1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-1 Chapter Eleven Return, Risk and the Security Market Line

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-2 11.1Expected Returns and Variances 11.2 Portfolios 11.3 Announcements, Surprises and Expected Returns 11.4 Risk: Systematic and Non-systematic 11.5 Diversification and Portfolio Risk 11.6 Systematic Risk and Beta 11.7 The Security Market Line 11.8 The Capital Market Line 11.9 Portfolio Characteristics 11.10 The SML and the Cost of Capital: A Preview Chapter Organisation

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-3 11.11Problems with the CAPM 11.12 Summary and Conclusions Chapter Organisation (continued)

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-4 Chapter Objectives Calculate the expected return and risk (standard deviation) of both a single asset and a portfolio. Distinguish between systematic and non-systematic risk. Explain the principle of diversification. Explain the capital asset pricing model (CAPM). Distinguish between the security market line (SML) and the capital market line (CML).

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-5 Expected Return and Variance Expected return—the weighted average of the distribution of possible returns in the future. Variance of returns—a measure of the dispersion of the distribution of possible returns. Rational investors like return and dislike risk.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-6 Example—Calculating Expected Return

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-7 Example—Calculating Variance

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-8 Example—Expected Return and Variance Expected Returns:

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-9 Example—Expected Return and Variance Variances: Standard deviations:

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-10 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’s expected return and standard deviation, just as with individual assets.

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-11 Portfolio Expected Returns The expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolio. m E(R p ) = ∑ w j E (R j ) j =1 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.

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-12 Example—Portfolio Return and Variance Assume 50 per cent of portfolio in asset A and 50 per cent in asset B.

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-13 Example—Portfolio Return and Variance Var(R p )  (0.50 x Var(R A )) + (0.50 x Var(R B )). By combining assets in a portfolio, the risks faced by the investor can significantly change.

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-14 Asset A returns 0.05 0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03 -0.04 -0.05 0.05 0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03 Asset B returns 0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03 Portfolio returns: 50% A and 50% B The Effect of Diversification on Portfolio Variance

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-15 Announcements, Surprises and Expected Returns Key Issues – What are the components of the total return? – What are the different types of risk? Expected and Unexpected Returns – Total return (R) = expected return (E(R))+ unexpected return (U) Announcements and News – Announcement = expected part + surprise – It is the surprise component that affects a stock’s price and, therefore, its return.

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-16 Risk Systematic risk: that component of total risk which is due to economy-wide factors. Non-systematic risk: that component of total risk which is unique to an asset or firm.

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-17 Standard Deviations of Monthly Portfolio Returns

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-18 Diversification The process of spreading investments across different assets, industries and countries to reduce risk. Total risk = systematic risk + non-systematic risk Non-systematic risk can be eliminated by diversification; systematic risk affects all assets and cannot be diversified away.

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-19 The Principle of Diversification Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns. This 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.

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-20 Portfolio Diversification

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-21 Systematic Risk The systematic risk principle states that the expected return on a risky asset depends only on the asset’s systematic risk. The amount of systematic risk in an asset relative to an average risky asset is measured by the beta coefficient. Std Deviation Beta Security A30%0.60 Security B10%1.20 Security A has greater total risk but less systematic risk (more non-systematic risk) than Security B.

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-22 Measuring Systemic Risk What does beta tell us? - A beta of 1 implies the asset has the same systematic risk as the overall market. -A beta < 1 implies the asset has less systematic risk than the overall market. -A beta > 1 implies the asset has more systematic risk than the overall market.

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-23 Beta Coefficients for Selected Companies

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-24 Example—Portfolio Beta Calculations AmountPortfolio ShareInvestedWeightsBeta (1)(2)(3)(4)(3)  (4) ABC Company $6 000 50%0.900.450 LMN Company4 00033%1.100.367 XYZ Company2 00017%1.300.217 Portfolio$12 000100%1.034

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-25 Example—Portfolio Expected Returns and Betas Assume you wish to hold a portfolio consisting of asset A and a riskless asset. Given the following information, calculate portfolio expected returns and portfolio betas, letting the proportion of funds invested in asset A range from 0 to 125 per cent. Asset A has a beta of 1.2 and an expected return of 18 per cent. The risk-free rate is 7 per cent. Asset A weights: 0 per cent, 25 per cent, 50 per cent, 75 per cent, 100 per cent and 125 per cent.

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-26 Example—Portfolio Expected Returns and Betas Proportion Portfolio Invested in ExpectedPortfolio Asset A (%)Risk-free Asset (%) Return (%) Beta 01007.000.00 25759.750.30 50 12.500.60 752515.250.90 100018.001.20 125 –25 20.751.50

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-27 Return, Risk and Equilibrium Key issues: – What is the relationship between risk and return? – What does security market equilibrium look like? The ratio of the risk premium to beta is the same for every asset. In other words, the reward-to-risk ratio for the market is constant and equal to:

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-28 Example—Asset Pricing Asset A has an expected return of 12 per cent and a beta of 1.40. Asset B has an expected return of 8 per cent and a beta of 0.80. Are these two assets valued correctly relative to each other if the risk-free rate is 5 per cent? Asset B offers insufficient return for its level of risk, relative to A. B’s price is too high; therefore, it is overvalued (or A is undervalued).

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-29 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 )/ß 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

30. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-30 Security Market Line (SML) Asset expected return (E (R i )) Asset beta (  i ) = E (R M ) – R f E (R M ) RfRf M = 1.0

31. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-31 The Capital Asset Pricing Model (CAPM) An equilibrium model of the relationship between risk and return. What determines an asset’s expected return? – The risk-free rate—the pure time value of money. – The market risk premium—the reward for bearing systematic risk. – The beta coefficient—a measure of the amount of systematic risk present in a particular asset.

32. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-32 Calculation of Systematic Risk Where:Cov = covariance i = random distribution of return for asset i M = random distribution of return for the market  M = standard deviation of market return

33. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-33 Covariance and Correlation The covariance term measures how returns change together—measured in absolute terms. The correlation coefficient measures how returns change together—measured in relative terms. Correlation coefficient ranges between –1.0 and +1.0. Where  i = standard deviation of the return on asset i.

34. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-34 Security Market Line versus Capital Market Line * SML explains the expected return for all assets. * CML explains the expected return for efficient portfolios.

35. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-35 Risk of a Portfolio Variance of a two-asset portfolio is calculated as: weighted variance of the expected return for each asset in the portfolio + twice the weighted covariance of the expected return on the first asset with the expected return on the second

36. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-36 Example—Risk of a Portfolio WeightingStd Deviation Asset A 0.3 0.26 Asset B 0.7 0.13 The covariance of the expected returns between A and B is 0.017.

37. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 11-37 Problems with CAPM Difficulties in estimating beta - thin trading - non-constant beta Using CAPM - adding explanatory variables - measure of market return