Chapter 11

RETURN AND RISK: THE CAPITAL ASSET PRICING

MODEL

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
11-1
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

11-2
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 Assets
11.6 Diversification
11.7 Riskless Borrowing and Lending
11.8 Market Equilibrium
11.9 Relationship between Risk and Expected Return
(CAPM)

11-3
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)

11-4
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
Scenario Probability Stock Fund Bond Fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

11-5
ected Return _ n
R   pi R i
i 1

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

11-6
Expected Return _ n
R   pi R i
i 1

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E ( rS )  1  ( 7%)  1  (12%)  1  ( 28%)

3 3 3
E ( rS )  11%
11-7
EXAMPLE

11-8
ANSWER
 E(r)A = (.60  .09) + (.40  .04)
 = .054 + .016
 = .07 = 7%
E(r)B = (.60  .15) + (.40  -.06)
 = .09 - .024
 = .066 = 6.6%

You should select stock A because it has a higher
expected return and also appears to be less risky.

11-9
 n _
Variance Var(R)   2   p i (R i  R ) 2
i 1

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(  7 %  11 %)  .0324 2

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Variance n _
Var(R)   2   p i (R i  R ) 2
i 1

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

1
.0205  (.0324  .0001  .0289)
3
11-11
Standard Deviation
( R1  R ) 2  ( R2  R ) 2   ( RT  R ) 2
SD  VAR 
T 1
Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

14 .3 %  0 .0205
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Example
 Kurt's Adventures, Inc. stock is quite cyclical. In a
boom economy, the stock is expected to return 30%
in comparison to 12% in a normal economy and a
negative 20% in a recessionary period. The
probability of a recession is 15%. There is a 30%
chance of a boom economy. The remainder of the
time, the economy will be at normal levels. What is
the standard deviation of the returns on Kurt's
Adventures, Inc. stock?

11-13
Answer
 E(r) = (.30  .30) + (.55  .12) + (.15  -.20)
 = .09 + .066 - .03 = .126

Var = .30  (.30 - .126)2 + .55  (.12 - .126)2
+ .15  (-.20 - .126)2
= .0090828 + .0000198 + .0159414
= .025044

Std dev = .025044 = .15825 = 15.83%

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Covariance

Stock Bond
Scenario Deviation Deviation Product Weighted
Recession -18% 10% -0.0180 -0.0060
Normal 1% 0% 0.0000 0.0000
Boom 17% -10% -0.0170 -0.0057
Sum -0.0117
Covariance -0.0117

“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)

 a b
 .0117
  0.998
(.143)(.082)

11-16
Example
 The variance of Stock A is .004, the variance of the
market is .007 and the covariance between the two
is .0026. What is the correlation coefficient?

 Standard deviation of A = .06325,

 Standard deviation of the market = .08366

 CORR = COV/(SDa.(SDm)
 = .0026/(.06325)(.08366)
 = .4913

11-17
11.3 The Return and Risk for Portfolios

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
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% invested in bonds and 50%
invested in stocks.
11-18
Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
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  w B rB  w S rS
5 %  50 %  (  7 %)  50 %  (17 %)
11-19
Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
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 )  w B E ( rB )  w S E ( rS )

9 %  50 %  (11 %)  50 %  ( 7 %) 11-20
Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The variance of the rate of return on the two risky assets

portfolio is
σ P2  (w B σ B ) 2  (w S σ S ) 2  2(w B σ B )(w S σ S )ρ BS
where BS is the correlation coefficient between the returns
on the stock and bond funds. 11-21
Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than either stocks or bonds held
in isolation.
11-22
Example
 A portfolio is made up of 75% of stock 1, and 25% of
stock 2. Stock 1 has a variance of .08, and stock 2 has
a variance of .035. The covariance between the stocks
is -.001. Calculate both the variance and the standard
deviation of the portfolio.

σ P2  (w B σ B ) 2  (w S σ S ) 2  2(w B σ B )(w S σ S )ρ BS
 Answer
 2 = (.75)2(.08) + (.25)2(.035) + 2(.25)(.75)
(-.001) = .00365
 = .06123

11-23
11.4 The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0% Portfolo Risk and Return Combinations
5% 7.0% 7.2%
10% 5.9% 7.4% 12.0% 100%
11.0%
15% 4.8% 7.6% stocks

Portfolio
Return
10.0%
20% 3.7% 7.8%
9.0%
25% 2.6% 8.0%
8.0% 100%
30% 1.4% 8.2%
7.0%
35% 0.4% 8.4%
6.0%
bonds
40% 0.9% 8.6%
5.0%
45% 2.0% 8.8%
0.0% 5.0% 10.0% 15.0% 20.0%
50.00% 3.08% 9.00%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0% We can consider other
80% 9.8% 10.2%
85% 10.9% 10.4% portfolio weights besides
90%
95%
12.1%
13.2%
10.6%
10.8%
50% in stocks and 50% in
100% 14.3% 11.0% bonds. 11-24
The Efficient Set for Two Assets
% in stocks Risk Return Portfolio Risk and Return Combinations
0% 8.2% 7.0%
5% 7.0% 7.2%
12.0%
10% 5.9% 7.4%
11.0%

Portfolio Return
15% 4.8% 7.6%
20% 3.7% 7.8% 10.0% 100%
25% 2.6% 8.0% 9.0% stocks
30% 1.4% 8.2% 8.0%
35% 0.4% 8.4% 7.0% 100%
40% 0.9% 8.6% 6.0%
45% 2.0% 8.8%
bonds
5.0%
50% 3.1% 9.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
55% 4.2% 9.2%
60% 5.3% 9.4% Portfolio Risk (standard deviation)
65% 6.4% 9.6%
70% 7.6% 9.8% Note that some portfolios are
75% 8.7% 10.0%
80% 9.8% 10.2% “better” than others. They have
85% 10.9% 10.4%
90% 12.1% 10.6% higher returns for the same level of
95%
100%
13.2%
14.3%
10.8%
11.0%
risk or less.
11-25
Portfolios with Various Correlations
return

100%
 = -1.0 stocks

 = 1.0
100%
 = 0.2
bonds


 Relationship depends on correlation coefficient
-1.0 <  < +1.0
 If= +1.0, no risk reduction is possible
 If= –1.0, complete risk reduction is possible 11-26
11.5 The Efficient Set for Many Securities

return

Individual
Assets

P
Consider a world with many risky assets; we can still identify the
opportunity set of risk-return combinations of various portfolios.

11-27
The Efficient Set for Many Securities

return tf rontier
c ien
effi
minimum
variance
portfolio

Individual Assets


The section of the opportunity set above the minimum varianceP portfolio is the
efficient frontier.

11-28
Announcements, Surprises, and Expected
Returns

The return on any security consists of two parts.
 First, the expected returns
 Second, the unexpected or risky returns
 A way to write the return on a stock in the coming month is:

R  R U
where
R is the expected part of the return
U is the unexpected part of the return
11-29
Announcements, Surprises, and Expected
Returns
 Any announcement can be broken down into two parts, the anticipated (or
expected) part and the surprise (or innovation):
Announcement = Expected part + Surprise.

 The expected part of any announcement is the

part of the information the market uses to form
the expectation, R, of the return on the stock.
 The surprise is the news that influences the
unanticipated return on the stock, U.
11-30
Diversification and Portfolio
Risk
 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.

11-31
Portfolio Risk and Number of Stocks

In a large portfolio the variance terms are

 effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n 11-32
Risk: Systematic and Unsystematic

 A systematic risk is any risk that affects a large number

of assets, each to a greater or lesser degree.
 An unsystematic risk is a risk that specifically affects a
single asset or small group of assets.
 Unsystematic risk can be diversified away.
 Examples of systematic risk include uncertainty about
general economic conditions, such as GNP, interest
rates or inflation.
 On the other hand, announcements specific to a single
company are examples of unsystematic risk.

11-33
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.

11-34
Optimal Portfolio with a Risk-Free Asset

return
100%
stocks

rf
100%
bonds


In addition to stocks and bonds, consider a world that also has risk-free
securities like T-bills.

11-35
11.7 Riskless Borrowing and Lending

L
return
CM 100%
stocks
Balanced
fund

rf
100%
bonds

Now investors can allocate their money across the T-bills and a balanced
mutual fund.

11-36
Riskless Borrowing and Lending
return
L
CM efficient frontier

rf

P

With a risk-free asset available and the efficient frontier identified, we choose
the capital allocation line with the steepest slope.

11-37
11.8 Market Equilibrium

return
L
CM efficient frontier

rf

P choose a point
With the capital allocation line identified, all investors
along the line—some combination of the risk-free asset and the market
portfolio M. In a world with homogeneous expectations, M is the same
for all investors.
11-38
Market Equilibrium

L
return

CM 100%
stocks
Balanced
fund

rf
100%
bonds


Where the investor chooses along the Capital Market Line
depends on her risk tolerance. The big point is that all
investors have the same CML.
11-39
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 ()of the security.
 Beta measures the responsiveness of a security to
movements in the market portfolio (i.e., systematic risk).

Cov ( Ri , RM )
i 
 ( RM )
2

11-40
Estimating with Regression
Security Returns

i ne
c L
s t i
r i
t e
r ac
ha
C Slope = i
Return on
market %

Ri =  i + iRm + ei
11-41
The Formula for Beta

Cov ( Ri , RM )  ( Ri )
i  
 ( RM )
2
 ( RM )

Clearly, your estimate of beta will

depend upon your choice of a proxy
for the market portfolio.

11-42
11.9 Relationship between Risk and
Expected Return (CAPM)
 Expected Return on the Market:

R M  R F  Market Risk Premium

• Expected return on an individual security:

R i  RF  β i  ( R M  RF )

Market Risk Premium

This applies to individual securities held within well-diversified
portfolios.
11-43
Expected Return on a Security

 This
formula is called the Capital Asset Pricing
Model (CAPM):

R i  RF  β i  ( R M  RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security

• Assume i = 0, then the expected return is RF.

• Assume i = 1, then R i  R M
11-44
Relationship Between Risk & Return
Expected return

R i  RF  β i  ( R M  RF )

RM

RF

1.0 

11-45
Relationship Between Risk & Return

13 .5 %
Expected
return

3%

1.5 

β i  1 .5 RF  3% R M  10 %
R i  3 %  1 .5  (10 %  3 %)  13 .5 % 11-46
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 expected return on the asset?

11-47