1. © 2012 McGraw-Hill Ryerson LimitedChapter 12 -1  Market Risk Premium: ◦ The risk premium of the market portfolio. It is the difference between market return and the return on risk free asset.  Benchmark Betas ◦ Since the return on a t-bill is fixed and unaffected by what happens in the market; the beta of the risk-free asset is zero. ◦ By definition, the beta of the market portfolio is 1. ◦ Given these benchmarks and the market risk premium, we can calculate the expected return on any asset. LO3

2. © 2012 McGraw-Hill Ryerson LimitedChapter 12 -2  Measuring return with given beta:  The Capital Asset Pricing Model (CAPM): Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium  According to the CAPM: LO3

3. © 2012 McGraw-Hill Ryerson LimitedChapter 12 -3  An example of measuring return with CAPM:  Calculate the expected return on a stock with a beta of 0.5 if T-bills return 4% and the market returns 11%. Expected Return =r j = r f +  ×[r m – r f ] = 4% + 0.5 × [11% - 4%] = 7.5% LO3

4. © 2012 McGraw-Hill Ryerson LimitedChapter 12 -4 CAPM 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 00.511.522.5 Beta of Asset Expected Return (%) Market Portfolio T-bill LO3

5. © 2012 McGraw-Hill Ryerson LimitedChapter 12 -5  Security Market Line (SML) ◦ The graph showing the relationship between the market risk of the security and its expected return is called the Security Market Line (SML). ◦ According to the CAPM, expected rates of return for all securities and all portfolios lie on the SML. LO3

6. © 2012 McGraw-Hill Ryerson LimitedChapter 12 -6 CAPM 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 00.511.52 Beta of Asset Expected Return (%) SML 2.3 Proposed Holding LO3

7. © 2012 McGraw-Hill Ryerson LimitedChapter 12 -7  How Well Does the CAPM Work? ◦ Studies have found the CAPM is too simple to capture exactly how stock markets work ◦ However, the CAPM does capture two fundamental financial principles:  Investors require extra return for taking on risk  Investors are primarily concerned with the market risk they cannot eliminate by diversification ◦ Thus, the CAPM is a good rule of thumb for pricing assets. ◦ Example: IMAX has a beta of 1.25 Expected Return = 4% + 1.25 × (11% - 4%) = 12.75% ◦ Thus, if IMAX were proposing an expansion project, you would discount its estimated cash flows at 12.75% LO3, LO4