Corporate Financial Policy: Risk, Return and the CAPM

Jide Wintoki

Fall 2013

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

1 / 13

Lecture Outline

The Relationship Between Risk and Return The Security Market Line Calculating Individual Stock Betas Validity and the Role of the CAPM Some Alternative Theories

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

2 / 13

Risk and Return

The return earned on investments represents the marginal benet of investing. Risk represents the marginal cost of investing. For any project to create value, the marginal benet must exceed the marginal cost of investing.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

3 / 13

Project or asset risk

In general, the risk of investing in any project or holding any asset consists of two components: Undiversiable risk (systematic risk, market risk)
Only systematic risk is priced in the market. This is the only type of risk that is relevant for capital budgeting or asset valuation. Beta is one way to measure the systematic risk of an asset.

Diversiable risk (unsystematic risk, idiosyncratic risk, or unique risk)

Investors do not care about unsystematic risk because it can be diversied away very cheaply.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

4 / 13

Capital Asset Pricing Model (CAPM)

E (Ri ) = Rf + i [E (Rm Rf )] Only beta changes from one security to the next. For that reason, analysts classify the CAPM as a single-factor model, meaning that just one variable explains dierences in returns across securities.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

5 / 13

The Security Market Line

Plots the relationship between expected return and betas In equilibrium, all assets lie on this line
If stock lies above the line:
Expected return is too high Investors bid up price until expected return falls

If stock lies below the line:

Expected return is too low Investors sell stock, driving down price until expected return rises

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

6 / 13

The Security Market Line

E(RP) A - Undervalued

SML

A RM

Slope = E(Rm) - RF = Market Risk Premium (MRP)

RF

B - Overvalued

=1.0

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

7 / 13

Beta

i =

im 2 m

The numerator is the covariance of the stock with the market. The denominator is the markets variance. In the CAPM, a stocks systematic risk is captured by beta. The higher the beta, the higher the expected return on the stock.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

8 / 13

Beta And Expected Return

Beta measures a stocks exposure to market risk The market risk premium is the reward for bearing market risk: Rm Rf

E(Ri) = Rf + [E(Rm) Rf]

Return for bearing no market risk (risk-free rate)

Stocks exposure to market risk (beta)

Reward for bearing market risk (market premium)

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

9 / 13

Calculating Expected Returns

E (Ri ) = Rf + i [E (Rm Rf )]

Assume
Riskfree rate = 2% Market risk premium = 6% If Stocks Beta Is Then Expected Return Is 0 2% 0.5 5% 1 8% 2 14% When Beta = 0, The Return Equals The Risk-Free Return When Beta = 1, The Return Equals The Expected Market Return
Jide Wintoki (University of Kansas) Business Investment (FIN 468) Fall 2013 10 / 13

Using The Security Market Line

The SML and where P&G and GE place on it r%
15 12.4% 10

SML

slope = E(Rm) RF = MRP = 10% - 2% = 8% = Y X

6.8% 5

Rf = 2%
P&G 1 GE 2

Fall 2013 11 / 13

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Alternatives To CAPM

Arbitrage Pricing Theory Ri Rf = i 1 (R1 Rf )+ i 2 (R2 Rf )+ i 3 (R3 Rf )+ . . . + in (Rn Rf ) Fama-French Model Ri Rf = + i 1 (Rm Rf ) + i 2 (Rsmall Rbig ) + i 3 (Rhigh Rlow ) Betas represent sensitivities to each source of risk. Terms in parentheses are the rewards for bearing each type of risk.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

12 / 13

The Current State of APT

Investors demand compensation for taking risk because they are risk averse. There is widespread agreement that systematic risk drives returns. You can measure systematic risk in several dierent ways depending on the asset pricing model you choose. The CAPM is still widely used in practice in both corporate nance and investment-oriented professions.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

13 / 13