Principles of Corporate Finance

Brealey and Myers

Sixth Edition

Risk and Return

Slides by
Matthew Will
Irwin/McGraw Hill

Chapter 8

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8- 2

Topics Covered
Markowitz Portfolio Theory
Risk and Return Relationship
Testing the CAPM
CAPM Alternatives

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Markowitz Portfolio Theory

Markowitz was the first person to observe
that there are no securities that are perfectly
positively or negatively correlated.
Thus, all stocks fall in the middle range and
the risk of a PF will always be less than the
simple weighted average of the individual
risks of the stocks in the PF.
Correlation coefficients make this possible.

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Markowitz Portfolio Theory

Expected Returns and Standard Deviations vary given
different weighted combinations of the stocks.
Expected Return (%)
McDonalds

45% McDonalds

Bristol-Myers Squibb
Standard Deviation

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Efficient Frontier
Each half egg shell represents the possible weighted combinations for two
stocks.
The composite of all stock sets constitutes the efficient frontier.
Expected Return (%)

Standard Deviation
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The efficient frontier represents the set of

portfolios that will give you the highest return
at each level of risk. Portfolios on the
efficient frontier are efficient in that there is
no other combination of stocks that offer that
high a return for the risk taken.

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Efficient Frontier
Example
Stocks
ABC Corp
Big Corp

28
42

Correlation Coefficient = .4
% of Portfolio
Avg Return
60%
15%
40%
21%

Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%

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Efficient Frontier
Example
Stocks
ABC Corp
Big Corp

28
42

Correlation Coefficient = .4
% of Portfolio
Avg Return
60%
15%
40%
21%

Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%

Lets Add stock New Corp to the portfolio

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Efficient Frontier
Example
Stocks
Portfolio
New Corp

28.1
30

Correlation Coefficient = .3
% of Portfolio
Avg Return
50%
17.4%
50%
19%

NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%

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8- 10

Efficient Frontier
Example
Stocks
Portfolio
New Corp

28.1
30

Correlation Coefficient = .3
% of Portfolio
Avg Return
50%
17.4%
50%
19%

NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%

NOTE: Higher return & Lower risk

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8- 11

Efficient Frontier
Example
Stocks
Portfolio
New Corp

28.1
30

Correlation Coefficient = .3
% of Portfolio
Avg Return
50%
17.4%
50%
19%

NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%

NOTE: Higher return & Lower risk

How did we do that?
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8- 12

Efficient Frontier
Example
Stocks
Portfolio
New Corp

28.1
30

Correlation Coefficient = .3
% of Portfolio
Avg Return
50%
17.4%
50%
19%

NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%

NOTE: Higher return & Lower risk

How did we do that?
DIVERSIFICATION
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8- 13

Efficient Frontier
Return

B
A
Risk
(measured
as )
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Efficient Frontier
Return

B
AB
A
Risk

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Efficient Frontier
Return

AB
A

Risk

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Efficient Frontier
Return

ABN AB
A

Risk

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Efficient Frontier
Goal is to move
up and left.

Return

WHY?

ABN AB
A

Risk

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Efficient Frontier
Return
Low Risk
High Return

Risk

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Efficient Frontier
Return
Low Risk

High Risk

High Return

High Return

Risk

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Efficient Frontier
Return
Low Risk

High Risk

High Return

High Return

Low Risk
Low Return
Risk

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8- 21

Efficient Frontier
Return
Low Risk

High Risk

High Return

High Return

Low Risk

High Risk

Low Return

Low Return
Risk

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8- 22

Efficient Frontier
Return
Low Risk

High Risk

High Return

High Return

Low Risk

High Risk

Low Return

Low Return
Risk

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8- 23

So far, we assume that all the securities on the efficient

set are risky. Alternatively, an investor could easily
combine a risky investment with an investment in a
riskless security.
The combination of the riskless asset and the risky
asset produces a liner risk/return line.
The introduction of a risk-free asset changes the
Markowitz efficient frontier into a straight line
(Capital Market Line). That is, CML can be viewed
as the efficient set of all assets, both risky and
riskless.
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8- 24

Capital Market Line

Return

Market Return = rm

Market Portfolio

Risk Free
Return

rf
Risk

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8- 25

With riskless borrowing and lending, the PF

of risky assets held by any investor would
always be point A. Regardless of the
investors tolerance for risk, he would never
choose any other point on the efficient set of
risk assets nor any point in the interior of the
feasible region.
Rather, he would combine the securities of A
with the riskless assets if he had high aversion
to risk.
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8- 26

Notice that the standard deviation of returns is on

the X-axis of the CML graph. Is this the relevant
measure of risk?
The standard deviation of expected returns measures
a stocks total risk. However, the risk that can be
easily diversified should not be compensated for.
If you want to plot return again risk, the risk
measure must be the measure of risk influencing
return. So, the proper relationship is return vs.
systematic risk.
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8- 27

Security Market Line

Return

Market Return = rm

.
Efficient Portfolio

Risk Free
Return

rf
1.0

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BETA

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Security Market Line

Return

Market Return = rm
Security Market
Line (SML)

Risk Free
Return

rf
1.0

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BETA

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8- 29

The relationship between expected return and

beta can be represented by the capital asset
pricing model.
Expected return on a security = rf + Beta of the
security * [E(Rm)-rf ]

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8- 30

Testing the CAPM

Beta vs. Average Risk Premium
Avg Risk Premium
1931-65

SML

30

20

Investors
Market
Portfolio

10

1.0
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Portfolio Beta

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Testing the CAPM

Beta vs. Average Risk Premium
Avg Risk Premium
1966-91

30

20

SML

Investors

10

Market
Portfolio

1.0
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Portfolio Beta

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