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CHAPTER 11 QUIZ

CHAPTER ORGANIZATION

Previously we learned some important lessons from capital market history. Most importantly, there is a reward, on

average, for bearing risk. We called this reward a risk premium. The second lesson is that this risk premium is larger for

riskier investments. Thus far, we have concentrated mainly on the return behavior of a few large portfolios. We need to

expand our consideration to include individual assets. Specifically, we have two tasks to accomplish. First, we have to

define risk and then discuss how to measure it. We then must quantify the relationship between an asset's risk and its

required return.

When we examine the risks associated with individual assets, we find there are two types of risk: systematic and

unsystematic. This distinction is crucial because, as we will see, systematic risk affects almost all assets in the

economy, at least to some degree, while unsystematic risk affects at most a small number of assets. We then develop the

principle of diversification, which shows that highly diversified portfolios will tend to have almost no unsystematic

risk.

The principle of diversification has an important implication: To a diversified investor, only systematic risk matters. It

follows that in deciding whether or not to buy a particular individual asset, a diversified investor will only be concerned

with that asset's systematic risk. This is a key observation, and it allows us to say a great deal about the risks and

returns on individual assets. In particular, it is the basis for a famous relationship between risk and return called the

security market line, or SML. To develop the SML, we introduce the equally famous beta coefficient, one of the

centerpieces of modern finance. Beta and the SML are key concepts because they supply us with at least part of the

answer to the question of how to go about determining the required return on an investment.

11.1

Expected Return The return on a risky asset expected in the future. Given all possible outcomes for a

particular investment, the average rate of return is called the expected return. The actual return can differ from

the expected return.

The expected return is a weighted average of the possible rates of return:

E(R) = (Pr1 x R1) + (Pr2

where T is the number of possible states of the economy, Pr1, Pr2, Pr3, and PrT are the probabilities of the

respective states of the economy, and R1, R2, R3, and RT are the possible rates of return. Further, we define the

expected risk premium as the expected return less the risk-free rate:

Prepared by Jim Keys

Based on the following information, calculate the expected return.

E(R) = [.20 x (-.07)] + [.55 x .13] + [.25 x .30] = (-.014) + (.0715) + (.075) = .1325 = 13.25%

n

Var(R) 2 p i (R i E(R)) 2

i 1

Variance measures the dispersion of points around the mean of a distribution. In this context, we are attempting

to characterize the variability of possible future security returns around the expected return. In other words, we

are trying to quantify risk and return. Variance measures the total risk of the possible returns.

Some experience confusion in understanding the mathematics of the variance calculation. They may have the feeling

that they should divide the variance of an expected return by (n-1). We point out that the probabilities account for this

division. We divide by n-1 in the historical variance because we are looking at a sample. If we looked at the entire

population (which is what we are doing with expected values), then we would divide by n to get our historical variance.

This is the same as saying that the probability of occurrence is the same for all observations and is equal to 1/n.

Based on the following information, calculate the variance and standard deviation.

Var(R) = .20(-.07 - .1325)2 + .55(.13 - .1325)2 + .25(.30 - .1325)2

Var(R) = (.00820125) + (.00000344) + (.00701406) = .01521875

SD(R) = (.01521875).5 = .123364 = 12.34%

11.2

Portfolio Weights The respective percentages of a portfolios total value invested in each of the assets in the

portfolio. Portfolio weights must sum to 1.0.

Portfolio Expected Returns The expected return for a portfolio is the weighted average of the expected returns

of the assets which are included in the portfolio:

E(Rp) = [x1 x E(R1)] + [x2 x E(R2)] + [x3 x E(R3)] + + [xn x E(Rn)] ,

where n is the number of assets in the portfolio, x1, x2, x3, and xn are the portfolio weights, and E(R1), E(R2),

E(R3), and E(Rn) are the expected returns on assets 1 through n.

You own a portfolio that is 20 percent invested in Stock X, 45 percent in Stock Y, and 35 percent in Stock Z. The

expected returns on these three stocks are 10 percent, 14 percent, and 16 percent, respectively. What is the expected

return on the portfolio?

E(Rp) = (.20 x .10) + (.45 x .14) + (.35 x .16) = .02 + .063 + .056 = .139 = 13.90%

Portfolio Variance - Unlike expected return, the variance of a portfolio is NOT the weighted sum of the

individual security variances. Combining securities into portfolios can reduce the total variability of returns.

Consider the following information:

a. Your portfolio is invested 30 percent each in A and C and 40 percent in B. What is the expected return of the

portfolio?

This portfolio does not have an equal weight in each asset. We first need to find the return of the portfolio in each state

of the economy. To do this, we will multiply the return of each asset by its portfolio weight and then sum the products

to get the portfolio return in each state of the economy. Doing so, we get:

Boom: E(Rp) = .30(.30) + .40(.45) + .30(.33) = .3690 or 36.90%

Good:

Bust: E(Rp) = .30(.20) + .40(.30) + .30(.09) = .2070 or 20.70%

And the expected return of the portfolio is:

Prepared by Jim Keys

b. What is the variance of this portfolio? The standard deviation?

To calculate the standard deviation, we first need to calculate the variance. To find the variance, we find the squared

deviations from the expected return. We then multiply each possible squared deviation by its probability, and then sum.

The result is the variance. So, the variance and standard deviation of the portfolio is:

p2 = .15(.3690 .0743)2 + .45(.1210 .0743)2 + .35(.0720 .0743)2 + .05(.2070 .0743)2 = .02546

p = (.02546).5 = .1596 or 15.96%

11.3

Expected and Unexpected Returns

Total return = R = expected return + unexpected return = E(R) + U,

where R stands for the actual total return for the year, E(R) represents the expected part of the return, and U

stands for the unexpected part of the return.

Thus, total return differs from expected return because of surprises, or news. This is one of the reasons that

realized returns differ from expected returns.

Announcement the release of information not previously available. Announcements have two parts: the

expected part and the surprise part. The expected part is discounted information used by the market to

estimate the expected return, while the surprise is news that influences the unexpected return. Discounted

information is information that is already included in the expected return (and the price). The tie-in to efficient

markets is obvious. The assumption here is that markets are semistrong form efficient.

It is easy to see the effect of unexpected news on stock prices and returns. Consider the following cases: (1) On August

9, 2000 it was announced that Eli-Lillys Prozac patent would not be extended, overturning a lower court decision. This

was unexpected and the price dropped from $108.531 to $76.875 (a 29% drop) in one day. (2) On September 22, 2000,

Intel issued an earnings warning and its stock price dropped from $61.468 to $47.937 (a 22% drop) in one day. On

September 30, 2004, Merck announced a voluntary recall of its arthritis and acute pain medication VIOXX following a

reported increased incidence of cardiovascular events. The stock dropped from $45.07 to $33 (a 37% drop). There are

plenty of other examples in which unexpected news causes a change in price and expected returns.

11.4

Risk consists of surprises. There are two kinds of surprises:

o Systematic risk is a surprise that affects a large number of assets, although at varying degrees. It is

sometimes called market risk or nondiversifiable risk.

Prepared by Jim Keys

o Unsystematic risk is a surprise that affects a small number of assets (or one). It is sometimes called

unique, asset-specific risk, or diversifiable risk.

Example: Changes in GDP, interest rates, and inflation are examples of systematic risk. Strikes, accidents, and

takeovers are examples of unsystematic risk.

R = E(R) + U

The unexpected return, U, has systematic and unsystematic portions. By definition, the unsystematic risk of one

asset is unrelated to the unsystematic risk of another.

R = E(R) + Systematic portion + Unsystematic portion

11.5

The Effect of Diversification: Another Lesson from Market History Diversification is the process of

combining assets to reduce risk. Studies of common stocks listed on the NYSE demonstrate that the standard

deviation of a portfolio decreases as the number of securities in the portfolio increases.

The Principle of Diversification Spreading an investment across a number of assets will eliminate some, but

not all, of the risk. The portion of variability present in a single security that is not present in a portfolio of

securities is called diversifiable risk. The level of variance that is present in a portfolio of assets is

nondiversifiable risk.

Diversification and Unsystematic Risk - When securities are combined into portfolios, their unique or

unsystematic risks tend to cancel out, leaving only the variability that affects all securities to some degree. Thus,

diversifiable risk is synonymous with unsystematic risk. Large portfolios have little or no unsystematic risk.

Diversification and Systematic Risk - Systematic risk cannot be eliminated by diversification since it represents

the variability due to influences that affect all securities to some degree. Therefore, systematic risk and

nondiversifiable risk are the same.

Total risk = Nondiversifiable risk + Diversifiable risk = Systematic risk + Unsystematic risk

11.6

The Systematic Risk Principle - The systematic risk principle: The reward for bearing risk depends only on the

systematic risk of the investment. The implication: The expected return on an asset depends only on that assets

systematic risk. A corollary: No matter how much total risk an asset has, its expected return depends only on its

systematic risk.

The text states that The underlying rationale for this principle is straightforward: Since unsystematic risk can be

eliminated at virtually no cost (by diversifying), there is no reward for bearing it. This is a crucial point that is

consistent with observed behavior. The rapid growth in mutual funds suggests that investors aggressively seek to

diversify their holdings. Further, barriers to diversification are minimal: many funds will open accounts with initial

deposits as small as $500. Many company-sponsored retirement plans will open accounts with much less.

Measuring Systematic Risk The systematic risk of an asset is measured by its beta coefficient (), which

measures the amount of systematic risk for a particular asset relative to the amount of systematic risk for the

average asset (by definition, M, the beta of the market portfolio equals 1.0). Since systematic risk is the

relevant risk for a well-diversified investor, the expected return is dependent on . This is true regardless of the

stocks standard deviation.

10

11

Based on what we've studied so far, you can see that beta is a pretty important topic. You might wonder then, are all

published betas created equal? Read on for a partial answer to this question.

We did some checking on betas and found some interesting results. The Value Line Investment Survey is one of the

best-known sources for information on publicly traded companies. However, with the explosion of online investing,

there has been a corresponding increase in the amount of investment information available online. We decided to

compare the betas presented by Value Line to those reported by Yahoo! Finance (finance.yahoo.com) and CNN Money

(money.cnn.com). What we found leads to an important note of caution.

Consider Amazon.com, the big online retailer. Its beta reported on the Internet was 3.75, which is much larger than

Value Line's beta of 1.25. Amazon.com wasn't the only stock that showed a divergence in betas from different sources.

In fact, for most of the technology companies we looked at, Value Line reported betas that were significantly lower than

their online cousins. For example, the online beta for Dell was 1.36, but Value Line reported 0.95. The online beta for

computer antivirus company McAfee was 2.88 versus a Value Line beta of 1.60. Value Line's betas are not always

lower. For example, the online beta for Yahoo! was 0.68, compared to Value Line's 1.55.

We also found some unusual, and even hard to believe, estimates for beta. Starwood Hotels had a very low online beta

of 0.00, while Value Line reported 1.35. The online estimate for Hormel Foods, the famous maker of Spam (the lunch

meat, not junk e-mail), was 0.06, compared to Value Line's 0.75. Perhaps the most outrageous reported betas were the

online betas for the International Fight League and Nano Jet Corp., with betas of 77.4 and 64.06 (notice the minus

sign!), respectively. Value Line did not report a beta for these companies. How do you suppose we should interpret a

beta of 64.06?

There are a few lessons to be learned from all of this. First, not all betas are created equal. Some are computed using

weekly returns and some using daily returns. Some are computed using 60 months of stock returns; some consider more

or less. Some betas are computed by comparing the stock to the S&P 500 index, while others use alternative indices.

Finally, some reporting firms (including Value Line) make adjustments to raw betas to reflect information other than

just the fluctuation in stock prices.

The second lesson is perhaps more subtle. We are interested in knowing what the betas of the stocks will be in the

future, but betas have to be estimated using historical data. Anytime we use the past to predict the future, there is the

danger of a poor estimate. As we will see later in the chapter (and the next one), it is very unlikely that International

Fight League has a beta anything like 77.4 or that Nano Jet Corp. has a beta of 64.06. Instead, the estimates are almost

certainly poor ones. The moral of the story is that, as with any financial tool, beta is not a black box that should be

taken without question.

The point that the market does not reward risks that are borne unnecessarily, should be strongly emphasized. Many

investment companies offer investors a choice between income-oriented mutual funds, containing both bonds and

stocks in established companies with higher dividend payouts, and growth-oriented funds that are typically composed

of stocks of smaller companies that retain most of their earnings for reinvestment in the firm. Investors that desire

growth-oriented funds typically assume a much greater degree of systematic risk and expect higher returns. However,

both types of funds eliminate the unsystematic portion of risk through diversification.

12

Portfolio Betas - While portfolio variance is not a weighted average of the individual asset betas, portfolio betas

are a weighted average of the individual asset betas.

p = (x1 x 1) + (x2 x 2) + (x3 x 3) + + (xn x n) ,

where n is the number of assets in the portfolio, x1, x2, x3, and xn are the portfolio weights, and 1, 2, 3, and n

are the betas of the assets in the portfolio.

Example:

11.7

Stock

Amount Invested

IBM

GM

Wal-Mart

$6,000

$4,000

$2,000

Portfolio

$12,000

Portfolio Weight

Beta Product

1.47

$4,000 / $12,000 = 33.33% 1.19

$2,000 / $12,000 = 16.67% 0.91

100%

.735

.397

.152

1.284

The Security Market Line - FinSim The graphic representation of the relationship between systematic risk and

expected return.

Beta and the Risk Premium - The relationship between a portfolios expected return, E(Rp), and its systematic

risk, p, is linear. The slope of the line is the reward-to-risk ratio, which indicates what an investors

compensation would be for taking on risk. The reward-to-risk ratio for a given asset equals its risk premium

divided by its beta.

A riskless asset has a beta of 0.When a risky asset with > 0 is combined with a riskless asset, the resulting

expected return is the weighted sum of the expected returns and the portfolio beta is the weighted sum of the

betas. By varying the amount invested in each asset, we can get an idea of the relationship between portfolio

expected returns and betas. As can be seen, all of the risk-return combinations lie on a straight line. Remember

that the equation for a line is:

y = mx + b

where y = expected return, x = beta, m = slope* = (E(RM) Rf), and b = y-intercept = risk-free rate

*Note: the slope is NOT beta.

Expected Returns and Systematic Risk

13

The Reward-to-Risk Ratio is the expected return per unit of systematic risk. In other words, it is the ratio of risk

premium to systematic risk. The basic argument is that since systematic risk is all that matters in determining

expected return, the reward-to-risk ratio must be the same for all assets. If it were not, people would buy the

asset with the higher reward-to-risk ratio (driving the price up and the return down).

The fundamental result is that, in a competitive market where only systematic risk affects E(R), the reward-torisk ratio must be the same for all assets in the market. Consequently, the expected returns and betas of all assets

must plot on the same straight line.

The Security Market Line - The line that gives the expected return/systematic risk combinations of assets in a

well-functioning, active financial market.

Consider a portfolio of all the assets in the market. This portfolio, by definition, has average systematic risk

with a beta of 1. Since all assets must lie on the SML when appropriately priced, the market portfolio must also

lie on the SML.

Let the expected return on the market portfolio = E(RM).

The slope of the SML = reward-to-risk ratio = [E(RM) Rf] / M = [E(RM) Rf] / 1 = E(RM) Rf

The term E(RM) - Rf is often referred to as the market risk premium, since it is the difference between the

expected return on a market portfolio and the risk-free rate.

If we let E(Ri) and i stand for the expected return and beta, respectively, on any asset in the market, then we

know that asset must plot on the SML. As a result, we know that its reward-to-risk ratio is the same as the

overall market's:

E(R i ) R f

i

E(R M ) R f

Rearranging terms, the equation for the SML can be written as:

Prepared by Jim Keys

14

where E(Ri) and i are the expected return and beta, respectively, for any asset (i).

This is the Capital Asset Pricing Model (CAPM), and indicates the expected return for any asset. The CAPM

demonstrates that the expected return for a given asset is a function of the following:

1.

2.

3.

the reward for bearing systematic risk, [E(RM) Rf]

the amount of systematic risk, i

A stock has a beta of 0.9, the expected return on the market is 13 percent, and the risk-free rate is 6 percent. What must

the expected return on this stock be?

E(Ri) = Rf + [E(RM) Rf] x i

E(Ri) = .06 + (.13 - .06)(0.9) = .1230 = 12.30%

A stock has an expected return of 17 percent, the risk-free rate is 5.5 percent, and the market risk premium is 8 percent.

What must the beta of this stock be?

.17 = .055 + (.08)(i)

.17 - .055 = (.08)(i)

i = .1150 / .08 = 1.4375

A stock has an expected return of 11.90 percent and a beta of .85, and the expected return on the market is 13 percent.

What must the risk-free rate be?

.1190 = Rf + (.13 - Rf)(.85)

.1190 = Rf + .1105 - .85(Rf)

Prepared by Jim Keys

15

Rf = .0085 / .15 = .056667 = 5.67%

TABLE 11.9

I.

Total return

The total return on an investment has two components: the expected return and the unexpected return. The

unexpected return comes about because of unanticipated events. The risk from investing stems from the

possibility of an unanticipated event.

II.

Total risk

The total risk of an investment is measured by the variance or, more commonly, the standard deviation of its

return.

III.

Systematic risks (also called market risks) are unanticipated events that affect almost all assets to some degree

because the effects are economywide. Unsystematic risks are unanticipated events that affect single assets or

small groups of assets. Unsystematic risks are also called unique or asset-specific risks.

IV.

Some, but not all, of the risk associated with a risky investment can be eliminated by diversification. The reason

is that unsystematic risks, which are unique to individual assets, tend to wash out in a large portfolio, but

systematic risks, which affect all of the assets in a portfolio to some extent, do not.

V.

Because unsystematic risk can be freely eliminated by diversification, the systematic risk principle states that the

reward for bearing risk depends only on the level of systematic risk. The level of systematic risk in a particular

asset, relative to the average, is given by the beta of that asset.

VI.

The reward-to-risk ratio for Asset i is the ratio of its risk premium, E(Ri) Rf) to its beta, i;

In a well-functioning market, this ratio is the same for every asset. As a result, when asset expected returns are

plotted against asset betas, all assets plot on the same straight line, called the security market line (SML).

VII.

From the SML, the expected return on Asset i can be written:

Prepared by Jim Keys

16

This is the capital asset pricing model (CAPM). The expected return on a risky asset thus has three components.

The first is the pure time value of money, Rf; the second is the market risk premium, [E(RM) Rf]; and the third is

the beta for that asset, i,.

11.8

The Basic Idea The SML describes investors opportunities in the financial markets in terms of systematic risk

(i.e., ) and expected return. As an example, a capital budgeting project must provide an expected return to

shareholders that exceeds the return available for investments of comparable risk in the financial markets.

Remember that in an efficient market, security investments have an NPV = 0, on average. However, this does not imply

that a companys investments in new projects must have an NPV of zero. Firms that can consistently invest in positive

NPV projects will trade at higher prices, all else equal.

The Cost of Capital The cost of capital for a capital budgeting project is the minimum required return for the

investment. Since this minimum is the expected return available in the financial markets for investments with a

specified risk level, it is also the shareholders opportunity cost. Therefore, the minimum required return on a

new investment is the firms cost of capital.

17

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