166

7

6hkFTLß
Introduction to
Risk and Return
we have maaa§ed to go tnrougn six onaptors
witnout dirootly addrossing tno problom oí risk, but
now tno |ig is up. Wo oan no longor bo satisíiod witn
vaguo statomonts liko "Tno opportunity oost oí oapital
doponds on tno risk oí tno pro|oot." Wo nood to know
now risk is doíinod, wnat tno links aro botwoon risk and
tno opportunity oost oí oapital, and now tno íinanoial
managor oan oopo witn risk in praotioal situations.
ín tnis onaptor wo oonoontrato on tno íirst oí tnoso
issuos and loavo tno otnor two to Cnaptors 8 and 9. Wo
start by summarizing moro tnan 100 yoars oí ovidonoo
on ratos oí roturn in oapital markots. Tnon wo tako a
íirst look at invostmont risks and snow now tnoy oan
bo roduood by portíolio divorsiíioation. Wo introduoo
you to bota, tno standard risk moasuro íor individual
soouritios.
Tno tnomos oí tnis onaptor, tnon, aro portíolio risk,
soourity risk, and divorsiíioation. For tno most part, wo
tako tno viow oí tno individual invostor. But at tno ond
oí tno onaptor wo turn tno problom around and ask
wnotnor divorsiíioation makos sonso as a oorporato
ob|ootivo.
PART 2
RISK
Iinancial analysts are blessed witl an enormous quantity ol data. Tlere are comprelensive
databases ol tle prices ol U.S. stocks, bonds, options, and commodities, as well as luge
amounts ol data lor securities in otler countries. We locus on a study by Dimson, Marsl, and
Staunton tlat measures tle listorical perlormance ol tlree portlolios ol U.S. securities.
1

1. A portlolio ol Treasury bills, tlat is, U.S. government debt securities maturing in less
tlan one year.
2

2. A portlolio ol U.S. government bonds.
3. A portlolio ol U.S. common stocks.
Tlese investments oller dillerent degrees ol risk. Treasury bills are about as sale an
investment as you can make. Tlere is no risk ol delault, and tleir slort maturity means
tlat tle prices ol Treasury bills are relatively stable. In lact, an investor wlo wisles to
lend money lor, say, tlree montls can aclieve a perlectly certain payoll by purclasing a
Treasury bill maturing in tlree montls. However, tle investor cannot lock in a rcu/ rate ol
return. Tlere is still some uncertainty about inllation.

1
See L. Dimson, I. R. Marsl, and M. Staunton, Trtumph c/ thc Opttmtsts: 101 Ycurs c/ Inzcstmcnt Fcturns (Irinceton, N}. Irinceton
University Iress, 2002).

2
Treasury bills were not issued belore 1919. ßelore tlat date tle interest rate used is tle commercial paper rate.
7·1 0ver a Century ol Caµital Market history in 0ne Easy Lesson
6hapIar 7 íntroduction to Risk and Return 167
ßy switcling to long-term government bonds, tle investor acquires an asset wlose price
lluctuates as interest rates vary. (ßond prices lall wlen interest rates rise and rise wlen inter-
est rates lall.) An investor wlo slilts lrom bonds to common stocks slares in all tle ups
and downs ol tle issuing companies.
Iigure 7.1 slows low your money would lave grown il you lad invested $1 at tle start
ol 1900 and reinvested all dividend or interest income in eacl ol tle tlree portlolios.
3

Iigure 7.2 is identical except tlat it depicts tle growtl in tle rcu/ value ol tle portlolio. We
locus lere on nominal values.
Investment perlormance coincides witl our intuitive risk ranking. A dollar invested in
tle salest investment, Treasury bills, would lave grown to $71 by tle end ol 2008, barely
enougl to keep up witl inllation. An investment in long-term Treasury bonds would lave
3
Iortlolio values are plotted on a log scale. Il tley were not, tle ending values lor tle common stock portlolio would run oll tle
top ol tle page.
 FI608£ 7.1
how an investment ol $1 at
the start ol 1OOO would have
grown by the end ol 2OO8,
assuming reinvestment ol
all dividend and interest
µayments.
5c0rcc: E. 0imson, F. R. Marsh,
and M. Staunton, Tri0mp| cf
t|c Uptimists: 101 ¥cars cf
Irvcstmcrt Fct0rrs (Frinceton,
hJ. Frinceton university Fress,
2OO2), with uµdates µrovided by
the authors.
1º00 1º10 1º20
Start oI year
1º30 1º40 1º50 1ºó0 1º70 1º80 1ºº0 2000
1
10
100
1,000
$14,27ó
$242
$71
10,000
100,000
Dollars (log scale)
Common stock
Bonds
Bills
1º00 1º10 1º20
Start oI year
1º30 1º40 1º50 1ºó0 1º70 1º80 1ºº0 2000
0.1
1
10
100
1,000
$582
$º.85
$2.88
10,000
100,000
Dollars (log scale)
Common stock
Bonds
Bills
 FI608£ 7.2
how an investment ol $1 at
the start ol 1OOO would have
grown in real terms by the
end ol 2OO8, assuming rein·
vestment ol all dividend and
interest µayments. Comµare
this µlot with Figure 7.1 ,
and note how inllation has
eroded the µurchasing µower
ol returns to investors.
5c0rcc: E. 0imson, F. R. Marsh,
and M. Staunton, Tri0mp| cf
t|c Uptimists: 101 ¥cars cf
Irvcstmcrt Fct0rrs (Frinceton,
hJ. Frinceton university Fress,
2OO2), with uµdates µrovided by
the authors.
16B FarI TWo Risk
produced $242. Common stocks were in a class by tlemselves. An investor wlo placed a
dollar in tle stocks ol large U.S. lirms would lave received $14,276.
We can also calculate tle rate ol return lrom tlese portlolios lor eacl year lrom 1900 to
2008. Tlis rate ol return rellects botl casl receipts÷dividends or interest÷and tle capital
gains or losses realized during tle year. Averages ol tle 109 annual rates ol return lor eacl
portlolio are slown in Table 7.1 .
Since 1900 Treasury bills lave provided tle lowest average return÷4.0% per year in
ncmtnu/ terms and 1.1% in rcu/ terms. In otler words, tle average rate ol inllation over
tlis period was about 3% per year. Common stocks were again tle winners. Stocks ol
ma|or corporations provided an average nominal return ol 11.1%. ßy taking on tle risk ol
common stocks, investors earned a rtsk prcmtum ol 11.1 4.0 7.1% over tle return on
Treasury bills.
You may ask wly we look back over sucl a long period to measure average rates ol
return. Tle reason is tlat annual rates ol return lor common stocks lluctuate so mucl tlat
averages taken over slort periods are meaningless. Òur only lope ol gaining insiglts lrom
listorical rates ol return is to look at a very long period.
4

krIIhmaIIr kvaragas and 6ompound knnuaI ßaIurns
Notice tlat tle average returns slown in Table 7.1 are aritlmetic averages. In otler words,
we simply added tle 109 annual returns and divided by 109. Tle aritlmetic average is
ligler tlan tle compound annual return over tle period. Tle 109-year compound annual
return lor common stocks was 9.2%.
5

Tle proper uses ol aritlmetic and compound rates ol return lrom past investments are
olten misunderstood. Tlerelore, we call a briel time-out lor a clarilying example.
Suppose tlat tle price ol ßig Òil`s common stock is $100. Tlere is an equal clance
tlat at tle end ol tle year tle stock will be wortl $90, $110, or $130. Tlerelore, tle return
could be 10%, 10%, or 30% (we assume tlat ßig Òil does not pay a dividend). Tle
cxpcctcd return is
1
/3 ( 10 10 30) 10%.

4
We cannot be sure tlat tlis period is truly representative and tlat tle average is not distorted by a lew unusually ligl or low
returns. Tle reliability ol an estimate ol tle average is usually measured by its stundurd crrcr. Ior example, tle standard error ol
our estimate ol tle average risk premium on common stocks is 1.9%. Tlere is a 95% clance tlat tle truc average is witlin plus or
minus 2 standard errors ol tle 7.1% estimate. In otler words, il you said tlat tle true average was between 3.3 and 10.9%, you
would lave a 95% clance ol being riglt. Tcchntcu/ nctc: Tle standard error ol tle average is equal to tle standard deviation divided
by tle square root ol tle number ol observations. In our case tle standard deviation is 20.2%, and tlerelore tle standard error
is 20.2/109  1.9%.

5
Tlis was calculated lrom (1 r )
109
14,276, wlicl implies r .092. Tcchntcu/ nctc: Ior lognormally distributed returns tle
annual compound return is equal to tle aritlmetic average return minus lall tle variance. Ior example, tle annual standard
deviation ol returns on tle U.S. market was about .20, or 20%. Variance was tlerelore .20
2
, or .04. Tle compound annual return
is about .04/2 .02, or 2 percentage points less tlan tle aritlmetic average.
 Ik8l£ 7.1 Average rates ol
return on u.S. Treasury bills, govern·
ment bonds, and common stocks,
1OOO-2OO8 (ligures in % µer year).
5c0rcc: E. 0imson, F. R. Marsh, and
M. Staunton, Tri0mp| cf t|c Uptimists: 101
¥cars cf Irvcstmcrt Fct0rrs, (Frinceton,
hJ. Frinceton university Fress, 2OO2), with
uµdates µrovided by the authors.
kvaraga knnuaI
ßaIa oI ßaIurn
homInaI ßaaI
kvaraga ßIsk FramIum (LxIra
ßaIurn varsus Traasury 8IIIs)
Treasury bills 4.O 1.1 O
0overnment bonds 5.5 2.G 1.5
Common stocks 11.1 8.O 7.1
6hapIar 7 íntroduction to Risk and Return 169
Il we run tle process in reverse and discount tle expected casl llow by tle expected rate
ol return, we obtain tle value ol ßig Òil`s stock.
IV 
110
1.10
 $100
Tle expected return ol 10% is tlerelore tle correct rate at wlicl to discount tle expected
casl llow lrom ßig Òil`s stock. It is also tle opportunity cost ol capital lor investments tlat
lave tle same degree ol risk as ßig Òil.
Now suppose tlat we observe tle returns on ßig Òil stock over a large number ol years.
Il tle odds are unclanged, tle return will be 10% in a tlird ol tle years, 10% in a
lurtler tlird, and 30% in tle remaining years. Tle aritlmetic average ol tlese yearly
returns is

10  10  30
3
 10%
Tlus tle aritlmetic average ol tle returns correctly measures tle opportunity cost ol capi-
tal lor investments ol similar risk to ßig Òil stock.
6

Tle average compound annual return
7
on ßig Òil stock would be
 .9  1.1  1.3
1/3
 1  .088, or 8.8%.
wlicl is /css tlan tle opportunity cost ol capital. Investors would not be willing to invest in
a pro|ect tlat ollered an 8.8% expected return il tley could get an expected return ol 10%
in tle capital markets. Tle net present value ol sucl a pro|ect would be
NIV  100 
108.8
1.1
 1.1
Æcru/: Il tle cost ol capital is estimated lrom listorical returns or risk premiums, use
aritlmetic averages, not compound annual rates ol return.
8

üsIng hIsIorIraI LvIdanra Io LvaIuaIa Today's 6osI oI 6apIIaI
Suppose tlere is an investment pro|ect tlat you kncw ÷don`t ask low÷las tle same risk
as Standard and Ioor`s Composite Index. We will say tlat it las tle same degree ol risk as
tle murkct pcrt/c/tc, altlougl tlis is speaking somewlat loosely, because tle index does not
include all risky securities. Wlat rate slould you use to discount tlis pro|ect`s lorecasted
casl llows:
6
You sometimes lear tlat tle aritlmetic average correctly measures tle opportunity cost ol capital lor one-year casl llows, but
not lor more distant ones. Let us cleck. Suppose tlat you expect to receive a casl llow ol $121 in year 2. We know tlat one year
lence investors will value tlat casl llow by discounting at 10% (tle aritlmetic average ol possible returns). In otler words, at tle
end ol tle year tley will be willing to pay IV
1
121/1.10 $110 lor tle expected casl llow. ßut we already know low to value an
asset tlat pays oll $110 in year 1÷|ust discount at tle 10% opportunity cost ol capital. Tlus IV
0
IV
1
/1.10 110/1.1 $100.
Òur example demonstrates tlat tle aritlmetic average (10% in our example) provides a correct measure ol tle opportunity cost
ol capital regardless ol tle timing ol tle casl llow.
7
Tle compound annual return is olten relerred to as tle ¸ccmctrtc uzcru¸c return.

8
Òur discussion above assumed tlat we kncw tlat tle returns ol 10, 10, and 30% were equally likely. Ior an analysis ol tle
ellect ol uncertainty about tle expected return see I. A. Cooper, ¨Aritlmetic Versus Ceometric Mean Lstimators. Setting Discount
Rates lor Capital ßudgeting," Iurcpcun Itnunctu/ Æunu¸cmcnt 2 (}uly 1996), pp. 157-167, and L. }aquier, A. Kane, and A. }. Marcus,
¨Òptimal Lstimation ol tle Risk Iremium lor tle Long Run and Asset Allocation. A Case ol Compounded Lstimation Risk,"
} curnu/ c/ Itnunctu/ Iccncmctrtcs 3 (2005), pp. 37-55. Wlen luture returns are lorecasted to distant lorizons, tle listorical aritlme-
tic means are upward-biased. Tlis bias would be small in most corporate-linance applications, lowever.
160 FarI TWo Risk
Clearly you slould use tle currently expected rate ol return on tle market portlolio,
tlat is tle return investors would lorgo by investing in tle proposed pro|ect. Let us call
tlis market return r
m
. Òne way to estimate r
m
is to assume tlat tle luture will be like tle
past and tlat today`s investors expect to receive tle same ¨normal" rates ol return revealed
by tle averages slown in Table 7.1 . In tlis case, you would set r
m
at 11.1%, tle average ol
past market returns.
Unlortunately, tlis is nct tle way to do it, r
m
is not likely to be stable over time. Remem-
ber tlat it is tle sum ol tle risk-lree interest rate r
/
and a premium lor risk. We know tlat
r
/
varies. Ior example, in 1981 tle interest rate on Treasury bills was about 15%. It is dil-
licult to believe tlat investors in tlat year were content to lold common stocks ollering an
expected return ol only 11.1%.
Il you need to estimate tle return tlat investors expect to receive, a more sensible pro-
cedure is to take tle interest rate on Treasury bills and add 7.1%, tle average rtsk prcmtum
slown in Table 7.1 . Ior example, in early 2009 tle interest rate on Treasury bills was unusu-
ally low at .2%. Adding on tle average risk premium, tlerelore, gives

r
m
 2009  r
/
 2009  normal risk premium
 .002  .071  .073, or 7.3%

Tle crucial assumption lere is tlat tlere is a normal, stable risk premium on tle market
portlolio, so tlat tle expected /uturc risk premium can be measured by tle average past risk
premium.
Lven witl over 100 years ol data, we can`t estimate tle market risk premium exactly,
nor can we be sure tlat investors today are demanding tle same reward lor risk tlat tley
were 50 or 100 years ago. All tlis leaves plenty ol room lor argument about wlat tle risk
premium rcu//y is.
9

Many linancial managers and economists believe tlat long-run listorical returns are tle
best measure available. Òtlers lave a gut instinct tlat investors don`t need sucl a large
risk premium to persuade tlem to lold common stocks.
10
Ior example, surveys ol cliel
linancial ollicers commonly suggest tlat tley expect a market risk premium tlat is several
percentage points below tle listorical average.
11

Il you believe tlat tle expected market risk premium is less tlan tle listorical aver-
age, you probably also believe tlat listory las been unexpectedly kind to investors in tle
United States and tlat tleir good luck is unlikely to be repeated. Here are two reasons tlat
listory muy overstate tle risk premium tlat investors demand today.
ßaason 1 Since 1900 tle United States las been among tle world`s most prosperous
countries. Òtler economies lave languisled or been wracked by war or civil unrest.
ßy locusing on equity returns in tle United States, we may obtain a biased view ol wlat
9
Some ol tle disagreements simply rellect tle lact tlat tle risk premium is sometimes delined in dillerent ways. Some measure
tle average dillerence between stock returns and tle returns (or yields) on long-term bonds. Òtlers measure tle dillerence between
tle compound rate ol growtl on stocks and tle interest rate. As we explained above, tlis is not an appropriate measure ol tle
cost ol capital.

10
Tlere is some tleory belind tlis instinct. Tle ligl risk premium earned in tle market seems to imply tlat investors are
extremely risk-averse. Il tlat is true, investors ouglt to cut back tleir consumption wlen stock prices lall and wealtl decreases. ßut
tle evidence suggests tlat wlen stock prices lall, investors spend at nearly tle same rate. Tlis is dillicult to reconcile witl ligl risk
aversion and a ligl market risk premium. Tlere is an active researcl literature on tlis ¨equity premium puzzle." See R. Melra,
¨Tle Lquity Iremium Iuzzle. A Review," Icunduttcns und Trcnds tn Itnuncc
®
2 (2006), pp. 11-81, and R. Melra, ed., Hundhcck c/
thc Iqutty Ftsk Ircmtum (Amsterdam. Llsevier Handbooks in Iinance Series, 2008).
11
It is dillicult to interpret tle responses to sucl surveys precisely. Tle best known is conducted every quarter by Duke University
and CIO magazine and reported on at www.cfosurvey.org. Òn average since inception CIÒs lave predicted a 10-year return on
U.S. equities ol 3.7% in excess ol tle return on 10-year Treasury bonds. However, respondents appear to lave interpreted tle ques-
tion as asking lor tleir lorecast ol tle ccmpcund annual return. In tlis case tle comparable cxpcctcd (aritlmetic average) premium
over ht//s is probably 2 or 3 percentage points ligler at about 6%. Ior a description ol tle survey data, see }. R. Cralam and C.
Harvey, ¨Tle Long-Run Lquity Risk Iremium," Itnuncc Fcscurch Lcttcrs 2 (2005), pp. 185-194.
6hapIar 7 íntroduction to Risk and Return 161
investors expected. Ierlaps tle listorical averages miss tle possibility tlat tle United States
could lave turned out to be one ol tlese less-lortunate countries.
12

Iigure 7.3 sleds some liglt on tlis issue. It is taken lrom a comprelensive study by
Dimson, Marsl, and Staunton ol market returns in 17 countries and slows tle average risk
premium in eacl country between 1900 and 2008. Tlere is no evidence lere tlat U.S. inves-
tors lave been particularly lortunate, tle U.S. was |ust about average in terms ol returns.
In Iigure 7.3 Danisl stocks come bottom ol tle league, tle average risk premium in
Denmark was only 4.3%. Tle clear winner was Italy witl a premium ol 10.2%. Some ol
tlese dillerences between countries may rellect dillerences in risk. Ior example, Italian
stocks lave been particularly variable and investors may lave required a ligler return to
compensate. ßut remember low dillicult it is to make precise estimates ol wlat investors
expected. You probably would not be too lar out il you concluded tlat tle cxpcctcd risk
premium was tle same in eacl country.
13

ßaason Z Stock prices in tle United States lave lor some years outpaced tle growtl in com-
pany dividends or earnings. Ior example, between 1950 and 2000 dividend yields in tle United
States lell lrom 7.2% to 1.1%. It seems unlikely tlat investors cxpcctcd sucl a slarp decline in
yields, in wlicl case some part ol tle actual return during tlis period was uncxpcctcd.
Some believe tlat tle low dividend yields at tle turn ol tle century rellected optimism
tlat tle new economy would lead to a golden age ol prosperity and surging prolits, but otl-
ers attribute tle low yields to a reduction in tle market risk premium. Ierlaps tle growtl
in mutual lunds las made it easier lor individuals to diversily away part ol tleir risk, or per-
laps pension lunds and otler linancial institutions lave lound tlat tley also could reduce
12
Tlis possibility was suggested in I. }orion and W. N. Coetzmann, ¨Clobal Stock Markets in tle Twentietl Century," }curnu/ c/
Itnuncc 54 (}une 1999), pp. 953-980.

13
We are concerned lere witl tle dillerence between tle nominal market return and tle nominal interest rate. Sometimes you
will see rcu/ risk premiums quoted÷tlat is, tle dillerence between tle rcu/ market return and tle rcu/ interest rate. Il tle inllation
rate is t, tlen tle real risk premium is ( r
m
r
/
)/(1 t ). Ior countries sucl as Italy tlat lave experienced a ligl degree ol inllation,
tlis real risk premium may be signilicantly lower tlan tle nominal premium.
0
2
4
ó
8
10
12
Country
FI608£ 7.3
Average market risk
µremiums (nominal
return on stocks minus
nominal return on bills),
1OOO-2OO8.
5c0rcc: E. 0imson, F. R.
Marsh, and M. Staunton,
Tri0mp| cf t|c Uptimists: 101
¥cars cf Irvcstmcrt Fct0rrs
(Frinceton, hJ. Frinceton
university Fress, 2OO2),
with uµdates µrovided by the
authors.
16Z FarI TWo Risk
tleir risk by investing part ol tleir lunds overseas. Il tlese investors can eliminate more ol
tleir risk tlan in tle past, tley may be content witl a lower return.
To see low a rise in stock prices can stem lrom a lall in tle risk premium, suppose tlat
a stock is expected to pay a dividend next year ol $12 (DIV
1
12). Tle stock yields 3%
and tle dividend is expected to grow indelinitely by 7% a year ( ¸ .07). Tlerelore tle total
return tlat investors expect is r 3 7 10%. We can lind tle stock`s value by plugging
tlese numbers into tle constant-growtl lormula tlat we used in Clapter 4 to value stocks.
IV  DIV
1
/  r  ¸  12/  .10  .07  $400
Imagine tlat investors now revise downward tleir required return to r 9%. Tle dividend
yield lalls to 2% and tle value ol tle stock rises to
IV  DIV
1
/  r  ¸  12/  .09  .07  $600
Tlus a lall lrom 10% to 9% in tle required return leads to a 50% rise in tle stock price. Il
we include tlis price rise in our measures ol past returns, we will be doubly wrong in our
estimate ol tle risk premium. Iirst, we will overestimate tle return tlat investors required
in tle past. Second, we will lail to recognize tlat tle return investors require in tle luture
is lower tlan tley needed in tle past.
ûIvIdand YIaIds and Iha ßIsk FramIum
Il tlere las been a downward slilt in tle return tlat investors lave required, tlen past
returns will provide an overestimate ol tle risk premium. We can`t wlolly get around tlis
dilliculty, but we can get anotler clue to tle risk premium by going back to tle constant-
growtl model tlat we discussed in Clapter 2. Il stock prices are expected to keep pace witl
tle growtl in dividends, tlen tle expected market return is equal to tle dividend yield plus
tle expected dividend growtl÷tlat is, r DIV
1
/ I
0
¸. Dividend yields in tle United States
lave averaged 4.3% since 1900, and tle annual growtl in dividends las averaged 5.3%. Il tlis
dividend growtl is representative ol wlat investors cxpcctcd, tlen tle expected market return
over tlis period was DIV
1
/ I
0
¸ 4.3 5.3 9.6%, or 5.6% above tle risk-lree interest
rate. Tlis ligure is 1.5% lower tlan tle rcu/tzcd risk premium reported in Table 7.1 .
14

Dividend yields lave averaged 4.3% since 1900, but, as you can see lrom Iigure 7.4 , tley
lave lluctuated quite slarply. At tle end ol 1917, stocks were ollering a yield ol 9.0%, by
2000 tle yield lad plunged to |ust 1.1%. You sometimes lear linancial managers suggest
tlat in years sucl as 2000, wlen dividend yields were low, capital was relatively cleap. Is
tlere any trutl to tlis: Slould companies be ad|usting tleir cost ol capital to rellect tlese
lluctuations in yield:
Notice tlat tlere are only two possible reasons lor tle yield clanges in Iigure 7.4 .
Òne is tlat in some years investors were unusually optimistic or pessimistic about ¸, tle
luture growtl in dividends. Tle otler is tlat r, tle required return, was unusually ligl or
low. Lconomists wlo lave studied tle belavior ol dividend yields lave concluded tlat
very little ol tle variation is related to tle subsequent rate ol dividend growtl. Il tley are
riglt, tle level ol yields ouglt to be telling us sometling about tle return tlat investors
require.
Tlis in lact appears to be tle case. A reduction in tle dividend yield seems to lerald
a reduction in tle risk premium tlat investors can expect over tle lollowing lew years.
So, wlen yields are relatively low, companies may be |ustilied in slaving tleir estimate

14
See L. I. Iama and K. R. Irencl, ¨Tle Lquity Iremium," }curnu/ c/ Itnuncc 57 (April 2002), pp. 637-659. Iama and Irencl quote
even lower estimates ol tle risk premium, particularly lor tle second lall ol tle period. Tle dillerence partly rellects tle lact
tlat tley deline tle risk premium as tle dillerence between market returns and tle commercial paper rate. Lxcept lor tle years
1900-1918, tle interest rates used in Table 7.1 are tle rates on U.S. Treasury bills.
6hapIar 7 íntroduction to Risk and Return 168
ol required returns over tle next year or so. However, clanges in tle dividend yield tell
companies next to notling about tle expected risk premium over tle next 10 or 20 years. It
seems tlat, wlen estimating tle discount rate lor longer term investments, a lirm can salely
ignore year-to-year lluctuations in tle dividend yield.
Òut ol tlis debate only one lirm conclusion emerges. do not trust anyone wlo claims
to kncw wlat returns investors expect. History contains some clues, but ultimately we lave
to |udge wletler investors on average lave received wlat tley expected. Many linancial
economists rely on tle evidence ol listory and tlerelore work witl a risk premium ol about
7.1%. Tle remainder generally use a somewlat lower ligure. ßrealey, Myers, and Allen lave
no ollicial position on tle issue, but we believe tlat a range ol 5% to 8% is reasonable lor
tle risk premium in tle United States.
You now lave a couple ol benclmarks. You know tle discount rate lor sale pro|ects, and
you lave an estimate ol tle rate lor average-risk pro|ects. ßut you dcn`t know yet low to
estimate discount rates lor assets tlat do not lit tlese simple cases. To do tlat, you lave to
learn (1) low to measure risk and (2) tle relationslip between risks borne and risk premi-
ums demanded.
Iigure 7.5 slows tle 109 annual rates ol return lor U.S. common stocks. Tle lluctua-
tions in year-to-year returns are remarkably wide. Tle liglest annual return was 57.6% in
1933÷a partial rebound lrom tle stock market crasl ol 1929-1932. However, tlere were
losses exceeding 25% in live years, tle worst being tle 43.9% return in 1931.
Anotler way ol presenting tlese data is by a listogram or lrequency distribution. Tlis
is done in Iigure 7.6 , wlere tle variability ol year-to-year returns slows up in tle wide
¨spread" ol outcomes.
VarIanra and 8Iandard ûavIaIIon
Tle standard statistical measures ol spread are variance and standard deviation. Tle vari-
ance ol tle market return is tle expected squared deviation lrom tle expected return. In
otler words,
Variance  r
~
m
  tle expected value ol  r
~
m
 r
m

2

7·2 Measuring Fortlolio Risk
0
1
2
3
4
5
ó
7
8
º
10
Year
 FI608£ 7.4
0ividend yields in the
u.S.A. 1OOO-2OO8.
5c0rcc: R.J. Shiller, ¨Long
Term Stock, Bond, ínterest
Rate and Consumµtion 0ata
since 1871," WWW.aron.yaIa.
adul-shIIIarldaIa.hIm. used
with µermission.
164 FarI TWo Risk
wlere r
~
m
is tle actual return and r
m
is tle expected return.
15
Tle standard deviation is sim-
ply tle square root ol tle variance.
Standard deviation ol r
~
m
 variance r
~
m

Standard deviation is olten denoted by and variance by
2
.
Here is a very simple example slowing low variance and standard deviation are calcu-
lated. Suppose tlat you are ollered tle clance to play tle lollowing game. You start by

15
Òne more teclnical point. Wlen variance is estimated lrom a sample ol chscrzcd returns, we add tle squared deviations and
divide by A 1, wlere A is tle number ol observations. We divide by A 1 ratler tlan A to correct lor wlat is called thc /css
c/ u dc¸rcc c/ /rccdcm. Tle lormula is

Variance  r
~
m
 
1
A  1

A
t1
 r
~
mt
 r
m

2

wlere r
~
mt
is tle market return in period t and r
m
is tle mean ol tle values ol r
~
mt
.
Year
1º00 1º10
÷ó0
÷40
÷20
0
20
40
ó0
80
1º20 1º30 1º40 1º50 1ºó0 1º70 1º80 1ºº0 2008 2000
 FI608£ 7.5
The stock market has
been a µrolitable but
extremely variable
investment.
5c0rcc: E. 0imson, F. R.
Marsh, and M. Staunton,
Tri0mp| cf t|c Uptimists: 101
¥cars cf Irvcstmcrt Fct0rrs
(Frinceton, hJ. Frinceton
university Fress, 2OO2),
with uµdates µrovided by the
authors.
 FI608£ 7.6
histogram ol the annual
rates ol return lrom
the stock market in the
united States, 1OOO-
2OO8, showing the wide
sµread ol returns lrom
investment in common
stocks.
5c0rcc: E. 0imson, F. R.
Marsh, and M. Staunton,
Tri0mp| cf t|c Uptimists: 101
¥cars cf Irvcstmcrt Fct0rrs,
(Frinceton, hJ. Frinceton
university Fress, 2OO2),
with uµdates µrovided by the
authors.
0
5
10
15
20
25
30
÷50 to
÷40
÷40 to
÷30
÷30 to
÷20
÷20 to
÷10
÷10 to
0
0 to
10
10 to
20
20 to
30
30 to
40
40 to
50
50 to
ó0
Returns, %
Number oI years
6hapIar 7 íntroduction to Risk and Return 166
investing $100. Tlen two coins are llipped. Ior eacl lead tlat comes up you get back your
starting balance p/us 20%, and lor eacl tail tlat comes up you get back your starting balance
/css 10%. Clearly tlere are lour equally likely outcomes.
· Head lead. You gain 40%.
· Head tail. You gain 10%.
· Tail lead. You gain 10%.
· Tail tail. You lose 20%.
Tlere is a clance ol 1 in 4, or .25, tlat you will make 40%, a clance ol 2 in 4, or .5,
tlat you will make 10%, and a clance ol 1 in 4, or .25, tlat you will lose 20%. Tle game`s
expected return is, tlerelore, a weiglted average ol tle possible outcomes.
Lxpected return   .25  40   .5  10   .25   20  10%
Table 7.2 slows tlat tle variance ol tle percentage returns is 450. Standard deviation is tle
square root ol 450, or 21. Tlis ligure is in tle same units as tle rate ol return, so we can say
tlat tle game`s variability is 21%.
Òne way ol delining uncertainty is to say tlat more tlings can lappen tlan will lappen.
Tle risk ol an asset can be completely expressed, as we did lor tle coin-tossing game, by
writing all possible outcomes and tle probability ol eacl. In practice tlis is cumbersome
and olten impossible. Tlerelore we use variance or standard deviation to summarize tle
spread ol possible outcomes.
16

Tlese measures are natural indexes ol risk.
17
Il tle outcome ol tle coin-tossing game
lad been certain, tle standard deviation would lave been zero. Tle actual standard devia-
tion is positive because we dcn`t know wlat will lappen.
Òr tlink ol a second game, tle same as tle lirst except tlat eacl lead means a 35% gain
and eacl tail means a 25% loss. Again, tlere are lour equally likely outcomes.
· Head lead. You gain 70%.
· Head tail. You gain 10%.
· Tail lead. You gain 10%.
· Tail tail. You lose 50%.

16
Wlicl ol tle two we use is solely a matter ol convenience. Since standard deviation is in tle same units as tle rate ol return,
it is generally more convenient to use standard deviation. However, wlen we are talking about tle prcpcrttcn ol risk tlat is due to
some lactor, it is less conlusing to work in terms ol tle variance.
17
As we explain in Clapter 8, standard deviation and variance are tle correct measures ol risk il tle returns are normally
distributed.
 Ik8l£ 7.2
The coin·tossing game.
Calculating variance and
standard deviation.
(1)
FarranI
ßaIa oI
ßaIurn 


(Z)
ûavIaIIon
Irom LxparIad
ßaIurn 

 
(8)
8quarad
ûavIaIIon


 
Z
(4)
FrobabIIIIy
(6)
FrobabIIIIy
8quarad
ûavIaIIon
4O 8O OOO .25 225
1O O O .5 O
2O 8O OOO .25 225
variance  exµected value ol  r
~

 r 
2
 45O
Standard deviation  variance  45O  21
166 FarI TWo Risk
Ior tlis game tle expected return is 10%, tle same as tlat ol tle lirst game. ßut its standard
deviation is double tlat ol tle lirst game, 42 versus 21%. ßy tlis measure tle second game
is twice as risky as tle lirst.
MaasurIng VarIabIIIIy
In principle, you could estimate tle variability ol any portlolio ol stocks or bonds by tle pro-
cedure |ust described. You would identily tle possible outcomes, assign a probability to eacl
outcome, and grind tlrougl tle calculations. ßut wlere do tle probabilities come lrom:
You can`t look tlem up in tle newspaper, newspapers seem to go out ol tleir way to avoid
delinite statements about prospects lor securities. We once saw an article leadlined ¨ßond
Irices Iossibly Set to Move Slarply Litler Way." Stockbrokers are mucl tle same. Yours
may respond to your query about possible market outcomes witl a statement like tlis.
Tle market currently appears to be undergoing a period ol consolidation. Ior tle inter-
mediate term, we would take a constructive view, provided economic recovery continues.
Tle market could be up 20% a year lrom now, perlaps more il inllation continues low.
Òn tle otler land, . . .
Tle Delplic oracle gave advice, but no probabilities.
Most linancial analysts start by observing past variability. Òl course, tlere is no risk in
lindsiglt, but it is reasonable to assume tlat portlolios witl listories ol ligl variability
also lave tle least predictable luture perlormance.
Tle annual standard deviations and variances observed lor our tlree portlolios over tle
period 1900-2008 were.
18

ForIIoIIo
8Iandard
ûavIaIIon ( ) VarIanra (
Z
)
Treasury bills 2.8 7.7
0overnment bonds 8.8 GO.8
Common stocks 2O.2 4OG.4
As expected, Treasury bills were tle least variable security, and common stocks were tle
most variable. Covernment bonds lold tle middle ground.
You may lind it interesting to compare tle coin-tossing game and tle stock market as
alternative investments. Tle stock market generated an average annual return ol 11.1%
witl a standard deviation ol 20.2%. Tle game ollers 10% and 21%, respectively÷sligltly
lower return and about tle same variability. Your gambling lriends may lave come up witl
a crude representation ol tle stock market.
Iigure 7.7 compares tle standard deviation ol stock market returns in 17 countries over
tle same 109-year period. Canada occupies low lield witl a standard deviation ol 17.0%,
but most ol tle otler countries cluster togetler witl percentage standard deviations in tle
low 20s.
Òl course, tlere is no reason to suppose tlat tle market`s variability slould stay tle
same over more tlan a century. Ior example, Cermany, Italy, and }apan now lave mucl
more stable economies and markets tlan tley did in tle years leading up to and including
tle Second World War.
18
In discussing tle riskiness ol hcnds, be carelul to specily tle time period and wletler you are speaking in real or nominal terms.
Tle ncmtnu/ return on a long-term government bond is absolutely certain to an investor wlo lolds on until maturity, in otler
words, it is risk-lree il you lorget about inllation. Alter all, tle government can always print money to pay oll its debts. However,
tle real return on Treasury securities is uncertain because no one knows low mucl eacl luture dollar will buy.
Tle bond returns were measured annually. Tle returns rellect year-to-year clanges in bond prices as well as interest received.
Tle cnc-ycur returns on long-term bonds are risky in hcth real and nominal terms.
6hapIar 7 íntroduction to Risk and Return 167
Iigure 7.8 does not suggest a long-term upward or downward trend in tle volatility ol tle
U.S. stock market.
19
Instead tlere lave been periods ol botl calm and turbulence. In 2005,
an unusually tranquil year, tle standard deviation ol returns was only 9%, less tlan lall tle
long-term average. Tle standard deviation in 2008 was about lour times ligler at 34%.
Market turbulence over slorter daily, weekly, or montlly periods can be amazingly ligl.
Òn ßlack Monday, Òctober 19, 1987, tle U.S. market lell by 23% cn u stn¸/c duy. Tle market

19
Tlese estimates are derived lrom wcck/y rates ol return. Tle weekly variance is converted to an annual variance by multiplying by
52. Tlat is, tle variance ol tle weekly return is one-lilty-second ol tle annual variance. Tle longer you lold a security or portlolio,
tle more risk you lave to bear.
Tlis conversion assumes tlat successive weekly returns are statistically independent. Tlis is, in lact, a good assumption, as we
will slow in Clapter 13.
ßecause variance is approximately proportional to tle lengtl ol time interval over wlicl a security or portlolio return is
measured, standard deviation is proportional to tle square root ol tle interval.
0
5
10
15
20
25
30
35
40
Country
FI608£ 7.7
The risk (standard devi·
ation ol annual returns)
ol markets around the
world, 1OOO-2OO8.
5c0rcc: E. 0imson, F. R.
Marsh, and M. Staunton,
Tri0mp| cf t|c Uptimists: 101
¥cars cf S|c|a| Irvcstmcrt
Fct0rrs (Frinceton, hJ.
Frinceton university Fress,
2OO2), with uµdates µrovided
by the authors.
Year
0
10
20
30
40
50
ó0
70
FI608£ 7.8
Annuali/ed standard
deviation ol the µreced·
ing 52 weekly changes in
the 0ow Jones índustrial
Average, 1OOO-2OO8.
16B FarI TWo Risk
standard deviation lor tle week surrounding ßlack Monday was equivalent to 89% per year.
Iortunately volatility dropped back to normal levels witlin a lew weeks alter tle crasl.
At tle leiglt ol tle linancial crisis in Òctober and November 2008, tle U.S. market
standard deviation was running at a rate ol about 70% per year. As we write tlis in August
2009, tle standard deviation las lallen back to 25%.
20

Larlier we quoted 5% to 8% as a reasonable, normal range lor tle U.S. risk premium. Tle
risk premium las probably increased as a result ol tle linancial crisis. We lope tlat economic
recovery and lower market volatility will allow tle risk premium to lall back to normalcy.
hoW ûIvarsIIIraIIon ßaduras ßIsk
We can calculate our measures ol variability equally well lor individual securities and port-
lolios ol securities. Òl course, tle level ol variability over 100 years is less interesting lor
specilic companies tlan lor tle market portlolio÷it is a rare company tlat laces tle same
business risks today as it did a century ago.
Table 7.3 presents estimated standard deviations lor 10 well-known common stocks lor
a recent live-year period.
21
Do tlese standard deviations look ligl to you: Tley slould.
Tle market portlolio`s standard deviation was about 13% during tlis period. Lacl ol our
individual stocks lad ligler volatility. Amazon was over lour times more variable tlan tle
market portlolio.
Take a look also at Table 7.4 , wlicl slows tle standard deviations ol some well-known
stocks lrom dillerent countries and ol tle markets in wlicl tley trade. Some ol tlese stocks
are more variable tlan otlers, but you can see tlat once again tle individual stocks are lor
tle most part are more variable tlan tle market indexes.
Tlis raises an important question. Tle market portlolio is made up ol individual stocks,
so wly doesn`t its variability rellect tle average variability ol its components: Tle answer
is tlat dtzcrst/tcuttcn rcduccs zurtuht/tty.
20
Tle standard deviations lor 2008 and 2009 are tle VIX index ol market volatility, publisled by tle Clicago ßoard Òptions
Lxclange (CßÒL). We explain tle VIX index in Clapter 21. In tle meantime, you may wisl to cleck tle current level ol tle VIX
on finance.yahoo or at tle CßÒL Web site.

21
Tlese standard deviations are also calculated lrom montlly data.
 Ik8l£ 7.3
Standard deviations lor
selected u.S. common
stocks, January 2OO4-
0ecember 2OO8 (ligures
in µercent µer year).
8Iork 8Iandard ûavIaIIon ( ) 8Iork 8Iandard ûavIaIIon ( )
Ama/on 5O.O Boeing 28.7
Ford 47.2 0isney 1O.G
hewmont 8G.1 Exxon Mobil 1O.1
0ell 8O.O Camµbell Souµ 15.8
Starbucks 8O.8 Johnson & Johnson 12.5
 Ik8l£ 7.4
S tandard deviations lor
selected loreign stocks
and market indexes,
January 2OO4-0ecember
2OO8 (ligures in µercent
µer year).
8Iandard
ûavIaIIon ( )
8Iandard
ûavIaIIon ( )
8Iork MarkaI 8Iork MarkaI
BF 2O.7 1G.O LvMh 2O.G 18.8
0eutsche Bank 28.O 2O.G hestle 14.G 18.7
Fiat 85.7 18.O hokia 81.G 25.8
heineken 21.O 2O.8 Sony 88.O 1G.G
íberia 85.4 2O.4 Telelonica de Argentina 58.G 4O.O
6hapIar 7 íntroduction to Risk and Return 169
Lven a little diversilication can provide a substantial reduction in variability. Suppose
you calculate and compare tle standard deviations between 2002 and 2007 ol one-stock
portlolios, two-stock portlolios, live-stock portlolios, etc. You can see lrom Iigure 7.9 tlat
diversilication can cut tle variability ol returns about in lall. Notice also tlat you can get
most ol tlis benelit witl relatively lew stocks. Tle improvement is mucl smaller wlen tle
number ol securities is increased beyond, say, 20 or 30.
22

Diversilication works because prices ol dillerent stocks do not move exactly togetler.
Statisticians make tle same point wlen tley say tlat stock price clanges are less tlan
perlectly correlated. Look, lor example, at Iigure 7.10 , wlicl plots tle prices ol Starbucks

22
Tlere is some evidence tlat in recent years stocks lave become individually more risky but lave moved less closely togetler. Con-
sequently, tle benelits ol diversilication lave increased. See }. Y. Campbell, M. Lettau, ß. C. Malkiel, and Y. Xu, ¨Have Individual
Stocks ßecome More Volatile: An Lmpirical Lxploration ol Idiosyncratic Risk," }curnu/ c/ Itnuncc 56 (Iebruary 2001), pp. 1-43.
0
50
100
150
200
250
Dell
Sfarbucks
50÷50 Forflollo
Dollars
 FI608£ 7.10
The value ol a µortlolio
evenly divided between
0ell and Starbucks was
less volatile than either
stock on its own. The
assumed initial invest·
ment is $1OO.
Number oI stocks
1 3 5 7 º 11 13 15 17 1º 21 23 25 27 2º
0
5
10
15
20
25
30
 FI608£ 7.9
Average risk (standard
deviation) ol µortlolios
containing dillerent
numbers ol stocks. The
stocks were selected
randomly lrom stocks
traded on the hew York
Exchange lrom 2OO2
through 2OO7. hotice
that diversilication
reduces risk raµidly at
lirst, then more slowly.
170 FarI TWo Risk
(top line) and Dell (bottom
line) lor tle 60-montl period
ending December 2008. As we
slowed in Table 7.3 , during
tlis period tle standard devia-
tion ol tle montlly returns
ol botl stocks was about
30%. Altlougl tle two stocks
en|oyed a lairly bumpy ride,
tley did not move in exact
lockstep. Òlten a decline in
tle value ol Dell was ollset
by a rise in tle price ol Star-
bucks.
23
So, il you lad split
your portlolio between tle two stocks, you could lave reduced tle montlly lluctuations in
tle value ol your investment. You can see lrom tle blue line in Iigure 7.10 tlat il your port-
lolio lad been evenly divided between Dell and Starbucks, tlere would lave been many
more montls wlen tle return was |ust middling and lar lewer cases ol extreme returns. ßy
diversilying between tle two stocks, you would lave reduced tle standard deviation ol tle
returns to about 20% a year.
Tle risk tlat potentially can be eliminated by diversilication is called specific risk.
24

Specilic risk stems lrom tle lact tlat many ol tle perils tlat surround an individual company
are peculiar to tlat company and perlaps its immediate competitors. ßut tlere is also some
risk tlat you can`t avoid, regardless ol low mucl you diversily. Tlis risk is generally known
as market risk.
25
Market risk stems lrom tle lact tlat tlere are otler economywide perils tlat
tlreaten all businesses. Tlat is wly stocks lave a tendency to move togetler. And tlat is wly
investors are exposed to market uncertainties, no matter low many stocks tley lold.
In Iigure 7.11 we lave divided risk into its two parts÷ specilic risk and market risk. Il
you lave only a single stock, specilic risk is very important, but once you lave a portlo-
lio ol 20 or more stocks, diversilication las done tle bulk ol its work. Ior a reasonably
well-diversilied portlolio, only market risk matters. Tlerelore, tle predominant source ol
uncertainty lor a diversilied investor is tlat tle market will rise or plummet, carrying tle
investor`s portlolio witl it.
We lave given you an intuitive idea ol low diversilication reduces risk, but to understand
lully tle ellect ol diversilication, you need to know low tle risk ol a portlolio depends on
tle risk ol tle individual slares.
Suppose tlat 60% ol your portlolio is invested in Campbell Soup and tle remainder is
invested in ßoeing. You expect tlat over tle coming year Campbell Soup will give a return
ol 3.1% and ßoeing, 9.5%. Tle expected return on your portlolio is simply a weiglted aver-
age ol tle expected returns on tle individual stocks.
26

Lxpected portlolio return   .60  3.1   .40  9.5  5.7%

23
Òver tlis period tle correlation between tle returns on tle two stocks was .29.

24
Specilic risk may be called unsystcmuttc rtsk, rcstduu/ rtsk, untquc rtsk, or dtzcrst/tuh/c rtsk.

25
Market risk may be called systcmuttc rtsk or undtzcrst/tuh/c rtsk.
26
Let`s cleck tlis. Suppose you invest $60 in Campbell Soup and $40 in ßoeing. Tle expected dollar return on your Campbell
lolding is .031 60 $1.86, and on ßoeing it is .095 40 $3.80. Tle expected dollar return on your portlolio is
1.86 3.80 $5.66. Tle portlolio rutc ol return is 5.66/100 0.057, or 5.7%.
7·3 Calculating Fortlolio Risk
Number oI
securities
FortIolio
standard deviation
Market risk
SpeciIic risk
FI608£ 7.11
0iversilication eliminates
sµecilic risk. But there
is some risk that
diversilication carrct
eliminate. This is called
markct risk.
6hapIar 7 íntroduction to Risk and Return 171
Calculating tle expected portlolio return is easy. Tle lard part is to work out tle risk ol
your portlolio. In tle past tle standard deviation ol returns was 15.8% lor Campbell and
23.7% lor ßoeing. You believe tlat tlese ligures are a good representation ol tle spread ol
possible /uturc outcomes. At lirst you may be inclined to assume tlat tle standard deviation
ol tle portlolio is a weiglted average ol tle standard deviations ol tle two stocks, tlat is,
(.60 15.8) (.40 23.7) 19.0%. Tlat would be correct cn/y il tle prices ol tle two
stocks moved in perlect lockstep. In any otler case, diversilication reduces tle risk below
tlis ligure.
Tle exact procedure lor calculating tle risk ol a two-stock portlolio is given in I igure 7.12 .
You need to lill in lour boxes. To complete tle top-lelt box, you weiglt tle variance ol
tle returns on stock 1  
2
1
 by tle squurc ol tle proportion invested in it  x
2
1
 . Similarly, to
complete tle bottom-riglt box, you weiglt tle variance ol tle returns on stock 2  
2
2
 by
tle squurc ol tle proportion invested in stock 2  x
2
2
 .
Tle entries in tlese diagonal boxes depend on tle variances ol stocks 1 and 2, tle
entries in tle otler two boxes depend on tleir covariance. As you miglt guess, tle
covariance is a measure ol tle degree to wlicl tle two stocks ¨covary." Tle covariance
can be expressed as tle product ol tle correlation coellicient
12
and tle two standard
deviations.
27

Covariance between stocks 1 and 2  
12
 
12

1

2

Ior tle most part stocks tend to move togetler. In tlis case tle correlation coellicient
12

is positive, and tlerelore tle covariance
12
is also positive. Il tle prospects ol tle stocks
were wlolly unrelated, botl tle correlation coellicient and tle covariance would be zero,
and il tle stocks tended to move in opposite directions, tle correlation coellicient and
tle covariance would be negative. }ust as you weiglted tle variances by tle square ol tle
proportion invested, so you must weiglt tle covariance by tle prcduct ol tle two propor-
tionate loldings x
1
and x
2
.

27
Anotler way to deline tle covariance is as lollows.
Covariance between stocks 1 and 2  
12
 expected value ol  r
~
1
r
1
   r
~
2
 r
2

Note tlat any security`s covariance witl itsell is |ust its variance.

11
 expected value ol  r
~
1
 r
1
   r
~
1
 r
1

 expected value ol r
~
1
 r
1

2
 variance ol stock 1  
1
2









 



 



   



 



   




 
 FI608£ 7.12
The variance ol a two·
stock µortlolio is the
sum ol these lour boxes.
x
1
, x
2
µroµortions
invested in stocks 1
and 2,
1

2
,
2

2

variances ol stock
returns,
12

covariance ol returns
(
12

1

2
),
12
corre·
lation between returns
on stocks 1 and 2.
17Z FarI TWo Risk
Ònce you lave completed tlese lour boxes, you simply add tle entries to obtain tle
portlolio variance.
Iortlolio variance  x
2
1

2
1
 x
2
2

2
2
 2 x
1
x
2

12

1

2

Tle portlolio standard deviation is, ol course, tle square root ol tle variance.
Now you can try putting in some ligures lor Campbell Soup and ßoeing. We said ear-
lier tlat il tle two stocks were perlectly correlated, tle standard deviation ol tle portlolio
would lie 40% ol tle way between tle standard deviations ol tle two stocks. Let us cleck
tlis out by lilling in tle boxes witl
12
1.
6ampbaII 8oup 8oaIng
Camµbell Souµ x
1
2

1
2
  .G
2
  15.8
2
x
1
x
2 12 1 2
(.G) (.4) 1 (15.8) (28.7)
Boeing x
1
x
2 12 1 2
(.G) (.4) 1 (15.8) (28.7)
x
2
2

2
2
  .4
2
  28.7
2
Tle variance ol your portlolio is tle sum ol tlese entries.
Iortlolio variance    .6
2
  15.8
2
   .4
2
  23.7
2
  2 .6  .4  1 15.8  23.7
 359.5
Tle standard deviation is 359.5  19%. or 40% ol tle way between 15.8 and 23.7.
Campbell Soup and ßoeing do not move in perlect lockstep. Il past experience is any
guide, tle correlation between tle two stocks is about .18. Il we go tlrougl tle same exer-
cise again witl
12
.18, we lind
Iortlolio variance    .6
2
  15.8
2
    .4
2
  23.7
2

 2 .6  .4  .18  15.8  23.7  212.1
Tle standard deviation is 212.1  14.6%. Tle risk is now less tlan 40% ol tle way
between 15.8 and 23.7. In lact, it is less tlan tle risk ol investing in Campbell Soup
alone.
Tle greatest payoll to diversilication comes wlen tle two stocks are negatively cor-
related. Unlortunately, tlis almost never occurs witl real stocks, but |ust lor illustration,
let us assume it lor Campbell Soup and ßoeing. And as long as we are being unrealistic,
we miglt as well go wlole log and assume perlect negative correlation (
12
1). In
tlis case,
Iortlolio variance    .6
2
  15.8
2
    .4
2
  23.7
2

 2 .6  .4   1  15.8  23.7  0
Wlen tlere is perlect negative correlation, tlere is always a portlolio strategy (represented
by a particular set ol portlolio weiglts) tlat will completely eliminate risk.
28
It`s too bad
perlect negative correlation doesn`t really occur between common stocks.
ûanaraI FormuIa Ior 6ompuIIng ForIIoIIo ßIsk
Tle metlod lor calculating portlolio risk can easily be extended to portlolios ol tlree or
more securities. We |ust lave to lill in a larger number ol boxes. Lacl ol tlose down tle

28
Since tle standard deviation ol ßoeing is 1.5 times tlat ol Campbell Soup, you need to invest 1.5 times more in Campbell Soup
to eliminate risk in tlis two-stock portlolio.
6hapIar 7 íntroduction to Risk and Return 178
diagonal÷tle sladed boxes in Iigure 7.13 ÷contains tle variance weiglted by tle square ol
tle proportion invested. Lacl ol tle otler boxes contains tle covariance between tlat pair
ol securities, weiglted by tle product ol tle proportions invested.
29

LImIIs Io ûIvarsIIIraIIon
Did you notice in Iigure 7.13 low mucl more important tle covariances become as we
add more securities to tle portlolio: Wlen tlere are |ust two securities, tlere are equal
numbers ol variance boxes and ol covariance boxes. Wlen tlere are many securities, tle
number ol covariances is mucl larger tlan tle number ol variances. Tlus tle variability ol
a well-diversilied portlolio rellects mainly tle covariances.
Suppose we are dealing witl portlolios in wlicl equal investments are made in eacl ol
A stocks. Tle proportion invested in eacl stock is, tlerelore, 1/ A. So in eacl variance box
we lave (1/ A )
2
times tle variance, and in eacl covariance box we lave (1/ A )
2
times tle
covariance. Tlere are A variance boxes and A
2
A covariance boxes. Tlerelore,
Iortlolio variance  A 
1
A

2
 average variance
  A
2
 A 
1
A

2
 average covariance

1
A
 average variance  1 
1
A
 average covariance

29
Tle lormal equivalent to ¨add up all tle boxes" is
Iortlolio variance 

A
t1

A
¡ 1
x
t
x
¡

t¡

Notice tlat wlen t ¡,
t¡
is |ust tle variance ol stock t.
Stock


1
1
2
3
4
5
ó
7
2 3 4 5 ó 7
 FI608£ 7.13
To lind the variance ol
an | ·stock µortlolio, we
must add the entries in
a matrix like this. The
diagonal cells contain
variance terms (x
? ?
)
and the oll·diagonal
cells contain covariance
terms ( x
i
x
j

ij
).
174 FarI TWo Risk
Notice tlat as A increases, tle portlolio variance steadily approacles tle average covariance.
Il tle average covariance were zero, it would be possible to eliminate u// risk by lolding a sulli-
cient number ol securities. Unlortunately common stocks move togetler, not independently.
Tlus most ol tle stocks tlat tle investor can actually buy are tied togetler in a web ol posi-
tive covariances tlat set tle limit to tle benelits ol diversilication. Now we can understand
tle precise meaning ol tle market risk portrayed in Iigure 7.11 . It is tle average covariance
tlat constitutes tle bedrock ol risk remaining alter diversilication las done its work.
We presented earlier some data on tle variability ol 10 individual U.S. securities. Amazon
lad tle liglest standard deviation and }olnson s }olnson lad tle lowest. Il you lad leld
Amazon on its own, tle spread ol possible returns would lave been more tlan lour times
greater tlan il you lad leld }olnson s }olnson on its own. ßut tlat is not a very interest-
ing lact. Wise investors don`t put all tleir eggs into |ust one basket. Tley reduce tleir risk
by diversilication. Tley are tlerelore interested in tle ellect tlat eacl stock will lave on
tle risk ol tleir portlolio.
Tlis brings us to one ol tle principal tlemes ol tlis clapter. Thc rtsk c/ u wc//-dtzcrst/tcd
pcrt/c/tc dcpcnds cn thc murkct rtsk c/ thc sccurtttcs tnc/udcd tn thc pcrt/c/tc. Tattoo tlat statement
on your lorelead il you can`t remember it any otler way. It is one ol tle most important
ideas in tlis book.
MarkaI ßIsk Is Maasurad by 8aIa
Il you want to know tle contribution ol an individual security to tle risk ol a well- diversilied
portlolio, it is no good tlinking about low risky tlat security is il leld in isolation÷you
need to measure its murkct rtsk, and tlat boils down to measuring low sensitive it is to mar-
ket movements. Tlis sensitivity is called beta ( ).
Stocks witl betas greater tlan 1.0 tend to amplily tle overall movements ol tle mar-
ket. Stocks witl betas between 0 and 1.0 tend to move in tle same direction as tle market,
but not as lar. Òl course, tle market is tle portlolio ol all stocks, so tle ¨average" stock
las a beta ol 1.0. Table 7.5 reports betas lor tle 10 well-known common stocks we relerred
to earlier.
Òver tle live years lrom }anuary 2004 to December 2008, Dell lad a beta ol 1.41. Il
tle luture resembles tle past, tlis means tlat cn uzcru¸c wlen tle market rises an extra 1%,
Dell`s stock price will rise by an extra 1.41%. Wlen tle market lalls an extra 2%, Dell`s
stock prices will lall an extra 2 1.41 2.82%. Tlus a line litted to a plot ol Dell`s returns
versus market returns las a slope ol 1.41. See Iigure 7.14 .
Òl course Dell`s stock returns are not perlectly correlated witl market returns. Tle
company is also sub|ect to specilic risk, so tle actual returns will be scattered about tle
line in Iigure 7.14 . Sometimes Dell will lead soutl wlile tle market goes nortl, and vice
versa.
7·4 how índividual Securities Allect Fortlolio Risk
 Ik8l£ 7.5
Betas lor selected u.S.
common stocks, January
2OO4-0ecember 2OO8.
8Iork
8aIa ( ) 8Iork 8aIa ( )
Ama/on 2.1G 0isney .OG
Ford 1.75 hewmont .G8
0ell 1.41 Exxon Mobil .55
Starbucks 1.1G Johnson & Johnson .5O
Boeing 1.14 Camµbell Souµ .8O
6hapIar 7 íntroduction to Risk and Return 176
Òl tle 10 stocks in Table 7.5
Dell las one ol tle liglest betas.
Campbell Soup is at tle otler
extreme. A line litted to a plot ol
Campbell Soup`s returns versus
market returns would be less steep.
Its slope would be only .30. Notice
tlat many ol tle stocks tlat lave
ligl standard deviations also lave
ligl betas. ßut tlat is not always
so. Ior example, Newmont, wlicl
las a relatively ligl standard
deviation, las |oined tle low-beta
stocks in tle riglt-land column
ol Table 7.5 . It seems tlat wlile
Newmont is a risky investment il
leld on its own, it makes a rela-
tively low contribution to tle risk
ol a diversilied portlolio.
}ust as we can measure low tle returns ol a U.S. stock are allected by lluctuations in tle
U.S. market, so we can measure low stocks in otler countries are allected by movements in
thctr markets. Table 7.6 slows tle betas lor tle sample ol stocks lrom otler countries.
Why 8arurIIy 8aIas ûaIarmIna ForIIoIIo ßIsk
Let us review tle two crucial points about security risk and portlolio risk.
· Market risk accounts lor most ol tle risk ol a well-diversilied portlolio.
· Tle beta ol an individual security measures its sensitivity to market movements.
It is easy to see wlere we are leaded. In a portlolio context, a security`s risk is measured by
beta. Ierlaps we could |ust |ump to tlat conclusion, but we would ratler explain it. Here is
an intuitive explanation. We provide a more teclnical one in lootnote 31.
Whara's 8adrork? Look back to Iigure 7.11 , wlicl slows low tle standard deviation ol
portlolio return depends on tle number ol securities in tle portlolio. Witl more securities,
and tlerelore better diversilication, portlolio risk declines until all specilic risk is eliminated
and only tle bedrock ol market risk remains.
Wlere`s bedrock: It depends on tle average beta ol tle securities selected.
Suppose we constructed a portlolio containing a large number ol stocks÷500, say÷
drawn randomly lrom tle wlole market. Wlat would we get: Tle market itsell, or a port-
lolio zcry close to it. Tle portlolio beta would be 1.0, and tle correlation witl tle market
would be 1.0. Il tle standard deviation ol tle market were 20% (rouglly its average lor
1900-2008), tlen tle portlolio standard deviation would also be 20%. Tlis is slown by tle
green line in Iigure 7.15 .
Return on
market, %
Return on Dell, %
1.41
1.0
 FI608£ 7.14
The return on 0ell stock
changes on average
by 1.41% lor each
additional 1% change in
the market return. Beta
is therelore 1.41.
8Iork 8aIa ( ) 8Iork 8aIa ( )
BF .4O LvMh .8G
0eutsche Bank 1.O7 hestle .85
Fiat 1.11 hokia 1.O7
heineken .58 Sony 1.82
íberia .5O Telelonica de Argentina .42
 Ik8l£ 7.6
Betas lor selected
loreign stocks, January
2OO4-0ecember 2OO8
(beta is measured rela·
tive to the stock's home
market).
176 FarI TWo Risk
ßut suppose we constructed tle portlolio lrom a large group ol stocks witl an average
beta ol 1.5. Again we would end up witl a 500-stock portlolio witl virtually no specilic
risk÷a portlolio tlat moves almost in lockstep witl tle market. However, thts portlolio`s
standard deviation would be 30%, 1.5 times tlat ol tle market.
30
A well-diversilied portlo-
lio witl a beta ol 1.5 will amplily every market move by 50% and end up witl 150% ol tle
market`s risk. Tle upper red line in Iigure 7.15 slows tlis case.
Òl course, we could repeat tle same experiment witl stocks witl a beta ol .5 and end up witl
a well-diversilied portlolio lall as risky as tle market. You can see tlis also in Iigure 7.15 .
Tle general point is tlis. Tle risk ol a well-diversilied portlolio is proportional to tle
portlolio beta, wlicl equals tle average beta ol tle securities included in tle portlolio.
Tlis slows you low portlolio risk is driven by security betas.
6aIruIaIIng 8aIa A statistician would deline tle beta ol stock t as

t
 
tm
/
m
2

wlere
tm
is tle cczurtuncc between tle stock returns and tle market returns and 
m
2
is tle
variance ol tle returns on tle market. It turns out tlat tlis ratio ol covariance to variance
measures a stock`s contribution to portlolio risk.
31


30
A 500-stock portlolio witl 1.5 would still lave some specilic risk because it would be unduly concentrated in ligl-beta
industries. Its actual standard deviation would be a bit ligler tlan 30%. Il tlat worries you, relax, we will slow you in Clapter 8
low you can construct a lully diversilied portlolio witl a beta ol 1.5 by borrowing and investing in tle market portlolio.
31
To understand wly, skip back to Iigure 7.13 . Lacl row ol boxes in Iigure 7.13 represents tle contribution ol tlat particular
security to tle portlolio`s risk. Ior example, tle contribution ol stock 1 is

x
1
x
1

11
 x
1
x
2

12


 x
1
 x
1

11
 x
2

12




wlere x
t
is tle proportion invested in stock t, and
t¡
is tle covariance between stocks t and ¡ (note.
tt
is equal to tle variance
ol stock t ). In otler words, tle contribution ol stock 1 to portlolio risk is equal to tle relative size ol tle lolding ( x
1
) times
tle average covariance between stock 1 and all tle stocks in tle portlolio. We can write tlis more concisely by saying tlat tle
contribution ol stock 1 to portlolio risk is equal to tle lolding size ( x
1
) times tle covariance between stock 1 and tle entire
portlolio (
1
p

).
To lind stock 1`s rc/uttzc contribution to risk we simply divide by tle portlolio variance to give x
1

1p
/
p
2
 . In otler words, it
is equal to tle lolding size ( x
1
) times tle beta ol stock 1 relative to tle portlolio 
1p
/
p
2
 .
We can calculate tle beta ol a stock relative to uny portlolio by simply taking its covariance witl tle portlolio and dividing by
tle portlolio`s variance. Il we wisl to lind a stock`s beta rc/uttzc tc thc murkct pcrt/c/tc we |ust calculate its covariance witl tle market
portlolio and divide by tle variance ol tle market.
ßeta relative to market portlolio 
covariance witl tle market
variance ol market


tm

2
m

Number oI securities
Average beta = 1.0: FortIolio risk (

) =

= 20%
Average beta = 1.5: FortIolio risk (

) = 30%
Average beta = .5: FortIolio risk (

) = 10%
0
1
10
20
30
40
50
ó0
70
80
3 5 7 º 11 13 15 17 1º 21 23 25
 FI608£ 7.15
The green line shows that a well·
diversilied µortlolio ol randomly
selected stocks ends uµ with 1
and a standard deviation equal to
the market's-in this case 2O%. The
uµµer red line shows that a well·
diversilied µortlolio with 1.5
has a standard deviation ol about
8O%-1.5 times that ol the market.
The lower brown line shows that a
well·diversilied µortlolio with .5
has a standard deviation ol about
1O%-hall that ol the market.
(or, more simply, beta)
6hapIar 7 íntroduction to Risk and Return 177
Here is a simple example ol low to do tle calculations. Columns 2 and 3 in Table 7.7
slow tle returns over a particular six-montl period on tle market and tle stock ol
tle Anclovy Queen restaurant clain. You can see tlat, altlougl botl investments
provided an average return ol 2%, Anclovy Queen`s stock was particularly sensitive
to market movements, rising more wlen tle market rises and lalling more wlen tle
market lalls.
Columns 4 and 5 slow tle deviations ol eacl montl`s return lrom tle average. To
calculate tle market variance, we need to average tle squared deviations ol tle market
returns (column 6). And to calculate tle covariance between tle stock returns and tle
market, we need to average tle product ol tle two deviations (column 7). ßeta is tle ratio
ol tle covariance to tle market variance, or 76/50.67 1.50. A diversilied portlolio ol
stocks witl tle same beta as Anclovy Queen would be one-and-a-lall times as volatile as
tle market.
We lave seen tlat diversilication reduces risk and, tlerelore, makes sense lor investors. ßut
does it also make sense lor tle lirm: Is a diversilied lirm more attractive to investors tlan
an undiversilied one: Il it is, we lave an cxtrcmc/y disturbing result. Il diversilication is an
appropriate corporate ob|ective, eacl pro|ect las to be analyzed as a potential addition to
tle lirm`s portlolio ol assets. Tle value ol tle diversilied package would be greater tlan tle
sum ol tle parts. So present values would no longer add.
Diversilication is undoubtedly a good tling, but tlat does not mean tlat lirms slould
practice it. Il investors were nct able to lold a large number ol securities, tlen tley
7·5 0iversilication and value Additivity
Tofal 304 45ó 2 2 Average
deviations
Product of
(7)
from average
returns
(coIs 4 5)
130
12
170
120
0
24
5quared
(ó)
deviation
from average
market return
100
4
100
ó4
0
3ó
Deviation
(5)
from average
Ancbovy O
return
÷13
ó
17
÷15
1
4
Deviation
(4)
from
average
market return
÷10
2
10
÷8
0
ó
(3)
Ancbovy O
return
÷11%
8
1º
÷13
3
ó
(2)
Market
return
÷8%
4
12
÷ó
2
8
(1)
Montb
1
2
3
4
5
ó
Befa ( ) =

/

2
= 7ó/50.ó7 = 1.5
Covarlance =
l
= 45ó/ó = 7ó
varlance =

2
= 304/ó = 50.ó7
 Ik8l£ 7.7 Calculating the variance ol the market returns and the covariance between the
returns on the market and those ol Anchovy 0ueen. Beta is the ratio ol the variance to the
covariance (i.e., 
tm
/
m
2
).
visit us at
www.mhhe.com/bma
17B FarI TWo Risk
miglt want lirms to diversily lor tlem. ßut investors cun diversily.
32
In many ways tley
can do so more easily tlan lirms. Individuals can invest in tle steel industry tlis week
and pull out next week. A lirm cannot do tlat. To be sure, tle individual would lave
to pay brokerage lees on tle purclase and sale ol steel company slares, but tlink ol tle
time and expense lor a lirm to acquire a steel company or to start up a new steel-making
operation.
You can probably see wlere we are leading. Il investors can diversily on tleir own
account, tley will not pay any cxtru lor lirms tlat diversily. And il tley lave a sulliciently
wide cloice ol securities, tley will not pay any /css because tley are unable to invest sepa-
rately in eacl lactory. Tlerelore, in countries like tle United States, wlicl lave large and
competitive capital markets, diversilication does not add to a lirm`s value or subtract lrom
it. Tle total value is tle sum ol its parts.
Tlis conclusion is important lor corporate linance, because it |ustilies adding present
values. Tle concept ol zu/uc uddtttztty is so important tlat we will give a lormal delinition
ol it. Il tle capital market establisles a value IV(A) lor asset A and IV(ß) lor ß, tle market
value ol a lirm tlat lolds only tlese two assets is
IV Aß  IV A  IV ß
A tlree-asset lirm combining assets A, ß, and C would be wortl IV(AßC) IV(A) IV(ß)
IV(C), and so on lor any number ol assets.
We lave relied on intuitive arguments lor value additivity. ßut tle concept is a general
one tlat can be proved lormally by several dillerent routes.
33
Tle concept seems to be
widely accepted, lor tlousands ol managers add tlousands ol present values daily, usually
witlout tlinking about it.

32
Òne ol tle simplest ways lor an individual to diversily is to buy slares in a mutual lund tlat lolds a diversilied portlolio.

33
You may wisl to reler to tle Appendix to Clapter 31, wlicl discusses diversilication and value additivity in tle context ol mergers.
Òur review ol capital market listory slowed tlat tle returns to investors lave varied according
to tle risks tley lave borne. At one extreme, very sale securities like U.S. Treasury bills lave
provided an average return over 109 years ol only 4.0% a year. Tle riskiest securities tlat we
looked at were common stocks. Tle stock market provided an average return ol 11.1%, a pre-
mium ol 7.1% over tle sale rate ol interest.
Tlis gives us two benclmarks lor tle opportunity cost ol capital. Il we are evaluating a sale
pro|ect, we discount at tle current risk-lree rate ol interest. Il we are evaluating a pro|ect ol aver-
age risk, we discount at tle expected return on tle average common stock. Historical evidence
suggests tlat tlis return is 7.1% above tle risk-lree rate, but many linancial managers and econo-
mists opt lor a lower ligure. Tlat still leaves us witl a lot ol assets tlat don`t lit tlese simple
cases. ßelore we can deal witl tlem, we need to learn low to measure risk.
Risk is best |udged in a portlolio context. Most investors do not put all tleir eggs into one
basket. Tley diversily. Tlus tle ellective risk ol any security cannot be |udged by an examination
ol tlat security alone. Iart ol tle uncertainty about tle security`s return is diversilied away wlen
tle security is grouped witl otlers in a portlolio.
Risk in investment means tlat luture returns are unpredictable. Tlis spread ol possible out-
comes is usually measured by standard deviation. Tle standard deviation ol tle murkct pcrt/c/tc,
generally represented by tle Standard and Ioor`s Composite Index, is around 15% to 20% a
year.
8üMMkßY
 
6hapIar 7 íntroduction to Risk and Return 179
Most individual stocks lave ligler standard deviations tlan tlis, but mucl ol tleir vari-
ability represents spcct/tc risk tlat can be eliminated by diversilication. Diversilication cannot
eliminate murkct risk. Diversilied portlolios are exposed to variation in tle general level ol tle
market.
A security`s contribution to tle risk ol a well-diversilied portlolio depends on low tle secu-
rity is liable to be allected by a general market decline. Tlis sensitivity to market movements
is known as hctu ( ). ßeta measures tle amount tlat investors expect tle stock price to clange
lor eacl additional 1% clange in tle market. Tle average beta ol all stocks is 1.0. A stock witl
a beta greater tlan 1 is unusually sensitive to market movements, a stock witl a beta below 1 is
unusually insensitive to market movements. Tle standard deviation ol a well-diversilied portlo-
lio is proportional to its beta. Tlus a diversilied portlolio invested in stocks witl a beta ol 2.0
will lave twice tle risk ol a diversilied portlolio witl a beta ol 1.0.
Òne tleme ol tlis clapter is tlat diversilication is a good tling /cr thc tnzcstcr. Tlis does
not imply tlat /trms slould diversily. Corporate diversilication is redundant il investors can
diversily on tleir own account. Since diversilication does not allect tle value ol tle lirm, pres-
ent values add even wlen risk is explicitly considered. Tlanks to zu/uc uddtttztty, tle net present
value rule lor capital budgeting works even under uncertainty.
In tlis clapter we lave introduced you to a number ol lormulas. Tley are reproduced in tle
endpapers to tle book. You slould take a look and cleck tlat you understand tlem.
Near tle end ol Clapter 9 we list some Lxcel lunctions tlat are uselul lor measuring tle risk
ol stocks and portlolios.
 
Icr tntcrnuttcnu/ cztdcncc cn murkct rcturns stncc 1900, scc:
L. Dimson, I. R. Marsl, and M. Staunton, Trtumph c/ thc Opttmtsts: 101 Ycurs c/ Inzcstmcnt
Fcturns (Irinceton, N}. Irinceton University Iress, 2002). More recent data is available in Tle
Credit Suisse Clobal Investment Returns Yearbook at www.tinyurl.com/DMSyearbook .
Thc Ihhctscn Ycurhcck ts u zu/uuh/c rcccrd c/ thc pcr/crmuncc c/ I.S. sccurtttcs stncc 1926:
Ihhctscn Stccks, ßcnds, ßt//s, und In//uttcn 2009 Ycurhcck (Clicago, IL. Morningstar, Inc., 2009).
Isc/u/ hccks und rcztcws cn thc cqutty rtsk prcmtum tnc/udc:
ß. Cornell, Thc Iqutty Ftsk Ircmtum: Thc Lcn¸-Fun Iuturc c/ thc Stcck Æurkct (New York. Wiley,
1999).
W. Coetzmann and R. Ibbotson, Thc Iqutty Ftsk Ircmtum: Issuys und Ixp/cruttcns (Òxlord
University Iress, 2006).
R. Melra (ed.), Hundhcck c/ Inzcstmcnts: Iqutty Ftsk Ircmtum 1 (Amsterdam, Nortl-Holland,
2007).
R. Melra and L. C. Irescott, ¨Tle Lquity Risk Iremium in Irospect," in Hundhcck c/ thc
Iccncmtcs c/ Itnuncc, eds. C. M. Constantinides, M. Harris, and R. M. Stulz (Amsterdam, Nortl-
Holland, 2003).
FüßThLß
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 
ScIcct probIcms arc avaiIabIc in McGraw-HiII Conncct.
PIcasc scc thc prcfacc for morc information.
8k8I6
1. A game ol clance ollers tle lollowing odds and payolls. Lacl play ol tle game costs
$100, so tle net prolit per play is tle payoll less $100.
Fßû8LLM 8LT8
1B0 FarI TWo Risk
FrobabIIIIy FayoII haI FroIII
.1O $5OO $4OO
.5O 1OO O
.4O O 1OO
Wlat are tle expected casl payoll and expected rate ol return: Calculate tle variance and
standard deviation ol tlis rate ol return.
2. Tle lollowing table slows tle nominal returns on tle U.S. stocks and tle rate ol inllation.
a. Wlat was tle standard deviation ol tle market returns:
b. Calculate tle average real return.
Yaar homInaI ßaIurn (%) InIIaIIon (%)
2OO4 12.5 8.8
2OO5 G.4 8.4
2OOG 15.8 2.5
2OO7 5.G 4.1
2OO8 87.2 O.1
3. During tle boom years ol 2003-2007, ace mutual lund manager Diana Sauros produced
tle lollowing percentage rates ol return. Rates ol return on tle market are given lor
comparison.
Z008 Z004 Z006 Z006 Z007
Ms. Sauros 8O.1 11.O 2.G 18.O 2.8
S&F 5OO 81.G 12.5 G.4 15.8 5.G
Calculate tle average return and standard deviation ol Ms. Sauros`s mutual lund. Did sle
do better or worse tlan tle market by tlese measures:
4. True or lalse:
a. Investors preler diversilied companies because tley are less risky.
b. Il stocks were perlectly positively correlated, diversilication would not reduce risk.
c. Diversilication over a large number ol assets completely eliminates risk.
d. Diversilication works only wlen assets are uncorrelated.
e. A stock witl a low standard deviation always contributes less to portlolio risk tlan a
stock witl a ligler standard deviation.
l. Tle contribution ol a stock to tle risk ol a well-diversilied portlolio depends on its
market risk.
g. A well-diversilied portlolio witl a beta ol 2.0 is twice as risky as tle market portlolio.
l. An undiversilied portlolio witl a beta ol 2.0 is less tlan twice as risky as tle market
portlolio.
5. In wlicl ol tle lollowing situations would you get tle largest reduction in risk by spread-
ing your investment across two stocks:
a. Tle two slares are perlectly correlated.
b. Tlere is no correlation.
c. Tlere is modest negative correlation.
d. Tlere is perlect negative correlation.
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6hapIar 7 íntroduction to Risk and Return 1B1
6. To calculate tle variance ol a tlree-stock portlolio, you need to add nine boxes.
Use tle same symbols tlat we used in tlis clapter, lor example, x
1
proportion invested
in stock 1 and
12
covariance between stocks 1 and 2. Now complete tle nine boxes.
7. Suppose tle standard deviation ol tle market return is 20%.
a. Wlat is tle standard deviation ol returns on a well-diversilied portlolio witl a beta ol 1.3:
b. Wlat is tle standard deviation ol returns on a well-diversilied portlolio witl a beta ol 0:
c. A well-diversilied portlolio las a standard deviation ol 15%. Wlat is its beta:
d. A poorly diversilied portlolio las a standard deviation ol 20%. Wlat can you say about
its beta:
8. A portlolio contains equal investments in 10 stocks. Iive lave a beta ol 1.2, tle remainder
lave a beta ol 1.4. Wlat is tle portlolio beta:
a. 1.3.
b. Creater tlan 1.3 because tle portlolio is not completely diversilied.
c. Less tlan 1.3 because diversilication reduces beta.
9. Wlat is tle beta ol eacl ol tle stocks slown in Table 7.8 :
 Ik8l£ 7.8
See Froblem O.
8Iork ßaIurn II MarkaI ßaIurn Is.
8Iork 10% 10%
A O 2O
B 2O 2O
C 8O O
0 15 15
E 1O 1O
IhTLßMLûIkTL
10. Here are inllation rates and U.S. stock market and Treasury bill returns between 1929 and
1933.
Yaar InIIaIIon 8Iork MarkaI ßaIurn T·8III ßaIurn
1O2O .2 14.5 4.8
1O8O G.O 28.8 2.4
1O81 O.5 48.O 1.1
1O82 1O.8 O.O 1.O
1O88 .5 57.8 .8
a. Wlat was tle real return on tle stock market in eacl year:
b. Wlat was tle average real return:
c. Wlat was tle risk premium in eacl year:
d. Wlat was tle average risk premium:
e. Wlat was tle standard deviation ol tle risk premium:
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1BZ FarI TWo Risk
11. Lacl ol tle lollowing statements is dangerous or misleading. Lxplain wly.
a. A long-term United States government bond is always absolutely sale.
b. All investors slould preler stocks to bonds because stocks oller ligler long-run rates ol
return.
c. Tle best practical lorecast ol luture rates ol return on tle stock market is a 5- or 10-year
average ol listorical returns.
12. Hippique s.a., wlicl owns a stable ol racelorses, las |ust invested in a mysterious black
stallion witl great lorm but disputed bloodlines. Some experts in lorsellesl predict tle
lorse will win tle coveted Irix de ßidet, otlers argue tlat it slould be put out to grass. Is
tlis a risky investment lor Hippique slarelolders: Lxplain.
13. Lonesome Culcl Mines las a standard deviation ol 42% per year and a beta ol .10.
Amalgamated Copper las a standard deviation ol 31% a year and a beta ol .66. Lxplain
wly Lonesome Culcl is tle saler investment lor a diversilied investor.
14. Hyacintl Macaw invests 60% ol ler lunds in stock I and tle balance in stock }. Tle stan-
dard deviation ol returns on I is 10%, and on } it is 20%. Calculate tle variance ol portlolio
returns, assuming
a. Tle correlation between tle returns is 1.0.
b. Tle correlation is .5.
c. Tle correlation is 0.
15. a. How many variance terms and low many covariance terms do you need to calculate tle
risk ol a 100-slare portlolio:
b. Suppose all stocks lad a standard deviation ol 30% and a correlation witl eacl otler ol
.4. Wlat is tle standard deviation ol tle returns on a portlolio tlat las equal loldings
in 50 stocks:
c. Wlat is tle standard deviation ol a lully diversilied portlolio ol sucl stocks:
16. Suppose tlat tle standard deviation ol returns lrom a typical slare is about .40 (or 40%) a
year. Tle correlation between tle returns ol eacl pair ol slares is about .3.
a. Calculate tle variance and standard deviation ol tle returns on a portlolio tlat las
equal investments in 2 slares, 3 slares, and so on, up to 10 slares.
b. Use your estimates to draw a grapl like Iigure 7.11 . How large is tle underlying market
risk tlat cannot be diversilied away:
c. Now repeat tle problem, assuming tlat tle correlation between eacl pair ol stocks is zero.
17. Table 7.9 slows standard deviations and correlation coellicients lor eiglt stocks lrom diller-
ent countries. Calculate tle variance ol a portlolio witl equal investments in eacl stock.
18. Your eccentric Aunt Claudia las lelt you $50,000 in Canadian Iacilic slares plus $50,000
casl. Unlortunately ler will requires tlat tle Canadian Iacilic stock not be sold lor one
year and tle $50,000 casl must be entirely invested in one ol tle stocks slown in Table 7.9 .
Wlat is tle salest attainable portlolio under tlese restrictions:
19. Tlere are lew, il any, real companies witl negative betas. ßut suppose you lound one witl
.25.
a. How would you expect tlis stock`s rate ol return to clange il tle overall market rose by
an extra 5%: Wlat il tle market lell by an extra 5%:
b. You lave $1 million invested in a well-diversilied portlolio ol stocks. Now you receive
an additional $20,000 bequest. Wlicl ol tle lollowing actions will yield tle salest
overall portlolio return:
i. Invest $20,000 in Treasury bills (wlicl lave 0).
ii. Invest $20,000 in stocks witl 1.
iii. Invest $20,000 in tle stock witl .25.
Lxplain your answer.
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6hapIar 7 íntroduction to Risk and Return 1B8
20. You can lorm a portlolio ol two assets, A and ß, wlose returns lave tle lollowing
claracteristics.
8Iork
LxparIad
ßaIurn
8Iandard
ûavIaIIon 6orraIaIIon
A 1O% 2O%
.5
B 15 4O
Il you demand an expected return ol 12%, wlat are tle portlolio weiglts: Wlat is tle
portlolio`s standard deviation:
6hkLLLhûL
21. Here are some listorical data on tle risk claracteristics ol Dell and McDonald`s.
ûaII MrûonaId's
(beta) 1.41 .77
Yearly standard deviation ol return (%) 8O.O 17.2
Assume tle standard deviation ol tle return on tle market was 15%.
a. Tle correlation coellicient ol Dell`s return versus McDonald`s is .31. Wlat is tle stan-
dard deviation ol a portlolio invested lall in Dell and lall in McDonald`s:
b. Wlat is tle standard deviation ol a portlolio invested one-tlird in Dell, one-tlird in
McDonald`s, and one-tlird in risk-lree Treasury bills:
c. Wlat is tle standard deviation il tle portlolio is split evenly between Dell and McDon-
ald`s and is linanced at 50% margin, i.e., tle investor puts up only 50% ol tle total
amount and borrows tle balance lrom tle broker:
d. Wlat is tle upprcxtmutc standard deviation ol a portlolio composed ol 100 stocks witl
betas ol 1.41 like Dell: How about 100 stocks like McDonald`s: ( Htnt: Iart (d) slould
not require anytling but tle simplest aritlmetic to answer.)
22. Suppose tlat Treasury bills oller a return ol about 6% and tle expected market risk pre-
mium is 8.5%. Tle standard deviation ol Treasury-bill returns is zero and tle standard
 Ik8l£ 7.9 Standard deviations ol returns and correlation coellicients lor a samµle ol eight stocks.
hote. Correlations and standard deviations are calculated using returns in each country's own currency, in other words, they assume that the investor is µrotected
against exchange risk.
6orraIaIIon 6oaIIIrIanIs
8F
6anadIan
FarIIIr
ûauIsrha
8ank FIaI haInakan LVMh hasIIá
TaIa
MoIors
8Iandard
ûavIaIIon
BF 1 O.1O O.28 O.2O O.84 O.8O O.1G O.OO 22.2%
Canadian
Facilic 1 O.48 O.81 O.8O O.84 O.17 O.4O 28.O
0eutsche
Bank 1 O.74 O.78 O.78 O.4O O.G8 2O.2
Fiat 1 O.GG O.G4 O.47 O.58 85.7
heineken 1 O.G4 O.51 O.5O 18.O
LvMh 1 O.52 O.GO 2O.8
hestle 1 O.48 15.4
Tata Motors 1 48.O
1B4 FarI TWo Risk
deviation ol market returns is 20%. Use tle lormula lor portlolio risk to calculate tle stan-
dard deviation ol portlolios witl dillerent proportions in Treasury bills and tle market.
( Actc: Tle covariance ol two rates ol return must be zero wlen tle standard deviation ol
one return is zero.) Crapl tle expected returns and standard deviations.
23. Calculate tle beta ol eacl ol tle stocks in Table 7.9 relative to a portlolio witl equal
investments in eacl stock.
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 
You can download data for the following questions from the Standard 8 Poor's Market
lnsight Web site ( www.mhhe.com/edumarketinsight )-see the ºMonthly Adjusted Prices"
spreadsheet-or from finance.yahoo.com. Refer to the useful Spreadsheet lunctions box
near the end of Chapter 9 for information on Excel functions.
1. Download to a spreadsleet tle last tlree years ol montlly ad|usted stock prices lor Coca-
Cola (KÒ), Citigroup (C), and Ilizer (IIL).
a. Calculate tle montlly returns.
b. Calculate tle montlly standard deviation ol tlose returns (see Section 7-2). Use tle
Lxcel lunction STDLVI to cleck your answer. Iind tle annualized standard deviation
by multiplying by tle square root ol 12.
c. Use tle Lxcel lunction CÒRRLL to calculate tle correlation coellicient between tle
montlly returns lor eacl pair ol stocks. Wlicl pair provides tle greatest gain lrom
diversilication:
d. Calculate tle standard deviation ol returns lor a portlolio witl equal investments in tle
tlree stocks.
2. Download to a spreadsleet tle last live years ol montlly ad|usted stock prices lor eacl ol
tle companies in Table 7.5 and lor tle Standard s Ioor`s Composite Index (SsI 500).
a. Calculate tle montlly returns.
b. Calculate beta lor eacl stock using tle Lxcel lunction SLÒIL, wlere tle ¨y" range relers
to tle stock return (tle dependent variable) and tle ¨x" range is tle market return (tle
independent variable).
c. How lave tle betas clanged lrom tlose reported in Table 7.5 :
3. A large mutual lund group sucl as Iidelity ollers a variety ol lunds. Tley include scctcr
/unds tlat specialize in particular industries and tndcx /unds tlat simply invest in tle market
index. Log on to www.fidelity.com and lind lirst tle standard deviation ol returns on tle
Iidelity Spartan 500 Index Iund, wlicl replicates tle SsI 500. Now lind tle standard
deviations lor dillerent sector lunds. Are tley larger or smaller tlan tle ligure lor tle index
lund: How do you interpret your lindings:
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1B6
PART 2
Ia 0haµter 7 wo bogan to oomo to grips witn tno
problom oí moasuring risk. Horo is tno story so íar.
Tno stook markot is risky booauso tnoro is a sproad
oí possiblo outoomos. Tno usual moasuro oí tnis sproad
is tno standard doviation or varianoo. Tno risk oí any
stook oan bo brokon down into two parts. Tnoro is
tno specific or øiversifiab|e risk tnat is poouliar to tnat
stook, and tnoro is tno market risk tnat is assooiatod
witn markotwido variations. ínvostors oan oliminato
spooiíio risk by nolding a woll-divorsiíiod portíolio, but
tnoy oannot oliminato markot risk. A|| tno risk oí a íully
divorsiíiod portíolio is markot risk.
A stook's oontribution to tno risk oí a íully divorsiíiod
portíolio doponds on its sonsitivity to markot onangos.
Tnis sonsitivity is gonorally known as beta. A soourity
witn a bota oí 1.0 nas avorago markot riska woll-
divorsiíiod portíolio oí suon soouritios nas tno samo
standard doviation as tno markot indox. A soourity witn
a bota oí .5 nas bolow-avorago markot riska woll-
divorsiíiod portíolio oí tnoso soouritios tonds to movo
nalí as íar as tno markot movos and nas nalí tno markot's
standard doviation.
ín tnis onaptor wo build on tnis nowíound knowlodgo.
Wo prosont loading tnoorios linking risk and roturn in a
oompotitivo ooonomy, and wo snow now tnoso tnoorios
oan bo usod to ostimato tno roturns roquirod by invostors
in diííoront stook-markot invostmonts. Wo start witn
tno most widoly usod tnoory, tno oapital assot prioing
modol, wnion builds dirootly on tno idoas dovolopod in
tno last onaptor. Wo will also look at anotnor olass oí
modols, known as arbitrago prioing or íaotor modols.
Tnon in Cnaptor 9 wo snow now tnoso idoas oan nolp
tno íinanoial managor oopo witn risk in praotioal oapital
budgoting situations.
Iortlolio Tleory and tle
Capital Asset Iricing Model
8
6hkFTLß
RISK
Most ol tle ideas in Clapter 7 date back to an article written in 1952 by Harry Markowitz.
1

Markowitz drew attention to tle common practice ol portlolio diversilication and slowed
exactly low an investor can reduce tle standard deviation ol portlolio returns by cloos-
ing stocks tlat do not move exactly togetler. ßut Markowitz did not stop tlere, le went
on to work out tle basic principles ol portlolio construction. Tlese principles are tle
loundation lor mucl ol wlat las been written about tle relationslip between risk and
return.
We begin witl Iigure 8.1, wlicl slows a listogram ol tle daily returns on IßM stock
lrom 1988 to 2008. Òn tlis listogram we lave superimposed a bell-slaped normal

1
H. M. Markowitz, ¨Iortlolio Selection," }curnu/ c/ Itnuncc 7 (Marcl 1952), pp. 77-91.
8·1 harry Markowit/ and the Birth ol Fortlolio Theory
1B6 FarI TWo Risk
d istribution. Tle result is typical. Wlen measured over a slort interval, tle past rates ol
return on any stock conlorm lairly closely to a normal distribution.
2
Normal distributions can be completely delined by two numbers. Òne is tle average or
expected return, tle otler is tle variance or standard deviation. Now you can see wly in
Clapter 7 we discussed tle calculation ol expected return and standard deviation. Tley are
not |ust arbitrary measures. il returns are normally distributed, expected return and stan-
dard deviation are tle cn/y two measures tlat an investor need consider.
Iigure 8.2 pictures tle distribution ol possible returns lrom tlree investments. A and ß
oller an expected return ol 10%, but A las tle mucl wider spread ol possible outcomes.
Its standard deviation is 15%, tle standard deviation ol ß is 7.5%. Most investors dislike
uncertainty and would tlerelore preler ß to A.
Now compare investments ß and C. Tlis time botl lave tle sumc standard deviation,
but tle expected return is 20% lrom stock C and only 10% lrom stock ß. Most investors
like ligl expected return and would tlerelore preler C to ß.
6ombInIng 8Iorks InIo ForIIoIIos
Suppose tlat you are wondering wletler to invest in tle slares ol Campbell Soup or
ßoeing. You decide tlat Campbell ollers an expected return ol 3.1% and ßoeing ollers an
expected return ol 9.5%. Alter looking back at tle past variability ol tle two stocks, you
also decide tlat tle standard deviation ol returns is 15.8% lor Campbell Soup and 23.7%
lor ßoeing. ßoeing ollers tle ligler expected return, but it is more risky.
Now tlere is no reason to restrict yoursell to lolding only one stock. Ior example, in
Section 7-3 we analyzed wlat would lappen il you invested 60% ol your money in Camp-
bell Soup and 40% in ßoeing. Tle expected return on tlis portlolio is about 5.7%, simply a
weiglted average ol tle expected returns on tle two loldings. Wlat about tle risk ol sucl a
portlolio: We know tlat tlanks to diversilication tle portlolio risk is less tlan tle a verage

2
Il you were to measure returns over /cn¸ intervals, tle distribution would be skewed. Ior example, you would encounter returns
greater tlan 100% but none less tlan 100%. Tle distribution ol returns over periods ol, say, one year would be better approxi-
mated by a /c¸ncrmu/ distribution. Tle lognormal distribution, like tle normal, is completely specilied by its mean and standard
deviation.
 FI608£ 8.1
0aily µrice changes lor
íBM are aµµroximately
normally distributed.
This µlot sµans 1O88
to 2OO8.
÷5.ó ÷7 ÷2.8 ÷4.2 ÷1.4 0 1.4 4.2 2.8 5.ó 7 7.7
0
0.5
1
1.5
2
2.5
3
3.5
4
Daily price changes, %
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model 1B7
Return, %
Frobability
Frobability
Frobability
lnvestment A
Return, %
lnvestment B
Return, %
lnvestment C
 FI608£ 8.2
ínvestments A and B both have an cxpcctcJ return ol 1O%, but because investment A has the greater
sµread ol pcssi||c returns, it is more risky than B. we can measure this sµread by the standard
d eviation. ínvestment A has a standard deviation ol 15%, B, 7.5%. Most investors would µreler B to A.
ínvestments B and C both have the same standard deviation, but C ollers a higher exµected return. Most
investors would µreler C to B.
1BB FarI TWo Risk
ol tle risks ol tle separate stocks. In lact, on tle basis ol past experience tle standard devia-
tion ol tlis portlolio is 14.6%.
3
Tle curved blue line in Iigure 8.3 slows tle expected return and risk tlat you could
aclieve by dillerent combinations ol tle two stocks. Wlicl ol tlese combinations is best
depends on your stomacl. Il you want to stake all on getting ricl quickly, you slould put
all your money in ßoeing. Il you want a more peacelul lile, you slould invest most ol your
money in Campbell Soup, but you slould keep at least a small investment in ßoeing.
4
We saw in Clapter 7 tlat tle gain lrom diversilication depends on low liglly tle
stocks are correlated. Iortunately, on past experience tlere is only a small positive correla-
tion between tle returns ol Campbell Soup and ßoeing ( .18). Il tleir stocks moved
in exact lockstep ( 1), tlere would be no gains at all lrom diversilication. You can see
tlis by tle brown dotted line in Iigure 8.3. Tle red dotted line in tle ligure slows a second
extreme (and equally unrealistic) case in wlicl tle returns on tle two stocks are perlectly
nc¸uttzc/y correlated ( 1). Il tlis were so, your portlolio would lave no risk.
In practice, you are not limited to investing in |ust two stocks. Ior example, you could
decide to cloose a portlolio lrom tle 10 stocks listed in tle lirst column ol Table 8.1. Alter
analyzing tle prospects lor eacl lirm, you come up witl lorecasts ol tleir returns. You are
most optimistic about tle outlook lor Amazon, and lorecast tlat it will provide a return ol
22.8%. At tle otler extreme, you are cautious about tle prospects lor }olnson s }olnson
and predict a return ol 3.8%. You use data lor tle past live years to estimate tle risk ol eacl
stock and tle correlation between tle returns on eacl pair ol stocks.
5
Now look at Iigure 8.4. Lacl diamond marks tle combination ol risk and return ollered by
a dillerent individual security. Ior example, Amazon las botl tle liglest standard deviation
and tle liglest expected return. It is represented by tle upper-riglt diamond in tle ligure.

3
We pointed out in Section 7-3 tlat tle correlation between tle returns ol Campbell Soup and ßoeing las been about .18. Tle
variance ol a portlolio wlicl is invested 60% in Campbell and 40% in ßoeing is
Variance  x
1
2

1
2
 x
2
2

2
2
 2x
1
x
2

12

1

2
   .6
2
  15.8
2
    .4
2
  23.7
2
  2 .6  .4  .18  15.8  23.7
 212.1
Tle portlolio standard deviation is 212.1  14.6%.
4
Tle portlolio witl tle minimum risk las 73.1% in Campbell Soup. We assume in Iigure 8.3 tlat you may not take negative
positions in eitler stock, i.e., we rule out slort sales.

5
Tlere are 45 dillerent correlation coellicients, so we lave not listed tlem in Table 8.1 .
Boeing
Campbell soup
40% in Boeing
0
1
2
3
4
5
ó
7
8
º
10
25 20 15 10 0 5
Standard deviation ( ), %
 FI608£ 8.3
The curved line illustrates how exµected
return and standard deviation change as
you hold dillerent combinations ol two
stocks. For examµle, il you invest 4O% ol
your money in Boeing and the remain·
der in Camµbell Souµ, your exµected
return is 12%, which is 4O% ol the way
between the exµected returns on the two
stocks. The standard deviation is 14.G%,
which is less than 4O% ol the way
between the standard deviations ol the
two stocks. This is because diversilica·
tion reduces risk.
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model 1B9
 Ik8l£ 8.1 Examµles ol ellicient µortlolios chosen lrom 1O stocks.
|ctc: Standard deviations and the correlations between stock returns were estimated lrom monthly returns,
January 2OO4- 0ecember 2OO8. Ellicient µortlolios are calculated assuming that short sales are µrohibited.
LIIIrIanI ForIIoIIos¬FarranIagas
kIIoraIad Io Larh 8Iork
8Iork
LxparIad
ßaIurn
8Iandard
ûavIaIIon k 8 6
Ama/on 22.8% 5O.O% 1OO 1O.O
Ford 1O.O 47.2 11.O
0ell 18.4 8O.O 1O.8
Starbucks O.O 8O.8 1O.7 8.G
Boeing O.5 28.7 1O.5
0isney 7.7 1O.G 11.2
hewmont 7.O 8G.1 O.O 1O.2
Exxon Mobil 4.7 1O.1 O.7 18.4
Johnson & Johnson 8.8 12.5 7.4 88.O
Camµbell Souµ 8.1 15.8 8.4 88.O
Exµected µortlolio return 22.8 1O.5 4.2
Fortlolio standard deviation 5O.O 1G.O 8.8
ßy lolding dillerent proportions ol tle 10 securities, you can obtain an even wider
selection ol risk and return. in lact, unywhcrc in tle sladed area in Iigure 8.4. ßut wlere in
tle sladed area is best: Well, wlat is your goal: Wlicl direction do you want to go: Tle
answer slould be obvious. you want to go up (to increase expected return) and to tle lelt
(to reduce risk). Co as lar as you can, and you will end up witl one ol tle portlolios tlat
lies along tle leavy solid line. Markowitz called tlem efficient portfolios. Tley oller tle
liglest expected return lor any level ol risk.
We will not calculate tlis set ol ellicient portlolios lere, but you may be interested
in low to do it. Tlink back to tle capital rationing problem in Section 5-4. Tlere we
wanted to deploy a limited amount ol capital investment in a mixture ol pro|ects to give
tle liglest NIV. Here we want to deploy an investor`s lunds to give tle liglest expected
return lor a given standard deviation. In principle, botl problems can be solved by lunt-
ing and pecking÷but only in principle. To solve tle capital rationing problem, we can
employ linear programming, to solve tle portlolio problem, we would turn to a variant
ol linear programming known as quudruttc prc¸rummtn¸. Civen tle expected return and
standard deviation lor eacl stock, as well as tle correlation between eacl pair ol stocks,
we could use a standard quadratic computer program to calculate tle set ol ellicient
portlolios.
Tlree ol tlese ellicient portlolios are marked in Iigure 8.4. Tleir compositions are sum-
marized in Table 8.1. Iortlolio ß ollers tle liglest expected return. it is invested entirely
in one stock, Amazon. Iortlolio C ollers tle minimum risk, you can see lrom Table 8.1
tlat it las large loldings in }olnson s }olnson and Campbell Soup, wlicl lave tle low-
est standard deviations. However, tle portlolio also las a sizable lolding in Newmont
even tlougl it is individually very risky. Tle reason: Òn past evidence tle lortunes ol
go ld-mining slares, sucl as Newmont, are almost uncorrelated witl tlose ol otler stocks
and so provide additional diversilication.
190 FarI TWo Risk
Table 8.1 also slows tle compositions ol a tlird ellicient portlolio witl intermediate
levels ol risk and expected return.
Òl course, large investment lunds can cloose lrom tlousands ol stocks and tlereby
aclieve a wider cloice ol risk and return. Tlis cloice is represented in Iigure 8.5 by tle
sladed, broken-egg-slaped area. Tle set ol ellicient portlolios is again marked by tle leavy
curved line.
Wa InIrodura 8orroWIng and LandIng
Now we introduce yet anotler possibility. Suppose tlat you can also lend or borrow
money at some risk-lree rate ol interest r
/
. Il you invest some ol your money in Treasury
bills (i.e., lend money) and place tle remainder in common stock portlolio S, you can
obtain any combination ol expected return and risk along tle straiglt line |oining r
/
and
A
0
5
10
15
20
25
20 10 0 30 40 50 ó0
Standard deviation ( ), %
C
B
 FI608£ 8.4
Each diamond shows the
exµected return and standard
deviation ol 1 ol the 1O stocks
in Table 8.1 . The shaded area
shows the µossible combina·
tions ol exµected return and
standard deviation lrom invest·
ing in a mixt0rc ol these stocks.
íl you like high exµected returns
and dislike high standard devia·
tions, you will µreler µortlolios
along the heavy line. These are
cfficicrt µortlolios. we have
marked the three ellicient µort·
lolios described in Table 8.1
(A, B, and C).


Expected
return (),
%
S
T
Standard deviation ( )
 FI608£ 8.5
Lending and borrowing extend
the range ol investment
µossibilities. íl you invest in
µortlolio S and lend or borrow
at the risk·lree interest rate,
r
f
, you can achieve any µoint
along the straight line lrom r
f
through S. This gives you a
higher exµected return lor any
level ol risk than il you just
invest in common stocks.
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model 191
S in Iigure 8.5. Since borrowing is merely negative lending, you can extend tle range ol
possibilities to tle riglt ol S by borrowing lunds at an interest rate ol r
/
and investing tlem
as well as your own money in portlolio S.
Let us put some numbers on tlis. Suppose tlat portlolio S las an expected return ol
15% and a standard deviation ol 16%. Treasury bills oller an interest rate (r
/
) ol 5% and are
risk-lree (i.e., tleir standard deviation is zero). Il you invest lall your money in portlolio S
and lend tle remainder at 5%, tle expected return on your investment is likewise lallway
between tle expected return on S and tle interest rate on Treasury bills.
r  
1

2
 expected return on S  
1

2
 interest rate
 10%
And tle standard deviation is lallway between tle standard deviation ol S and tle standard
deviation ol Treasury bills.
6
  
1

2
 standard deviation ol S  
1

2
 standard deviation ol bills
 8%
Òr suppose tlat you decide to go lor tle big time. You borrow at tle Treasury bill rate
an amount equal to your initial wealtl, and you invest everytling in portlolio S. You lave
twice your own money invested in S, but you lave to puy interest on tle loan. Tlerelore
your expected return is
r   2  expected return on S   1  interest rate
 25%
And tle standard deviation ol your investment is
   2  standard deviation ol S   1  standard deviation ol bills 
 32%
You can see lrom Iigure 8.5 tlat wlen you lend a portion ol your money, you end up part-
way between r
/
and S, il you can borrow money at tle risk-lree rate, you can extend your
possibilities beyond S. You can also see tlat regardless ol tle level ol risk you cloose, you
can get tle liglest expected return by a mixture ol portlolio S and borrowing or lending. S
is tle hcst ellicient portlolio. Tlere is no reason ever to lold, say, portlolio T.
Il you lave a grapl ol ellicient portlolios, as in Iigure 8.5, linding tlis best ellicient
portlolio is easy. Start on tle vertical axis at r
/
and draw tle steepest line you can to tle
curved leavy line ol ellicient portlolios. Tlat line will be tangent to tle leavy line. Tle
ellicient portlolio at tle tangency point is better tlan all tle otlers. Notice tlat it ollers
tle liglest ruttc ol risk premium to standard deviation. Tlis ratio ol tle risk premium to
tle standard deviation is called tle Shurpc ruttc:
Slarpe ratio 
Risk premium
Standard deviation

r  r
/


Investors track Slarpe ratios to measure tle risk-ad|usted perlormance ol investment man-
agers. (Take a look at tle mini-case at tle end ol tlis clapter.)
We can now separate tle investor`s |ob into two stages. Iirst, tle best portlolio ol com-
mon stocks must be selected÷S in our example. Second, tlis portlolio must be blended
witl borrowing or lending to obtain an exposure to risk tlat suits tle particular investor`s
taste. Lacl investor, tlerelore, slould put money into |ust two benclmark investments÷a
risky portlolio S and a risk-lree loan (borrowing or lending).

6
Il you want to cleck tlis, write down tle lormula lor tle standard deviation ol a two-stock portlolio.
Standard deviation  x
1
2

1
2
 x
2
2

2
2
 2x
1
x
2 12

1

2

Now see wlat lappens wlen security 2 is riskless, i.e., wlen
2
0.
19Z FarI TWo Risk
Wlat does portlolio S look like: Il you lave better inlormation tlan your rivals, you
will want tle portlolio to include relatively large investments in tle stocks you tlink are
undervalued. ßut in a competitive market you are unlikely to lave a monopoly ol good
ideas. In tlat case tlere is no reason to lold a dillerent portlolio ol common stocks lrom
anybody else. In otler words, you miglt |ust as well lold tle market portlolio. Tlat is wly
many prolessional investors invest in a market-index portlolio and wly most otlers lold
well-diversilied portlolios.
In Clapter 7 we looked at tle returns on selected investments. Tle least risky investment
was U.S. Treasury bills. Since tle return on Treasury bills is lixed, it is unallected by wlat
lappens to tle market. In otler words, Treasury bills lave a beta ol 0. We also considered
a mucl riskier investment, tle market portlolio ol common stocks. Tlis las average market
risk. its beta is 1.0.
Wise investors don`t take risks |ust lor lun. Tley are playing witl real money. Tlere-
lore, tley require a ligler return lrom tle market portlolio tlan lrom Treasury bills. Tle
dillerence between tle return on tle market and tle interest rate is termed tle murkct rtsk
prcmtum. Since 1900 tle market risk premium (r
m
r
/
) las averaged 7.1% a year.
In Iigure 8.6 we lave plotted tle risk and expected return lrom Treasury bills and tle
market portlolio. You can see tlat Treasury bills lave a beta ol 0 and a risk premium ol
0.
7
Tle market portlolio las a beta ol 1 and a risk premium ol r
m
r
/
. Tlis gives us two
benclmarks lor tle expected risk premium. ßut wlat is tle expected risk premium wlen
beta is not 0 or 1:
In tle mid-1960s tlree economists÷William Slarpe, }oln Lintner, and }ack Treynor÷
produced an answer to tlis question.
8
Tleir answer is known as tle capital asset pricing

7
Remember tlat tle risk premium is tle dillerence between tle investment`s expected return and tle risk-lree rate. Ior Treasury
bills, tle dillerence is zero.
8
W. I. Slarpe, ¨Capital Asset Irices. A Tleory ol Market Lquilibrium under Conditions ol Risk," }curnu/ c/ Itnuncc 19 (September
1964), pp. 425-442, and }. Lintner, ¨Tle Valuation ol Risk Assets and tle Selection ol Risky Investments in Stock Iortlolios and
Capital ßudgets," Fcztcw c/ Iccncmtcs und Stuttsttcs 47 (Iebruary 1965), pp. 13-37. Treynor`s article las not been publisled.
8·2 The Relationshiµ Between Risk and Return
 FI608£ 8.6
The caµital asset µricing
model states that the
exµected risk µremium
on each investment is
µroµortional to its beta.
This means that each
investment should lie
on the sloµing security
market line connecting
Treasury bills and the
market µortlolio.
0 .5 1.0 2.0
Treasury bills
Market portIolio
Security market line
Expected return
on investment




beta
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model 198
model, or CAPM. Tle model`s message is botl startling and simple. In a competitive
market, tle expected risk premium varies in direct proportion to beta. Tlis means tlat
in Iigure 8.6 all investments must plot along tle sloping line, known as tle security
market line. Tle expected risk premium on an investment witl a beta ol .5 is, tlerelore,
hu// tle expected risk premium on tle market, tle expected risk premium on an invest-
ment witl a beta ol 2 is twtcc tle expected risk premium on tle market. We can write
tlis relationslip as
Lxpected risk premium on stock  beta  expected risk premium on market
r  r
/
  r
m
 r
/

8oma LsIImaIas oI LxparIad ßaIurns
ßelore we tell you wlere tle lormula comes lrom, let us use it to ligure out wlat returns
investors are looking lor lrom particular stocks. To do tlis, we need tlree numbers. , r
/
,
and r
m
r
/
. We gave you estimates ol tle betas ol 10 stocks in Table 7.5. In Iebruary 2009
tle interest rate on Treasury bills was about .2%.
How about tle market risk premium: As we pointed out in tle last clapter, we can`t
measure r
m
r
/
witl precision. Irom past evidence it appears to be 7.1%, altlougl many
economists and linancial managers would lorecast a sligltly lower ligure. Let us use 7% in
tlis example.
Table 8.2 puts tlese numbers togetler to give an estimate ol tle expected return on
eacl stock. Tle stock witl tle liglest beta in our sample is Amazon. Òur estimate ol tle
expected return lrom Amazon is 15.4%. Tle stock witl tle lowest beta is Campbell Soup.
Òur estimate ol its expected return is 2.4%, 2.2% more tlan tle interest rate on Treasury
bills. Notice tlat tlese expected returns are not tle same as tle lypotletical lorecasts ol
return tlat we assumed in Table 8.1 to generate tle ellicient lrontier.
You can also use tle capital asset pricing model to lind tle discount rate lor a new capi-
tal investment. Ior example, suppose tlat you are analyzing a proposal by Dell to expand
its capacity. At wlat rate slould you discount tle lorecasted casl llows: According to
Table 8.2, investors are looking lor a return ol 10.2% lrom businesses witl tle risk ol Dell.
So tle cost ol capital lor a lurtler investment in tle same business is 10.2%.
9

9
Remember tlat instead ol investing in plant and maclinery, tle lirm could return tle money to tle slarelolders. Tle opportu-
nity cost ol investing is tle return tlat slarelolders could expect to earn by buying linancial assets. Tlis expected return depends
on tle market risk ol tle assets.
 Ik8l£ 8.2 These
estimates ol the returns
exµected by investors
in February 2OOO were
based on the caµital
asset µricing model. we
assumed .2% lor the
interest rate r
f
and 7%
lor the exµected risk
µremium r
m
r
f
.
8Iork 8aIa ( )
LxparIad ßaIurn
|

(



)]
Ama/on 2.1G 15.4
Ford 1.75 12.G
0ell 1.41 1O.2
Starbucks 1.1G 8.4
Boeing 1.14 8.8
0isney .OG 7.O
hewmont .G8 4.7
Exxon Mobil .55 4.2
Johnson & Johnson .5O 8.8
Camµbell Souµ .8O 2.4
194 FarI TWo Risk
In practice, cloosing a discount rate is seldom so easy. (Alter all, you can`t expect to
be paid a lat salary |ust lor plugging numbers into a lormula.) Ior example, you must
learn low to ad|ust tle expected return lor tle extra risk caused by company borrowing.
Also you need to consider tle dillerence between slort- and long-term interest rates.
In early 2009 slort-term interest rates were at record lows and well below long-term
rates. It is possible tlat investors were content witl tle prospect ol quite modest equity
returns in tle slort run, but tley almost certainly required ligler long-run returns tlan
tle ligures slown in Table 8.2.
10
Il tlat is so, a cost ol capital based on slort-term rates
may be inappropriate lor long-term capital investments. ßut tlese relinements can wait
until later.
ßavIaW oI Iha 6apIIaI kssaI FrIrIng ModaI
Let us review tle basic principles ol portlolio selection.
1. Investors like ligl expected return and low standard deviation. Common stock
portlolios tlat oller tle liglest expected return lor a given standard deviation are
known as c//tctcnt pcrt/c/tcs.
2. Il tle investor can lend or borrow at tle risk-lree rate ol interest, one ellicient
p ortlolio is better tlan all tle otlers. tle portlolio tlat ollers tle liglest ratio ol risk
premium to standard deviation (tlat is, portlolio S in Iigure 8.5). A risk-averse inves-
tor will put part ol lis money in tlis ellicient portlolio and part in tle risk-lree asset.
A risk-tolerant investor may put all ler money in tlis portlolio or sle may borrow
and put in even more.
3. Tle composition ol tlis best ellicient portlolio depends on tle investor`s assessments
ol expected returns, standard deviations, and correlations. ßut suppose everybody
las tle same inlormation and tle same assessments. Il tlere is no superior inlorma-
tion, eacl investor slould lold tle same portlolio as everybody else, in otler words,
everyone slould lold tle market portlolio.
Now let us go back to tle risk ol individual stocks.
4. Do not look at tle risk ol a stock in isolation but at its contribution to portlolio risk.
Tlis contribution depends on tle stock`s sensitivity to clanges in tle value ol tle
portlolio.
5. A stock`s sensitivity to clanges in tle value ol tle murkct portlolio is known as hctu.
ßeta, tlerelore, measures tle marginal contribution ol a stock to tle risk ol tle mar-
ket portlolio.
Now il everyone lolds tle market portlolio, and il beta measures eacl security`s contribu-
tion to tle market portlolio risk, tlen it is no surprise tlat tle risk premium demanded by
investors is proportional to beta. Tlat is wlat tle CAIM says.
WhaI II a 8Iork ûId hoI LIa on Iha 8arurIIy MarkaI LIna?
Imagine tlat you encounter stock A in Iigure 8.7. Would you buy it: We lope not
11
÷il
you want an investment witl a beta ol .5, you could get a ligler expected return by invest-
ing lall your money in Treasury bills and lall in tle market portlolio. Il everybody slares
your view ol tle stock`s prospects, tle price ol A will lave to lall until tle expected return
matcles wlat you could get elsewlere.
10
Tle estimates in Table 8.2 may also be too low lor tle shcrt tcrm il investors required a ligler risk premium in tle slort term to
compensate lor tle unusual market volatility in 2009.

11
Unless, ol course, we were trying to sell it.
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model 196
Wlat about stock ß in Iigure 8.7: Would you be tempted by its ligl return: You
wouldn`t il you were smart. You could get a ligler expected return lor tle same beta by
borrowing 50 cents lor every dollar ol your own money and investing in tle market port-
lolio. Again, il everybody agrees witl your assessment, tle price ol stock ß cannot lold.
It will lave to lall until tle expected return on ß is equal to tle expected return on tle
combination ol borrowing and investment in tle market portlolio.
12
We lave made our point. An investor can always obtain an expected risk premium ol
(r
m
r
/
) by lolding a mixture ol tle market portlolio and a risk-lree loan. So in well-
lunctioning markets nobody will lold a stock tlat ollers an expected risk premium ol /css
tlan (r
m
r
/
). ßut wlat about tle otler possibility: Are tlere stocks tlat oller a ligler
expected risk premium: In otler words, are tlere any tlat lie above tle security market
line in Iigure 8.7: Il we take all stocks togetler, we lave tle market portlolio. Tlerelore,
we know tlat stocks cn uzcru¸c lie on tle line. Since none lies hc/cw tle line, tlen tlere
also can`t be any tlat lie uhczc tle line. Tlus eacl and every stock must lie on tle security
market line and oller an expected risk premium ol
r  r
/
  r
m
 r
/

Any economic model is a simplilied statement ol reality. We need to simplily in order to
interpret wlat is going on around us. ßut we also need to know low mucl laitl we can
place in our model.
Let us begin witl some matters about wlicl tlere is broad agreement. Iirst, lew people
quarrel witl tle idea tlat investors require some extra return lor taking on risk. Tlat is wly
common stocks lave given on average a ligler return tlan U.S. Treasury bills. Wlo would
want to invest in risky common stocks il tley ollered only tle sumc expected return as bills:
We would not, and we suspect you would not eitler.
Second, investors do appear to be concerned principally witl tlose risks tlat tley can-
not eliminate by diversilication. Il tlis were not so, we slould lind tlat stock prices increase
wlenever two companies merge to spread tleir risks. And we slould lind tlat investment

12
Investing in A or ß only would be stupid, you would lold an undiversilied portlolio.
8·3 validity and Role ol the Caµital Asset Fricing Model
Market
portIolio
Security
market line
1.5 1.0 .5 0
Expected return




beta
Stock B
Stock A
 FI608£ 8.7
ín equilibrium no
stock can lie below the
security market line. For
examµle, instead ol buy·
ing stock A, investors
would µreler to lend µart
ol their money and µut
the balance in the market
µortlolio. And instead
ol buying stock B, they
would µreler to borrow
and invest in the market
µortlolio.
196 FarI TWo Risk
companies wlicl invest in tle slares ol otler lirms are more liglly valued tlan tle slares
tley lold. ßut we do not observe eitler plenomenon. Mergers undertaken |ust to spread
risk do not increase stock prices, and investment companies are no more liglly valued tlan
tle stocks tley lold.
Tle capital asset pricing model captures tlese ideas in a simple way. Tlat is wly linan-
cial managers lind it a convenient tool lor coming to grips witl tle slippery notion ol risk
and wly nearly tlree-quarters ol tlem use it to estimate tle cost ol capital.
13
It is also wly
economists olten use tle capital asset pricing model to demonstrate important ideas in
linance even wlen tlere are otler ways to prove tlese ideas. ßut tlat does not mean tlat
tle capital asset pricing model is ultimate trutl. We will see later tlat it las several unsatis-
lactory leatures, and we will look at some alternative tleories. Nobody knows wletler one
ol tlese alternative tleories is eventually going to come out on top or wletler tlere are
otler, better models ol risk and return tlat lave not yet seen tle liglt ol day.
TasIs oI Iha 6apIIaI kssaI FrIrIng ModaI
Imagine tlat in 1931 ten investors gatlered togetler in a Wall Street bar and agreed to
establisl investment trust lunds lor tleir clildren. Lacl investor decided to lollow a dil-
lerent strategy. Investor 1 opted to buy tle 10% ol tle New York Stock Lxclange stocks
witl tle lowest estimated betas, investor 2 close tle 10% witl tle next-lowest betas, and
so on, up to investor 10, wlo proposed to buy tle stocks witl tle liglest betas. Tley also
planned tlat at tle end ol eacl year tley would reestimate tle betas ol all NYSL stocks and
reconstitute tleir portlolios.
14
And so tley parted witl mucl cordiality and good wisles.
In time tle 10 investors all passed away, but tleir clildren agreed to meet in early 2009
in tle same bar to compare tle perlormance ol tleir portlolios. Iigure 8.8 slows low tley
lad lared. Investor 1`s portlolio turned out to be mucl less risky tlan tle market, its beta
was only .49. However, investor 1 also realized tle lowest return, 8.0% above tle risk-lree
rate ol interest. At tle otler extreme, tle beta ol investor 10`s portlolio was 1.53, about
tlree times tlat ol investor 1`s portlolio. ßut investor 10 was rewarded witl tle liglest
return, averaging 14.3% a year above tle interest rate. So over tlis 77-year period returns
did indeed increase witl beta.
As you can see lrom Iigure 8.8, tle market portlolio over tle same 77-year period pro-
vided an average return ol 11.8% above tle interest rate
15
and (ol course) lad a beta ol
1.0. Tle CAIM predicts tlat tle risk premium slould increase in proportion to beta, so
tlat tle returns ol eacl portlolio slould lie on tle upward-sloping security market line in
I igure 8.8. Since tle market provided a risk premium ol 11.8%, investor 1`s portlolio, witl
a beta ol .49, slould lave provided a risk premium ol 5.8% and investor 10`s portlolio, witl
a beta ol 1.53, slould lave given a premium ol 18.1%. You can see tlat, wlile ligl-beta
stocks perlormed better tlan low-beta stocks, tle dillerence was not as great as tle CAIM
predicts.
Altlougl Iigure 8.8 provides broad support lor tle CAIM, critics lave pointed out tlat
tle slope ol tle line las been particularly llat in recent years. Ior example, Iigure 8.9 slows
low our 10 investors lared between 1966 and 2008. Now it is less clear wlo is buying tle
drinks. returns are pretty mucl in line witl tle CAIM witl tle important exception ol tle

13
See }. R. Cralam and C. R. Harvey, ¨Tle Tleory and Iractice ol Corporate Iinance. Lvidence lrom tle Iield," }curnu/ c/ Itnun-
ctu/ Iccncmtcs 61 (2001), pp. 187-243. A number ol tle managers surveyed reported using more tlan one metlod to estimate tle
cost ol capital. Seventy-tlree percent used tle capital asset pricing model, wlile 39% stated tley used tle average listorical stock
return and 34% used tle capital asset pricing model witl some extra risk lactors.

14
ßetas were estimated using returns over tle previous 60 montls.
15
In Iigure 8.8 tle stocks in tle ¨market portlolio" are weiglted equally. Since tle stocks ol small lirms lave provided ligler
average returns tlan tlose ol large lirms, tle risk premium on an equally weiglted index is ligler tlan on a value-weiglted index.
Tlis is one reason lor tle dillerence between tle 11.8% market risk premium in Iigure 8.8 and tle 7.1% premium reported in
Table 7.1.
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model 197
two liglest-risk portlolios. Investor 10, wlo rode tle roller coaster ol a ligl-beta portlolio,
earned a return tlat was below tlat ol tle market. Òl course, belore 1966 tle line was cor-
respondingly steeper. Tlis is also slown in Iigure 8.9.
FortIolio beta
lnvestor 1
lnvestor 10
Market
portIolio
Market line
2
3
4
5
ó
7
8 º
0
2
4
ó
8
10
12
14
1ó
Average risk premium,
1º31÷2008, %
0 .4 .2 .ó .8 1.0 1.2 1.4 1.8 2 1.ó
M
 FI608£ 8.8
The caµital asset µricing model states
that the exµected risk µremium lrom
any investment should lie on the
security market line. The dots show
the actual average risk µremiums lrom
µortlolios with dillerent betas. The
high·beta µortlolios generated higher
average returns, just as µredicted by
the CAFM. But the high·beta µortlolios
µlotted below the market line, and the
low·beta µortlolios µlotted above. A
line litted to the 1O µortlolio returns
would be ¨llatter" than the market line.
5c0rcc: F. Black, ¨Beta and Return," Jc0rra|
cf Fcrtfc|ic Maraçcmcrt 2O (Fall 1OO8), µµ.
8-18. © 1OO8 ínstitutional ínvestor. used with
µermission. we are gratelul to Adam
Kolasinski lor uµdating the calculations.
5
0
0
35
25
30
20
15
10
0.4 0.2 0.ó
FortIolio beta
0.8 1.0 1.2 1.4 1.8 1.ó
Market
line
2
3
4
5
ó
7
8
º
2
0
0
14
10
12
8
ó
4
0.4 0.2 0.ó
FortIolio beta
0.8 1.0 1.2 1.4 1.8 1.ó
Market
line
2
3
4
5 ó
7
8
º
lnvestor 10
lnvestor 10
Market
portIolio
lnvestor 1
lnvestor 1
M
Market
portIolio
M
 FI608£ 8.9
The relationshiµ between beta and
actual average return has been weaker
since the mid·1OGOs. Stocks with
the highest betas have µrovided µoor
returns.
5c0rcc: F. Black, ¨Beta and Return," Jc0rra|
cf Fcrtfc|ic Maraçcmcrt 2O (Fall 1OO8), µµ.
8-18. © 1OO8 ínstitutional ínvestor. used with
µermission. we are gratelul to Adam
Kolasinski lor uµdating the calculations.
19B FarI TWo Risk
Wlat is going on lere: It is lard to say. Delenders ol tle capital asset pricing model
emplasize tlat it is concerned witl cxpcctcd returns, wlereas we can observe only uctuu/
returns. Actual stock returns rellect expectations, but tley also embody lots ol ¨noise"÷tle
steady llow ol surprises tlat conceal wletler on average investors lave received tle returns
tley expected. Tlis noise may make it impossible to |udge wletler tle model lolds better
in one period tlan anotler.
16
Ierlaps tle best tlat we can do is to locus on tle longest
period lor wlicl tlere is reasonable data. Tlis would take us back to Iigure 8.8, wlicl sug-
gests tlat expected returns do indeed increase witl beta, tlougl less rapidly tlan tle simple
version ol tle CAIM predicts.
17
Tle CAIM las also come under lire on a second lront. altlougl return las not risen
witl beta in recent years, it las been related to otler measures. Ior example, tle red line in
Iigure 8.10 slows tle cumulative dillerence between tle returns on small-lirm stocks and
large-lirm stocks. Il you lad bouglt tle slares witl tle smallest market capitalizations and
sold tlose witl tle largest capitalizations, tlis is low your wealtl would lave clanged.
You can see tlat small-cap stocks did not always do well, but over tle long laul tleir own-
ers lave made substantially ligler returns. Since tle end ol 1926 tle average annual diller-
ence between tle returns on tle two groups ol stocks las been 3.6%.
Now look at tle green line in Iigure 8.10, wlicl slows tle cumulative dillerence between
tle returns on value stocks and growtl stocks. Value stocks lere are delined as tlose witl
ligl ratios ol book value to market value. Crowtl stocks are tlose witl low ratios ol book
to market. Notice tlat value stocks lave provided a ligler long-run return tlan growtl
stocks.
18
Since 1926 tle average annual dillerence between tle returns on value and growtl
stocks las been 5.2%.
Iigure 8.10 does not lit well witl tle CAIM, wlicl predicts tlat beta is tle cn/y reason
tlat expected returns diller. It seems tlat investors saw risks in ¨small-cap" stocks and value
stocks tlat were not captured by beta.
19
Take value stocks, lor example. Many ol tlese
stocks may lave sold below book value because tle lirms were in serious trouble, il tle
economy slowed unexpectedly, tle lirms miglt lave collapsed altogetler. Tlerelore, inves-
tors, wlose |obs could also be on tle line in a recession, may lave regarded tlese stocks as
particularly risky and demanded compensation in tle lorm ol ligler expected returns. Il
tlat were tle case, tle simple version ol tle CAIM cannot be tle wlole trutl.
Again, it is lard to |udge low seriously tle CAIM is damaged by tlis linding. Tle
relationslip among stock returns and lirm size and book-to-market ratio las been well
documented. However, il you look long and lard at past returns, you are bound to lind
some strategy tlat |ust by clance would lave worked in tle past. Tlis practice is known as
¨data-mining" or ¨data snooping." Maybe tle size and book-to-market ellects are simply
clance results tlat stem lrom data snooping. Il so, tley slould lave vanisled once tley
were discovered. Tlere is some evidence tlat tlis is tle case. Ior example, il you look again
at Iigure 8.10, you will see tlat in tle past 25 years small-lirm stocks lave underperlormed
|ust about as olten as tley lave overperlormed.

16
A second problem witl testing tle model is tlat tle market portlolio slould contain all risky investments, including stocks,
bonds, commodities, real estate÷even luman capital. Most market indexes contain only a sample ol common stocks.
17
We say ¨simple version" because Iiscler ßlack las slown tlat il tlere are borrowing restrictions, tlere slould still exist a positive
relationslip between expected return and beta, but tle security market line would be less steep as a result. See I. ßlack, ¨Capital
Market Lquilibrium witl Restricted ßorrowing," }curnu/ c/ ßustncss 45 (}uly 1972), pp. 444-455.
18
Iama and Irencl calculated tle returns on portlolios designed to take advantage ol tle size ellect and tle book-to-market ellect.
See L. I. Iama and K. R. Irencl, ¨Tle Cross-Section ol Lxpected Stock Returns," }curnu/ c/ Itnunctu/ Iccncmtcs 47 (}une 1992),
pp. 427-465. Wlen calculating tle returns on tlese portlolios, Iama and Irencl control lor dillerences in lirm size wlen com-
paring stocks witl low and ligl book-to-market ratios. Similarly, tley control lor dillerences in tle book-to-market ratio wlen
comparing small- and large-lirm stocks. Ior details ol tle metlodology and updated returns on tle size and book-to-market lactors
see Kennetl Irencl`s Web site ( mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html ).
19
An investor wlo bouglt small-company stocks and sold large-company stocks would lave incurred some risk. Her portlolio
would lave lad a beta ol .28. Tlis is not nearly large enougl to explain tle dillerence in returns. Tlere is no simple relationslip
between tle return on tle value- and growtl-stock portlolios and beta.
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model 199
Tlere is no doubt tlat tle evidence on tle CAIM is less convincing tlan sclolars once
tlouglt. ßut it will be lard to re|ect tle CAIM beyond all reasonable doubt. Since data
and statistics are unlikely to give linal answers, tle plausibility ol tle CAIM thccry will lave
to be weigled along witl tle empirical ¨lacts."
kssumpIIons bahInd Iha 6apIIaI kssaI FrIrIng ModaI
Tle capital asset pricing model rests on several assumptions tlat we did not lully spell out.
Ior example, we assumed tlat investment in U.S. Treasury bills is risk-lree. It is true tlat
tlere is little clance ol delault, but bills do not guarantee a rcu/ return. Tlere is still some
uncertainty about inllation. Anotler assumption was tlat investors can hcrrcw money at
tle same rate ol interest at wlicl tley can lend. Cenerally borrowing rates are ligler tlan
lending rates.
It turns out tlat many ol tlese assumptions are not crucial, and witl a little pusling and
pulling it is possible to modily tle capital asset pricing model to landle tlem. Tle really
important idea is tlat investors are content to invest tleir money in a limited number ol
benclmark portlolios. (In tle basic CAIM tlese benclmarks are Treasury bills and tle
market portlolio.)
In tlese modilied CAIMs expected return still depends on market risk, but tle delini-
tion ol market risk depends on tle nature ol tle benclmark portlolios. In practice, none ol
tlese alternative capital asset pricing models is as widely used as tle standard version.
Tle capital asset pricing model pictures investors as solely concerned witl tle level and
uncertainty ol tleir luture wealtl. ßut tlis could be too simplistic. Ior example, investors
may become accustomed to a particular standard ol living, so tlat poverty tomorrow may
be particularly dillicult to bear il you were wealtly yesterday. ßelavioral psyclologists lave
also observed tlat investors do not locus solely on tle currcnt value ol tleir loldings, but
look back at wletler tleir investments are slowing a prolit. A gain, lowever small, may be
8·4 Some Alternative Theories
High minus low book-to-market
Small minus big
1
0.1
10
100
Year
1º2ó 1º32 1º38 1º44 1º50 1º5ó 1ºó2 1ºó8 1º74 1º8ó 1ºº2 1ºº8 2004 1º80
 FI608£ 8.10
The red line shows the
cumulative dillerence
between the returns on
small·lirm and large·lirm
stocks. The green line
shows the cumulative
dillerence between the
returns on high book·
to·market·value stocks
(i.e., value stocks) and
low book·to·market·
value stocks (i.e., growth
stocks).
5c0rcc: Kenneth French's
web site, mba.Iurk.darI·
mouIh.adulpagaslIaruIIyl
kan.IranrhldaIa_IIbrary.hImI .
used with µermission.
Z00 FarI TWo Risk
an additional source ol satislaction. Tle capital asset pricing model does not allow lor tle
possibility tlat investors may take account ol tle price at wlicl tley purclased stock and
leel elated wlen tleir investment is in tle black and depressed wlen it is in tle red.
20
krbIIraga FrIrIng Thaory
Tle capital asset pricing tleory begins witl an analysis ol low investors construct ellicient
portlolios. Steplen Ross`s arbitrage pricing theory, or APT, comes lrom a dillerent lam-
ily entirely. It does not ask wlicl portlolios are ellicient. Instead, it starts by ussumtn¸ tlat
eacl stock`s return depends partly on pervasive macroeconomic inlluences or ¨lactors" and
partly on ¨noise"÷events tlat are unique to tlat company. Moreover, tle return is assumed
to obey tle lollowing simple relationslip.
Return  u  h
1
 r
lactor 1
  h
2
 r
lactor 2
  h
3
 r
lactor 3
 

 noise
Tle tleory does not say wlat tle lactors are. tlere could be an oil price lactor, an interest-
rate lactor, and so on. Tle return on tle market portlolio mt¸ht serve as one lactor, but tlen
again it miglt not.
Some stocks will be more sensitive to a particular lactor tlan otler stocks. Lxxon Mobil
would be more sensitive to an oil lactor tlan, say, Coca-Cola. Il lactor 1 picks up unex-
pected clanges in oil prices, h
1
will be ligler lor Lxxon Mobil.
Ior any individual stock tlere are two sources ol risk. Iirst is tle risk tlat stems lrom
tle pervasive macroeconomic lactors. Tlis cannot be eliminated by diversilication. Second
is tle risk arising lrom possible events tlat are specilic to tle company. Diversilication
eliminates specilic risk, and diversilied investors can tlerelore ignore it wlen deciding
wletler to buy or sell a stock. Tle expected risk premium on a stock is allected by lactor
or macroeconomic risk, it is nct allected by specilic risk.
Arbitrage pricing tleory states tlat tle expected risk premium on a stock slould depend
on tle expected risk premium associated witl eacl lactor and tle stock`s sensitivity to eacl
ol tle lactors (h
1
, h
2
, h
3
, etc.). Tlus tle lormula is
21
Lxpected risk premium  r  r
/
 h
1
 r
lactor 1
 r
/
  h
2
 r
lactor 2
 r
/
 

Notice tlat tlis lormula makes two statements.
1. Il you plug in a value ol zero lor eacl ol tle h`s in tle lormula, tle expected risk pre-
mium is zero. A diversilied portlolio tlat is constructed to lave zero sensitivity to eacl
macroeconomic lactor is essentially risk-lree and tlerelore must be priced to oller tle
risk-lree rate ol interest. Il tle portlolio ollered a ligler return, investors could make a
risk-lree (or ¨arbitrage") prolit by borrowing to buy tle portlolio. Il it ollered a lower
return, you could make an arbitrage prolit by running tle strategy in reverse, in otler
words, you would sc// tle diversilied zero-sensitivity portlolio and tnzcst tle proceeds
in U.S. Treasury bills.
2. A diversilied portlolio tlat is constructed to lave exposure to, say, lactor 1, will oller
a risk premium, wlicl will vary in direct proportion to tle portlolio`s sensitivity to
tlat lactor. Ior example, imagine tlat you construct two portlolios, A and ß, tlat are
allected only by lactor 1. Il portlolio A is twice as sensitive as portlolio ß to lactor 1,

20
We discuss aversion to loss again in Clapter 13. Tle implications lor asset pricing are explored in S. ßenartzi and R. Tlaler,
¨Myopic Loss Aversion and tle Lquity Iremium Iuzzle," Quurtcr/y }curnu/ c/ Iccncmtcs 110 (1995), pp. 75-92, and in N. ßarberis,
M. Huang, and T. Santos, ¨Irospect Tleory and Asset Irices," Quurtcr/y }curnu/ c/ Iccncmtcs 116 (2001), pp. 1-53.
21
Tlere may be some macroeconomic lactors tlat investors are simply not worried about. Ior example, some macroeconomists
believe tlat money supply doesn`t matter and tlerelore investors are not worried about inllation. Sucl lactors would not com-
mand a risk premium. Tley would drop out ol tle AIT lormula lor expected return.
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model Z01
portlolio A must oller twice tle risk premium. Tlerelore, il you divided your money
equally between U.S. Treasury bills and portlolio A, your combined portlolio would
lave exactly tle same sensitivity to lactor 1 as portlolio ß and would oller tle same
risk premium.
Suppose tlat tle arbitrage pricing lormula did nct lold. Ior example, suppose tlat
tle combination ol Treasury bills and portlolio A ollered a ligler return. In tlat case
investors could make an arbitrage prolit by selling portlolio ß and investing tle pro-
ceeds in tle mixture ol bills and portlolio A.
Tle arbitrage tlat we lave described applies to well-diversilied portlolios, wlere tle
specilic risk las been diversilied away. ßut il tle arbitrage pricing relationslip lolds lor
all diversilied portlolios, it must generally lold lor tle individual stocks. Lacl stock must
oller an expected return commensurate witl its contribution to portlolio risk. In tle AIT,
tlis contribution depends on tle sensitivity ol tle stock`s return to unexpected clanges in
tle macroeconomic lactors.
k 6omparIson oI Iha 6apIIaI kssaI FrIrIng ModaI
and krbIIraga FrIrIng Thaory
Like tle capital asset pricing model, arbitrage pricing tleory stresses tlat expected return
depends on tle risk stemming lrom economywide inlluences and is not allected by specilic
risk. You can tlink ol tle lactors in arbitrage pricing as representing special portlolios ol stocks
tlat tend to be sub|ect to a common inlluence. Il tle expected risk premium on eacl ol tlese
portlolios is proportional to tle portlolio`s market beta, tlen tle arbitrage pricing tleory and
tle capital asset pricing model will give tle same answer. In any otler case tley will not.
How do tle two tleories stack up: Arbitrage pricing las some attractive leatures. Ior
example, tle market portlolio tlat plays sucl a central role in tle capital asset pricing
model does not leature in arbitrage pricing tleory.
22
So we do not lave to worry about tle
problem ol measuring tle market portlolio, and in principle we can test tle arbitrage pric-
ing tleory even il we lave data on only a sample ol risky assets.
Unlortunately you win some and lose some. Arbitrage pricing tleory does not tell us
wlat tle underlying lactors are÷unlike tle capital asset pricing model, wlicl collapses u//
macroeconomic risks into a well-delined stn¸/c lactor, tle return on tle market portlolio.
Tha Thraa·FarIor ModaI
Look back at tle equation lor AIT. To estimate expected returns, you lirst need to lollow
tlree steps.
Stcp 1: Identily a reasonably slort list ol macroeconomic lactors tlat could allect
stock returns.
Stcp 2: Lstimate tle expected risk premium on eacl ol tlese lactors (r
lactor 1
r
/
, etc.).
Stcp 3: Measure tle sensitivity ol eacl stock to tle lactors (h
1
, h
2
, etc.).
Òne way to slortcut tlis process is to take advantage ol tle researcl by Iama and Irencl,
wlicl slowed tlat stocks ol small lirms and tlose witl a ligl book-to-market ratio lave
provided above-average returns. Tlis could simply be a coincidence. ßut tlere is also some
evidence tlat tlese lactors are related to company prolitability and tlerelore may be pick-
ing up risk lactors tlat are lelt out ol tle simple CAIM.
23

22
Òl course, tle market portlolio muy turn out to be one ol tle lactors, but tlat is not a necessary implication ol arbitrage pricing
tleory.
23
L. I. Iama and K. R. Irencl, ¨Size and ßook-to-Market Iactors in Larnings and Returns," }curnu/ c/ Itnuncc 50 (1995), pp.
131-155.
Z0Z FarI TWo Risk
Il investors do demand an extra return lor taking on exposure to tlese lactors, tlen
we lave a measure ol tle expected return tlat looks very mucl like arbitrage pricing
tleory.
r  r
/
 h
market
 r
market lactor
  h
size
 r
size lactor
  h
book-to-market
 r
book-to-market lactor

Tlis is commonly known as tle Iama-Irencl tlree-lactor model. Using it to esti-
mate expected returns is tle same as applying tle arbitrage pricing tleory. Here is an
example.
24
8Iap 1. IdanIIIy Iha FarIors Iama and Irencl lave already identilied tle tlree lactors tlat
appear to determine expected returns. Tle returns on eacl ol tlese lactors are
FarIor Maasurad by
Market lactor Return on market index mir0s risk·lree interest rate
Si/e lactor Return on small·lirm stocks |css return on
large·lirm stocks
Book·to·market lactor Return on high book·to·market·ratio stocks
|css return on low book·to·market·ratio stocks
8Iap Z. LsIImaIa Iha ßIsk FramIum Ior Larh FarIor We will keep to our ligure ol 7% lor tle
market risk premium. History may provide a guide to tle risk premium lor tle otler two
lactors. As we saw earlier, between 1926 and 2008 tle dillerence between tle annual returns
on small and large capitalization stocks averaged 3.6% a year, wlile tle dillerence between
tle returns on stocks witl ligl and low book-to-market ratios averaged 5.2%.
8Iap 8. LsIImaIa Iha FarIor 8ansIIIvIIIas Some stocks are more sensitive tlan otlers to
lluctuations in tle returns on tle tlree lactors. You can see tlis lrom tle lirst tlree columns
ol numbers in Table 8.3, wlicl slow some estimates ol tle lactor sensitivities ol 10 indus-
try groups lor tle 60 montls ending in December 2008. Ior example, an increase ol 1%
in tle return on tle book-to-market lactor rcduccs tle return on computer stocks by .87%
but tncrcuscs tle return on utility stocks by .77%. In otler words, wlen value stocks (ligl
book-to-market) outperlorm growtl stocks (low book-to-market), computer stocks tend to
perlorm relatively badly and utility stocks do relatively well.
Ònce you lave estimated tle lactor sensitivities, it is a simple matter to multiply eacl ol
tlem by tle expected lactor return and add up tle results. Ior example, tle expected risk
premium on computer stocks is r r
/
(1.43 7) (.22 3.6) (.87 5.2) 6.3%. To
calculate tle return tlat investors expected in 2008 we need to add on tle risk-lree interest
rate ol about .2%. Tlus tle tlree-lactor model suggests tlat expected return on computer
stocks in 2008 was .2 6.3 6.5%.
Compare tlis ligure witl tle expected return estimate using tle capital asset pricing
model (tle linal column ol Table 8.3). Tle tlree-lactor model provides a substantially
lower estimate ol tle expected return lor computer stocks. Wly: Largely because computer
stocks are growtl stocks witl a low exposure ( .87) to tle book-to-market lactor. Tle
tlree-lactor model produces a lower expected return lor growtl stocks, but it produces a
ligler ligure lor value stocks sucl as tlose ol auto and construction companies wlicl lave
a ligl book-to-market ratio.

24
Tle tlree-lactor model was lirst used to estimate tle cost ol capital lor dillerent industry groups by Iama and Irencl. See
L. I. Iama and K. R. Irencl, ¨Industry Costs ol Lquity," }curnu/ c/ Itnunctu/ Iccncmtcs 43 (1997), pp. 153-193. Iama and
Irencl emplasize tle imprecision in using eitler tle CAIM or an AIT-style model to estimate tle returns tlat investors
expect.
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model Z08
Tle basic principles ol portlolio selection boil down to a commonsense statement tlat inves-
tors try to increase tle expected return on tleir portlolios and to reduce tle standard deviation
ol tlat return. A portlolio tlat gives tle liglest expected return lor a given standard deviation,
or tle lowest standard deviation lor a given expected return, is known as an c//tctcnt pcrt/c/tc. To
work out wlicl portlolios are ellicient, an investor must be able to state tle expected return and
standard deviation ol eacl stock and tle degree ol correlation between eacl pair ol stocks.
Investors wlo are restricted to lolding common stocks slould cloose ellicient portlolios
tlat suit tleir attitudes to risk. ßut investors wlo can also borrow and lend at tle risk-lree rate ol
interest slould cloose tle hcst common stock portlolio rc¸urd/css ol tleir attitudes to risk. Hav-
ing done tlat, tley can tlen set tle risk ol tleir overall portlolio by deciding wlat proportion
ol tleir money tley are willing to invest in stocks. Tle best ellicient portlolio ollers tle liglest
ratio ol lorecasted risk premium to portlolio standard deviation.
Ior an investor wlo las only tle same opportunities and inlormation as everybody else, tle best
stock portlolio is tle same as tle best stock portlolio lor otler investors. In otler words, le or sle
slould invest in a mixture ol tle market portlolio and a risk-lree loan (i.e., borrowing or lending).
A stock`s marginal contribution to portlolio risk is measured by its sensitivity to clanges in tle
value ol tle portlolio. Tle marginal contribution ol a stock to tle risk ol tle murkct pcrt/c/tc is mea-
sured by hctu. Tlat is tle lundamental idea belind tle capital asset pricing model (CAIM), wlicl
concludes tlat eacl security`s expected risk premium slould increase in proportion to its beta.
Lxpected risk premium  beta  market risk premium
r  r
/
  r
m
 r
/

Tle capital asset pricing tleory is tle best-known model ol risk and return. It is plausible
and widely used but lar lrom perlect. Actual returns are related to beta over tle long run, but
tle relationslip is not as strong as tle CAIM predicts, and otler lactors seem to explain returns
better since tle mid-1960s. Stocks ol small companies, and stocks witl ligl book values relative
to market prices, appear to lave risks not captured by tle CAIM.
8üMMkßY
 Ik8l£ 8.3 Estimates ol exµected equity returns lor selected industries using the Fama-French three·lactor model
and the CAFM.
`
The exµected return equals the risk·lree interest rate µlus the lactor sensitivities multiµlied by the lactor risk µremiums, that is,
r
f
(|
market
7) (|
si/e
8.G) (|
book · to · market
5.2).
``
Estimated as r
f
(r
m
r
f
), that is, r
f
7. hote that we used simp|c regression to estimate in the CAFM lormula. This beta may, therelore,
be dillerent lrom b
market
that we estimated lrom a m0|tip|c regression ol stock returns on the three lactors.
Thraa·FarIor ModaI
FarIor 8ansIIIvIIIas 6kFM

markaI

sIta

book · Io · markaI
LxparIad
ßaIurn
*
LxparIad
ßaIurn
**
Autos 1.51 .O7 .O1 15.7 7.O
Banks 1.1G .25 .72 11.1 G.2
Chemicals 1.O2 .O7 .G1 1O.2 5.5
Comµuters 1.48 .22 .87 G.5 12.8
Construction 1.4O .4G .O8 1G.G 7.G
Food .58 .15 .47 5.8 2.7
0il and gas .85 .18 .54 8.5 4.8
Fharmaceuticals .5O .82 .18 1.O 4.8
Telecoms 1.O5 .2O .1G 5.7 7.8
utilities .G1 .O1 .77 8.4 2.4
 
Z04 FarI TWo Risk
Tle arbitrage pricing tleory ollers an alternative tleory ol risk and return. It states tlat tle
expected risk premium on a stock slould depend on tle stock`s exposure to several pervasive
macroeconomic lactors tlat allect stock returns.
Lxpected risk premium  h
1
 r
lactor 1
 r
/
  h
2
 r
lactor 2
 r
/
 


Here h `s represent tle individual security`s sensitivities to tle lactors, and r
lactor
r
/
is tle risk
premium demanded by investors wlo are exposed to tlis lactor.
Arbitrage pricing tleory does not say wlat tlese lactors are. It asks lor economists to lunt
lor unknown game witl tleir statistical toolkits. Iama and Irencl lave suggested tlree lactors.
· Tle return on tle market portlolio less tle risk-lree rate ol interest.
· Tle dillerence between tle return on small- and large-lirm stocks.
· Tle dillerence between tle return on stocks witl ligl book-to-market ratios and stocks witl
low book-to-market ratios.
In tle Iama-Irencl tlree-lactor model, tle expected return on eacl stock depends on its expo-
sure to tlese tlree lactors.
Lacl ol tlese dillerent models ol risk and return las its lan club. However, all linancial economists
agree on two basic ideas. (1) Investors require extra expected return lor taking on risk, and (2) tley
appear to be concerned predominantly witl tle risk tlat tley cannot eliminate by diversilication.
Near tle end ol Clapter 9 we list some Lxcel Iunctions tlat are uselul lor measuring tle risk
ol stocks and portlolios.
 
 
. numhcr c/ tcxthccks cn pcrt/c/tc sc/ccttcn cxp/utn hcth Æurkcwttz`s crt¸tnu/ thccry und scmc tn¸cntcus
stmp/t/tcd zcrstcns. Scc, /cr cxump/c:
L. }. Llton, M. }. Cruber, S. }. ßrown, and W. N. Coetzmann. Æcdcrn Icrt/c/tc Thccry und
Inzcstmcnt .nu/ysts, 7tl ed. (New York. }oln Wiley s Sons, 2007).
Thc /ttcruturc cn thc cupttu/ ussct prtctn¸ mcdc/ ts cncrmcus. Thcrc urc dczcns c/ puh/tshcd tcsts c/ thc cupttu/
ussct prtctn¸ mcdc/. Itshcr ß/uck`s pupcr ts u zcry rcuduh/c cxump/c. Dtscusstcns c/ thc thccry tcnd tc hc mcrc
unccmprcmtstn¸. Twc cxcc//cnt hut udzunccd cxump/cs urc Cumphc//`s surzcy pupcr und Ccchrunc`s hcck.
I. ßlack, ¨ßeta and Return," }curnu/ c/ Icrt/c/tc Æunu¸cmcnt 20 (Iall 1993), pp. 8-18.
}. Y. Campbell, ¨Asset Iricing at tle Millennium," }curnu/ c/ Itnuncc 55 (August 2000),
pp. 1515-1567.
}. H. Coclrane, .ssct Irtctn¸, revised ed. (Irinceton, N}. Irinceton University Iress, 2004).
FüßThLß
ßLkûIhû
ScIcct probIcms arc avaiIabIc in McGraw-HiII Conncct.
PIcasc scc thc prcfacc for morc information.
8k8I6
1. Here are returns and standard deviations lor lour investments.
ßaIurn
8Iandard
ûavIaIIon
Treasury bills G % O%
Stock F 1O 14
Stock 0 14.5 28
Stock R 21 2G
Fßû8LLM 8LT8
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model Z06
Calculate tle standard deviations ol tle lollowing portlolios.
a. 50% in Treasury bills, 50% in stock I.
b. 50% eacl in Q and R, assuming tle slares lave
· perlect positive correlation
· perlect negative correlation
· no correlation
c. Ilot a ligure like Iigure 8.3 lor Q and R, assuming a correlation coellicient ol .5.
d. Stock Q las a lower return tlan R but a ligler standard deviation. Does tlat mean tlat
Q`s price is too ligl or tlat R`s price is too low:
2. Ior eacl ol tle lollowing pairs ol investments, state wlicl would always be prelerred by a
rational investor (assuming tlat tlese are tle cn/y investments available to tle investor).
a. Iortlolio A r  18%   20%
Iortlolio ß r  14%   20%

b. Iortlolio C r  15%   18%
Iortlolio D r  13%   8%

c. Iortlolio L r  14%   16%
Iortlolio I r  14%   10%

3. Use tle long-term data on security returns in Sections 7-1 and 7-2 to calculate tle listorical
level ol tle Slarpe ratio ol tle market portlolio.
4. Iigure 8.11 below purports to slow tle range ol attainable combinations ol expected return
and standard deviation.
a. Wlicl diagram is incorrectly drawn and wly:
b. Wlicl is tle ellicient set ol portlolios:
c. Il r
/
is tle rate ol interest, mark witl an X tle optimal stock portlolio.
5. a. Ilot tle lollowing risky portlolios on a grapl.
ForIIoIIo
k 8 6 û L F û h
Exµected return (r), % 1O 12.5 15 1G 17 18 18 2O
Standard deviation ( ), % 28 21 25 2O 2O 82 85 45
b. Iive ol tlese portlolios are ellicient, and tlree are not. Wlicl are tn ellicient ones:
c. Suppose you can also borrow and lend at an interest rate ol 12%. Wlicl ol tle above
portlolios las tle liglest Slarpe ratio:

B
C
A

B
C
A




() ()
 FI608£ 8.11
See Froblem 4.
Z06 FarI TWo Risk
d. Suppose you are prepared to tolerate a standard deviation ol 25%. Wlat is tle maxi-
mum expected return tlat you can aclieve il you cannot borrow or lend:
e. Wlat is your optimal strategy il you can borrow or lend at 12% and are prepared to
tolerate a standard deviation ol 25%: Wlat is tle maximum expected return tlat you
can aclieve witl tlis risk:
6. Suppose tlat tle Treasury bill rate were 6% ratler tlan 4%. Assume tlat tle expected
return on tle market stays at 10%. Use tle betas in Table 8.2 .
a. Calculate tle expected return lrom Dell.
b. Iind tle liglest expected return tlat is ollered by one ol tlese stocks.
c. Iind tle lowest expected return tlat is ollered by one ol tlese stocks.
d. Would Iord oller a ligler or lower expected return il tle interest rate were 6% ratler
tlan 4%: Assume tlat tle expected market return stays at 10%.
e. Would Lxxon Mobil oller a ligler or lower expected return il tle interest rate were
8%:
7. True or lalse:
a. Tle CAIM implies tlat il you could lind an investment witl a negative beta, its
expected return would be less tlan tle interest rate.
b. Tle expected return on an investment witl a beta ol 2.0 is twice as ligl as tle expected
return on tle market.
c. Il a stock lies below tle security market line, it is undervalued.
8. Consider a tlree-lactor AIT model. Tle lactors and associated risk premiums are
FarIor ßIsk FramIum
Change in 0hF 5%
Change in energy µrices 1
Change in long·term interest rates 2
Calculate expected rates ol return on tle lollowing stocks. Tle risk-lree interest rate is 7%.
a. A stock wlose return is uncorrelated witl all tlree lactors.
b. A stock witl average exposure to eacl lactor (i.e., witl h 1 lor eacl).
c. A pure-play energy stock witl ligl exposure to tle energy lactor ( h 2) but zero expo-
sure to tle otler two lactors.
d. An aluminum company stock witl average sensitivity to clanges in interest rates and
CNI, but negative exposure ol h 1.5 to tle energy lactor. (Tle aluminum company
is energy-intensive and sullers wlen energy prices rise.)
IhTLßMLûIkTL
9. True or lalse: Lxplain or qualily as necessary.
a. Investors demand ligler expected rates ol return on stocks witl more variable rates ol
return.
b. Tle CAIM predicts tlat a security witl a beta ol 0 will oller a zero expected return.
c. An investor wlo puts $10,000 in Treasury bills and $20,000 in tle market portlolio will
lave a beta ol 2.0.
d. Investors demand ligler expected rates ol return lrom stocks witl returns tlat are
liglly exposed to macroeconomic risks.
e. Investors demand ligler expected rates ol return lrom stocks witl returns tlat are very
sensitive to lluctuations in tle stock market.
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model Z07
10. Look back at tle calculation lor Campbell Soup and ßoeing in Section 8.1 . Recalcu-
late tle expected portlolio return and standard deviation lor dillerent values ol x
1
and
x
2
, assuming tle correlation coellicient
12
0. Ilot tle range ol possible combina-
tions ol expected return and standard deviation as in Iigure 8.3 . Repeat tle problem lor

12
.5.
11. Mark Harrywitz proposes to invest in two slares, X and Y. He expects a return ol 12%
lrom X and 8% lrom Y. Tle standard deviation ol returns is 8% lor X and 5% lor Y. Tle
correlation coellicient between tle returns is .2.
a. Compute tle expected return and standard deviation ol tle lollowing portlolios.
ForIIoIIo FarranIaga In X FarranIaga In Y
1 5O 5O
2 25 75
8 75 25
b. Sketcl tle set ol portlolios composed ol X and Y.
c. Suppose tlat Mr. Harrywitz can also borrow or lend at an interest rate ol 5%. Slow on
your sketcl low tlis alters lis opportunities. Civen tlat le can borrow or lend, wlat
proportions ol tle common stock portlolio slould be invested in X and Y:
12. Lbenezer Scrooge las invested 60% ol lis money in slare A and tle remainder in slare ß.
He assesses tleir prospects as lollows.
k 8
Exµected return (%) 15 2O
Standard deviation (%) 2O 22
Correlation between returns .5
a. Wlat are tle expected return and standard deviation ol returns on lis portlolio:
b. How would your answer clange il tle correlation coellicient were 0 or .5:
c. Is Mr. Scrooge`s portlolio better or worse tlan one invested entirely in slare A, or is it
not possible to say:
13. Look back at Iroblem 3 in Clapter 7. Tle risk-lree interest rate in eacl ol tlese years was
as lollows.
Z008 Z004 Z006 Z006 Z007
ínterest rate% 1.O1 1.87 8.15 4.78 4.8G
a. Calculate tle average return and standard deviation ol returns lor Ms. Sauros`s portlo-
lio and lor tle market. Use tlese ligures to calculate tle Slarpe ratio lor tle portlolio
and tle market. Òn tlis measure did Ms. Sauros perlorm better or worse tlan tle
market:
b. Now calculate tle average return tlat you could lave earned over tlis period il you lad
leld a combination ol tle market and a risk-lree loan. Make sure tlat tle combination
las tle same beta as Ms. Sauros`s portlolio. Would your average return on tlis portlo-
lio lave been ligler or lower:
Lxplain your results.
14. Look back at Table 7.5 on page 174.
a. Wlat is tle beta ol a portlolio tlat las 40% invested in Disney and 60% in Lxxon
Mobil:
visit us at
www.mhhe.com/bma
Z0B FarI TWo Risk
b. Would you invest in tlis portlolio il you lad no superior inlormation about tle pros-
pects lor tlese stocks: Devise an alternative portlolio witl tle same expected return and
less risk.
c. Now repeat parts (a) and (b) witl a portlolio tlat las 40% invested in Amazon and 60%
in Dell.
15. Tle Treasury bill rate is 4%, and tle expected return on tle market portlolio is 12%. Using
tle capital asset pricing model.
a. Draw a grapl similar to Iigure 8.6 slowing low tle expected return varies witl beta.
b. Wlat is tle risk premium on tle market:
c. Wlat is tle required return on an investment witl a beta ol 1.5:
d. Il an investment witl a beta ol .8 ollers an expected return ol 9.8%, does it lave a posi-
tive NIV:
e. Il tle market expects a return ol 11.2% lrom stock X, wlat is its beta:
16. Iercival Hygiene las $10 million invested in long-term corporate bonds. Tlis bond
portlolio`s expected annual rate ol return is 9%, and tle annual standard deviation is
10%.
Amanda Reckonwitl, Iercival`s linancial adviser, recommends tlat Iercival consider
investing in an index lund tlat closely tracks tle Standard s Ioor`s 500 index. Tle index
las an expected return ol 14%, and its standard deviation is 16%.
a. Suppose Iercival puts all lis money in a combination ol tle index lund and Treasury
bills. Can le tlereby improve lis expected rate ol return witlout clanging tle risk ol
lis portlolio: Tle Treasury bill yield is 6%.
b. Could Iercival do even better by investing equal amounts in tle corporate bond port-
lolio and tle index lund: Tle correlation between tle bond portlolio and tle index
lund is .1.
17. Lpsilon Corp. is evaluating an expansion ol its business. Tle casl-llow lorecasts lor tle
pro|ect are as lollows.
Yaars 6ash FIoW ($ mIIIIons)
O 1OO
1-1O 15
Tle lirm`s existing assets lave a beta ol 1.4. Tle risk-lree interest rate is 4% and tle expected
return on tle market portlolio is 12%. Wlat is tle pro|ect`s NIV:
18. Some true or lalse questions about tle AIT.
a. Tle AIT lactors cannot rellect diversiliable risks.
b. Tle market rate ol return cannot be an AIT lactor.
c. Tlere is no tleory tlat specilically identilies tle AIT lactors.
d. Tle AIT model could be true but not very uselul, lor example, il tle relevant lactors
clange unpredictably.
19. Consider tle lollowing simplilied AIT model.
FarIor
LxparIad ßIsk
FramIum
Market G.4%
ínterest rate .G
Yield sµread 5.1
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model Z09
Calculate tle expected return lor tle lollowing stocks. Assume r
/
5%.
FarIor ßIsk Lxposuras
MarkaI InIarasI ßaIa YIaId 8praad
8Iork (
1
) (
Z
) (
8
)
F 1.O 2.O .2
F
2
1.2 O .8
F
8
.8 .5 1.O
20. Look again at Iroblem 19. Consider a portlolio witl equal investments in stocks I, I
2
,
and I
3
.
a. Wlat are tle lactor risk exposures lor tle portlolio:
b. Wlat is tle portlolio`s expected return:
21. Tle lollowing table slows tle sensitivity ol lour stocks to tle tlree Iama-Irencl lactors.
Lstimate tle expected return on eacl stock assuming tlat tle interest rate is .2%, tle
expected risk premium on tle market is 7%, tle expected risk premium on tle size lactor
is 3.6%, and tle expected risk premium on tle book-to-market lactor is 5.2%.
8oaIng
1ohnson &
1ohnson ûoW 6hamIraI MIrrosoII
Market O.GG O.54 1.O5 O.O1
Si/e 1.1O O.58 O.15 O.O4
Book·to·market O.7G O.1O O.77 O.4O
6hkLLLhûL
22. In lootnote 4 we noted tlat tle minimum-risk portlolio contained an investment ol 73.1%
in Campbell Soup and 26.9% in ßoeing. Irove it. ( Htnt: You need a little calculus to do so.)
23. Look again at tle set ol tle tlree ellicient portlolios tlat we calculated in Section 8.1 .
a. Il tle interest rate is 10%, wlicl ol tle lour ellicient portlolios slould you lold:
b. Wlat is tle beta ol eacl lolding relative to tlat portlolio: ( Htnt: Note tlat il a portlolio
is ellicient, tle expected risk premium on eacl lolding must be proportional to tle
beta ol tle stock rc/uttzc tc thut pcrt/c/tc. )
c. How would your answers to (a) and (b) clange il tle interest rate were 5%:
24. Tle lollowing question illustrates tle AIT. Imagine tlat tlere are only two pervasive mac-
roeconomic lactors. Investments X, Y, and Z lave tle lollowing sensitivities to tlese two
lactors.
InvasImanI 
1

Z
X 1.75 .25
Y 1.OO 2.OO
Z 2.OO 1.OO
We assume tlat tle expected risk premium is 4% on lactor 1 and 8% on lactor 2. Treasury
bills obviously oller zero risk premium.
a. According to tle AIT, wlat is tle risk premium on eacl ol tle tlree stocks:
b. Suppose you buy $200 ol X and $50 ol Y and sell $150 ol Z. Wlat is tle sensitivity ol
your portlolio to eacl ol tle two lactors: Wlat is tle expected risk premium:
Z10 FarI TWo Risk
c. Suppose you buy $80 ol X and $60 ol Y and sell $40 ol Z. Wlat is tle sensitivity ol
your portlolio to eacl ol tle two lactors: Wlat is tle expected risk premium:
d. Iinally, suppose you buy $160 ol X and $20 ol Y and sell $80 ol Z. Wlat is your
portlolio`s sensitivity now to eacl ol tle two lactors: And wlat is tle expected risk
premium:
e. Suggest two possible ways tlat you could construct a lund tlat las a sensitivity ol .5
to lactor 1 only. ( Htnt: Òne portlolio contains an investment in Treasury bills.) Now
compare tle risk premiums on eacl ol tlese two investments.
l. Suppose tlat tle AIT did nct lold and tlat X ollered a risk premium ol 8%, Y ollered
a premium ol 14%, and Z ollered a premium ol 16%. Devise an investment tlat las
zero sensitivity to eacl lactor and tlat las a positive risk premium.
 
You can download data for the following questions from the Standard 8 Poor's Market
lnsight Web site ( www.mhhe.com/edumarketinsight )-see the ºMonthly Adjusted Prices"
spreadsheet-or from finance.yahoo.com.
Actc: Wlen we calculated tle ellicient portlolios in Table 8.1 , we assumed tlat tle
in vestor could not lold slort positions (i.e., lave negative loldings). Tle book`s Web site
( www.mhhe.com/bma ) contains an Lxcel program lor calculating tle ellicient lrontier witl
slort sales. (We are gratelul to Simon Cervais lor providing us witl a copy ol tlis program.)
Lxcel lunctions SLÒIL, STDLV, and CÒRRLL are especially uselul lor answering tle lol-
lowing questions.
1. a. Look at tle ellicient portlolios constructed lrom tle 10 stocks in Table 8.1 . How does
tle possibility ol slort sales improve tle cloices open to tle investor:
b. Now download up to 10 years ol montlly returns lor 10 dillerent stocks and enter tlem
into tle Lxcel program. Lnter some plausible ligures lor tle expected return on eacl
stock and lind tle set ol ellicient portlolios.
2. Iind a low-risk stock÷Lxxon Mobil or Kellogg would be a good candidate. Use montlly
returns lor tle most recent tlree years to conlirm tlat tle beta is less tlan 1.0. Now estimate
tle annual standard deviation lor tle stock and tle SsI index, and tle correlation between
tle returns on tle stock and tle index. Iorecast tle expected return lor tle stock, assuming
tle CAIM lolds, witl a market return ol 12% and a risk-lree rate ol 5%.
a. Ilot a grapl like Iigure 8.5 slowing tle combinations ol risk and return lrom a portlolio
invested in your low-risk stock and tle market. Vary tle lraction invested in tle stock
lrom 0 to 100%.
b. Suppose tlat you can borrow or lend at 5%. Would you invest in some combination
ol your low-risk stock and tle market, or would you simply invest in tle market:
Lxplain.
c. Suppose tlat you lorecasted a return on tle stock tlat is 5 percentage points ligler
tlan tle CAIM return used in part (b). Redo parts (a) and (b) witl tle ligler lorecasted
return.
d. Iind a ligl-risk stock and redo parts (a) and (b).
3. Recalculate tle betas lor tle stocks in Table 8.2 using tle latest 60 montlly returns.
Recalculate expected rates ol return lrom tle CAIM lormula, using a current risk-lree
rate and a market risk premium ol 7%. How lave tle expected returns clanged lrom
Table 8.2 :
ßLkL·TIML
ûkTk khkLY8I8
6hapIar B Fortlolio Theory and the Caµital Asset Fricing Model Z11
1ohn and Marsha on ForIIoIIo 8aIarIIon
Thc sccnc: }oln and Marsla lold lands in a cozy Irencl restaurant in downtown Manlattan,
several years belore tle mini-case in Clapter 9. Marsla is a lutures-market trader. }oln manages
a $125 million common-stock portlolio lor a large pension lund. Tley lave |ust ordered tourne-
dos linanciere lor tle main course and llan linanciere lor dessert. }oln reads tle linancial pages
ol Thc Wu// Strcct }curnu/ by candleliglt.
]ohn: Wow! Iotato lutures lit tleir daily limit. Let`s add an order ol gratin dauplinoise. Did
you manage to ledge tle lorward interest rate on tlat euro loan:
matsha: }oln, please lold up tlat paper. ( Hc dccs sc rc/uctunt/y. ) }oln, I love you. Will you marry
me:
]ohn: Òl, Marsla, I love you too, but . . . tlere`s sometling you must know about me÷
sometling I`ve never told anyone.
matsha (ccnccrncd) : }oln, wlat is it:
]ohn: I tlink I`m a closet indexer.
matsha: Wlat: Wly:
]ohn: My portlolio returns always seem to track tle SsI 500 market index. Sometimes I do a
little better, occasionally a little worse. ßut tle correlation between my returns and tle mar-
ket returns is over 90%.
matsha: Wlat`s wrong witl tlat: Your client wants a diversilied portlolio ol large-cap stocks.
Òl course your portlolio will lollow tle market.
]ohn: Wly doesn`t my client |ust buy an index lund: Wly is le paying mc° Am I really adding
value by active management: I try, but I guess I`m |ust an . . . indexer.
matsha: Òl, }oln, I know you`re adding value. You were a star security analyst.
]ohn: It`s not easy to lind stocks tlat are truly over- or undervalued. I lave lirm opinions about
a lew, ol course.
matsha: You were explaining wly Iioneer Cypsum is a good buy. And you`re bullisl on Clobal
Mining.
]ohn: Riglt, Iioneer. ( Iu//s hundwrtttcn nctcs /rcm hts ccut pcckct. ) Stock price $87.50. I estimate
tle expected return as 11% witl an annual standard deviation ol 32%.
matsha: Ònly 11%: You`re lorecasting a market return ol 12.5%.
]ohn: Yes, I`m using a market risk premium ol 7.5% and tle risk-lree interest rate is about 5%.
Tlat gives 12.5%. ßut Iioneer`s beta is only .65. I was going to buy 30,000 slares tlis morn-
ing, but I lost my nerve. I`ve got to stay diversilied.
matsha: Have you tried modern portlolio tleory:
]ohn: MIT: Not practical. Looks great in textbooks, wlere tley slow ellicient lrontiers witl
5 or 10 stocks. ßut I cloose lrom lundreds, maybe tlousands, ol stocks. Wlere do I get tle
inputs lor 1,000 stocks: Tlat`s a million variances and covariances!
matsha: Actually only about 500,000, dear. Tle covariances above tle diagonal are tle same as
tle covariances below. ßut you`re riglt, most ol tle estimates would be out-ol-date or |ust
garbage.
]ohn: To say notling about tle expected returns. Carbage in, garbage out.
matsha: ßut }oln, you don`t need to solve lor 1,000 portlolio weiglts. You only need a land-
lul. Here`s tle trick. Take your benclmark, tle SsI 500, as security 1. Tlat`s wlat you would
MIhI·6k8L
 
Z1Z FarI TWo Risk
end up witl as an indexer. Tlen consider a lew securities you really know sometling about.
Iioneer could be security 2, lor example. Clobal, security 3. And so on. Tlen you could put
your wonderlul linancial mind to work.
]ohn: I get it. active management means selling oll some ol tle benclmark portlolio and invest-
ing tle proceeds in specilic stocks like Iioneer. ßut low do I decide wletler Iioneer really
improves tle portlolio: Lven il it does, low mucl slould I buy:
matsha: }ust maximize tle Slarpe ratio, dear.
]ohn: I`ve got it! Tle answer is yes!
matsha: Wlat`s tle question:
]ohn: You asked me to marry you. Tle answer is yes. Wlere slould we go on our loneymoon:
matsha: How about Australia: I`d love to visit tle Sydney Iutures Lxclange.
ûüL8TIûh8
 Table 8.4 reproduces }oln`s notes on Iioneer Cypsum and Clobal Mining. Calculate tle
expected return, risk premium, and standard deviation ol a portlolio invested partly in tle
market and partly in Iioneer. (You can calculate tle necessary inputs lrom tle betas and
standard deviations given in tle table.) Does adding Iioneer to tle market benclmark
improve tle Slarpe ratio: How mucl slould }oln invest in Iioneer and low mucl in tle
market:
 Repeat tle analysis lor Clobal Mining. Wlat slould }oln do in tlis case: Assume tlat
Clobal accounts lor .75% ol tle SsI index.
 Ik8l£ 8.4 John's
notes on Fioneer 0yµsum
and 0lobal Mining.
FIonaar ûypsum ûIobaI MInIng
Exµected return 11.O% 12.O%
Standard deviation 82% 2O%
Beta .G5 1.22
Stock µrice $87.5O $1O5.OO