Bond Capm

Corporate Finance (1 of 2)
Fifth Edition, Global Edition
Chapter 6
Valuing Bonds
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Chapter Outline
6.1 Bond Cash Flows, Prices, and Yields
6.2 Dynamic Behavior of Bond Prices
6.3 The Yield Curve and Bond Arbitrage

6.1 Bond Cash Flows, Prices, and
Yields (1 of 2)
• Bond Terminology
– Bond Certificate
 States the terms of the bond
– Maturity Date
 Final repayment date
– Term
 The time remaining until the repayment date
– Coupon
 Promised interest payments

6.1 Bond Cash Flows, Prices, and
Yields (2 of 2)
• Bond Terminology
– Face Value
 Notional amount used to compute the interest
payments
– Coupon Rate
– Determines the amount of each coupon payment,
expressed as an Rate
– Coupon Payment
Coupon Rate × Face Value
CPN =
Number of Coupon Payments per Year
Zero-Coupon Bonds (1 of 7)
• Zero-Coupon Bond
– Does not make coupon payments
– Always sells at a discount (a price lower than face
value), so they are also called pure discount bonds
– Treasury Bills are U.S. government zero-coupon
bonds with a maturity of up to one year.

• Suppose that a one-year, risk-free, zero-coupon bond with
a $100,000 face value has an initial price of $96,618.36.
The cash flows would be
– Although the bond pays no “interest,” your

compensation is the difference between the initial price
and the face value.

• Yield to Maturity
– The discount rate that sets the present value of the
promised bond payments equal to the current market
price of the bond
 Price of a Zero-Coupon bond
FV
P =
(1 + YTM n ) n

– For the one-year zero coupon bond:
100, 000
96, 618.36 =
(1 + YTM 1)
100, 000
1 + YTM 1 = = 1.035
96, 618.36
 Thus, the YTM is 3.5%

– Yield to Maturity of an n-Year Zero-Coupon Bond
1
 FV  n
YTM n =   1
 P 

Textbook Example 6.1 (1 of 2)
Yields for Different Maturities
Problem
Suppose the following zero-coupon bonds are trading at the
prices shown below per $100 face value. Determine the
corresponding spot interest rates that determine the zero
coupon yield curve.
Maturity 1 Year 2 Years 3 Years 4 Years

Price $96.62 $92.45 $87.63 $83.06

Alternative Example 6.1 (1 of 2)
• Problem
– Suppose that the following zero-coupon bonds are
selling at the prices shown below per $100 face value.
Determine the corresponding yield to maturity for each
bond.
Maturity 1 Year 2 Years 3 Years 4 Years

Price $98.04 $95.18 $91.51 $87.14

• Risk-Free Interest Rates
– A default-free zero-coupon bond that matures on date
n provides a risk-free return over the same period
– Thus, the Law of One Price guarantees that the risk-
free interest rate equals the yield to maturity on such a
bond
– Risk-Free Interest Rate with Maturity n
rn = YTM n

• Risk-Free Interest Rates
– Spot Interest Rate
 Another term for a default-free, zero-coupon yield
– Zero-Coupon Yield Curve
 A plot of the yield of risk-free zero-coupon bonds as
a function of the bond’s maturity date

Coupon Bonds (1 of 2)
• Coupon Bonds
– Pay face value at maturity
– Pay regular coupon interest payments
• Treasury Notes
– U.S. Treasury coupon security with original maturities
of 1–10 years
• Treasury Bonds
– U.S. Treasury coupon security with original maturities
over 10 years

The Cash Flows of a Coupon Bond
Problem
The U.S. Treasury has just issued a five-year, $1000 bond
with a 5% coupon rate and semiannual coupons. What cash
flows will you receive if you hold this bond until maturity?

• Problem
– Suppose that Procter & Gamble has just issued a 10-
year, $1000 bond with a 4% coupon rate and
semiannual coupon payments. What cash flows will
you receive if you hold the bond until maturity?

Coupon Bonds (2 of 2)
– The YTM is the single discount rate that equates the
present value of the bond’s remaining cash flows to its
current price
– Yield to Maturity of a Coupon Bond
1 1  FV
P = CPN × 1  +
y (1 + y ) N  (1 + y ) N

Computing the Yield to Maturity of a Coupon Bond
Problem
Consider the five-year, $1000 bond with a 5% coupon rate
and semiannual coupons described in Example 6.2. If this
bond is currently trading for a price of $957.35, what is the
bond’s yield to maturity?

• Problem
– Consider the following semi-annual bond:
 $1000 par value
 7 years until maturity
 9% coupon rate
 Price is $1,080.55
– What is the bond’s yield to maturity?

Computing a Bond Price from Its Yield to Maturity
Problem
Consider again the five-year, $1000 bond with a 5% coupon
rate and semiannual coupons presented in Example 6.3.
Suppose you are told that its yield to maturity has increased
to 6.30% (expressed as an APR with semiannual
compounding). What price is the bond trading for now?

• Problem
– Consider the bond in the previous example.
 Suppose its yield to maturity has increased to 10%
– What is the bond’s new price?

6.2 Dynamic Behavior of Bond Prices
• Discount
– A bond is selling at a discount if the price is less than
the face value
• Par
– A bond is selling at par if the price is equal to the face
value
• Premium
– A bond is selling at a premium if the price is greater
than the face value

Discounts and Premiums (1 of 3)
• If a coupon bond trades at a discount, an investor will earn
a return both from receiving the coupons and from
receiving a face value that exceeds the price paid for the
bond.
– If a bond trades at a discount, its yield to maturity will
exceed its coupon rate.

• If a coupon bond trades at a premium, it will earn a return
from receiving the coupons, but this return will be
diminished by receiving a face value less than the price
paid for the bond.
• Most coupon bonds have a coupon rate so that the bonds
will initially trade at, or very close to, par.

Table 6.1 Bond Prices Immediately After a Coupon Payment
When the bond price is We say the bond trades This occurs when
greater than the face “above par” or “at a Coupon Rate > Yield
value premium” to Maturity
equal to the face value “at par” Coupon Rate = Yield
to Maturity
less than the face value “below par” or “at a Coupon Rate < Yield
discount” to Maturity

Determining the Discount or Premium of a Coupon Bond
Problem
Consider three 30-year bonds with annual coupon
payments. One bond has a 10% coupon rate, one has a 5%
coupon rate, and one has a 3% coupon rate. If the yield to
maturity of each bond is 5%, what is the price of each bond
per $100 face value? Which bond trades at a premium,
which trades at a discount, and which trades at par?

• Problem
– Suppose that Procter & Gamble issued a bond that has
seven years remaining until maturity, a $1000 face
value, and a 4% coupon rate with annual coupon
payments. If the current market interest rate is 3%,
what is bond’s premium or discount? What if the
current market rate is 6%?

Time and Bond Prices
• Holding all other things constant, a bond’s yield to maturity
will not change over time.
• Holding all other things constant, the price of discount or
premium bond will move toward par value over time.
• If a bond’s yield to maturity has not changed, then the I RR
of an investment in the bond equals its yield to maturity
even if you sell the bond early.

The Effect of Time on the Price of a Coupon Bond
Problem
Consider a 30-year bond with a 10% coupon rate (annual
payments) and a $100 face value. What is the initial price of
this bond if it has a 5% yield to maturity? If the yield to
maturity is unchanged, what will the price be immediately
before and after the first coupon is paid?

• Problem
– Suppose that W MT issued a bond that has ten years
remaining until maturity, a $1000 face value, and a 3%
coupon rate with annual coupon payments. If the
current market interest rate is 5%, what is the current
price of the bond? What will the price be in 4 years,
assuming the current market rate remains unchanged?

Figure 6.1 The Effect of Time on Bond
Prices

Interest Rate Changes and Bond Prices
(1 of 2)
• There is an inverse relationship between interest rates and

bond prices.
– As interest rates and bond yields rise, bond prices fall.
– As interest rates and bond yields fall, bond prices rise.

Interest Rate Changes and Bond Prices
(2 of 2)
• The sensitivity of a bond’s price to changes in interest

rates is measured by the bond’s duration.
– Bonds with high durations are highly sensitive to
interest rate changes.
– Bonds with low durations are less sensitive to interest
rate changes.

The Interest Rate Sensitivity of Bonds
Problem
Consider a 15-year zero-coupon bond and a 30-year coupon
bond with 10% annual coupons. By what percentage will the
price of each bond change if its yield to maturity increases
from 5% to 6%?

• Problem
– The University of Pennsylvania sold $300 million of
100-year bonds with a yield to maturity of 4.67%.
Assuming the bonds were sold at par and pay an
annual coupon, by what percentage will the price of the
bond change if its yield to maturity decreases by 1%?
Increases by 2%?

Figure 6.2 Yield to Maturity and Bond
Price Fluctuations over Time

6.3 The Yield Curve and Bond Arbitrage
• Using the Law of One Price and the yields of default-free

zero-coupon bonds, one can determine the price and yield
of any other default-free bond.
• The yield curve provides sufficient information to evaluate
all such bonds.

Replicating a Coupon Bond (1 of 3)
• Replicating a three-year $1000 bond that pays 10% annual
coupon using three zero-coupon bonds:

Table 6.2 Yields and Prices (per $100 Face Value) for Zero-
Coupon Bonds
Maturity 1 year 2years 3 years 4 years
YTM 3.50% 4.00% 4.50% 4.75%
Price $96.62 $92.45 $87.63 $83.06%

• By the Law of One Price, the three-year coupon bond must

trade for a price of $1153.

Valuing a Coupon Bond Using Zero-
Coupon Yields
• The price of a coupon bond must equal the present value
of its coupon payments and face value.
– Price of a Coupon Bond
V = PV(Bond Cash Flows)
CPN CPN CPN + FV
= + 2
++
1 + YTM 1 (1 + YTM 2 ) (1 + YTM n ) n
100 100 100 + 1000

P= + 2
+ 3
= $1153
1.035 1.04 1.045

Coupon Bond Yields
• Given the yields for zero-coupon bonds, we can price a
coupon bond
100 100 100 + 1000
P = 1153 = + 2
+
(1 + y ) (1 + y ) (1 + y )3
100 100 100 + 1000

P= + 2
+ 3
= $1153
1.0444 1.0444 1.0444
Blank N P E R RA T E PV PM T FV Excel Formula
Given 3 blank −1,153 100 1,000 blank
Solve for Rate blank 4.44% blank blank blank = RATE(3, 100,
−1153, 1000)

Yields on Bonds with the Same Maturity
Problem
Given the following zero-coupon yields, compare the yield to
maturity for a three-year, zero-coupon bond; a three-year
coupon bond with 4% annual coupons; and a three-year
coupon bond with 10% annual coupons. All of these bonds
are default free.
Maturity 1 year 2 years 3 years 4 years
Zero- coupon YTM 3.50% 4.00% 4.50% 4.75%

Treasury Yield Curves
• Treasury Coupon-Paying Yield Curve
– Often referred to as “the yield curve”
• On-the-Run Bonds
– Most recently issued bonds
– The yield curve is often a plot of the yields on these
bonds.

6.4 Corporate Bonds
• Corporate Bonds
– Issued by corporations
• Credit Risk
– Risk of default

Corporate Bond Yields (1 of 9)
• Investors pay less for bonds with credit risk than they
would for an otherwise identical default-free bond.
• The yield of bonds with credit risk will be higher than that
of otherwise identical default-free bonds.

• No Default
– Consider a one-year, zero-coupon Treasury Bill with a
YTM of 4%.
 What is the price?
1000 1000
P= = = $961.54
1 + YTM 1 1.04
1 4 1000
N I/YR PV PMT FV
-961.54

• Certain Default
– Suppose now bond issuer will pay 90% of the
obligation.
 What is the price?
900 900
P= = = $865.38
1 + YTM 1 1.04
1 4 900
N I/YR PV PMT FV
-865.38

• Certain Default
– When computing the yield to maturity for a bond with
certain default, the promised rather than the actual
cash flows are used.
FV 1000
YTM = 1 =  1 = 15.56%
P 865.38
900
= 1.04
865.38

• Certain Default
– The yield to maturity of a certain default bond is not
equal to the expected return of investing in the bond.
– The yield to maturity will always be higher than the
expected return of investing in the bond.

• Risk of Default
– Consider a one-year, $1000, zero-coupon bond issued.
– Assume that the bond payoffs are uncertain.
 There is a 50% chance that the bond will repay its
face value in full and a 50% chance that the bond
will default and you will receive $900.
– Thus, you would expect to receive $950.
 Because of the uncertainty, the discount rate is
5.1%.

• Risk of Default
– The price of the bond will be
950
P= = $903.90
1.051
– The yield to maturity will be
FV 1000
YTM = 1=  1 = 10.63%
P 903.90

• Risk of Default
– A bond’s expected return will be less than the yield to
maturity if there is a risk of default.
– A higher yield to maturity does not necessarily imply
that a bond’s expected return is higher.

Table 6.3 Price, Expected Return, and Yield to Maturity of a
One-Year, Zero-Coupon Avant Bond with Different
Likelihoods of Default
Avant Bond (1-year, zero- Yield to Expected

coupon) Bond Price Maturity Return
Default Free $961.54 4.00% 4%
50% Chance of Default $903.90 10.63% 5.1%
Certain Default $865.38 15.56% 4%

Bond Ratings
• Investment Grade Bonds
• Speculative Bonds
– Also known as Junk Bonds or High-Yield Bonds

Table 6.4 Bond Ratings (1 of 2)

Table 6.4 Bond Ratings (2 of 2)
[Table 6.4 continued]
*Ratings: Moody’s/Standard & Poor’s

Source: www.moodys.com
Corporate Yield Curves
• Default Spread
– Also known as Credit Spread
– The difference between the yield on corporate bonds
and Treasury yields

Figure 6.3 Corporate Yield Curves for
Various Ratings, February 2018
Source: Bloomberg
Figure 6.4 Yield Spreads and the
Financial Crisis
Source: Bloomberg.com
6.5 Sovereign Bonds
• Bonds issued by national governments
– U.S. Treasury securities are generally considered to be
default free.
– All sovereign bonds are not default-free,
 e.g., Greece defaulted on its outstanding debt in
2012.
– Importance of inflation expectations.
 Potential to “inflate away” the debt.
– European sovereign debt, the EM U, and the ECB.

Figure 6.5 Percent of Debtor Countries
in Default or Restructuring Debt, 1800–
2006
Source: Data from This Time Is Different, Carmen Reinhart and Kenneth Rogoff,
Princeton University Press, 2009.
Figure 6.6 European Government Bond
Yields, 1976–2018
Source: Federal Reserve Economic Data, research.stlouisfed.org/fred2.

Corporate Finance
Fifth Edition, Global Edition
Chapter 10
Capital Markets and the Pricing of Risk
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Chapter Outline
10.1 Risk and Return: Insights from 92 Years of Investor
History
10.2 Common Measures of Risk and Return
10.3 Historical Returns of Stocks and Bonds
10.4 The Historical Tradeoff Between Risk and Return
10.5 Common Versus Independent Risk
10.6 Diversification in Stock Portfolios
10.7 Measuring Systematic Risk
10.8 Beta and the Cost of Capital

10.1 Risk and Return: Insights from 92
Years of Investor History (1 of 4)
• How would $100 have grown if it were placed in one of the
following investments?
– Standard & Poor’s 500: 90 U.S. stocks up to 1957 and
500 after that. Leaders in their industries and among
the largest firms traded on U.S. Markets
– Small stocks: Securities traded on the NYSE with
market capitalizations in the bottom 20%

• How would $100 have grown if it were placed in one of the
following investments?
– World Portfolio: International stocks from all the world’s
major stock markets in North America, Europe, and
Asia
– Corporate Bonds: Long-term, A A A -rated U.S.
corporate bonds with maturities of approximately 20
years
– Treasury Bills: An investment in three-month Treasury
bills

Figure 10.1 Value of $100 Invested at
the End of 1925
Source: Chicago Center for Research in Security Prices, Standard and

Poor’s, M S C I, and Global Financial Data.
• Small stocks had the highest long-term returns, while T-
Bills had the lowest long-term returns
• Small stocks had the largest fluctuations in price, while T-
Bills had the lowest
– Higher risk requires a higher return

• Few people ever make an investment for 92 years
• More realistic investment horizons and different initial
investment dates can greatly influence each investment's
risk and return

Figure 10.2 Value of $100 Invested in
Alternative Investment for Differing
Horizons
Source: Chicago Center for Research in Security Prices, Standard and Poor’s, MSCI, and
Global Financial Data.
10.2 Common Measures of Risk and
Return
• Probability Distributions
– When an investment is risky, it may earn different returns
– Each possible return has some likelihood of occurring
– This information is summarized with a probability
distribution, which assigns a probability, PR , that each
possible return, R, will occur
 Assume BFI stock currently trades for $100 per share
 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

Table 10.1 Probability Distribution of
Returns for B F I

Figure 10.3 Probability Distribution of
Returns for B F I

Expected Return
• Expected (Mean) Return
– Calculated as a weighted average of the possible
returns, where the weights correspond to the
probabilities.
Expected Return = E  R  =  R PR × R
E  RBFI  = 25%(0.20) + 50%(0.10) + 25%(0.40) = 10%

Variance and Standard Deviation (1 of 2)
• Variance
– The expected squared deviation from the mean
Var ( R ) = E  R  E  R   =  R PR × R  E  R 
 
2 2
 
• Standard Deviation
– The square root of the variance
SD( R ) = Var ( R )
• Both are measures of the risk of a probability distribution

Variance and Standard Deviation (2 of 2)
• For BFI, the variance and standard deviation are
Var  RBFI  = 25% × (0.20  0.10) 2 + 50% × (0.10  0.10) 2

+ 25% × (0.40  0.10) 2 = 0.045
SD( R ) = Var ( R ) = 0.045 = 21.2%

– In finance, the standard deviation of a return is also
referred to as its volatility
– The standard deviation is easier to interpret because it
is in the same units as the returns themselves

Calculating the Expected Return and Volatility
Problem
– Suppose A M C stock is equally likely to have a 45%
return or a −25% return. What are its expected return
and volatility?

Problem
– TXU stock is has the following probability distribution:
Probability Return
.25 8%
.55 10%
.20 12%
– What are its expected return and standard

deviation?

Figure 10.4 Probability Distributions for
B F I and A M C Returns

10.3 Historical Returns of Stocks and
Bonds (1 of 4)
• Computing Historical Returns
– Realized Return
 The return that actually occurs over a particular time
period
Divt + 1 + Pt + 1 Divt + 1 Divt + 1  Pt

Rt + 1 = 1= +
Pt Pt Pt
= Dividend Yield + Capital Gain Rate

Bonds (2 of 4)
– If you hold the stock beyond the date of the first
dividend, then to compute your return you must specify
how you invest any dividends you receive in the interim
– Let’s assume that all dividends are immediately
reinvested and used to purchase additional shares
of the same stock or security

Bonds (3 of 4)
– If a stock pays dividends at the end of each quarter,
with realized returns RQ1, . . . ,RQ4 each quarter, then its
annual realized return, Rannual, is computed as follows:
1 + Rannual = (1 + RQ1 )(1 + RQ 2 )(1 + RQ 3 )(1 + RQ 4 )

Realized Returns for Microsoft Stock
Problem
What were the realized annual returns for Microsoft stock in
2004 and 2008?

Date Price Dividend Return Date Price($) Dividend Return
12/31/13 27.37 Blank Blank 12/31/07 35.06 Blank Blank

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% 5/31/08 27.32 0.11 6.11%
12/31/04 26.72 Blank −2.45% 8/19/08 19.62 0.11 −7.89%
Blank Blank Blank Blank 11/18/08 19.44 0.13 −27.71%
Blank Blank Blank Blank 12/31/08 Blank Blank −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)(0.7229)(0.9908)  1 = 43.39%

Problem
– What were the realized annual returns for N R G stock
in 2012 and in 2018?

Solution
– First, we look up stock price data for N R G at the start
and end of the year, as well as dividend dates. From
these data, we construct the following table:
Date Price($) Dividend($) Return Date Price($) Dividend($) Return

Blank Blank
12/31/2011 58.69 blank 12/31/2017 6.73 0
1/31/2012 61.44 0.26 5.13% 3/31/2018 5.72 0 −15.01%
4/30/2012 63.94 0.26 4.49% 6/30/2018 4.81 0 −15.91%
7/31/2012 48.5 0.26 −23.74% 9/30/2018 5.2 0 8.11%
10/31/2012 54.88 0.29 13.75% 12/31/2018 2.29 0 −55.96%

Blank Blank blank
12/31/2012 53.31 blank −2.86% blank

Solution
– We compute each period’s return using Eq. 10.4. For
example, the return from December 31, 2011, to
January 31, 2012, is
61.44 + 0.26
 1 = 5.13%
58.69
– We then determine annual returns using Eq. 10.5:
R2012 = (1.0513)(1.0449)(0.7626)(1.1375)(0.9714)  1 = 7.43%
R2018 = (0.8499)(0.8409)(1.0811)(0.440)  1 = 66.0%

Solution
– Note that, since NRG did not pay dividends during
2018, the return can also be computed as follows:
2.29
- 1 = - 66.0%
6.73

Table 10.2 Realized Return for the S&P 500, Microsoft,
and Treasury Bills, 2005–2017
S&P 500 Dividends S&P 500 Realized Microsoft 1-Month T-

Year End
Index Paid* Returned Realized Return Bill Return
2004 1211.92 Blank Blank Blank Blank
2005 1248.29 23.15 4.9 % −0.9 % 3%
2006 1418.3 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 % −44.4 % 1.5 %
2009 1115.1 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%
2012 1426.19 32.67 16 % 5.8 % 0.1 %
2013 1848.36 39.75 32.4 % 44.3 % 0%
2014 2058.9 42.47 13.7 % 27.6 % 0%
2015 2043.94 43.45 1.4 % 22.7 % 0%
2016 2238.83 49.56 12 % 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 the year, assuming they were reinvested when paid.
Source: Standard & Poor’s, Microsoft and U.S. Treasury Data
Bonds (4 of 4)
– By counting the number of times a realized return falls
within a particular range, we can estimate the
underlying probability distribution
– Empirical Distribution
 When the probability distribution is plotted using
historical data

Figure 10.5 The Empirical Distribution of Annual
Returns for U.S. Large Stocks (S&P 500), Small
Stocks, Corporate Bonds, and Treasury Bills,
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%

Average Annual Return
1 1 T
R =  R1 + R2 +  + RT  =  Rt
T T t =1
– Where Rt is the realized return of a security in year t,
for the years 1 through T
 Using the data from Table 10.2, the average annual
return for the S&P 500 from 2005 to 2017 is as
follows:
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 Variance and Volatility of Returns
• Variance Estimate Using Realized Returns
1 T
  Rt  R 
2
Var ( R) =
T 1 t =1
– The estimate of the standard deviation is the square
root of the variance

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 returns of the S&P
500 during this period to be 10.0%. Therefore,
1
Var ( R) =
T 1 t
 ( Rt  R) 2
1
= [(0.049  0.100) 2 + (0.158  0.100)2 + ... + (0.218  0.100)2 ]
13  1
= 0.029
The volatility or standard deviation is therefore SD( R) = Var ( R) = 0.029 = 17.0%

Problem
– Using the data from Table 10.2, what are the variance
and standard deviation of Microsoft’s returns from 2008
to 2017?

• Solution:
– First, we need to calculate the average return for
Microsoft’s over that time period, using Eq. 10.6:
1
R = (44.4% + 60.5%  6.5%  4.5% + 5.8%
10
+ 44.3% + 27.6% + 22.7% +15.1% + 40.7%)
= 16.1%

Next, we calculate the variance using Eq. 10.7:
1
 t ( Rt  R )
2
Var ( R ) =
T 1
1
= ( 44.4%  16.1%) 2 + (60.5%  16.1%) 2 + ... + (27.5%  16.1%)2 
10  1
= 9.17%
The standard deviation is therefore

SD( R ) = Var ( R) = 9.17% = 30.28%

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 (1 of 2)
• We can use a security’s historical average return to
estimate its actual expected return. However, the average
return is just an estimate of the expected return.
– Standard Error
 A statistical measure of the degree of estimation
error

Estimation Error: Using Past Returns to
Predict the Future (2 of 2)
• Standard Error of the Estimate of the Expected Return
SD(Individual Risk)
SD(Average of Independent, Identical Risks) =
Number of Observations
• 95% Confidence Interval

Historical Average Return ± (2 × Standard Error)
– For the S&P 500 (1926–2017)
 19.8% 
12.0% ± 2   = 12.0% ± 4.1%
 92 
 Or a range from 7.9% to 16.1%
The Accuracy of Expected Return Estimates
Problem
– Using the returns for the S&P 500 from 2005 to 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% ÷ 13 = 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!

Problem:
– Using the data from Alternative Example 10.3, what is
the 95% confidence interval you would estimate for
Microsoft’s expected return?

Solution:
– The 95% confidence interval for Microsoft’s expected
return is calculated as follows:
 30.28% 
16.1% ± 2   = 16.1% ± 19.1%
 10 
– Or a range from − 3.0% to 35.3%

10.4 The Historical Tradeoff Between
Risk and Return
• The Returns of Large Portfolios
– Excess Returns
 The difference between the average return for an
investment and the average return for T-Bills

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 (Average
Return Volatility Return in Excess of
Investment (Standard Deviation) 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 The Historical Tradeoff Between
Risk and Return in Large Portfolios
Source: CRSP, Morgan Stanley Capital International

The Returns of Individual Stocks
• Is there a positive relationship between volatility and
average returns for individual stocks?
– As shown on the next slide, there is no precise
relationship between volatility and average return for
individual stocks
 Larger stocks tend to have lower volatility than
smaller stocks
 All stocks tend to have higher risk and lower returns
than large portfolios

Figure 10.7 Historical Volatility and Return
for 500 Individual Stocks, Ranked Annually
by Size
Source: CRSP
10.5 Common Versus Independent Risk
• Common Risk
– Risk that is perfectly correlated
 Risk that affects all securities
• Independent Risk
– Risk that is uncorrelated
 Risk that affects a particular security
• Diversification
– The averaging out of independent risks in a large
portfolio

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) = (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
9, 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—losing 35 ´ $9 million = $315 million if the bet wins. For this
reason, casinos often impose limits on the amount of any individual bet.
10.6 Diversification in Stock
Portfolios (1 of 7)
• Firm-Specific Versus Systematic Risk
– Firm Specific News
 Good or bad news about an individual company
– Market-Wide News
 News that affects all stocks, such as news about the
economy

Portfolios (2 of 7)
– Independent Risks
 Due to firm-specific news
– Also known as
• Firm-Specific Risk
• Idiosyncratic Risk
• Unique Risk
• Unsystematic Risk
• Diversifiable Risk

Portfolios (3 of 7)
– Common Risks
 Due to market-wide news
– Also known as
• Systematic Risk
• Undiversifiable Risk
• Market Risk

Portfolios (4 of 7)
– When many stocks are combined in a large portfolio,
the firm-specific risks for each stock will average out
and be diversified
– The systematic risk, however, will affect all firms and
will not be diversified

Portfolios (5 of 7)
– Consider two types of firms:
 Type S firms are affected only by systematic risk
– There is a 50% chance the economy will be
strong and type S stocks will earn a return of
40%
– There is a 50% chance the economy will be
weak and their return will be −20%
– Because all these firms face the same
systematic risk, holding a large portfolio of type S
firms will not diversify the risk
Portfolios (6 of 7)
– Consider two types of firms:
 Type I firms are affected only by 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

Portfolios (7 of 7)
– Actual firms are affected by both market-wide risks and
firm-specific risks
– When firms carry both types of risk, only the
unsystematic risk will be diversified when many firm’s
stocks are combined into a portfolio
– The volatility will therefore decline until only the
systematic risk remains

Figure 10.8 Volatility of Portfolios of
Type S and I Stocks

Portfolio Volatility
Problem
– What is the volatility of the average return of ten type S
firms? What is the volatility of the average return of ten
type I firms?

Solution
Type S firms have equally likely returns of 40% or −20%. Their expected return
1 1
is 2 (40%) + (20%) = 10%, so
2
1 1
SD ( RS ) = (0.40  0.10) 2 + ( 0.20  0.10) 2 = 30%
2 2
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 (35%) + 1 (  25%) = 5% , so
2 2
1 1
SD ( R1 ) = (0.35  0.05) 2 + ( 0.25  0.05) 2 = 30%
2 2
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% ÷ 10 = 9.5% , as shown in Figure
10.8.
No Arbitrage and the Risk Premium (1 of 4)
• The risk premium for diversifiable risk is zero, so

investors are not compensated for holding 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 opportunity to earn something for nothing would
quickly be exploited and eliminated
– Because investors can eliminate firm-specific risk “for
free” by diversifying their portfolios, they will not require
or earn a reward or risk premium for holding it

• The risk premium of a security is determined by its

systematic risk and does not depend on its
diversifiable risk
– This 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
premium that investors will earn

– Standard deviation is not an appropriate measure of

risk for an individual security
– 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

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
10.7 Measuring Systematic Risk (1 of 4)
• To measure the systematic risk of a stock, determine how
much of the variability of its return is due to systematic risk
versus unsystematic risk
– To determine how sensitive a stock is to systematic
risk, look at the average change in the return for each
1% change in the return of a portfolio that fluctuates
solely due to systematic risk

• Efficient Portfolio
– A portfolio that contains only systematic risk
– There is no way to reduce the volatility of the portfolio
without lowering its expected return
• Market Portfolio
– An efficient portfolio that contains all shares and
securities in the market
 The S&P 500 is often used as a proxy for the market
portfolio

• Sensitivity to Systematic Risk: Beta (β)
– The expected percent change in the excess return
of a security for a 1% change in the excess return
of the market portfolio
 Beta differs from volatility. Volatility measures total
risk (systematic plus unsystematic risk), while beta
is a measure of only systematic risk

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
βs = 60% = 0.833. That is, each 1% change in the return
72%
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 excepted return, whether
0%
the economy is strong or weak, β1 = 72% = 0.
Problem
– Suppose the market portfolio tends to increase by 52%
when the economy is strong and decline by 21% when
the economy is weak.
– What is the beta of a type S firm whose return is 55%
on average when the economy is strong and −24%
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 52% − (−21%) = 73% change in the return
of the market portfolio.
– The type S firm’s return changes by 55% − (−24%) =
79% on average.
79%
– Thus the firm’s beta is βS = = 1.082.
73%
That is, each 1% change in the return of the market
portfolio leads to a 1.082% change in the type S firm’s
return on average.

Solution
– 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
0%
the economy is strong or weak, β1 = 72% = 0.

Table 10.6 Betas with Respect to the S&P 500 for
Individual Stocks (Based on Monthly Data for
2013–2018) (1 of 4)
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

2013–2018) (2 of 4)
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
Source: Capital IQ
2013–2018) (3 of 4)
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

2013–2018) (4 of 4)
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: Capital IQ
• Interpreting Beta (β)
– A security’s beta is related to how sensitive its
underlying revenues and cash flows are to general
economic conditions
– Stocks in cyclical industries are likely to be more
sensitive to systematic risk and have higher betas than
stocks in less sensitive industries

10.8 Beta and the Cost of Capital (1 of 3)
• Estimating the Risk Premium

– Market risk premium
 The market risk premium is the reward investors
expect to earn for holding a portfolio with a beta of 1
Market Risk Premium = E  RMkt   rf

• Adjusting for Beta

– Estimating a Traded Security’s Cost of Capital of an
investment from Its Beta
E  R  = Risk -Free Interest Rate + Risk Premium

= rf + β × ( E  RMkt   rf )

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
1 1
return of the market E[ R ] = 2 (0.47) + 2 (0.25) = 11% and the market risk
Mkt
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 + βS × ( E[ RMkt ]  rf ) = 5% + 0.833× (11%  5%) = 10%
1 1
This matches their expected return: (40%) + ( 20%) = 10%.
2 2
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).
Problem
– Assume the economy has a 60% chance of the market
return will be 15% next year and a 40% chance the
market return will be 5% next year.
– Assume the risk-free rate is 6%.
– If Microsoft’s beta is 1.18, what is its expected
return next year?

Solution
E[R Mkt ] = (60% ×15%) + (40% × 5%) = 11%
E[R] = rf + β × (E[R Mkt ]  rf )
E[R] = 6% + 1.18× (11%  6%)
E[R] = 6% + 5.9% = 11.9%

• Equation 10.11 is often referred to as the Capital Asset

Pricing Model (CAPM )
– It is the most important method for estimating the cost
of capital that is used in practice

Capital Asset Pricing Model (CAPM)
• Capital asset pricing model (CAPM) is a principle that

explains how the price of capital assets can be determined
based on the reaction of investors in choosing a portfolio in
the capital market.
• Choosing a portfolio depends on the attitude of the
investor towards risk and return.
• Most investors, in general, are conservative and possess
risk averse attitude.

• Non-risky asset refers to asset that has a standard
deviation equals to zero.
• In other words, the actual return is the same as the
expected return. In reality, there would not be any asset
that is totally free from risk. However, there are assets with
very low risks.

• According to the CAPM concept, an investor will choose
any combination of assets that are risky and non-risky in
an efficient portfolio along the capital market line
(CML). The reason for choosing this portfolio is to create a
situation of an optimum risk-return replacement. CML is a
straight line graph that is tangent with the efficient frontier
curve

• Prior to this, you have seen the graph that forms the CML that is the
illustration that connects the rate of return value with the measurement
of overall risks (standard deviation). Now, you will learn the
relationship between rates of return with the measurement of
systematic risk (beta).
• This relationship is illustrated by the security market line (SML). In
theory, SML will fluctuate from time to time depending on the changes
in the estimation of inflation, risk aversion and beta shares.

• Assume the portfolio consisted of investments in security X (where its beta is 1.5
and the expected return is 18 per cent) and risk-free security (where rf is 7 per
cent). 30 per cent of the investment is invested in security X, while 70 per cent is
invested in the risk-free security.
• Assume the portfolio comprised of investments in security Y (where its beta is
1.1 and the expected return is 14 per cent) and risk-free security (where rf is 7
per cent). 30 per cent of the investment is invested in security Y, while 70 per
cent is invested in the risk-free security.

• You are considering two alternatives in buying shares from
either Company A or Company B. The share broker had
prepared an estimated return for both these shares as follows:
(a)Draw a bar chart for the shares in Company A and Company

B.
(b) Calculate the range of probability distribution for the return of
shares
in Company A and Company B.
(c) Determine which of the shares is riskier.

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Corporate Finance (1 of 2)

Fifth Edition, Global Edition

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– Although the bond pays no “interest,” your

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 Thus, the YTM is 3.5%

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Maturity 1 Year 2 Years 3 Years 4 Years

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Maturity 1 Year 2 Years 3 Years 4 Years

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– Yield to Maturity of a Coupon Bond

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• There is an inverse relationship between interest rates and

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• The sensitivity of a bond’s price to changes in interest

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• Using the Law of One Price and the yields of default-free

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Price $96.62 $92.45 $87.63 $83.06%

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• By the Law of One Price, the three-year coupon bond must

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100 100 100 + 1000

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100 100 100 + 1000

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