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CHAPTER 6

Risk, Return, and the Capital Asset Pricing

Model (CAPM)

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Topics in Chapter 6

Basic return measurement Types of Risk addressed in Ch 6

Stand-alone (total) risk Portfolio (market) risk

Relationship between risk and return: CAPM/SML

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Investment Returns

Returns may be: actual or expected.

Returns can be expressed in: dollars or percentage.

Returns include changes in asset value.

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What is investment risk?

Risk exists any time returns are not known with certainty.

Why is risk important?

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Stand-Alone Risk

Stand-alone (total) risk is the risk facing an investor (firm) who owns only one asset.

Measures of stand-alone risk: Standard deviation Variance Coefficient of variation (CV)

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Adding Stocks to a Portfolio

What happens to the risk of a one-stock portfolio as additional randomly selected stocks are included?

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stock ≈ 35%Many stocks ≈ 20%

-75 -60 -45 -30 -15 0 15 30 45 60 75 90 105

Returns (% )

1 stock2 stocksMany stocks

810 20 30 40 2,000 stocks

Company Specific (Diversifiable) Risk

Market Risk

20%

0

Stand-Alone Risk, p

p

35%

Risk vs. Number of Stock in Portfolio

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Stand-alone risk = Market risk + Diversifiable risk

Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification.

Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that can be eliminated by diversification.

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Beta

Market risk is measured by beta. Beta indicates:

A stock’s contribution to the risk of a diversified portfolio

The stock’s volatility relative to the market:

beta > 1.0 high risk beta = 1.0 average risk

beta < 1.0 low risk

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Using a Regression to Estimate Beta

To estimate a stock’s beta, plot the stock’s returns on the Y axis and market returns on the X axis.

The slope of the line of best fit as estimated through regression is the stock’s beta coefficient, or b.

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Use the SML to calculate an asset’s required return.

The Security Market Line (SML) is part of CAPM. The equation for the SML is:

ri = rRF + (RPM)i ri is the required return on security i rRF is the risk-free interest rate RPM is the risk premium on the market i is the beta for security i