1

Risk and Rates of Chapter 6

Return
 4
Interest Rate
Interest rate represents the cost of money
It is the opportunity cost of money:
It shows the return lost from not investing in a
comparable risk investment.
It is expected to compensate the investor for the time,
inflation, and risk.
 5
Interest Rates
Conceptually:
 6
Interest Rates
Conceptually:
Nominal
risk-free
Interest
Rate
krf
 7
Interest Rates
Conceptually:
Nominal
risk-free
Interest =
Rate
krf
 8
Interest Rates
Conceptually:
Nominal Real
risk-free risk-free
Interest = Interest
Rate Rate
krf k*
 9
Interest Rates
Conceptually:
Nominal Real
risk-free risk-free
Interest = Interest +
Rate Rate
krf k*
 10
Interest Rates
Conceptually:
Nominal Real Inflation-
risk-free risk-free risk
Interest = Interest + premium
Rate Rate
IRP
krf k*
 11
Interest Rates
Conceptually:
Nominal Real Inflation-
risk-free risk-free risk
Interest = Interest + premium
Rate Rate
IRP
krf k*
Mathematically:
 12
Interest Rates
Conceptually:
Nominal Real Inflation-
risk-free risk-free risk
Interest = Interest + premium
Rate Rate
IRP
krf k*
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)
 13
Interest Rates
Conceptually:
Nominal Real Inflation-
risk-free risk-free risk
Interest = Interest + premium
Rate Rate
IRP
krf k*
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)
This is known as the “Fisher Effect”
 14
Interest Rates

Suppose the real rate is 3%, and the nominal

rate is 8%. What is the inflation rate premium?
(1 + krf) = (1 + k*) (1 + IRP)
(1.08) = (1.03) (1 + IRP)
(1 + IRP) = (1.0485), so
IRP = 4.85%
 15
Term Structure of Interest Rates
The pattern of rates of return for debt
securities that differ only in the length
of time to maturity.
 16
Term Structure of Interest Rates
The pattern of rates of return for debt
securities that differ only in the length
of time to maturity.

yield
to
maturity

time to maturity (years)

 17
Term Structure of Interest Rates
The pattern of rates of return for debt
securities that differ only in the length
of time to maturity.

yield
to
maturity

time to maturity (years)

 18
Term Structure of Interest Rates

The yield curve may be downward sloping or

“inverted” if rates are expected to fall.

yield
to
maturity

time to maturity (years)

 19
Term Structure of Interest Rates

The yield curve may be downward sloping or

“inverted” if rates are expected to fall.

yield
to
maturity

time to maturity (years)

 20
For a Treasury security, what is the
required rate of return?
 21
For a Treasury security, what is the
required rate of return?

Required
rate of =
return
 22
For a Treasury security, what is the
required rate of return?

Required Risk-free
rate of = rate of
return return

Since Treasuries are essentially free of default

risk, the rate of return on a Treasury security
is considered the “risk-free” rate of return.
 23
For a corporate stock or bond, what is the
required rate of return?
 24
For a corporate stock or bond, what is the
required rate of return?

Required
rate of =
return
 25
For a corporate stock or bond, what is the
required rate of return?

Required Risk-free
rate of = rate of
return return
 26
For a corporate stock or bond, what is the
required rate of return?

Required Risk-free Risk

rate of = rate of + premium
return return

How large of a risk premium should we require

to buy a corporate security?
 Returns 27

Expected Return - the return that an

investor expects to earn on an asset,
given its price, growth potential, etc.

Required Return - the return that an

investor requires on an asset given
its risk and market interest rates.
 28
Risk and Rates of Return
Two Components of return
Periodic cash flows
 29
Risk and Rates of Return
Two Components of return
Periodic cash flows
Price Change (capital gains)
 30
Risk and Rates of Return
Holding Period return
 31
Risk and Rates of Return
Holding Period return

Pt + Dt
= ---------- - 1
Pt-1
 32
Risk and Rates of Return
Holding Period return

Pt + Dt
= ---------- - 1
Pt-1

(Pt - Pt-1) + Dt
= ----------------
Pt-1
 33
Risk and Rates of Return
Expected Return
Expected return is based on expected cash flows (not
accounting profits)
Return can be expressed as Cash
Flows or Percentage Return
 34
Risk and Rates of Return
Expected Return
Expected return is based on expected cash flows (not
accounting profits)
In an uncertain world future cash flows are not known
with certainty
 35
Risk and Rates of Return
Expected Return
Expected return is based on expected cash flows (not
accounting profits)
In uncertain world future cash flows are not known with
certainty
To calculate expected return, compute the weighted
average of all possible returns
 36
Risk and Rates of Return
Expected Return
Expected return is based on expected cash flows (not
accounting profits)
In uncertain world future cash flows are not known with
certainty
To calculate expected return, compute the weighted
average of possible returns
Calculating Expected Return:
N
k  k iP( k i )
i1
 37
Risk and Rates of Return
Expected Return
Expected return is based on expected cash flows (not
accounting profits)
In uncertain world future cash flows are not known with
certainty
To calculate expected return, compute the weighted
average of possible returns
Calculating Expected Return:
N
k  k iP( k i )
i1
where
ki = Return state i
P(ki) = Probability of ki occurring
N = Number of possible states
 38
Risk and Rates of Return
Expected Return Calculation
Example
You are evaluating ElCat Corporation’s common stock. You
estimate the following returns given different states of the
economy
State of Economy Probability Return
Economic Downturn .10 –5%
Zero Growth .20 5%
Moderate Growth .40 10%
High Growth .30 20%
 39
Risk and Rates of Return
Expected Return Calculation
Example
You are evaluating ElCat Corporation’s common stock. You
estimate the following returns given different states of the
economy
State of Economy Probability Return
Economic Downturn .10 x –5% = –0.5%
Zero Growth .20 5%
Moderate Growth .40 10%
High Growth .30 20%

N
k  k iP(k i )
i 1
 40
Risk and Rates of Return
Expected Return Calculation
Example
You are evaluating ElCat Corporation’s common stock. You
estimate the following returns given different states of the
economy
State of Economy Probability Return
Economic Downturn .10 x –5% = –0.5%
Zero Growth .20 x 5% = 1%
Moderate Growth .40 10%
High Growth .30 20%

N
k  k iP(k i )
i 1
 41
Risk and Rates of Return
Expected Return Calculation
Example
You are evaluating ElCat Corporation’s common stock. You
estimate the following returns given different states of the
economy
State of Economy Probability Return
Economic Downturn .10 x –5% = –0.5%
Zero Growth .20 x 5% = 1%
Moderate Growth .40 x 10% = 4%
High Growth .30 20%

N
k  k iP(k i )
i 1
 42
Risk and Rates of Return
Expected Return Calculation
Example
You are evaluating ElCat Corporation’s common stock. You
estimate the following returns given different states of the
economy
State of Economy Probability Return
Economic Downturn .10 x –5% = –0.5%
Zero Growth .20 x 5% = 1%
Moderate Growth .40 x 10% = 4%
High Growth .30 x 20% = 6%

N
k  k iP(k i )
i 1
 43
Risk and Rates of Return
Expected Return Calculation
Example
You are evaluating ElCat Corporation’s common stock. You
estimate the following returns given different states of the
economy
State of Economy Probability Return
Economic Downturn .10 x –5% = –0.5%
Zero Growth .20 x 5% = 1%
Moderate Growth .40 x 10% = 4%
High Growth .30 x 20% = 6%
k = 10.5%
N
k  k iP(k i )
i 1
 44
Risk and Rates of Return
Expected Return Calculation
Example
You are evaluating ElCat Corporation’s common stock. You
estimate the following returns given different states of the
economy
State of Economy Probability Return
Economic Downturn .10 x –5% = –0.5%
Zero Growth .20 x 5% = 1%
Moderate Growth .40 x 10% = 4%
High Growth .30 x 20% = 6%
k = 10.5%
N
k  k iP(k i ) Expected (or average) rate
i 1 of return on stock is 10.5%
 45
Risk and Rates of Return
Risk
Risk is the uncertainty of future outcomes
 46
Risk and Rates of Return
Risk
Risk is the uncertainty of future outcomes
Example
You evaluate two investments: ElCat Corporation’s
common stock and a one year Gov't Bond paying 6%. The
return on the Gov't Bond does not depend on the state of
the economy--you are guaranteed a 6% return.
 47
Risk and Rates of Return
Risk
Risk is the uncertainty of future outcomes
Example
You evaluate two investments: ElCat Corporation’s
common stock and a one year Gov't Bond paying 6%. The
return on the Gov't Bond does not depend on the state of
the economy--you are guaranteed a 6% return.

Probability T-Bill
of Return
100%

6% Return
 48
Risk and Rates of Return
Risk
Risk is the uncertainty of future outcomes
Example
You evaluate two investments: ElCat Corporation’s
common stock and a one year Gov't Bond paying 6%. The
return on the Gov't Bond does not depend on the state of
the economy--you are guaranteed a 6% return.

Probability T-Bill Probability ElCat Corp

of Return of Return
100%

40%
30%
20%
10%
6% Return –5% 5% 10% 20% Return
 49
Risk and Rates of Return
Risk
Risk is the uncertainty of future outcomes
Example
You evaluate two investments: ElCat Corporation’s
common stock and a one year Gov't Bond paying 6%. The
return on the Gov't Bond does not depend on the state of
the economy--you are guaranteed a 6% return.

Probability T-Bill Probability ElCat Corp

of Return There is risk in of
Owning
Return ElCat stock,
100% no risk in owning the Treasury Bill
40%
30%
20%
10%
6% Return –5% 5% 10% 20% Return
 50
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
 51
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
 52
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
 53
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 –5%
Zero Growth .20 5%
Moderate Growth .40 10%
High Growth .30 20%
 54
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 5%
Moderate Growth .40 10%
High Growth .30 20%
 55
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
Moderate Growth .40 10%
High Growth .30 20%
 56
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%2
High Growth .30 20%
 57
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2– --
Zero Growth .20 x ( 5% 10.5%)2 = 6.05%2
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
 58
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
s2 = 57.25%2
 59
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
s2 = 57.25%2
s = 57.25%2
 60
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
s2 = 57.25%2
s = 57.25%2
s = 7.57%
 61
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
s2 = 57.25%2
Higher standard deviation, higher risk s = 57.25%2
s = 7.57%
 62
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns. NOTE: The
N
 (k i  k )
standard
s 2
P(k i ) deviation of the
i 1 T-Bill is 0%
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
s2 = 57.25%2
Higher standard deviation, higher risk s = 57.25%2
s = 7.57%
 63
Risk and Rates of Return
Measuring Risk
Standard Deviation (s) measure the dispersion of
returns.
N
s  i
(k  k ) 2
P(k i )
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2

Can compare the s of 7.57 to another s2 = 57.25%2

s = 57.25%2
stock with expected return of 10.5% s = 7.57%
Risk and Rates of Return 64

Measuring Risk
Standard Deviation (s) for historical data can be used
to measure the dispersion of historical returns.

N
1
s 
(n  1) _ i 1
( ki  k ) 2
Risk and Rates of Return 65

Use the following data to calculate the historical return

of XYZ
Year Return
1992 12%
1993 16%
1994 -8%
1995 6%
 66
Risk and Rates of Return
Risk and Diversification
Risk of a company's stock can be separated into two
parts:
 67
Risk and Rates of Return
Risk and Diversification
Risk of a company's stock can be separated into two
parts:
Firm Specific Risk - Risk due to factors within the firm
 68
Risk and Rates of Return
Risk and Diversification
Risk of a company's stock can be separated into two
parts:
Firm Specific Risk - Risk due to factors within the firm
Stock price will most likely fall if a major government
contract is discontinued unexpectedly.
 69
Risk and Rates of Return
Risk and Diversification
Risk of a company's stock can be separated into two
parts:
Firm Specific Risk - Risk due to factors within the firm
Market related Risk - Risk due to overall market
conditions
 70
Risk and Rates of Return
Risk and Diversification
Risk of a company's stock can be separated into two
parts:
Firm Specific Risk - Risk due to factors within the firm
Market related Risk - Risk due to overall market
conditions
Stock price is likely to rise if overall stock market is
doing well.
 71
Risk and Rates of Return
Risk and Diversification
Risk of a company's stock can be separated into two
parts:
Firm Specific Risk - Risk due to factors within the firm
Market related Risk - Risk due to overall market
conditions
Diversification: If investors hold stock of many
companies, the firm specific risk will be canceled out:
Investors diversify portfolio.
 72
Risk and Rates of Return
Risk and Diversification
Risk of a company's stock can be separated into two
parts:
Firm Specific Risk - Risk due to factors within the firm
Market related Risk - Risk due to overall market
conditions
Diversification: If investors hold stock of many
companies, the firm specific risk will be canceled out:
Investors diversify portfolio.
Firm specific risk also called diversifiable
risk or unsystematic risk
 73
Risk and Rates of Return
Risk and Diversification
Risk of a company's stock can be separated into two
parts:
Firm Specific Risk - Risk due to factors within the firm
Market related Risk - Risk due to overall market
conditions
Diversification: If investors hold stock of many
companies, the firm specific risk will be canceled out:
Investors diversify portfolio.
Even if hold many stocks, cannot eliminate the market
related risk
 74
Risk and Rates of Return
Risk and Diversification
Risk of a company's stock can be separated into two
parts:
Firm Specific Risk - Risk due to factors within the firm
Market related Risk - Risk due to overall market
conditions
Diversification: If investors hold stock of many
companies, the firm specific risk will be canceled out:
Investors diversify portfolio.
Even if hold many stocks, cannot eliminate the market
related risk Market related risk is also called non-diversifiable
risk or systematic risk
 75
Risk and Rates of Return
Risk and Diversification
If an investor holds enough stocks in portfolio (about
20) company specific (diversifiable) risk is virtually
eliminated
 76
Risk and Rates of Return
Risk and Diversification
If an investor holds enough stocks in portfolio (about
20) company specific (diversifiable) risk is virtually
eliminated

Variability
of Returns

Market
Related Risk
Number of stocks in Portfolio
 77
Risk and Rates of Return
Risk and Diversification
If an investor holds enough stocks in portfolio (about
20) company specific (diversifiable) risk is virtually
eliminated

Variability
of Returns

Firm Specific
Risk

Number of stocks in Portfolio

 78
Risk and Rates of Return
Risk and Diversification
If an investor holds enough stocks in portfolio (about
20) company specific (diversifiable) risk is virtually
eliminated

Variability
of Returns

Total
Risk

Number of stocks in Portfolio

 79
Risk and Rates of Return
Risk and Diversification
If an investor holds enough stocks in portfolio (about
20) company specific (diversifiable) risk is virtually
eliminated

Variability
of Returns

20
Number of stocks in Portfolio
 80
Risk and Rates of Return
Risk and Diversification
If an investor holds enough stocks in portfolio (about
20) company specific (diversifiable) risk is virtually
eliminated
Holding a general stock mutual fund (not a specific
industry fund) is similar to holding a well-diversified
portfolio.
Variability
of Returns

20
Number of stocks in Portfolio
 81
Risk and Rates of Return
Measuring Market Risk
Market risk is the risk of the overall market. To
measure the market risk we need to compare
individual stock returns to the overall market returns.
 82
Risk and Rates of Return
Measuring Market Risk
Market risk is the risk of the overall market. To
measure the market risk we need to compare
individual stock returns to the overall market returns.
A proxy for the market is usually used: An index of
stocks such as the S&P 500
 83
Risk and Rates of Return
Measuring Market Risk
Market risk is the risk of the overall market, so to
measure need to compare individual stock returns to
the overall market returns.
A proxy for the market is usually used: An index of
stocks such as the S&P 500
Market risk measures how individual stock returns are
affected by this market
 84
Risk and Rates of Return
Measuring Market Risk
Market risk is the risk of the overall market, so to
measure need to compare individual stock returns to
the overall market returns.
A proxy for the market is usually used: An index of
stocks such as the S&P 500
Market risk measures how individual stock returns are
affected by this market
Regress individual stock returns on Market index
 85
Risk and Rates of Return
Measuring Market Risk
Regress individual stock returns on Market index
PepsiCo 15%
Return

10%

5%
S&P
Return
-15% -10% -5% 5% 10% 15%

-5%

-10%

-15%
 86
Risk and Rates of Return
Measuring Market Risk
Regress individual stock returns on Market index
PepsiCo 15%
Return

10%

5%
S&P
Return
-15% -10% -5% 5% 10% 15%

Jan 1992 -5%

PepsiCo -0.37%
S&P -1.99%
-10%

-15%
 87
Risk and Rates of Return
Measuring Market Risk
Regress individual stock returns on Market index
PepsiCo 15%
Return

10%

5%
S&P
Return
-15% -10% -5% 5% 10% 15%

-5%
Plot Remaining
Points -10%

-15%
 88
Risk and Rates of Return
Measuring Market Risk
Regress individual stock returns on Market index
PepsiCo 15%
Return

10%
Fit Regression
Line 5%
S&P
Return
-15% -10% -5% 5% 10% 15%

-5%

-10%

-15%
 89
Risk and Rates of Return
Measuring Market Risk
Regress individual stock returns on Market index
PepsiCo 15%
Return

10%

5%
S&P
Return
-15% -10% -5% 5% 10% 15%

-5%

-10%
rise 5.5%
Slope = = = 1.1
run 5%
-15%
 90
Risk and Rates of Return
Measuring Market Risk
Market Risk is measured by Beta
 91
Risk and Rates of Return
Measuring Market Risk
Market Risk is measured by Beta
Beta is the slope of the characteristic line
PepsiCo 15%
Return

10%

5%
S&P
Return
-15% -10% -5% 5% 10% 15%

-5%

-10%
rise 5.5%
Slope = = = 1.1 = Beta (b)
run 5%
-15%
 92
Risk and Rates of Return
Measuring Market Risk
Market Risk is measured by Beta
Beta is the slope of the characteristic line
Interpreting Beta
Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk
 93
Risk and Rates of Return
Measuring Market Risk
Market Risk is measured by Beta
Beta is the slope of the characteristic line
Interpreting Beta
Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk
Beta < 1
Low Risk Company
Return on stock will be less affected by the market than average
 94
Risk and Rates of Return
Measuring Market Risk
Market Risk is measured by Beta
Beta is the slope of the characteristic line
Interpreting Beta
Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk
Beta < 1
Low Risk Company
Return on stock will be less affected by the market than average
Beta > 1
High Market Risk Company
Stock return will be more affected by the market than average
 95
Risk and Rates of Return

Required Minimum rate of return necessary to

Rate of = attract investors to buy funds
Return
 96
Risk and Rates of Return

Required Minimum rate of return necessary to

Rate of = attract investors to buy funds
Return

Required rate of return, K, depends on the risk-free

rate(Krf) and the risk premium(Krp)
 97
Risk and Rates of Return

Required Minimum rate of return necessary to

Rate of = attract investors to buy funds
Return

Required rate of return, K, depends on the risk-free

rate(Krf) and the risk premium(Krp)
Using the capital asset pricing model (CAPM) the
risk premium(Krp) depends on market risk
 98
Risk and Rates of Return

Required Minimum rate of return necessary to

Rate of = attract investors to buy funds
Return

Required rate of return, K, depends on the risk-free

rate(Krf) and the risk premium(Krp)
Using the capital asset pricing model (CAPM) the
risk premium(Krp) depends on market risk
Security Market Line

Kj = Krf + bj ( Km – Krf )

where:
Kj = required rate of return on the jth security
Bj = Beta for the jth security
 99
Risk and Rates of Return
Security Market Line

Kj = Krf + bj ( Km – Krf )
Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
 100
Risk and Rates of Return
Security Market Line

Kj = Krf + bj ( Km – Krf )
Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
Kj = 5% + bj (12% – 5% )
 101
Risk and Rates of Return
Security Market Line

Kj = Krf + bj ( Km – Krf )
Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%

10%

5%
Risk Free Rate

.50 1.0 1.5 Beta

 102
Risk and Rates of Return
Security Market Line

Kj = Krf + bj ( Km – Krf )
Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%

12%
10% Risk & Return
on market
5%

.50 1.0 1.5 Beta

 103
Risk and Rates of Return
Security Market Line

Kj = Krf + bj ( Km – Krf )
Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
SML

Market
10%

Connect Points for

5% Security Market Line

.50 1.0 1.5 Beta

 104
Risk and Rates of Return
Security Market Line

Kj = Krf + bj ( Km – Krf )
Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
SML
If b of security j =1.2
Market
10%

5%

.50 1.0 1.5 Beta

 105
Risk and Rates of Return
Security Market Line

Kj = Krf + bj ( Km – Krf )
Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
SML
j If b of security j =1.2
Market
10% Kj = 5%+1.2(12% – 5%)

5%

.50 1.0 1.2 1.5 Beta

 106
Risk and Rates of Return
Security Market Line

Kj = Krf + bj ( Km – Krf )
Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
SML
13.4% j If b of security j =1.2
Market
10% Kj = 5%+1.2(12% – 5%)
=13.4%
5%

.50 1.0 1.2 1.5 Beta

 107
Risk and Rates of Return
Security Market Line

Kj = Krf + bj ( Km – Krf )
Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
SML
13.4% j If b of security j =1.2
Market
10% Kj = 5%+1.2(12% – 5%)
=13.4%
5% If b = 1.2, investors will
require a 13.4% return
on the stock
.50 1.0 1.2 1.5 Beta
 108
Risk and Rates of Return
ki : Expected (or required) rate of return from an
investment i.
KRF : Risk free rate of return (e.g., 3 moth T-Bill rate)
kM : Expected return from a market (e.g., S&P500)
portfolio
(kM - kRF) : Market Risk Premium
b(kM - kRF) : Risk Premium on asset i
 109
Risk and Rates of Return
Portfolio Return = S wi x ki

Return of a portfolio is the weighted average return of

individual securities in the portfolio.

Portfolio beta = S wi x bi
Beta of a portfolio is the weighted average beta of
individual securities in the portfolio.