12) FINA 2303 - Spring 2017 - Chapter 12 - 8april17

FINA 2303
Financial Management
Veronique LAFON-VINAIS
Associate Professor of Business Education, Dept of
Finance
Spring 2017
SYSTEMATIC RISK AND THE EQUITY RISK PREMIUM
PART II - CHAPTER 12
2
Chapter Outline
12.1 The Expected Return of a Portfolio
12.2 The Volatility of a Portfolio
12.3 Measuring Systematic Risk
12.4 Putting it All Together: The Capital Asset Pricing
Model
Copyright 2015 Pearson Education, Inc. All rights reserved.
FINA 2303 Chapter 12 - Outline 3

Learning Objectives
Calculate the expected return and volatility (standard
deviation) of a portfolio
Understand the relation between systematic risk and the
market portfolio
Measure systematic risk
Use the Capital Asset Pricing Model (CAPM) to compute
the cost of equity capital for a stock
FINA 2303 Chapter 12 Learning Objectives 4

In Chapter 11 we found:
For large portfolios, investors expect higher returns for higher
risk
The same does not hold true for individual stocks
Stocks have both unsystematic and systematic risk
only systematic risk is rewarded
rational investors should choose to diversify
FINA 2303 Chapter 12 The Expected Return of a Portfolio 5

Portfolio weights
The fraction of the total portfolio held in each investment in the
portfolio:
Value of investment i
wi (Eq. 12.1)
Total value of portfolio
Portfolio weights add up to 100% (that is, w1 + w2 + + wN

= 100%)
They represent the way we have divided our money between
the different individual investments in the portfolio

Application: Portfolio Weights
Portfolio weights for a portfolio of 200 shares of Apple
at $200 per share and 100 shares of Coca-Cola at $60
per share:
200 $200 1000 $60

wApple 40% wCoca Cola 60%
100, 000 100, 000

The return on a portfolio, Rp
The weighted average of the returns on the investments in the
portfolio, where the weights correspond to the portfolio
weights:
(Eq. 12.2)

Example 12.1: Calculating Portfolio Returns
Problem:
Suppose you invest $100,000 in a portfolio.
You buy 200 shares of Apple at $200 per share
($40,000) and 1,000 shares of Coca-Cola at $60 per
share ($60,000).
If Apples stock goes up to $240 per share and Coca-
Cola stock falls to $57 per share and neither paid
dividends, what is the new value of the portfolio?
What return did the portfolio earn?

Example 12.1 Calculating Portfolio Returns
Problem (contd):
Show that Eq. 12.2 is true by calculating the individual
returns of the stocks and multiplying them by their
weights in the portfolio.
(Eq. 12.2)
If you dont buy or sell any shares after the price

change, what are the new portfolio weights?

Solution:
Plan:
Your portfolio:
200 shares of Apple: $200 $240 ($40 capital gain per
share)
1,000 shares of Coca-Cola: $60 $57 ($3 capital loss
per share)

Plan (contd):
To calculate the return on your portfolio, compute its
value using the new prices and compare it to the
original $100,000 investment.
To confirm that Eq. 12.2 is true, compute the return on
each stock individually using Eq. 11.1 from Chapter 11,
multiply those returns by their original weights in the
portfolio, and compare your answer to the return you
just calculated for the portfolio as a whole.

Execute:
The new value of your Apple stock is 200 $240 =
$48,000 and the new value of your Coke stock is 1,000
$57 = $57,000.
So, the new value of your portfolio is $48,000 +57,000
= $105,000, for a gain of $5,000 or a 5% return on your
initial $100,000 investment.
Since neither stock paid any dividends, we calculate
their returns simply as the capital gain or loss divided
by the purchase price. The return on Apple stock was
$40/$200 = 20%, and the return on Coca-Cola stock
was -$3/$60 = -5%. Copyright 2015 Pearson Education, Inc. All rights reserved.

Execute (contd):
The initial portfolio weights were $40,000/$100,000 =
40% for Apple and $60,000/$100,000 = 60% for Coca-
Cola, so we can also compute the return of the portfolio
from Eq. 12.2 as
RP wApple RApple wCoke RCoke 0.40 20% 0.60(5%) 5%

Execute (contd):
After the price change, the new portfolio weights are
equal to the value of your investment in each stock
divided by the new portfolio value:
200 $240 1000 $57

wApple 45.71% wCoca Cola 54.29%
105,000 105,000

Evaluate:
The $3,000 loss on your investment in Coca-Cola was
offset by the $8,000 gain in your investment in Apple,
for a total gain of $5,000 or 5%.
The same result comes from giving a 40% weight to
the 20% return on Apple and a 60% weight to the -5%
loss on Coca-Colayou have a total net return of 5%.

Evaluate (contd):
After a year, the portfolio weight on Apple has
increased and the weight on Coca-Cola has
decreased.
Note that without trading, the portfolio weights will
increase for the stock(s) in the portfolio whose returns
are above the overall portfolio return.

Evaluate (contd):
The charts below show the initial and ending weights
on Apple (shown in yellow) and Coca-Cola (shown in
red).

Your Turn!
Problem:
Suppose you invest $158,000 and buy 2,000 shares of
Microsoft at $25 per share ($50,000) and 3,000 shares of
Pepsi at $36 per share ($108,000).
If Microsofts stock goes up to $33 per share and Pepsi
stock falls to $32 per share and neither paid dividends,
what is the new value of the portfolio? What return did
the portfolio earn?
Show that Eq. 11.2 is true by calculating the individual
returns of the stocks and multiplying them by their weights
in the portfolio. If you dont buy or sell any shares after the
price change, what are the new portfolio weights?

Your Turn (PRS please)
The value of the portfolio is now:
$159,000
$162,000
$168,000
The return is:
1%
2%
2.5%
The new portfolio weights are:
31.6 and 68.4
40.7 and 59.3
54.71 and 54.29
FINA 2303 Chapter 12 Historical Risks and Returns of Stocks 20
Solution to Example 12.1a: Calculating
Portfolio Returns
Plan:
Your portfolio:
2,000 shares of MSFT: $25 $33 ($8 capital gain)
3,000 shares of PEP: $36 $32 ($4 capital loss)

Portfolio Returns
Plan (contd):
To calculate the return on your portfolio, compute its
value using the new prices and compare it to the
original $158,000 investment.
To confirm that Eq. 12.2 is true, compute the return on
each stock individually using Eq. 11.1 from Chapter 11,
multiply those returns by their original weights in the
portfolio, and compare your answer to the return you
just calculated for the portfolio as a whole.

Portfolio Returns
Execute:
The new value of your Microsoft stock is 2,000 $33 =
$66,000 and the new value of your Pepsi stock is 3,000
$32 = $96,000.
So, the new value of your portfolio is $66,000 +96,000
= $162,000, for a gain of $4,000 or a 2.5% return on
your initial $158,000 investment.
RP wMicrosoftRMicrosoft wPepsi RPepsi 0.316 32% 0.684 11.1% 2.5%

Portfolio Returns
Execute (contd):
Since neither stock paid any dividends, we calculate
their returns as the capital gain or loss divided by the
purchase price. The return on Microsoft stock was
$8/$25 = 32%, and the return on Pepsi stock was -
$4/$36 = -11.1%.
The initial portfolio weights were $50,000/$158,000 =
31.6% for Microsoft and $108,000/$158,000 = 68.4%
for Pepsi, so we can also compute portfolio return from
Eq. 11.2 as:
RP wMicrosoftRMicrosoft wPepsi RPepsi 0.316 32% 0.684 11.1% 2.5%
Portfolio Returns
Execute (contd):
After the price change, the new portfolio weights are
equal to the value of your investment in each stock
divided by the new portfolio value:
2,000 $33 3,000 $32
wMicrosoft 40.7% wPepsi 59.3%
$162,000 $162,000

Portfolio Returns
Evaluate:
The $12,000 loss on your investment in Pepsi was
offset by the $16,000 gain in your investment in
Microsoft, for a total gain of $4,000 or 2.5%.
The same result comes from giving a 31.6% weight to
the 32% return on Microsoft and a 68.4% weight to the
-11.1% loss on Pepsiyou have a total net return of
2.5%.

The expected return of a portfolio
In Ch. 11 we used the historical average return of a security
as its expected return
We can use these expected returns to compute the
expected return of a portfolio, which is simply the weighted
average of the expected returns of the investments within
it, using the portfolio weights:
E RP w1E R1 w2 E R2 ... wn E Rn (Eq. 12.3)

Summary: Portfolio Expected Return and
Variance
When considering a portfolio of stocks, it is of critical
importance to calculate its average return / expected
return as well as its standard deviation.
Defining the portfolio weights as:

= =

The Portfolio Return is:

= = 1 . 1 + 2 . 2 + 3 . 3 + 4 . 4 +
The Portfolio Expected Return is simply the weighted

linear combination of the Expected Returns of the
stocks: =
= 1 . 1 + 2 . 2 + 3 . 3 + 4 . 4 +

Table 12.1 Summary of Portfolio Concepts

Example 12.2: Portfolio Expected Return
Problem:
Suppose you invest $10,000 in Boeing (BA) stock, and
$30,000 in Merck (MRK) stock.
You expect a return of 10% for Boeing, and 16% for
Merck.
What is the expected return for your portfolio?

Example 12.2 Portfolio Expected Return
Solution:
Plan:
You have a total of $40,000 invested:
$10,000/$40,000 = 25% in Boeing: E[RF]=10%
$30,000/$40,000 = 75% in Merck: E[RTYC]=16%
Using Eq. 12.3, compute the expected return on your
whole portfolio by multiplying the expected returns of
the stocks in your portfolio by their respective portfolio
weights.

Example 12.2 Portfolio Expected Return
Execute:
The expected return on your portfolio is:
E[ RP ] wBA E[ RBA ] wMRK E[ RMRK ]

E[ RP ] 0.25 10% 0.75 16% 14.5%

Example 12.2: Portfolio Expected Return
Evaluate:
The importance of each stock for the expected return
of the overall portfolio is determined by the relative
amount of money you have invested in it.
Most (75%) of your money is invested in Merck, so the
overall expected return of the portfolio is much closer
to Mercks expected return than it is to Boeings.

Your Turn!
Problem:
Suppose you invest $20,000 in Citigroup (C) stock, and
$80,000 in General Electric (GE) stock.
You expect a return of 18% for Citigroup, and 14% for
GE.
What is the expected return for your portfolio?

The expected return is:
14.5%
14.8%
15.1%

Solution to Example 12.2a: Portfolio
Expected Return
Plan:
You have a total of $100,000 invested:
$20,000/$100,000 = 20% in Citigroup: E[RC]=18%
$80,000/$100,000 = 80% in GE: E[RGE]=14%
Using Eq. 11.3, compute the expected return on your
whole portfolio by weighting the expected returns of the
stocks in your portfolio by their portfolio weights.

Expected Return
Execute:
The expected return on your portfolio is:
E[ RP ] wC E[ RC ] wGE E[ RGE ]
E[ RP ] 0.20 18% 0.80 14% 14.8%

Expected Return
Evaluate
The importance of each stock for the expected return
of the overall portfolio is determined by the relative
amount of money you have invested in it.
Most (80%) of your money is invested in GE, so the
overall expected return of the portfolio is much closer
to GEs expected return than it is to Citigroups.

Investors care about return, but also risk
When we combine stocks in a portfolio, some risk is
eliminated through diversification
Remaining risk depends upon the degree to which the stocks
share common risk
The volatility of a portfolio is the total risk, measured as
standard deviation, of the portfolio
We learned all this in Ch. 10!
FINA 2303 Chapter 12 The Volatility of a Portfolio 39

Application: The Volatility of a Portfolio
Table 12.2 shows returns for three hypothetical stocks,
along with their average returns and volatilities
Note that while the three stocks have the same
volatility and average return, the pattern of returns
differs
When the airline stocks performed well, the oil stock
did poorly, and when the airlines did poorly, the oil
stock did well

Table 12.2 Returns for Three Stocks, and
Portfolios of Pairs of Stocks

Application: The Volatility of a Portfolio
Table 12.2 shows returns for two portfolios:
An equal investment in the two airlines, North Air and West Air
An equal investment in West Air and Tex Oil
Average return of both portfolios is equal to the
average return of the stocks
Volatilities (standard deviations) are very different

Figure 12.1 Volatility of
Airline and Oil Portfolios
In Panel (a) we see that the
airline stocks move in synch,
so that a portfolio made up
of two airline stocks doesnt
provide much diversification
In Panel (b), because the
airline and oil stocks often
move in opposite directions,
the portfolio achieves
greater diversification and
lower volatility.

This example demonstrates two important truths
By combining stocks into a portfolio, we reduce risk
through diversification
The amount of risk that is eliminated depends upon the
degree to which the stocks move together
Combining airline stocks reduces volatility only slightly
compared to the individual stocks
Combining airline and oil stocks reduces volatility below that
of either stock

Portfolio Expected Return and Variance
The risk of a portfolio is measured by the Variance (= square of
Standard Deviation) of the Return of that Portfolio, which is
related to the Variances or Standard Deviations of the Returns of
the components of that Portfolio.
If R is the Return of the Portfolio (or a single stock), the Variance

Var(R) of the Portfolio (or a single stock) is:
=
2
() = =1
= 2
1
Of course the Variance of the Portfolio is related to the Variances

of the single stocks in that Portfolio but also (because the Var
formula is quadratic) how those stocks vary related to one
another.
Variance and Covariance
Similar to the Variance for 1 stock, for 2 stocks the
Covariance is defined as:
=
=1 A A . B B
(A , B ) =
1
Where RAi and RBi are the Returns of A and B and

and are the Expected Return of A and B.
If A = B then:
(A , B ) = (A )

Correlation
In order to understand better the relative behavior of
the stocks, the Correlation is defined as:
(A , B )
, =
.
The correlation varies between:

A minimum of -1 when stocks are always moving in opposite
direction, to
0 when stocks relative behavior show no common tendency,
to
A maximum of +1 when stocks are always moving in the same
direction.

Measuring Stocks Co-Movement: Correlation
The previous application showed that to find the risk of a
portfolio, we need to know more than just the risk of the
component stocks: we need to know the degree to which
the stocks returns move together
To find the risk of a portfolio, we need to know
The risk of the component stocks
The degree to which they move together
The stocks correlation is such a measure. Correlation
ranges from -1 to +1, and measures the degree to which
the returns share common risk

Correlation is calculated as the covariance of the returns
divided by the product of the standard deviations of each
return
Correlation is scaled covariance and is defined as
Cov( Ri , R j )
Corr ( Ri , R j )
SD( Ri ) SD( R j )

In this chart correlation is -1, which
means the two stocks move in
opposite directions
Correlations
A Return
A Return
B Return Correlation = -1
B Return
Correlation = 1
Correlation = 0
A Return
In this chart correlation is 1, which B Return
means the two stocks move together
Here correlation is 0, which means

the two stocks move in completely
unrelated directions

Figure 12.2 Correlation
Correlation is a barometer of the degree to which the returns share common risk. The
closer to +1 the more the returns move together as a result of common risk; at zero,
returns are uncorrelated, because of independent risk; the closer to -1, the more the
returns move in opposite direction (negative correlation)

Portfolio Expected Return and Variance
The Variance of a Portfolio of 2 stocks A and B with
respective weights wA and wB is:
() = 2 . (A ) + 2. . . (A , B ) + 2 . (B )
Which can also be written as:
() = = . + . , . . . . + .
Generally speaking, volatility and correlation are easier

to use for financial maths than variance and covariance

Putting it Together
The volatility of a portfolio is the total risk, measured
as standard deviation, of the portfolio
By combining stocks in a portfolio, we can reduce risk
through diversification
The amount of risk that is eliminated depends on the
correlation between the stocks

Stock returns tend to move together if they are affected
similarly by economic events
Stocks in the same industry tend to have more highly
correlated returns than stocks in different industries
Table 12.3 shows several stocks
Volatility of individual stock returns
Correlation between them
The table can be read across rows or down columns

Table 12.3 Estimated Annual Volatilities and Correlations for
Selected Stocks. (Based on Monthly Returns, Jan 2001-Dec 2012)
Correlations were computed based on the returns of the stocks

Blue shadow boxes show the correlation of a stock with itself (which has to be 1).
Each correlation appears twice : see red boxes for Ford and Goodyear, which also have the
highest correlation.
All correlations are positive, so the stocks tend to move together.
The lowest correlation (green boxes) is between Apple and Berkshire Hathaway.

Computing a Portfolios Variance and Standard
Deviation
The formula for the variance of a two-stock portfolio is: (Eq. 12.4)
Accounting for the Accounting for the
risk of stock 1 risk of stock 2 Adjustment for how much the two stocks move together
Var ( RP ) w12 SD( R1 ) 2 w22 SD( R2 ) 2 2 w1w2Corr ( R1 , R2 ) SD( R1 ) SD( R2 )
Which can also be expressed as:

() = = . + . , . . . . + .

The three parts of Eq. 12.4 each account for an important
determinant of the overall variance of the portfolio:
Accounting for the Accounting for the
risk of stock 1 risk of stock 2 Adjustment for how much the two stocks move together
Var ( RP ) w12 SD( R1 ) 2 w22 SD( R2 ) 2 2 w1w2Corr ( R1 , R2 ) SD( R1 ) SD( R2 )
the risk of stock 1

the risk of stock 2
an adjustment for how much the two stocks move together
(their correlation, given as Corr(R1,R2))

The equation demonstrates that with a positive amount
invested in each stock, the more the stocks move
together, and the higher their correlation, the more
volatile the portfolio will be.
The portfolio will have the greatest variance if the
stocks all have a perfect positive correlation of +1.
In fact, when combining stocks in a portfolio, unless the
stocks all have a perfect positive correlation of +1 to
each other, the risk of the portfolio will be lower than
the weighted average volatility of the individual stocks.

The expected return of a portfolio is equal to the
weighted average expected return of its stocks, but the
volatility of a portfolio is less than the weighted
average volatility.
Risk of the portfolio is lower than the weighted average
of the individual stocks volatility, unless all the stocks
all have perfect positive correlation with each other, so
we can eliminate some volatility by diversifying.

Example 12.3 Computing the Volatility of a
Two-Stock Portfolio
Problem:
Using the data from Table 12.3 below, what is the volatility (standard
deviation) of a portfolio with equal amounts invested in Apple and
Microsoft stock?
What is the standard deviation of a portfolio with equal amounts
invested in Apple and Starbucks?

Two-Stock Portfolio
Solution: Weight Volatility Correlation with
Apple
Plan: Apple 0.50 0.41 1
Microsoft 0.50 0.28 0.48
Apple 0.50 0.41 1
Starbucks 0.50 0.32 0.38
With the portfolio weights, volatility, and correlations of

the stocks in the two portfolios, we have all the
information we need to use Eq. 12.4 to compute the
variance of each portfolio.
After computing the portfolios variance, we can take
the square root to get the portfolios standard deviation.

Two-Stock Portfolio

Example 12.3 Computing the Volatility of
Two-Stock Portfolio
For the portfolio of Apple and Starbucks
The standard deviation (volatility) of this portfolio is:

Two-Stock Portfolio
Evaluate:
The weights, standard deviations, and correlation of the two
stocks are needed to compute the variance and then the
standard deviation of the portfolio.
Here, we computed the standard deviation of the portfolio of
Apple and Microsoft to be 29.9% and of Apple and
Starbucks to be 30.4%.
Note that the portfolio of Apple and Starbucks is less
volatile than either of the individual stocks. It is also about
equally volatile as the portfolio of Apple and Microsoft.
Even though Starbucks is more volatile than Microsoft, its
lower correlation with Apple leads to greater diversification
benefits in the portfolio, which offsets Starbucks higher
volatility.

Your Turn!
Problem:
Using the data from Table 12.3, what is the volatility (standard deviation)
of a portfolio with equal amounts invested in Ford and Apple stock?
What is the standard deviation of a portfolio with equal amounts
invested in Ford and Target?

the volatility (standard
deviation) of a portfolio with
equal amounts invested in
Ford and Apple stock is:
37.3
39.6
42.7
the standard deviation of a
portfolio with equal amounts
invested in Ford and Target is:
37.3
39.6
42.7

Solution to Example 12.3a: Computing the
Volatility of Two-Stock Portfolio
Plan: Weight Volatility Correlation with Ford
Apple 0.50 0.41 0.23
Ford 0.50 0.59 1.00
Target 0.50 0.26 0.46
Ford 0.50 0.59 1.00
With the portfolio weights, volatility, and correlations of

the stocks in the two portfolios, we have all the
information we need to use Eq. 12.4 to compute the
variance of each portfolio.
After computing the portfolios variance, we can take
the square root to get the portfolios standard deviation.

Execute (contd):
For the portfolio of Ford and Apple:
And the standard deviation (volatility) of this portfolio is:

Execute (contd):
For the portfolio of Ford and Target:

Evaluate:
The weights, standard deviations, and correlations of
the two stocks are needed to compute the variance
and then the standard deviation of the portfolio.
Here, we computed the standard deviation of the
portfolio of Ford and Apple to be 39.6% and of Ford
and Target to be 37.3%.
Note that the portfolio of Ford and Apple is less volatile
than either of the individual stocks.

Example 12.4 Reducing Risk Without
Sacrificing Return
Problem:
Based on historical data, your expected annual return
for Target is 6% and for Berkshire Hathaway is 5%.
What is the expected return and risk (standard
deviation) of your portfolio if you only hold Target?
If you split your money evenly between Target and
Berkshire, what is the expected return and risk of
your portfolio?

Sacrificing Return
Solution:
Plan:
From Table 12.3 we can get the standard deviations of Target and Berkshire
stock along with their correlation:
SD(RTGT)=0.26, SD(RBRK)=0.17, Corr(RTGT,RBRK)=0.27
With this information and the information from the problem, we can compute the
expected return of the portfolio using Eq. 12.3 and its variance using Eq. 12.4

Sacrificing Return
Execute:
For the all-Target portfolio, we have 100% of our
money in Target stock, so the expected return and
standard deviation of our portfolio is simply the
expected return and standard deviation of that stock:
E[RTGT] = 0.06 (6%)
SD(RTGT) = 0.26 (26%)

Sacrificing Return
Execute (contd):
However, when we invest our money 50% in Berkshire
and 50% in Target, the expected return is:
E[Rp] = wBRKE[RBRK] + wTGTE[RTGT]
= 0.5(0.05) + 0.5(0.06) = 0.055 (5.5%)

Sacrificing Return
For a portfolio of equal weights of Target and
Berkshire, applying Eq.12.4 we find:
Var(Rp) =
(.50^2)(.17^2)+(.50^2)(.26^2)+2(.50)(.50)(.26)(.17)(.27)
= 0.0301
And the standard deviation is the square root of the
variance, so SD(Rp)=0.0301 = 0.1735 or 17.35%

Sacrificing Return
Evaluate:
For a very small reduction in expected return (from 6%
to 5.5%), we gain a large reduction in risk (from 26% to
17.35%).
This is the advantage of portfolios: by selecting stocks
with low correlation but similar expected returns, we
achieve our desired expected return at the lowest
possible risk.

Your Turn!
Problem:
Based on historical data, your expected annual return
for Microsoft is 6% and for Starbucks is 8%.
What is the expected return and risk (standard
deviation) of your portfolio if you only hold
Microsoft?
If you split your money evenly between Microsoft and
Starbucks, what is the expected return and risk of
your portfolio?

the expected return and risk
(standard deviation) of your
portfolio if you only hold
Microsoft
6% and 28%
8% and 28%
7% and 24.8%
the expected return and risk
of a portfolio of equal weights
Microsoft and Starbucks is:
6% and 28%
8% and 28%
7% and 24.8%

Solution to Example 12.4a: Reducing Risk
Without Sacrificing Return
Plan:
From Table 12.3 we can get the standard deviations of Microsoft and Starbucks
stock along with their correlation:
SD(RMSFT) = 0.28, SD(RSBUX) = 0.32, Corr(RMSFT,RSBUX) = 0.36
With this information and the information from the problem, we can compute the
expected return of the portfolio using Eq. 12.3 and its variance using Eq. 12.4

Execute:
For the all-Microsoft portfolio, we have 100% of our
money in Microsoft stock, so the expected return and
standard deviation of our portfolio is simply the
expected return and standard deviation of that stock:
E[RMSFT] = 0.06 (6%), SD(RMSFT) = 0.28 (28%)

Execute (contd):
However, when we invest our money 50% in Microsoft
and 50% in Starbucks, the expected return is:
E[Rp] = wMSFTE[RMSFT] + wSBUXE[RSBUX]
= 0.5(0.06) + 0.5(0.08) = 0.07 (7%)

We determine the variance of the portfolio composed
of equal weights Starbucks and Microsoft
And the resulting standard deviation (volatility) of the

portfolio

Evaluate:
For a relatively large (1%) increase in expected return
from 6% to 7%, we gain a (relatively small) reduction in
risk from 28% to 24.76%.
This is the advantage of portfolios: by selecting stocks
with low correlation but similar expected returns, we
achieve our desired expected return at the lowest
possible risk.

The Volatility of a Large Portfolio
We can gain additional benefits of diversification by holding more
than two stocks in our portfolio
As we add more stocks, the diversifiable firm-specific risk for each
stock matters less and less; only risk that is common to all of the
stocks in the portfolio continues to matter.
In Fig 12.4 (next slide) we graph the volatility of an equally
weighted portfolio with different numbers of stocks.
In an equally weighted portfolio the same amount of money is
invested in each stock.
Note that the volatility declines as the number of stocks grows. In
fact, nearly half the volatility of individual stocks is eliminated in a
large portfolio by diversification

Figure 12.4 Volatility of an Equally Weighted
Portfolio versus the Number of Stocks
The graph is based
on the assumption
that each stock
has a volatility of
40% and a
correlation with
other stocks of
.28, which are
averages for large
stocks in the US

The benefit of diversification is most dramatic initially, but
declines as the portfolio grows: going from 1 to 2 stocks reduces
risk much more than going from 100 to 101 stocks
Even for a very large portfolio we cannot eliminate all the
risks: systematic risk remains

Application 1: Portfolio with 2 Stocks
2 stocks A and B with the following Expected Return, Volatility and
Correlation: Exp. Return Volatity Correlation A B
A 16% 41% A 1 -0.3
B 10% 28% B -0.3 1
The Volatility Matrix and the Covariance Matrix are:

Volatity A B Variance A B
A 41% 0 A 0.168 (0.034)
B 0 28% B (0.034) 0.078
Portfolio Weights
So an equally weighted Portfolio A 50%
of the two stocks A and B B 50%
Would have the following Portfolio:
Variance 0.044
Variance, Volatility and Expected Return Volatility 21.1%
Expected Return 13.0%
FINA 2303 Chapter 12 The Volatility of a Portfolio
Breakdown of calculations
Given a portfolio with 2 stocks A and B, each with the
following Expected Return, Volatility and Correlation:
Exp. Return Volatity Correlation A B
A 16% 41% A 1 -0.3
B 10% 28% B -0.3 1
We apply the formulas we have learned

() = . + .
() = = . + . , . . . . + .
to calculate the expected return:

() = . % + . % = %

Breakdown of calculations
To calculate the variance:
() =
= (. ) (. ) + (. ) . . . .

+ (. ) (. ) = .
And the volatility:

= . %
Because of the negative correlation between A & B, it is

possible to lower the volatility of the portfolio, i.e. risk,
while keeping a decent return, but we can do better.

Application 2: portfolio with 2 stocks
unequally weighted
2 stocks A and B with the following Expected Return,
Volatility and Correlation:
Exp. Return Volatity Correlation A B
A 16% 41% A 1 -0.3
B 10% 28% B -0.3 1
If the Weights are changed to 35.78% and 64.22%, given

the formulas we have learned
() = . + .
() = = . + . , . . . . + .
We calculate the expected return

() = . % + . % = . %

Application 2: portfolio with 2 stocks
unequally weighted
the variance:
() =
= (. ) (. )
+ (. ) . . . .

+ (. ) (. ) = .
And the volatility

= . %
While the Expected Return has been lowered from
13% to 12.1% the Volatility (Risk) is lowered from
21.1% to 19.5% by changing the weightings of stocks
A and B in the Portfolio
Application 3: Portfolio with 3 stocks
3 stocks A, B & C with the following Expected Return, Volatility &
Correlation
Exp Return Volatity Correlation A B C
A 16% 41% A 1 -0.3 -1
B 10% 28% B -0.3 1 -0.2
C 7% 10% C -1 -0.2 1
The Volatility Matrix and the Covariance Matrix are:

Volatity A B C Variance A B C
A 41% 0 0 A 0.168 (0.034) -0.041
B 0 28% 0% B (0.034) 0.078 -0.0056
C 0 0% 10% C (0.041) -0.0056 0.01
An equally weighted Portfolio Has the following Variance, Volatility &
Expected Return Portfolio Weights Portfolio:
A 33.33% Variance 0.010
B 33.33% Volatility 10.2%
C 33.34% Expected Return 11.0%
Application 4: 3 Stocks unequally weighted
3 stocks A, B & C with the following Expected Return, Volatility & Correlation
Exp Return Volatity Correlation A B C
A 16% 41% A 1 -0.3 -1
B 10% 28% B -0.3 1 -0.2
C 7% 10% C -1 -0.2 1
Changing the weights, for instance, to: Portfolio Weights
A 33.33%
B 10.00%
C 56.67%
It has now the following Variance, Volatility & Portfolio:
Expected Return Variance 0.004
Volatility 6.5%
Expected Return 10.3%
While the Expected Return has been lowered from 11% to 10.3% the Volatility (Risk) is
lowered from 10.2% to 6.5% by changing the weightings of stocks A, B & C in the
Portfolio

Diversification and its limits
Putting our examples together, if we measure the Expected
Return per unit of risk (i.e. Expected Return/Volatility), we
find:
With stock A, the ratio is 0.39 (16%/41%) and with stock B, its 0.357
With an equally weighted A and B Portfolio, it is 0.616
With a fine-tuned weighting for A and B, it is 0.623
With an equally weighted A, B and C Portfolio, it is 1.074
By changing a bit the weightings, it is 1.580

Diversification and its limits
In other words, by diversifying our portfolio and changing
the weights, we can reduce risk and increase returns.
This is contingent upon the correlation of the stocks
But with more stocks, there are limits to the improvement to
the Portfolio Return/Risk from negative correlations
between stocks.
If we add more and more stocks, ~ THE MARKET, equally
weighted or cap weighted in the Portfolio, the Volatility
would converge to some lower limit representing the
systematic non-diversifiable risk, the market risk.

Our goal is to understand the impact of risk on the firms
investors so we can:
quantify the relation between risk and required return
produce a discount rate for present value calculations
To recap:
The amount of a stocks risk that is removed by diversification
depends on its correlation with other stocks in the portfolio that you
put it in
With a large enough portfolio, you can diversify away all
unsystematic risk, but you will still be left with systematic risk
FINA 2303 Chapter 12 Measuring Systematic Risk 96

Role of the Market Portfolio
The sum of all investors portfolios must equal the portfolio of
all risky securities in the market
The market portfolio is the portfolio of all risky investments,
held in proportion to their value
Thus, the market portfolio contains more of the largest
companies and less of the smallest companies

Application: Measuring Systematic Risk
Imagine that there are only two companies in the stock
market, each with 1,000 shares outstanding:

Application: Measuring Systematic Risk
Aggregate market portfolio is 1,000 shares of each,
and has a total value of $50,000 with:
80% ($40,000/$50,000) in A
20% ($10,000/$50,000) in B
The sum of everyones portfolios must be the market
portfolio
Since stocks are held in proportion to their market
capitalization (value), we say that the portfolio is value-
weighted

The investment in each security is proportional to its
market capitalization, which is the total market value
of its outstanding shares:
Market Value of a Firm Number of Shares Outstanding Price per share
(Eq. 12.5)
We have seen this before in Ch.2 and later chapters

Stock Market Indexes as the Market Portfolio
In practice we use a market proxya portfolio whose return
should track the underlying, unobservable market portfolio
The most common proxy portfolios are market indexes
A market index reports the market value of a broad based
portfolio of securities; for example:
Dow Jones Industrial Average (DJIA): portfolio of 30 large stocks
was created in 1884 and is one of the oldest stock market
indexes
S&P 500: a value weighted portfolio of 500 of the largest US
stocks. The composition of the index is based on certain criteria
determined by the index provider Standard & Poors. It is one of the
most commonly used US indexes.
https://www.youtube.com/watch?v=RWjrH9KZrHs

Figure 12.5 The S&P 500
Panel (a) shows
the 500 firms of
the S&P 500 as a
fraction of the
approximately
7,000 US public
firms.
Panel (b) shows
the S&P 500 firms
importance in
terms of market
cap these 500
firms represent
~70% of the total
capitalization of
the 7,000 public
firms

What about us?
The Hang Seng Index
https://www.youtube.com/watch?v=Jr2gjIYZRts
http://www.google.com/finance?ei=QnrnWOH9H8aQ0A
SYn4XgCg&q=Hang+seng+index&=

Game! Connect the index to its country!
1
2
A) SSE Composite
3
B) Kospi
C) Nifty
D) Taiex
E) Nikkei
5 4
Index Funds and ETFs
A good way to invest in a market portfolio is to buy an
index mutual fund
The index fund replicates the performance of the index
buying the components of the index in the same
proportion as the index.
John Boggle, founder of Vanguard, launched the
Vanguard S&P 500 Index Fund in 1976.
http://quote.morningstar.com/fund/chart.aspx?t=VFINX
Another way is to invest in an ETF (Exchange Traded
Fund) that also replicates the performance of an index
Two of the better known ETFs is SPDR and iShares
Fun Investing!
The $1 million bet by Warren Buffett
http://www.wsj.com/video/buffett-1-million-bet-index-funds-vs-hedge-funds/CD21601D-
C540-4443-A091-2EDCAA6130B1.html

Market Risk and Beta
We can use the relation between an individual stocks returns
and the market portfolios returns to measure the amount of
systematic risk present in that stock
We compare a stocks historical returns to the markets
historical returns to determine a stocks beta ()
a stocks beta () is the expected percentage change in the
excess return of a security for a 1% change in the excess return
of the market (or other benchmark of the portfolio)
It measures the stocks sensitivity to fluctuations in the market
portfolio
Use excess returns security return less the risk-free rate

What Is Beta
In a portfolio, a part of it is diversifiable while another
part is the systematic risk, the market risk which is not
diversifiable.
For a given stock A, which part is linked to The
Market M ? (A ,M ) (A ,M )
= =
( ) M 2
Once the market reference, equity index, is known, the

Beta indicates how a single stock tracks that market
reference.

Market Risk and Beta
There are many data sources that provide estimates of beta
Most use 2 to 5 years of weekly or monthly returns
Most use the S&P 500 as the market portfolio
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile
/Betas.html

The beta of the overall market portfolio is 1
Many industries and companies have betas
higher/lower than 1
Differences in betas by industry are related to the sensitivity of
each industrys profits to the general health of the economy

Important Note
Volatility (standard deviation) and beta are measured in different
units:
Volatility is expressed in %
Beta is unitless
Even though total risk (volatility) is equal to the sum of systematic
risk (measured by beta) and firm-specific risk, our measure of
volatility does not have to be a bigger number than our
measure for beta
Example: Microsoft has total risk of 28% (0.28) and beta of 1.0,
which is greater than 0.28. Because volatility is measured in %
and beta is not, volatility doesnt have to be greater than beta. So
a stock like Boston Beer can have a higher volatility (standard
deviation) than Microsoft (35%) and a lower beat (0.9). The
following Figure 12.6 shows one possible breakdown of risk for
Microsoft and Boston Beer consistent with these data.

Figure 12.6 Systematic versus Firm-Specific Risk in
Boston Beer and Microsoft
Beta, measuring systematic risk,
and standard deviation,
measuring total risk, are in
different units.
Even though Microsofts total
risk (standard deviation) is 0.28
(28%), its beta, measuring only
systematic risk, is 1.0.
In this case, the beta of 1
corresponds to a breakdown in
total risk as depicted in the
figure.
Formally, the portion of
Microsofts total risk that is in
common with the market is
calculated by multiplying the
correlation between Microsoft
and the market by the standard
deviation of Microsoft.

Example 12.5 Total Risk Versus Systematic
Risk
Problem:
Suppose that in the coming year, you expect SysCos
stock to have a standard deviation of 30% and a beta
of 1.2, and UniCos stock to have a standard deviation
of 41% and a beta of 0.6.
Which stock carries more total risk?
Which has more systematic risk?

Risk
Solution:
Plan:
Standard Deviation Beta ()
(Total Risk) (Systematic Risk)
SysCo 30% 1.2
UniCo 41% 0.6

Risk
Execute:
Total risk is measured by standard deviation;
therefore, UniCos stock has more total risk.
Systematic risk is measured by beta. SysCo has a
higher beta, and so has more systematic risk.

Risk
Evaluate:
a stock can have high total risk, but if a lot of it is
diversifiable, it can still have low or average systematic
risk.

Your Turn!
Problem:
Suppose that in the coming year, you expect
Rackspace Hostings stock to have a standard
deviation of 40% and a beta of 1.4, and SolarWinds
stock to have a standard deviation of 31% and a beta
of 1.9.
Which stock carries more total risk?
Which has more systematic risk?

The stock that carries more
total risk is
Rackspace
Solarwind
The stock that carries more
systematic risk is:
Rackspace
Solarwind

Solution to Example 12.5a: Total Risk Versus
Systematic Risk
Plan:
Standard Deviation Beta ()

(Total Risk) (Systematic Risk)
Rackspace 40% 1.4
SolarWinds 31% 1.9

Solution to Example 12.5a: Total Risk Versus
Systematic Risk
Execute:
Total risk is measured by standard deviation;
therefore, Rackspace Hostings stock has more total
risk.
Systematic risk is measured by beta. SolarWinds
has a higher beta, and so has more systematic risk.

Example 12.5a Total Risk Versus Systematic
Risk
Evaluate:
Astock can have high total risk, but if a lot of it is
diversifiable, it can still have low or average systematic
risk.

Estimating Beta from Historical Returns
Beta is the expected percentage change in the excess return
of the security for a 1% change in the excess return of the
market portfolio
The amount by which risks that affect the overall market are
amplified or dampened in a given stock or investment.
(A ,M ) (A ,M )
= = 2
(M )
Where Ra is the return of stock A and Rm is the return of the

market

Application: Estimating Beta from Historical
Returns
Apples stock for example (Figure 12.7):
The overall tendency is for Apple to have a high return when
the market is up and a low return when the market is down
Apple tends to move in the same direction as the market, but
its movements are larger
The pattern suggests that Apples beta is greater than one

Figure 12.7 Monthly Excess Returns for Apple Stock and
for the S&P 500, January 2008-December 2012

Returns
We can see Apples sensitivity to the market even more
clearly by plotting Apples returns as a function of S&P
500s returns, as shown in the next Figure 12.8
Each point in this figure represents the returns of Apple
and the S&P 500 for one of the months in Figure 12.7.
For example, in May 2009, Apples return was 7.9%
and the S&P500s was 5.3%
As the scatterplot makes clear, Apples returns have a
positive correlation with the market: Apple tends to go
up when the market is up, and vice versa.

Figure 12.8 Scatterplot of Monthly Returns for Apple versus the
S&P 500, January 2008 through December 2012

In practice, we use linear regression to estimate the
relation
The output of the linear regression is the best-fitting line that
represents the historical relation between the stock and the
market
The slope of this line is our estimate of its beta
The slope tells us how much, on average, the stocks excess
return changed for a 1% change in the markets excess return

Returns
In Fig. 12.85, the best fitting line shows that a 1% change in
the markets returns corresponds to about a 1.2% change in
Apples return.
So, Apples return moves about 1.2 times the overall markets
movement
=> Apples beta is 1.2
Beta capture the systematic market risk of a security.
The best fitting line captures the components of a securitys
returns that can be explained by market-risk factors.
Deviations from the best-fitting line result from risk that is
not related to the market as a whole: that risk is diversifiable
risk that averages out in a large portfolio Copyright 2015 Pearson Education, Inc. All rights reserved.

Pop Quiz!
What is the Beta of a risk-free investment? Justify

12.4 Putting It All Together: The Capital
Asset Pricing Model
One of our goals in this chapter is to compute the cost
of equity capital
The best available expected return offered in the market on a
similar investment
To compute the cost of equity capital, we need to know
the relation between the stocks risk and its expected
return
FINA 2303 Chapter 12 The CAPM 130

Asset Pricing Model
The CAPM Equation Relating Risk to Expected Return
Only systematic risk determines expected returns
Firm-specific risk is diversifiable and does not warrant extra
return
The expected return on any investment comes from:
A baseline rate of return to compensate for inflation and the time
value of money, even with no risk of losing money
A risk premium that varies with the systematic risk
Expected Return = Risk-free rate + Risk Premium for
Systematic Risk

Asset Pricing Model
Beta is our measure of the amount of systematic risk
in an investment
So the expected return for investment i = Risk Free
Rate + Beta (of i) X Risk Premium per Unit of
Systematic Risk
How to calculate the risk premium? A natural estimate
is the historical average excess return on the market
portfolio, also known as market/equity risk premium.
This leads us to the equation for the expected return of
an investment, the Capital Asset Pricing Model
(CAPM) Copyright 2015 Pearson Education, Inc. All rights reserved.

Asset Pricing Model
The Capital Asset Pricing Model (CAPM)
The equation for the expected return of an investment:
Systematic
risk premium E[ Ri ] rf i E[ RMkt ] rf Market risk premium
of the
investment Risk Premium for Security i
(Eq. 12.6)
Risk free rate
The CAPM simply says that the return we should expect on
any investment is equal to the risk-free rate of return plus a
risk premium proportional to the amount of systematic
risk in the investment
Specifically, the risk premium is equal to the market risk
premium multiplied by the amount of systematic risk of
the investment

Putting It All Together: The Capital Asset
Pricing Model (CAPM)
The CAPM says that the expected return on any
investment is equal to the risk-free rate of return plus a
risk premium proportional to the amount of systematic
risk in the investment
The risk premium is equal to the market risk premium times
the amount of systematic risk present in the investment,
measured by its beta (i)
When graphed, it is called the security market line (SML)
= +
FINA 2303 Chapter 12 The CAPM

How to Infer Stock Return from Market
Return?
From the CAPM, we have the Security Market Line,
SML, which links the Expected Return of a security to
the Risk Free Rate, the Beta of the security and the
Expected Market Return
That is = +
Which for special cases:
If = 1 => R = R Market , i.e. the exposure is to the whole stock market
If = 0 => R = RFree , i.e. no exposure to the stock market
High beta stocks amplify market return and risks, low beta
stocks amortize them
The Market-Risk Premium is: R Market R Free

Asset Pricing Model
Since investors will not invest in a security unless they can
expect at lest the return expressed by the C APM, we also
call this return the required return of an investment.
The required return is the expected return of an
investment that is necessary to compensate for the risk of
undertaking the investment

Example 12.6 Computing the Expected
Return for a Stock
Problem:
Suppose the risk-free return is 3% and you measure
the market risk premium to be 6%.
Apple has a beta of 1.2.
According to the CAPM, what is its expected
return?

Return for a Stock
Solution:
Plan:
We can use Eq 12.6 to compute the expected return
according to the CAPM.
For that equation, we will need the market risk
premium, the risk-free return, and the stocks beta.
We have all of these inputs, so we are ready to go.
E[ Ri ] rf i E[ RMkt ] rf (Eq. 12.6)
Risk Premium for Security i

Return for a Stock
Execute:
Using Eq. 12.6:

Return for a Stock
Evaluate:
Because of Apples beta of 1.2, investors will require a
risk premium of 7.2% (6% x 1.2) over the risk-free rate
for investments in its stock to compensate for the
systematic risk of Apple stock.
This leads to a total expected return of 10.2%.

Your Turn!
Problem:
Suppose the risk-free return is 5% and you measure
the market risk premium to be 7%.
Best Buy has a beta of 1.5.
According to the CAPM, what is its expected
return?

The required (expected) return
is:
10.2%
11.9%
15.5%

Expected Return for a Stock
Plan:
We can use Eq 12.6 to compute the expected return
according to the CAPM.
For that equation, we will need the market risk
premium, the risk-free return, and the stocks beta.
We have all of these inputs, so we are ready to go.


Execute:
Using Eq. 12.6:
E[ RBBY ] rf BBY ( E[ RMkt ] rf ) 5% 1.5(7%)

15.5%

Evaluate:
Because of Best Buys beta of 1.5, investors will
require a risk premium of 10.5% over the risk-free rate
for investments in its stock to compensate for the
systematic risk of Best Buy stock.
This leads to a total expected return of 15.5%.

Asset Pricing Model
The Security Market Line
The CAPM implies a linear relation between a stocks beta
and its expected return
This line is graphed in Figure 12.9(b) as the line through the
1.6
risk-free investment (with a beta of zero) and the market (with
a beta of one); it is called the security market line (SML)
Recall that there is no clear relation between a stocks
standard deviation (volatility) and its expected return
The relation between risk and return for individual securities
is only evident when we measure market risk rather than total
risk

Figure 12.9 Expected Returns, Volatility, and
Beta (Panel A)
The graph compares the
standard deviation
(volatility) and expected
(required) returns of stocks
including Apple.
Some of the stocks are
identified.
There is no relation
between total risk and
expected return.
It is clear that we could not
predict Boston Beers
expected return using its
total risk.

Figure 12.9 Expected Returns, Volatility, and
Beta (Panel B)
The security market line
(SML) in green on the
graph shows the expected
return for Apple and each
of the stocks as a function
of its beta with the market.
According to the CAPM, all
stocks and portfolios -
including the market
portfolio - should lie on the
SML.
Thus, Apples expected
return can be determined
by its beta, which measures
its systematic risk.

Example 12.7: A Negative Beta Stock
Problem:
Suppose the stock of Bankruptcy Auction Services,
Inc. (BAS) has a negative beta of -0.30.
How does its expected return compare to the risk-
free rate, according to the CAPM?
Does your result make sense?

Example 12.7 A Negative Beta Stock
Solution:
Plan:
We can use the CAPM equation, Eq. 12.6, to compute the
expected return of this negative beta stock just like we
would a positive beta stock.
We dont have the risk-free rate or the market risk premium,
but the problem doesnt ask us for the exact expected
return, just whether or not it will be more or less than the
risk-free rate. Using Eq. 12.6, we can answer that question.
E[ Ri ] rf i E[ RMkt ] rf
(Eq. 12.6)

Execute:
Because the expected return of the market is higher
than the risk-free rate, Eq. 12.6 implies that the
expected return of Bankruptcy Auction Services (BAS)
will be below the risk-free rate.
As long as the market risk premium is positive (as long
as people demand a higher return for investing in the
market than for a risk-free investment), then the
second term in Eq. 12.6 will have to be negative if the
beta is negative.

Execute (contd):
For example, if the risk-free rate is 4% and the market
risk premium is 6%,
E[RBAS] = 4% - 0.30(6%) = 2.2%.
(See Figure 12.9: the SML drops below rf for < 0.)

Evaluate:
This result seems oddwhy would investors be willing
to accept a 2.2% expected return on this stock when
they can invest in a safe investment and earn 4%?
The answer is that a savvy investor will not hold BAS
alone; instead, the investor will hold it in combination
with other securities as part of a well-diversified
portfolio.
These other securities will tend to rise and fall with the
market.

Evaluate (contd):
But because BAS has a negative beta, its correlation
with the market is negative, which means that BAS
tends to perform well when the rest of the market is
doing poorly.
Therefore, by holding BAS, an investor can reduce the
overall market risk of the portfolio. In a sense, BAS is
recession insurance for a portfolio, and investors will
pay for this insurance by accepting a lower return.

Your Turn
Problem:
Suppose the stock of Ace Marketing & Promotions
(AMKT) has a negative beta of -0.70.
How does its expected return compare to the risk-
free rate, according to the CAPM?
Does your result make sense?

is:
Higher than the risk-free rate
Same as the risk-free rate
Lower than the risk-free rate

Solution to Example 12.7a: A Negative Beta
Stock
Plan:
We can use the CAPM equation, Eq. 12.6, to compute the
expected return of this negative beta stock just like we
would a positive beta stock.
We dont have the risk-free rate or the market risk premium,
but the problem doesnt ask us for the exact expected
return, just whether or not it will be more or less than the
risk-free rate.
Using Eq. 12.6, we can answer that question.

Risk Premium for Security i Copyright 2015 Pearson Education, Inc. All rights reserved.

Stock
Execute:
Because the expected return of the market is higher
than the risk-free rate, Eq. 12.6 implies that the
expected return of Ace Marketing & Promotions
(AMKT) will be below the risk-free rate.
As long as the market risk premium is positive (as
long as people demand a higher return for investing in
the market than for a risk-free investment), then the
second term in Eq. 12.6 will have to be negative if the
beta is negative.

Stock
Execute (contd):
For example, if the risk-free rate is 5% and the market
risk premium is 7%,
E[RAMKT] = 5% - 0.70(7%) = 0.1%.
(See Figure 11.9: the SML drops below rf for < 0.)

Stock
Evaluate:
This result seems oddwhy would investors be willing
to accept a 0.1% expected return on this stock when
they can invest in a safe investment and earn 5%?
The answer is that a savvy investor will not hold AMKT
alone; instead, the investor will hold it in combination
with other securities as part of a well-diversified
portfolio.
These other securities will tend to rise and fall with the
market.

Stock
Evaluate (cont):
But because AMKT has a negative beta, its correlation
with the market is negative, which means that AMKT
tends to perform well when the rest of the market is
doing poorly.
Therefore, by holding AMKT, an investor can reduce
the overall market risk of the portfolio.
In a sense, AMKT is recession insurance for a
portfolio, and investors will pay for this insurance by
accepting a lower return.

Asset Pricing Model
The CAPM and Portfolios
We can apply the SML to portfolios as well as individual
securities
The market portfolio is on the SML, and according to the CAPM,
other portfolios (such as mutual funds) are also on the SML
Therefore, the expected return of a portfolio should correspond
to the portfolios beta
The beta of a portfolio made up of securities each with weight wi
is:
P w11 w2 2 ... wn n (Eq. 12.7)

Example 12.8 The Expected Return of a
Portfolio
Problem:
Suppose drug-maker Pfizer (PFE) has a beta of 0.7,
whereas the beta of Google (GOOG) is 0.9.
If the risk free interest rate is 3% and the market risk
premium is 6%, what is the expected return of an
equally weighted portfolio of Pfizer and Google,
according to the CAPM?

Portfolio
Solution:
Plan:
We have the following information:
rf = 3%,
E[RMkt] - rf = 6%
PFE:
PFE = 0.7,
wPFE = 0.50
GOOG:
GOOG = 0.9,
wGOOG = 0.50

Portfolio
Plan (contd):
We can compute the expected return of the portfolio
two ways.
First, we can use the CAPM (Eq. 12.6) to compute the
expected return of each stock and then compute the
expected return for the portfolio using Eq. 12.3.
Or, we could compute the beta of the portfolio using
Eq. 12.7 and then use the CAPM (Eq. 12.6) to find the
portfolios expected return.
Risk Premium for Security i Copyright 2015 Pearson Education, Inc. All rights reserved.

Portfolio
Execute:
Using the first approach, we compute the expected
return for PFE and GOOG:
E[RPFE] = rf + PFE(E[RMkt] rf)
E[RGOOG] = rf + GOOG(E[RMkt] rf)
E[RPFE] = 3% + 0.7(6%)= 7.2%
E[RGOOG] = 3% + 0.9(6%)= 8.4%
Then the expected return of the equally weighted
portfolio P is:
E[RP] = 0.5(7.2%) + 0.5(8.4%) = 7.8%

Portfolio
Execute (contd):
Alternatively, we can compute the beta of the portfolio
using Eq. 12.7:
P w11 w2 2 ... wn n
P = wPFEPFE + wGOOGGOOG
P = (0.5)(0.7) + (0.5)(0.9) = 0.8
We can then find the portfolios expected return from
the CAPM:
E[RP] = rf + P(E[RMkt] rf)
E[RP] = 3% + 0.8(6%) = 7.8% Copyright 2015 Pearson Education, Inc. All rights reserved.

Portfolio
Evaluate
The CAPM is an effective tool for analyzing securities
and portfolios of those securities.
You can compute the expected return of each security
using its beta and then compute the weighted average
of those expected returns to determine the portfolios
expected return.
Or, you can compute the weighted average of the
securities betas to get the portfolios beta and then
compute the expected return of the portfolio using the
CAPM. Either way, you will get the same answer.

Your Turn!
Problem:
Suppose Ford (F) has a beta of 2.67, whereas the
beta of Safeway (SWY) is 0.72.
If the risk free interest rate is 3% and the market risk
premium is 6%, what is the expected return of an
equally weighted portfolio of Ford and Safeway,
according to the CAPM?

is:
7.8%
13.07%
16.79%

Solution to Example 12.8a: The Expected
Return of a Portfolio
Plan:
We have the following information:
rf = 3%,
E[RMkt] - rf = 6%
F:
F = 2.67,
wF = 0.50
SWY:
SWY = 0.72,
wSWY = 0.50

Plan (contd):
We can compute the expected return of the portfolio two
ways.
First, we can use the CAPM (Eq. 12.6) to compute the
expected return of each stock and then compute the
expected return for the portfolio using Eq. 12.3.
Or, we could compute the beta of the portfolio using Eq.
12.7 and then use the CAPM (Eq. 12.6) to find the
portfolios expected return.
(Eq. 12.6)

Execute:
Using the first approach, we compute the expected
return for F and SWY:
E[RF] = rf + F(E[RMkt] rf)
E[RSWY] = rf + SWY(E[RMkt] rf)
E[RF] = 3% + 2.67(6%)=19.02%
E[RSWY] = 3% + 0.72(6%)=7.32%
Then the expected return of the equally weighted
portfolio P is:
E[RP] = 0.5(19.02%) + 0.5(7.32%) = 13.17%

Execute (contd):
Alternatively, we can compute the beta of the portfolio
using Eq. 12.7:
P = wFF + wSWYSWY
P = (0.5)(2.67) + (0.5)(0.72) = 1.695
We can then find the portfolios expected return from
the CAPM:
E[RP] = rf + P(E[RMkt] rf)
E[RP] = 3% + 1.695(6%) = 13.17%

Evaluate:
The CAPM is an effective tool for analyzing securities
and portfolios of those securities.
You can compute the expected return of each security
using its beta and then compute the weighted average
of those expected returns to determine the portfolios
expected return.
Or, you can compute the weighted average of the
securities betas to get the portfolios beta and then
compute the expected return of the portfolio using the
CAPM. Either way, you will get the same answer.

Asset Pricing Model
Summary of the Capital Asset Pricing Model
Investors require a risk premium proportional to the amount of
systematic risk they are bearing
We can measure systematic risk using beta ()
The most common way to estimate beta is to use linear
regression the slope of the line is the stocks beta
The CAPM says we can compute the expected (required)
return of any investment using the following equation:
which, when graphed is called the security market line


Estimating the Cost of Equity
Two possible ways (there are others)
FINA 2303 Chapter 12 The CAPM

Chapter Quiz
1. How is the expected return of a portfolio related to the
expected returns of the stocks in the portfolio?
2. What determines how much risk will be eliminated by
combining stocks in a portfolio?
3. What is the market portfolio?
4. What does beta tell us?
5. What does the CAPM say about the required return of a
security?
6. What is the Security Market Line?
178

12) FINA 2303 - Spring 2017 - Chapter 12 - 8april17

Diunggah oleh

Informasi Dokumen

Judul Asli

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

12) FINA 2303 - Spring 2017 - Chapter 12 - 8april17

Diunggah oleh

Hak Cipta:

Format Tersedia

FINA 2303

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 - Outline 3

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 Learning Objectives 4

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 5

Portfolio weights add up to 100% (that is, w1 + w2 + + wN

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 6

200 $200 1000 $60

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 7

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 8

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 9

If you dont buy or sell any shares after the price

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 10

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 11

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 12

FINA 2303 Chapter 12 The Expected Return of a Portfolio 13

RP wApple RApple wCoke RCoke 0.40 20% 0.60(5%) 5%

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 14

200 $240 1000 $57

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 15

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 16

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 17

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 18

FINA 2303 Chapter 12 The Expected Return of a Portfolio 19

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 21

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 22

RP wMicrosoftRMicrosoft wPepsi RPepsi 0.316 32% 0.684 11.1% 2.5%

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 23

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 25

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 26

E RP w1E R1 w2 E R2 ... wn E Rn (Eq. 12.3)

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 27

The Portfolio Return is:

The Portfolio Expected Return is simply the weighted

FINA 2303 Chapter 12 The Expected Return of a Portfolio 28

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 29

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 30

Copyright 2015 Pearson Education, Inc. All rights reserved.

FINA 2303 Chapter 12 The Expected Return of a Portfolio 31

E[ RP ] wBA E[ RBA ] wMRK E[ RMRK ]

Copyright 2015 Pearson Education, Inc. All rights reserved.