Chapter 8
Chapter 8
Chapter 8
Chapter 8
Risk and Return—
Capital Market
Theory
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Principles Applied in This Chapter
• Principle 2: There is a Risk-Return Tradeoff.
• Principle 4: Market Prices Reflect Information.
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8.1 PORTFOLIO RETURNS AND PORTFOLIO RISK
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Portfolio Returns and Portfolio Risk
• With appropriate diversification, you can lower the
risk of your portfolio without lowering it’s expected
rate of return.
• Those risks that can be eliminated by
diversification are not necessarily rewarded in the
financial marketplace.
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Calculating the Expected Return of a
Portfolio (1 of 2)
• To calculate a portfolio’s expected rate of return,
we weight each individual investment’s expected
rate of return using the fraction of the portfolio that
is invested in each investment.
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Calculating the Expected Return of a
Portfolio (2 of 2)
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Step 1: Picture the Problem
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Step 2: Decide on a Solution Strategy (1 of 2)
• The portfolio expected rate of return is simply a
weighted average of the expected rates of return
of the investments in the portfolio.
• We can use equation 8-1 to calculate the
expected rate of return for Penny’s portfolio.
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Step 2: Decide on a Solution Strategy (2 of 2)
• We have to fill in the third column (Product) to
calculate the weighted average.
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Step 3: Solve (1 of 2)
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Step 3: Solve (2 of 2)
Alternatively, we can fill out the following table from
step 2 to get the same result.
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Step 4: Analyze
• The expected return is 9% for a portfolio
composed of 25% each in treasury bills and
Emerson Electric stock and 50% in Starbucks.
• If we change the percentage invested in each
asset, it will result in a change in the expected
return for the portfolio.
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Evaluating Portfolio Risk: Portfolio
Diversification
• The effect of reducing risks by including a large
number of investments in a portfolio is called
diversification.
• The diversification gains achieved will depend on
the degree of correlation among the
investments, measured by correlation
coefficient.
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Portfolio Diversification
The correlation coefficient can range from −1.0
(perfect negative correlation), meaning that two
variables move in perfectly opposite directions to
+1.0 (perfect positive correlation). Lower the
correlation, greater will be the diversification
benefits.
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Diversification Lessons
1. A portfolio can be less risky than the average
risk of its individual investments.
2. The key to reducing risk through diversification is
to combine investments whose returns are not
perfectly positively correlated.
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Calculating the Standard Deviation of a
Portfolio’s Returns
• W1, W2, and W3 = the proportions of the portfolio that are invested in assets 1, 2, and 3, respectively.
• 1, 2, and 3 = the standard deviations in the rates of return earned by assets 1, 2, and 3, respectively.
• i, j = the correlation between the rates of return earned by assets i and j. The symbol 1, 2 (pronounced
“rho”) represents correlation between the rates of return for asset 1 and asset 2.
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Figure 8-1 Diversification and the Correlation Coefficient—
Apple and Coca—Cola (1 of 2)
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Figure 8-1 Diversification and the Correlation Coefficient—
Apple and Coca—Cola (2 of 2)
Legend:
Correlation Expected Return Standard Deviation
−1.00 0.14 0%
−0.80 0.14 6%
−0.60 0.14 9%
−0.40 0.14 11%
−0.20 0.14 13%
0.0 0.14 14%
0.20 0.14 15%
0.40 0.14 17%
0.60 0.14 18%
0.80 0.14 19%
1.00 0.14 20%
All portfolios are comprised of equal investments in Apple and Coca-Cola shares.
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The Impact of Correlation Coefficient on
the Risk of the Portfolio
We observe (from figure 8.1) that lower the
correlation, greater is the benefit of diversification.
+1 No benefit
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CHECKPOINT 8.2: CHECK YOURSELF
Evaluating a Portfolio’s Risk and Return
Evaluate the expected return and standard deviation of the portfolio of the S&P500
index fund and the international fund where the correlation is estimated to be .20 and
Sarah still places half of her money in each of the funds.
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Step 1: Picture the Problem
Sarah can visualize the expected return, standard
deviation and weights as shown below, with the
need to determine the numbers for the empty
boxes.
Investment Fund Expected Return Standard Deviation Investment Weight
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Step 2: Decide on a Solution Strategy
• The portfolio expected return is a simple weighted
average of the expected rates of return of the two
investments given by equation 8-1.
• The standard deviation of the portfolio can be
calculated using equation 8-2. We are given the
correlation to be equal to 0.20.
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Step 3: Solve (1 of 2)
E(rportfolio)
= WS&P500 E(rS&P500) + WInternational E(rInternational)
= .5 (12) + .5(14)
= 13%
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Step 3: Solve (2 of 2)
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Step 4: Analyze
• A simple weighted average of the standard
deviation of the two funds would have resulted in
a standard deviation of 25% (20 x .5 + 30 x .5) for
the portfolio.
• However, the standard deviation of the portfolio is
less than 25% (19.62%) because of the
diversification benefits (with correlation being less
than 1).
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8.2 SYSTEMATIC RISK AND THE
MARKET PORTFOLIO
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Systematic Risk and Market Portfolio (1 of 3)
CAPM theory assumes that investors chose to hold
the optimally diversified portfolio that includes all of
the economy’s assets (referred to as the market
portfolio). According to the CAPM, the relevant risk
of an investment is determined by how it contributes
to the risk of this market portfolio.
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Systematic Risk and Market Portfolio (2 of 3)
To understand how an investment contributes to the
risk of the portfolio, we categorize the risks of the
individual investments into two categories:
– Systematic risk, and
– Unsystematic risk
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Systematic Risk and Market Portfolio (3 of 3)
• The systematic risk component measures the
contribution of the investment to the risk of the
market portfolio. For example: War, recession.
• The unsystematic risk is the element of risk that
does not contribute to the risk of the market and is
diversified away. For example: Product recall,
labor strike, change of management.
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Diversification and Unsystematic Risk
Figure 8-2 illustrates that, as the number of
securities in a portfolio increases, the contribution of
the unsystematic risk to the standard deviation of
the portfolio declines while the systematic risk is not
reduced. Thus large portfolios will not be affected by
unsystematic risk.
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Figure 8.2 Portfolio Risk and the Number of Investments in
the Portfolio
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Systematic Risk and Beta
Systematic risk is measured by beta coefficient,
which estimates the extent to which a particular
investment’s returns vary with the returns on the
market portfolio. In practice, it is estimated as the
slope of a straight line (see figure 8-3).
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Calculating Portfolio Beta (1 of 2)
The portfolio beta measures the systematic risk of
the portfolio.
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Calculating Portfolio Beta (2 of 2)
Example Consider a portfolio that is comprised of
four investments with betas equal to 1.50, 0.75,
1.80 and 0.60 respectively. If you invest equal
amount in each investment, what will be the beta for
the portfolio?
= .25(1.50) + .25(0.75) + .25(1.80) + .25 (0.60)
= 1.16
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8.3 THE SECURITY MARKET LINE AND THE CAPM
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The Security Market Line and the CAPM
(1 of 3)
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Figure 8.4 Risk and Return for Portfolios Containing the
Market and the Risk—Free Security (1 of 2)
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Figure 8.4 Risk and Return for Portfolios Containing the
Market and the Risk—Free Security (2 of 2)
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The Security Market Line and the CAPM
(2 of 3)
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The Security Market Line and the CAPM
(3 of 3)
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Using the CAPM to Estimate the Expected
Rate of Return
Equation 8-6 implies that higher the systematic risk
of an investment, other things remaining the same,
the higher will be the expected rate of return an
investor would require to invest in the asset.
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CHECKPOINT 8.3: CHECK YOURSELF
Estimating the Expected Rate of Return Using the CAPM
Estimate the expected rates of return for the three utility companies, found in Table 8-
1, using the 4.5% risk-free rate and market risk premium of 6%.
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Step 1: Picture the Problem (1 of 2)
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Step 1: Picture the Problem (2 of 2)
The graph shows that as beta increases, the
expected return also increases. When beta = 0, the
expected return is equal to the risk free rate of
4.5%.
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Step 2: Decide on a Solution Strategy
We can determine the required rate of return by
using CAPM equation 8-6. The betas for the three
utilities companies (Yahoo Finance estimates) are:
AEP = 0.74, DUK = 0.40, CNP = 0.82
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Step 3: Solve (1 of 2)
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Step 3: Solve (2 of 2)
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Step 4: Analyze
The expected rates of return on the stocks vary
depending on their beta. Higher the beta, higher is
the expected return.
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Key Terms (1 of 2)
• Beta coefficient
• Capital asset pricing model (CAPM)
• Correlation coefficient
• Diversification
• Diversifiable risk
• Market portfolio
• Market risk premium
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Key Terms (2 of 2)
• Non-diversifiable risk
• Portfolio beta
• Security market line
• Systematic risk
• Unsystematic risk
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Copyright
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