Chapter

11
Return and Risk: The
Capital Asset Pricing
Model (CAPM)

Key Concepts and Skills

Know how to calculate expected returns
Know how to calculate covariances, correlations,
and betas
Understand the impact of diversification
Understand the systematic risk principle
Understand the security market line
Understand the risk-return tradeoff
Be able to use the Capital Asset Pricing Model

11-2

Chapter Outline
11.1 Individual Securities
11.2 Expected Return, Variance, and Covariance
11.3 The Return and Risk for Portfolios
11.4 The Efficient Set for Two Assets
11.5 The Efficient Set for Many Assets
11.6 Diversification
11.7 Riskless Borrowing and Lending
11.8 Market Equilibrium
11.9 Relationship between Risk and Expected Return
(CAPM)
11-3

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)

11-4

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.

11-5

Expected Return

E ( R)

pR
i 1

i
11-6

Variance & St. Deviation

2 pi ( Ri E ( R)) 2

i 1

11-7

Covariance & Correlation

Deviation is computed as Ri E(Ri), compares return in

each state to the expected return.
Cov(a,b)

ab

11-8

11.3 Return and Risk for Portfolios

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.

11-9

Portfolios

The rate of return on the portfolio is a weighted average of the

returns on the stocks and bonds in the portfolio:

Note that an equally weighted portfolio (50% in stocks and 50%

in bonds) has less risk than the weighted average of St.dev of
each fund (XSS + XBB)

11-10

Importance of Correlation
As long as Correl < 1, then
Portfolio St.Dev

P <

WSS + WBB

XSS + XBB: weighted average of the

standard deviations of the individual funds.

What is value of P for

a. Correl=-1?
b. Correl=+1?
c. Correl=0

11-11

The Efficient Set for Two Assets

Opportunity Set and Efficient Frontier
7%

100%
stock
s

6%
5%
4%
3%
2%

100%
bonds

1%
0%
2%

4%

6%

8%

10%

12%

14%

16%

18%

This is what we get when considering

different combinations between S & B.
Note that some portfolios are better than
others. They have higher returns for the
same level of risk or less.

11-12

Portfolios with Various Correlations

Letsseehowthisworksusingourfunds

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
11-13

return

11.5 The Efficient Set for Many Securities

Individual
Assets

P
Consider a world with many risky assets; we can still
identify the opportunity set of risk-return combinations
of various portfolios.
11-14

return

The Efficient Set for Many Securities

c
effi

nt
o
r
f
t
i en

ier

minimum
variance
portfolio

IndividualAssets

P
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
11-15

Announcements, Surprises, and

Expected Returns
The return on any security consists of two parts.
First, the expected returns
Second, the unexpected or risky returns

A way to write the return on a stock in the coming

month is:
R R U
where
Ris the expected
partof thereturn
U is the unexpected
partof thereturn
11-16

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.

Theexpectedpartofanyannouncementisthe
partoftheinformationthemarketusestoform
theexpectation,R,ofthereturnonthestock.
Thesurpriseisthenewsthatinfluencesthe
unanticipatedreturnonthestock,U.
11-17

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.

11-18

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
11-19

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.
11-20

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.

11-21

return

Optimal Portfolio with a Risk-Free

Asset
100%
stocks

rf
100%
bonds

In addition to stocks and bonds, consider a world

that also has risk-free securities like T-bills.
11-22

return

11.7 Riskless Borrowing and Lending

CM

L
100%
stocks

Balanced
fund

rf
100%
bonds

Now investors can allocate their money across the

T-bills and a balanced mutual fund.
11-23

return

Riskless Borrowing and Lending

L
CM

efficient frontier

rf

P
With a risk-free asset available and the efficient frontier identified,
we choose the capital allocation line with the steepest slope.
11-24

return

11.8 Market Equilibrium

CM

L
efficient frontier

M
rf

P
With the capital allocation line identified, all investors choose a
point along the linesome combination of the risk-free asset and
the market portfolio M. In a world with homogeneous
expectations, M is the same for all investors.
11-25

return

Market Equilibrium
CM

L
100%
stocks

Balanced
fund

rf
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.
11-26

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 () of the security.
Beta measures the responsiveness of a security
to movements in the market portfolio (i.e.,
systematic risk).

Cov(Ri,RM )
2(RM )
11-27

Security Returns

Estimating with Regression

te
c
ra
a
Ch

ti
s
i
r

ne
i
L

Slope = i
Return on
market %

R i = i + i Rm + e i

11-28

The Formula for Beta

(Ri )
i

2
(RM )
(RM )
Cov(Ri,RM )

Clearly,yourestimateofbetawill
dependuponyourchoiceofaproxy
forthemarketportfolio.
11-29

R
iFR
M
aFrkeit
R
i(skMP
rR
em
iF)u
M

11.9 Relationship between Risk and

Expected Return (CAPM)

Expected Return on the Market:

Expectedreturnonanindividualsecurity:

MarketRiskPremium

This applies to individual securities held within welldiversified portfolios.

11-30

R
i
M

Expected Return on a Security

This formula is called the Capital Asset Pricing Model
(CAPM):

Ri RF i (RM RF )
Expected
return on
a security

Risk-free
=
+
rate

Beta of the
security

Market risk
premium

Assumei=0,thentheexpectedreturnisRF.
Assumei=1,then

11-31

Expected return

Relationship Between Risk & Return

Ri RF i (RM RF )

RM
RF
1.0

11-32

Expected
return

Relationship Between Risk & Return

13.5%
3%
1.5

i 1.5

RF 3%

RM 10%

Ri 3% 1.5 (10% 3%) 13.5%

11-33

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 expected return on the asset?
11-34