LN08Titman 449327 12 LN08

Chapter 8
Risk and Return

Capital Market
Theory
Slide Contents
Principles Applied in This Chapter
Learning Objectives
1. Portfolio Returns and Portfolio Risk
2. Systematic Risk and the Market Portfolio
3. The Security Market Line and the CAPM
Key Terms
Copyright 2014 Pearson Education, Inc. All rights reserved.
8-2
Learning Objectives
1. Calculate the expected rate of return and
volatility for a portfolio of investments and
describe how diversification affects the
returns to a portfolio of investments.
2. Understand the concept of systematic risk
for an individual investment and calculate
portfolio systematic risk (beta).
3. Estimate an investors required rate of
return using the Capital Asset Pricing
Model.
8-3
Principles Applied in This Chapter

Principle 2: There is a Risk-Return Tradeoff.
Principle 4: Market Prices Reflect
Information.
8-4
8.1 PORTFOLIO RETURNS

AND PORTFOLIO RISK
8-5
Portfolio Returns and Portfolio Risk

With appropriate diversification, you can
lower the risk of your portfolio without
lowering the portfolios expected rate of
return.
Those risks that can be eliminated by
diversification are not necessarily rewarded
in the financial marketplace.
8-6
Calculating the Expected Return of a

Portfolio
To calculate a portfolios expected rate of
return, we weight each individual investments
expected rate of return using the fraction of
the portfolio that is invested in each
investment.
8-7
Calculating the Expected Return of a

Portfolio (cont.)
E(rportfolio) = the expected rate of return on a

portfolio of n assets.
Wi = the portfolio weight for asset i.
E(ri ) = the expected rate of return earned by
asset i.
W1 E(r1) = the contribution of asset 1 to the
portfolio expected return.
8-8
CHECKPOINT 8.1:
CHECK YOURSELF
Calculating a Portfolios
Expected Rate of Return
Evaluate the expected return for Pennys portfolio
where she places a quarter of her money in
Treasury bills, half in Starbucks stock, and the
remainder in Emerson Electric stock.
8-9
Step 1: Picture the Problem

14%
12%
10%
8%
6%
Starbucks
Emerson
Electric
4%
2%
T-bills
0%
8-10
Step 2: Decide on a Solution

Strategy
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 Pennys portfolio.
8-11

Strategy (cont.)
We have to fill in the third column (Product)
to calculate the weighted average.
Portfolio
E(Return)
X Weight
Treasury
bills
4.0%
.25
EMR stock
8.0%
.25
SBUX stock
12.0%
.50
= Product
We can also use equation 8-1 to solve the

problem.
8-12
Step 3: Solve
E(rportfolio) = .25 .04 + .25 .08 + .50

.12
= .09 or 9%
8-13
Step 3: Solve (cont.)

Alternatively, we can fill out the following
table from step 2 to get the same result.
Portfolio
E(Return)
X Weight
= Product
Treasury
bills
4.0%
.25
1%
EMR stock
8.0%
.25
2%
SBUX
stock
12.0%
.50
6%
Expected
Return on
Portfolio
9%
8-14
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.
8-15
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.
8-16
Portfolio Diversification (cont.)

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.
8-17
Diversification Lessons
1. A portfolio can be less risky than the
average risk of its individual investments in
the portfolio.
2. The key to reducing risk through
diversification - combine investments
whose returns are not perfectly positively
correlated.
8-18
Calculating the Standard Deviation

of a Portfolios Returns
8-19
Figure 8-1 Diversification and the

Correlation CoefficientApple and CocaCola
8-20
Figure 8-1 Diversification and the

Correlation CoefficientApple and CocaCola (cont.)
8-21
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.
Correlation between
investment returns
Diversification
Benefits
+1
No benefit
0.0
Substantial benefit
-1
Maximum benefit.
Indeed, the risk of
portfolio can be
reduced to zero.
8-22
CHECKPOINT 8.2:
CHECK YOURSELF
Evaluating a Portfolios Risk and Return
Evaluate the expected return and standard deviation
of the portfolio of the S&P500 and the
international fund where the correlation is
assumed to be .20 and Sarah still places half of
her money in each of the funds.
8-23

Sarah can visualize the expected return,
standard deviation and weights as shown
below, with the need to determine the numbers
for the empty boxes.
Investme
nt Fund
Expected
Return
Standard
Deviation
Investme
nt Weight
S&P500
fund
12%
20%
50%
Internatio
nal Fund
14%
30%
50%
Portfolio
100%
8-24

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.
8-25
Step 3: Solve
E(rportfolio)
= WS&P500 E(rS&P500) + WInternational E(rInternational)
= .5 (12) + .5(14)
= 13%
8-26
Standard deviation of Portfolio

= { (.52x.22)+(.52x.32)+(2x.5x.5x.20x.2x.3)}
= {.0385}
= .1962 or 19.62%
8-27
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).
8-28
8.2 SYSTEMATIC RISK AND

THE MARKET PORTFOLIO
8-29
Systematic Risk and Market Portfolio

According to the CAPM, the relevant risk of an
investment relates to how the investment
contributes to the risk of this market portfolio.
CAPM assumes that investors chose to hold
the optimally diversified portfolio that includes
all of the economys assets (referred to as the
market portfolio).
8-30

(cont.)
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
8-31

(cont.)
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.
8-32
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.
8-33
Figure 8.2 Portfolio Risk and the Number

of Investments in the Portfolio
8-34
Systematic Risk and Beta

Systematic risk is measured by beta
coefficient, which estimates the extent to
which a particular investments 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).
8-35
Figure 8.3 Estimating Home Depots

(HD) Beta Coefficient
8-36
Figure 8.3 Estimating Home Depots

(HD) Beta Coefficient (cont.)
8-37
Beta
Table 8-1 illustrates the wide variation in
Betas for various companies. Utilities
companies can be considered less risky
because of their lower betas. For example,
based on the beta estimates, a 1% drop in
market could lead to a .74% drop in AEP but a
much greater 2.9% drop in AAPL.
8-38
Table 8.1 Beta Coefficients for

Selected Companies
8-39
Calculating Portfolio Beta

The portfolio beta measures the systematic
risk of the portfolio.
8-40
Calculating Portfolio Beta (cont.)

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
8-41
8.3 THE SECURITY MARKET

LINE AND THE CAPM
8-42
The Security Market Line and the

CAPM
CAPM describes how the betas relate to the
expected rates of return. Investors will
require a higher rate of return on
investments with higher betas.
Figure 8-4 provides the expected returns
and betas for portfolios comprised of market
portfolio and risk-free asset.
8-43
Figure 8.4 Risk and Return for Portfolios

Containing the Market and the Risk-Free Security
8-44
Figure 8.4 Risk and Return for Portfolios

Containing the Market and the Risk-Free Security
(cont.)
8-45

CAPM (cont.)
The straight line relationship between the
betas and expected returns in Figure 8-4 is
called the security market line (SML), and
its slope is often referred to as the reward to
risk ratio.
8-46

CAPM (cont.)
SML is a graphical representation of the
CAPM.
SML can be expressed as the following
equation, which is often referred to as the
CAPM pricing equation:
8-47
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.
8-48
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%.
8-49

18.0%
16.0%
14.0%
Expected Return
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
0
0.5
1.5
2.5
BETA
8-50

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%.
8-51

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
8-52
Step 3: Solve
Beta (AEP) = 4.5% + 0.74(6) = 8.94%

Beta (DUK) = 4.5% + 0.40(6) = 6.9%
Beta (CNP) = 4.5% + 0.82(6) = 9.42%
8-53

Expected Return for 3 Stocks
10.0%
9.4%
9.0%
8.9%
8.0%
Expected Return
7.0%
6.9%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
Beta
8-54
Step 4: Analyze
The expected rates of return on the stocks
vary depending on their beta. Higher the
beta, higher is the expected return.
8-55
Key Terms
Beta coefficient
Capital asset pricing model (CAPM)
Correlation coefficient
Diversification
Diversifiable risk
Market portfolio
Market risk premium
8-56
Key Terms (cont.)
Non-diversifiable risk
Portfolio beta
Security market line
Systematic risk
Unsystematic risk
8-57

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Chapter 8

Risk and Return

Copyright 2014 Pearson Education, Inc. All rights reserved.

Principles Applied in This Chapter

Copyright 2014 Pearson Education, Inc. All rights reserved.

8.1 PORTFOLIO RETURNS

Copyright 2014 Pearson Education, Inc. All rights reserved.

Portfolio Returns and Portfolio Risk

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Expected Return of a

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Expected Return of a

E(rportfolio) = the expected rate of return on a

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 1: Picture the Problem

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 2: Decide on a Solution

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 2: Decide on a Solution

We can also use equation 8-1 to solve the

E(rportfolio) = .25 .04 + .25 .08 + .50

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 3: Solve (cont.)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Evaluating Portfolio Risk: Portfolio

The diversification gains achieved will depend

Copyright 2014 Pearson Education, Inc. All rights reserved.

Portfolio Diversification (cont.)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Standard Deviation

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 8-1 Diversification and the

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 8-1 Diversification and the

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Impact of Correlation Coefficient

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 1: Picture the Problem

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 2: Decide on a Solution

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 3: Solve (cont.)

Standard deviation of Portfolio

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

8.2 SYSTEMATIC RISK AND

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Systematic Risk and Market Portfolio

Copyright 2014 Pearson Education, Inc. All rights reserved.

Systematic Risk and Market Portfolio

Copyright 2014 Pearson Education, Inc. All rights reserved.

Systematic Risk and Market Portfolio

Diversification and Unsystematic

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 8.2 Portfolio Risk and the Number

Copyright 2014 Pearson Education, Inc. All rights reserved.

Systematic Risk and Beta

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 8.3 Estimating Home Depots

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