Chapter 10 Return and Risk: The Capital-

Asset-Pricing Model (CAPM)

10-1
Fifth
Edition
 10.1 Individual Securities

Corporate

10.2 Expected Return, Variance, and Covariance

 10.3 The Return and Risk for Portfolios
 10.4 The Efficient Set for Two Assets
Finance

 10.5 The Efficient Set for Many Securities

 10.6 Diversification: An Example
 10.7 Riskless Borrowing and Lending
 10.8 Market Equilibrium
 10.9 Relationship between Risk and Expected Return
(CAPM)
 10.10 Summary and Conclusions
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Ross
 Appendix 10A: Is Beta Dead?
.
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Jaffe
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
 Expected (Ex Ante) Return, Variance, and
Covariance
10-2
Fifth
Edition

 Expected Return: E(R) = S (ps x Rs)

Corporate

 Variance: s2 = S {ps x [Rs - E(R)]2}

Finance

 Standard Deviation = s

 Covariance: sAB = S {ps x [Rs,A - E(RA)] x [Rs,B -

E(RB)]}

 Correlation Coefficient: rAB = sAB / (sA sB)

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Ross

.
Westerfield
Jaffe
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
 Return and Risk for Portfolios (2 Assets)
10-3
Fifth
Edition
Corporate

 Expected Return of a Portfolio:

E(Rp) = XAE(R)A + XB E(R)B
Finance

 Variance of a Portfolio:
sp2 = XA2sA2 + XB2sB2 + 2 XA XB sAB

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Ross

.
Westerfield
Jaffe
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
 An Example of Portfolio Return and Risk
10-4
Fifth
Edition

Stock Investment Xi E.(Ri) si2

Corporate

IBM $5000 50% 0.09 0.01

HM $5000 50% 0.13 0.04
Total $10000 100%
Finance

 sIBM,HM = 0
 E[Rp] = (0.5)(0.09) + (0.5)(0.13) = 11%

 sp2 =(.5)2(.01) + (.5)2(.04) + 2(.5)(.5)(0) = 0.0125

 sp = (0.0125)(1/2) = 0.1118

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Ross

.
Westerfield
Jaffe
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
 Efficient Sets and Diversification
10-5
Fifth
Edition

r = -1
Corporate

E(R)

-1 < r<1

r =1
Finance

MV

MV
MV

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Ross s
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Westerfield
Jaffe
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
 Capital Market Line
10-6
Fifth
Edition
Expected return
of portfolio
Capital market line
Corporate

.5
Y
.
Finance

.
4

Risk-free
rate (Rf ) X .
Standard
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Ross deviation of
portfolio’s return.
.
Westerfield
Jaffe
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
 Security Market Line
10-7
Fifth
Edition
Expected return
on security (%) Security market
Corporate

line (SML)

Rm
. . T
Finance

Rf
. S

Beta of
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Ross
0.8 1 security
.
Westerfield
Jaffe
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999