1

FINANCIAL MANAGEMENT
Lecture 6: Risk and return
Capital Asset Pricing Model
Assoc.Prof.Dr. NGUYEN THU THUY
Faculty of Business Administration
FOREIGN TRADE UNIVERSITY
Contents
1. Relation between risk and return
2. Estimation of risk/return of a security
3. Evaluation of risk/return of a
portfolio
4. Capital Asset Pricing Model (CAPM)
and its applications
5. WACC cost of capital
2
Holding Period Returns - HPR
l One share of stock is purchased today for $100. One
year later the stock price is $116.91 and it has paid a
dividend of $4.50
l Dollar profit =dividend +capital gain
l Dollar profit =dividend +[ending price beginning
price] =dividend +[P
1
P
0
]
=4.50 +[116.91 100] =4.50 +16.91 =$21.41
l Total one-year HPR =[dividend +P
1
P
0
] / P
0
=4.50/100 +(116.91 100)/100 =0.045 +0.1691
=0.2141 or 21.41%
l HPR consists of 4.5% dividend yield and 16.91%
capital gains yield
Introduction to risk and return
l Stock and bond returns: usually stated in terms of mean
return & standard deviation (=measure of risk or
dispersion of individual returns around the mean)
Year U.S. T-bills S&P 500
1981
1982
1983
1984
1985
0.1471
0.1054
0.0880
0.0985
0.0772
-0.0491
0.2141
0.2251
0.0627
0.3216
Mean return 10.324% 15.488%
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Introduction to risk and return
l Variance
l Standard deviation
1
) (
1
2
2
-
-
=

=
n
r r
n
i
i
s
1
) (
1
2
-
-
=

=
n
r r
n
i
i
s
Introduction to risk and return
l Calculate the std.deviation of S&P500
1981-1985
= 14.69% (mean = 15.49%)
l T-bills: defined as riskless investment
(mean = 10.32%)
l Realized risk premium for S&P500:
15.49% - 10.32% = 5.17%per year
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Historical record of investment classes
and returns in the U.S. during 1926-2002
Investment Mean returns Std. deviation
Treasury bills
Long-term T-bonds
Long-term Corp. bonds
Large firm stocks
Small firm stocks
3.8%
5.8%
6.2%
12.2%
16.9%
3.2%
9.4%
8.7%
20.5%
33.2%
Inflation 3.1% 4.4%
Compared to T-bills, large firm stocks earned an average
realized risk premium =12.2 3.8 =8.4%
The normal distribution & stock returns
Histograms of annual returns for both large and small firms
closely resemble a normal distribution or bell curve.
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The normal distribution & stock returns
The normal distribution & stock returns
- With the normal distribution, we can expect that:
- 68.26% of the annual returns are in the range of +/-
one std.dev. of the mean return
- 95.44% of the annual returns are in the range of +/-
two std.dev. of the mean return
- 99.74% of the annual returns are in the range of +/-
three std.dev. of the mean return
- During 1926-2002: large firm returns are
described by a mean return of 12.2% and a
std.dev. of 20.5%
- We expect about 68% of the annual returns fall within
the range from -8.3% to +32.7%
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A single securitys return
l Expected (ex ante) return:
Future possible states s of the economy
p
s
: probability of state s occurring
R
s
: return on the security if state s occurs

=
= =
K
s
s s
R p R R E
1
) (
l Variance

=
- =
K
s
s s
R R p
1
2 2
) ( s
iance var = s
l Std. dev.
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Two securities
l Covariance between any two securities:
l Correlation coefficient between any two
securities:

=
- - =
K
s
B B s A A s s AB
R R R R p
1
, ,
) )( ( s
) /(
B A AB AB
s s s r =
Risk and return of a two stock portfolio
Outcomes Probability p
s
R
A
R
B
Boom
Normal
Bust
0.25
0.50
0.25
20%
10%
0%
5%
10%
15%
Lets calculate the expected return, covariance
and correlation of the portfolio
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Risk and return of a two stock portfolio
Expected return:
10 . 0 = =
B A
R R
Std. deviation:
% 071 . 7 =
A
s
% 536 . 3 =
B
s
Covariance:
Correlation coefficient:
% 25 . 0 - =
AB
s
0 . 1 ) 03536 . 0 )( 07071 . 0 /( 0025 . 0 ) /( - = - = =
B A AB AB
s s s r
Security B: very unusual highest return in downturns,
lowest returns in boom times concept of diversification
Diversification
l Suppose we invest $100 in A and $200 in B. Dollar returns
under each possible outcome:
Outcome Prob. CF on
$100 in A
CF on
$200 in B
Total CF % return
on $300
in A&B
Boom
Normal
Bust
0.25
0.50
0.25
$120
$110
$100
$210
$220
$230

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Diversification
l Suppose we invest $100 in A and $200 in B. Dollar returns
under each possible outcome:
Outcome Prob. CF on
$100 in A
CF on
$200 in B
Total CF % return
on $300
in A&B
Boom
Normal
Bust
0.25
0.50
0.25
$120
$110
$100
$210
$220
$230
$330
$330
$330
10%
10%
10%
- Expected return =10%
- Variance =0.00
- Std.dev =0.00 (no risk)
Diversification
l Works in many cases
l Correlation between two securities:
Positively correlated: 0 <
AB
<1
Perfectly positively correlated:
AB
=1
Negatively correlated: -1 <
AB
<0
Perfectly negatively correlated:
AB
=-1
Uncorrelated:
AB
=0
In which case, will diversification not work?
Only when
AB
=1
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Return and risk for portfolios
l Expected return of a portfolio:

=
= =
N
i
i i P P
R X R R E
1
) (

= = =
+ =
N
i
N
j i j
ij j i
N
i
i i P
X X X
1 , 1 1
2 2 2
2 s s s
l Variance of a portfolio:
X
i
=% (or weight) of the portfolio in security i
N =number of securities in the portfolio.
Sum of weights =1
The case of portfolio of 2 securities
) ( ) ( ) (
B B A A P
R E X R E X R E + =
AB B A B B A A P
X X X X s s s s 2
2 2 2 2 2
+ + =
l The above example:
10 . 0 ) ( =
P
R E
0
2
=
P
s
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Efficient sets and diversification
Efficient sets and diversification
l As long as <1, std.dev. of a portfolio is less
than the weighted average of std.dev. of the
individual securities thats why
diversification works
l Efficient sets =portfolios within the investment
opport. set that represent the best return-risk
combinations
the portfolios must have the highest expected
return at a given std.dev. relative to all other
portfolios in the invest.opport.set
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Efficient set for many securities
CALs =Capital Allocation Lines =infinite linear combinations of
the riskless asset and a portfolio of risky assets.
Capital market equilibrium & CAPM
CML =identical for all rational investors
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Systematic vs. unsystematic risk
l A rational investor will only hold the well-
diversified Market portfolio
l Diversification eliminates part of the risk of an
individual security
l The only relevant risk =a securitys contribution
toward the std.dev. of the well-diversified portfo.
Total risk of indivi.securi. = systematic risk +
unsystemati c (diversifi able) risk
Systematic vs. unsystematic risk
l A typical stock: 25% (75%) of its total return variance is
driven by systematic (unsystematic) risk.
l The 75% is specific/unique to the firm firm-specific
risk unsystematic, diversifiable.
l A market portfolio of stocks: 100% of return variance is
due to risk that is macroeconomic or market in nature
nondiversifiable risk.
l Because firm-specific risk is diversifiable, it should be
irrelevant.
l Only the market or systematic risk is now relevant as
it affects all stocks in some degree.
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Relation between portfolio risk and
number of securities in a portfolio
CAPM model
l All rational investors identify exactly the same ORP
portfolio of risky assets the only to choose is the
Market portfolio.
l Beta (): relevant risk of any security as
contribution to the risk of Market portfolio.
l Market portfolio has Beta = 1, by definition. Ideally, it
is a global wealth portfolio of all assets certainly
unobservable a stock market index, e.g., S&P500, is
usually used
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CAPM definition of Beta
l Linear relationship between required return and Beta for
an individual security i under CAPM:
2
,
/
M M i i
s s b =
[ ]
F M i F i
R R R R - + = b
R
M
R
F
=market risk premium extra
compensation for risk that risk adverse investors
require for holding the market portfolio
CAPM - example
l Apple Computer has a Beta of 0.8;
l R
M
(S&P500) =10%; R
F
=5%
R
APPL
=0.05 +0.8*(0.10 0.05) =0.09 or 9%
Note:
(0.10 0.05) =5% =market risk premium
0.8*(0.10 0.05) =4% =risk premium for Apple
Computer stock
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Security Market Line - SML
SML refers to the relationship of the required return of an
individual asset to its Beta =graphical depiction of the
linear CAPM equation
CAPM, SML & mispricing of stocks
l Under CAPM: any assets required return should be a
function of its Beta its return should fall exactly on the
SML.
l If not on the SML the stock is mispriced.
l Example: Youre an analyst and know the true beta of IBM.
True
IBM
=2.0; R
M
=10%; R
F
=6%
R
IBM
=0.06 +2.0*(0.10 0.06) =14% per year
Dividend next year =$1.00 per share, with permanent
growth rate g =6% per year
The correct price should be:
P
0
=Div/(r-g) =1.00/(0.14-0.06) =$12.50 per share
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Example of mispricing (cont.)
l If the market has priced the stock incorrectly (perhaps
because the market or investors estimate the risk
incorrectly)
The stock is priced by the market to yield an expected return of r =
16%per year (too high rate of return) mispriced and selling at
P
0
=1.00/(0.16-0.06) =$10.00 per share
The stock is undervalued at $10.00, and you would
recommend that this stock should be purchased.
The stock is priced by the market to yield an expected return of r =
12%per year (too low rate of return) mispriced and selling at
P
0
=1.00/(0.12-0.06) =$16.67 per share
The stock is overvalued at $16.67, and you would recommend
that this stock should be sold or perhaps even shorted.
Mispricing should be enventually corrected
l The stock lies aboveSML: undervalued
The numerous purchasing activities force the
stock prices go up back to its correct value
of $12.5 per share
l The stock lies belowSML: overvalued
The numerous selling activities force the
stock price go down back to its correct
value of $12.5 per share
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Drawbacks of CAPM
l Problems while using CAPM
Size effect: stocks of companies with small
market cap outperform those with large market
cap (ceteris paribus)
The effect of P/E and M-to-B ratio: stocks of
companies with low P/E and MB outperform
those with high P/E and MB cao (ceteris paribus)
The effect of month/day/season not very
consistent over time.
Multifactor models
l Fama-French three-factor model (FF model):
Fama, Eugene F.; French, Kenneth R. (1993). "Common Risk
Factors in the Returns on Stocks and Bonds". Journal of Financial
Economics 33 (1): 356
Introducing 2 more factors (besides market factor) to
the asset pricing model: size (SMB factor) and MB (HML
factor)
Explaining more variance of the stock returns
l Other authors try to add other different
things/factors
l Momentum (past/historical stock prices) is
something important too
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Estimating equity Betas for publicly
traded firms
l Betas are traditionally estimated from a
linear regression of the firms stock returns
on the returns of a market index.
l OLS to estimate the Beta of General
Electrics common stock:
GE example (cont.)
l GEs monthly common stock excess returns for
J an.1997 Dec.1999 are regressed against the
excess returns to the CRSP value weighted
market index
Riskfree rate =return on one-month T-bills
CRSP =Center for Research in Security Prices at the
Uni. of Chicago
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GE example (cont.)
GE example (cont.)
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Some notes on WACC
l Cost of preferred stock
l Another method to estimate the
cost of common stock
Cost of preferred stock
k
p
= D
p
/P
0
k
p
: The cost of preferred sstock
D
p
: Dividend on the preferred stock
P
0
: Net sales from issuing the preferred stock
(Price Issuing costs if any)
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Cost of common stock another look
Dividend Growth Model
g : Constant rate of dividend growth
k
e
: Required rate of return
D
1
: Expected dividend on the common stock
in the next period
P
0
: Current share price
D
1
P
0
k
e
= + g