.92%

• Compare to return on X of 10.5% and standard deviation of

3.12%
• And return on Z of 9.4% and standard deviation of .48%
Expected versus Unexpected Returns

• Realized returns are generally not equal to

expected returns
• There is the expected component and the
unexpected component
 Expected Returns

• “Discounted” information used by the market

to estimate the expected return
• Already included in the expected return (and
the price).
• Note tie-in to efficient markets. Assumption:
markets are semistrong efficient.
Unexpected Returns

• At any point in time, the unexpected return

can be either positive or negative
• Over time, the average of the unexpected
component is zero
Announcements and News

• Announcements and news contain both an

expected component and a surprise component
• It is the surprise component that affects a
stock’s price and therefore its return
• This is very obvious when we watch how
stock prices move when an unexpected
announcement is made or earnings are
different than anticipated
Efficient Markets

• Efficient markets are a result of investors

trading on the unexpected portion of
announcements
• The easier it is to trade on surprises, the more
efficient markets should be
• Efficient markets involve random price
changes because we cannot predict surprises
Systematic Risk

• Risk factors that affect a large number of

assets
• Also known as non-diversifiable risk or
market risk
• Includes such things as changes in GDP,
inflation, interest rates, etc.
Unsystematic Risk

• Risk factors that affect a limited number of

assets
• Also known as unique risk and asset-specific
risk
• Includes such things as labor strikes, part
shortages, etc.
Returns

• Total Return = expected return + unexpected

return
• Unexpected return = systematic portion +
unsystematic portion
• Therefore, total return can be expressed as
follows:
• Total Return = expected return + systematic
portion + unsystematic portion
Diversification

• Portfolio diversification is the investment in

several different asset classes or sectors
• Diversification is not just holding a lot of
assets
• For example, if you own 50 internet stocks,
you are not diversified
• However, if you own 50 stocks that span 20
different industries, then you are diversified
The Principle of Diversification
• Diversification can substantially reduce the
variability of returns without an equivalent
reduction in expected returns
• This reduction in risk arises because worse
than expected returns from one asset are offset
by better than expected returns from another
• However, there is a minimum level of risk that
cannot be diversified away and that is the
systematic portion
FIGURE 13.1
Diversifiable Risk

• The risk that can be eliminated by combining

assets into a portfolio
• Often considered the same as unsystematic,
unique or asset-specific risk
• If we hold only one asset, or assets in the same
industry, then we are exposing ourselves to
risk that we could diversify away
Total Risk

• Total risk = systematic risk + unsystematic

risk
• The standard deviation of returns is a measure
of total risk
• For well diversified portfolios, unsystematic
risk is very small
• Consequently, the total risk for a diversified
portfolio is essentially equivalent to the
systematic risk
Systematic Risk Principle

• There is a reward for bearing risk

• There is not a reward for bearing risk
unnecessarily
• The expected return on a risky asset depends
only on that asset’s systematic risk since
unsystematic risk can be diversified away
Measuring Systematic Risk

• How do we measure systematic risk?

• We use the beta coefficient to measure
systematic risk
• What does beta tell us?
– A beta of 1 implies the asset has the same
systematic risk as the overall market
– A beta < 1 implies the asset has less systematic
risk than the overall market
– A beta > 1 implies the asset has more systematic
risk than the overall market
Total versus Systematic Risk

• Consider the following information:

Standard Deviation Beta
– Security C 20% 1.25
– Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher
expected return?
 Portfolio Betas

• Portfolio variance is not a weighted average of

the individual asset betas,
• Portfolio betas are a weighted average of the
individual asset betas
Example: Portfolio Betas
• Consider the following example with the
following four securities
– Security Weight Beta
– DCLK .133 3.69
– KO .2 0.64
– INTC .167 1.64
– KEI .4 1.79
• What is the portfolio beta?
• .133(3.69) + .2(.64) + .167(1.64) + .4(1.79) =
1.61
Beta and the Risk Premium

• Remember that the risk premium = expected

return – risk-free rate
• The higher the beta, the greater the risk
premium should be
• Can we define the relationship between the
risk premium and beta so that we can estimate
the expected return?
– YES!
Example: Portfolio Expected Returns and Betas

30%

25%
E(RA)
20%
Expected Return

15%

10%
Rf
5%

0%
0 0.5 1 1.5 A 2 2.5 3
Beta
Reward-to-Risk Ratio: Definition and Example
• The reward-to-risk ratio is the slope of the line
illustrated in the previous example
– Slope = (E(RA) – Rf) / (A – 0)
– Reward-to-risk ratio for previous example =
(20 – 8) / (1.6 – 0) = 7.5
• What if an asset has a reward-to-risk ratio of 8
(implying that the asset plots above the line)?
• What if an asset has a reward-to-risk ratio of 7
(implying that the asset plots below the line)?
Market Equilibrium

• In equilibrium, all assets and portfolios must

have the same reward-to-risk ratio and they all
must equal the reward-to-risk ratio for the
market

E ( RA )  R f E ( RM  R f )

A M
Security Market Line

• The security market line (SML) is the

representation of market equilibrium
• The slope of the SML is the reward-to-risk
ratio: (E(RM) – Rf) / M
• But since the beta for the market is ALWAYS
equal to one, the slope can be rewritten
• Slope = E(RM) – Rf = market risk premium
The Capital Asset Pricing Model (CAPM)

• The capital asset pricing model defines the

relationship between risk and return
• E(RA) = Rf + A(E(RM) – Rf)
• If we know an asset’s systematic risk, we can
use the CAPM to determine its expected
return
• This is true whether we are talking about
financial assets or physical assets
Factors Affecting Expected Return

• Pure time value of money – measured by the

risk-free rate
• Reward for bearing systematic risk –
measured by the market risk premium
• Amount of systematic risk – measured by beta
Example - CAPM
• Consider the betas for each of the assets given earlier.
If the risk-free rate is 4.5% and the market risk
premium is 8.5%, what is the expected return for
each?

Security Beta Expected Return

DCLK 3.69 4.5 + 3.69(8.5) = 35.865%
KO .64 4.5 + .64(8.5) = 9.940%
INTC 1.64 4.5 + 1.64(8.5) = 18.440%
KEI 1.79 4.5 + 1.79(8.5) = 19.715%
Quick Quiz
• How do you compute the expected return and
standard deviation for an individual asset? For a
portfolio?
• What is the difference between systematic and
unsystematic risk?
• What type of risk is relevant for determining the
expected return?
• Consider an asset with a beta of 1.2, a risk-free rate
of 5% and a market return of 13%.
– What is the reward-to-risk ratio in equilibrium?
– What is the expected return on the asset?