Risk and Return, CAPM

Returns
• Rupee Returns
Dividends
• the sum of the cash received
and the change in value of the
asset, in rupees. Ending market
value

Time 0 1
•Percentage Returns
–the sum of the cash received and the
change in value of the asset divided by
Initial
the original investment.
investment

9-2
Returns
Rupee Return = Dividend + Change in Market Value

rupee return
Percentage return =
beginning market value

dividend + change in market value

=
beginning market value

= dividend yield + capital gains yield

Returns: Example
• Suppose you bought 100 shares of Wal-Mart (WMT) one
year ago today at $25. Over the last year, you received
$20 in dividends (= 20 cents per share × 100 shares). At
the end of the year, the stock sells for $30. How did you
do?
• Quite well. You invested $25 × 100 = $2,500. At the end
of the year, you have stock worth $3,000 and cash
dividends of $20. Your dollar gain was $520 = $20 +
($3,000 – $2,500).
• Your percentage gain for the year is $520
20.8% =
$2,500
9-4
Returns: Example
Dollar Return:
$20
$520 gain

$3,000

Time 0 1
Percentage Return:

$520
-$2,500 20.8% =
$2,500
9-5
Holding-Period Returns
• The holding period return is the return that
an investor would get when holding an
investment over a period of n years, when
the return during year i is given as ri:

holding period return =

= (1 + r1 )  (1 + r2 )   (1 + rn )  1

9-6
Holding Period Return: Example
• Suppose your investment provides the following returns
over a four-year period:

Year Return Your holding period return =

1 10% = (1 + r1 )  (1 + r2 )  (1 + r3 )  (1 + r4 )  1
2 -5%
3 20% = (1.10)  (.95)  (1.20)  (1.15)  1
4 15% = .4421 = 44.21%

9-7
Holding Period Return: Example
• An investor who held this investment would have
actually realized an annual return of 9.58%:
Year Return Geometric average return =
1 10% (1 + rg ) 4 = (1 + r1 )  (1 + r2 )  (1 + r3 )  (1 + r4 )
2 -5%
3 20% rg = 4 (1.10)  (.95)  (1.20)  (1.15)  1
4 15% = .095844 = 9.58%
So, our investor made 9.58% on his money for four
years, realizing a holding period return of 44.21%
1.4421 = (1.095844) 4
9-8
Holding Period Return: Example
• Note that the geometric average is not the same thing as
the arithmetic average:

Year Return
r1 + r2 + r3 + r4
1 10% Arithmetic average return =
2 -5%
4
10%  5% + 20% + 15%
3 20% = = 10%
4 15% 4

9-9
Holding Period Returns
• A famous set of studies dealing with the rates of returns on common
stocks, bonds, and Treasury bills was conducted by Roger Ibbotson
and Rex Sinquefield.
• They present year-by-year historical rates of return starting in 1926
for the following five important types of financial instruments in the
United States:
• Large-Company Common Stocks
• Small-company Common Stocks
• Long-Term Corporate Bonds
• Long-Term U.S. Government Bonds
• U.S. Treasury Bills

9-10
Return Statistics
• The history of capital market returns can be summarized by
describing the
• average return
( R1 +  + RT )
R=
T
• the standard deviation of those returns

( R1  R) 2 + ( R2  R) 2 +  ( RT  R) 2
SD = VAR =
• the frequency distribution of the returns. T 1

9-11
Average Stock Returns and Risk-Free Returns

• The Risk Premium is the additional return (over and

above the risk-free rate) resulting from bearing risk.
• One of the most significant observations of stock market
data is this long-run excess of stock return over the risk-
free return.
• The average excess return from large company common stocks
for the period 1926 through 1999 was 8.4% = 12.2% – 3.8%
• The average excess return from small company common stocks
for the period 1926 through 1999 was 13.2% = 16.9% – 3.8%
• The average excess return from long-term corporate bonds for
the period 1926 through 1999 was 2.4% = 6.2% – 3.8%

9-12
Risk Statistics
• There is no universally agreed-upon definition of risk.
• The measures of risk that we discuss are variance and standard
deviation.
• The standard deviation is the standard statistical measure of the spread of a
sample, and it will be the measure we use most of this time.
• Its interpretation is facilitated by a discussion of the normal distribution.

9-13
Normal Distribution
• A large enough sample drawn from a normal distribution
looks like a bell-shaped curve.
Probability

The probability that a yearly return will

fall within 20.1 percent of the mean of
13.3 percent will be approximately
2/3.

– 3s – 2s – 1s 0 + 1s + 2s + 3s
– 49.3% – 28.8% – 8.3% 12.2% 32.7% 53.2% 73.7%
Return on
68.26% large company common
stocks
95.44%

99.74%
9-14
Individual Securities
• The characteristics of individual securities that are of interest are the:
• Expected Return
• Variance and Standard Deviation
• Covariance and Correlation

10-15
Expected Return, Variance,
and Covariance
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

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.

10-16
Expected Return, Variance,
and Covariance

Stock fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

10-17
Expected Return, Variance,
and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E ( rS ) = 1 ( 7%) + 1 (12%) + 1 ( 28%)

3 3 3
E ( rS ) =11%
10-18
Expected Return, Variance,
and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E ( rB ) = 1 (17%) + 1 ( 7%) + 1 ( 3%)

3 3 3
E ( rB ) = 7%
10-19
Expected Return, Variance,
and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(11%  7%) = 3.24%

2

10-20
Expected Return, Variance, and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(11% 12%) = .01%

 2

10-21
Expected Return, Variance, and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(11% 28%) = 2.89%

 2

10-22
Expected Return, Variance, and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

1
2.05% = (3.24% + 0.01% + 2.89%)
3
10-23
Expected Return, Variance, and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

14.3% = 0.0205

10-24
The Return and Risk for Portfolios
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
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.

10-25
The Return and Risk for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
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%)
10-26
The Return and Risk for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
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

9.5% = 50% (12%) + 50% ( 7%)

10-27
The Return and Risk for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
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
12.5% = 50% ( 28%) + 50% ( 3%)
10-28
The Return and Risk for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
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 ( rP ) = wB E ( rB ) + wS E ( rS )
9% = 50% (11%) + 50% ( 7%)
10-29
The Return and Risk for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The variance of the rate of return on the two risky assets portfolio is

σP2 = (wB σB )2 + (wS σS )2 + 2(wB σB )(wS σS )ρBS

where BS is the correlation coefficient between the returns on the stock and bond funds.

10-30
The Return and Risk for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
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 stocks
or bonds held in isolation.

10-31
10-32

The Efficient Set for Two Assets

% in stocks Risk Return
0% 8.2% 7.0%
Portfolo Risk and Return Combinations

Portfolio Return
5% 7.0% 7.2%
10% 5.9% 7.4%
12.0%
15% 4.8% 7.6%
11.0%
20% 3.7% 7.8%
10.0% 100%
25% 2.6% 8.0%
9.0% stocks
30% 1.4% 8.2%
35% 0.4% 8.4% 8.0%
40% 0.9% 8.6% 7.0% 100%
45% 2.0% 8.8% 6.0% bonds
50.00% 3.08% 9.00% 5.0%
55% 4.2% 9.2% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
60% 5.3% 9.4%
65% 6.4% 9.6%
Portfolio Risk (standard deviation)
70% 7.6% 9.8%
We can consider other portfolio
75% 8.7% 10.0%
80% 9.8% 10.2% weights besides 50% in stocks and 50%
85% 10.9% 10.4% in bonds …
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
10-33

The Efficient Set for Two Assets

% in stocks Risk Return
0%
0% 8.2%
8.2% 7.0%
7.0%
Portfolo Risk and Return Combinations

Portfolio Return
5%
5% 7.0%
7.0% 7.2%
7.2%
10%
10% 5.9%
5.9% 7.4%
7.4%
12.0%
15%
15% 4.8%
4.8% 7.6%
7.6%
11.0%
20%
20% 3.7%
3.7% 7.8%
7.8%
10.0% 100%
25%
25% 2.6%
2.6% 8.0%
8.0%
9.0% stocks
30%
30% 1.4%
1.4% 8.2%
8.2%
35%
35% 0.4%
0.4% 8.4%
8.4% 8.0%
40%
40% 0.9%
0.9% 8.6%
8.6% 7.0% 100%
45%
45% 2.0%
2.0% 8.8%
8.8% 6.0% bonds
50%
50% 3.1%
3.1% 9.0%
9.0% 5.0%
55%
55% 4.2%
4.2% 9.2%
9.2% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
60%
60% 5.3%
5.3% 9.4%
9.4%
65%
65% 6.4%
6.4% 9.6%
9.6%
Portfolio Risk (standard deviation)
70%
70% 7.6%
7.6% 9.8%
9.8%
We can consider other portfolio
75%
75% 8.7%
8.7% 10.0%
10.0%
80%
80% 9.8%
9.8% 10.2%
10.2% weights besides 50% in stocks and 50%
85%
85% 10.9%
10.9% 10.4%
10.4% in bonds …
90%
90% 12.1%
12.1% 10.6%
10.6%
95%
95% 13.2%
13.2% 10.8%
10.8%
100%
100% 14.3%
14.3% 11.0%
11.0%
10-34

The Efficient Set for Two Assets

% in stocks Risk Return
Portfolo Risk and Return Combinations

Portfolio Return
0% 8.2% 7.0%
5% 7.0% 7.2%
12.0%
10% 5.9% 7.4%
11.0%
15% 4.8% 7.6%
20% 3.7% 7.8%
10.0% 100%
25% 2.6% 8.0%
9.0% stocks
8.0%
30% 1.4% 8.2%
35% 0.4% 8.4% 7.0%
40% 0.9% 8.6% 6.0% 100%
45% 2.0% 8.8% 5.0% bonds
50% 3.1% 9.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
55% 4.2% 9.2%
Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6% Note that some portfolios are “better” than
70% 7.6% 9.8% others. They have higher returns for the same
75% 8.7% 10.0% level of risk or less.
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6% These compromise the efficient
95% 13.2% 10.8% frontier.
100% 14.3% 11.0%
Two-Security Portfolios with Various Correlations

100%

return
 = -1.0
stocks

 = 1.0

 = 0.2
100%
bonds
s
• 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
10-35
10-36

Portfolio Risk as a Function of the Number of Stocks

in the Portfolio
In a large portfolio the variance terms are effectively diversified away, but
s the covariance terms are not.

Diversifiable Risk; Nonsystematic

Risk; Firm Specific Risk; Unique
Risk

Portfolio risk
Nondiversifiable risk;
Systematic Risk; Market Risk

Thus diversification can eliminate some, n

but not all of the risk of individual securities.
The Efficient Set for Many Securities

return Individual Assets

sP
Consider a world with many risky assets; we can still
identify the opportunity set of risk-return combinations
of various portfolios.
10-37
The Efficient Set for Many Securities

return
minimum
variance
portfolio

Individual Assets

sP

Given the opportunity set we can identify the minimum

variance portfolio.

10-38
The Efficient Set for Many Securities

return
minimum
variance
portfolio

Individual Assets

sP

The section of the opportunity set above the minimum

variance portfolio is the efficient frontier.

10-39
Optimal Risky Portfolio with a Risk-Free Asset

return
100%
stocks

rf
100%
bonds
s
In addition to stocks and bonds, consider a world that also
has risk-free securities like T-bills

10-40
Riskless Borrowing and Lending

return
100%
stocks
Balanced
fund

rf
100%
bonds
s
Now investors can allocate their money across the T-bills
and a balanced mutual fund

10-41
Riskless Borrowing and Lending

return
rf

sP
With a risk-free asset available and the efficient frontier
identified, we choose the capital allocation line with the
steepest slope
10-42
 Market Equilibrium

return
M

rf

sP

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.
10-43
The Separation Property

return
M

rf

sP
The Separation Property states that the market portfolio, M, is the
same for all investors—they can separate their risk aversion from
their choice of the market portfolio.

10-44
The Separation Property

return
M

rf

sP
Investor risk aversion is revealed in their choice of where to stay
along the capital allocation line—not in their choice of the line.

10-45
Market Equilibrium

return
100%
stocks
Balanced
fund

rf
100%
bonds
s

Just where the investor chooses along the Capital Asset Line
depends on his risk tolerance. The big point though is that all
investors have the same CML.
10-46
Market Equilibrium

return
100%
stocks
Optimal
Risky
Portfolio
rf
100%
bonds
s
All investors have the same CML because they all have the
same optimal risky portfolio given the risk-free rate.

10-47
The Separation Property

return
100%
stocks
Optimal
Risky
Portfolio
rf
100%
bonds
s
The separation property implies that portfolio choice can be
separated into two tasks: (1) determine the optimal risky portfolio,
and (2) selecting a point on the CML.

10-48
Optimal Risky Portfolio with a Risk-Free Asset

return
100%
stocks

1 First Second Optimal Risky

r f Optimal Portfolio

0 Risky
r f
Portfolio
100%
bonds
s
By the way, the optimal risky portfolio depends on the
risk-free rate as well as the risky assets.

10-49
 Definition of Risk When Investors Hold
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.

Cov( R i , R M )
bi =
s ( RM )
2

10-50
Estimating b with regression

Security Returns
Slope = bi
Return on
market %

Ri = a i + biRm + ei
10-51
The Formula for Beta

Cov ( Ri , RM )
bi =
s2 ( RM )

Clearly, your estimate of beta will depend upon your

choice of a proxy for the market portfolio.

10-52
Relationship between Risk and Expected Return (CAPM)

Expected Return on the Market:

R M = RF + Market Risk Premium
Expected return on an individual security:
Ri = RF + βi  ( R M  RF )

Market Risk Premium

This applies to individual securities held within well-

diversified portfolios.
10-53
Expected Return on an Individual Security

• This formula is called the Capital Asset Pricing Model

(CAPM)

Ri = RF + βi ( R M  RF )
Expected
return on a Risk-free Beta of the Market risk
= rate + security × premium
security

• Assume bi = 0, then the expected return is RF.

• Assume bi = 1, then R i = R M

10-54
Relationship Between Risk & Expected Return

R i = R F + βi  ( R M  R F )
Expected return

RM

RF
1.0 b

10-55
Relationship Between Risk & Expected Return

Expected return
13.5%

3%

1.5 b

β i = 1.5 RF = 3%
R M =10%
R i = 3% + 1.5  (10%  3%) = 13.5%
10-56
Arbitrage Pricing Theory
Arbitrage arises if an investor can construct a
zero investment portfolio with a sure profit.
• Since no investment is required, an investor
can create large positions to secure large
levels of profit.
• In efficient markets, profitable arbitrage
opportunities will quickly disappear.

11-57
Factor Models: Announcements,
Surprises, and Expected Returns
• The return on any security consists of two parts.
• First the expected returns
• Second is the 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 unexpectedpart of the return
11-58
Factor Models: Announcements, Surprises,
and Expected Returns
• 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 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.
11-59
Systematic Risk and Betas
• For example, suppose we have identified three systematic risks
on which we want to focus:
1. Inflation
2. GDP growth
3. The dollar-euro R = R +m +ε
spot exchange
rate, S($,€) R = R + βI FI + βGDP FGDP + βS FS + ε
• Our model is: βI is the inflation beta
βGDP is the GDP beta
βS is the spot exchange rate beta
ε is the unsystematic risk

11-60
Systematic Risk and Betas: Example
R = R + βI FI + βGDP FGDP + βS FS + ε
• Suppose we have made the following estimates:
1. bI = -2.30
2. bGDP = 1.50
3. bS = 0.50.
• Finally, the firm was able to attract a “superstar” CEO
and this unanticipated development contributes 1% to
the return.
ε = 1%

R = R  2.30  FI +1.50  FGDP + 0.50  FS +1%

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Systematic Risk and Betas: Example
R = R  2.30 5% +1.50  FGDP + 0.50  FS +1%
If it was the case that the rate of GDP growth was
expected to be 4%, but in fact was 1%, then
FGDP = Surprise in the rate of GDP growth
= actual – expected
= 1% – 4%
= – 3%

R = R  2.30 5% +1.50 ( 3%) + 0.50  FS +1%

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Systematic Risk and Betas: Example
R = R  2.30 5% +1.50 ( 3%) + 0.50  FS +1%
If it was the case that dollar-euro spot exchange rate,
S($,€), was expected to increase by 10%, but in fact
remained stable during the time period, then
FS = Surprise in the exchange rate
= actual – expected
= 0% – 10%
= – 10%

R = R  2.30 5% +1.50 ( 3%) + 0.50 ( 10%) +1%

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