Chapter Outline

11.1 Individual Securities

11.2 Expected Return, Variance, and Covariance
11.3 The Return and Risk for Portfolios
11.4 The Efficient Set for Two Assets
11.5 The Efficient Set for Many Assets
11.6 Diversification
11.7 Riskless Borrowing and Lending
11.8 Market Equilibrium
11.9 Relationship between Risk and Expected Return
(CAPM)

Chapter 11
Return and Risk: The Capital Asset Pricing
Model

McGraw-Hill/Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

11.2 Expected Return, Variance, and

Covariance

11.1 Individual Securities

The characteristics of individual securities

that are of interest are the:

11-1

Consider the following two risky asset

world. There is a 1/3 chance of each state of
the economy, and the only assets are a stock
fund and a bond fund.

Expected Return
Variance and Standard Deviation
Covariance and Correlation (to another security
or index)

Scenario
Recession
Normal
Boom
11-2

Rate of Return
Probability Stock Fund Bond Fund
33.3%
-7%
17%
33.3%
12%
7%
33.3%
28%
-3%
11-3

Expected Return

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Expected Return

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Bond
Rate of
Return
17%
7%
-3%
7.00%
0.0067
8.2%

Fund
Squared
Deviation
0.0100
0.0000
0.0100

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
0.0100
7%
0.0000
-3%
0.0100
7.00%
0.0067
8.2%

E (rS ) 1 (7%) 1 (12%) 1 (28%)

3
3
3
11-4

Variance

E (rS ) 11%

11-5

Variance

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
0.0100
7%
0.0000
-3%
0.0100
7.00%
0.0067
8.2%

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

.0205

(7% 11%) .0324

2

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
0.0100
7%
0.0000
-3%
0.0100
7.00%
0.0067
8.2%

(.0324 .0001 .0289)

3
11-6

11-7

Covariance

Standard Deviation
Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
0.0100
7%
0.0000
-3%
0.0100
7.00%
0.0067
8.2%

Scenario
Recession
Normal
Boom
Sum
Covariance

Stock
Bond
Deviation Deviation
-18%
10%
1%
0%
17%
-10%

Product
-0.0180
0.0000
-0.0170

Weighted
-0.0060
0.0000
-0.0057
-0.0117
-0.0117

Deviation compares return in each state to the expected return.

0.0205

Weighted takes the product of the deviations multiplied by the

probability of that state.
11-8

Correlation

11.3 The Return and Risk for Portfolios

Cov( a, b)

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

a b
.0117

11-9

0.998

(.143)(. 082)

11-10

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
0.0100
7%
0.0000
-3%
0.0100
7.00%
0.0067
8.2%

Note that stocks have a higher expected return than bonds

and higher risk. Let us turn now to the risk-return tradeoff
of a portfolio that is 50% invested in bonds and 50%
invested in stocks.

11-11

Portfolios

Portfolios
Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Scenario
Recession
Normal
Boom

squared deviation
0.0016
0.0000
0.0012

Expected return
Variance
Standard Deviation

9.0%
0.0010
3.08%

5% 50% (7%) 50% (17%)

9% 50% (11%) 50% (7%)

11-12

Portfolios

11-13

Portfolios
Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%
11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

squared deviation
0.0016
0.0000
0.0012

Scenario
Recession
Normal
Boom

9.0%
0.0010
3.08%

Expected return
Variance
Standard Deviation

The variance of the rate of return on the two risky assets

portfolio is
2

11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

squared deviation
0.0016
0.0000
0.0012

9.0%
0.0010
3.08%

An equally weighted portfolio (50% in stocks and 50%

in bonds) has less risk than either stocks or bonds held
in isolation.

where BS is the correlation coefficient between the returns

on the stock and bond funds.

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Observe the decrease in risk that diversification offers.

P (wB B ) (wS S ) 2(wB B )(w S S ) BS

2

9.0%
0.0010
3.08%

E (rP ) wB E (rB ) wS E (rS )

rP wB rB wS rS

Expected return
Variance
Standard Deviation

7.00%
0.0067
8.16%

The expected rate of return on the portfolio is a weighted

average of the expected returns on the securities in the
portfolio.

The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:

Scenario
Recession
Normal
Boom

11.00%
0.0205
14.31%

squared deviation
0.0016
0.0000
0.0012

11-14

11-15

Risk

Return

0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50.00%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%

8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.08%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%

7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.00%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%

Portfolo Risk and Return Combinations

Portfolio
Return

% in stocks

12.0%
11.0%
10.0%
9.0%
8.0%
7.0%
6.0%
5.0%
0.0%

100%
stocks
100%
bonds
5.0%

10.0%

15.0%

20.0%

Portfolio Risk (standard deviation)

We can consider other

portfolio weights besides
50% in stocks and 50% in
bonds.

= 1.0
= 0.2

Relationship depends on correlation

coefficient
-1.0 < < +1.0
If = +1.0, no risk reduction is possible
If = 1.0, complete risk reduction is possible

7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.0%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%

Portfolo Risk and Return Combinations

12.0%
11.0%

100%
stocks

10.0%
9.0%
8.0%
7.0%

100%
bonds

6.0%
5.0%
0.0%

2.0%

4.0%

6.0%

8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

Note that some portfolios are

better than others. They have
higher returns for the same level of
risk or less.
11-17

return

retun
rn

Return

8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.1%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%

11.5 The Efficient Set for Many Securities

100%
stocks

100%
bonds

Risk

0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
11-16

Portfolios with Various Correlations

= -1.0

% in stocks

Portfolio Return

The Efficient Set for Two Assets

11.4 The Efficient Set for Two Assets

Individual
Assets

Consider a world with many risky assets; we

can still identify the opportunity set of riskreturn combinations of various portfolios.
11-18

11-19

The Efficient Set for Many Securities

Announcements, Surprises, and Expected

Returns

return

The return on any security consists of two parts.

minimum
variance
portfolio

Individual Assets

First, the expected returns

Second, the unexpected or risky returns

A way to write the return on a stock in the

coming month is:
R R U

The section of the opportunity set above the

minimum variance portfolio is the efficient
frontier.

where
R is the expected part of the return
U is the unexpected part of the return
11-20

Announcements, Surprises, and Expected

Returns

Any announcement can be broken down into two

parts, the anticipated (or expected) part and the
surprise (or innovation):
Announcement = Expected part + Surprise.
The expected part of any announcement is the
part of the information the market uses to form
the expectation, R, of the return on the stock.
The surprise is the news that influences the
unanticipated return on the stock, U.
11-22

11-21

Diversification and Portfolio Risk

Diversification can substantially reduce the
variability of returns without an equivalent
reduction in expected returns.
This reduction in risk arises because worse
than expected returns from one asset are offset
by better than expected returns from another.
However, there is a minimum level of risk that
cannot be diversified away, and that is the
systematic portion.

11-23

Portfolio Risk and Number of Stocks

In a large portfolio the variance terms are

effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n

Risk: Systematic and Unsystematic

A systematic risk is any risk that affects a large

number of assets, each to a greater or lesser degree.
An unsystematic risk is a risk that specifically affects
a single asset or small group of assets.
Unsystematic risk can be diversified away.
Examples of systematic risk include uncertainty
about general economic conditions, such as GNP,
interest rates or inflation.
On the other hand, announcements specific to a
single company are examples of unsystematic risk.

11-24

Total Risk

11-25

Optimal Portfolio with a Risk-Free Asset

Total risk = systematic risk + unsystematic risk

The standard deviation of returns is a measure
of total risk.
For well-diversified portfolios, unsystematic
risk is very small.
Consequently, the total risk for a diversified
portfolio is essentially equivalent to the
systematic risk.

return

100%
stocks

rf
100%
bonds

In addition to stocks and bonds, consider a world

that also has risk-free securities like T-bills.
11-26

11-27

Riskless Borrowing and Lending

return

return

11.7 Riskless Borrowing and Lending

100%
stocks
Balanced
fund

rf

rf

100%
bonds

Now investors can allocate their money across

the T-bills and a balanced mutual fund.
11-28

11-29

Market Equilibrium
return

return

11.8 Market Equilibrium

With a risk-free asset available and the efficient

frontier identified, we choose the capital
allocation line with the steepest slope.

100%
stocks
Balanced
fund

M
rf

rf

100%
bonds

With the capital allocation line identified, all investors choose a

point along the linesome combination of the risk-free asset
and the market portfolio M. In a world with homogeneous
expectations, M is the same for all investors.

Where the investor chooses along the Capital Market

Line depends on her risk tolerance. The big point is that
all investors have the same CML.
11-30

11-31

Risk When Holding the Market Portfolio

Researchers have shown that the best measure

of the risk of a security in a large portfolio is
the beta (b)of the security.
Beta measures the responsiveness of a
security to movements in the market portfolio
(i.e., systematic risk).
bi

Security Returns

Estimating b with Regression

Slope = bi
Return on
market %

Cov( Ri , RM )

( RM )
2

Ri = a i + b iRm + ei
11-32

11-33

11.9 Relationship between Risk and

Expected Return (CAPM)

The Formula for Beta

bi

Cov( Ri , RM )

( RM )
2

( Ri )

Expected Return on the Market:

R M RF Market Risk Premium

( RM )

Expected return on an individual security:

Clearly, your estimate of beta will

depend upon your choice of a proxy
for the market portfolio.

R i RF i ( R M RF )
Market Risk Premium

This applies to individual securities held within welldiversified portfolios.

11-34

11-35

Relationship Between Risk & Return

Expected Return on a Security

This formula is called the Capital Asset
Pricing Model (CAPM):

Expected return

R i RF i ( R M RF )
Expected
return on
a security

RiskBeta of the
+

free rate
security

Market risk
premium

R i RF i ( R M RF )

RM

RF
1.0

Assume bi = 0, then the expected return is RF.

Assume bi = 1, then Ri R M
11-36

11-37

Expected
return

Relationship Between Risk & Return

13.5%

3%
1.5

i 1.5

RF 3%

R M 10%

R i 3% 1.5 (10% 3%) 13.5%

11-38

10