Corporate Finance Thirteenth Edition

Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe / Bradford D. Jordan

Chapter 11

Return, Risk, and the Capital Asset Pricing Model

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 Key Concepts and Skills
• Know how to calculate expected returns.
• Know how to calculate covariances, correlations, and
betas.
• Understand the impact of diversification.
• Understand the systematic risk principle.
• Understand the security market line.
• Understand the risk-return tradeoff.
• Be able to use the Capital Asset Pricing Model.

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 Chapter Outline
11.1 Individual Securities
11.2 Expected Return, Variance, and Covariance
11.3 The Return and Risk for Portfolios
11.4 The Efficient Set for Two Assets
11.5 The Efficient Set for Many Securities
11.6 Diversification
11.7 Riskless Borrowing and Lending
11.8 Market Equilibrium
11.9 Relationship between Risk and Expected Return (CAPM)

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 11.1 Individual Securities
The characteristics of individual securities that are of interest
are the:
• Expected Return.
• Variance and Standard Deviation.
• Covariance and Correlation (to another security or index).

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 11.2 Expected Return, Variance, and
Covariance
Consider the following two risky asset world. There is a 1/ 3
chance of each state of the economy, and the only assets
are a stock fund and a bond fund
Rate of Return: Rate of Return:
Scenario Probability Stock Fund Bond Fund
Recession 33.3% −7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% −3%

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 Expected Return
Stock Stock Fund: Bond Fund: Bond Fund:
Fund: Rate Squared Rate of Squared
Scenario of Return Deviation Return Deviation
Recession −7% .0324 17% .0100
Normal 12% .0001 7% .0000
Boom 28% .0289 −3% .0100
Expected return 11.00% 7.00%
Variance .0205 .0067
Standard 14.3% 8.2%
Deviation

( 1 1 1
E ( rS )= ´ ( -7% ) + ´ (12% ) + ´ ( 28% )
! " = $ "% ∗ *("% ) 3 3 3
%&' E ( rS ) = 11%

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 Variance ( -7% - 11% )
2
= .0324

Stock Stock Fund: Bond Fund: Bond Fund:

Fund: Rate Squared Rate of Squared
Scenario of Return Deviation Return Deviation
Recession −7% .0324 17% .0100
Normal 12% .0001 7% .0000
Boom 28% .0289 −3% .0100
Expected return 11.00% 7.00%
Variance .0205 .0067
Standard 14.3% 8.2%
Deviation
( 1
! " = $(*% −,(*))" ∗ /(*% )
Variance = .0205 = (.0324 + .0001 + .0289 )
3
%&'
SD = .0205 = .143, or 14.3%

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 Covariance

Stock Bond
Scenario Deviation Deviation Product Weighted
Recession −18% 10% −.0180 −.0060
Normal 1% 0% 0 0
Boom 17% −10% −.0170 −.0057
Sum −.0117
Covariance −.0117

“Deviation” compares return in each state to the expected

return.
“Weighted” takes the product of the deviations multiplied by
the probability of that state.

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 Correlation

Cov ( a, b )
r=
sa sb
-.0117
r= = -.999
(.143)(.082 )

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Portfolios

• A portfolio is a group of assets such as stocks or bonds

held by an investor.
• The risk-return trade-off for a portfolio is measured by the
portfolio expected return and standard deviation.

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 11.3 The Return and Risk for Portfolios
Stock Fund: Bond Fund:
Stock Fund: Squared Bond Fund: Rate Squared
Scenario Rate of Return Deviation of Return Deviation
Recession −7% .0324 17% .0100
Normal 12% .0001 7% .0000
Boom 28% .0289 −3% .0100
Expected return 11.00% 7.00%
Variance .0205 .0067
Standard Deviation 14.3% 8.2%

Note that stocks have a higher expected return than bonds

and higher risk. Let us turn now to the risk-return tradeoff of a
portfolio that is 50 percent invested in bonds and 50
percent invested in stocks.

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 Portfolios
Rate of Return: Rate of Return: Squared
Scenario Stock fund Bond fund Portfolios Deviation
Recession −7% 17% 5.0% .0016
Normal 12% 7% 9.5% .0000
Boom 28% −3% 12.5% .0012
Expected return 11.00% 7.00% 9.0%
Variance .0205 .0067 .0010
Standard Deviation 14.31% 8.16% 3.08%

The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:
rP = wB rB + wS rS

5% = 50% ´ ( -7% ) + 50% ´ (17% )

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 Portfolios
Rate of Return: Rate of Return: Squared
Scenario Stock fund Bond fund Portfolios Deviation
Recession −7% 17% 5.0% .0016
Normal 12% 7% 9.5% .0000
Boom 28% −3% 12.5% .0012
Expected return 11.00% 7.00% 9.0%
Variance .0205 .0067 .0010
Standard Deviation 14.31% 8.16% 3.08%

The expected rate of return on the portfolio is a weighted average

of the expected returns on the securities in the portfolio.
E ( rP ) = wB E ( rB ) + wS E ( rS )
9% = 50% ´ (11% ) + 50% ´ ( 7% )

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 Portfolios
Rate of Return: Rate of Return: Squared
Scenario Stock fund Bond fund Portfolios Deviation
Recession −7% 17% 5.0% .0016
Normal 12% 7% 9.5% .0000
Boom 28% −3% 12.5% .0012
Expected return 11.00% 7.00% 9.0%
Variance .0205 .0067 .0010
Standard Deviation 14.31% 8.16% 3.08%

The variance of the rate of return on the two risky assets portfolio is
s 2p = ( wB s B ) + ( wS s S ) + 2 ( wB s B ) ( wS s S ) r BS
2 2

where r BS is the correlation coefficient between the returns on the stock

and bond funds.

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 Portfolios
Rate of Return: Rate of Return: Squared
Scenario Stock fund Bond fund Portfolios Deviation
Recession −7% 17% 5.0% .0016
Normal 12% 7% 9.5% .0000
Boom 28% −3% 12.5% .0012
Expected return 11.00% 7.00% 9.0%
Variance .0205 .0067 .0010
Standard Deviation 14.31% 8.16% 3.08%

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50 percent in stocks and 50 percent
in bonds) has less risk than either stocks or bonds held in isolation.
This is not always the case.

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 Diversification
• Portfolio diversification is the investment in several different
asset classes, sectors, or countries.
• invest 50 stocks in 20 different industry.
• invest 50 stocks in 20 different industry in 10 countries.
• This strategy reduces an investor’s overall risk profile.

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 11.4 The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
49% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
We can consider other portfolio
75% 8.7% 10.0%
80% 9.8% 10.2% weights besides 50 percent in
85% 10.9% 10.4% stocks and 50 percent in bonds.
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
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 Portfolios with Various Correlations

Relationship depends on correlation coefficient.

-1.0 £ r £ +1.0

If r = +1.0, no risk reduction is possible.

If r = -1.0, complete risk reduction is possible.
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 11.5 The Efficient Set for Many Securities

Consider a world with many risky assets; we can still identify

the opportunity set of risk-return combinations of various
portfolios.

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 The Efficient Set for Many Securities

The section of the opportunity set above the minimum

variance portfolio is the efficient frontier.

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 Returns and Diversifications

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 Risk: Systematic and Unsystematic
• Total risk incluses two components:
• A systematic risk is any risk that affects a large number
of assets, each to a greater or lesser degree.
• Examples: uncertainty about general economic
conditions, such as GNP, interest rates or inflation.
• An unsystematic risk is a risk that specifically affects a
single asset or small group of assets.
• Examples: announcements specific to a single company
are examples of unsystematic risk.
• Unsystematic risk can be diversified away.

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 Portfolio Risk and Number of Stocks
Diversification helps to eliminate the unsystematic
portion of risk.

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 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.

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 11.7 Riskless Borrowing and Lending

The relationship between risk and expected return for portfolios

composed of one risky asset and the riskless asset.
The opportunity set is straight, not curved.
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 Optimal Portfolio with a Risk-Free Asset

Point Q: a portfolio of risky assets (securities)

Line I: the feasible set of an investment in the riskless asset with the portfolio Q
Line II: the feasible set of an investment in the riskless asset with the portfolio A

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 Optimal Portfolio with a Risk-Free Asset

• Curve XAY: efficient frontier of risky assets

• Point A: a portfolio of risky assets on the “efficient frontier”
• Point 4 & 5: combinations of the riskless asset and portfolio A
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 Optimal Portfolio with a Risk-Free Asset

• Line I is not optimal

• Line II is tangent to the efficient frontier of risky assets => provides the
investors with the best possible opportunities => the efficient set of all
assets, both risky and riskless.
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 Optimal Portfolio with a Risk-Free Asset
• The investor’s investment decision
consists of two separate steps:
• Step 1. Estimate the expected returns
and SDs of individual assets, and the
covariances between pairs of assets,
and compute the efficient set of risky
assets (curve XAY). Then, determine
point A i,e, the tangency between Rf
and curve XAY⇒ Point A denotes the
portfolio of risky assets that investors
will hold.
• Step 2. One has to determine how he
• More tolerance of risk → choose
will combine point A (the portfolio of
risky assets) with the riskless assets,
i.e, the point for investment on Line II.
• Less tolerance of risk → choose
=> degree of risk aversion

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 11.8 Market Equilibrium

Assumption of homogeneous expectations

• In a world where all investors possess the same estimates on
expected returns, variances, and covariances => All investors have
the same line II.
• If all investors choose the same portfolio of risky assets, we can know
that it is a market value weighted portfolio of all existing securities →
So called “market portfolio”
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 Market Equilibrium

Where the investor chooses along the capital market line

(CML) depends on her risk tolerance.
The market portfolio is a market-value-weighted portfolio
of all existing securities.
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 Risk When Holding the Market Portfolio
Researchers have shown that the best measure of the risk
of a security in a large portfolio is the beta ( b ) of the
security.
Beta measures the responsiveness of a security to
movements in the market portfolio (i.e., systematic risk).

Cov ( Ri , RM )
bi =
s 2 ( RM )
Example: beta of firm J = 1.5 => the returns of firm J are magnified 1.5 times
over those of market => Firm J is more risky than the market

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 Estimating beta with Regression

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 11.9 Relationship Between Risk and
Expected Return (CAPM)
Expected return on the market:

R M = RF + Marketriskpremium

Expected return on an individual security:

(
R i = RF + bi ´ R M - RF
!"#"$
)
Market risk premium

This applies to individual securities held within well-

diversified portfolios.

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 Capital asset pricing model (CAPM)

This formula is called the capital asset pricing model (CAPM):

(
R i = RF + bi ´ R M - RF )
Expected return on a security = Risk-free rate + Beta of the
security × Market risk premium

Assume bi = 0, then the expected return is RF .

Assume bi = 1, then R i = R M

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 Relationship Between Risk & Return

CAPM model

Security market line (SML)

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 Relationship Between Risk & Return

bi = 1.5 RF = 3% R M = 10%

R i = 3% + 1.5 ´ (10% - 3% ) = 13.5%

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 CML and SML

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 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
percent, and a market return of 13 percent.
• What is the expected return on the asset?

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 Suggested excercises
• Questions and Problems
• 5, 9, 10, 16, 22, 28, 29, 30, 31,36, 37

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