18/09/2021

CHAPTER 3
RISK AND RETURN

Presented by Dr. Duong Thi Thuy An

Autumn 2021-2022

CHAPTER OUTLINE
[Link] returns vs. Percentage returns
[Link] average return and variance
[Link] vs. Geometric average returns
[Link] Returns and Variances of a single asset
[Link], expected returns and variances of a portfolio of 2 assets
[Link] and Portfolio Risk
[Link]: Systematic, Unsystematic Risk and Beta
[Link] Security Market Line
[Link] SML and the Cost of Capital: A Preview
*****Reading: RWJ 12edition: Chapter 12,13

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Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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EXPECTED LEARNING OUTCOMES

Know how to calculate the return on an investment
Understand the historical returns on various types of investments
Understand the historical risks on various types of investments
Know how to calculate expected returns
Understand the impact of diversification
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

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Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

SIX FUNDAMENTAL PRINCIPLES OF FINANCE

P1: There Is No Such Thing As A Free Lunch
P2: Other Things Equal, Individuals :
􀂃 Prefer more money to less (non-satiation)
􀂃 Prefer money now to later (impatience)
􀂃 Prefer to avoid risk (risk aversion)
P3: All Agents Act To Further Their Own Self-Interest
P4: Financial Market Prices Shift to Equalize Supply and Demand
P5: Financial Markets Are Highly Adaptive and Competitive
P6: Risk-Sharing and Frictions Are Central to Financial Innovation

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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DOLLAR RETURNS
• Total dollar return = income from investment + capital gain (loss) due to
change in price
• Example 1:
▪ You bought a bond for $1000 one year ago. You have received two coupons of $30
each. You can sell the bond for $1025 today. What is your total dollar return?
• Income = 30 + 30 = 60
• Capital gain = 1025 – 1000 = 25
• Total dollar return = 60 + 25 = $85

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

PERCENTAGE RETURNS
• It is generally more intuitive to think in terms of percentage, rather than dollar, returns
• Dividend yield (or income yield) = income / beginning price
• Capital gains yield = (ending price – beginning price) / beginning price
• Total percentage return = dividend yield + capital gains yield
Example 1 (Cont.):
Dividend yield (income yield)=60/1000=6%
Capital gains yield= (1025-1000)/1000=2.5%
Total percentage return= 6%+2.5%=8.5%

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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EXAMPLE 2: CALCULATING RETURNS

• You bought a stock for $35, and you received dividends of $1.25. The stock
is now selling for $40.

▪ What is your dollar return?

• Dollar return = 1.25 + (40 – 35) = $6.25

▪ What is your percentage return?

• Dividend yield = 1.25 / 35 = 3.57%
• Capital gains yield = (40 – 35) / 35 = 14.29%
• Total percentage return = 3.57 + 14.29 = 17.86%

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

FIGURE 12.4: A $1 INVESTMENT IN DIFFERENT TYPES OF PORTFOLIOS OV ER 1925-2013

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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FIGURE A: YEAR-BY-YEAR TOTAL RETURNS ON FIGURE B: YEAR-BY-YEAR TOTAL RETURNS

SMALL-COMPANY STOCKS ON LONG-TERM GOVERNMENT BONDS

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Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

AVERAGE RETURN: ARITHMETIC VS. GEOMETRIC

• Arithmetic Mean Return (AM)
AM =  Ri / n
where  Ri = the sum of all the annual return, i=1,2….,n.
n = number of years
• Geometric Mean Return (GM)
Example: Year Beginning Value Ending Value Ri
1 100 115 ?
2 115 138 ?
3 138 110.4 ?

Arithmetic mean return=

Geometric mean return=
Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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AVERAGE RETURN: ARITHMETIC VS. GEOMETRIC MEAN

• Arithmetic average – return earned in an average period over multiple periods
• Geometric average – average compound return per period over multiple periods
• The geometric average will be less than the arithmetic average unless all the returns are
equal
• Which is better?
▪ The arithmetic average is overly optimistic for long horizons
▪ The geometric average is overly pessimistic for short horizons
▪ So, the answer depends on the planning period under consideration
• 15 – 20 years or less: use the arithmetic
• 20 – 40 years or so: split the difference between them
• 40 + years: use the geometric
Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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AVERAGE RETURNS
Investment Average Return
Large Stocks 12.1%
Small Stocks 16.9%
Long-term Corporate Bonds 6.3%

Long-term Government Bonds 5.9%

U.S. Treasury Bills 3.5%

Inflation 3.0%

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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RISK PREMIUMS

• The “extra” return earned for taking on risk

• Treasury bills are considered to be risk-free

• The risk premium is the return over and above the risk-free rate

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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TABLE 12.3: AVERAGE ANNUAL RETURNS AND RISK PREMIUMS

Investment Average Return Risk Premium

Large Stocks 12.1% 8.6%

Small Stocks 16.9% 13.4%

Long-term Corporate Bonds 6.3% 2.8%

Long-term Government Bonds 5.9% 2.4%

U.S. Treasury Bills 3.5% 0.0%

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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VARIANCE AND STANDARD DEVIATION OVER A PERIOD

• Variance and standard deviation measure the volatility of asset returns
• The greater the volatility, the greater the uncertainty
• Historical variance = sum of squared deviations from the mean / (number of observations
– 1)

where R1, R2,…RT is return at time 1, 2, …,T; 𝑅 is the average return over the whole period.

• Standard deviation = square root of the variance= 𝑉𝑎𝑟(𝑅)

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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EXAMPLE: VARIANCE AND STANDARD DEVIATION OVER A PERIOD

Year Actual Average Deviation from the Mean Squared Deviation
Return Return
1 .15 .105 .045 .002025

2 .09 .105 -.015 .000225

3 .06 .105 -.045 .002025

4 .12 .105 .015 .000225

Totals .42 .00 .0045

Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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EXPECTED RETURNS OF A SINGLE ASSET OVER SCENARIOS

• Expected returns are based on the probabilities of possible outcomes
• In this context, “expected” means average if the process is repeated
many times
• Expected return is equal to the sum of the potential returns 𝑅𝑖 multiplied
with the orresponding probability of the returns 𝑃𝑖
𝑛

Expected Return = ෍(Probability of Return) × (Possible Return)

𝑖=1

n
or E ( R ) =  pi Ri
i =1
17 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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EXAMPLE: EXPECTED RETURNS OF A SINGLE ASSET

• Suppose you have predicted the following returns for stocks C and T in
three possible states of the economy. What are the expected returns?

State Probability C T
Boom 0.3 15 25
Normal 0.5 10 20
Recession ??? 2 1

• RC = .3(15) + .5(10) + .2(2) = 9.9%

• RT = .3(25) + .5(20) + .2(1) = 17.7%

18 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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VARIANCE AND STANDARD DEVIATION OF A SINGLE ASSET

• Variance and standard deviation measure the volatility of returns
• Using unequal probabilities for the entire range of possibilities
• Weighted average of squared deviations
𝑛

Variance 𝜎 2 = ෍ Probability × Possible Return − Expected Return 2

𝑖=1
n
Or σ =  pi ( Ri − E ( R )) 2
2

i =1

Standard deviation is the square root of the variance

19 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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EXAMPLE: EXPECTED RETURN AND VARIANCE OF A SINGLE ASSET

Price return [Ri-E(Ri)]^2 [Ri-E(Ri)]*[Rj-E(Rj]
time index GMD MBB index GMD MBB index GMD MBB Index-GMD Index-MBB
1 710 16,450 13,786
2 783 18,000 13,743 10.3% 9.4% -0.3% 0.13% 0.08% 0.48% 0.01% -0.36%
3 854 19,400 14,906 9.2% 7.8% 8.5% 0.07% 0.01% 0.03% -0.03% -0.03%
4 791 17,800 13,484 -7.4% -8.2% -9.5% 1.98% 2.21% 2.61% 2.44% 2.70%
5 889 23,800 15,337 12.4% 33.7% 13.7% 0.33% 7.34% 0.51% 1.42% 0.24%
6 950 23,450 18,628 6.9% -1.5% 21.5% 0.00% 0.65% 2.20% -0.03% 0.03%
7 1,020 29,500 20,808 7.4% 25.8% 11.7% 0.01% 3.68% 0.26% 0.12% 0.02%
8 1,194 35,750 26,750 17.1% 21.2% 28.6% 1.10% 2.12% 4.81% 1.26% 1.98%
9 1,169 32,700 27,350 -2.1% -8.5% 2.2% 0.77% 2.30% 0.19% 1.55% 0.65%
10 1,239 33,500 30,200 6.0% 2.4% 10.4% 0.00% 0.17% 0.14% 0.04% 0.00%
Mean of return 6.6% 9.1% 9.6%
Variance of return 0.55% 2.25% 1.30%
Covariance 0.85% 0.65%
Correlation 0.76 0.77
20 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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PORTFOLIOS
▪ A portfolio is simply a specific combination of securities, usually defined
by portfolio weights that sum to 1:

• 𝜔𝑖 is the weight of security i; 𝑁𝑖 is the number of security i; 𝑃𝑖 is the price

of security i.

21 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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EXAMPLE: PORTFOLIO WEIGHTS

• Suppose you have $15,000 to invest and you have purchased securities
in the following amounts. What are your portfolio weights in each
security?
• $2000 of DCLK
• $3000 of KO
• $4000 of INTC
• $6000 of KEI
•DCLK: 2/15 = .133
•KO: 3/15 = .2
•INTC: 4/15 = .267
•KEI: 6/15 = .4
22 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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PORTFOLIO EXPECTED RETURNS AND VARIANCE

• The expected return of a portfolio is the weighted average of the expected returns of the
respective assets in the portfolio
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜: 𝐸 𝑅𝑝𝑜𝑟𝑡 = 𝑤𝑖 𝐸 𝑅𝑖 + 𝑤𝑗 𝐸 𝑅𝑗

𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜: 𝑉𝑎𝑟 𝑅𝑝𝑜𝑟𝑡 = 𝑤𝑖2 𝜎𝑖2 + 𝑤𝑗2 𝜎𝑗2 + 2𝑤𝑖 𝑤𝑗 𝐶𝑜𝑣𝑖𝑗

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 (stdev): 𝜎𝑝𝑜𝑟𝑡 = 𝑉𝑎𝑟 𝑅𝑃

Where:
• 𝜔𝑖 is the weight of security i
• 𝐸 𝑅𝑖 : expected return of security i
• 𝐶𝑜𝑣𝑖𝑗 : Covariance of security i and j

23 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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PORTFOLIO EXPECTED RETURNS AND VARIANCE-COVARIANCE OF RETURNS

• A measure of the degree to which two variables “move together” relative to their
individual mean values over time
• For two assets, i and j, the covariance of rates of return is defined as :
𝑛 𝑛
1 1
𝐶𝑜𝑣𝑖𝑗 = ෍ 𝑅𝑖𝑡 − 𝐸 𝑅𝑖 𝑅𝑗𝑡 − 𝐸 𝑅𝑗 𝐶𝑜𝑣𝑖𝑗 = ෍ 𝑅𝑖𝑡 − 𝐸 𝑅𝑖 𝑅𝑗𝑡 − 𝐸 𝑅𝑗
𝑛 𝑛−1
𝑡=1 𝑡=1
• The covariance of a variable with itself:
𝑛 𝑛
𝑅𝑖𝑡 − 𝐸 𝑅𝑖 𝑅𝑖𝑡 − 𝐸 𝑅𝑖 𝑅𝑖𝑡 − 𝐸 𝑅𝑖 2
𝐶𝑜𝑣𝑖𝑖 = ෍ =෍ = 𝜎2
𝑛 𝑛
𝑡=1 𝑡=1

• Note: when applying to sample data, we divide the values by (n – 1) rather than
by n to avoid statistical bias.

24 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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PORTFOLIO EXPECTED RETURNS AND VARIANCE-CORRELATION

• The correlation coefficient is obtained by standardizing (dividing) the covariance
by the product of the individual standard deviations
Where:
𝐶𝑜𝑣𝑖𝑗
𝜌𝑖𝑗 = ρij = correlation coefficient of returns
𝜎𝑖 𝜎𝑗 σi = standard deviation of Ri
σj = standard deviation of Rj
Note: when sample data is used, σ is divided by (n – 1) to avoid statistical bias.
• The coefficient can vary only in the range +1 to −1
• A value of +1 would indicate perfect positive correlation. This means that returns for
the two assets move together in a positively and completely linear manner
• A value of −1 would indicate perfect negative correlation. This means that the returns
for two assets move together in a completely linear manner, but in opposite directions
Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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EXAMPLE: COVARIANCE, CORRELATION BETWEEN TWO RISKY ASSETS

Price return [Ri-E(Ri)]^2 [Ri-E(Ri)]*[Rj-E(Rj]
time index GMD MBB index GMD MBB index GMD MBB Index-GMD Index-MBB
1 710 16,450 13,786
2 783 18,000 13,743 10.3% 9.4% -0.3% 0.13% 0.08% 0.48% 0.01% -0.36%
3 854 19,400 14,906 9.2% 7.8% 8.5% 0.07% 0.01% 0.03% -0.03% -0.03%
4 791 17,800 13,484 -7.4% -8.2% -9.5% 1.98% 2.21% 2.61% 2.44% 2.70%
5 889 23,800 15,337 12.4% 33.7% 13.7% 0.33% 7.34% 0.51% 1.42% 0.24%
6 950 23,450 18,628 6.9% -1.5% 21.5% 0.00% 0.65% 2.20% -0.03% 0.03%
7 1,020 29,500 20,808 7.4% 25.8% 11.7% 0.01% 3.68% 0.26% 0.12% 0.02%
8 1,194 35,750 26,750 17.1% 21.2% 28.6% 1.10% 2.12% 4.81% 1.26% 1.98%
9 1,169 32,700 27,350 -2.1% -8.5% 2.2% 0.77% 2.30% 0.19% 1.55% 0.65%
10 1,239 33,500 30,200 6.0% 2.4% 10.4% 0.00% 0.17% 0.14% 0.04% 0.00%
Mean of return 6.6% 9.1% 9.6%
Variance of return 0.55% 2.25% 1.30%
Covariance 0.85% 0.65%
Correlation 0.76 0.77
26 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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EXAMPLE: COVARIANCE, CORRELATION BETWEEN TWO RISKY ASSETS

Price return [Ri-E(Ri)]^2 [Ri-E(Ri)]*[Rj-E(Rj]
time index GMD MBB index GMD MBB index GMD MBB Index-GMD Index-MBB
1 710 16,450 13,786
2 783 18,000 13,743 10.3% 9.4% -0.3% 0.13% 0.08% 0.48% 0.01% -0.36%
3 854 19,400 14,906 9.2% 7.8% 8.5% 0.07% 0.01% 0.03% -0.03% -0.03%
4 791 17,800 13,484 -7.4% -8.2% -9.5% 1.98% 2.21% 2.61% 2.44% 2.70%
5 889 23,800 15,337 12.4% 33.7% 13.7% 0.33% 7.34% 0.51% 1.42% 0.24%
6 950 23,450 18,628 6.9% -1.5% 21.5% 0.00% 0.65% 2.20% -0.03% 0.03%
7 1,020 29,500 20,808 7.4% 25.8% 11.7% 0.01% 3.68% 0.26% 0.12% 0.02%
8 1,194 35,750 26,750 17.1% 21.2% 28.6% 1.10% 2.12% 4.81% 1.26% 1.98%
9 1,169 32,700 27,350 -2.1% -8.5% 2.2% 0.77% 2.30% 0.19% 1.55% 0.65%
10 1,239 33,500 30,200 6.0% 2.4% 10.4% 0.00% 0.17% 0.14% 0.04% 0.00%
Mean of return 6.6% 9.1% 9.6%
Variance of return 0.55% 2.25% 1.30%
Covariance 0.85% 0.65%
Correlation 0.76 0.77
27 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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PORTFOLIO OF TWO RISKY ASSETS -EXAMPLE

• Example: From 2018-2021, Gemadept had an average monthly return of 1.75%
and a std dev of 9.73%. Military bank had an average return of 1.08% and a
std dev of 6.23%. Their correlation is [Link] would a portfolio of the two
stocks perform, given the weight in the following table?

w_GMD w_MBB E[RP] var(RP) stdev(RP)

0 1 1.08% 0.3881% 6.23%
0.25 0.75 1.25% 0.3616% 6.01%
0.5 0.5 1.42% 0.4459% 6.68%
0.75 0.25 1.58% 0.6409% 8.01%
1 0 1.75% 0.9467% 9.73%

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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PORTFOLIO OF TWO RISKY ASSETS -MEAN/STANDARD DEVIATION TRADE-OFF

Mean/SD Trade-Off for Portfolios of GMD and MBB

1.90% GMD
Expected return (E[Rp])

1.70% Efficient frontier 1.75%

1.50% 1.58%
1.42% stdev(RP)
1.30% 1.25%
1.10% 1.08%
0.90% MBB
0.70%
0.50%
4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00% 11.00%
Standard deviation (stdev (Rp))

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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PORTFOLIO DIVERSIFICATION
• Portfolio diversification is the investment 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
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

30 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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TABLE 13.7

31 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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FIGURE 13.1- THE POWER OF DIVERSIFICATION

32 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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SYSTEMATIC RISK VS. UNSYSTEMATIC RISK

Systematic Risk Unsystematic risk
• Risk factors that affect a large number of • Risk factors that affect a limited number of
assets assets
• Also known as non-diversifiable risk or • Also known as unique risk and asset-specific
market risk risk, idiosyncratic risk, diversifiable risk
• Includes such things as changes in GDP, • Includes such things as labor strikes, part
inflation, interest rates, etc. shortages, etc.
• There is a reward for bearing risk • The risk that can be eliminated by combining
assets into a portfolio
• There is not a reward for bearing risk
unnecessarily • If we hold only one asset, or assets in the same
industry, then we are exposing ourselves to risk
• The expected return on a risky asset that we could diversify away
depends only on that asset’s systematic
risk since unsystematic risk can be
diversified away

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Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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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

34 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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MEASURING SYSTEMATIC RISK

• How do we measure systematic risk?
• We use the beta coefficient
• 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

35 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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WHAT WE HAVE LEARNED SO FAR….

▪ Portfolio risk depends primarily on covariances
– Not stocks’ individual volatilities
▪ Diversification reduces risk
– But risk common to all firms cannot be diversified away
• Everyone has a portfolio on the same efficient frontier
• Hold the tangency portfolio M: Suppose all investors hold the same portfolio M; what must M
be?
→M is the market portfolio
▪ Hold the tangency portfolio M
– The tangency portfolio has the highest expected return for a given level of risk (i.e., the
highest Sharpe ratio)

36 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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PORTFOLIO: EFFICIENT FRONTIER, TANGENCY PORTFOLIO

2.4%

1.8% Military bank

Tangency
Expected Return

portfolio M
Vinamilk
1.2%
Gemadept

0.6%

T-Bill

0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation of Return

Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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TABLE 13.8

Insert Table 13.8 here

38 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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TOTAL VS. SYSTEMATIC RISK

• Consider the following information:
Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95

• Which security has more total risk?

• Which security has more systematic risk?
• Which security should have the higher expected return?

39 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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WORK THE WEB EXAMPLE

• Many sites provide betas for companies
• International stock market: Yahoo Finance provides beta, plus a lot of
other information under its Key Statistics link
• Vietnam stock market: [Link], [Link]

40 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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EXAMPLE: PORTFOLIO BETAS

• Consider the previous example with the following four securities
Security Weight Beta
DCLK .133 2.685
KO .2 0.195
INTC .267 2.161
KEI .4 2.434
• What is the portfolio beta?
• .133(2.685) + .2(.195) + .267(2.161) + .4(2.434) = 1.947

41 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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BETA AND THE RISK PREMIUM

• Remember that the risk premium = expected return – risk-free rate
• The higher the beta, the 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!

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EXAMPLE: PORTFOLIO EXPECTED RETURNS AND BETAS

30%

25%
Expected Return

E(RA)
20%

15%

10%
R
f
5%
A
0%
0 0.5 1 1.5 2 2.5 3
Beta

43 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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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)

• 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)?

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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

E ( RA ) − R f E ( RM − R f )
=
A M

45 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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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, the slope can
be rewritten
• Slope = E(RM) – Rf = market risk premium

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THE CAPITAL ASSET PRICING MODEL (CAPM)

• The capital asset pricing model defines the relationship between risk and
return
• 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

47 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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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

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EXAMPLE - CAPM
• Consider the betas for each of the assets given earlier. If the risk-free rate is 4.15%
and the market risk premium is 8.5%, what is the expected return for each?

Security Beta Expected Return

DCLK 2.685 4.15 + 2.685(8.5) = 26.97%
KO 0.195 4.15 + 0.195(8.5) = 5.81%
INTC 2.161 4.15 + 2.161(8.5) = 22.52%
KEI 2.434 4.15 + 2.434(8.5) = 24.84%

49 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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FIGURE 13.4

50 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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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?

51 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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COMPREHENSIVE PROBLEM
• The risk free rate is 4%, and the required return on the market is 12%.
What is the required return on an asset with a beta of 1.5?
• What is the reward/risk ratio?
• What is the required return on a portfolio consisting of 40% of the asset
above and the rest in an asset with an average amount of systematic
risk?

52 Dr. Duong Thi Thuy An Faculty of Finance Banking University of Ho Chi Minh City

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END OF CHAPTER

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