CHAPTER 6

Risk, Return, and

the Capital Asset Pricing
Model

1
Topics in Chapter
 Basic return concepts
 Basic risk concepts
 Stand-alone risk
 Portfolio (market) risk
 Risk and return: CAPM/SML

2
What are investment
returns?
 Investment returns measure the
financial results of an investment.
 Returns may be historical or
prospective (anticipated).
 Returns can be expressed in:
 Dollar terms.
 Percentage terms.

3
 An investment costs $1,000 and
is sold after 1 year for $1,100.

Dollar return:
$ Received - $ Invested
$1,100 - $1,000 = $100.
Percentage return:
$ Return/$ Invested
$100/$1,000 = 0.10 = 10%.
4
What is investment risk?
 Typically, investment returns are
not known with certainty.
 Investment risk pertains to the
probability of earning a return less
than that expected.
 The greater the chance of a return
far below the expected return, the
greater the risk.

5
Probability Distribution:
Which stock is riskier?
Why?

Stock A
Stock B

-30 -15 0 15 30 45 60
Returns (% )

6
Consider the Following
Investment Alternatives
Econ. Prob T-Bill Alta Repo Am F. MP
.
- -
Bust 8.0%
0.10 22.0% 28.0% 10.0% 13.0%
Below
8.0 -2.0 14.7 -10.0 1.0
avg. 0.20

Avg. 8.0 20.0 0.0 7.0 15.0

0.40
Above
8.0 35.0 -10.0 45.0 29.0
avg. 0.20

Boom 8.0 50.0 -20.0 30.0 43.0

0.10 7
What is unique about the
T-bill return?
 The T-bill will return 8% regardless
of the state of the economy.
 Is the T-bill riskless? Explain.

8
Alta Inds. and Repo Men
vs. the Economy
 Alta Inds. moves with the
economy, so it is positively
correlated with the economy. This
is the typical situation.
 Repo Men moves counter to the
economy. Such negative
correlation is unusual.

9
Alta has the highest rate of
return. Does that make it
best?
^
r
Alta 17.4%
Market 15.0
Am. Foam 13.8
T-bill 8.0
Repo Men 1.7
10
deviation
of returns for each
alternative?

σ = Standard deviation

σ = √ Variance = √ σ2

= √ ^
∑ (ri – r)2 Pi.
i=1

11
Standard Deviation of
Alternatives

T-bills = 0.0%. Repo = 13.4%.

Alta = 20.0%. Am Foam = 18.8%.
Market = 15.3%.

12
Stand-Alone Risk
 Standard deviation measures the
stand-alone risk of an investment.
 The larger the standard deviation,
the higher the probability that
returns will be far below the
expected return.

13
Expected Return versus
Risk
Expected
Security return Risk, 
Alta Inds. 17.4% 20.0%
Market 15.0 15.3
Am. Foam 13.8 18.8
T-bills 8.0 0.0
Repo Men 1.7 13.4

14
Coefficient of Variation
(CV)
 CV = Standard deviation / expected
return
 CVT-BILLS = 0.0% / 8.0% = 0.0.
 CVAlta Inds = 20.0% / 17.4% = 1.1.
 CVRepo Men = 13.4% / 1.7% = 7.9.
 CVAm. Foam = 18.8% / 13.8% = 1.4.
 CVM = 15.3% / 15.0% = 1.0.
15
Expected Return versus
Coefficient of Variation
Expecte
d Risk: Risk:
Security return  CV

Alta Inds 17.4% 20.0% 1.1

Market 15.0 15.3 1.0
Am. Foam 13.8 18.8 1.4
T-bills 8.0 0.0 0.0
Repo Men 16
Return vs. Risk (Std. Dev.):
Which investment is best?
20.0%
18.0% Alta
16.0%
Mkt
14.0% Am. Foam
Return

12.0%
10.0%
8.0% T-bills
6.0%
4.0%
2.0% Repo
0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Risk (Std. Dev.)

17
Portfolio Risk and Return

Assume a two-stock portfolio with

$50,000 in Alta Inds. and $50,000 in
Repo Men.

Calculate ^rp and p.

18
 Portfolio Expected Return

^
rp is a weighted average (wi is % of
portfolio in stock i):
n
^ ^
rp = wiri
i=1
^
rp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.

19
Alternative Method: Find
portfolio return in each
economic state
Port.=
0.5(Alta)
+
Econom 0.5(Rep
y Prob. Alta Repo o)
Bust 0.10 -22.0% 28.0% 3.0%
Below 0.20 -2.0 14.7 6.4
avg.
Average 0.40 20.0 0.0 10.0
Above 0.20 35.0 -10.0 12.5
avg.
Boom 0.10 50.0 -20.0 15.0
20
Use portfolio outcomes to
estimate risk and expected
return

^
rp = 9.6%.
p = 3.3%.
CVp = 0.34.

21
Portfolio vs. Its
Components
 Portfolio expected return (9.6%) is
between Alta (17.4%) and Repo
(1.7%)
 Portfolio standard deviation is much
lower than:
 either stock (20% and 13.4%).
 average of Alta and Repo (16.7%).
 The reason is due to negative
correlation () between Alta and Repo.

22
Two-Stock Portfolios
 Two stocks can be combined to form
a riskless portfolio if  = -1.0.
 Risk is not reduced at all if the two
stocks have  = +1.0.
 In general, stocks have  ≈ 0.35, so
risk is lowered but not eliminated.
 Investors typically hold many stocks.
 What happens when  = 0?

23
Adding Stocks to a
Portfolio
 What would happen to the risk of an
average 1-stock portfolio as more
randomly selected stocks were added?
 p would decrease because the added
stocks would not be perfectly
correlated, but the expected portfolio
return would remain relatively
constant.

24
 stock ≈ 35%
Many stocks ≈ 20%

1 stock
2 stocks
Many stocks

-75 -60 -45 -30 -15 0 15 30 45 60 75 90 10

5
Returns (% )

25
 Risk vs. Number of Stock
in Portfolio
p
Company Specific
35%
(Diversifiable) Risk
Stand-Alone Risk, p

20%
Market Risk

0
10 20 30 40 2,000 stocks
26
Stand-alone risk = Market
risk + Diversifiable risk
 Market risk is that part of a
security’s stand-alone risk that
cannot be eliminated by
diversification.
 Firm-specific, or diversifiable, risk
is that part of a security’s stand-
alone risk that can be eliminated
by diversification.
27
Conclusions
 As more stocks are added, each new
stock has a smaller risk-reducing impact
on the portfolio.
 p falls very slowly after about 40 stocks
are included. The lower limit for p is
about 20%=M .
 By forming well-diversified portfolios,
investors can eliminate about half the
risk of owning a single stock.
28
Can an investor holding one stock
earn a return commensurate with its
risk?
 No. Rational investors will minimize
risk by holding portfolios.
 They bear only market risk, so prices
and returns reflect this lower risk.
 The one-stock investor bears higher
(stand-alone) risk, so the return is
less than that required by the risk.

29
 Correlation & Risk for a
Two Stock Portfolio
 The tendency of two variables to move together is called correlation,
and the correlation coefficient measures this tendency

Simplified as: Correlation(RA,RB) = Covariance(RA, RB) / (A * B)

 The correlation coefficient can range from +1.0, denoting that the
two variables move up and down in perfect synchronization, to -1.0,
denoting that the variables always move in exactly opposite
directions.
 A correlation coefficient of zero indicates that the two variables 30
are not related to each other at all—that is, changes in one variable are
 Correlation & Risk for a
Two Stock Portfolio
 Correlation(RA,RB) = Covariance(RA, RB) / (A * B)

Covariance(RA, RB):

31
How is market risk
measured for individual
securities?
 Market risk, which is relevant for
stocks held in well-diversified
portfolios, is defined as the
contribution of a security to the
overall riskiness of the portfolio.
 It is measured by a stock’s beta
coefficient. For stock i, its beta is:
 bi = (i,M i) / M
32
How are betas calculated?
 In addition to measuring a stock’s
contribution of risk to a portfolio,
beta also which measures the
stock’s volatility relative to the
market.

33
 Beta
 The beta of a portfolio, bp, is the weighted average
of the betas of the stocks in the portfolio, with the
weights equal to the same weights used to create the
portfolio. This can be written as:

 For example, suppose an investor owns a $100,000 portfolio consisting

of $25,000 invested in each of four stocks; the stocks have betas of
0.6, 1.2, 1.2, 1.4. The weight of each stock in the portfolio is
$25,000/$100,000=25%.

34
 Standard Deviation & Beta
1. A portfolio with a beta greater than 1 will
have a bigger standard deviation than the
market portfolio.
2. A portfolio with a beta equal to 1 will have the
same standard deviation as the market.
3. A portfolio with a beta less than 1 will have a
smaller standard deviation than the market.
we can see the impact that each individual stock
beta has on the risk of a well-diversified
portfolio:

35
36
 Estimating Beta
 The beta coefficient used by investors should reflect the
relationship between a stock’s expected return and the
market’s expected return during some future period.
 However, people generally calculate betas using data
from some past period and then assume that the stock’s
risk will be the same in the future as it was in the past.

37
Using a Regression to
Estimate Beta
 Run a regression with returns on
the stock in question plotted on the
Y axis and returns on the market
portfolio plotted on the X axis.
 The slope of the regression line,
which measures relative volatility,
is defined as the stock’s beta
coefficient, or b.
38
Use the historical stock
returns to calculate the beta
for PQU.
Year Marke PQU
t
1 25.7% 40.0%
2 -
8.0% 15.0%
3 - -
11.0% 15.0%
4 15.0% 35.0%
5 32.5% 10.0%
39
 Calculating Beta for PQU

50%
40%
30%
PQU Return

20%
10%
0%
-10%
rPQU = 0.8308 rM + 0.0256
-20%
-30% R2 = 0.3546
-30% -20% -10% 0% 10% 20% 30% 40% 50%
Market Return

40
What is beta for PQU?
 The regression line, and hence
beta, can be found using a
calculator with a regression
function or a spreadsheet program.
In this example, b = 0.83.

41
Calculating Beta in
Practice
 Many analysts use the S&P 500 to
find the market return.
 Analysts typically use four or five
years’ of monthly returns to
establish the regression line.
 Some analysts use 52 weeks of
weekly returns.

42
How is beta interpreted?
 If b = 1.0, stock has average risk.
 If b > 1.0, stock is riskier than
average.
 If b < 1.0, stock is less risky than
average.
 Most stocks have betas in the range
of 0.5 to 1.5.
 Can a stock have a negative beta?
43
Expected Return versus
Market Risk: Which
investment is best?
Expected
Return
Security (%) Risk, b
Alta 17.4 1.29
Market 15.0 1.00
Am. Foam 13.8 0.68
T-bills 8.0 0.00
Repo Men 1.7 -0.86
44
each
alternative’s required
return.
 The Security Market Line (SML) is
part of the Capital Asset Pricing
Model (CAPM).

 SML: ri = rRF + (RPM)bi .

 Assume rRF = 8%; rM = rM = 15%.
 RPM = (rM - rRF) = 15% - 8% = 7%.
45
Required Rates of Return
 rAlta = 8.0% + (7%)(1.29) = 17%.
 rM = 8.0% + (7%)(1.00) = 15.0%.
 rAm. F. = 8.0% + (7%)(0.68) =
12.8%.
 rT-bill = 8.0% + (7%)(0.00) = 8.0%.
 rRepo = 8.0% + (7%)(-0.86) = 2.0%.

46
Expected versus Required
Returns (%)
Exp. Req.
r r
Alta 17.4 17.0
Undervalue
d
Market 15.0 15.0 Fairly
valued
Am. F. 13.8 12.8
Undervalue47
SML: ri = rRF + (RPM) bi
ri = 8% + (7%) bi

ri (%)
Alta . Market
rM = 15 . .
rRF = 8 . T-bills Am. Foam

Repo
. Risk, bi
-1 0 1 2
48
Calculate beta for a
portfolio with 50% Alta
and 50% Repo

bp = Weighted average
= 0.5(bAlta) + 0.5(bRepo)
= 0.5(1.29) + 0.5(-0.86)
= 0.22.

49
Required Return on the
Alta/Repo Portfolio?

rp = Weighted average r
= 0.5(17%) + 0.5(2%) = 9.5%.

Or use SML:

rp = rRF + (RPM) bp
= 8.0% + 7%(0.22) = 9.5%.

50
 Impact of Inflation Change
on SML

r (%) New SML  I = 3%

SML2

18 SML1
15
11 Original situation
8

0 0.5 1.0 1.5 Risk, bi

51
 Impact of Risk Aversion
Change

SML2
r (%) After change

18 SML1
15  RPM = 3%

8 Original situation

Risk, bi 52
1.0
 Fama-French three-
factor model
The first factor is the market risk premium, which is the market return,
rM, minus the risk-free rate, rRF. Thus, their model begins like the CAPM, but they go
on to add a second and third factor.

To form the second factor, they ranked all actively traded stocks by size
and then divided them into two portfolios, one consisting of small
stocks and one consisting of big stocks. They calculated the return on
each of these two portfolios and created a third portfolio by subtracting
the return on the big portfolio from that of the small one. They called
this the SMB (small minus big) portfolio. This portfolio is
designed to measure the variation in stock returns that is
caused by the size effect.

To form the third factor, they ranked all stocks according to their book-
to-market (B/M) ratios. They placed the 30% of stocks with the highest
ratios into a portfolio they called the H portfolio (for high B/M ratios) 53
and placed the 30% of stocks with the lowest ratios into a portfolio
54
55