Capital Asset Pricing Model (CAPM) E[Ri] = RF +

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i (RM

RF)
1

Capital Asset Pricing Model

Risk and Return

State Boom Normal Recession Probability .3 .4 .3 1.0 1. Find the expected return for Company A and B. 2. Find the standard deviation for Company A and B. Company A Return 100% 15% -70% Company B Return 20% 15% 10%

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Capital Asset Pricing Model

Find Expected Return

State Boom Normal Recession Probability .3 .4 .3 1.0
E(R A ) ! .3(100)  .4(15)  .3(-70) ! 15% E(R B ) ! .3(20)  .4(15)  .3(10) ! 15%
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Company A Return 100% 15% -70%

Company B Return 20% 15% 10%

Find Standard Deviation

State Boom Normal Recession Probability .3 .4 .3 1.0
WA !

Company A Return 100% 15% -70%

Company B Return 20% 15% 10%

? ?

1 .3(100 - 15) 2  .4(15 - 15) 2  .3(-70 - 15) 2 2

! 65% W B ! .3(20 - 15)  .4(15 -15)

=3.8%
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1 2 2  .3(10 - 15)

Risk and Return

Expected Return 15%
Standard Deviation

4.0%

Risk

65.8%

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Capital Asset Pricing Model

Portfolio Risk and the Phantom Egg Crusher

Your Portfolio Market

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Capital Asset Pricing Model

Lessons from P.E.C.

1. Assets are not held in isolation; rather, they are held as parts of portfolios. 2. Assets are priced according to their value in a portfolio. 3. Investors are concerned about how the portfolio of stocks perform--not individual stocks.

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Capital Asset Pricing Model

Risk and Return

State Sunny Normal Rainy Sun Tan Return 33% 12% -9% Umbrella Return -9% 12% 33% Probability of State 1/3 1/3 1/3

Expected return for Sun Tan Company = 12% Expected return for Umbrella Company = 12% Standard deviation for Sun Tan Company = 17.15% Standard deviation for Umbrella Company = 17.15%
Find the expected return and standard deviation for a portfolio which invests half its money in the Sun Tan and half its money in Umbrella Company.

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Capital Asset Pricing Model

Portfolio Risk and Return

State Sunny Normal Rainy Sun Tan Return 33% 12% -9% Umbrella Return -9% 12% 33% Probability of State 1/3 1/3 1/3

E?R 50/50 A! .5(12%)  .5(12%) ! 12% W 50/50 { .5(17.15%)  .5(17.15%) Why not?
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Portfolio Risk and Return

State Sunny Normal Rainy Sun Tan Return 33% 12% -9% Umbrella Return -9% 12% 33% Probability of State 1/3 1/3 1/3

State Sunny Normal Rainy

Return .5(33) + .5( - 9) = 12% .5(12) + .5(12) = 12% .5( - 9) + .5(33) = 12%

No deviation from 12%! W 50/50 ! 0

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Capital Asset Pricing Model

10

Lessons from Tahitian Island

1. 2. 3. Combining securities into portfolios reduces risk. How? A portion of a stocks variability in return is canceled by complementary variations in the return of other securities However, since to some extent stock prices (and returns) tend to move in tandem, not all variability can be eliminated through diversification. or Even investors holding diversified portfolios are exposed to the risk inherent in the overall performance of the stock market. Therefore, Total Risk = unsystematic + systematic diversifiable nondiversifiable firm specific market

4.

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Capital Asset Pricing Model

11

Portfolio Choice
U 2 U1 U 0
Expected Return

Risk

Standard Deviation

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Capital Asset Pricing Model

12

Risk and Return

Expected Return
2

=-1 =1
1

Risk

Standard Deviation

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Capital Asset Pricing Model

13

Variability of Returns Compared with Size of Portfolio

Average annual standard deviation (%) 49% Unsystematic or diversifiable risk (related to company-unique events) 24% -

19% Total Risk Systematic or nondiversifiable risk (result of general market influences) 10
Capital Asset Pricing Model

1
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20

25

Number of stocks in portfolio

14

Risk & Return

Expected Return

X Efficient frontier X X X X X X X X X
RF --

Risk

Std dev

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Capital Asset Pricing Model

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Risk & Return

Expected Return

RM -X X X RF -Risk

X Efficient frontier X X X X X X

Std dev

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Capital Asset Pricing Model

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Security Market Line: Risk/Return Trade-Off with CAPM

Expected Return

SML

RF --

Systematic Risk
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Security Market Line: E[Ri] = RF + i (RM RF)

Expected Return

SML RM --

RF -| 1 | 2

Systematic Risk
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Capital Asset Pricing Model

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CAPM
Provides a convenient measure of systematic risk of the volatility of an asset relative to the markets volatility. is this measure--gauges the tendency of a securitys return to move in tandem with the overall markets return. Average systematic risk High systematic risk, more volatile than the market Low systematic risk, less volatile than the market

F !1 F "1 F 1

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Capital Asset Pricing Model

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Betas for a Five-year Period (1987-1992)

Company Name (1987-1992) Beta 0.65 0.70 0.75 0.85 0.95 1.00 1.05 1.15 1.35 1.65 1.90
Capital Asset Pricing Model 20

Tucson Electric Power California Power & Lighting Litton Industries Tootsie Roll Quaker Oats Standard & Poors 500 Stock Index Procter & Gamble General Motors Southwest Airlines Merrill Lynch Roberts Pharmaceutical
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2006 Betas:

The SML and WACC

Expected return
SML = 8% 16% -15% -14% --

B A
Incorrect rejection

Incorrect acceptance WACC = 15%

R f ! 7% --

F A ! .60 F Firm ! 1.0

F B ! 1.2

Beta

If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency toward incorrectly accepting risky projects and incorrectly rejecting less risky projects.
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The SML and the Subjective Approach

Expected return
SML

20% -WACC = 14% -10% -High risk (+6%)

R f ! 7% -Low risk (-4%)

Moderate risk (+0%)

Beta
With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firms WACC.

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Capital Asset Pricing Model

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Finding Beta for Three Companies: High, Average, and Low Risk & Market

Year 1 2 3

RH
10% 20% 25%

RA
10% 10% 20%

RL
10% 0% 15%

RM
10% 10% 20%

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Capital Asset Pricing Model

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The Concept of Beta (cont.)

Return on Stock i, Ri (%)
Stock H, High Risk: 30 -20 -Stock L, Low Risk: 10 -| -20 | -10 0 -10 --20 -| 10 | 20 | 30 = 0.5 = 1.5 = 1.0

Stock A, Average Risk:

Return on the market

Rm (%)

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Capital Asset Pricing Model

24

Summary of Relationship Between Risk and Return

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Capital Asset Pricing Model

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