Lecture 5. Return and Risk: The Capital Asset Pricing Model

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1 Lecture 5 Return and Risk: The Capital Asset Pricing Model

2 Outline 1 Individual Securities 2 Expected Return, Variance, and Covariance 3 The Return and Risk for Portfolios 4 The Efficient Set for Two Assets 5 The Efficient Set for Many Assets 6 Diversification 7 Riskless Borrowing and Lending 8 Market Equilibrium 9 Relationship between Risk and Expected Return (CAPM) 11-1

3 References Ross, S., Westerfield, R. and Jaffe, J. (2013), Corporate Finance (10 th Edition), McGraw Hill/Irvin. (Chapter 11) Moyer, R.C., McGuigan, J.R., and Rao, R.P. (2015), Contemporary Financial Management (13 th Edition), Cengage Learning. (Chapter 8) 11-2

4 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) 11-3

5 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% 11-4

6 Expected Return Stock Fund Bond Fund Rate of Squared Rate of Squared Scenario Return Deviation Return Deviation Recession -7% % Normal 12% % Boom 28% % Expected return 11.00% 7.00% Variance Standard Deviation 14.3% 8.2% 11-5

7 Expected Return Stock Fund Bond Fund Rate of Squared Rate of Squared Scenario Return Deviation Return Deviation Recession -7% % Normal 12% % Boom 28% % Expected return 11.00% 7.00% Variance Standard Deviation 14.3% 8.2% E( r E( r S S ) ) 1 ( 7%) 3 11% 1 3 (12%) 1 3 (28%) 11-6

8 Variance Stock Fund Bond Fund Rate of Squared Rate of Squared Scenario Return Deviation Return Deviation Recession -7% % Normal 12% % Boom 28% % Expected return 11.00% 7.00% Variance Standard Deviation 14.3% 8.2% ( 7% 11%)

9 Variance Stock Fund Bond Fund Rate of Squared Rate of Squared Scenario Return Deviation Return Deviation Recession -7% % Normal 12% % Boom 28% % Expected return 11.00% 7.00% Variance Standard Deviation 14.3% 8.2% ( )

10 Standard Deviation Stock Fund Bond Fund Rate of Squared Rate of Squared Scenario Return Deviation Return Deviation Recession -7% % Normal 12% % Boom 28% % Expected return 11.00% 7.00% Variance Standard Deviation 14.3% 8.2% 14.3%

11 Covariance Stock Bond Scenario Deviation Deviation Product Weighted Recession -18% 10% Normal 1% 0% Boom 17% -10% Sum Covariance Deviation compares return in each state to the expected return. Weighted takes the product of the deviations multiplied by the probability of that state

12 Correlation Cov( a, b) a b.0117 (.143)(.082)

13 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% % Normal 12% % Boom 28% % Expected return 11.00% 7.00% Variance 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

14 Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% Normal 12% 7% 9.5% Boom 28% -3% 12.5% Expected return 11.00% 7.00% 9.0% Variance 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: r P w B r B w 5% 50% ( 7%) 50% (17%) S r S 11-13

15 Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% Normal 12% 7% 9.5% Boom 28% -3% 12.5% Expected return 11.00% 7.00% 9.0% Variance 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 r ) w E( r ) w E( r ) ( P B B S S 9% 50% (11%) 50% (7%) 11-14

16 Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% Normal 12% 7% 9.5% Boom 28% -3% 12.5% Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% The variance of the rate of return on the two risky assets portfolio is σ P (wbσ B ) (ws σ S ) 2(wBσ B )(ws σ S )ρbs where BS is the correlation coefficient between the returns on the stock and bond funds

17 Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% Normal 12% 7% 9.5% Boom 28% -3% 12.5% Expected return 11.00% 7.00% 9.0% Variance 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

18 11.4 The Efficient Set for Two Assets % 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% 45% 2.0% 8.8% 50.00% 3.08% 9.00% 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% 80% 9.8% 10.2% 85% 10.9% 10.4% 90% 12.1% 10.6% 95% 13.2% 10.8% 100% 14.3% 11.0% Portfolio Return 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% Portfolo Risk and Return Combinations 100% bonds 0.0% 5.0% 10.0% 15.0% 20.0% Portfolio Risk (standard deviation) We can consider other portfolio weights besides 50% in stocks and 50% in bonds. 100% stocks 11-17

19 The Efficient Set for Two Assets % 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% 45% 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% 80% 9.8% 10.2% 85% 10.9% 10.4% 90% 12.1% 10.6% 95% 13.2% 10.8% 100% 14.3% 11.0% Portfolio Return 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% Portfolio Risk and Return Combinations 100% bonds 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Portfolio Risk (standard deviation) 100% stocks Note that some portfolios are better than others. They have higher returns for the same level of risk or less

20 return Portfolios with Various Correlations = % stocks 100% bonds = 0.2 = 1.0 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 11-19

21 return 11.5 The Efficient Set for Many Securities Individual Assets Consider a world with many risky assets; we can still identify the opportunity set of riskreturn combinations of various portfolios. P 11-20

22 return The Efficient Set for Many Securities minimum variance portfolio Individual Assets The section of the opportunity set above the minimum variance portfolio is the efficient frontier. P 11-21

23 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

24 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 11-23

25 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

26 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

27 return Optimal Portfolio with a Risk-Free Asset 100% stocks r f 100% bonds In addition to stocks and bonds, consider a world that also has risk-free securities like T-bills

28 return 11.7 Riskless Borrowing and Lending Balanced fund 100% stocks r f 100% bonds Now investors can allocate their money across the T-bills and a balanced mutual fund

29 return Riskless Borrowing and Lending r f P With a risk-free asset available and the efficient frontier identified, we choose the capital allocation line with the steepest slope

30 return 11.8 Market Equilibrium M r f 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. P 11-29

31 return Market Equilibrium Balanced fund 100% stocks r f 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

32 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 (b)of the security. Beta measures the responsiveness of a security to movements in the market portfolio (i.e., systematic risk). b i Cov( R 2 i, ( R R M M ) ) 11-31

33 Security Returns Estimating b with Regression Slope = b i Return on market % R i = a i + b i R m + e i 11-32

34 11-33 The Formula for Beta ) ( ) ( ) ( ) ( 2, M i M M i i R R R R R Cov b Clearly, your estimate of beta will depend upon your choice of a proxy for the market portfolio.

35 11.9 Relationship between Risk and Expected Return (CAPM) Expected Return on the Market: RM R F Market Risk Premium Expected return on an individual security: R i R F β i ( R M R F ) Market Risk Premium This applies to individual securities held within welldiversified portfolios

36 Expected Return on a Security This formula is called the Capital Asset Pricing Model (CAPM): R i R F β i ( R M R F ) Expected return on a security = Riskfree rate + Beta of the security Market risk premium Assume b i = 0, then the expected return is R F. Assume b i = 1, then Ri RM 11-35

37 Expected return Relationship Between Risk & Return R i R F β i ( R M R F ) R M R F 1.0 b 11-36

38 Expected return Relationship Between Risk & Return 13.5% 3% 1.5 b β 1.5 i Ri R F 3% RM 10% 3% 1.5 (10% 3%) 13.5% 11-37

39 Questions?

Chapter 11. Return and Risk: The Capital Asset Pricing Model (CAPM) Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 11. Return and Risk: The Capital Asset Pricing Model (CAPM) Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11 Return and Risk: The Capital Asset Pricing Model (CAPM) McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved. 11-0 Know how to calculate expected returns Know