FINC 3330 - Chapter 11 (Risk and Return)

I. Portfolio Theory
II. Capital Asset Pricing Model (CAPM)
III. Security Market Line (SML)

I. Portfolio Theory
In real life, investors do not hold only one individual type of asset. Rather, they hold portfolios of
assets. An investor portfolio is composed of diverse types of assets. In addition to direct
investment in financial markets, investors have stakes in pension funds, life insurance policies
with savings components, homes, and not least, the earning power of their skills (human capital).

To understand why investors own a portfolio of assets, suppose you own only one stock, IBM.
What would be the sources of risk to this “portfolio”? First, there is the risk that comes from
conditions in the general economy, such as business cycles, inflation, interest rates, exchange
rates. None of these factors can be predicted with certainty, and all affect the rate of return on
IBM stock. In addition to these macroeconomic factors, there are firm-specific influences, such
as IBM’s success in research and development, and personnel changes. These factors affect IBM
without significantly affecting other firms in the economy.

Now consider a naïve diversification strategy, in which you include additional securities in your
portfolio. For example, place half your funds in Exxon and half in IBM. To the extent that firm-
specific influences on the two stocks differ, diversification should reduce portfolio risk. For
example, when oil prices fall, hurting Exxon, computer prices might rise, helping IBM. The two
effects are offsetting and stabilize portfolio return. If you continue to diversify into many more
stocks, you continue to spread out our exposure to firm-specific factors, and portfolio volatility
should continue to fall. Ultimately, however, even with a large number of stocks, you cannot
avoid risk altogether, since virtually all securities are affected by the common macroeconomic
factors, such as business cycles. The risk that remains even after extensive diversification is
called market risk (or systematic risk or non-diversifiable risk) – this risk that is attributable to
market-wide risk sources. The risk that can be eliminated by diversification is called unique risk,
or firm-specific risk, or nonsystematic risk, or diversifiable risk.

II. Capital Asset Pricing Model (CAPM)

The CAPM implies that, as individuals attempt to optimize their personal portfolios, all investors
will choose to hold the market portfolio as their optimal risky portfolio, differing only in the
amount invested in it versus the risk-free rate.

E(r ) = r + β [E(r ) – r ]
i f i M f

where E(r ) is the expected return on asset i; E(r ) is the expected return on the market portfolio
i M

M; r s the risk-free rate; and β is the beta coefficient of asset i - beta is a measure of systematic
f I

risk – it measures the extent to which returns on the stock and the market move together (β = 1
for the market portfolio; β > 1 if the asset is riskier than the market portfolio; β < 1 if the asset is
less risky than the market portfolio).
III. Security Market Line (SML)
The expected return – beta relationship can be portrayed graphically as the security market line
(SML). The slope of the SML is the risk premium of the market portfolio. Given the risk of an
investment, as measured by its beta, the SML provides the required rate of return necessary to
compensate investors for both risk as well as the time value of money.

In the real world, however, investors will apply their own analysis and they will find an actual
expected return which may be compared to the CAPM prediction. “Fairly priced” assets plot
exactly on the SML. Good buys, or underpriced assets, plot above the SML – given their betas,
their expected returns are greater than dictated by CAPM. Overpriced assets will plot below the
SML – given their betas, their expected returns are lower than dictated by CAPM.

Thus, we may say that security analysis is about uncovering the assets that plot above or below
the SML. The portfolio manager will then have to increase the weights of securities above the
SML and decrease the weights of securities below the SML.