Chapte

r 13

Return, Risk, and the

Security Market Line

13-1
McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
Expected Returns and Variances
Portfolios
Announcements, Surprises, and
Expected Returns
Risk: Systematic and Unsystematic
Diversification and Portfolio Risk
Systematic Risk and Beta
The Security Market Line
The SML and the Cost of Capital: A
Preview
13-2

Expected Returns
Expected returns are based on the
probabilities of possible outcomes
In this context, expected means
average if the process is repeated
many times
The expected return does not
n
even have to be a possible
return

E ( R ) pi Ri
i 1

13-3

Example: Expected
Returns
Suppose you have predicted the
following returns for stocks C and T in
three possible states of the economy.
1. What is the probability of
Recession?
State
Probability C
T
Boom
0.3
15% 25%
Normal
0.5
10%
20%
Recession
???
2%
1%
13-4

Probabilities add up to 100% (or 1.0) thus

1.0 0.3 0.5 = 0.2 or 20%

Example: Expected
Returns
Suppose you have predicted the
following returns for stocks C and T in
three possible states of the economy.
2. What are the expected returns?
State
Probability C
T
Boom
0.3
15%
25%
Normal
0.5
10%
20%
Recession
0.2
2%
1%

13-5

RC = .3(15%) + .5(10%) + .2(2%) = 9.9%

RT = .3(25%) + .5(20%) + .2(1%) =
17.7%

Example: Expected
Returns
The three states of the economy
still apply to stocks C and T.
3. If the risk-free rate is 4.15%, what
is the risk premium for C & T?
RC = .3(15%) + .5(10%) + .2(2%) = 9.9%
RT = .3(25%) + .5(20%) + .2(1%) = 17.7%

Stock Cs risk premium: 9.9 - 4.15 = 5.75%

Stock Ts risk premium: 17.7 - 4.15 =
13.55%
13-6

Variance and
Standard Deviation
Variance and standard deviation
measure the volatility of returns
Using unequal probabilities for the
entire range of possible outcomes
Weighted average of squared
deviations
n

pi ( Ri E ( R))
2

i 1

13-7

Example: Variance
and Standard
Deviation
Considering the previous example of
stocks
C and Probability
T:
State
C
T
Boom
0.3
15% 25%
Normal
0.5
10%
20%
Recession
0.2
2%
1%
Expected return
9.9%
17.7%

13-8

What are the variance and St. Dev of Stock

C?
2 = .3(15%-9.9%)2 + .5(10%-9.9%)2 + .2(2%9.9%)2 = 0.2029%
= 4.50%

and Standard
Deviation
What is the variance and standard
deviation for T?
State
Probability
C
T
Boom
0.3
15% 25%
Normal
0.5
10%
20%
Recession
0.2
2%
1%
Expected return
9.9%
17.7%

Stock T
2 = .3(25%-17.7%)2 + .5(20%-17.7%)2 + .2(1%17.7%)2 = 0.7441%
= 8.63%
13-9

Another Example
Consider the following
information:
State
Probability
ABC, Inc.
(%)
Boom
.25
15%
Normal
.50
8%
Slowdown
.15
4%
Recession
.10
- 3%

13-10

What
is the +
expected
return?+ .1(E(R)
= .25(15%)
.5(8%) + .15(4%)
3%) = 8.05%

Another Example
Consider the following
information:
State
Probability
ABC, Inc. (%)
Boom
.25
15%
Normal
.50
8%
Slowdown
.15
4%
Recession
.10
- 3%

13-11

2
2
Variance
=

=
.25(15%-8.05%)
+.
What is the
variance?
5(8%-8.05%)2 + .15(4%-8.05%)2 + .1(3%-8.05%)2
= 0.267475
Standard Deviation
= = 26.7475
= 5.17%

Portfolios
A portfolio is a
collection of
assets

13-12

An assets risk
and return are
important in how
they affect the
risk and return of

Portfolios

13-13

The risk/return
trade-off for a
portfolio is
measured by the
portfolios
expected return Risk
and standard
deviation, just
as with
individual assets

Return

Example: Portfolio
Weights
Suppose you have
$15,000 to invest and you
have purchased securities
in the following amounts:
$2000 of DCLK
$3000 of KO
$4000 of INTC
$6000 of KEI

13-14

Example: Portfolio
Weights
What are your portfolio
weights in each security?
$2,000 of
$3,000 of
$4,000 of
$6,000 of
$15,000

13-15

DCLK
DCLK: 2/15 = .
KO 133
INTCKO: 3/15 = .200
KEI INTC: 4/15 = .267
KEI: 6/15 = .400
15/15 = 1.000

Portfolio Expected
Returns
The expected return of a portfolio is
the weighted average of the
expected returns of the respective
m
assets in the portfolio

E ( RP ) w j E ( R j )
j 1

13-16

You can also find the expected return

by finding the portfolio return in
each possible state and computing
the expected value as we did with
individual securities

Example: Expected
Portfolio Returns
Consider the portfolio weights
computed previously. The
individual stocks have the
following expected returns:

DCLK: 19.69%
KO: 5.25%
INTC: 16.65%
KEI: 18.24%

13-17

Example: Expected
Portfolio Returns
1. What is the expected return
on this portfolio?

Return Weight
DCLK:
19.69% .133
KO: 5.25% .200
INTC: 16.65% .267
KEI: 18.24% .400
E(RP) = .133(19.69%) + .2(5.25%) + .
267(16.65%) + .4(18.24%)
13-18

= 15.41%

Portfolio Variance
Compute the expected portfolio
return, the variance, and the
standard deviation using the same
formula as for an individual asset
Compute the portfolio return for
each state:
RP = w1R1 + w2R2 + + wmRm

13-19

Example: Portfolio
Variance
Consider the following
information:

13-20

State

Probability

Boom
Bust

.4
.6

30% -5%
-10% 25%

Example: Portfolio
Variance
Consider the following
information:
State
Prob.
A B
Boom
.4
30% -5%
Bust
.6
-10%return
25%
What is
the expected
for

asset A? VarA, St. DevA?

o E(RA) = .4(30%) + .6(-10%) = 6%
o Variance(A) = .4(30% - 6%)2 + .6(-10% - 6%)2
= 3.84%
13-21

o Std. Dev.(A) = 19.6%

Example: Portfolio
Variance
Consider the following
information:
State
Prob.
A B
Boom
.4 30% -5%
Bust .6 -10% 25%
What is E(RB) ? VarB? St. DevB?
o E(RB) = .4(-5%) + .6(25%) = 13%
o Variance(B) = .4(-5%-13%)2 + .6(25%13%)2 = 2.16%
13-22

o Std. Dev.(B) = 14.7%

Example: Portfolio
Variance
Consider the following
information:
State Probability A
B
Boom .4
30%
-5%
Bust .6
-10%
25%
If you invest 50% of your money in Asset A,
what is the expected return for the
portfolio?
If 50% of the investment is in Asset A, then
50% (100% - 50%) must be invested in
Asset B as the total asset allocation must be
100%
13-23

Wi =
100%

Example: Portfolio
Variance
Consider the following information:
State
Boom
Bust
E(R)
Sigma

Prob.
A
B..
.4
30%
-5%
.6
-10%
25%
6%
13%
19.6%
14.7%

If you invest 50% of your money in Asset A,

a. what is the expected return for the portfolio
If a boom? If a bust?
b. What is expected return for the whole
portfolio (that is, considering both states of
the economy)?

13-24

a. E(RP_Boom) = .5(30%) + .5(-5%) =

12.5%
E(RP_Bust) = .5(-10%) + .5(25%) =

Example: Portfolio
Variance
Consider the following information:
State
Boom
Bust
E(R)
Sigma

Prob.
A
B..
.4
30%
-5%
.6
-10%
25%
6%
13%
19.6%
14.7%

Another way of computing Portfolio

returns :
Exp. portfolio return = .5(6%) + .
E(RP) = =
WA9.5%
E(RA) + WB E(RB) + WC E(RC) + . +
5(13%)
WN E(RN)

13-25

N: number of assets in the portfolio

Wi : weight of asseti in the portfolio

Example: Portfolio
Variance

What is the variance of the

portfolio?
Variance of portfolio =

.4(12.5%-9.5%)2 + .6(7.5%-9.5%)2
= 0.06%
Standard deviation = 2.45%
13-26

Another Example
Consider the following information:

What are the expected return and

standard deviation for a portfolio
that is equally distributed between
X, Y, & Z?
13-27

Expected vs.
Unexpected Returns
Realized returns are generally
NOT equal to expected returns
There is the expected component
and the unexpected component
At any point in time, the unexpected
return can be either positive or
negative
13-28

Over time, the average of the

unexpected component is zero

Announcements and
News
Announcements
and news contain
both an expected
component and a
surprise component
It is the surprise
component that
affects a stocks
price and therefore

13-29

Announcements and
News
This surprise is
very obvious
when we watch
how stock prices
move when an
unexpected
announcement is
made or earnings
are different than
anticipated
13-30

Systematic Risk
Risk factors that
affect a large
number of assets
Also known as nondiversifiable risk or
market risk

13-31

Includes such
things as changes
in GDP, inflation,
interest rates, etc.

Unsystematic Risk
Risk factors that affect
a limited number of
assets
Also known as unique
risk and asset-specific
risk
Includes such things as
labor strikes, part

13-32

Computing Returns
Total Return = expected return +
unexpected return
Unexpected return = systematic
portion + unsystematic portion
Therefore, total return can be
expressed as follows:

13-33

Total Return = expected return +

[systematic portion +
unsystematic portion]

Diversification
Portfolio diversification is the
investment in several different asset
classes or sectors

13-34

Diversification is not just holding a

Diversification

13-35

For example, if
you own 5 airline
stocks, you are
not diversified
However, if you
own 50 stocks
that span 20
different
industries, then

Total Risk
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

13-36

Consequently, the total risk for a

diversified portfolio is essentially
equivalent to just the systematic
risk

Diversification

13-37

Diversification

13-38

The Principle of
Diversification
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-thanexpected returns from another

13-39

However, there is a minimum level of

risk that cannot be diversified away
and that is the systematic portion

Measuring
Systematic Risk
How do we measure systematic
risk?
We use the beta coefficient

What does beta tell us?

13-40

A beta of 1 implies the asset

has the same systematic risk
as the overall market

A beta < 1 implies the asset

has less systematic risk than
the overall market

Actual Company
Betas

13-41

Total vs. Systematic

Risk
Consider the following
information:
St.Dev Beta
Security C
20%
Security K
30%

13-42

1.25
0.95

1. Which security has more total

risk?
K because the standard deviation
is greater than C
2. Which security has more
systematic risk?

Total vs. Systematic

Risk
Consider the following
information:
St.Dev Beta
Security C
20%
Security K
30%

1.25
0.95

3. Which security should have

the higher expected return?

13-43

C because a well diversified

investor cars about systematic
risk. These investors would

Example: Portfolio
Betas
Consider the previous example with
the following four securities:
Security
DCLK
KO
INTC
KEI

Weight
Beta
.133
2.685
.2
0.195
.267
2.161
.4
2.434

What is the portfolio beta?

13-44

.133(2.685) + .2(.195) + .
267(2.161) + .4(2.434)
= 1.947

Beta and the Risk

Premium
Remember that the risk premium
= expected return risk-free
rate
The higher the beta, the greater
the risk premium should be

13-45

Can we define the relationship

between the risk premium and
beta so that we can estimate the
expected return?

Example: Portfolio Expected

Returns and Betas: The SML

E(RA)

Rf

13-46

Security Market Line

The security market line (SML) is the
representation of market equilibrium
The slope of the SML is the reward-torisk ratio: (E(RM) Rf) / M
But since the beta for the market is
ALWAYS equal to one, the slope can be
rewritten:
13-47

Slope = E(RM) Rf = market risk

premium

Reward-to-Risk Ratio:
Definition and
Example
The reward-to-risk ratio is the slope
of the line illustrated in the previous
example
Slope = (E(RA) Rf) / ( A 0)
Reward-to-risk ratio for previous example
=
(20 8) / (1.6 0) = 7.5

What if an asset has a reward-to-risk

ratio of 8 (implying that the asset
plots above the line)?
13-48

What if an asset has a reward-to-risk

Market Equilibrium
In equilibrium, all assets and
portfolios must have the same
reward-to-risk ratio, and they
all must equal the reward-torisk ratio for the market
E(RA ) Rf E(RM Rf )

A
M

13-49

The Capital Asset

Pricing Model (CAPM)
The capital asset pricing model
defines
the relationship between risk and
return:
E(RA) = Rf + A(E(RM) Rf)
If we know an assets systematic
risk, we can use the CAPM to
determine its expected return
13-50

Example - CAPM
Consider the betas for each of the
assets given earlier. If the risk-free
rate is 4.15% and the market risk
premium is 8.5%,
What is the expected return for each?

13-51

Securit
y

Beta

Expected Return

DCLK

2.685

4.15 + 2.685(8.5) = 26.97%

KO

0.195

4.15 + 0.195(8.5) = 5.81%

INTC

2.161

4.15 + 2.161(8.5) = 22.52%

KEI

2.434

4.15 + 2.434(8.5) = 24.84%

The CAPM

13-52

Quick Quiz
How do you compute the expected
return and standard deviation for an
individual asset? For a portfolio?
What is the difference between
systematic and unsystematic risk?
What type of risk is relevant for
determining the expected return?
Consider an asset with a beta of 1.2,
a risk-free rate of 5%, and a market
return of 13%.
13-53

What is the expected return on the

Comprehensive
Problem
1. The risk free rate is 4%, and the
required return on the market is
12%. What is the required return on
an asset with a beta of 1.5?
2. What is the reward/risk ratio?

13-54

Terminology
Portfolio
Expected Return
Unsystematic Risk
Systematic Risk
Security Market Line (SML)
Beta
Capital Asset Pricing Model
(CAPM)
13-55

Formulas
n

E ( R ) pi Ri
i 1

pi ( Ri E ( R)) 2
2

i 1

Expected return on an
investment
Variance of an entire
population, not a sample

Expected return on a
E ( RP ) w j E ( R j ) portfolio
j 1
E ( RA ) R f E ( RM R f )

A
M

Slope = E(RM) Rf = market risk

premium
CAPM = E(RA) = Rf + A(E(RM) Rf)
13-56

Key Concepts and

Skills

Calculate expected returns

Describe the impact of
diversification

Define the systematic risk

principle

Construct the security market

line

Evaluate the risk-return

trade-off
13-57

Compute the cost of equity

What are the most

important topics of
this chapter?

13-58

1. Measuring portfolio returns

2. Using Std. Dev. and Variance to
measure portfolio risk
3. Diversification can significantly
reduce unsystematic risk
4. Beta measures systematic risk
5. The slope of the Security Market
Line = the market risk premium
6. The Capital Asset Pricing Model
(CAPM) provides us a
measurement of a stocks required
rate of return.