Download Risk and Return

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:

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
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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s1 stock ≈ 35%
sMany stocks ≈ 20%
1 stock
2 stocks
Many stocks
-75 -60 -45 -30 -15 0
15 30 45 60 75 90 10
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Returns (%)
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Risk vs. Number of Stock in
Portfolio
sp
Company Specific
(Diversifiable) Risk
35%
Stand-Alone Risk, sp
20%
Market Risk
0
10
20
30
40
2,000 stocks8
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
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
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)bi
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ri is the required return on security i
rRF is the risk-free interest rate
RPM is the risk premium on the market
bi is the beta for security i
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