10

Estimating
Risk and Return
Finance 3rd Edition

Cornett, Adair, and Nofsinger

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Expected Returns
Expected return is a forward-looking

calculation
Includes risk measures

10-2

Expected Return
Multiply each possible return by the

probability of that return occurring

10-3

Risk Premiums
Required return is the return that investors

demand for the level of risk taken

Risk premium is the reward investors

require for taking risk

Market risk premium is the reward for

taking unsystematic stock market risk

10-4

The Market Portfolio

Capital Asset Pricing Model (CAPM)
Best known capital asset pricing model
Starts with modern portfolio theory

10-5

Efficient Frontier
The Efficient Frontier demonstrates the

highest expected return for each level of

risk

10-6

Efficient Frontier
Adding a risk-free asset improves return for

each level of risk

10-7

CAPM
Calculate the Security Market Line for

risk/return relationship
Substituting into line equation results in

CAPM

10-8

Beta
Measures the sensitivity of a stock or

portfolio to market risk

Beta greater than 1 = more risky than market

(higher risk premium)

Beta less than 1 = less risky (lower risk

premium)

10-9

Security Market Line

Shows relationship between risk and return

for any stock or portfolio

Similar to capital market line
Risk is characterized by beta, not standard

deviation

10-10

Security Market Line --Beta as Risk Measure

10-11

Portfolio Beta
Weighted average of portfolio stocks betas

10-12

Finding Beta
Two ways
Can compute with data from companys and

market portfolio returns

Find in published data from financial outlets

10-13

Capital Market Efficiency

Efficient markets feature
Many buyers and sellers
No high barriers to entry
Free and available information
Low trading or transaction costs

10-14

Efficient Market Hypothesis

States that security prices fully reflect all

available information
Three levels
Weak form
Semistrong form
Strong form

10-15

Weak-form Efficiency
Current prices reflect all information derived

from trading
Includes current and past stock prices and

trading volume

10-16

Semistrong Form Efficiency

Current prices reflect all available public

information
Includes information like financial statements,

news, analysts opinions

10-17

Strong-form Efficiency
Current prices reflect all information
Public
Privately-held information

10-18

Behavioral Finance
People behave in irrational ways
Both optimism and pessimism can be extreme
Overconfidence is tendency to overestimate

knowledge and underestimate risk

10-19

Implications for Financial Managers

Managers must...
understand the risk/return relationship and

implications
address stockholders concerns and

requirements

10-20

Constant-Growth Model
Assumes stock is efficiently priced

Uses dividend and price data and forward

estimate

10-21