Return, Risk, and the Security Market Line Chapter Thirteen

Corporate FinanceCh13-1 Prof. Oh, KUMBA Key Concepts and Skills  Understand the systematic risk principle  Understand the security market line  Understand the risk-return trade-off  Be able to use the Capital Asset Pricing Model(CAPM)

Corporate FinanceCh13-2 Prof. Oh, KUMBA Systematic Risk vs Unsystematic Risk  Risk factors that affect a large number of assets (vs limited number of assets)  Also known as non-diversifiable risk or market risk (vs diversifiable or asset- specific risk)  Includes such things as changes in GDP, inflation, interest rates, etc. (vs labor strikes, part shortage, etc.)

Corporate FinanceCh13-3 Prof. Oh, KUMBA Figure 13.1

Corporate FinanceCh13-4 Prof. Oh, KUMBA Systematic Risk Principle and beta  The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away( see Figure 13.1)  We use the beta coefficient to measure systematic risk  What does beta tell us? (see Table 13.8) A beta of 1 implies the asset has the same systematic risk as the overall market A beta )1 implies the asset has less (more) systematic risk than the overall market

Corporate FinanceCh13-5 Prof. Oh, KUMBA Table 13.8

Corporate FinanceCh13-6 Prof. Oh, KUMBA Total versus Systematic Risk  Consider the following information: Standard DeviationBeta Security C20%1.25 Security K30%0.95  Which security has more total risk?  Which security has more systematic risk?  Which security should have the higher expected return?

Corporate FinanceCh13-7 Prof. Oh, KUMBA Portfolio Expected Returns and Betas -how risk is rewarded in the market? RfRf E(R A ) AA

Corporate FinanceCh13-8 Prof. Oh, KUMBA Reward-to-Risk Ratio  The reward-to-risk ratio is the slope of the line illustrated in the previous example Slope = (E(R A ) – R f ) / ( A – 0) Reward-to-risk ratio for previous example =(20 – 8) / (1.6 – 0) = 7.5  Meaning? Asset A has a risk premium of 7.5% per unit of its systematic risk  What if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above the line)? What if 7?

Corporate FinanceCh13-9 Prof. Oh, KUMBA Market Equilibrium  In equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal the reward-to-risk ratio for the market

Corporate FinanceCh13-10 Prof. Oh, KUMBA Security Market Line  The security market line (SML) is the representation of market equilibrium  The slope of the SML is the reward-to-risk ratio: (E(R M ) – R f ) /  M  But since the beta for the market is ALWAYS equal to one, the slope can be rewritten  Slope = E(R M ) – R f = market risk premium (see Figure 13.4)  In market equilibrium, every asset should be on SML

Corporate FinanceCh13-11 Prof. Oh, KUMBA 2010 Security Market Line(SML)

Corporate FinanceCh13-12 Prof. Oh, KUMBA The Capital Asset Pricing Model  The capital asset pricing model (CAPM) defines the relationship between risk and return  E(R A ) = R f +  A (E(R M ) – R f )  If we know an asset’s systematic risk, we can use the CAPM to determine its expected return  This is true whether we are talking about financial assets or physical assets

Corporate FinanceCh13-13 Prof. Oh, KUMBA 2010 Factors Affecting Expected Return  Pure time value of money – measured by the risk-free rate  Reward for bearing systematic risk – measured by the market risk premium (=E(R M ) – R f )  Amount of systematic risk – measured by beta

Corporate FinanceCh13-14 Prof. Oh, KUMBA 2010 Example - CAPM  Consider the betas for each of the assets given earlier. If the risk-free rate is 4.5% and the market risk premium is 8.5%, what is the expected return for each? SecurityBetaExpected Return A (8.5) = % B (8.5) = 9.940% C (8.5) = % D (8.5) = %