Capital Asset Pricing Model

(CAPM)
E[Ri] = RF + i (RM RF)
09/27/16

Capital Asset Pricing Model

Risk and Return

Probability
.3

Company A
Return
100%

Normal

.4

15%

15%

Recession

.3

-70%

10%

State
Boom

Company B
Return
20%

1.0
1. Find the expected return for Company A and B.
2. Find the standard deviation for Company A and B.

09/27/16

Capital Asset Pricing Model

Find Expected Return

Probability
.3

Company A
Return
100%

Normal

.4

15%

15%

Recession

.3

-70%

10%

State
Boom

Company B
Return
20%

1.0
E(R A ) .3(100) .4(15) .3(-70)
15%
E(R B ) .3(20) .4(15) .3(10)
15%
09/27/16

Capital Asset Pricing Model

Find Standard Deviation

Probability

Company A
Return

Boom

.3

100%

20%

Normal

.4

15%

15%

Recession

.3

-70%

10%

State

Company B
Return

1.0

1
.3(100 - 15) 2 .4(15 - 15) 2 .3(-70 - 15) 2 2

A
65%

B .3(20 - 15) .4(15 - 15)

1
2 2
.3(10 - 15)

=3.8%
09/27/16

Capital Asset Pricing Model

Risk and Return

Expected
Return
15%

4.0%

09/27/16

Risk

65.8%

Capital Asset Pricing Model

Standard
Deviation

Portfolio Risk and the Phantom

Egg Crusher
Market

Your Portfolio

09/27/16

Capital Asset Pricing Model

Lessons from P.E.C.

1. Assets are not held in isolation; rather,
they are held as parts of portfolios.
2. Assets are priced according to their value
in a portfolio.
3. Investors are concerned about how the
portfolio of stocks perform--not individual
stocks.

09/27/16

Capital Asset Pricing Model

Risk and Return

State

Sun Tan
Return

Umbrella
Return

Probability
of State

Sunny

33%

-9%

1/3

Normal

12%

12%

1/3

Rainy

-9%

33%

1/3

Expected return for Sun Tan Company = 12%

Expected return for Umbrella Company = 12%
Standard deviation for Sun Tan Company = 17.15%
Standard deviation for Umbrella Company = 17.15%
Find the expected return and standard deviation for a portfolio which invests
half its money in the Sun Tan and half its money in Umbrella Company.

09/27/16

Capital Asset Pricing Model

Portfolio Risk and Return

State

Umbrella
Return

Sun Tan
Return

Probability
of State

Sunny

33%

-9%

1/3

Normal

12%

12%

1/3

Rainy

-9%

33%

1/3

E R 50/50 .5(12%) .5(12%)

50/50

12%
.5(17.15%) .5(17.15%)
Why not?

09/27/16

Capital Asset Pricing Model

Portfolio Risk and Return

State

Umbrella
Return

Sun Tan
Return

Probability
of State

Sunny

33%

-9%

1/3

Normal

12%

12%

1/3

Rainy

-9%

33%

1/3

State

Return

Sunny

.5(33) + .5( - 9) = 12%

Normal

.5(12) + .5(12) = 12%

Rainy

.5( - 9) + .5(33) = 12%

09/27/16

Capital Asset Pricing Model

No deviation from 12%!

50/50 0

10

Lessons from Tahitian Island

1.
2.
3.

4.

09/27/16

Combining securities into portfolios reduces risk.

How? A portion of a stocks variability in return is canceled by
complementary variations in the return of other securities
However, since to some extent stock prices (and returns) tend to move in
tandem, not all variability can be eliminated through diversification.
or
Even investors holding diversified portfolios are exposed to the risk
inherent in the overall performance of the stock market.
Therefore,
Total Risk = unsystematic +
systematic
diversifiable
nondiversifiable
firm specific
market

Capital Asset Pricing Model

11

Portfolio Choice
U 2 U1 U 0
Expected
Return

Risk

09/27/16

Capital Asset Pricing Model

Standard
Deviation

12

Risk and Return

Expected
Return
2

=-1
1

= 1

Risk

09/27/16

Capital Asset Pricing Model

Standard
Deviation

13

Variability of Returns Compared

with Size of Portfolio
Average annual
standard deviation (%)
49% Unsystematic or diversifiable
risk (related to company-unique events)
24% 19% Total Risk

1
09/27/16

Systematic or nondiversifiable
risk (result of general market
influences)
10

20
Capital Asset Pricing Model

25

Number of stocks
in portfolio
14

Risk & Return

Expected
Return

X Efficient frontier
X
X
X
X
X
X
X
X X
RF --

Risk

09/27/16

Std dev

Capital Asset Pricing Model

15

Risk & Return

Expected
Return
B

RM --

ing
w
o
orr

X Efficient frontier
di n
n
e
L

X
X
X

X
X

X
X

RF -Risk

09/27/16

Std dev

Capital Asset Pricing Model

16

Security Market Line: Risk/Return

Trade-Off with CAPM
Expected
Return

SML

RF --

Systematic
Risk
09/27/16

Capital Asset Pricing Model

17

Security Market Line:

E[Ri] = RF + i (RM RF)
Expected
Return

SML
RM --

RF --

Systematic
Risk
09/27/16

|
1

Capital Asset Pricing Model

|
2

18

CAPM
Provides a convenient measure of systematic risk of the volatility of an
asset relative to the markets volatility.

is this measure--gauges the tendency of a securitys return to move in

tandem with the overall markets return.

Average systematic risk

High systematic risk, more volatile than the market

Low systematic risk, less volatile than the market

09/27/16

Capital Asset Pricing Model

19

Betas for a Five-year Period

(1987-1992)
Company Name

(1987-1992)

Beta

Tucson Electric Power

0.65

California Power & Lighting

0.70

Litton Industries

0.75

Tootsie Roll

0.85

Quaker Oats

0.95

Standard & Poors 500 Stock

Index

1.00

Procter & Gamble

1.05

General Motors

1.15

Southwest Airlines

1.35

Merrill Lynch

1.65

Roberts Pharmaceutical

1.90

09/27/16

Capital Asset Pricing Model

2006 Betas:

20

The SML and WACC

Expected
return
SML
= 8%
16% -15% -14% --

B
A

Incorrect
acceptance
WACC = 15%

Incorrect
rejection

R f 7% --

A .60 Firm 1.0

B 1.2

Beta

If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency toward incorrectly
accepting risky projects and incorrectly rejecting less risky projects.
09/27/16

Capital Asset Pricing Model

21

The SML and the Subjective Approach

Expected
return

SML

20% -High risk

(+6%)

WACC = 14% -10% --

R f 7% -Low risk
(-4%)

Moderate risk
(+0%)

Beta
With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is
then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firms WACC.

09/27/16

Capital Asset Pricing Model

22

Finding Beta for Three Companies:

High, Average, and Low Risk & Market
Year

09/27/16

RH

RA

RL

10%

10%

10%

10%

20%

10%

0%

10%

25%

20%

15%

20%

Capital Asset Pricing Model

RM

23

The Concept of Beta (cont.)

Return on Stock i, Ri (%)
Stock H, High Risk: = 1.5
30 --

Stock A, Average Risk: = 1.0

20 -Stock L, Low Risk: = 0.5

10 -|
-20

|
-10

|
10

|
20

-10 --20 --

09/27/16

Capital Asset Pricing Model

|
30

Return on
the
market

Rm (%)

24

Summary of
Relationship
Between Risk
and Return

09/27/16

Capital Asset Pricing Model

25