Lecture 8:

A. Capital Markets
B. Risk & Return
C. SML/CAPM
IN capital markets, you sell securities that are attractive to
investors.
Total Return = Income +Capital Gain
Stock Total Return % = Dividend Yield + Capital Gains Yield
= Next Dividend/ Pt +(Pt+1 Pt/Pt)
See Pp. 376 -377
Disney 2013 Return:
Div Yield = $0.86/52.19 = 1.65%
Capital Gains Yield = 76.4 -52.19/ 52.19 = 46.35%
Total Return = 1.65% + 46.39% = 48.04%
Another way of talking about risk is volatility. Small Companies
stock is more volatile.
US Treasury Bills are risk free. 0% Risk Premium. .Everything else is
measured against it.
Long term Government Bonds have interest rate risks.
First Lesson : Reward for bearing Risk!
More volatility = more risk
Variance measure risk
Average squared difference b/w the average return and actual
return
Standard deviation
Total Risk measured by variance or standard deviation.
For Historica Returns Only
Var(R ) = 1/T-1 x ( R1 R)2 + (R2 R)2 . + (Rt R)2)

Supertech Example From book

pp.389
Q7 From Book.
1
2
3
4
5

0.17
0.22
0.08
-0.15
0.1

0.084
0.084
0.084
0.084
0.084

0.086
0.136
-0.004
-0.234
0.016

0.007396
0.018496
0.000016
0.054756
0.000256

var. = 0.089/4 = 0.02225

s.d = 0.149 = 14 %
Normal Curve Bell Shaped
Large company normal curve -> Average return 11.9, SD = 20.4%
2/3 probablity that reurn in a given year is b/w 0.119 0.204 =
-8.5%
AND 0.119+0.204 = 32.3%

Thusoursecondlessonisthis:Thegreaterthepotentialreward,thegreateris
therisk.

EfficientCapitalMarkets:
1. Efficientmarkethypothesis(EFm)
a. Strongformefficient;pricesreflectjustabouteverything,thereis
noinsiderinformation
b. SemiStrong;pricesreflectallpublicallyavailableinformation,
thereispossiblyaninsiderinformation.
c. Weakformefficient;Pricesreflectastocksownpastprices.
Future Events
1. Expected Return = Probability * Outcome
2. Example: $100 lottery ticket at fundraiser
a. P($10 prze) = 0.85
b. P($100 prize) = 0.1
c. P($1000 prize) = 0.05
Expected Value = $68.5

Example of calcl. Variance and SD of Prediction from book in

different times Recession, Normal.
Proablity, Valye, Expected value, Deviation, Deviations2 , Probability
x Squared deviation.
Sum of Probability * Sq. Deviation = variance
Portfolio is a group of securities.
Portfolio expected return:
1. Its a weighted average f expected return of each stock in
portfolio
2. E (Rp) = x1*R1 +x2*R2 +xn*Rn
3. Example 30% tock 1 and E(R1) = 15%,
50% stock 2 and E(R2) = 10%
20% stock 3 and E(R3) = 17%
Expected return on portfolio = 12.9%
Diversification Diversifying stocks balances out losses and profits,
and reduces variations.
Based on what diversified stocks table we looked at, take look at
pages 418-19
2 Types of Risks
a. Systematic Risks = market risk = non-diversiable risks
Examples: National or world wide recession, Interest rates,
inflation. You cannot get away from it by diversifying
b. Unsystematic Risk = Diversifiable risks, unique or firm specific
risk
c. Examples: Exceptional new product, Financial Fraud (if you
only own enron, you suffer huge loss), labor disputes, law
suites(Toyota stocks have suffered from this)
Market will reward only systematic risk. How uch you are
compensated is how sensitive that stock is to systematic risk.
Which brings us to the question, how do we measure systematic risk
Measuring S. Risk
a. Beta Coefficient
b. See total risk vs. Beta on pp 429
Std. Deviation measures total risk
But expected return & risk premium depend on beta only

c. Beta measures volatility with respect to total market, Beta >1,

= more volatile than market, Beta <1 less volatile than
market.
d. Disney beta 1.21, Kuoger beta 0.7 , P&G beta 0.38 , Tiffany
beta 1.72
Capital Asset pRicing model(CAPM)
E(R on any security) = Risk free rate +Market Risk Premium * Beta
This Equation defines security market line.
Graph on PP. 431
Can find epected return given beta, And slope of line E(Rm) Rf.