Return, Risk, and the

Security Market Line

Key Concepts and Skills

• Know how to calculate expected returns

• Understand the impact of diversification
• Understand the systematic risk principle
• Understand the security market line
• Understand the risk-return trade-off
• Be able to use the Capital Asset Pricing Model

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Chapter Outline

• Expected Returns and Variances

• Portfolios
• Announcements, Surprises, and Expected Returns
• Risk: Systematic and Unsystematic
• Diversification and Portfolio Risk
• Systematic Risk and Beta
• The Security Market Line
• The SML and the Cost of Capital: A Preview

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Expected Returns

• Expected returns are based on the probabilities of possible outcomes

• In this context, “expected” means average if the process is repeated
many times
• The “expected” return does not even have to be a possible return

n
E ( R )  pi Ri
i 1

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Example: Expected Returns

• Suppose you have predicted the following returns for stocks C and T
in three possible states of nature. What are the expected returns?
• State Probability C T
• Boom 0.3 15 25
• Normal 0.5 10 20
• Recession 0.2 2 1

• RC = .3(15) + .5(10) + .2(2) = 9.99%

• RT = .3(25) + .5(20) + .2(1) = 17.7%

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Variance and Standard Deviation

• Variance and standard deviation still measure the volatility of returns

• Using unequal probabilities for the entire range of possibilities
• Weighted average of squared deviations

n
σ 2  pi ( Ri  E ( R)) 2
i 1

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Example: Variance and Standard
Deviation

• Consider the previous example. What are the

variance and standard deviation for each stock?
• Stock C
• 2 = .3(15-9.9)2 + .5(10-9.9)2 + .2(2-9.9)2 = 20.29
•  = 4.5
• Stock T
• 2 = .3(25-17.7)2 + .5(20-17.7)2 + .2(1-17.7)2 = 74.41
•  = 8.63

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Another Example

• Consider the following information:

• State Probability ABC, Inc. (%)
• Boom .25 15
• Normal .50 8
• Slowdown .15 4
• Recession .10 -3
• What is the expected return?
• What is the variance?
• What is the standard deviation?

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Portfolios

• A portfolio is a collection of assets

• An asset’s risk and return are important in how they affect the risk
and return of the portfolio
• The risk-return trade-off for a portfolio is measured by the portfolio
expected return and standard deviation, just as with individual assets

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Example: Portfolio Weights

• Suppose you have $15,000 to invest and you have purchased

securities in the following amounts. What are your portfolio weights
in each security?
• $2000 of DCLK
• $3000 of KO
• $4000 of INTC
• $6000 of KEI
• DCLK: 2/15 = .133
• KO: 3/15 = .2
• INTC: 4/15 = .267
• KEI: 6/15 = .4

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Portfolio Expected Returns

• The expected return of a portfolio is the weighted

average of the expected returns for each asset in
the portfolio
m
E ( RP )  w j E ( R j )
j 1
• You can also find the expected return by finding the
portfolio return in each possible state and
computing the expected value as we did with
individual securities
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Example: Expected Portfolio Returns

• Consider the portfolio weights computed previously.

If the individual stocks have the following expected
returns, what is the expected return for the
portfolio?
• DCLK: 19.69%
• KO: 5.25%
• INTC: 16.65%
• KEI: 18.24%
• E(RP) = .133(19.69) + .2(5.25) + .167(16.65)
+ .4(18.24) = 13.75%

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Portfolio Variance

• Compute the portfolio return for each state:

RP = w1R1 + w2R2 + … + wmRm
• Compute the expected portfolio return using the same formula as for
an individual asset
• Compute the portfolio variance and standard deviation using the
same formulas as for an individual asset

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Example: Portfolio Variance

• Consider the following information

• Invest 50% of your money in Asset A
• State Probability A B
• Boom .4 30% -5% Portfolio
• Bust .6 -10% 25% 12.5%
• What are the expected return and standard deviation for each asset?
7.5%
• What are the expected return and standard deviation for the
portfolio?

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Another Example

• Consider the following information

• State Probability X Z
• Boom .25 15% 10%
• Normal .60 10% 9%
• Recession .15 5% 10%
• What are the expected return and standard deviation for a portfolio
with an investment of $6000 in asset X and $4000 in asset Z?

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Expected versus Unexpected
Returns
• Realized returns are generally not equal to expected returns
• There is the expected component and the unexpected component
• At any point in time, the unexpected return can be either positive or negative
• Over time, the average of the unexpected component is zero

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Announcements and News

• Announcements and news contain both an expected component and

a surprise component
• It is the surprise component that affects a stock’s price and therefore
its return
• This is very obvious when we watch how stock prices move when an
unexpected announcement is made or earnings are different than
anticipated

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Efficient Markets

• Efficient markets are a result of investors trading on the unexpected

portion of announcements
• The easier it is to trade on surprises, the more efficient markets
should be
• Efficient markets involve random price changes because we cannot
predict surprises

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Systematic Risk

• Risk factors that affect a large number of assets

• Also known as non-diversifiable risk or market risk
• Includes such things as changes in GDP, inflation, interest rates, etc.

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Unsystematic Risk

• Risk factors that affect a limited number of assets

• Also known as unique risk and asset-specific risk
• Includes such things as labor strikes, part shortages, etc.

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Returns

• Total Return = expected return + unexpected return

• Unexpected return = systematic portion + unsystematic portion
• Therefore, total return can be expressed as follows:
• Total Return = expected return + systematic portion + unsystematic
portion

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Diversification

• Portfolio diversification is the investment in several different asset

classes or sectors
• Diversification is not just holding a lot of assets
• For example, if you own 50 internet stocks, you are not diversified
• However, if you own 50 stocks that span 20 different industries, then
you are diversified

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Table 13.7

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The Principle of Diversification

• 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

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Figure 13.1

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Diversifiable Risk

• The risk that can be eliminated by combining assets into a portfolio

• Often considered the same as unsystematic, unique or asset-specific
risk
• If we hold only one asset, or assets in the same industry, then we are
exposing ourselves to risk that we could diversify away

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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

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Systematic Risk Principle

• There is a reward for bearing risk

• There is not a reward for bearing risk unnecessarily
• The expected return on a risky asset depends only on that asset’s
systematic risk since unsystematic risk can be diversified away

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Table 13.8

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Measuring Systematic Risk

• How do we measure systematic risk?

• We use the beta coefficient to measure systematic risk
• What does beta tell us?
• A beta of 1 implies the asset has the same systematic risk as the overall
market
• A beta < 1 implies the asset has less systematic risk than the overall market
• A beta > 1 implies the asset has more systematic risk than the overall market

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Total versus Systematic Risk

• Consider the following information:

Standard Deviation Beta
• Security C 20% 1.25
• Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher expected return?

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Work the Web Example

• Many sites provide betas for companies

• Yahoo Finance provides beta, plus a lot of other information under its
key statistics link
• Click on the web surfer to go to Yahoo Finance
• Enter a ticker symbol and get a basic quote
• Click on key statistics

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Example: Portfolio Betas

• Consider the previous example with the following

four securities
• Security Weight Beta
• DCLK .133 2.685
• KO .2 0.195
• INTC .167 2.161
• KEI .4 2.434
• What is the portfolio beta?
• .133(2.685) + .2(.195) + .167(2.161) + .4(2.434) =
1.731
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Beta and the Risk Premium

• Remember that the risk premium = expected return – risk-free rate

• The higher the beta, the greater the risk premium should be
• Can we define the relationship between the risk premium and beta
so that we can estimate the expected return?
• YES!

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Example: Portfolio Expected Returns
and Betas

30%

25%
E(RA)
Expected Return

20%

15%

10%
Rf
5%

0%
0 0.5 1 1.5A 2 2.5 3
Beta

13-35
Reward-to-Risk Ratio: Definition and
Example

• The reward-to-risk ratio is the slope of the line illustrated in the

previous example
• Slope = (E(RA) – Rf) / (A – 0)
• Reward-to-risk ratio for previous example =
(20 – 8) / (1.6 – 0) = 7.5
• What if an asset has a reward-to-risk ratio of 8 (implying that the
asset plots above the line)?
• What if an asset has a reward-to-risk ratio of 7 (implying that the
asset plots below the line)?

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Market Equilibrium

• In equilibrium, all assets and portfolios must have the same reward-
to-risk ratio and they all must equal the reward-to-risk ratio for the
market

E ( RA )  R f E ( RM  R f )

A M

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Security Market Line

• The security market line (SML) is the representation of market

equilibrium
• The slope of the SML is the reward-to-risk ratio: (E(RM) – Rf) / M
• But since the beta for the market is ALWAYS equal to one, the slope
can be rewritten
• Slope = E(RM) – Rf = market risk premium

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The Capital Asset Pricing Model
(CAPM)
• The capital asset pricing model defines the relationship between risk
and return
• E(RA) = Rf + A(E(RM) – Rf)
• If we know an asset’s systematic risk, we can use the CAPM to
determine its expected return
• This is true whether we are talking about financial assets or physical
assets

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Factors Affecting Expected Return

• Pure time value of money – measured by the risk-free rate

• Reward for bearing systematic risk – measured by the market risk
premium
• Amount of systematic risk – measured by beta

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Example - CAPM

• Consider the betas for each of the assets given earlier.

If the risk-free rate is 2.13% and the market risk
premium is 8.6%, what is the expected return for
each?

Security Beta Expected Return

DCLK 2.685 2.13 + 2.685(8.6) = 25.22%
KO 0.195 2.13 + 0.195(8.6) = 3.81%
INTC 2.161 2.13 + 2.161(8.6) = 20.71%
KEI 2.434 2.13 + 2.434(8.6) = 23.06%

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Figure 13.4

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Quick Quiz

• How do you compute the expected return and

standard deviation for an individual asset? For a
portfolio?
• What is the difference between systematic and
unsystematic risk?
• What type of risk is relevant for determining the
expected return?
• Consider an asset with a beta of 1.2, a risk-free rate of
5% and a market return of 13%.
• What is the reward-to-risk ratio in equilibrium?
• What is the expected return on the asset?
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 13
End of Chapter