12/6/2007

Chapter 6. Tool Kit for Risk, Return, and the Capital Asset Pricing Model

INVESTMENT RETURNS (Section 6.1)

Amount invested $1,000

Amount received in one year $1,100

Dollar return $100

Rate of return 10%

STAND-ALONE RISK (Section 6.2)

The relationship between risk and return is a fundamental axiom in finance. Generally speaking, it is totally logical to assume that
investors are only willing to assume additional risk if they are adequately compensated with additional return. This idea is rather
fundamental, but the difficulty in finance arises from interpreting the exact nature of this relationship (accepting that risk aversion
differs from investor to investor). Risk and return interact to determine security prices, hence its paramount importance in finance.

PROBABILITY DISTRIBUTION

The probability distribution is a listing of all possible outcomes and the corresponding probability.

Demand for the Probability of this Rate of Return on stock

company's products demand occurring if this demand occurs
Sale.com Basic Foods
Strong 0.30 100% 40%
Normal 0.40 15% 15%
Weak 0.30 -70% -10%
1.00

EXPECTED RATE OF RETURN

The expected rate of return is the rate of return that is expected to be realized from an investment. It is determined as the weighted
average of the probability distribution of returns.
 Demand for the Probability of this Sale.com Basic Foods
company's products demand occurring Rate of Return Product Rate of Return Product

Strong 0.3 100% 30% 40% 12%

Normal 0.4 15% 6% 15% 6%
Weak 0.3 -70% -21% -10% -3%
1.0
EXPECTED RATE OF RETURN, r hat 15% 15%

MEASURING STAND-ALONE RISK: THE STANDARD DEVIATION

To calculate the standard deviation, there are a few steps. First find the differences of all the possible returns from the expected return.
Second, square that difference. Third, multiply the squared number by the probability of its occurrence. Fourth, find the sum of all the
weighted squares. And lastly, take the square root of that number. Let us apply this procedure to find the standard deviation 'of
Sale.com's returns.

Demand for the Probability of this Deviation from r hat Squared deviation Sq Dev * Prob.
company's products demand occurring Sale.com
Strong 0.3 85% 72.2500% 21.6750%
Normal 0.4 0% 0.0000% 0.0000%
Weak 0.3 -85% 72.2500% 21.6750%
Sum: 43.3500%
Std. Dev. = Square root of sum 65.84% Sq. root can be
65.84% found in two ways
 Probability of this
demand occurring Basic Foods
Strong 0.3 25% 6.25% 1.88%
Normal 0.4 0% 0.00% 0.00%
Weak 0.3 -25% 6.25% 1.88%
3.75%
Std. Dev. = Square root of sum 19.36% Sq. root can be
19.36% found in two ways

USING HISTORICAL DATA

Realized
Year return
2006 15%
2007 -5%
2008 20%

Average =AVERAGE(C68:C70) = 10.0%

Standard deviation =STDEV(C68:C70) = 13.2%

MEASURING STAND-ALONE RISK: THE COEFFICIENT OF VARIATION

The coefficient of variation indicates the risk per unit of return, and is calculated by dividing the standard deviation by the expected
return.
Std. Dev. Expected return CV
Sale.com 65.84% 15% 4.39
Basic Foods 19.36% 15% 1.29

RISK IN A PORTFOLIO CONTEXT (Section 6.3)

The expected return on a portfolio is simply a weighted average of the expected returns of the individual assets in the portfolio.
Consider the following portfolio.

Stock Portfolio weight Expected Return

Southwest Airlines 0.25 15.0%
Starbucks 0.25 12.0%
FedEx 0.25 10.0%
Dell 0.25 9.0%
Portfolio's Expected Return 11.50%

RISK IN A PORTFOLIO CONTEXT (Section 6.3)

Portfolios of stocks are created to diversify investors from unnecessary risk. The diversifiable, or idiosyncratic, risk is eliminated as more stocks are
added. Diversification effects are strongest when combining uncorrelated assets. The next few tables (and corresponding graphs) illustrate how
creating two-stock portfolios with different correlations between stocks affects the expected return and risk of various fictional portfolios.

PERFECT NEGATIVE CORRELATION

Weights
wW
Two-stock portfolio (with perfect negative
0.5 correlation, r = -1.0)
Re turn
wM 0.5
50%
Year Stock W Stock M Portfolio WM 40%
2004 40% -10% 15% 30%
2005 -10% 40% 15%
20%
2006 35% -5% 15%
2007 -5% 35% 15% 10%
2008 15% 15% 15% 0%
Average return = 15.00% 15.00% 15.00%
-10%
Standard deviation = 22.64% 22.64% 0.00%
orrelation coefficient = -1.00 -20%
2004 2005 2006 2007
Ye ar

CONCLUSION: When two stocks are perfectly negatively correlated, diversification is its strongest, and in this case the portfolio return is a certain
(no risk) 15%. Of course, this situation is very rare.

PERFECT POSITIVE CORRELATION

Weights
Two-stock portfolio (with perfect positive
wM 0.5 correlation, r = +1.0)
wM' 0.5 Return
50%
Year Stock M Stock M' Portfolio MM' 40%
2004 40% 40% 40% 30%
2005 -10% -10% -10%
20%
2006 35% 35% 35%
2007 -5% -5% -5% 10%
2008 15% 15% 15% 0%
Average return = 15.00% 15.00% 15.00%
-10%

-20%
2004 2005 2006 2007
Year
 Return
50%

40%

30%

20%

10%

0%

-10%
Standard deviation = 22.64% 22.64% 22.64%
-20%
orrelation coefficient = 1.00
2004 2005 2006 2007
Year

CONCLUSION: When two stocks are perfectly positively correlated, diversification has no effect and the portfolio's risk is a weighted average of its
stock's risk. Note, in this graph only the portfolio returns are visible, but realize that the stock returns follow the same path. In other words, the line
shown is actually all three lines at once.

PARTIAL "AVERAGE" POSITIVE CORRELATION

Weights
wW Two-stock portfolio (with partial, "average" positive correlation, r
0.5
wV 0.5 Re turn
50%
Year Stock W Stock Y Portfolio WY
40%
2004 40% 40% 40%
30%
2005 -10% 15% 3%
2006 35% -5% 15% 20%
2007 -5% -10% -8% 10%
2008 15% 35% 25%
0%
Average return = 15.00% 15.00% 15.00%
-10%
Standard deviation = 22.64% 22.64% 18.62%
orrelation coefficient = 0.35 -20%
2004 2005 2006 2007
Year

CONCLUSION: In this case where two stocks are somewhat correlated, diversification is effective in lowering portfolio risk. Here, the portfolio
return is an average of the stock returns and risk is reduced from 22.64% per stock to 18.62% for the portfolio. If more similarly-correlated stocks
were added, risk would continue to fall.

CONTRIBUTION TO MARKET RISK: BETA

The beta coefficient measures the amount of risk that a stock contributes to the market portfolio. It also reflects the
tendency of a stock to move up and down with the market. Shown below in the chart and in the table are the returns
for three stocks and for the stock market.

Beta Graph
30%
Stocks returns

Stock L
0% Stock A
-10% 0% 10% 20% Stock H
 Beta Graph
30%

Stocks returns
Stock L
0% Stock A
-10% 0% 10% 20% Stock H

-30%

Market returns

Returns on The Market and on Stocks L (for Low), A (for Average), and H (for High)
Year rM rH rA rL
1 10% 10% 10% 10%
2 20% 30% 20% 15%
3 -10% -30% -10% 0%

= 15.28% 30.55% 15.28% 7.64%

Correlation of stock
with Market, i,M 1.00 1.00 1.00
Covariance of stock
with Market, COVi,M 4.67% 2.33% 1.17%

Method 1:
bi = ri,M ( i / M) 2.0 1.0 0.5

Method 2:
bi = COVi,M / ( M)2 2.0 1.0 0.5

Method 3:

b = slope of regression 2.0 1.0 0.5 We use the SLOPE function.

CALCULATING BETA COEFFICIENTS (Section 6.4)

Now we show how to calculate beta for an actual company, General Electric.

Step 1. Acquire Data

We downloaded stock prices and dividends from http://finance.yahoo.com for General Electric, using its ticker
symbol GE. We also downloaded data for the S&P 500 Index (^SPX), which contains 500 actively traded large
stocks. For example, to download the GE data, enter its ticker symbol and click Go. then select Historical Prices
from the left side of the page. After the daily prices come up, get monthly prices by entering the start date and the
end date. Yahoo provides monthly prices as of the first trading day of the month. Note that these prices are
"adjusted" to reflect any dividends or stock splits. Download the data by right-clicking below the data where its has
"Dowload to Spreadsheet".

Step 2. Calculate Returns

We used the percentage change in adjusted prices (which already reflect dividends) for GE to calculate returns. We
used the percentage change for the S&P 500 Index as the market return.

Now go to the bottom of the data, row 317.

r M r i
Market Level (S&P GE Adjusted Stock
Date 500 Index) Market Return Price GE Return
April 2007 1482.37 4.3% 36.86 4.2%
March 2007 1420.86 1.0% 35.36 1.3%
February 2007 1406.82 -2.2% 34.91 -2.4%
January 2007 1438.24 1.4% 35.77 -3.1%
December 2006 1418.30 1.3% 36.92 6.2%
November 2006 1400.63 1.6% 34.75 0.5%
October 2006 1377.94 3.2% 34.58 -0.5%
September 2006 1335.85 2.5% 34.77 4.4%
August 2006 1303.82 2.1% 33.31 4.2%
July 2006 1276.66 0.5% 31.97 -0.8%
June 2006 1270.20 0.0% 32.23 -3.1%
May 2006 1270.09 -3.1% 33.25 -1.0%
April 2006 1310.61 1.2% 33.57 -0.6%
March 2006 1294.87 1.1% 33.76 5.8%
February 2006 1280.66 0.0% 31.90 1.1%
January 2006 1280.08 2.5% 31.55 -6.6%
December 2005 1248.29 -0.1% 33.77 -1.2%
November 2005 1249.48 3.5% 34.17 5.3%
October 2005 1207.01 -1.8% 32.44 0.7%
September 2005 1228.81 0.7% 32.21 0.8%
August 2005 1220.33 -1.1% 31.94 -2.6%
July 2005 1234.18 3.6% 32.79 -0.4%
 June 2005 1191.33 0.0% 32.93 -4.4%
May 2005 1191.50 3.0% 34.45 0.8%
April 2005 1156.85 -2.0% 34.19 0.4%
March 2005 1180.59 -1.9% 34.06 2.4%
February 2005 1203.60 1.9% 33.25 -1.9%
January 2005 1181.27 -2.5% 33.91 -1.0%
December 2004 1211.92 3.2% 34.26 3.8%
November 2004 1173.82 3.9% 32.99 3.6%
October 2004 1130.20 1.4% 31.83 1.6%
September 2004 1114.58 0.9% 31.33 3.0%
August 2004 1104.24 0.2% 30.41 -1.4%
July 2004 1101.72 -3.4% 30.84 2.6%
June 2004 1140.84 1.8% 30.05 4.7%
May 2004 1120.68 1.2% 28.69 3.9%
April 2004 1107.30 -1.7% 27.61 -1.9%
March 2004 1126.21 -1.6% 28.14 -6.1%
February 2004 1144.94 1.2% 29.98 -2.7%
January 2004 1131.13 1.7% 30.82 8.6%
December 2003 1111.92 5.1% 28.39 8.8%
November 2003 1058.20 0.7% 26.10 -1.2%
October 2003 1050.71 5.5% 26.41 -2.7%
September 2003 995.97 -1.2% 27.14 1.5%
August 2003 1008.01 1.8% 26.75 4.0%
July 2003 990.31 1.6% 25.73 -0.8%
June 2003 974.50 1.1% 25.95 0.6%
May 2003 963.59 5.1% 25.80 -2.5%
April 2003 916.92 NA 26.47 NA

Average return (annual) 12.3% 9.0%

Standard deviation (annual) 7.5% 12.0%
Correlation between GE and the market. 0.28
Beta (using the SLOPE function) 0.44

Step 3. Examine the Data

Using the AVERAGE function and the STDEV function, we found the average historical return and standard
deviation for GE and the market. (We converted these from monthly figures to annual figures. Notice that you must
multiply the monthly standard deviation by the square root of 12, and not 12, to convert it to an annual basis.) These
are shown in the rows above. We also used the CORREL function to find the correlation between GE and the
market.
Step 4. Plot the Data and Calculate Beta

Using the Chart Wizard, we plotted the GE returns on the y-axis and the market returns on the x-axis. We also used
the menu Chart > Options to add a trend line, and to display the regression equation and R 2 on the chart. The chart
is shown below.

Historical Realized Returns

on GE, ri (%)
r i
30.0%

r i r M
20.0%

10.0%

f(x) = 0.4414513501x + 0.0029595612

0.0%
-30.0% -20.0% -10.0% R = 0.0%
0.076948692
10.0% 20.0% 30.0%

-10.0% Historical Realized Returns

on the Market, rM r (%)
M
-20.0%

-30.0%

THE RELATIONSHIP BETWEEN RISK AND RATES OF RETURN (Section 6.5)

The SML shows the relationship between the stock's beta and its required return, as predicted by the CAPM.

rRF 6% << Varies over time, but is constant for all companies at any given time.
rM 11% << Varies over time, but is constant for all companies at any given time.
bi 0.5 << Varies over time, and varies by company.
The SML predicts stock i's required return to be:

ri = rRF + bi(RPM)
ri = rRF + bi(rM - rRF)
ri = 6% + 0.5(11% - 6%)
ri = 8.5%

With the above data, we can generate a Security Market Line that will be flexible enough to allow for changes in
any of the input factors. We generate a table of values for beta and expected returns, and then plot the graph as a scatter diagram.

Required Return
Beta 8.5%
0.00 6.0%
0.50 8.5%
1.00 11.0%
1.50 13.5%
2.00 16.0%

Security Market Line

18.0%
Required Return

12.0%

6.0%

0.0%
0.00 0.50 1.00 1.50 2.00 2.50
Beta
 Security Market Line
18.0%

Required Return
12.0%

6.0%

0.0%
0.00 0.50 1.00 1.50 2.00 2.50
Beta

The Security Market Line shows the projected changes in expected return, due to changes in the beta coefficient. However, we can also
look at the potential changes in the required return due to variation of other factors, namely the market return and risk-free rate. In
other words, we can see how required returns can be influenced by changing inflation and risk aversion. The level of investor risk
aversion is measured by the market risk premium (rM-rRF), which is also the slope of the SML. Hence, an increase in the market return
results in an increase in the maturity risk premium, other things held constant.

We will look at two potential conditions as shown in the following columns:

OR
Scenario 1. Inflation Increases: Scenario 2. Investors become more risk averse:
Risk-free Rate 6% Risk-free Rate 6%
Change in inflation 2% Old Market Return 11%
Old Market Return 11% Increase in MRP 2.5%
New Market Return 13% New Market Return 13.5%
Beta 0.50 Beta 0.50

Required Return 10.5% Required Return 9.75%

Now, we can see how these two factors can affect a Security Market Line, by creating a data table for the required return with
different beta coefficients.
Required Return
Risk aversion
Beta Original Situation Inflation increases increases
8.5% 10.5% 9.75%
0.00 6.00% 8.00% 6.00%
0.50 8.50% 10.50% 9.75%
1.00 11.00% 13.00% 13.50%
1.50 13.50% 15.50% 17.25%
2.00 16.00% 18.00% 21.00%

The SML Under Different Conditions

25.00%

20.00%
Required Returns

15.00% Original
Inflation up
10.00%
Risk aversion up
5.00%

0.00%
0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 2.00
Beta

The graph shows that as risk as measured by beta increases, so does the required rate of return on securities. However, the required
return for any given beta varies depending on the position and slope of the SML.
SECTION 6.1
SOLUTIONS TO SELF-TEST

3 Suppose you pay $500 for an investment that returns $600 in one year. What is
the annual rate of return?

Amount invested $500

Amount received in one $600

Dollar return $100

Rate of return 20%

SECTION 6.2
SOLUTIONS TO SELF-TEST

9 An investment has a 30% chance of producing a 25% return, a 40% chance of producing a 10% return,
and a 30% chance of producing a -15% return. What is its expected return? What is its standard
deviation?

Probability Return Prob x Ret.

30% 25% 7.5%
40% 10% 4.0%
30% -15% -4.5%
Expected return = 7.0%

Deviation from
Probability Return expected return Deviation2 Prob x Dev.2
30% 25% 18.0% 3.240% 0.972%
40% 10% 3.0% 0.090% 0.036%
30% -15% -22.0% 4.840% 1.452%
Variance = 2.460%
Standard deviation = 15.7%

10 A stocks returns for the past three years are 10%, -15%, and 35%. What is the historical
average return? What is the historical sample standard deviation?

Realized
Year return
1 10%
2 -15%
3 35%

Average = 10.0%
Standard deviation = 25.0%

11 An investment has an expected return of 15% and a standard deviation of 30%. What is its coefficient
of variation?

Expected return 15.0%

Standard deviation 30.0%

Coefficient of variation 2.0

ucing a 10% return,
s standard

hat is its coefficient

SECTION 6.3
SOLUTIONS TO SELF-TEST

7 An investor has a 3-stock portfolio with $25,000 invested in Dell, $50,000 invested in Ford, and
$25,000 invested in Wal-Mart. Dells beta is estimated to be 1.20, Fords beta is estimated to be 0.80,
and Wal-Marts beta is estimated to be 1.0. What is the estimated beta of the investors portfolio?

Stock Investment Beta Weight Beta x Weight

Dell $25,000 1.2 0.25 0.30
Ford $50,000 0.8 0.50 0.40
Wal-Mart $25,000 1.0 0.25 0.25
Total $100,000
Portfolio beta = 0.95
SECTION 6.5
SOLUTIONS TO SELF-TEST

6 A stock has a beta of 1.4. Assume that the risk-free rate is 5.5% and the market risk premium is
5%. What is the stocks required rate of return?

Beta 1.4
Risk-free rate 5.5%
Market risk premium 5.0%

Required rate of return 12.50%