Chapter 2: Investors, Derivatives, and Risk Management

Chapter objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Section 2.1. Evaluating the risk and the return of individual securities and portfolios. . . . 3
Section 2.1.1. The risk of investing in IBM. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Section 2.1.2. Evaluating the expected return and the risk of a portfolio. . . . . . 11
Section 2.2. The benefits from diversification and their implications for expected returns.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Section 2.2.1. The risk-free asset and the capital asset pricing model . . . . . . . . . 21
Section 2.2.2. The risk premium for a security. . . . . . . . . . . . . . . . . . . . . . . . . . 24
Section 2.3. Diversification and risk management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Section 2.3.1. Risk management and shareholder wealth. . . . . . . . . . . . . . . . . . 36
Section 2.3.2. Risk management and shareholder clienteles . . . . . . . . . . . . . . . . 41
Section 2.3.3. The risk management irrelevance proposition. . . . . . . . . . . . . . . 46
1) Diversifiable risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2) Systematic risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
3) Risks valued by investors differently than predicted by the CAPM . . . 46
Hedging irrelevance proposition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Section 2.4. Risk management by investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Section 2.5. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Literature Note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Key concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Review questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Questions and exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Figure 2.1. Cumulative probability function for IBM and for a stock with same return and
twice the volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Figure 2.2. Normal density function for IBM assuming an expected return of 13% and a
volatility of 30% and of a stock with the same expected return but twice the
volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Figure 2.3. Efficient frontier without a riskless asset . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Figure 2.4. The benefits from diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Figure 2.5. Efficient frontier without a riskless asset. . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Figure 2.6. Efficient frontier with a risk-free asset. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Figure 2.7. The CAPM. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
Box: T-bills. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Box: The CAPM in practice. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
SUMMARY OUTPUT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

Chapter 2: Investors, Derivatives, and Risk Management
December 1, 1999

Ren M. Stulz 1997, 1999
1
Chapter objectives
1. Review expected return and volatility for a security and a portfolio.
2. Use the normal distribution to make statements about the distribution of returns of a portfolio.
3. Evaluate the risk of a security in a portfolio.
4. Show how the capital asset pricing model is used to obtain the expected return of a security.
4. Demonstrate how hedging affects firm value in perfect financial markets.
5. Show how investors evaluate risk management policies of firms in perfect financial markets.
6. Show how investors can use risk management and derivatives in perfect financial markets to make
themselves better off.
2
During the 1980s and part of the 1990s, two gold mining companies differed dramatically in
their risk management policies. One company, Homestake, had a policy of not managing its gold price
risk at all. Another company, American Barrick, had a policy of eliminating most of its gold price risk
using derivatives. In this chapter we investigate whether investors prefer one policy to the other and
why. More broadly, we consider how investors evaluate the risk management policies of the firms
in which they invest. In particular, we answer the following question: When does an investor want
a firm in which she holds shares to spend money to reduce the volatility of its stock price?
To find out how investors evaluate firm risk management policies, we have to study how
investors decide to invest their money and how they evaluate the riskiness of their investments. We
therefore examine first the problem of an investor that can invest in two stocks, one of them IBM and
the other a fictional one that we call XYZ. This examination allows us to review concepts of risk and
return and to see how one can use a probability distribution to estimate the risk of losing specific
amounts of capital invested in risky securities. Throughout this book, it will be of crucial importance
for us to be able to answer questions such as: How likely is it that the value of a portfolio of securities
will fall by more than 10% over the next year? In this chapter, we show how to answer this question
when the portfolio does not include derivatives.
Investors have two powerful risk management tools at their disposal that enable them to
invest their wealth with a level of risk that is optimal for them. The first tool is asset allocation. An
investors asset allocation specifies how her wealth is allocated across types of securities or asset
classes. For instance, for an investor who invests in equities and the risk-free asset, the asset
allocation decision involves choosing the fraction of his wealth invested in equities. By investing less
in equities and more in the risk-free asset, the investor reduces the risk of her invested wealth. The
3
second tool is diversification. Once the investor has decided how much to invest in an asset class,
she has to decide which securities to hold and in which proportion. A portfolios diversification is the
extent to which the funds invested are distributed across securities to reduce the dependence of the
portfolios return on the return of individual securities. If a portfolio has only one security, it is not
diversified and the investor always loses if that security performs poorly. A diversified portfolio can
have a positive return even though some of its securities make losses because the gains from the other
securities can offset these losses. Diversification therefore reduces the risk of funds invested in an
asset class. We will show that these risk management tools imply that investors do not need the help
of individual firms to achieve their optimal risk-return takeoff. Because of the availability of these risk
management tools, investors only benefit from a firms risk management policy if that policy
increases the present value of the cash flows the firm is expected to generate. In the next chapter, we
demonstrate when and how risk management by firms can make investors better off.
After having seen the conditions that must be met for a firms risk management policy to
increase firm value, we turn to the question of when investors have to use derivatives as additional
risk management tools. We will see that derivatives enable investors to purchase insurance, to hedge,
and to take advantage of their views more efficiently.
Section 2.1. Evaluating the risk and the return of individual securities and portfolios.
Consider the situation of an investor with wealth of $100,000 that she wants to invest for one
year. Her broker recommends two common stocks, IBM and XYZ. The investor knows about IBM,
but has never heard of XYZ. She therefore decides that first she wants to understand what her wealth
will amount to after holding IBM shares for one year. Her wealth at the end of the year will be her
4
initial wealth times one plus the rate of return of the stock over that period. The rate of return of the
stock is given by the price appreciation plus the dividend payments divided by the stock price at the
beginning of the year. So, if the stock price is $100 at the beginning of the year, the dividend is $5,
and the stock price appreciates by $20 during the year, the rate of return is (20 + 5)/100 or 25%.
Throughout the analysis in this chapter, we assume that the frictions which affect financial
markets are unimportant. More specifically, we assume that there are no taxes, no transaction costs,
no costs to writing and enforcing contracts, no restrictions on investments in securities, no differences
in information across investors, and investors take prices as given because they are too small to affect
prices. Financial economists call markets that satisfy the assumptions we just listed perfect financial
markets. The assumption of the absence of frictions stretches belief, but it allows us to zero in on
first-order effects and to make the point that in the presence of perfect financial markets risk
management cannot increase the value of a firm. In chapter 3, we relax the assumption of perfect
financial markets and show how departures from this assumption make it possible for risk
management to create value for firms. For instance, taxes make it advantageous for firms and
individuals to have more income when their tax rate is low and less when their tax rate is high. Risk
management with derivatives can help firms and individuals achieve this objective.
Section 2.1.1. The risk of investing in IBM.
Since stock returns are uncertain, the investor has to figure out which outcomes are likely and
which are not. To do this, she has to be able to measure the likelihood of possible returns. The
statistical tool used to measure the likelihood of various returns for a stock is called the stocks
return probability distribution. A probability distribution provides a quantitative measure of the
5
likelihood of the possible outcomes or realizations for a random variable. Consider an urn full of balls
with numbers on them. There are multiple balls with the same number on them. We can think of a
random variable as the outcome of drawing a ball from the urn. The urn has lots of different balls, so
that we do not know which number will come up. The probability distribution specifies how likely
it is that we will draw a ball with a given number by assigning a probability for each number that can
take values between zero and one. If many balls have the same number, it is more likely that we will
draw a ball with that number so that the probability of drawing this number is higher than the
probability of drawing a number which is on fewer balls. Since a ball has to be drawn, the sum of the
probabilities for the various balls or distinct outcomes has to sum to one. If we could draw from the
urn a large number of times putting the balls back in the urn after having drawn them, the average
number drawn would be the expected value. More precisely, the expected value is a probability
weighted average of the possible distinct outcomes of the random variable. For returns, the
expected value of the return is the return that the investor expects to receive. For instance, if a stock
can have only one of two returns, 10% with probability 0.4 and 15% with probability 0.6, its expected
return is 0.4*10% + 0.6*15% or 13%.
The expected value of the return of IBM, in short IBMs expected return, gives us the
average return our investor would earn if next year was repeated over and over, each time yielding
a different return drawn from the distribution of the return of IBM. Everything else equal, the investor
is better off the greater the expected return of IBM. We will see later in this chapter that a reasonable
estimate of the expected return of IBM is about 13% per year. However, over the next year, the
return on IBM could be very different from 13% because the return is random. For instance, we will
find out that using a probability distribution for the return of IBM allows us to say that there is a 5%
6
chance of a return greater than 50% over a year for IBM. The most common probability distribution
used for stock returns is the normal distribution. There is substantial empirical evidence that this
distribution provides a good approximation of the true, unknown, distribution of stock returns.
Though we use the normal distribution in this chapter, it will be important later on for us to explore
how good this approximation is and whether the limitations of this approximation matter for risk
management.
The investor will also want to know something about the risk of the stock. The variance
of a random variable is a quantitative measure of how the numbers drawn from the urn are spread
around their expected value and hence provides a measure of risk. More precisely, it is a probability
weighted average of the square of the differences between the distinct outcomes of a random variable
and its expected value. Using our example of a return of 10% with probability 0.6 and a return of
15% with probability 0.4, the decimal variance of the return is 0.4*(0.10 - 0.13)
2
+ 0.6*(0.15 - 0.13)
2
or 0.0006. For returns, the variance is in units of the square of return differences from their expected
value. The square root of the variance is expressed in the same units as the returns. As a result, the
square root of the return variance is in the same units as the returns. The square root of the variance
is called the standard deviation. In finance, the standard deviation of returns is generally called the
volatility of returns. For our example, the square root of 0.0006 is 0.0245. Since the volatility is in
the same units as the returns, we can use a volatility in percent or 2.45%. As returns are spread
farther from the expected return, volatility increases. For instance, if instead of having returns of 10%
and 15% in our example, we have returns of 2.5% and 20%, the expected return is unaffected but the
volatility becomes 8.57% instead of 2.45%.
If IBMs return volatility is low, the absolute value of the difference between IBMs return
7
and its expected value is likely to be small so that a return substantially larger or smaller than the
expected return would be surprising. In contrast, if IBMs return volatility is high, a large positive or
negative return would not be as surprising. As volatility increases, therefore, the investor becomes
less likely to get a return close to the expected return. In particular, she becomes more likely to have
low wealth at the end of the year, which she would view adversely, or really high wealth, which she
would like. Investors are generally risk-averse, meaning that the adverse effect of an increase in
volatility is more important for them than the positive effect, so that on net they are worse off when
volatility increases for a given expected return.
The cumulative distribution function of a random variable x specifies, for any number X,
the probability that the realization of the random variable will be no greater than X. We denote the
probability that the random variable x has a realization no greater than X as prob(x # X). For our urn
example, the cumulative distribution function specifies the probability that we will draw a ball with
a number no greater than X. If the urn has balls with numbers from one to ten, the probability
distribution function could specify that the probability of drawing a ball with a number no greater than
6 is 0.4. When a random variable is normally distributed, its cumulative distribution function depends
only on its expected value and on its volatility. A reasonable estimate of the volatility of the IBM
stock return is 30%. With an expected return of 13% and a volatility of 30%, we can draw the
cumulative distribution function for the return of IBM. The cumulative distribution function for IBM
is plotted in Figure 2.1. It is plotted with returns on the horizontal axis and probabilities on the
vertical axis. For a given return, the function specifies the probability that the return of IBM will not
exceed that return. To use the cumulative distribution function, we choose a value on the horizontal
axis, say 0%. The corresponding value on the vertical axis tells us the probability that IBM will earn
8
less than 0%. This probability is 0.32. In other words, there is a 32% chance that over one year, IBM
will have a negative return. Such probability numbers are easy to compute for the normal distribution
using the NORMDIST function of Excel. Suppose we want to know how likely it is that IBM will
earn less than 10% over one year. To get the probability that the return will be less than 10%, we
choose x = 0.10. The mean is 0.13 and the standard deviation is 0.30. We finally write TRUE in the
last line to obtain the cumulative distribution function. The result is 0.46. This number means that
there is a 46% chance that the return of IBM will be less than 10% over a year.
Our investor is likely to be worried about making losses. Using the normal distribution, we
can tell her the probability of losing more than some specific amount. If our investor would like to
know how likely it is that she will have less than $100,000 at the end of the year if she invests in IBM,
we can compute the probability of a loss using the NORMDIST function by noticing that a loss means
a return of less than 0%. We therefore use x = 0 in our above example instead of x = 0.1. We find that
there is a 33% chance that the investor will lose money. This probability depends on the expected
return. As the expected return of IBM increases, the probability of making a loss falls.
Another concern our investor might have is how likely it is that her wealth will be low enough
that she will not be able to pay for living expenses. For instance, the investor might decide that she
needs to have $50,000 to live on at the end of the year. She understands that by putting all her wealth
in a stock, she takes the risk that she will have less than that amount at the end of the year and will
be bankrupt. However, she wants that risk to be less than 5%. Using the NORMDIST function, the
probability of a 50% loss for IBM is 0.018. Our investor can therefore invest in IBM given her
objective of making sure that there is a 95% chance that she will have $50,000 at the end
of the year.
9
The probability density function of a random variable tells us the change in prob(x # X)
as X goes to its next possible value. If the random variable takes discrete values, the probability
density function tells us the probability of x taking the next higher value. In our example of the urn,
the probability density function tells us the probability of drawing a given number from the urn. We
used the example where the urn has balls with numbers from one through ten and the probability of
drawing a ball with a number no greater than six is 0.4. Suppose that the probability of drawing a ball
with a number no greater than seven is 0.6. In this case, 0.6 - 0.4 is the probability density function
evaluated at seven and it tells us that the probability of drawing the number seven is 0.2. If the
random variable is continuous, the next higher value than X is infinitesimally close to X.
Consequently, the probability density function tells us the increase in prob(x # X) as X increases by
an infinitesimal amount, say ,. This corresponds to the probability of x being between X and X + ,.
If we wanted to obtain the probability of x being in an interval between X and X + 2,, we would add
the probability of x being in an interval between X and X + , and then the probability of x being in
an interval between X + , to X + 2,. More generally, we can also obtain the probability that x will
be in an interval from X to X by adding upthe probability density function from X to X, so that
the probability that x will take a value in an interval corresponds to the area under the probability
density function from X to X.
In the case of IBM, we see that the cumulative distribution function first increases slowly, then
more sharply, and finally again slowly. This explains that the probability density function of IBM
shown in Figure 2.2. first has a value close to zero, increases to reach a peak, and then falls again.
This bell-shaped probability density function is characteristic of the normal distribution. Note that this
bell-shaped function is symmetric around the expected value of the distribution. This means that the
10
cumulative distribution function increases to the same extent when evaluated at two returns that have
the same distance from the mean on the horizontal axis. For comparison, the figure shows the
distribution of the return of a security that has twice the volatility of IBM but the same expected
return. The distribution of the more volatile security has more weight in the tails and less around the
mean than IBM, implying that outcomes substantially away from the mean are more likely. The
distribution of the more volatile security shows a limitation of the normal distribution: It does not
exclude returns worse than -100%. In general, this is not a serious problem, but we will discuss this
problem in more detail in chapter 7.
When interpreting probabilities such as the 0.18 probability of losing 50% of an investment
in IBM, it is common to state that if our investor invests in IBM for 100 years, she can expect to lose
more than 50% of her beginning of year investment slightly less than two years out of 100. Such a
statement requires that returns of IBM are independent across years. Two random variables a and
b are independent if knowing the realization of random variable a tells us nothing about the realization
of random variable b. The returns to IBM in years i and j are independent if knowing the return of
IBM in year i tells us nothing about the return of IBM in year j. Another way to put this is that,
irrespective of what IBM earned in the previous year (e.g., +100% or - 50%), our best estimate of
the mean return for IBM is 13%.
There are two good reasons for why it makes sense to consider stock returns to be
independent across years. First, this seems to be generally the case statistically. Second, if this was
not roughly the case, there would be money on the table for investors. To see this, suppose that if
IBM earns 100% in one year it is likely to have a negative return the following year. Investors who
know that would sell IBM since they would not want to hold a stock whose value is expected to fall.
11
By their actions, investors would bring pressure on IBMs share price. Eventually, the stock price will
be low enough that it is not expected to fall and that investing in IBM is a reasonable investment. The
lesson from this is that whenever security prices do not incorporate past information about the history
of the stock price, investors take actions that make the security price incorporate that information.
The result is that markets are generally weak-form efficient. The market for a security is weak-form
efficient if all past information about the past history of that security is incorporated in its price. With
a weak-form efficient market, technical analysis which attempts to forecast returns based on
information about past returns is useless. In general, public information gets incorporated in security
prices quickly. A market where public information is immediately incorporated in prices is called a
semi-strong form efficient market. In such a market, no money can be made by trading on
information published in the Wall Street Journal because that information is already incorporated
in security prices. A strong form efficient market is one where all economically relevant information
is incorporated in prices, public or not. In the following, we will call a market to be efficient when
it is semi-strong form efficient, so that all public information is incorporated in prices.
Section 2.1.2. Evaluating the expected return and the risk of a portfolio.
To be thorough, the investor wants to consider XYZ. She first wants to know if she would
be better off investing $100,000 in XYZ rather than in IBM. She finds out that the expected return
of XYZ is 26% and the standard deviation of the return is 60%. In other words, XYZ has twice the
expected return and twice the standard deviation of IBM. This means that, using volatility as a
summary risk measure, XYZ is riskier than IBM. Figure 2.2. shows the probability density function
of a return distribution that has twice the volatility of IBM. Since XYZ has twice the expected return,
12
its probability density function would be that distribution moved to the right so that its mean is 26%.
It turns out that the probability that the price of XYZ will fall by 50% is 10.2%. Consequently, our
investor cannot invest all her wealth in XYZ because the probability of losing $50,000 would exceed
5%.
We now consider the volatility and expected return of a portfolio that includes both IBM and
XYZ shares. At the end of the year, the investors portfolio will be $100,000 times one plus the
return of her portfolio. The return of a portfolio is the sum of the return on each security in the
portfolio times the fraction of the portfolio invested in the security. The fraction of the portfolio
invested in a security is generally called the portfolio share of that security. Using w
i
for the portfolio
share of the i-th security in a portfolio with N securities and R
i
for the return on the i-th security, we
have the following formula for the portfolio return:
(2.1.) w R Portfolio Return
i i
i 1
N
=
=

Suppose the investor puts $75,000 in IBM and $25,000 in XYZ. The portfolio share of IBM is
$75,000/$100,000 or 0.75. If, for illustration, the return of IBM is 20% and the return on XYZ is -
10%, applying formula (2.1.) gives us a portfolio return in decimal form of:

0.75*0.20 + 0.25*(-0.10) = 0.125
In this case, the wealth of the investor at the end of the year is 100,000(1+0.125) or $125,000.
At the start of the year, the investor has to make a decision based on what she expects the
13
distribution of returns to be. She therefore wants to compute the expected return of the portfolio and
the return volatility of the portfolio. Denote by E(x) the expected return of random variable x, for any
x. To compute the portfolios expected return, it is useful to use two properties of expectations. First,
the expected value of a random variable multiplied by a constant is the constant times the expected
value of the random variable. Suppose a can take value a
1
with probability p and a
2
with probability
1-p.

If k is a constant, we have that E(k*a) = pka
1
+ (1-p)k a
2
= k[pa
1
+ (1-p)a
2
] = kE(a).
Consequently, the expected value of the return of a security times its portfolio share, E(w
i
R
i
) is equal
to w
i
E(R
i
). Second, the expected value of a sum of random variables is the sum of the expected values
of the random variables. Consider the case of random variables which have only two outcomes, so
that a
1
and b
1
have respectively outcomes a and b with probability p and a
2
and b
2
with probability
(1-p). With this notation, we have E(a + b) = p(a
1
+ b
1
) + (1-p)(a
2
+ b
2
) = pa
1
+ (1-p)a
2
+ pb
1
+(1-
p)b
2
= E(a) + E(b). This second property implies that if the portfolio has only securities 1 and 2, so
that we want to compute E(w
1
R
1
+ w
2
R
2
), this is equal to E(w
1
R
1
) + E(w
2
R
2
), which is equal to
w
1
E(R
1
) + w
2
E(R
2
) because of the first property. With these properties of expectations, the expected
return of a portfolio is therefore the portfolio share weighted average of the securities in the portfolio:
(2.2.) w E(R ) Portfolio Expected Return
i i
i 1
N
=

=
Applying this formula to our problem, we find that the expected return of the investors portfolio in
decimal form is:
0.75*0.13 + 0.25*0.26 = 0.1625
Our investor therefore expects her wealth to be 100,000*(1 + 0.1625) or $116,250 at the end of the
14
year.
Our investor naturally wants to be able to compare the risk of her portfolio to the risk of
investing all her wealth in IBM or XYZ. To do that, she has to compute the volatility of the portfolio
return. The volatility is the square root of the variance. The variance of a portfolios return is the
expected value of the square of the difference between the portfolios return and its expected return,
E[R
p
- E(R
p
)]
2
. To get the volatility of the portfolio return, it is best to first compute the variance and
then take the square root of the variance. To compute the variance of the portfolio return, we first
need to review two properties of the variance. Denote by Var(x) the variance of random variable x,
for any x. The first property is that the variance of a constant times random variable a is the constant
squared times the variance of a. For instance, the variance of 10 times a is 100 times the variance of
a. This follows from the definition of the variance of a as E[a - E(a)]
2
. If we compute the variance
of ka, we have E[ka - E(ka)]
2
. Since k is not a random variable, we can remove it from the
expectation to get the variance of ka as k
2
E[a - E(a)]
2
. This implies that Var(w
i
R
i
) = w
i
2
Var(R
i
).
To obtain the variance of a + b, we have to compute E[a+b - E(a + b)]
2
. Remember that the square
of a sum of two terms is the sum of each term squared plus two times the cross-product of the two
numbers (the square of 5 + 4 is 5
2
+ 4
2
+ 2*5*4, or 81). Consequently:
Var(a + b) = E[a + b - E(a + b)]
2
= E[a - E(a) + b - E(b)]
2
= E[a - E(a)]
2
+ E[b - E(b)]
2
+

2E[a - E(a)][b - E(b)]
= Var(a) + Var(b) + 2Cov(a,b)
15
The bold term is the covariance between a and b, denoted by Cov(a,b). The covariance is a measure
of how a and b move together. It can take negative as well as positive values. Its value increases as
a and b are more likely to exceed their expected values simultaneously. If the covariance is zero, the
fact that a exceeds its expected value provides no information about whether b exceeds its expected
value also. The covariance is closely related to the correlation coefficient. The correlation coefficient
takes values between minus one and plus one. If a and b have a correlation coefficient of one, they
move in lockstep in the same direction. If the correlation coefficient is -1, they move in lockstep in
the opposite direction. Finally, if the correlation coefficient is zero, a and b are independent. Denote
by Vol(x) the volatility of x, for any x, and by Corr(x,y) the correlation between x and y, for any x
and y. If one knows the correlation coefficient, one can obtain the covariance by using the following
formula:
Cov(a,b) = Corr(a,b)*Vol(a)*Vol(b)
The variance of a and b increases with the covariance of a and b since an increase in the covariance
makes it less likely that an unexpected low value of a is offset by an unexpected high value of b. It
therefore follows that the Var(a + b) increases with the correlation between a and b. In the special
case where a and b have the same volatility, a + b has no risk if the correlation coefficient between
a and b is minus one because a high value of one of the variables is always exactly offset by a low
value of the other, insuring that the sum of the realizations of the random variables is always equal
to the sum of their expected values. To see this, suppose that both random variables have a volatility
of 0.2 and a correlation coefficient of minus one. Applying our formula for the covariance, we have
16
w Var(R ) w w Cov(R , R ) Variance of Portfolio Return
i
2
i i j i j
j i
N
i 1
N N
+ =
= =

i 1
that the covariance between a and b is equal to -1*0.2*0.2, which is -0.04. The variance of each
random variable is the square of 0.2, or 0.04. Applying our formula, we have that Var(a + b) is equal
to 0.04 + 0.04 - 2*0.04 = 0. Note that if a and b are the same random variables, they have a
correlation coefficient of plus one, so that Cov(a,b) is Cov(a,a) = 1*Vol(a)Vol(a), which is Var(a).
Hence, the covariance of a random variable with itself is its variance.
Consider the variance of the return of a portfolio with securities 1 and 2, Var(w
1
R
1
+ w
2
R
2
).
Using the formula for the variance of a sum, we have that Var(w
1
R
1
+ w
2
R
2
) is equal to Var(w
1
R
1
)
+ Var(w
2
R
2
) +2Cov(w
1
R
1
,w
2
R
2
). Using the result that the variance of ka is k
2
Var(a), we have that
w
1
2
Var(R
1
) + w
2
2
Var(R
2
) +2w
1
w
2
Cov(R
1
,R
2
). More generally, therefore, the formula for the variance
of the return of a portfolio is:

(2.3.)
Applying the formula to our portfolio of IBM and XYZ, we need to know the covariance between
the return of the two securities. Lets assume that the correlation coefficient between the two
securities is 0.5. In this case, the covariance is 0.5*0.30*0.60 or 0.09. This gives us the following
variance:
0.75
2
*0.3
2
+ 0.25
2
*0.6
2
+2*0.25*0.75*0.5*0.3*0.6 = 0.11
The volatility of the portfolio is the square root of 0.11, which is 0.33. Our investor therefore
discovers that by investing less in IBM and investing some of her wealth in a stock that has twice the
volatility of IBM, she can increase her expected return from 13% to 16.25%, but in doing so she
17
increases the volatility of her portfolio from 30% to 32.70%. We cannot determine a priori which
of the three possible investments (investing in IBM, XYZ, or the portfolio) the investor prefers. This
is because the portfolio has a higher expected return than IBM but has higher volatility. We know that
the investor would prefer the portfolio if it had a higher expected return than IBM and less volatility,
but this is not the case. An investor who is risk-averse is willing to give up some expected return in
exchange for less risk. If the investor dislikes risk sufficiently, she prefers IBM to the portfolio
because IBM has less risk even though it has less expected return. By altering portfolio shares, the
investor can create many possible portfolios. In the next section, we study how the investor can
choose among these portfolios.
Section 2.2. The benefits from diversification and their implications for expected returns.
We now consider the case where the return correlation coefficient between IBM and XYZ
is zero. In this case, the decimal variance of the portfolio is 0.07 and the volatility is 26%. As can be
seen from the formula for the expected return of a portfolio (equation (2.1.)), the expected return of
a portfolio does not depend on the covariance of the securities that compose the portfolio.
Consequently, as the correlation coefficient between IBM and XYZ changes, the expected return of
the portfolio is unchanged. However, as a result of selling some of the low volatility stock and buying
some of the high volatility stock, the volatility of the portfolio falls from 30% to 26% for a constant
expected return. This means that when IBM and XYZ are independent, an investor who has all her
wealth invested in IBM can become unambiguously better off by selling some IBM shares and buying
shares in a company whose stock return has twice the volatility of IBM.
That our investor wants to invest in XYZ despite its high volatility is made clear in figure 2.3.
18
In that figure, we draw all the combinations of expected return and volatility that can be obtained by
investing in IBM and XYZ. We do not restrict portfolio shares to be positive. This means that we
allow investors to sell shares of one company short as long as all their wealth is fully invested so that
the portfolio shares sum to one. With a short-sale, an investor borrows shares from a third party and
sells them. When the investor wants to close the position, she must buy shares and deliver them to
the lender. If the share price increases, the investor loses because she has to pay more for the shares
she delivers than she received for the shares she sold. In contrast, a short-sale position benefits from
decreases in the share price. With a short-sale, the investor has a negative portfolio share in a security
because she has to spend an amount of money at maturity to unwind the short-sale of one share equal
to the price of the share at the beginning of the period plus its return. Consequently, if a share is sold
short, its return has to be paid rather than received. The upward-sloping part of the curve drawn in
figure 2.3. is called the efficient frontier. Our investor wants to choose portfolios on the efficient
frontier because, for each volatility, there is a portfolio on the efficient frontier that has a higher
expected return than any other portfolio with the same volatility. In the case of the volatility of IBM,
there is a portfolio on the frontier that has the same volatility but a higher expected return, so that
IBM is not on the efficient frontier. That portfolio, portfolio y in the figure, has an expected return
of 18.2%. The investor would always prefer that portfolio to holding only shares of IBM.
The investor prefers the portfolio to holding only shares of IBM because she benefits from
diversification. The benefit of spreading a portfolios holdings across different securities is the
volatility reduction that naturally occurs when one invests in securities whose returns are not perfectly
correlated: the poor outcomes of some securities are offset by the good outcomes of other securities.
In our example, XYZ could do well when IBM does poorly. This cannot happen when both securities
19
( )
Volatility of portfolio (1/ N) *0.3
N*(1/ N) *0.3 ((1/ N) *0.3 )
2 2
i 1
N
0.5
2 2
0.5
2 0.5
=

= =
=

are perfectly correlated because then they always do well or poorly together. As the securities become
less correlated, it becomes more likely that one security does well and the other poorly at the same
time. In the extreme case where the correlation coefficient is minus one, IBM always does well when
XYZ does poorly, so that one can create a portfolio of IBM and XYZ that has no risk. To create such
a portfolio, choose the portfolio shares of XYZ and IBM that sum to one and that set the variance
of the portfolio equal to zero. The portfolio share of XYZ is 0.285 and the portfolio share of IBM
is 0.715. This offsetting effect due to diversification means that the outcomes of a portfolio are less
dispersed than the outcomes of many and sometimes all of the individual securities that comprise the
portfolio.
To show that it is possible for diversification to make the volatility of a portfolio smaller than
the volatility of any security in the portfolio, it is useful to consider the following example. Suppose
that an investor can choose to invest among many uncorrelated securities that all have the same
volatility and the same expected return as IBM. In this case, putting the entire portfolio in one
security yields a volatility of 30% and an expected return of 13%. Dividing ones wealth among N
such uncorrelated securities has no impact on the expected return because all securities have the same
expected return. However, using our formula, we find that the volatility of the portfolio is:
Applying this result, we find that for N = 10, the volatility is 9%, for N = 100 it is 3%, and for N =
1000 it is less than 1%. As N is increased further, the volatility becomes infinitesimal. In other words,
20
by holding uncorrelated securities, one can eliminate portfolio volatility if one holds sufficiently many
of these securities! Risk that disappears in a well-diversified portfolio is called diversifiable risk. In
our example, all of the risk of each security becomes diversifiable as N increases.
In the real world, though, securities tend to be positively correlated because changes in
aggregate economic activity affect most firms. For instance, news of the onset of a recession is
generally bad news for almost all firms. As a result, one cannot eliminate risk through diversification
but one can reduce it. Figure 2.4. shows how investors can substantially reduce risk by diversifying
using common stocks available throughout the world. The figure shows how, on average, the
variance of an equally-weighted portfolio of randomly chosen securities is related to the number of
securities in the portfolio. As in our simple example, the variance of a portfolio falls as the number
of securities is increased. This is because, as the number of securities increases, it becomes more likely
that some bad event that affects one security is offset by some good event that affects another
security. Interestingly, however, most of the benefit from diversification takes place when one goes
from one security to ten. Going from 50 securities in a portfolio to 100 does not bring much in terms
of variance reduction. Another important point from the figure is that the variance falls more if one
selects securities randomly in the global universe of securities rather than just within the U.S. The
lower variance of the portfolios consisting of both U.S. and foreign securities reflects the benefits
from international diversification.
Irrespective of the universe from which one chooses securities to invest in, there is always an
efficient frontier that has the same form as the one drawn in figure 2.3. With two securities, they are
both on the frontier. With more securities, this is no longer the case. In fact, with many securities,
individual securities are generally inside the frontier so that holding a portfolio dominates holding a
21
single security because of the benefits of diversification. Figure 2.5. shows the efficient frontier
estimated at a point in time. Because of the availability of international diversification, a well-
diversified portfolio of U.S. stocks is inside the efficient frontier and is dominated by internationally
diversified portfolios. In other words, an investor holding a well-diversified portfolio of U.S. stocks
would be able to reduce risk by diversifying internationally without sacrificing expected return.
Section 2.2.1. The risk-free asset and the capital asset pricing model.
So far, we assumed that the investor could form her portfolio holding shares of IBM and
XYZ. Lets now assume that there is a third asset, an asset which has no risk over the investment
horizon of the investor. An example of such an asset would be a Treasury Bill, which we abbreviate
as T-bill. T-bills are discount bonds. Discount bonds are bonds where the interest payment comes
in the form of the capital appreciation of the bond. Hence, the bond pays par at maturity and sells for
less than par before maturity. Since they are obligations of the Federal government, T-bills have no
default risk. Consequently, they have a sure return if held to maturity since the gain to the holder is
par minus the price she paid for the T-bill. Consider the case where the one-year T-bill has a yield of
5%. This means that our investor can earn 5% for sure by holding the T-bill. The box on T-bills
shows how they are quoted and how one can use a quote to obtain a yield.
By having an asset allocation where she invests some of her money in the T-bill, the investor
can decrease the volatility of her end-of-year wealth. For instance, our investor could put half of her
money in T-bills and the other half in the portfolio on the frontier with the smallest volatility. This
minimum-volatility portfolio has an expected return of 15.6% and a standard deviation of 26.83%.
As a result (using our formulas for the expected return and the volatility of a portfolio), her portfolio
22
would have a volatility of 13.42% and an expected return of 12.8%. All combinations of the
minimum-volatility portfolio and the risk-free asset lie on a straight line that intersects the efficient
frontier at the minimum-volatility portfolio. Portfolios on that straight line to the left of the minimum-
volatility portfolio have positive investments in the risk-free asset. To the right of the minimum-
volatility portfolio, the investor borrows to invest in stocks. Figure 2.6. shows this straight line.
Figure 2.6. suggests that the investor could do better by combining the risk-free asset with a portfolio
more to the right on the efficient frontier than the minimum-volatility portfolio because then all
possible combinations would have a higher return. However, the investor cannot do better than
combining the risk-free asset with portfolio m. This is because in that case the straight line is tangent
to the efficient frontier at m. There is no straight line starting at the risk-free rate that touches the
efficient frontier at least at one point and has a steeper slope than the line tangent to m. Hence, the
investor could not invest on a line with a steeper slope because she could not find a portfolio of
stocks to create that line!
There is a tangency portfolio irrespective of the universe of securities one uses to form the
efficient frontier as long as one can invest in a risk-free asset. We already saw, however, that investors
benefit from forming portfolios using the largest possible universe of securities. As long as investors
agree on the expected returns, volatilities, and covariances of securities, they end up looking at the
same efficient frontier if they behave optimally. In this case, our reasoning implies that they all want
to invest in portfolio m. This can only be possible if portfolio m is the market portfolio. The market
portfolio is a portfolio of all securities available with each portfolio share the fraction of the market
value of that security in the total capitalization of all securities or aggregate wealth. IBM is a much
smaller fraction of the wealth of investors invested in U.S. securities (on June 30, 1999, it was 2.09%
23
of the S&P500 index). Consequently, if the portfolio share of IBM is 10%, there is too much demand
for IBM given its expected return. This means that its expected return has to decrease so that
investors want to hold less of IBM. This process continues until the expected return of IBM is such
that investors want to hold the existing shares of IBM at the current price. Consequently, the demand
and supply of shares are equal for each firm when portfolio m is such that the portfolio of each
security in the portfolio corresponds to its market value divided by the market value of all securities.
If all investors have the same views on expected returns, volatilities, and covariances of
securities, all of them hold the same portfolio of risky securities, portfolio m, the market portfolio.
To achieve the right volatility for their invested wealth, they allocate their wealth to the market
portfolio and to the risk-free asset. Investors who have little aversion to risk borrow to invest more
than their wealth in the market portfolio. In contrast, the most risk-averse investors put most or all
of their wealth in the risk-free asset. Note that if investors have different views on expected returns,
volatilities and covariances of securities, on average, they still must hold portfolio m because the
market portfolio has to be held. Further, for each investor, there is always a tangency portfolio and
she always allocates her wealth between the tangency portfolio and the risk-free asset if she trades
off risk and return. In the case of investors who invest in the market portfolio, we know exactly their
reward for bearing volatility risk since the expected return they earn in excess of the risk-free rate is
given by the slope of the tangency line. These investors therefore earn (E(R
m
) - R
f
)/F
m
per unit of
volatility, where R
m
is the return of portfolio m, F
m
is its volatility, and R
f
is the risk-free rate. The
excess of the expected return of a security or of a portfolio over the risk-free rate is called the risk
premium of that security or portfolio. A risk premium on a security or a portfolio is the reward the
investor expects to receive for bearing the risk associated with that security or portfolio. E(R
m
) - R
f
24
is therefore the risk premium on the market portfolio.
Section 2.2.2. The risk premium for a security.
We now consider the determinants of the risk premium of an individual security. To start this
discussion, it is useful to go back to our example where we had N securities with uncorrelated
returns. As N gets large, a portfolio of these securities has almost no volatility. An investor who
invests in such a portfolio should therefore earn the risk-free rate. Otherwise, there would be an
opportunity to make money for sure if N is large enough. A strategy which makes money for sure
with a net investment of zero is called an arbitrage strategy. Suppose that the portfolio earns 10%
and the risk-free rate is 5%. Investing in the portfolio and borrowing at the risk-free rate earns five
cents per dollar invested in the portfolio for sure without requiring any capital. Such an arbitrage
strategy cannot persist because investors make it disappear by taking advantage of it. The only way
it cannot exist is if each security in the portfolio earns the risk-free rate. In this case, the risk of each
security in the portfolio is completely diversifiable and consequently no security earns a risk premium.
Now, we consider the case where a portfolio has some risk that is not diversifiable. This is
the risk left when the investor holds a diversified portfolio and is the only risk the investor cares
about. Because it is not diversifiable, such risk is common to many securities and is generally called
systematic risk. In the aggregate, there must be risk that cannot be diversified away because most
firms benefit as economic activity unexpectedly improves. Consequently, the risk of the market
portfolio cannot be diversified because it captures the risk associated with aggregate economic
fluctuations. However, securities that belong to the market portfolio can have both systematic risk
and risk that is diversifiable.
25
Cov(R R = Cov( w R R = w Cov(R R
p p i i p
N
i i p
i=1
N
, ) , ) , )
i=

1
The market portfolio has to be held in the aggregate. Consequently, since all investors who
invest in risky securities do so by investing in the market portfolio, expected returns of securities must
be such that our investor is content with holding the market portfolio as her portfolio of risky
securities. For the investor to hold a security that belongs to the market portfolio, it has to be that the
risk premium on that security is just sufficient to induce her not to change her portfolio. This means
that the change in the portfolios expected return resulting from a very small increase in the investors
holdings of the security must just compensate for the change in the portfolios risk. If this is not the
case, the investor will change her portfolio shares and will no longer hold the market portfolio.
To understand how the risk premium on a security is determined, it is useful to note that the
formula for the variance of the return of an arbitrary portfolio, R
p
, can be written as the portfolio
share weighted sum of the return covariances of the securities in the portfolio with the portfolio. To
understand why this is so, remember that the return covariance of a security with itself is the return
variance of that security. Consequently, the variance of the return of a portfolio can be written as the
return covariance of the portfolio with itself. The return of the portfolio is a portfolio share weighted
sum of the returns of the securities. Therefore, the variance of the return of the portfolio is the
covariance of the portfolio share weighted sum of returns of the securities in the portfolio with the
return of the portfolio. Since the covariance of a sum of random variables with R
p
is equal to the sum
of the covariances of the random variables with R
p
, it follows that the variance of the portfolio returns
is equal to a portfolio share weighted sum of the return covariances of the securities with the portfolio
return:
(2.4.)
26
Consequently, the variance of the return of a portfolio is a portfolio share weighted average of the
covariances of the returns of the securities in the portfolio with the return of the portfolio. Equation
(2.4.) makes clear that a portfolio is risky to the extent that the returns of its securities covary with
the return of the portfolio.
Lets now consider the following experiment. Suppose that security z in the market portfolio has
a zero return covariance with the market portfolio, so that Cov(R
z
,R
m
) = 0. Now, lets decrease
slightly the portfolio share of security z and increase by the same decimal amount the portfolio share
of security i. Changing portfolio shares has a feedback effect: Since it changes the distribution of the
return of the portfolio, the return covariance of all securities with the portfolio is altered. If the
change in portfolio shares is small enough, the feedback effect becomes a second-order effect and can
be ignored. Consequently, as we change the portfolio shares of securities i and z, none of the
covariances change in equation (2.4.). By assumption, the other portfolio shares are kept constant.
Letting the change in portfolio share of security i be ), so that the portfolio share after the change
is w
i
+ ), the impact on the volatility of the portfolio of the change in portfolio shares is therefore
equal to )cov(R
i
,R
p
) - )cov(R
z
,R
p
). Since Cov(R
z
,R
p
) is equal to zero, increasing the portfolio share
of security i by ) and decreasing the portfolio share of security z by ) therefore changes the volatility
of the portfolio by )cov(R
i
,R
p
). Security i can have a zero, positive, or negative return covariance
with the portfolio. Lets consider each case in turn:
1) Security i has a zero return covariance with the market portfolio. In this case, the
volatility of the portfolio return does not change if we increase the holding of security i at the expense
of the holding of security z. Since the risk of the portfolio is unaffected by our change, the expected
27
return of the portfolio should be unaffected, so that securities z and i must have the same expected
return. If the two securities have a different expected return, the investor would want to change the
portfolio shares. For instance, if security z has a higher expected return than security i, the investor
would want to invest more in security z and less in security i. In this case, she would not hold the
market portfolio anymore, but every other investor would want to make the same change so that
nobody would hold the market portfolio.
2) Security i has a positive covariance with the market portfolio. Since security i has a
positive return covariance with the portfolio, it is more likely to have a good (bad) return when the
portfolio has a good (bad) return. This means holding more of security i will tend to increase the
good returns of the portfolio and worsen the bad returns of the portfolio, thereby increasing its
volatility. This can be verified by looking at the formula for the volatility of the portfolio return: By
increasing the portfolio share of security i and decreasing the portfolio share of security z, we increase
the weight of a security with a positive return covariance with the market portfolio and thereby
increase the weighted sum of the covariances. If security z is expected to earn the same as security
i, the investor would want to sell security i to purchase more of security z since doing so would
decrease the risk of the portfolio without affecting its expected return. Consequently, for the investor
to be satisfied with its portfolio, security i must be expected to earn more than security z.
3) Security i has a negative return covariance with the market portfolio. In this case, the
reasoning is the opposite from the previous case. Adding more of security i to the portfolio reduces
the weighted sum of the covariances, so that security i has to have a lower expected return than
security z.
28
In equilibrium it must the case that no investor wants to change her security holdings. The
reasoning that we used leads to three important results that must hold in equilibrium:
Result I: A securitys expected return should depend only on its return covariance with
the market portfolio. Suppose that securities i and j have the same return covariance with the
market portfolio but different expected returns. A slight increase in the holding of the security that
has the higher expected return and decrease in the holding of the other security would create a
portfolio with a higher expected return than the market portfolio but with the same volatility. In that
case, no investor would want to hold the market portfolio. Consequently, securities l and j cannot
have different expected returns in equilibrium.
Result II: A security that has a zero return covariance with the market portfolio should
have an expected return equal to the return of the risk-free security. Suppose that this is not the
case. The investor can then increase the expected return of the portfolio without changing its volatility
by investing slightly more in the security with the higher expected return and slightly less in the
security with the lower expected return.
Result III: A securitys risk premium is proportional to its return covariance with the
market portfolio. Suppose that securities i and j have positive but different return covariances with
the market portfolio. If security i has k times the return covariance of security j with the market
portfolio, its risk premium must be k times the risk premium of security j. To see why this is true, note
that we can always combine security i and security z in a portfolio. Let h be the weight of security i
29
hCov(R , R ) (1 h)Cov(R , R ) Cov(R , R )
i m z m j m
+ =
in that portfolio and (1-h) the weight of security z. We can choose h to be such that the portfolio of
securities i and z has the same return covariance with the market portfolio as security j:
(2.5.)
If h is chosen so that equation (2.5.) holds, the portfolio should have the same expected excess return
as security j since the portfolio and the security have the same return covariance with the market
portfolio. Otherwise, the investor could increase the expected return on her invested wealth without
changing its return volatility by investing in the security and shorting the portfolio with holdings of
securities i and z if the security has a higher expected return than the portfolio or taking the opposite
position if the security has a lower expected return than the portfolio. To find h, remember that the
return covariance of security z with the market portfolio is zero and that the return covariance of
security i with the market portfolio is k times the return covariance of security j with the market
portfolio. Consequently, we can rewrite equation (2.5.) as:
(2.6.) hCov(R R h)Cov(R R h * k *Cov(R R
i m z m j m
, ) ( , ) , ) + = 1
Therefore, by choosing h equal to 1/k so that h*k is equal to one, we choose h so that the
return covariance of the portfolio containing securities z and i with the market portfolio is the same
as the return covariance with the market portfolio of security j. We already know from the Second
Result that security z must earn the risk-free rate. From the First Result, it must therefore be that the
portfolio with portfolio share h in security i and (1-h) in security z has the same expected return as
30
hE(R ) (1 h)R E(R )
i f j
+ =
security j:
(2.7.)
If we subtract the risk-free rate from both sides of this equation, we have h times the risk premium
of security j on the left-hand side and the risk premium of security j on the right-hand side. Dividing
both sides of the resulting equation by h and remembering that h is equal to 1/k, we obtain:
(2.8.)
[ ]
E(R R k E(R R
i f j f
) ) =
Consequently, the risk premium on security i is k times the risk premium on security j as
predicted. By definition, k is the return covariance of security i with the market portfolio divided by
the return covariance of security j with the market portfolio. Replacing k by its definition in the
equation and rearranging, we have:
(2.9.)
[ ]
E(R R
Cov(R R
Cov(R R
E(R R
i f
i m
j m
j f
)
, )
, )
) =
This equation has to apply if security j is the market portfolio. If it does not, one can create a security
that has the same return covariance with the market portfolio as the market portfolio but a different
expected return. As a result, the investor would increase her holding of that security and decrease her
holding of the market portfolio if that security has a higher expected return than the market portfolio.
The return covariance of the market portfolio with itself is simply the variance of the return of the
market portfolio. Lets choose security j to be the market portfolio in our equation. Remember that
31
[ ] [ ] E(R R = w E(R R w E(R R
pf f i i f
i=1
N
i m f
) ) ) =


i
in our analysis, security i has a return covariance with the market portfolio that is k times the return
covariance of security j with the market portfolio. If security j is the market portfolio, its return
covariance with the market portfolio is the return variance of the market portfolio. When security j
is the market portfolio, k is therefore equal to Covariance(R
i
,R
m
)/Variance(R
m
), which is called
security is beta, or $
i
. In this case, our equation becomes:
Capital asset pricing model
(2.10.)
[ ]
E(R - R = E(R - R
i f i m f
) )
The capital asset pricing model (CAPM) tells us how the expected return of a security is
determined. The CAPM states that the expected excess return of a risky security is equal to the
systematic risk of that security measured by its beta times the markets risk premium. Importantly,
with the CAPM diversifiable risk has no impact on a securitys expected excess return. The relation
between expected return and beta that results from the CAPM is shown in figure 2.7.
Our reasoning for why the CAPM must hold with our assumptions implies that the CAPM
must hold for portfolios. Since a portfolios return is a portfolio share weighted average of the return
of the securities in the portfolio, the only way that the CAPM does not apply to a portfolio is if it does
not apply to one or more of its constituent securities. We can therefore multiply equation (2.10.) by
the portfolio share and add up across securities to obtain the expected excess return of the portfolio:
The portfolio share weighted sum of the securities in the portfolio is equal to the beta of the portfolio
32
w
Cov(R R
Var(R
=
Cov(w R R
Var(R
=
Cov( w R R
Var(R
=
Cov(R R
Var(R
=
i
i m
m i=1
N
i i m
m i=1
N i i
N
m
m
p m
m
p
, )
)
, )
)
, )
)
, )
)


= i 1

obtained by dividing the return covariance of the portfolio with the market with the return variance
of the market. This is because the return covariance of the portfolio with the market portfolio is the
portfolio share weighted average of the return covariances of the securities in the portfolio:
To see how the CAPM model works, suppose that the risk-free rate is 5%, the market risk premium
is 6% and the $ of IBM is 1.33. In this case, the expected return of IBM is:
Expected return of IBM = 5% + 1.33*[6%] = 13%
This is the value we used earlier for IBM. The box on the CAPM in practice shows how
implementing the CAPM for IBM leads to the above numbers.
Consider a portfolio worth one dollar that has an investment of $1.33 in the market portfolio
and -$0.33 in the risk-free asset. The value of the portfolio is $1, so that the portfolio share of the
investment in the market is (1.33/1) and the portfolio share of the investment in the risk-free asset is
(-0.33/1). The beta of the market is one and the beta of the risk-free asset is zero. Consequently, this
portfolio has a beta equal to the portfolio share weighted average of the beta of its securities, or
(1.33/*1)*1 + (- 0.33/1)*0 =1.33, which is the beta of IBM. If the investor holds this portfolio, she
has the same systematic risk and therefore ought to receive the same expected return as if she had
invested a dollar in IBM. The actual return on IBM will be the return of the portfolio plus
33
diversifiable risk that does not affect the expected return. The return of the portfolio is R
F
+ 1.33(R
m
- R
F
). The return of IBM is R
F
+ 1.33(R
m
- R
F
) plus diversifiable risk whose expected value is zero.
If IBM is expected to earn more than the portfolio, then the investor can make an economic profit
by holding IBM and shorting the portfolio. By doing this, she invests no money of her own and bears
no systematic risk, yet earns a positive expected return corresponding to the difference between the
expected return of the portfolio and of IBM.
Section 2.3. Diversification and risk management.
We now discuss how an investor values a firm when the CAPM holds. Once we understand
this, we can find out when risk management increases firm value. For simplicity, lets start with a firm
that lives one year only and is an all-equity firm. At the end of the year, the firm has a cash flow of
C and nothing else. The cash flow is the cash generated by the firm that can be paid out to
shareholders. The firm then pays that cash flow to equity as a liquidating dividend. Viewed from
today, the cash flow is random. The value of the firm today is the present value of receiving the cash
flow in one year. We denote this value by V. To be specific, suppose that the firm is a gold mining
firm. It will produce 1M ounces of gold this year, but after that it cannot produce gold any longer and
liquidates. For simplicity, the firm has no costs and taxes are ignored. Markets are assumed to be
perfect. At the end of the year, the firm makes a payment to its shareholders corresponding to the
market value of 1M ounces of gold.
If the firm is riskless, its value V is the cash flow discounted at the risk-free rate, C/(1+R
f
).
For instance, if the gold price is fixed at $350 an ounce and the risk-free rate is 5%, the value of the
firm is $350M/(1+0.05) or $333.33M. The reason for this is that one can invest $333.33M in the risk-
34
free asset and obtain $350M at the end of the year. Consequently, if firm value differs from
$333.33M, there is an arbitrage opportunity. Suppose that firm value is $300m and the firm has one
million shares. Consider an investor who buys a share and finances the purchase by borrowing. At
maturity, she has to repay $300(1+0.05), or $315 and she receives $350, making a sure profit of $35
per share. If firm value is more than the present value of the cash flow, investors make money for sure
by selling shares short and investing the proceeds in the risk-free asset.
Lets now consider the case where the cash flow is random. In our example, this is because
the price of gold is random. The return of a share is the random liquidating cash flow C divided by
the firm value at the beginning of the year, V, minus one. Since C is equal to a quantity of gold times
the price of gold, the return is perfectly correlated with the return on an ounce of gold so that the firm
must have the same beta as gold. We know from the CAPM that any financial asset must have the
same expected return as the expected return of a portfolio invested in the market portfolio and in the
risk-free asset that has the same beta as the financial asset. Suppose, for the sake of illustration, that
the beta of gold is 0.5. The expected return on a share of the firm has to be the expected return on
a portfolio with a beta of 0.5. Such a portfolio can be constructed by investing an amount equal to
half the value of the share in the market portfolio and the same amount in the risk-free asset. If the
firm is expected to earn more than this portfolio, investors earn an economic profit by investing in the
firm and financing the investment in the firm by shorting the portfolio since they expect to earn an
economic profit without taking on any systematic risk. This strategy has risk, but that risk is
diversifiable and hence does not matter for investors with diversified portfolios.
We now use this approach to value the firm. Shareholders receive the cash flow in one year
for an investment today equal to the value of the firm. This means that the cash flow is equal to the
35
[ ]
E(C)
1 R E(R ) R
V
f M F
+ +
=

E(C)
1+ R E(R R
M
1+ 0.05 + 0.5(0.06)
M
f M f
+
= =
[ ) ]
$350
$324.074
value of the firm times one plus the rate of return of the firm. We know that the expected return of
the firm has to be given by the CAPM equation, so that it is the risk-free rate plus the firms beta
times the risk premium on the market. Consequently, firm value must be such that:
(2.12.)
[ ] ( )
E(C) V 1 R E(R ) R
f m f
= + +
If we know the distribution of the cash flow C, the risk-free rate R
f
, the $ of the firm, and the risk
premium on the market E(R
M
) - R
f
, we can compute V because it is the only variable in the equation
that we do not know. Solving for V, we get:
(2.13.)
Using this formula, we can value our gold mining firm. Lets say that the expected gold price is $350.
In this case, the expected payoff to shareholders is $350M, which is one million ounces times the
expected price of one ounce. As before, we use a risk-free rate of 5% and a risk premium on the
market portfolio of 6%. Consequently:

We therefore obtain the value of the firm by discounting the cash flow to equity at the expected return
required by the CAPM. Our approach extends naturally to firms expected to live more than one year.
The value of such a firm for its shareholders is the present value of the cash flows to equity. Nothing
else affects the value of the firm for its shareholders - they only care about the present value of cash
36
the firm generates over time for them. We can therefore value equity in general by computing the sum
of the present values of all future cash flows to equity using the approach we used above to value one
such future cash flow. For a levered firm, one will often consider the value of the firm to be the sum
of debt and equity. This simply means that the value of the firm is the present value of the cash flows
to the debt and equity holders.
Cash flow to equity is computed as net income plus depreciation and other non-cash charges
minus investment. To get cash flow to the debt and equity holders, one adds to cash flow to equity
the payments made to debt holders. Note that the cash flow to equity does not necessarily correspond
each year to the payouts to equity. In particular, firms smooth dividends. For instance, a firm could
have a positive cash flow to equity in excess of its planned dividend. It would then keep the excess
cash flow in liquid assets and pay it to shareholders later. However, all cash generated by the firm
after debt payments belongs to equity and hence contributes to firm value whether it is paid out in a
year or not.
Section 2.3.1. Risk management and shareholder wealth.
Consider now the question we set out to answer in this chapter: Would shareholders want
a firm to spend cash to decrease the volatility of its cash flow when the only benefit of risk
management is to decrease share return volatility? Lets assume that the shareholders of the firm are
investors who care only about the expected return and the volatility of their wealth invested in
securities, so that they are optimally diversified and have chosen the optimal level of risk for their
portfolios. We saw in the previous section that the volatility of the return of a share can be
decomposed into systematic risk, which is not diversifiable, and other risk, unsystematic risk, which
37
is diversifiable. We consider separately a risk management policy that decreases unsystematic risk and
one that decreases systematic risk. A firm can reduce risk through financial transactions or through
changes in its operations. We first consider the case where the firm uses financial risk management
and then discuss how our reasoning extends to changes in the firms operations to reduce risk.
1) Financial risk management policy that decreases the firms unsystematic risk.
Consider the following situation. A firm has a market value of $1 billion. Suppose that its
management can sell the unsystematic risk of the firms shares to an investment bank by paying
$50M. We can think of such a transaction as a hedge offered by the investment bank which exactly
offsets the firms unsystematic risk. Would shareholders ever want the firm to make such a payment
when the only benefit to them of the payment is to eliminate the unsystematic risk of their shares? We
already know that firm value does not depend on unsystematic risk when expected cash flow is given.
Consider then a risk management policy eliminating unsystematic risk that decreases expected cash
flow by its cost but has no other impact on expected cash flow. Since the value of the firm is the
expected cash flow discounted at the rate determined by the systematic risk of the firm, this risk
management policy does not affect the rate at which cash flow is discounted. In terms of our
valuation equation, this policy decreases the numerator of the valuation equation without a change
in the denominator, so that firm value decreases.
Shareholders are diversified and do not care about diversifiable risks. Therefore, they are not
willing to discount expected cash flow at a lower rate if the firm makes cash flow less risky by
eliminating unsystematic risk. This means that if shareholders could vote on a proposal to implement
risk management to decrease the firms diversifiable risk at a cost, they would vote no and refuse to
incur the cost as long as the only effect of risk management on expected cash flow is to decrease
38
expected cash flow by the cost of risk management. Managers will therefore never be rewarded by
shareholders for decreasing the firms diversifiable risk at a cost because shareholders can eliminate
the firms diversifiable risk through diversification at zero cost. For shareholders to value a decrease
in unsystematic risk, it has to increase their wealth and hence the share price.
2) Financial risk management policy that decreases the firms systematic risk. We now
evaluate whether it is worthwhile for management to incur costs to decrease the firms systematic risk
through financial transactions. Consider a firm that decides to reduce its beta. Its only motivation for
this action is that it believes that it will make its shares more attractive to investors. The firm can
easily reduce its beta by taking a short position in the market since such a position has a negative beta.
The proceeds of the short position can be invested in the risk-free asset. This investment has a beta
of zero. In our discussion of IBM, we saw that a portfolio of $1.33 invested in the market and of
$0.33 borrowed in the risk-free asset has the same beta as an investment of one dollar invested in the
market. Consequently, if IBM was an all-equity firm, the management of IBM could make IBM a
zero beta firm by selling short $1.33 of the market and investing the proceeds in the risk-free asset
for each dollar of market value. Would investors be willing to pay for IBM management to do this?
The answer is no because the action of IBMs management creates no value for its shareholders. In
perfect financial markets, a shareholder could create a zero beta portfolio long in IBM shares, short
in the market, and long in the risk-free asset. Hence, the investor would not be willing to pay for the
management of IBM to do something for her that she could do at zero cost on her own.
Remember that investors are assumed to be optimally diversified. Each investor chooses her
optimal asset allocation consisting of an investment in the risk-free asset and an investment in the
market portfolio. Consequently, if IBM were to reduce its beta, this means that the portfolio that
39
investors hold will have less risk. However, investors wanted this level of risk because of the reward
they expected to obtain in the form of a higher expected return. As IBM reduces its beta, therefore,
investors no longer hold the portfolio that they had chosen. They will therefore want to get back to
that portfolio by changing their asset allocation. In perfect financial markets, investors can costlessly
get back to their initial asset allocation by increasing their holdings of the risky portfolio and
decreasing their holdings of the safe asset. They would therefore object if IBM expended real
resources to decrease its beta. It follows from this discussion that investors choose the level of risk
of their portfolio through their own asset allocation. They do not need the help of firms whose shares
they own for that purpose.
Comparing our discussion of the reduction in unsystematic risk with our discussion of the
reduction in systematic risk creates a paradox. When we discussed the reduction in unsystematic risk,
we argued that shareholders cannot gain from a costly reduction in unsystematic risk undertaken for
the sole purpose of decreasing the return volatility because such a reduction decreases the numerator
of the present value formula without affecting the denominator. Yet, the reduction in systematic risk
obviously decreases the denominator of the present value formula for shares since it decreases the
discount rate. Why is it then that decreasing systematic risk does not increase the value of the shares?
The reason is that decreasing systematic risk has a cost, in that it decreases expected cash flow. To
get rid of its systematic risk, IBM has to sell short the market. Selling short the market earns a
negative risk premium since holding the market long has a positive risk premium. Hence, the expected
cash flow of IBM has to fall by the risk premium of the short sale. The impact of the short sale on
firm value is therefore the sum of two effects. The first effect is the decrease in expected cash flow
and the second is the decrease in the discount rate. The two effects cancel out. They have to for a
40
simple reason. Going short the market is equivalent to getting perfect insurance against market
fluctuations. In perfect markets, insurance is priced at its fair value. This means that the risk premium
IBM would earn by not changing its systematic risk has to be paid to whoever will now bear this
systematic risk. Hence, financial risk management in this case just determines who bears the
systematic risk, but IBMs shareholders charge the same price for market risk as anybody else since
that price is determined by the CAPM. Consequently, IBM management cannot create value by
selling market risk to other investors at the price that shareholders would require to bear that risk.
We have focused on financial risk management in our reasoning. A firm could change its
systematic risk or its unsystematic risk by changing its operations. Our reasoning applies in this case
also, but with a twist. Lets first look at unsystematic risk. Decreasing unsystematic risk does not
make shareholders better off if the only benefit of doing so is to reduce share return volatility. It does
not matter therefore whether the decrease in share volatility is due to financial transactions or to
operating changes. In contrast, if the firm can change its operations costlessly to reduce its beta
without changing its expected cash flow, firm value increases because expected cash flow is
discounted at a lower rate. Hence, decreasing cash flow beta through operating changes is worth it
if firm value increases as a result. On financial markets, every investor charges the same for systematic
risk. This means that nobody can make money from selling systematic risk to one group of investors
instead of another. The ability to change an investments beta through operating changes depends on
technology and strategy. A firm can become more flexible so that it has less fixed costs in cyclical
downturns. This greater flexibility translates into a lower beta. If flexibility has low cost but a large
impact on beta, the firms shareholders are better off if the firm increases its flexibility. If greater
flexibility has a high cost, shareholders will not want it because having it will decrease share value.
41
Hedging that only reduces systematic or idiosyncratic risk for shareholders has no impact on
the value of the shares in our analysis. This is because when the firm reduces risk, it is not doing
anything that shareholders could not do on their own equally well with the same consequences.
Shareholders can diversify to eliminate unsystematic risk and they can change their asset allocation
between the risk-free investment and the investment in the market to get the systematic risk they want
to bear. With our assumption of perfect markets, risk management just redistributes risk across
investors who charge the same price for bearing it. For risk management to create value for the firm,
the firm has to transfer risks to investors for whom bearing these risks is less expensive than it is for
the firm. With the assumptions of this section, this cannot happen. Consequently, for this to happen,
there must exist financial market imperfections.
Section 2.3.2. Risk management and shareholder clienteles.
In the introduction, we mentioned that one gold firm, Homestake, had for a long time a policy
of not hedging at all. Homestake justified its policy as follows in its 1990 annual report (p. 12):
So that its shareholders might capture the full benefit of increases in the price of gold,
Homestake does not hedge its gold production. As a result of this policy, Homestakes
earnings are more volatile than those of many other gold producers. The Company believes
that its shareholders will achieve maximum benefit from such a policy over the long-term.
The reasoning in this statement is that some investors want to benefit from gold price movements and
that therefore giving them this benefit increases firm value. These investors form a clientele the firm
42
caters to. Our analysis so far does not account for the possible existence of clienteles such as
investors wanting to bear gold price risks. With the CAPM, investors care only about their portfolios
expected return and volatility. They do not care about their portfolios sensitivity to other variables,
such as gold prices. However, the CAPM has limitations in explaining the returns of securities. For
instance, small firms earn more on average than predicted by the CAPM. It is possible that investors
require a risk premium to bear some risks other than the CAPMs systematic risk. For instance, they
might want a risk premium to bear inflation risk. The existence of such risk premia could explain why
small firms earn more on average than predicted by the CAPM. It could be the case, then, that
investors value gold price risk. To see the impact of additional risk premia besides the market risk
premium on our reasoning about the benefits of hedging, lets suppose that Homestake is right and
that investors want exposures to specific prices and see what that implies for our analysis of the
implications of hedging for firm value.
For our analysis, lets consider explicitly the case where the firm hedges its gold price risk
with a forward contract on gold. We denote by Q the firms production and by G the price of gold
in one year. There is no uncertainty about Q.
Lets start with the case where there is no clientele effect to have a benchmark. In this case,
the CAPM applies. Empirically, gold has a beta close to zero. Suppose now for the sake of argument
that the gold beta is actually zero. In this case, all the risk of the gold producing firm is diversifiable.
This means that hedging does not affect the gold firms value if our analysis is right. Lets make sure
that this is the case. The firm eliminates gold price risk by selling gold forward at a price F per unit,
the forward price. In this case, the value of the cash flow to shareholders when the gold is sold is FQ,
which is known today. Firm value today is FQ discounted at the risk-free rate. If the firm does not
43
hedge, the expected cash flow to shareholders is E(G)Q. In this case, firm value is obtained by
discounting E(G)Q at the risk-free rate since there is no systematic risk. The difference between the
hedged value of the firm and its unhedged value is [F - E(G)]Q/(1 + R
f
). With our assumptions, the
hedged firm is worth more than the unhedged firm if the forward price exceeds the expected spot
price, which is if F - E(G) is positive. Remember that with a short forward position we receive F for
delivering gold worth G per ounce. F - E(G) is therefore equal to the expected payoff from selling
one ounce of gold forward at the price F. If this expected payoff is positive, it means that one expects
to make a profit on a short forward position without making an investment since opening a forward
contract requires no cash. The only way we can expect to make money without investing any of our
own in the absence of arbitrage opportunities is if the expected payoff is a reward for bearing risk.
However, we assumed that the risk associated with the gold price is diversifiable, so that F - G
represents diversifiable risk. The expected value of F - G has to be zero, since diversifiable risk does
not earn a risk premium. Consequently, FQ = E(G)Q and hedging does not affect the firms value.
Consider now the case where gold has a positive beta. By taking a long forward position in
gold which pays G - F, one takes on systematic risk. The only way investors would enter such a
position is if they are rewarded with a risk premium, which means that they expect to make money
out of the long forward position. Hence, if gold has systematic risk, it must be that E(G) > F, so that
the expected payout to shareholders is lower if the firm hedges than if it does not. If the firm is
hedged, the cash flow has no systematic risk and the expected cash flow is discounted at the risk-free
rate. If the firm is not hedged, the cash flow has systematic risk, so that the higher expected cash flow
of the unhedged firm is discounted at a higher discount rate than the lower expected cash flow of the
hedged firm. The lower discount rate used for the unhedged firm just offsets the fact that expected
44
cash flow is lower for the hedged firm, so that the present value of expected cash flow is the same
whether the firm hedges or not. An investor today must be indifferent between paying FQ in one year
or receiving GQ at that time. Otherwise, the forward contract has a value different from zero since
the payoff to a long forward position to buy Q units of gold is GQ - FQ, which cannot be the case.
Hence, the present value of FQ and of GQ must be the same.
The argument extends naturally to the case where some investors value exposure to gold for
its own sake. Since investors value exposure to gold, they are willing to pay for it and hence the risk
premium attached to gold price risk is lower than predicted by the CAPM. This means that exposure
to gold lowers the discount rate of an asset relative to what it would be if exposure to gold was not
valuable to some investors. Consequently, investors who want exposure to gold bid up forward prices
since forward contracts enable these investors to acquire exposure to gold. If the firm does not hedge,
its share price reflects the benefit from exposure to gold that the market values because its discount
rate is lower. In contrast, if the firm hedges, its shareholders are no longer exposed to gold. However,
to hedge, the firm sells exposure to gold to investors by enabling them to take long positions in
forward contracts. Consequently, the firm earns a premium for selling exposure to gold that increases
its expected cash flow. Hence, shareholders can earn the premium for gold exposure either by having
exposure to gold and thereby lowering the discount rate that applies to the firms cash flow or by
selling exposure to gold and earning the risk premium that accrues to short forward positions. The
firm has a natural exposure to gold and it is just a matter of which investors bear it. In our reasoning,
it does not matter whether the firms shareholders themselves are shareholders who value gold
exposure or not. If the firm gets rid of its gold exposure, the firms shareholders can buy it on their
own. Irrespective of how investors who value gold exposure get this exposure, they will have to pay
45
the same price for it since otherwise the same good - gold exposure - would have different prices on
the capital markets, making it possible for investors to put on arbitrage trades that profit from these
price differences. As a result, if the firms shareholders value gold exposure, they will get it one way
or another, but they will always pay the same price for it which will make them indifferent as to where
they get it.
An important lesson from this analysis is that the value of the firm is the same whether the firm
hedges or not irrespective of how the forward price is determined. This lesson holds because there
are arbitrage opportunities if hedging creates value with our assumptions. Suppose that firm value
for the hedged firm is higher than for the unhedged firm. In this case, an investor can create a share
of the hedged firm on his own by buying a share of the unhedged firm and selling one ounce of gold
forward at the price F. His cash cost today is the price of a share since the forward position has no
cash cost today. Having created a share of the hedged firm through homemade hedging, the investor
can then sell the share hedged through homemade hedging at the price of the share of the hedged
firm. There is no difference between the two shares and hence they should sell for the same price.
Through this transaction, the investor makes a profit equal to the difference between the share price
of the hedged firm and the share price of the unhedged firm. This profit has no risk attached to it and
is, consequently, an arbitrage profit. Consequently, firm value must be the same whether the firm
hedges or not with our assumptions.
It follows from our analysis that the clientele argument of Homestake is not correct. With
perfect financial markets, anybody can get exposure to gold without the help of Homestake. For
instance, if Homestake can take a long forward position, so can investors. If Homestake increases its
value by hedging, then investors can buy the unhedged Homestake, create a hedged Homestake on
46
their own account with a forward transaction and sell it on the equity markets. On net, they make
money! This cannot be. Whenever investors can do on their own what the firm does, in other words,
whenever homemade hedging is possible, the firm cannot possibly contribute value through hedging.
Section 2.3.3. The risk management irrelevance proposition.
Throughout this section, we saw that the firm cannot create value by hedging risks when the
price of bearing these risks within the firm is the same as the price of bearing them outside of the firm.
In this chapter, the only cost of bearing risks within the firm is the risk premium attached to these
risks by the capital markets when they value the firm. The same risk premium is required by the
capital markets for bearing these risks outside the firm. Consequently, shareholders can alter the
firms risk on their own through homemade hedging at the same terms as the firm and the firm has
nothing to contribute to the shareholders welfare through risk management. Lets make sure that this
is the case:
1) Diversifiable risk. It does not affect the share price and investors do not care about it
because it gets diversified within their portfolios. Hence, eliminating it does not affect firm value.
2) Systematic risk. Shareholders require the same risk premium for it as all investors. Hence,
eliminating it for the shareholders just means having other investors bear it at the same cost. Again,
this cannot create value.
3) Risks valued by investors differently than predicted by the CAPM. Again,
shareholders and other investors charge the same price for bearing such risks.
The bottom line from this can be summarized in the hedging irrelevance proposition:
47
Hedging irrelevance proposition. Hedging a risk does not increase firm value when the cost
of bearing the risk is the same whether the risk is born within the firm or outside the firm by the
capital markets.
Section 2.4. Risk management by investors.
We saw so far that firms have no reason to adopt risk management policies to help investors
manage their portfolio risks when investors are well-diversified. We now consider whether investors
have reasons to do more than simply diversify and allocate their wealth between the market portfolio
and the risk-free asset optimally. Lets go back to the investor considered in the first section. Suppose
that investor does not want to take the risk of losing more than $50,000. For such an investor, the
only solution given the approach developed so far would be to invest in the risk-free asset at least the
present value of $50,000 invested at the risk-free rate. In one year, this investment would then
amount to $50,000. At the risk-free rate of 7%, this amounts to $46,729. She can then invest the rest
in the market, so her investment in the market is $52,271. With this strategy, the most the investor
can gain for each 1% return in the market is $522.71. The investor might want more exposure to the
market.
To get a different exposure to the market, the investor could create a levered position in
stocks. However, as soon as she borrows to invest more in the market, she takes the risk of ending
up with a loss on her levered position so that she has less than $50,000 at the end of the year. A static
investment strategy is one that involves no trades between the purchase of a portfolio and the time
the portfolio is liquidated. The only static investment strategy which guarantees that the investor will
have $50,000 at the end of the year but benefits more if the market increases than an investment in
48
the market of $52,271 is a strategy that involves buying call options.
Consider the following strategy. The investor invests $100,000 in the market portfolio minus
the cost of buying a put with an exercise price at $50,000. With this strategy, the investor has an
exposure to the market which is much larger than $50,000. The exact amount of the exposure
depends on the cost of the put. However, a put on an investment in the market at $100,000 with an
exercise price of $50,000 will be extremely cheap - less than one hundred dollars because the
probability of the market losing 50% is very small. Consequently, the investor can essentially invest
$100,000 in the market and eliminate the risk of losing more than $50,000. She could not achieve this
payoff with a static investment strategy without using derivatives. Using derivatives, the investor
could achieve lots of different payoffs. For instance, she could buy a call option on a $100,000
investment in the market portfolio with an exercise price of $100,000 and invest the remainder in the
risk-free asset. As long as the volatility of the market portfolio is not too high, this strategy
guarantees wealth in excess of $100,000 at the end of the year and participation in the market
increases from the current level equal to an investment in the market of $100,000. Such a strategy
is called a portfolio insurance strategy in that it guarantees an amount of wealth at the end of the
investment period at least equal to the current wealth. In chapter 13, we will see exactly how to
implement portfolio insurance.
Derivatives enable investors to achieve payoffs that they could not achieve otherwise. They
can also allow them to take advantage of information in ways that they could not otherwise. The
concept of market efficiency means that all public information is incorporated in prices. However, it
does not preclude that an investor might disagree with the market or have information that the market
does not have. Such an investor might then use derivatives to take advantage of her views.
49
Suppose, for instance, that our investor believes that it is highly likely that IBM will exceed $120 in
one year when it is $100 currently. If she feels that this outcome is more likely than the market thinks
it is, she can capitalize on her view by buying a call option with exercise price at $120. Even more
effectively, she might buy an exotic derivative such as a digital cash or nothing call with exercise price
at $120. This derivative pays off a fixed amount if and only if the price of the underlying exceeds the
exercise price. Suppose that this digital pays $100,000 if IBM exceeds $120. The digital pays all of
its promised payment if IBM sells for $120.01. In contrast, a call on a share of IBM with exercise
price of $120 pays only one cent if IBM is at $120.01. Consequently, the digital call is a more
effective option to take advantage of the view that there is an extremely high probability that IBM
will be above $120 in one year when one does not know more than that.
An important use of risk management by investors occurs when investors have information
that leads them to want to hold more of some securities than the market portfolio. For instance, our
investor might believe that IBM is undervalued, which makes its purchase attractive. If our investor
puts all her wealth in IBM to take advantage of her knowledge, she ends up with a portfolio that is
not at all diversified. To reduce the risk of her IBM position, she might decide to hedge the risks of
IBM that she can hedge. An obvious risk she can hedge is the market risk. She can therefore use a
derivative, such as an index futures contract, to hedge this risk. Another case where hedging is often
used is in international investment. An investor might believe that investing in a foreign country is
advantageous, but she feels that there is no reward to bearing foreign exchange risk. She can then use
derivatives to eliminate exchange rate risk.
This discussion shows that risk management can make individual investors better off. It can
allow investors to choose more appropriate payoff patterns from their investments, to hedge the risks
50
that they do not want to bear because they feel that the reward is too low, and to allow them to
capitalize more effectively on their views.
Section 2.5. Conclusion.
In this chapter, we first examined how investors evaluate the risk of securities. We saw how,
using a distribution function, one can evaluate the probability of various outcomes for the return of
a security. This ability we developed to specify the probability that a security will experience a return
smaller than some number will be of crucial importance throughout this book. We then saw that
investors can diversify and that this ability to diversify effects how they evaluate the riskiness of a
security. When holding a portfolio, an investor measures the riskiness of a security by its contribution
to the risk of the portfolio. Under some conditions, the best portfolio of risky securities an investor
can hold is the market portfolio. A securitys contribution to the risk of the market portfolio is its
systematic risk. A securitys unsystematic risk does not affect the riskiness of the portfolio. This
fundamental result allowed us to present the capital asset pricing model, which states that a securitys
risk premium is given by its beta times the risk premium on the market portfolio. The CAPM allowed
us to compute the value of future cash flows. We saw that only the systematic risk of cash flows
affects the rate at which expected future cash flows are discounted.
We then showed that in perfect financial markets, hedging does not affect firm value. We
showed that this is true for hedging through financial instruments systematic as well as unsystematic
risks. Further, we demonstrated that if investors have preferences for some types of risks, like gold
price risks, it is still the case that hedging is irrelevant in perfect financial markets. The reasoning was
straightforward and led to the hedging irrelevance proposition: if it costs the same for a firm to bear
51
a risk as it does for the firm to pay somebody else to bear it, hedging cannot increase firm value.
In the last section, we discussed when investors can be made better off using derivatives. This
is the case when diversification and asset allocation are not sufficient risk management tools. Such
a situation can arise, for instance, when the investor wants to construct a portfolio that requires no
trading after being put together, that guarantees some amount of wealth at some future date and yet
enables her to gain substantially from increases in the stock market. Such a portfolio is an insured
portfolio and it requires positions in options to be established. Though we saw how investors can be
made better off by using derivatives, we did not see how firms could increase their value through the
use of derivatives. The next chapter address this issue.
52
Literature Note
Much research examines the appropriateness of the assumption of the normal distribution for
security returns. Fama (1965) argues that stock returns are well-described by the normal distribution
and that these returns are independent across time. Later in this book, we will discuss some of the
issues raised in that research.
Fama (1970) presents the definitions of market efficiency and reviews the evidence. He
updated his review in Fama (1991). Over the recent past, several papers have questioned the
assumption that stock returns are independent across time. These papers examine the serial
correlation of stock returns. By serial correlation, we mean the correlation of a random variable
between two contiguous periods of equal length. Lo and McKinlay (1988) provide some evidence
of negative serial correlation for daily returns. Jegadeesh and Titman (1993) show that six month
returns have positive serial correlation. Finally, Fama and French (1988) find that returns measured
over periods of several years have negative serial correlation. This literature suggests that there is
some evidence that the distribution of returns depends on their recent history. Such evidence is
consistent with market efficiency if the recent history of stock returns is helpful to forecast the risk
of stocks, so that changes in expected returns reflect changes in risk. Later in this book, we will
discuss how to account for dependence in returns across time. None of the results of this chapter are
fundamentally altered. In particular, these results did not require the returns of IBM to be independent
across years. All they required was the distribution of the next years return to be normal.
The fundamental results on diversification and the CAPM were discovered respectively by
Markovitz (1952) and Sharpe (1964). Each of these authors was awarded a share of the Nobel
Memorial Prize in Economics in 1990. Textbooks on investments cover this material in much greater
53
details than we did here. Elton and Gruber provide an extensive presentation of portfolio theory. The
valuation theory using the CAPM is discussed in corporate finance textbooks or textbooks specialized
in valuation. For corporate finance textbooks, see Brealey and Myers (1999) or Jordan, Ross and
Westerfield. A book devoted to valuation is Copeland, Koller, and Murrin (1996).
The hedging irrelevance result is discussed in Smith and Stulz (1985). This result is a natural
extension of the leverage irrelevance result of Modigliani and Miller. They argue that in perfect
markets leverage cannot increase firm value. Their result led to the award of a Nobel Memorial Prize
in Economics in 1990 for Miller. Modigliani received such a Prize earlier for a different contribution.
Risk management in the gold industry has been the object of several papers and cases. The
firm American Barrick discussed in the introduction is the object of a Harvard Business School case.
Tufano (1996) compares the risk management practices of gold mining firms. His work is discussed
more in chapter 4.
One statement of the argument that foreign exchange hedging is advantageous for diversified
portfolios is Perold and Schulman (1988).
54
Key concepts
Cumulative distribution function, normal distribution, expected return, variance, covariance,
diversification, asset allocation, capital asset pricing model, beta, risk premium, homemade hedging,
risk management
55
Review questions
1. Consider a stock return that follows the normal distribution. What do you need to know to
compute the probability that the stocks return will be less than 10% over the coming year?
2. What are the three types of financial market efficiency?
3. What does diversification of a portfolio do to the distribution of the portfolios return?
4. What is beta?
5. When does beta measure risk?
6. For a given expected cash flow, how does the beta of the cash flow affects its current value?
7. How does hedging affect firm value if financial markets are perfect?
8. Why can hedging affect a firms expected cash flow when it does not affect its value?
9. Why is it that the fact that some investors have a preference for gold exposure does not mean that
a gold producing firm should not hedge its gold exposure.
10. What is the risk management irrelevance proposition?
56
11. How come risk management cannot be used to change firm value but can be used to change
investor welfare when financial markets are perfect?
57
Questions and exercises
1. The typical level of the monthly volatility of the S&P500 index is about 4%. Using a risk premium
of 0.5% and a risk-free rate of 5% p.a., what is the probability that a portfolio of $100,000 invested
in the S&P500 will lose $5,000 or more during the next month? How would your answer change if
you used current interest rates from T-bills?
2. During 1997, the monthly volatility on S&P500 increased to about 4.5% from its typical value of
4%. Using the current risk-free rate, construct a portfolio worth $100,000 invested in the S&P500
and the risk-free asset that has the same probability of losing $5,000 or more in a month when the
S&P500 volatility is 4.5% as $100,000 invested in the S&P500 when the S&P500 volatility is 4%.
3. Compute the expected return and the volatility of return of a portfolio that has a portfolio share
of 0.9 in the S&P500 and 0.1 in an emerging market index. The S&P500 has a volatility of return of
15% and an expected return of 12%. The emerging market has a volatility of return of 30% and an
expected return of 10%. The correlation between the emerging market index return and the S&P500
is 0.1.
4. If the S&P500 is a good proxy for the market portfolio in the CAPM and the CAPM applies to the
emerging market index, use the information in question 3 to compute the beta and risk premium for
the emerging market index.
58
5. Compute the beta of the portfolio described in question 4 with respect to the S&P500.
6. A firm has an expected cash flow of $500m in one year. The beta of the common stock of the firm
is 0.8 and this cash flow has the same risk as the firm as a whole. Using a risk-free rate of 6% and a
risk premium on the market portfolio of 6%, what is the present value of the cash flow. If the beta
of the firm doubles, what happens to the present value of the cash flow?
7. With the data used in the previous question, consider the impact on the firm of hedging the cash
flow against systematic risk. If management wants to eliminate the systematic risk of the cash flow
completely, how could it do so? How much would the firm have to pay investors to bear the
systematic risk of the cash flow?
8. Consider the situation you analyzed in question 6. To hedge the firms systematic risk, management
has to pay investors to bear this risk. Why is it that the value of the firm for shareholders does not fall
when the firm pays other investors to bear the systematic risk of the cash flow?
9. The management of a gold producing firm agrees with hedging irrelevance result and has
concluded that it applies to the firm. However, the CEO wants to hedge because the price of gold has
fallen over the last month. He asks for your advice. What do you tell him?
10. Consider again an investment in the emerging market portfolio discussed earlier. Now, you
consider investing $100,000 in that portfolio because you think it is a good investment. You decide
59
that you are going to ignore the benefits from diversification, in that all your wealth will be invested
in that portfolio. Your broker nevertheless presents you with an investment in a default-free bond in
the currency of the emerging country which matures in one year. The regression beta in a regression
of the dollar return of the portfolio on the return of the foreign currency bond is 1. The expected
return on the foreign currency bond is 5% in dollars and the volatility is 10%. Compute the expected
return of a portfolio with $100,000 in the emerging market portfolio, -$50,000 in the foreign currency
bond, and $50,000 in the domestic risk-free asset which earns 5% per year. How does this portfolio
differ from the portfolio that has only an investment in the emerging market portfolio? Which one
would you choose and why? Could you create a portfolio with investments in the emerging market
portfolio, in the emerging market currency risk-free bond and in the risk-free asset which is has the
same mean but a lower volatility?
60
Figure 2.1. Cumulative probability function for IBM and for a stock with same return and
twice the volatility.
The expected return of IBM is 13% and its volatility is 30%. The horizontal line corresponds to a
probability of 0.05. The cumulative probability function of IBM crosses that line at a return almost
twice as high as the cumulative probability function of the riskier stock. There is a 5% chance that
IBM will have a lower return than the one corresponding to the intersection of the IBM cumulative
distribution function and the horizontal line, which is a return of -36%. There is a 5% change that the
stock with twice the volatility of IBM will have a return lower than -0.66%.
Stock with twice the volatility
Probability
Return in decimal form
IBM
61
Figure 2.2. Normal density function for IBM assuming an expected return of 13% and a
volatility of 30% and of a stock with the same expected return but twice the volatility.


This figure shows the probability density function of the one-year return of IBM assuming an
expected return of 13% and a volatility of 30%. It also shows the probability density function of the
one-year return of a stock that has the same expected return but twice the volatility of return of IBM.
Probability density
Probability density function of IBM
Probability density function
of the more volatile stock
Decimal return
62
Figure 2.3. Efficient frontier without a riskless asset. The function represented in the figure gives
all the combinations of expected return and volatility that can be obtained with investments in IBM
and XYZ. The point where the volatility is the smallest has an expected return of 15.6% and a
standard deviation of 26.83%. The portfolio on the upward-sloping part of the efficient frontier that
has the same volatility as a portfolio wholly invested in IBM has an expected return of 18.2%.
63
Figure 2.4. The benefits from diversification. This figure shows how total variance falls as more
securities are added to a portfolio. Consequently, 100% represents the variance of a typical U.S.
stock. As randomly chosen securities are added to the portfolio, its variance falls, but more so if the
stocks are chosen among both U.S. and non-U.S. stocks than only among U.S. stocks.
64
Figure 2.5. The efficient frontier using national portfolios. This figure shows the efficient frontier
estimated using the dollar monthly returns on country indices from 1980 to 1990.
65

Figure 2.6. Efficient frontier with a risk-free asset.
The function giving all the expected return and the volatility of all combinations of holdings in IBM
and XYZ is reproduced here. The risk-free asset has a return of 5%. By combining the risk-free asset
and a portfolio on the frontier, the investor can obtain all the expected return and volatility
combinations on the straight line that meets the frontier at the portfolio of risky assets chosen to form
these combinations. The figure shows two such lines. The line with the steeper slope is tangent to the
efficient frontier at portfolio m. The investor cannot form combinations of the risk-free asset and a
risky portfolio that dominate combinations formed from the risk-free asset and portfolio m.
Expected returns
Volatility
Portfolio m
66
Expected
return
Beta
1
R
E(R
m
)
The security
market line

Figure 2.7. The CAPM. The straight line titled the security market line gives the expected return
of a security for a given beta. This line intersects the vertical axis at the risk-free rate and has a value
equal to the expected return on the market portfolio for a beta of one.
67
Box: T-bills.
T-bills are securities issued by the U.S. government that mature in one year or less. They pay
no coupon, so that the investors dollar return is the difference between the price paid on sale or at
maturity and the price paid on purchase. Suppose that T-bills maturing in one year sell for $95 per
$100 of face value. This means that the holding period return computed annually is 5.26% (100*5/95)
because each investment of $95 returns $5 of interest after one year.
Exhibit 2.2.1. shows the quotes for T-bills provided by the Wall Street Journal. T-bills are
quoted on a bank discount basis. The price of a T-bill is quoted as a discount equal to:
D(t,t+n/365) = (360/n)(100-P(t,t+n/365))
where D(t,t+n/365) is the discount for a T-bill that matures in n days and P(t,t+n/365) is the price of
the same T-bill. The bank discount method uses 360 days for the year. Suppose that the price of a
90-day T-bill, P(t,t+90/365), is $98.5. In this case, the T-bill would be quoted at a discount of 6.00.
From the discount rate, one can recover the price using the formula:
P(t,t+n/365) = 100 - (n/360)D(t,t+365/n)
For our example, we have 100 - (90/360)6.00 = 98.5.
In the Wall Street Journal, two discounts are quoted for each bill, however. This is because
the dealers have to be compensated for their services. Lets look at how this works for the bill
maturing in 92 days. For that bill, there is a bid discount of 5.07 corresponding to a price of 98.7043
(100-(92/360)5.07) and asked discount of 5.05 corresponding to a price 98.7096. The dealer buys
at the lower price and sells at the higher price. However, when the dealer quotes discounts, the higher
discount corresponds to the buy price and the lower discount corresponds to the price at which the
bidder sells. This is because to get the price one has to subtract the discount multiplied by the fraction
of 360 days the bill has left before it matures.
1
For a detailed analysis of the difference in the cost of capital between using a local and a global
index, see Stulz (1995).
68
Box: The CAPM in practice.
The CAPM provides a formula for the expected return on a security required by capital
markets in equilibrium. To implement the CAPM to obtain the expected return on a security, we need
to:
Step 1. Identify a proxy for the market portfolio.
Step 2. Identify the appropriate risk-free rate.
Step 3. Estimate the risk premium on the market portfolio.
Step 4. Estimate the $ of the security.
If we are trying to find the expected return of a security over the next month, the next year, or longer
in the future, all steps involve forecasts except for the first two steps. Using discount bonds of the
appropriate maturity, we can always find the risk-free rate of return for the next month, the next year,
or longer in the future. However, irrespective of which proxy for the market portfolio one uses, one
has to forecast its risk premium and one has to forecast the $ of the security.
What is the appropriate proxy for the market portfolio? Remember that the market portfolio
represents how the wealth of investors is invested when the assumptions of the CAPM hold. We
cannot observe the market portfolio directly and therefore we have to use a proxy for it. Most
applications of the CAPM in the U.S. involve the use of some broad U.S. index, such as the S&P500,
as a proxy for the market portfolio. As capital markets become more global, however, this solution
loses its appeal. Investors can put their wealth in securities all over the world. Hence, instead of
investing in the U.S. market portfolio, one would expect investors to invest in the world market
portfolio. Proxies for the U.S. market portfolio are generally highly correlated with proxies for the
world market portfolio, so that using the U.S. market portfolio in U.S. applications of the CAPM is
unlikely to lead to significant mistakes. However, in smaller countries, the market portfolio cannot
be the market portfolio of these countries. For instance, it would not make sense to apply the CAPM
in Switzerland using a Swiss index as a proxy for the market portfolio. Instead, one should use a
world market index, such as the Financial Times-Goldman Sachs World Index or the Morgan Stanley-
Capital International Word Index.
1

Having chosen a proxy for the market portfolio, one has to estimate its risk premium.
Typically, applications of the CAPM use the past history of returns on the proxy chosen to estimate
the risk premium. The problem with doing so is that the resulting estimate of the risk premium
depends on the period of time one looks at. The table shows average returns for the U.S. market
portfolio in excess of the risk-free rate over various periods of time as well as average returns for the
world market portfolio in dollars in excess of the risk-free rate. Estimates of the risk premium used
in practice have decreased substantially over recent years. Many practitioners now use an estimate
of 6%.
How do we get $? Consider a security that has traded for a number of years. Suppose that
the relation between the return of that security and the return on the proxy for the market portfolio
is expected to be the same in the future as it was in the past. In this case, one can estimate $ over the
past and apply it to the future. To estimate $, one uses linear regression. To do so, one defines a
69
sample period over which one wants to estimate $. Typically, one uses five or six years of monthly
returns. Having defined the sample period, one estimates the following equation over the sample
period using regression analysis:
R
C
(t) = c + bR
M
(t) + e(t)
In this equation, e(t) is residual risk. It has mean zero and is uncorrelated with the return on the
market portfolio. Hence, it corresponds to idiosyncratic risk. The estimate for b will then be used as
the $ of the stock.
Let look at an example using data for IBM. We have data from January 1992 to the end of
September 1997, sixty-nine observations in total. We use as the market portfolio the S&P500 index.
Using Excel, we can get the beta estimate for IBM using the regression program in data analysis
under tools (it has to be loaded first if it has not been done already). We use the return of IBM in
decimal form as the dependent or Y variable and the return on the S&P500 as the independent or X
variable. We use a constant in the regression. The Excel output is reproduced below. The estimates
are:
Return on IBM = -0.00123 + 1.371152*Return on S&P500
The standard error associated with the beta estimate is 0.33592. The difference between the beta
estimate and the unknown true beta is a normally distributed random variable with zero mean. Using
our knowledge about probabilities and the normal distribution, we can find that there is a 95% chance
that the true beta of IBM is between 0.7053 and 2.037004. The t-statistic is the ratio of the estimate
to its standard error. It provides a test here of the hypothesis that the beta of IBM is greater than
zero. A t-statistic greater than 1.65 means that we can reject this hypothesis in that there is only a 5%
chance or less that zero is in the confidence interval constructed around the estimate of beta. Here,
the t-statistic is 4.110271. This means that zero is 4.110271 standard errors from 1.371152. The
probability that the true beta would be that many standard errors below the mean is the p-value
0.00011. As the standard error falls, the confidence interval around the coefficient estimates becomes
more narrow. Consequently, we can make stronger statements about the true beta. The R-square
coefficient of 0.201376 means that the return of the S&P500 explains a fraction 0.201376 of the
volatility of the IBM return. As this R-square increases, the independent variable explains more of
the variation in the dependent variable. As one adds independent variables in a regression, the R-
square increases. The adjusted R-square takes this effect into account and hence is a more useful
guide of the explanatory power of the independent variables when comparing across regressions
which have different numbers of independent variables.
70
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.44875
R Square 0.201376
Adjusted R
Square
0.189457
S t a n d a r d
Error
0.076619
Observations 69
Coefficients Standard
Error
t-Stat P-value
Intercept -0.00123 0.010118 -0.12157 0.903604
X Variable 1.371152 0.333592 4.110271 0.00011