Ross Corporate 13e PPT CH11 Accessible

Because learning changes everything.
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
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
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.
© McGraw Hill, LLC 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 Securities
11.6 Diversification
11.7 Riskless Borrowing and Lending
11.8 Market Equilibrium
11.9 Relationship between Risk and Expected Return (CAPM)

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).

11.2 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%

Expected Return – I
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

Expected Return – II
Recession −7% .0324 17% .0100
Normal 12% .0001 7% .0000
Boom 28% .0289 −3% .0100
Standard 14.3% 8.2%
Deviation
1 1 1
E rS   7%   12%   28% 
3 3 3
E rS  11%

Variance – I
Recession −7% .0324 17% .0100
Normal 12% .0001 7% .0000
Boom 28% .0289 −3% .0100
Standard 14.3% 8.2%
Deviation
 7%  11% 
2
.0324

Variance – II
Recession −7% .0324 17% .0100
Normal 12% .0001 7% .0000
Boom 28% .0289 −3% .0100
Standard 14.3% 8.2%
Deviation
1
.0205  .0324  .0001  .0289 
3

Standard Deviation
Recession −7% .0324 17% .0100
Normal 12% .0001 7% .0000
Boom 28% .0289 −3% .0100
Standard 14.3% 8.2%
Deviation
.0205 .143, or 14.3%

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.

Correlation
Cov a, b 

a b
 .0117
  .999
.143.082 

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
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.

Portfolios – I
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% 

Portfolios – II
Recession −7% 17% 5.0% .0016
Normal 12% 7% 9.5% .0000
Boom 28% −3% 12.5% .0012
Variance .0205 .0067 .0010
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% 

Portfolios – III
Recession −7% 17% 5.0% .0016
Normal 12% 7% 9.5% .0000
Boom 28% −3% 12.5% .0012
Variance .0205 .0067 .0010
The variance of the rate of return on the two risky assets portfolio
is
 2p wB  B   wS  S   2 wB  B wS  S   BS
2 2
where  BS is the correlation coefficient between the returns on the stock

and bond funds.

Portfolios – IV
Recession −7% 17% 5.0% .0016
Normal 12% 7% 9.5% .0000
Boom 28% −3% 12.5% .0012
Variance .0205 .0067 .0010
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.

11.4 The Efficient Set for Two Assets – I
% 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%
75% 8.7% 10.0%
We can consider other portfolio
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%
Access the text alternative for slide images

The Efficient Set for Two Assets – II
% 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%
75% 8.7% 10.0%
Note that some portfolios are
80% 9.8% 10.2% “better” than others. They have
85% 10.9% 10.4% higher returns for the same level
90% 12.1% 10.6%
95% 13.2% 10.8%
of risk or less.
100% 14.3% 11.0%

Portfolios with Various Correlations
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.
11.5 The Efficient Set for Many Securities - I
Consider a world with many risky assets; we can still identify

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

The Efficient Set for Many Securities – II
The section of the opportunity set above the minimum

variance portfolio is the efficient frontier.

Announcements, Surprises, and Expected
Returns – I
The return on any security consists of two parts.
• Expected returns.
• 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

Announcements, Surprises, and Expected
Returns – II
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.

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.

Portfolio Risk and Number of Stocks
In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.

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.

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.

Optimal Portfolio with a Risk-Free Asset
In addition to stocks and bonds, consider a world that also

has risk-free securities like T-bills.

11.7 Riskless Borrowing and Lending – I
Now investors can allocate their money across the T-bills and
a balanced mutual fund.

Riskless Borrowing and Lending – II
With a risk-free asset available and the efficient frontier

identified, we choose the capital allocation line with the
steepest slope.
11.8 Market Equilibrium – I
With the capital allocation line identified, all investors choose

a point 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.
Market Equilibrium – II
Where the investor chooses along the capital market line

(CML) depends on her risk tolerance. The big point is that
all investors have the same CML.

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 
 2  RM 

Estimating beta with Regression

The Formula for Beta
Cov  Ri , RM    Ri 
i  
 2  RM    RM 
Clearly, your estimate of beta will depend upon your choice

of a proxy for the market portfolio.

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  i  R M  RF
    

Market risk premium
This applies to individual securities held within well-

diversified portfolios.

Expected Return on a Security
This formula is called the capital asset pricing model (CAPM):

R i  RF   i  R M  RF 
Expected return on a security = Risk-free rate + Beta of the
security × Market risk premium
Assume i 0, then the expected return is RF .
Assume  i 1, then R i  R M

Relationship Between Risk & Return - I

Relationship Between Risk & Return - II
i 1.5 RF 3% R M 10%
R i 3%  1.5 10%  3%  13.5%

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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Because learning changes everything.

Corporate Finance Thirteenth Edition

Return, Risk, and the Capital Asset Pricing Model

© McGraw Hill, LLC 2

© McGraw Hill, LLC 3

© McGraw Hill, LLC 4

© McGraw Hill, LLC 5

© McGraw Hill, LLC 6

© McGraw Hill, LLC 7

© McGraw Hill, LLC 8

© McGraw Hill, LLC 9

.0205 .143, or 14.3%

© McGraw Hill, LLC 10

“Deviation” compares return in each state to the expected

© McGraw Hill, LLC 11

© McGraw Hill, LLC 12

Note that stocks have a higher expected return than bonds

© McGraw Hill, LLC 13

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

5% 50%  7%   50% 17% 

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

© McGraw Hill, LLC 15

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

© McGraw Hill, LLC 16

Observe the decrease in risk that diversification offers.

© McGraw Hill, LLC 17

Access the text alternative for slide images

Access the text alternative for slide images

Relationship depends on correlation coefficient.

If  1.0, no risk reduction is possible.

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

© McGraw Hill, LLC 21

The section of the opportunity set above the minimum

Access the text alternative for slide images

A way to write the return on a stock in the coming month is:

U is the unexpected part of the return

© McGraw Hill, LLC 23

The expected part of any announcement is the part of the

© McGraw Hill, LLC 24

© McGraw Hill, LLC 25

Access the text alternative for slide images

© McGraw Hill, LLC 27

© McGraw Hill, LLC 28

In addition to stocks and bonds, consider a world that also

Access the text alternative for slide images

Access the text alternative for slide images

With a risk-free asset available and the efficient frontier

With the capital allocation line identified, all investors choose

Where the investor chooses along the capital market line

Access the text alternative for slide images

© McGraw Hill, LLC 34

Access the text alternative for slide images

Clearly, your estimate of beta will depend upon your choice

© McGraw Hill, LLC 36

Expected return on an individual security:

This applies to individual securities held within well-

© McGraw Hill, LLC 37

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

Assume  i 1, then R i  R M

© McGraw Hill, LLC 38