Chapter 6

Chapter 6:
Risk, Return, and the

Capital Asset Pricing
Model
Financial Management, 3e
Megginson, Smart, and Graham
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Systematic Risk and Asset

Pricing
Investors can only expect

compensation
for systematic risk:
Contribution of an assets risk to a

diversified portfolio
Measured by beta
The capital asset pricing model

(CAPM) relates an assets return to
its systematic risk.
Assumes that rational, risk-averse

investors select efficient portfolios
The Efficient Frontier with Two

Assets
The Efficient Frontier with Many

Assets
Efficient portfolios achieve the highest possible return for any level of volatility.
Expanding the Feasible Set on

the Efficient Frontier
The broader the range of investments in the feasible set,

the greater the risk reduction achievable through
diversification.
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Example: Efficient Frontier with

Many Assets
Efficient Frontier with Many

Assets
Expected Return (per month) and

Standard Deviation for Various Portfolios
Portfolios of Risky and RiskFree Assets
Portfolio
A: 50% risky, 50% risk-free
MF: 100% risky

B: Borrowing to invest over
100%
Expected
Return
Standard
Deviation
9%
15%
12%
30%
16.5%
52.5%
Figure 6.5 Portfolios of Risky and

Risk-Free Assets
Additional Example: Risk-Free Borrowing

and Lending
Risky asset
X
Risk-free
asset Y
Three possible returns:

-10%; 10%; 30%
Return: 6%
Expected return
10%
Standard deviation
16.3%
Buying asset Y = Lending

money at 6% interest
How would a portfolio with $100 (50%) in asset X

and $100 (50%) in asset Y perform?
$100 Asset X
$100 Asset Y
Three possible returns:

-2%; 8%; 18%
Expected return
8%
Standard deviation
8.16%
Portfolio return and volatility are exactly halfway between

those of the risky asset and the risk-free asset.
Risk-Free Borrowing and Lending

What if we sell short asset Y instead of buying it?
Borrow $100 at 6%
Must repay $106
Invest $300 in X:
Original $200 investment plus $100 in borrowed funds
When X Pays 10%
Net Return on $200 Investment
$270 - $106 - $200

18%
$200
When X Pays 10%
$330 - $106 - $200

12%
$200
When X Pays 30%
$390 - $106 - $200

42%
$200
Expected return on the portfolio is 12%.

Higher expected return comes at the expense of greater volatility.
Risk-Free Borrowing And Lending

The more we invest in X, the higher the expected
return.
The expected return is higher, but so is the volatility.

This relationship is linear.
Portfolio
Expected
Return
Standard
Deviation
50% risky, 50% risk-free
8%
8.16%
100% risky, 0% risk free
10%
16.33%
150% risky, -50% risk free
12%
24.50%
Portfolios of Risky and

Risk-Free Assets
E(RP)
12%
10%
8%
Rf=6%
8.16%
16.33%
24.50%
Figure 6.6 A New Efficient

Frontier
Line L3
defines a new
efficient frontier
Figure 6.7 Finding the Optimal

Portfolio
Finding the Optimal Risky

Portfolio
If investors can borrow and lend at the riskfree rate, then from the entire feasible set
of risky portfolios, one portfolio will emerge
that maximizes the return investors can
expect for a given standard deviation.
To determine the composition of the

optimal portfolio, you need to know the
expected return and standard deviation for
every risky asset, as well as the covariance
between every pair of assets.
The Market Portfolio

Only one risky portfolio is efficient.
Suppose investors agree on which portfolio is
efficient.
Equilibrium requires this to be the market

portfolio.
Market portfolio: Value weighted portfolio of
all available risky assets
The line connecting Rf to the market portfolio
is called the Capital Market Line
Figure 6.6 A New Efficient

Frontier: The Capital Market
Line (CML)
The Capital
Market Line
(CML)
The market
portfolio
The Capital Market Line
The line connecting Rf to the market

portfolio is called the Capital Market Line
(CML).
The CML quantifies the relationship

between the expected return and standard
deviation for combinations of the risk-free
asset and the market portfolio:
Capital Asset Pricing Model

(CAPM)
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 differences in returns across
securities.
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.
Figure 6.8 The Security Market

Line
E(Ri)
SML
A: Undervalued
Rm
Rf
A Slope of SML = R R =
m
f
Market Risk Premium (MRP)
B: Overvalued
=1.0
Example: Expected Return
Beta
im
i 2
m
The numerator is the covariance of the stock

with the market.
The denominator is the markets variance.
A stocks systematic risk is captured by beta.

The higher the beta, the higher the expected return on the
stock
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
Stocks
exposure to
market risk
Reward for
bearing
market risk
Calculating Expected Returns

E(Ri) = Rf + [E(Rm) Rf]
Assume
Risk-free rate = 2%
Expected return on the market = 8%
If stocks beta is
Then expected return

is
2%
0.5
5%
8%
14%
When = 0, the return equals the risk-free rate.

When = 1, the return equals the expected market return.
Estimating Beta by Regression

Coach Inc.:
Beta of 1.61 is above average, indicating relatively high market
risk.
The general tendency is for Coach shares to perform very well
(poorly) when the overall stock market is up (down).
Estimating Beta by Regression

ConAgra:
Beta of 0.11 indicates a very low level of market risk.
This sample period, ConAgra stock moved more or less
independently of the overall market.
Criticisms of the CAPM
Model is based on expected returns, which

are unobservable.
CAPM is a one-period model and does not

account for changing expectations.
Because even Treasury bonds are not free

of all types of risk, Rf is not known precisely.
Market indices (such as the S&P 500) are an

imperfect proxy for the true market
portfolio.
The relationship between stock returns and

estimated betas is flatter than predicted
and not stable over time.
The Fama-French Model

Ri R f i1 Rm R f i 2 Rsmall Rbig i 3 Rhigh Rlow
In the Fama-French model, asset returns are

affected by three factors:
The market risk premium

A size effect measured by the return on a portfolio of
small stocks, minus the return on a portfolio of large stocks
A value effect measured by the return on a portfolio of
stocks with high book-to-market ratios, minus the return
on a portfolio of stocks with low book-to-market ratios
Betas represent sensitivities to each source of risk.

Terms in parentheses are the rewards for bearing
each type of risk.
The Current State of Asset

Pricing Theory
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 different ways depending on
the asset pricing model you choose.
The
CAPM is still widely used in

practice in both corporate finance and
investment-oriented professions.

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Chapter 6:

Risk, Return, and the

Systematic Risk and Asset

Investors can only expect

Contribution of an assets risk to a

The capital asset pricing model

Assumes that rational, risk-averse

The Efficient Frontier with Two

The Efficient Frontier with Many

Expanding the Feasible Set on

The broader the range of investments in the feasible set,

Example: Efficient Frontier with

Efficient Frontier with Many

Expected Return (per month) and

Portfolios of Risky and RiskFree Assets

A: 50% risky, 50% risk-free

MF: 100% risky

Figure 6.5 Portfolios of Risky and

Additional Example: Risk-Free Borrowing

Three possible returns:

Buying asset Y = Lending

How would a portfolio with $100 (50%) in asset X

Three possible returns:

Portfolio return and volatility are exactly halfway between

Risk-Free Borrowing and Lending

Net Return on $200 Investment

$270 - $106 - $200

When X Pays 10%

Net Return on $200 Investment

$330 - $106 - $200

When X Pays 30%

Net Return on $200 Investment

$390 - $106 - $200

Expected return on the portfolio is 12%.

Risk-Free Borrowing And Lending

The expected return is higher, but so is the volatility.

50% risky, 50% risk-free

100% risky, 0% risk free

150% risky, -50% risk free

Portfolios of Risky and

Figure 6.6 A New Efficient

Figure 6.7 Finding the Optimal

Finding the Optimal Risky

To determine the composition of the

The Market Portfolio

Equilibrium requires this to be the market

Figure 6.6 A New Efficient

The Capital Market Line

The line connecting Rf to the market

The CML quantifies the relationship

Capital Asset Pricing Model

Only beta changes from one security

The Security Market Line

the relationship between

equilibrium, all assets lie on this line

stock lies above the line

return is too high.

stock lies below the line

return is too low.

Figure 6.8 The Security Market

Example: Expected Return

The numerator is the covariance of the stock

The denominator is the markets variance.