0. Chapter 12
Systematic Risk
& Equity
Risk Premium

1. Key Concepts and Skills
Know how to calculate expected returns
Understand impact of diversification
Understand systematic risk principle
Understand security market line
Understand risk-return trade-off

2. Chapter Outline Expected Returns and Variances Portfolios
Announcements, Surprises, and Expected Returns
Risk: Systematic and Unsystematic
Diversification and Portfolio Risk
Systematic Risk and Beta
The Security Market Line
The SML and the Cost of Capital: A Preview

3. Expected Returns
Expected returns are based on probabilities of possible outcomes
In this context, “expected” means average if process is repeated many times
“Expected” return does not even have to be a possible return
Use the following example to illustrate the mathematical nature of expected returns:
Consider a game where you toss a fair coin: If it is Heads then student A pays student B $1. If it is Tails then student B pays student A $1. Most students will remember from their statistics that the expected value is $0 (=.5(1) + .5(-1)). That means that if the game is played over and over then each student should expect to break-even. However, if the game is only played once, then one student will win $1 and one will lose $1.

4. Example: Expected Returns
You have predicted the following returns on Coke and Tyco stock in three possible economic states. What are the expected returns?
State Probability Coke Tyco
Boom
Normal
Recession ???
RC =
RT =
What is the probability of a recession? 0.2
If the risk-free rate is 6.15%, what is the risk premium?
Stock C: 9.99 – 6.15 = 3.84%
Stock T: 17.7 – 6.15 = 11.55%

5. Variance and Standard Deviation
Variance and standard deviation still measure the volatility of returns
Using unequal probabilities for the entire range of possibilities
Weighted average of squared deviations
It’s important to point out that these formulas are for populations, unlike the formulas in chapter 10 that were for samples (dividing by n-1 instead of n).
Remind the students that standard deviation is the square root of the variance

6. Example: Variance and Standard Deviation
Consider the previous example. What are the variance (2) and standard deviation () for Coke and Tyco?
Coke stock
State Prob. C Ret. Ave Diff Diff2 Wtd Diff2
Boom
Normal
Recess. O
Tyco stock
2 = ? =
 = ? =

7. Another Example Consider the following information:
State Probability ABC, Inc.
Boom
Normal
Slowdown
Recession
What is the expected return?
What is the variance?
What is the standard deviation?
E(R) = .25(.15) + .5(.08) + .15(.04) + .1(-.03) = .0805
Variance = .25( )2 + .5( ) ( )2 + .1( )2 =
Standard Deviation =

8. Portfolio Context Semester Grade based on 3 exams
Exam Grade
25% 80
25% 60
50% 70
Portfolio of 3 Stocks
Invested Return
IBM % 8%
Disney 25% 6%
AOL 50% 7%

9. Portfolios A portfolio is a collection of assets
An asset’s risk and return is important in how it affects the risk and return of the portfolio
The risk-return trade-off for a portfolio is measured by the portfolio’ expected return and standard deviation, just as with individual assets

10. Diversification
Portfolio diversification =investing in several different asset classes or sectors
Diversification is not just holding a lot of assets
For example, if you own 50 internet stocks, you are not diversified
However, if you own 50 stocks that span 20 different industries, then you are diversified
Video Note: “Portfolio Management” looks at the value of diversification using Tower Records

11. Example: Portfolio Weights
Suppose you have invested money and have purchased securities in the following amounts. What are your portfolio weights in each security?
$2000 of IBM
$3000 of MCD
$4000 of GE
$6000 of HP
DCLK – Doubleclick
KO – Coca-Cola
INTC – Intel
KEI – Keithley Industries
Show the students that the sum of the weights = 1

12. Portfolio Expected Returns
The expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolio
You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities

13. Example: Expected Portfolio Returns
Consider the portfolio weights computed previously. What is the expected return for the portfolio if the individual stocks have the following expected returns?
IBM: 19.65%
MCD: 8.96%
GE: 9.67%
HP: 8.13%
E(RP) =Portfolio Expected Return

14. Portfolio Return Prob 2
Have $10,000 to invest. You invest in stock X (expected return 15%) & stock Y (expected return 9%). Goal: Portfolio return of 13.30%. How much is invested in each stock?

15. Portfolio Variance
Compute the portfolio return for each state: RP = w1R1 + w2R2 + … + wmRm
Compute the expected portfolio return using the same formula as for an individual asset
Compute the portfolio variance and standard deviation using the same formulas as for an individual asset
The instructor’s manual provides information on how to compute the portfolio variance using the correlation or covariance between assets.

16. Example: Portfolio Variance
What is the expected return and standard deviation for each asset & portfolio considering the following?
Invest 50% of your money in Asset A
State Probability A B Portfolio
Boom % -5% 12.5%
Bust % 25% 7.5%
If A and B are your only choices, what percent are you investing in Asset B?
Asset A: E(RA) = .4(30) + .6(-10) = 6%
Variance(A) = .4(30-6)2 + .6(-10-6)2 = 384
Std. Dev.(A) = 19.6%
Asset B: E(RB) = .4(-5) + .6(25) = 13%
Variance(B) = .4(-5-13)2 + .6(25-13)2 = 216
Std. Dev.(B) = 14.7%
Portfolio (solutions to portfolio return in each state appear with mouse click after last question)
Portfolio return in boom = .5(30) + .5(-5) = 12.5
Portfolio return in bust = .5(-10) + .5(25) = 7.5
Expected return = .4(12.5) + .6(7.5) = 9.5 or
Expected return = .5(6) + .5(13) = 9.5
Variance of portfolio = .4( )2 + .6( )2 = 6
Standard deviation = 2.45%
Note that the variance is NOT equal to .5(384) + .5(216) = 300 and
Standard deviation is NOT equal to .5(19.6) + .5(14.7) = 17.17%
What would the expected return and standard deviation for the portfolio be if we invested 3/7 of our money in A and 4/7 in B? Portfolio return = 10% and standard deviation = 0

17. Example: Portfolio Variance #2: What is the expected return and standard deviation for a portfolio with an investment of $6000 in asset X and $4000 in asset Z?
Considering the following information
State Probability X Z
Boom % 10%
Normal % 9%
Recession % 10%
Portfolio return in Boom: .6(15) + .4(10) = 13%
Portfolio return in Normal: .6(10) + .4(9) = 9.6%
Portfolio return in Recession: .6(5) + .4(10) = 7%
Expected return = .25(13) + .6(9.6) + .15(7) = 10.06%
Variance = .25( )2 + .6( ) ( )2 =
Standard deviation = 1.92%
Compare to return on X of 10.5% and standard deviation of 3.12%
And return on Z of 9.4% and standard deviation of .48%

18. Expected versus Unexpected Returns
Realized returns are generally not equal to expected returns
There is expected component and the unexpected (surprise) component in total (realized) return
At any point in time, unexpected return can be either + or -
Over time, average of unexpected component is zero

19. Announcements and News
Announcements and news contain both an expected component and a surprise component
Surprise component affects stock’s price & return
Is very obvious when watching how stock prices move when unexpected announcement is made or earnings are different than anticipated

20. Efficient Markets
Efficient markets are a result of investors trading on unexpected portion of announcements
Easier it is to trade on surprises, the more efficient markets should be
Efficient markets involve random price changes because cannot predict surprises

21. Systematic Risk Risk factors that affect a large number of assets
Also known as non-diversifiable risk or market risk
Includes such things as changes in GDP, inflation, interest rates, etc.

22. Unsystematic Risk Risk factors that affect a limited number of assets
Also known as unique risk, asset-specific risk, or firm-specific risk
Includes such things as labor strikes, part shortages, etc.
Can be diversified away

23. Returns Total Return = expected return + unexpected return
Unexpected return = systematic portion + unsystematic portion
Therefore, total return can be expressed as follows:
Total Return = expected return + systematic portion + unsystematic portion

24. Diversification
Portfolio diversification =investing in several different asset classes or sectors
Diversification is not just holding a lot of assets
For example, if you own 50 internet stocks, you are not diversified
However, if you own 50 stocks that span 20 different industries, then you are diversified
Video Note: “Portfolio Management” looks at the value of diversification using Tower Records

25. The Principle of Diversification
Diversification can substantially reduce the riskiness (variability) of returns with a smaller reduction in expected returns
Reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another
However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion

26. Diversification & Portfolios
Return S.Dev.
IBM GE HP
MCD

27. Correlation Coefficient R = rho
R=1 : Perfect + correlation
R= -1 : Perfect – correlation
R<1 : Partially correlated

28. Table 11.7 %

29. Figure 11.1 Average annual standard deviation (%) Diversifiable risk
Nondiversifiable risk
Number of stocks in portfolio
49.2
23.9
19.2 1 10 20 30 40
1,000

30. Diversifiable Risk
The risk that can be eliminated by combining assets into a portfolio
Often considered the same as unsystematic, unique or asset-specific risk
If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away

31. Total Risk Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure of total risk
For well diversified portfolios, unsystematic risk is very small
Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk

32. Systematic Risk Principle
There is a reward for bearing risk
There is not a reward for bearing risk unnecessarily
The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away

33. Measuring Systematic (Market) Risk
Measure of systematic risk?
Beta coefficient measures systematic risk
What does beta tell?
Beta of 1: asset has same systematic risk as overall market
Beta < 1: asset has less systematic risk than overall market
Beta > 1: asset has more systematic risk than overall market

34. Table 11.8
(I)
www: Click on the web surfer icon to go to where you can do searches for various betas. Students are often interested to see the range of betas that are out there.

35. Total versus Systematic Risk
Consider the following information:
Standard Deviation Beta
Security C 20%
Security K 30%
Which security has more total risk?
Which security has more systematic risk?
Which security should have the higher expected return?
Security K has the higher total risk
Security C has the higher systematic risk
Security C should have the higher expected return

36. Standard Deviation v. Beta
S.D. measures stand-alone risk (in isolation)
Total risk
Beta measures systematic or market risk
Prudent investor holds portfolio, so Beta becomes key

37. Example: Portfolio Betas
Consider the previous example with the following four securities
Security Weight Beta
IBM
MCD GE HP
What is the portfolio beta?
Which security has the highest systematic risk? DCLK
Which security has the lowest systematic risk? KEI
Is the systematic risk of the portfolio more or less than the market? more

38. Beta Prob. 2
You own a portfolio equally invested in a risk-free asset & two stocks. One stock’s Beta is 1.9, and total portfolio is equally as risky as the market, what’s Beta for the other stock?

39. Beta and the Risk Premium
Remember that risk premium = expected return – risk-free rate
Higher the beta, greater the risk premium should be
Can we define the relationship between the risk premium and beta so that we can estimate the expected return?
YES!

40. Example: Portfolio Expected Returns and Betas
E(RA) Rf
Based on the example in the book.
Point out that there is a linear relationship between beta and expected return. Ask if the students remember the form of the equation for a line.
Y = mx + b
E(R) = slope (Beta) + y-intercept
The y-intercept is = the risk-free rate, so all we need is the slope A

41. Reward-to-Risk Ratio: Definition and Example
The reward-to-risk ratio is the slope of the line illustrated in the previous example
Slope = (E(RA) – Rf) / (A – 0)
Where: E(RA)= expected return on stock A
Rf=risk-free rate of return on T-bills
A= Beta for stock A (a measure of the stock’s riskiness)
SO: (E(RA) – Rf)= return on the risk premium for stock A
Reward-to-risk ratio for previous example = (20 – 8) / (1.6 – 0) = 7.5
What if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above the line)?
What if an asset has a reward-to-risk ratio of 7 (implying that the asset plots below the line)?
Ask students if they remember how to compute the slope of a line: rise / run
The Reward-to Risk Ratio is the expected return per unit of systematic risk, or the ratio of risk premium to systematic risk.
If the reward-to-risk ratio = 8, then investors will want to buy the asset. This will drive the price up and the return down (remember time value of money and valuation). When will trading stop? When the reward-to-risk ratio reaches 7.5.
If the reward-to-risk ratio = 7, then investors will want to sell the asset. This will drive the price down and the return up. When will trading stop? When the reward-to-risk ratio reaches 7.5.

42. 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
“A’s ”Reward-to- Market’s Reward-to-
Risk Ratio Risk Ratio
Systematic risk as all that matters in determining expected return since unsystematic can be diversified away. Therefore, the reward-to-risk ratio
must be the same for all assets in the marketplace. If not, people would buy the asset with the higher reward-to-risk ratio (driving up the price and down the return to some new equilibrium).

43. 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(RM) – Rf) / M
But since the Beta for the market is ALWAYS equal to one, M=1, the slope can be rewritten:
Slope = Return on the Market (E(RM)) – Risk-free rate of return (Rf) = market risk premium
OR: Market risk premium = E(RM) - Rf
Based on the discussion earlier, we now have all the components of the line:
E(R) = [E(RM) – Rf] + Rf

44. Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) defines the relationship between risk and return
Expected return on stock A = Risk-free return +
Beta of stock A(Return on Mrkt -- Risk free return)
Where: Return on the market – risk free return
= Market risk premium
E(RA) = Rf + A(E(RM) – Rf)
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

45. 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
Amount of systematic risk – measured by beta

46. Example - CAPM
Consider the betas for each of the assets given earlier. If the risk-free rate is 6.15% and the market risk premium is 9.5%, what is the expected return for each?
Security Beta Expected Return
IBM
MCD GE HP

47. E(Ri) = Rf + [E(RM) - Rf] X I
Figure 11.4
= E(RM) - Rf
E(RM) Rf
M=1.0
Asset beta (I)
Asset expected return (E(Ri))
The slope of the security market line is equal to the market risk premium, i.e., the reward for bearing an average amount of systematic risk. The equation describing the SML can be written:
E(Ri) = Rf + [E(RM) - Rf] X I
which is the capital asset pricing model, or CAPM.

48. Figure 11.4
Risk, or Beta
Expected Return

49. Chapter 11 Quick Quiz
How do you compute the expected return and standard deviation for an individual asset? For a portfolio?
What is the difference between systematic and unsystematic risk?
What type of risk is relevant for determining the expected return?
Consider an asset with a beta of 1.2, a risk-free rate of 5% and a market return of 13%.
What is the reward-to-risk ratio in equilibrium?
What is the expected return on the asset?
Reward-to-risk ratio = 13 – 5 = 8%
Expected return = (8) = 14.6%