Capital Asset Pricing Model

Capital Asset Pricing Model
(CAPM)
E[Ri] = RF + i (RM RF)
09/27/16
Risk and Return

Probability
.3
Company A
Return
100%
Normal
.4
15%
15%
Recession
.3
-70%
10%
State
Boom
Company B
Return
20%
1.0
1. Find the expected return for Company A and B.
2. Find the standard deviation for Company A and B.
09/27/16
Find Expected Return

Probability
.3
Company A
Return
100%
Normal
.4
15%
15%
Recession
.3
-70%
10%
State
Boom
Company B
Return
20%
1.0
E(R A ) .3(100) .4(15) .3(-70)
15%
E(R B ) .3(20) .4(15) .3(10)
15%
09/27/16
Find Standard Deviation

Probability
Company A
Return
Boom
.3
100%
20%
Normal
.4
15%
15%
Recession
.3
-70%
10%
State
Company B
Return
1.0
1
.3(100 - 15) 2 .4(15 - 15) 2 .3(-70 - 15) 2 2
A
65%
B .3(20 - 15) .4(15 - 15)
1
2 2
.3(10 - 15)
=3.8%
09/27/16
Risk and Return

Expected
Return
15%
4.0%
09/27/16
Risk
65.8%
Standard
Deviation
Portfolio Risk and the Phantom

Egg Crusher
Market
Your Portfolio
09/27/16
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.
09/27/16
Risk and Return

State
Sun Tan
Return
Umbrella
Return
Probability
of State
Sunny
33%
-9%
1/3
Normal
12%
12%
1/3
Rainy
-9%
33%
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.
09/27/16
Portfolio Risk and Return

State
Umbrella
Return
Sun Tan
Return
Probability
of State
Sunny
33%
-9%
1/3
Normal
12%
12%
1/3
Rainy
-9%
33%
1/3
E R 50/50 .5(12%) .5(12%)
50/50
12%
.5(17.15%) .5(17.15%)
Why not?
09/27/16
Portfolio Risk and Return

State
Umbrella
Return
Sun Tan
Return
Probability
of State
Sunny
33%
-9%
1/3
Normal
12%
12%
1/3
Rainy
-9%
33%
1/3
State
Return
Sunny
.5(33) + .5( - 9) = 12%
Normal
.5(12) + .5(12) = 12%
Rainy
.5( - 9) + .5(33) = 12%
09/27/16
No deviation from 12%!
50/50 0
10
Lessons from Tahitian Island

1.
2.
3.
4.
09/27/16
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
11
Portfolio Choice
U 2 U1 U 0
Expected
Return
Risk
09/27/16
Standard
Deviation
12
Risk and Return

Expected
Return
2
=-1
1
= 1
Risk
09/27/16
Standard
Deviation
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
1
09/27/16
Systematic or nondiversifiable
risk (result of general market
influences)
10
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
09/27/16
Std dev
15
Risk & Return

Expected
Return
B
RM --
ing
w
o
orr
X Efficient frontier
di n
n
e
L
X
X
X
X
X
X
X
RF -Risk
09/27/16
Std dev
16
Security Market Line: Risk/Return

Trade-Off with CAPM
Expected
Return
SML
RF --
Systematic
Risk
09/27/16
17
Security Market Line:

E[Ri] = RF + i (RM RF)
Expected
Return
SML
RM --
RF --
Systematic
Risk
09/27/16
|
1
|
2
18
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
09/27/16
19
Betas for a Five-year Period

(1987-1992)
Company Name
(1987-1992)
Beta
Tucson Electric Power
0.65
California Power & Lighting
0.70
Litton Industries
0.75
Tootsie Roll
0.85
Quaker Oats
0.95
Standard & Poors 500 Stock

Index
1.00
Procter & Gamble
1.05
General Motors
1.15
Southwest Airlines
1.35
Merrill Lynch
1.65
Roberts Pharmaceutical
1.90
09/27/16
2006 Betas:
20
The SML and WACC

Expected
return
SML
= 8%
16% -15% -14% --
B
A
Incorrect
acceptance
WACC = 15%
Incorrect
rejection
R f 7% --
A .60 Firm 1.0
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.
09/27/16
21
The SML and the Subjective Approach

Expected
return
SML
20% -High risk

(+6%)
WACC = 14% -10% --
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.
09/27/16
22
Finding Beta for Three Companies:

High, Average, and Low Risk & Market
Year
09/27/16
RH
RA
RL
10%
10%
10%
10%
20%
10%
0%
10%
25%
20%
15%
20%
RM
23
The Concept of Beta (cont.)

Return on Stock i, Ri (%)
Stock H, High Risk: = 1.5
30 --
Stock A, Average Risk: = 1.0
20 -Stock L, Low Risk: = 0.5
10 -|
-20
|
-10
|
10
|
20
-10 --20 --
09/27/16
|
30
Return on
the
market
Rm (%)
24
Summary of
Relationship
Between Risk
and Return
09/27/16
25

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