7/14/2015Capital Asset Pricing Model1 Capital Asset Pricing Model (CAPM) E[R i ] = R F + β i (R M – R F )

7/14/2015Capital Asset Pricing Model2 Risk and Return StateProbability Company A Return Company B Return Boom.3100%20% Normal.415% Recession.3-70%10% Find the expected return for Company A and B. 2.Find the standard deviation for Company A and B.

7/14/2015Capital Asset Pricing Model3 Find Expected Return StateProbability Company A Return Company B Return Boom.3100%20% Normal.415% Recession.3-70%10% 1.0

7/14/2015Capital Asset Pricing Model4 Find Standard Deviation StateProbability Company A Return Company B Return Boom.3100%20% Normal.415% Recession.3-70%10% 1.0 =3.8%

7/14/2015Capital Asset Pricing Model5 Risk and Return Expected Return 15% 4.0%Risk65.8% Standard Deviation ||

7/14/2015Capital Asset Pricing Model6 Portfolio Risk and the Phantom Egg Crusher Your Portfolio Market

7/14/2015Capital Asset Pricing Model7 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.

7/14/2015Capital Asset Pricing Model8 Risk and Return State Sun Tan Return Umbrella Return Probability of State Sunny33%-9%1/3 Normal12% 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.

7/14/2015Capital Asset Pricing Model9 Portfolio Risk and Return State Sun Tan Return Umbrella Return Probability of State Sunny33%-9%1/3 Normal12% 1/3 Rainy-9%33%1/3

7/14/2015Capital Asset Pricing Model10 Portfolio Risk and Return State Sun Tan Return Umbrella Return Probability of State Sunny33%-9%1/3 Normal12% 1/3 Rainy-9%33%1/3 StateReturn Sunny.5(33) +.5( - 9) = 12% Normal.5(12) +.5(12) = 12% Rainy.5( - 9) +.5(33) = 12%

7/14/2015Capital Asset Pricing Model11 Lessons from Tahitian Island 1.Combining securities into portfolios reduces risk. 2.How? A portion of a stock’s variability in return is canceled by complementary variations in the return of other securities 3.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. 4.Therefore, Total Risk= unsystematic + systematic diversifiable nondiversifiable firm specific market

7/14/2015Capital Asset Pricing Model12 Portfolio Choice Expected Return Risk Standard Deviation

7/14/2015Capital Asset Pricing Model13 Risk and Return Expected Return Risk Standard Deviation ρ = ρ= 1

7/14/2015Capital Asset Pricing Model14 Variability of Returns Compared with Size of Portfolio % - 24% - 19% - Systematic or nondiversifiable risk (result of general market influences) Unsystematic or diversifiable risk (related to company-unique events) Total Risk Number of stocks in portfolio Average annual standard deviation (%)

7/14/2015Capital Asset Pricing Model15 Risk & Return Expected Return Efficient frontier RiskStd dev X XXXXXX X X R F -- X

7/14/2015Capital Asset Pricing Model16 Risk & Return Expected Return Efficient frontier RiskStd dev X XXXXXX X X R F -- Lending Borrowing X R M --

7/14/2015Capital Asset Pricing Model17 Security Market Line: Risk/Return Trade-Off with CAPM Expected Return Systematic Risk R F -- SML β

7/14/2015Capital Asset Pricing Model18 Security Market Line: E[R i ] = R F + β i (R M – R F ) Expected Return Systematic Risk R F -- SML R M | β

7/14/2015Capital Asset Pricing Model19 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 security’s return to move in tandem with the overall market’s return. Average systematic risk High systematic risk, more volatile than the market Low systematic risk, less volatile than the market

7/14/2015Capital Asset Pricing Model20 Betas for a Five-year Period ( ) Company Name ( )Beta Tucson Electric Power0.65 California Power & Lighting0.70 Litton Industries0.75 Tootsie Roll0.85 Quaker Oats0.95 Standard & Poor’s 500 Stock Index 1.00 Procter & Gamble1.05 General Motors1.15 Southwest Airlines1.35 Merrill Lynch1.65 Roberts Pharmaceutical Betas:

7/14/2015Capital Asset Pricing Model21 The SML and WACC Expected return 16% -- 14% -- 7% -- 15% -- A B Incorrect rejection = 8% SML WACC = 15% Beta Incorrect acceptance 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.

7/14/2015Capital Asset Pricing Model22 The SML and the Subjective Approach Expected return 14% -- 10% -- 7% -- Low risk (-4%) SML Beta WACC = Moderate risk (+0%) High risk (+6%) 20% -- 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 firm’s WACC.

7/14/2015Capital Asset Pricing Model23 Finding Beta for Three Companies: High, Average, and Low Risk & Market Year 110% 2 20% 10%0% 10% 325%20%15%20%

7/14/2015Capital Asset Pricing Model24 The Concept of Beta (cont.) Return on Stock i, Return on the market | |||||| Stock L, Low Risk: β = 0.5 Stock A, Average Risk: β = 1.0 Stock H, High Risk: β = 1.5

7/14/2015Capital Asset Pricing Model25 Summary of Relationship Between Risk and Return