FINA1310 CORPORATE FINANCE

Lecture 6. Return, Risk and the Capital Market

Instructor: Dr. Mingzhu TAI

HKU Business School
The University of Hong Kong
Review of Lecture 5: Stock Valuation
• The general case
𝐷" 𝐷# 𝐷$
𝑃! = + #+ 1+𝑅 $ +⋯
(1 + 𝑅) 1+𝑅

• Special cases
‒ Zero Growth (Constant Dividend)
𝐷
𝑃! =
𝑅
‒ Constant Growth
𝐷%&" 𝐷% ×(1 + 𝑔)
𝑃% = =
𝑅−𝑔 𝑅−𝑔
‒ Nonconstant Growth
§ Calculating stage by stage

• Components of the required return

𝐷%&"
𝑅= +𝑔
𝑃%
• Valuing equity using peer multiples
FINA1310 Lecture 6: Return, Risk and the Capital Market 2
Today’s Roadmap
• Return and Risk: observing the capital markets
‒ Calculating the historical return and variance
‒ The Historical Return and Risk in the markets
• Market Efficiency Theories
• Expected Returns and Variances
‒ Single assets
‒ Portfolios
• Diversification and Portfolio Risk
• Capital Asset Pricing Model (CAPM)
• Textbook Reading: Chapter 12 (Some Lessons from Capital Market
History), 13 (Return, Risk, and the Security Market Line)

FINA1310 Lecture 6: Return, Risk and the Capital Market 3

Today’s Roadmap
• Return and Risk: observing the capital markets
‒ Calculating the historical return and variance
‒ The Historical Return and Risk in the markets
• Market Efficiency Theories
• Expected Returns and Variances
‒ Single assets
‒ Portfolios
• Diversification and Portfolio Risk
• Capital Asset Pricing Model (CAPM)
• Textbook Reading: Chapter 12, 13

FINA1310 Lecture 6: Return, Risk and the Capital Market 4

Return Calculation
Dollar Returns
• Income from investment : 𝐷!"#
‒ Dividend/ coupon income
‒ Net profit from the investment project
• Capital gain or loss due to changes in asset price: (𝑃!"#−𝑃! )
‒ Change in stock/ bond price
‒ Change in the value of fixed assets (land, building, equipment, …)
‒ No matter whether you keep the asset or actually sell it

Total Dollar Return = Income from Investment + Capital Gain (Loss)

(Dollar Return on Stock) (Dividend Income) (Change in Stock Price)

FINA1310 Lecture 6: Return, Risk and the Capital Market 5

Return Calculation
Dollar Returns
Total Dollar Return = Income from Investment + Capital Gain (Loss)
(Dollar Return on Stock) (Dividend Income) (Change in Stock Price)

• Example
You bought 1,000 shares of stock at $5 per share at the beginning of the year. Over the year, the
stock paid a dividend of $0.20 per share.
• What is your dollar return if the stock price rises to $5.50 per share at the end of the year?
‒ Dividend Income: $0.20 × 1,000 = $200
‒ Capital Gain: ($5.50 - $5.00) × 1,000 = $500
Total Dollar Return = $200 + $500 = $700

FINA1310 Lecture 6: Return, Risk and the Capital Market 6

Return Calculation
Dollar Returns
Total Dollar Return = Income from Investment + Capital Gain (Loss)
(Dollar Return on Stock) (Dividend Income) (Change in Stock Price)

• Example
You bought 1,000 shares of stock at $5 per share at the beginning of the year. Over the year, the
stock paid a dividend of $0.20 per share.
• What is your dollar return if the stock price drops to $4.60 per share at the end of the year?
‒ Dividend Income: $0.20 × 1,000 = $200
‒ Capital Loss: ($4.60 - $5.00) × 1,000 = -$400
Total Dollar Return = $200 - $400 = -$200

FINA1310 Lecture 6: Return, Risk and the Capital Market 7

Return Calculation
Percentage Returns
• Yield from investment: 𝐷!"#/𝑃!
‒ Dividend yield of stock
‒ Current yield of bond
‒ ROA of the investment project
• Capital gains yield (percentage changes in asset price): (𝑃!"#−𝑃! )/𝑃!
‒ Capital gain or loss from every dollar invested at the beginning
Total Percentage Return = Yield from Investment + Capital Gains Yield
(Rate of Return on Stock) (Dividend Yield) (∆% in Stock Price)

𝑫𝒕"𝟏 (𝑷𝒕"𝟏 −𝑷𝒕 )

𝑹𝒕"𝟏 = +
𝑷𝒕 𝑷𝒕

FINA1310 Lecture 6: Return, Risk and the Capital Market 8

Return Calculation
Percentage Returns
Total Percentage Return = Yield from Investment + Capital Gains Yield
(Rate of Return on Stock) (Dividend Yield) (∆% in Stock Price)

• Example
You bought some stock at $25 per share at the beginning of the year. Over the year, the stock paid a
dividend of $2 per share.
• What is your percentage return if the stock price rises to $35 per share at the end of the year?
‒ Dividend Yield: $2/$25 = 8%
‒ Capital Gain Yield: ($35 - $25) /$25= 40%
Total Percentage Return = 8% + 40% = 48%

FINA1310 Lecture 6: Return, Risk and the Capital Market 9

Return Calculation
Percentage Returns
Total Percentage Return = Yield from Investment + Capital Gains Yield
(Rate of Return on Stock) (Dividend Yield) (∆% in Stock Price)

• Example
You bought some stock at $25 per share at the beginning of the year. Over the year, the stock paid a
dividend of $2 per share.
• What is your percentage return if the stock price drops to $20 per share at the end of the year?
‒ Dividend Yield: $2/$25 = 8%
‒ Capital Loss Yield: ($20 - $25) /$25= -20%
Total Percentage Return = 8% - 20% = -12%

FINA1310 Lecture 6: Return, Risk and the Capital Market 10

The Historical Returns
Large-Company Stock

FINA1310 Lecture 6: Return, Risk and the Capital Market 11

The Historical Returns
Small-Company Stock

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The Historical Returns

FINA1310 Lecture 6: Return, Risk and the Capital Market 13

The Historical Returns

FINA1310 Lecture 6: Return, Risk and the Capital Market 14

The Historical Returns
• Observation 1:
‒ Across different years, the returns could be very different for an asset

• Question 1:
‒ How do we summarize the different returns across years?

FINA1310 Lecture 6: Return, Risk and the Capital Market 15

Historical Average Returns
Assume there are T periods in the past, and the return is R1 for period 1, R2 for
period 2, … , and RT for period T:
• Arithmetic Average Return
𝟏
)=
𝑹 𝑹 + 𝑹𝟐 + ⋯ + 𝑹𝑻
𝑻 𝟏
‒ The typical return for an average period
• Geometric Average Return
) = 𝟏 + 𝑹𝟏 × 𝟏 + 𝑹𝟐 × ⋯× 𝟏 + 𝑹𝑻 𝟏/𝑻 − 𝟏
𝑹
‒ The average annual return by investing compoundingly for T periods
• Forecasting the future return
‒ The arithmetic average return: forecasting the short-term return (could be too high in the
long run)
‒ The geometric average return : forecasting the long-term return (could be too low in the
short run)

FINA1310 Lecture 6: Return, Risk and the Capital Market 16

Historical Average Returns
• Example Year Annual Returns
The annual return for S&P 500 large-cap stocks 1926 13.75%

between 1926-1930: 1927 35.70%

1928 45.08%
1929 -8.80%
1930 -25.13%
• Arithmetic Average Return
1
𝑅. = 13.75 + 35.70 + 45.08 − 8.80 − 25.13 = 12.12%
5
• Geometric Average Return
𝑅. = 1 + 13.75 × 1 + 35.70 × 1 + 45.08 × 1 − 8.80 × 1 − 25.13 '/( −1
= 8.87%

FINA1310 Lecture 6: Return, Risk and the Capital Market 17

Historical Average Returns
• Average Annual Returns, 1926-2013:
Investment Average Return (Arithmetic)
Inflation 3.0%
U.S. Treasury Bills 3.5%
Long-Term Government Bonds 5.9%
Long-Term Corporate Bonds 6.3%
Large-Company Stocks 12.1%
Small-Company Stocks 16.9%

(The best guess on the annual return in a typical year)

FINA1310 Lecture 6: Return, Risk and the Capital Market 18

The Historical Returns
• Observation 2:
‒ Across different assets, the average return could be very different

• Question 2:
‒ What leads to the different returns across different assets?

FINA1310 Lecture 6: Return, Risk and the Capital Market 19

Historical Variances and Standard Deviations
How returns across years fluctuate from the average:

• Historical Variance
‒ Average squared difference between the actual annual return and the (arithmetic) average
return
𝟏
𝝈 𝟐
: = ) 𝟐 + 𝑹𝟐 − 𝑹
𝑹𝟏 − 𝑹 ) 𝟐 + ⋯ + 𝑹𝑻 − 𝑹 ) 𝟐
𝑻−𝟏
• Historical Standard Deviation
‒ Square root of the variance
𝟏
𝝈
:= :𝟐
𝝈 = )
𝑹𝟏 − 𝑹 𝟐 )
+ 𝑹𝟐 − 𝑹 𝟐 )
+ ⋯ + 𝑹𝑻 − 𝑹 𝟐
𝑻−𝟏
• The historical variance and standard deviation measure how risky the asset was
historically.

FINA1310 Lecture 6: Return, Risk and the Capital Market 20

Historical Variances and Standard Deviations
How returns across years fluctuate from the average:
0.2 0.2
Var=0.005 Var=0.0003
SD = 0.073 SD = 0.016
0.1 0.1

0 0

-0.1 -0.1

-0.2 -0.2
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Year Year

FINA1310 Lecture 6: Return, Risk and the Capital Market 21

Historical Variances and Standard Deviations
Example:
An investment had returns in the past four years as below.
• What is the historical average return over these four years?
• What are the historical variance and standard deviation?
(1) (2) (3) (4)
Actual Return Average Return Deviation Squared Deviation
(1) – (2)
Year 1 0.10 0.04 0.06 0.0036
Year 2 0.12 0.04 0.08 0.0064
Year 3 0.03 0.04 -0.01 0.0001
Year 4 -0.09 0.04 -0.13 0.0169
Totals 0.16 0.00 0.009 ← Variance
0.095 ← Standard Deviation

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Historical Returns and Risk

Risky assets:
• Uncertainty in future cash flows
• Exposed to interest rate risk;
• Real returns are higher;

Risk free asset:

• Free of default risk;
(Government backed)
• Free of interest rate risk;
(Given its short life)
• Tiny real return;

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Historical Returns and Risk
• Lesson I.
Risky assets earn a risk premium on average
‒ Risk premium: the excess return earned as a reward for bearing risk
• Lesson II.
The greater the risk, the greater the potential reward on average
‒ Risk ↑⇒ Risk Premium ↑
Investment Average Return Standard Deviation Risk Premium
U.S. Treasury Bills 3.5% 3.1% 0.0%
Long-Term Government Bonds 5.9% 9.8% 2.4%
Long-Term Corporate Bonds 6.3% 8.4% 2.8%
Large-Company Stocks 12.1% 20.2% 8.6%
Small-Company Stocks 16.9% 32.3% 13.4%

FINA1310 Lecture 6: Return, Risk and the Capital Market 24

Today’s Roadmap
• Return and Risk: observing the capital markets
‒ Calculating the historical return and variance
‒ The Historical Return and Risk in the markets
• Market Efficiency Theories
• Expected Returns and Variances
‒ Single assets
‒ Portfolios
• Diversification and Portfolio Risk
• Capital Asset Pricing Model (CAPM)
• Textbook Reading: Chapter 12, 13

FINA1310 Lecture 6: Return, Risk and the Capital Market 25

Capital Market Efficiency
The role of capital markets:
• Resource allocation
‒ Bring together investors (who have money and look for investment
opportunities) and businesses (who have investment projects and need
money) to create more value
• Price discovery
‒ Determine the asset prices through the interaction between buyers and
sellers
• Information revelation
‒ Reveal information about returns and risk from prices and transaction records

FINA1310 Lecture 6: Return, Risk and the Capital Market 26

Capital Market Efficiency
What Makes Markets Efficient?
• There are many investors out there doing research
§ As new information comes to market, this information is analyzed and trades
are made based on this information
(Good news comes in: demand ↑ ⟹ price ↑)
(Bad news comes in: demand ↓ ⟹ price ↓)
§ Therefore, prices should reflect all information available to investors

• If investors stop researching stocks, then the market will not be

efficient

FINA1310 Lecture 6: Return, Risk and the Capital Market 27

Capital Market Efficiency
• An efficient capital market:
‒ Assets in the market are “fairly” priced
‒ Current market prices fully reflect available information about the “true”
value of the assets
• Why prices change?
‒ New information arrives
(New information about the future cash flows and required returns)
• Capital market efficiency:
The extent to which prices adjust quickly and correctly in response to new
information

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Example: Price Responses to News

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Efficient Market Hypothesis

• Efficient Market Hypothesis (EMH):

Well-organized capital markets (e.g. large stock exchanges such as
NYSE) are efficient markets.
In such markets, current prices fully reflect available information.

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EMH: Implications

• Prices:
‒ Prices reflect the “fair” value of assets according to the available information
‒ When new information arrives, prices adjust immediately to the new “fair”
level

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Expected and Unexpected News
• Prices do not always go up with good news and go down with bad
news. Does this suggests that EMH fails?
‒ Not necessarily.

• Decomposing an announcement:
Announcement = Expected Part + Surprise

Incorporated in the past price Price response at announcement

• Whether the news is good or bad depends on the surprise part

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EMH: Implications
• Prices:
‒ Prices reflect the “fair” value of assets according to the available information
‒ When new information arrives, prices adjust immediately to the new “fair”
level
• Returns:
‒ No free lunch: you can not earn excess return without baring additional risk
‒ You always face the tradeoff between return and risk
‒ Active fund management cannot have “supreme” risk-adjusted returns

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EMH: Common Misconceptions
1. Efficient markets DO NOT imply that investors cannot make money
What they DO mean:
‒ On average, you will earn a return that just compensates the risk you bear
‒ On average, you cannot earn “free money” without bearing more risk

2. Market efficiency will NOT protect you from wrong choices:

If you do not diversify (“put all your eggs in one basket”):
‒ For the same return, you may bear more risk
‒ For the same amount of risk that you bear, you may earn a lower return

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EMH: Three Forms of Market Efficiency
• Efficient market Hypothesis (EMH):
‒ Current market prices fully reflect available information
• Information:
‒ Three categories
• Three forms of market efficiency:
‒ Each form corresponds to a specific information category
Information from market:
Prices/volume/…
Semistrong form
Strong form
All publicly available information
All Information
Weak form

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Strong Form Efficiency
• Concept:
‒ Current market prices reflect all information of every kind
(Including both public and private information)
• Implications:
‒ There is no way at all to earn excess returns without bearing more risk
• Reality:
‒ Not very well supported by empirical evidence from the financial markets
(e.g. insider trading)

FINA1310 Lecture 6: Return, Risk and the Capital Market 36

Semistrong Form Efficiency
• Concept:
‒ Current market prices reflect all publicly available information
(e.g. Financial statements, news releases, past trading information, …)
• Implications:
‒ There is no way to earn excess returns by doing financial analysis based on
public information
(e.g. fundamental analysis, technical analysis, …)
‒ There are chances to earn excess returns if you know private information
• Reality:
‒ Controversial, depending on the specific market, security, and time horizon

FINA1310 Lecture 6: Return, Risk and the Capital Market 37

Weak Form Efficiency
• Concept:
‒ Current market prices reflect all market information in the past
(e.g. prices, volume, …)
• Implications:
‒ There is no way to earn excess returns by doing technical analysis based on
market information
‒ You might still have a chance with fundamental analysis
• Reality:
‒ Likely true, at least in the long run

FINA1310 Lecture 6: Return, Risk and the Capital Market 38

Today’s Roadmap
• Return and Risk: observing the capital markets
‒ Calculating the historical return and variance
‒ The Historical Return and Risk in the markets
• Market Efficiency Theories
• Expected Returns and Variances
‒ Single assets
‒ Portfolios
• Diversification and Portfolio Risk
• Capital Asset Pricing Model (CAPM)
• Textbook Reading: Chapter 12, 13

FINA1310 Lecture 6: Return, Risk and the Capital Market 39

Expected Returns and Variances
• The future return (or cash flows) could be different under different states of the
economy
(Good States: high return) State 1 State 2 … State N
(Bad States: low return) Probability 𝑝! 𝑝" 𝑝#
Return if State Occurs 𝑅! 𝑅" 𝑅#
• Expected Return (Mean Return):
‒ What you expect to earn on average Notice: 𝑝" + 𝑝# + ⋯ + 𝑝' = 1

𝐸 𝑅 = 𝑝! 𝑅! + 𝑝" 𝑅" + ⋯ + 𝑝# 𝑅#
• Variance:
‒ How dispersed the possible outcomes are (from the expected return)
‒ A measure of risk in the future
𝑉𝑎𝑟 𝑅 = 𝜎 " = 𝑝! 𝑅! − 𝐸 𝑅 " + 𝑝" 𝑅" − 𝐸 𝑅 " + ⋯ + 𝑝# 𝑅# − 𝐸 𝑅 "

• Standard Deviation:
𝜎= 𝑉𝑎𝑟(𝑅)

FINA1310 Lecture 6: Return, Risk and the Capital Market 40

Expected and Historical
• For the future return: State 1 State 2 … State N
Probability 𝑝" 𝑝# 𝑝'
‒ Expected Return:
Return if State Occurs 𝑅" 𝑅# 𝑅'
𝐸 𝑅 = 𝑝' 𝑅' + 𝑝) 𝑅) + ⋯ + 𝑝* 𝑅*
Notice: 𝑝! + 𝑝" + ⋯ + 𝑝# = 1
‒ Variance:
𝑉𝑎𝑟 𝑅 = 𝑝' 𝑅' − 𝐸 𝑅 ) + 𝑝) 𝑅) − 𝐸 𝑅 ) + ⋯ + 𝑝) 𝑅) − 𝐸 𝑅 )

• For the historical return:

‒ Historical (Arithmetic) Average return:
§ An “estimation” of the future expected return
1
.
𝑅 = (𝑅' + 𝑅) + ⋯ + 𝑅+ ) Year 1 Year 2 … Year T
𝑇
‒ Historical Variance: Actual Return 𝑅" 𝑅# 𝑅(

§ An “estimation” of the future variance

1
𝜎D ) = . ) +(𝑅) − 𝑅)
(𝑅' − 𝑅) . ) + ⋯ + (𝑅+ − 𝑅)
. )
𝑇−1

FINA1310 Lecture 6: Return, Risk and the Capital Market 41

Expected Returns and Variances
Example:
• Returns vary across different states of economy
State of Economy Probability of the State Return if State Occurs
Stock A Stock B
Boom 0.3 20% 15%
Normal 0.5 10% 10%
Recession 0.2 5% 8%

FINA1310 Lecture 6: Return, Risk and the Capital Market 42

Expected Returns and Variances
Example:
• Expected Returns
Stock A Stock B
(1) (2) (3) (4) (5) (6)
State of Probability of Return if State Product Return if State Product
Economy the State Occurs (2) × (3) Occurs (2) × (5)
Boom 0.3 20% 6.0% 15% 4.5%
Normal 0.5 10% 5.0% 10% 5.0%
Recession 0.2 5% 1.0% 8% 1.6%
Totals 1.0 𝐸 𝑅 $ = 12.0% 𝐸 𝑅 % = 11.1%

FINA1310 Lecture 6: Return, Risk and the Capital Market 43

Expected Returns and Variances
Example:
• Variances
Stock A Stock B
(1) (2) (3) (4) (5) (6)
State of Probability of Squared Product Squared Product
Economy the State Deviation (2) × (3) Deviation (2) × (5)
" "
Boom 0.3 0.2 − 0.12 0.00192 0.15 − 0.111 0.00046
" "
Normal 0.5 0.1 − 0.12 0.00020 0.1 − 0.111 0.00006
Recession 0.2 0.05 − 0.12 " 0.00098 0.08 − 0.111 " 0.00019
Totals 1.0 𝑉𝑎𝑟 𝑅 $ = 0.00310 𝑉𝑎𝑟 𝑅 % = 0.00071
𝐸 𝑅 $ = 12.0% 𝐸 𝑅 % = 11.1%

FINA1310 Lecture 6: Return, Risk and the Capital Market 44

Expected Returns and Variances
Example:
• Returns and Risks

Risk Premium = Expected Return – Risk-Free Rate

Expected Return Variance Risk-Free Rate Risk Premium

Stock A 12% 0.0117 10% 12%-10%=2%
Stock B 11.1% 0.002603 10% 11.1%-10%=1.1%

FINA1310 Lecture 6: Return, Risk and the Capital Market 45

Portfolios
• A Portfolio
‒ A collection of assets
• Portfolio Weights
‒ Percentage share of the total portfolio value
that is invested in each single asset in the portfolio
‒ The portfolio weights of all assets in the portfolio sum up to 1
• Example
If there are two stocks, A and B in the portfolio:
No. Shares Price per share Total Value Portfolio Weight
Stock A 100 $30 $3,000 60%
Stock B 500 $4 $2,000 40%
Portfolio $5,000
FINA1310 Lecture 6: Return, Risk and the Capital Market 46
Portfolio Weights
• Features of portfolio weights:
‒ The portfolio weights of all assets in the portfolio sum up to 1
‒ A portfolio weight could be positive or negative
Asset Value Portfolio Weight
Risk-Free Asset -$400 -0.4
• Negative portfolio weight: Stock A -$600 -0.6
Stock B +$2,000 2
You have $1,000 to invest: Total $1,000 1

1) You borrow $400 at the risk-free rate

2) You short sell 20 shares of Stock A ($30/share)
3) You purchase 500 shares of Stock B ($4/share)

FINA1310 Lecture 6: Return, Risk and the Capital Market 47

Portfolio Expected Return
• Method I.
1) Calculate the portfolio return at each state
2) Calculate the expected return by treating the portfolio as a single asset
Portfolio Weight State 1 State 2 … State N Expected Return
Probability 𝑝! 𝑝" … 𝑝&
Stock 1 𝑤! 𝑅!! 𝑅"! … !
𝑅#
Stock 2 𝑤" 𝑅!" 𝑅"" … 𝑅#"
… …
Stock S 𝑤' 𝑅!' 𝑅"' … 𝑅#'
, , , ,
Portfolio ∑+)*" 𝑤) =1 𝑅" =∑+)*" 𝑤) 𝑅") 𝑅# =∑+)*" 𝑤) 𝑅#) … 𝑅' =∑+)*" 𝑤) 𝑅'
)
𝐸 𝑅 , =∑'
-*" 𝑝- 𝑅-

𝒑 𝒑 𝒑 𝒑
𝑬 𝑹𝒑 = 𝒑𝟏 𝑹𝟏 + 𝒑𝟐 𝑹𝟐 + ⋯ + 𝒑𝑵𝑹𝑵= ∑𝑵
𝒌/𝟏 𝒑𝒌 𝑹𝒌 = ∑ 𝑵
𝒌/𝟏 𝒑𝒌 ∑ 𝑺
𝒊/𝟏 𝒘𝒊 𝑹𝒊
𝒌

FINA1310 Lecture 6: Return, Risk and the Capital Market 48

Portfolio Expected Return
• Method II.
1) Calculate the expected return of each asset in the portfolio
2) Calculate the weighted average of these expected returns
Portfolio Weight State 1 State 2 … State N Expected Return
Probability 𝑝! 𝑝" 𝑝&
Stock 1 𝑤! 𝑅!! 𝑅"! !
𝑅# 𝐸 𝑅" =∑' "
-*" 𝑝- 𝑅-

Stock 2 𝑤" 𝑅!" 𝑅"" 𝑅#" 𝐸 𝑅 # = ∑' #

-*" 𝑝- 𝑅-

…
Stock S 𝑤( 𝑅!( 𝑅"( 𝑅#( 𝐸 𝑅 . =∑' .
-*" 𝑝- 𝑅-

Portfolio ∑+)*" 𝑤) =1 𝐸 𝑅 , =∑.)*" 𝑤) 𝐸(𝑅 ) )

𝑬 𝑹𝒑 = 𝒘𝟏 𝑬 𝑹𝟏 + 𝒘𝟐 𝑬 𝑹𝟐 + ⋯ + 𝒘𝑺𝑬(𝑹𝑺)= ∑𝑺𝒊/𝟏 𝒘𝒊 𝑬 𝑹𝒊 = ∑𝑺𝒊/𝟏 𝒘𝒊 ∑𝑵

𝒌/𝟏 𝒑𝒌 𝑹𝒊
𝒌

FINA1310 Lecture 6: Return, Risk and the Capital Market 49

Portfolio Expected Return
• Method I.
1) Calculate the portfolio return at each state
2) Calculate the expected return by treating the portfolio as a single asset
• Example:
Portfolio Weight Boom Normal Recession
Probability 0.3 0.5 0.2
Stock 1 60% 20% 10% 5%
Stock 2 40% 15% 10% 8%
Portfolio 0.6×0.2 + 0.4×0.15 0.6×0.1 + 0.4×0.1 0.6×0.05 + 0.4×0.08
= 0.18 = 0.10 = 0.062

𝐸 𝑅6 = 0.3×0.18 + 0.5×0.10 + 0.2×0.062 = 0.1164

FINA1310 Lecture 6: Return, Risk and the Capital Market 50

Portfolio Expected Return
• Method II.
1) Calculate the expected return of each asset in the portfolio
2) Calculate the weighted average of these expected returns
• Example:
Portfolio Weight Boom Normal Recession E(R)
Probability 0.3 0.5 0.2
Stock 1 60% 20% 10% 5% 12.0%
Stock 2 40% 15% 10% 8% 11.1%

𝐸 𝑅6 = 0.6×0.12 + 0.4×0.111 = 0.1164

FINA1310 Lecture 6: Return, Risk and the Capital Market 51

Portfolio Variance
• Method I.
1) Calculate the portfolio return at each state
2) Calculate the variance by treating the portfolio as a single asset
Portfolio Weight State 1 State 2 … State N
Probability 𝑝! 𝑝" 𝑝&
Stock 1 𝑤! 𝑅!! 𝑅"! !
𝑅#
Stock 2 𝑤" 𝑅!" 𝑅"" 𝑅#"
…
Stock S 𝑤( 𝑅!( 𝑅"( 𝑅#(
, , ,
Portfolio ∑+)*" 𝑤) =1 𝑅" =∑+)*" 𝑤) 𝑅") 𝑅# =∑+)*" 𝑤) 𝑅#) 𝑅' =∑+)*" 𝑤) 𝑅'
)

𝑵 𝒑 𝟐
𝑽𝒂𝒓 𝑹𝒑 = 𝒌9𝟏 𝒑𝒌 𝑹𝒌 − 𝑬 𝑹𝒑
∑

FINA1310 Lecture 6: Return, Risk and the Capital Market 52

Portfolio Variance
• Method I.
1) Calculate the portfolio return at each state
2) Calculate the variance by treating the portfolio as a single asset
• Example:
Portfolio Weight Boom Normal Recession
Probability 0.3 0.5 0.2
Stock 1 60% 20% 10% 5%
Stock 2 40% 15% 10% 8%
Portfolio 0.6×0.2 + 0.4×0.15 0.6×0.1 + 0.4×0.1 0.6×0.05 + 0.4×0.08
= 0.18 = 0.10 = 0.062

𝑉𝑎𝑟 𝑅8 = 0.3× 0.18 − 0.1164 9 + 0.5× 0.1 − 0.1164 9 + 0.2× 0.062 − 0.1164 9
= 0.0019

FINA1310 Lecture 6: Return, Risk and the Capital Market 53

Portfolio Variance
• A different example:
Portfolio Boom Normal Recession Expected Variance
Weight Return
Probability 0.25 0.5 0.25
Stock 1 50% 20% 10% 0% 10% 0.005
Stock 2 50% 20% 10% 0% 10% 0.005
Stock 2’ 50% 0% 10% 20% 10% 0.005
Portfolio 0.5×0.2 0.5×0.1 0.5×0 10% 0.005
1+2 + 0.5×0.2 + 0.5×0.1 + 0.5×0
= 0.2 = 0.10 =0
Portfolio 0.5×0.2 0.5×0.1 0.5×0 10% 0
1+2’ + 0.5×0 + 0.5×0.1 + 0.5×0.20
= 0.10 = 0.10 = 0.10

FINA1310 Lecture 6: Return, Risk and the Capital Market 54

Portfolio Variance
• Method II.
1) Calculate the variance and covariance of each asset (pair) in the portfolio
• Covariance
‒ The joint variability between two assets
‒ How the returns of two assets correspond to the states
𝑪𝒐𝒗 𝑹𝑨 , 𝑹𝑩 = 𝒑𝟏 × 𝑹𝑨𝟏 − 𝑬(𝑹𝑨 ) × 𝑹𝑩 𝑩 𝑨
𝟏 − 𝑬(𝑹 ) + ⋯ + 𝒑𝑵 × 𝑹𝑵 − 𝑬 𝑹
𝑨
× 𝑹𝑩
𝑵−𝑬 𝑹
𝑩

State 1 State 2 … State N

Probability 𝑝! 𝑝" 𝑝&
Stock A 𝑅!- 𝑅"- 𝑅#-
Stock B 𝑅!. 𝑅". 𝑅#.

FINA1310 Lecture 6: Return, Risk and the Capital Market 55

Portfolio Variance
• Method II.
1) Calculate the variance and covariance of each asset in the portfolio
• Correlation
‒ Covariance divided by the two standard deviations
𝑨𝑩 𝑨 𝑩
𝑪𝒐𝒗 𝑹𝑨 , 𝑹𝑩
𝝆 ≡ 𝑪𝒐𝒓𝒓 𝑹 , 𝑹 =
𝝈𝑨 𝝈𝑩
• 𝐶𝑜𝑟𝑟 𝑅 2 , 𝑅3 ∈ [−1, 1];
• 𝐶𝑜𝑟𝑟 𝑅 2 , 𝑅3 > 0:
‒ A and B correspond to the states in a similar way
• 𝐶𝑜𝑟𝑟 𝑅 2 , 𝑅3 < 0:
‒ A and B correspond to the states in an opposite way
• 𝐶𝑜𝑟𝑟 𝑅 $ , 𝑅 % = 0:
‒ A and B correspond to the states independently

FINA1310 Lecture 6: Return, Risk and the Capital Market 56

Portfolio Variance
• Method II.
2) Calculate the portfolio variance based on the single-asset variances and
covariances
𝑉𝑎𝑟 𝑅N =∑PO9# 𝑤OQ𝑉𝑎𝑟 𝑅O + ∑ORS 𝑤O 𝑤S 𝐶𝑜𝑣(𝑅O , 𝑅 S )

𝑽𝒂𝒓 𝑹𝑷 = ∑𝑺𝒊9𝟏 𝒘𝟐𝒊 𝝈𝟐𝒊 + ∑𝒊R𝒋 𝒘𝒊 𝒘𝒋 𝝆𝒊𝒋 𝝈𝒊 𝝈𝒋

Stock 1 (𝑤! ) Stock 2 (𝑤" ) … Stock S (𝑤( )

Stock 1 (𝑤! ) 𝑤!" 𝜎!" 𝑤! 𝑤" 𝜌!" 𝜎! 𝜎" … 𝑤! 𝑤' 𝜌!' 𝜎! 𝜎'
Stock 2 (𝑤" ) 𝑤! 𝑤" 𝜌!" 𝜎! 𝜎" 𝑤"" 𝜎"" … 𝑤" 𝑤' 𝜌"' 𝜎" 𝜎'
… … … … …
Stock S (𝑤( ) 𝑤! 𝑤' 𝜌!' 𝜎! 𝜎' 𝑤" 𝑤' 𝜌"' 𝜎" 𝜎' … 𝑤'" 𝜎'"

FINA1310 Lecture 6: Return, Risk and the Capital Market 57

Portfolio Variance
• Method II.
1) Calculate the variance and covariance of each asset in the portfolio
2) Calculate the portfolio variance based on the single-asset variances and covariances
• Example:
‒ 𝜎') = 0.00310
‒ 𝜎)) = 0.00071
4.6× 4.)84.') × 4.'(84.''' "4.(× 4.'84.') ×(4.'84.''')"4.)× 4.4(84.') ×(4.4;84.''')
‒ 𝜌') = = 0.9983
4.446'4× 4.444<'

Portfolio Weight Boom Normal Recession

Probability 0.3 0.5 0.2
Stock 1 60% 20% 10% 5%
Stock 2 40% 15% 10% 8%

FINA1310 Lecture 6: Return, Risk and the Capital Market 58

Portfolio Variance
• Method II.
1) Calculate the variance and covariance of each asset in the portfolio
2) Calculate the portfolio variance based on the single-asset variances and covariances
• Example:
‒ 𝜎!" = 0.00310
‒ 𝜎"" = 0.00071
).+× )."-).!" × ).!.-).!!! /)..× ).!-).!" ×().!-).!!!)/)."× ).).-).!" ×().)2-).!!!)
‒ 𝜌!" = = 0.9983
).))+!)× ).)))3!

Stock 1 (𝑤! ) Stock 2 (𝑤/ )

Stock 1 (𝑤! ) 𝑤!" 𝜎!" 𝑤! 𝑤" 𝜌!" 𝜎! 𝜎"
Stock 2 (𝑤" ) 𝑤! 𝑤" 𝜌!" 𝜎! 𝜎" 𝑤"" 𝜎""

𝑉𝑎𝑟 𝑅 4 = 𝑤!" 𝜎!" + 𝑤"" 𝜎"" + 2𝑤! 𝑤" 𝜌!" 𝜎! 𝜎"

= 0.6" ×0.0031 + 0.4" ×0.00071 + 2×0.6×0.4×0.9983× 0.0031× 0.00071 = 0.0019

FINA1310 Lecture 6: Return, Risk and the Capital Market 59

Portfolio Return and Variance
• Example
You are investing in three stocks.
Stock 1: $20 per share; expected return 𝐸 𝑅# = 20%; variance 𝜎#Q = 25%;
Stock 2: $5 per share; expected return 𝐸 𝑅Q = 12%; variance 𝜎QQ = 16%;
Stock 3: $10 per share; expected return 𝐸 𝑅Z = 18%; variance 𝜎ZQ = 20.25%.
The correlations between each pair of stocks are 𝜌#Q = 0.3; 𝜌QZ = 0.1; 𝜌#Z = 0.6.

What is the portfolio expected return and variance if you buy 500 shares of Stock 1,
1,000 shares of Stock 2, and you further short sell 500 shares of Stock 3?

FINA1310 Lecture 6: Return, Risk and the Capital Market 60

Portfolio Return and Variance
Stock 1: $20 per share; expected return 𝐸 𝑅' = 20%; variance 𝜎') = 25%;
Stock 2: $5 per share; expected return 𝐸 𝑅) = 12%; variance 𝜎)) = 16%;
Stock 3: $10 per share; expected return 𝐸 𝑅6 = 18%; variance 𝜎6) = 20.25%.
The correlations between each pair of stocks are 𝜌') = 0.3; 𝜌)6 = 0.1; 𝜌'6 = 0.6.
What is the portfolio expected return and variance if you buy 500 shares of Stock 1, 1,000 shares of
Stock 2, and you further short sell 500 shares of Stock 3?
$"1×311
• 𝑤! = =1
$"1×3114$3×!,1116$!1×311
$3×!,111
• 𝑤" = = 0.5
$"1×3114$3×!,1116$!1×311
6$!1×311
• 𝑤7 = = −0.5
$"1×3114$3×!,1116$!1×311

• 𝐸 𝑅8 = 𝑤! 𝐸 𝑅! + 𝑤" 𝐸 𝑅" + 𝑤7 𝐸 𝑅7 = 17%

• 𝑉𝑎𝑟 𝑅8 = 𝑤!" 𝜎!" + 𝑤"" 𝜎"" + 𝑤7" 𝜎7" + 2𝑤! 𝑤" 𝜌!" 𝜎! 𝜎" + 2𝑤" 𝑤7 𝜌"7 𝜎" 𝜎7 + 2𝑤! 𝑤7 𝜌!7 𝜎! 𝜎7 = 25.66%

FINA1310 Lecture 6: Return, Risk and the Capital Market 61

Portfolio Return and Variance
• Example
You are investing in two stocks.
Stock 1: $20 per share; expected return 𝐸 𝑅# = 20%; variance 𝜎#Q = 25%;
Stock 2: $5 per share; expected return 𝐸 𝑅Q = 12%; variance 𝜎QQ = 16%.
The risk-free rate is 5%. The correlation between the two stocks is 𝜌#Q = 0.3.

What is the portfolio expected return and variance if you buy 500 shares of Stock 1,
1,000 shares of Stock 2, and you borrow $5,000 at the risk-free rate?

FINA1310 Lecture 6: Return, Risk and the Capital Market 62

Portfolio Return and Variance
Stock 1: $20 per share; expected return 𝐸 𝑅' = 20%; variance 𝜎') = 25%;
Stock 2: $5 per share; expected return 𝐸 𝑅) = 12%; variance 𝜎)) = 16%.
The risk-free rate is 5%. The correlation between the two stocks is 𝜌') = 0.3.
What is the portfolio expected return and variance if you buy 500 shares of Stock 1, 1,000 shares of
Stock 2, and you borrow $5,000 at the risk-free rate?
$"1×311
• 𝑤! = =1
$"1×3114$3×!,1116$3,111
$3×!,111
• 𝑤" = $"1×3114$3×!,1116$3,111 = 0.5
6$3,111
• 𝑤7 = $"1×3114$3×!,1116$3,111 = −0.5

• 𝐸 𝑅8 = 𝑤! 𝐸 𝑅! + 𝑤" 𝐸 𝑅" + 𝑤7 𝑅9 = 23.5%

• 𝑉𝑎𝑟 𝑅8 = 𝑤!" 𝜎!" + 𝑤"" 𝜎"" + 2𝑤! 𝑤" 𝜌!" 𝜎! 𝜎" = 35%

FINA1310 Lecture 6: Return, Risk and the Capital Market 63

Portfolio Mean-Variance Analysis
• Expected Return: Asset payoff
• Variance/ Standard deviation: Asset risk
Higher Return,
Lower Risk

Expected Return

Standard Deviation
FINA1310 Lecture 6: Return, Risk and the Capital Market 64
Portfolio Mean-Variance Analysis
• Example: two risky assets

Expected Return

Standard Deviation

FINA1310 Lecture 6: Return, Risk and the Capital Market 65

Today’s Roadmap
• Return and Risk: observing the capital markets
‒ Calculating the historical return and variance
‒ The Historical Return and Risk in the markets
• Market Efficiency Theories
• Expected Returns and Variances
‒ Single assets
‒ Portfolios
• Diversification and Portfolio Risk
• Capital Asset Pricing Model (CAPM)
• Textbook Reading: Chapter 12, 13

FINA1310 Lecture 6: Return, Risk and the Capital Market 66

Diversification
• If we have n assets, all with expected return E(R)=0.2 and standard deviation
σ=0.1. For an equal-weighted portfolio, what is the portfolio expected return and
variance if the correlation between any two assets is ρ=0.5?
#
E(𝑹𝒑 )=𝑛× \ ×𝐸(𝑅) = 0.2
# Q \(\]#) # \]#
𝑽𝒂𝒓 𝑹𝒑 =𝑛× \ ×𝜎 Q + \5 ×𝜌𝜎 Q = \ 𝜎 Q + \ 𝜌𝜎 Q
# \]# #
=\ ×0.01 + \ ×0.005 = 0.005× 1 + \

• How does n affects the portfolio variance?

n ↑ ⟹ 𝑉𝑎𝑟 𝑅6 ↓

FINA1310 Lecture 6: Return, Risk and the Capital Market 67

Diversification
• If we have n assets, all with standard deviation σ=0.1 and the correlation
between any two assets is ρ:
𝒑
1 Q 𝑛−1 Q 1−𝜌
𝑽𝒂𝒓 𝑹 = 𝜎 + 𝜌𝜎 = + 𝜌 𝜎Q
𝑛 𝑛 𝑛
• When 0<ρ<1:
lim 𝑉𝑎𝑟 𝑅6 = 𝜌𝜎 Q
\→_
• When ρ=1:
𝑉𝑎𝑟 𝑅6 = 𝜎 Q = 0.01

• When ρ=0:
#
𝑉𝑎𝑟 𝑅6 = \ 𝜎 Q
lim 𝑉𝑎𝑟 𝑅6 = 0
\→_

FINA1310 Lecture 6: Return, Risk and the Capital Market 68

Diversification
0.012

𝜌=1
0.01

Portfolio Variance 0.008

0.006
𝜌 = 0.5

0.004

0.002

𝜌=0
0
1 6 11 16 21 26 31
Number of assets: n

FINA1310 Lecture 6: Return, Risk and the Capital Market 69

Diversification
By randomly selecting
NYSE stocks:

FINA1310 Lecture 6: Return, Risk and the Capital Market 70

Diversification

FINA1310 Lecture 6: Return, Risk and the Capital Market 71

Diversification
• Principle of Diversification:
‒ Adding more assets into the portfolio can reduce portfolio risk without reducing portfolio
expected return (by an equivalent extent)

• Intuition:
‒ When one asset falls into a bad state and realizes a low return, other assets may still be in
good states and have high returns, which offsets the lower return for the first asset

• Notice:
‒ The less correlated are the portfolio assets, the better the effect of diversification
‒ When all portfolio assets are perfectly correlated then there is no diversification effect
‒ There is a minimum level of risk that cannot be eliminated through diversification

FINA1310 Lecture 6: Return, Risk and the Capital Market 72

Today’s Roadmap
• Return and Risk: observing the capital markets
‒ Calculating the historical return and variance
‒ The Historical Return and Risk in the markets
• Market Efficiency Theories
• Expected Returns and Variances
‒ Single assets
‒ Portfolios
• Diversification and Portfolio Risk
• Capital Asset Pricing Model (CAPM)
• Textbook Reading: Chapter 12, 13

FINA1310 Lecture 6: Return, Risk and the Capital Market 73

Risk
• Systematic Risk:
‒ The type of risk that affects many assets (market risk)
‒ It cannot be eliminated through diversification (undiversifiable risk)
‒ e.g. uncertainty with GDP, inflation, interest rate, …

• Unsystematic Risk:
‒ The type of risk that only affects one single asset or a small group of assets
(idiosyncratic risk)
‒ It can be eliminated through diversification (diversifiable risk)
‒ e.g. CEO death, accidents during production, …

FINA1310 Lecture 6: Return, Risk and the Capital Market 74

Risk
• What the variance and standard deviation measure is the total risk:

Total Risk = Systematic Risk + Unsystematic Risk

• For one single asset or a portfolio with a small number of assets:

‒ Total risk could include a significant portion of unsystematic risk
• For a well-diversified portfolio with many assets:
‒ Total risk is essentially all systematic risk, as the unsystematic part is almost all
diversified away

FINA1310 Lecture 6: Return, Risk and the Capital Market 75

Risk and Return
• The Systematic Risk Principle:
‒ The reward for bearing risk is only determined by the systematic risk

Total Risk = Systematic Risk + Unsystematic Risk

Expected Return = Risk-Free Rate + Risk Premium

Expected Return = Risk-Free Rate + Amount of systematic risk × Risk premium for
every unit of systematic risk

FINA1310 Lecture 6: Return, Risk and the Capital Market 76

Measuring Systematic Risk: Beta
• Beta (β):
‒ How much systematic risk a particular asset has relative to average
• Measuring Beta:
Benchmark: The Market Portfolio
‒ A portfolio made of all assets in the market, with weights equal to the asset
market value
• Market Beta:
𝛽𝑀 = 1
• Beta of asset 𝑖:
𝑪𝒐𝒗(𝑹𝒊 , 𝑹𝑴 ) 𝝈𝒊
𝜷𝒊 = 𝑽𝒂𝒓(𝑹𝑴 )
= 𝝆𝒊𝑴 𝝈
𝑴

FINA1310 Lecture 6: Return, Risk and the Capital Market 77

Measuring Systematic Risk: Beta
Implication of Beta:

• The higher beta is, the higher the systematic risk

‒ β = 1:
§ The asset has the same systematic risk as the overall market
‒ β > 1:
§ The asset has more systematic risk than the overall market
‒ β < 1:
§ The asset has less systematic risk than the overall market

FINA1310 Lecture 6: Return, Risk and the Capital Market 78

Measuring Systematic Risk: Beta

FINA1310 Lecture 6: Return, Risk and the Capital Market 79

Measuring Systematic Risk: Beta
• Example:
Which of the following two assets has:
1) Higher total risk?
2) Higher systematic risk?
3) Higher risk premium?
4) Higher expected return?

Standard Deviation Beta

Asset A 20% 1.2
Asset B 30% 0.6

FINA1310 Lecture 6: Return, Risk and the Capital Market 80

Portfolio Beta
1) Find the beta of each asset in the portfolio
2) Portfolio Beta equals to the weighted average of these asset betas

𝜷𝒑 =∑𝑺𝒊V𝟏 𝒘𝒊 𝜷𝒊

Portfolio Weight
Stock 1 𝑤!
Stock 2 𝑤"
…
Stock S 𝑤(

FINA1310 Lecture 6: Return, Risk and the Capital Market 81

Portfolio Beta
• Example:
You are thinking of buying the following four stocks by:
1) 200 shares of stock A
2) 400 shares of stock B
3) 50 shares of stock C
4) 500 shares of stock D
What is the beta of this portfolio?

Price per Share Beta

Stock A $20 1.2
Stock B $5 0.6
Stock C $100 2.8
Stock D $10 0.3

FINA1310 Lecture 6: Return, Risk and the Capital Market 82

Portfolio Beta
• Example:
You are thinking of buying the following four stocks by:
1) 200 shares of stock A
2) 400 shares of stock B
3) 50 shares of stock C
4) 500 shares of stock D
What is the beta of this portfolio?
Price per Share Beta Portfolio Weight Beta × Weight
Stock A $20 1.2 0.25 0.3
Stock B $5 0.6 0.125 0.075
Stock C $100 2.8 0.3125 0.875
Stock D $10 0.3 0.3125 0.09375
Portfolio 𝛽8 = 1.34375

FINA1310 Lecture 6: Return, Risk and the Capital Market 83

Risk and Return
• The Systematic Risk Principle:
‒ The reward for bearing risk is only determined by the systematic risk

Total Risk = Systematic Risk + Unsystematic Risk

Expected Return = Risk-Free Rate + Risk Premium

Expected Return = Risk-Free Rate + Amount of systematic risk (β) × Risk premium
for every unit of systematic risk

FINA1310 Lecture 6: Return, Risk and the Capital Market 84

Capital Asset Pricing Model (CAPM)
Expected Return = Risk-Free Rate + Amount of systematic risk (β) × Risk premium
for every unit of systematic risk
• Market Beta:
𝛽𝑀 = 1
• Market Expected Return:
𝐸 𝑅= = 𝑅> + 𝛽= ×Risk Premium for 1 Unit of Systematic Risk
• Risk Premium for 1 Unit of Systematic Risk:
𝐸 𝑅e − 𝑅f
• Expected Return:
𝑬 𝑹 𝒊 = 𝑹 𝒇 + 𝜷𝒊 × 𝑬 𝑹 𝑴 − 𝑹 𝒇

FINA1310 Lecture 6: Return, Risk and the Capital Market 85

Capital Asset Pricing Model (CAPM)
• CAPM:
𝑬 𝑹 𝒊 = 𝑹 𝒇 + 𝜷𝒊 × 𝑬 𝑹 𝑴 − 𝑹 𝒇
‒ 𝑅> :
§ Risk-free rate
§ Measuring the pure time value of money
‒ 𝐸 𝑅= − 𝑅> :
§ Market risk premium
§ Measuring the reward for bearing the market systematic risk
‒ 𝛽? :
§ Beta for asset 𝑖
§ Measuring the amount of systematic risk

• The expected return only depends on the systematic risk

• The CAPM works for both individual assets and portfolios

FINA1310 Lecture 6: Return, Risk and the Capital Market 86

Capital Asset Pricing Model (CAPM)
• Example
A stock has a beta coefficient 1.5. If the risk-free rate is 3% and the expected return
of the market portfolio is 15%, what is the expected return of this stock?

𝐸 𝑅 = 𝑅Y + 𝛽× 𝐸 𝑟Z − 𝑅Y
= 0.03 + 1.5× 0.15 − 0.03 = 21%

FINA1310 Lecture 6: Return, Risk and the Capital Market 87

Capital Asset Pricing Model (CAPM)
• Example
A stock’s expected return is 25%. If the risk-free rate is 5% and the expected return
of the market portfolio is 20%, what is the beta of this stock?

𝐸 𝑅 = 𝑅Y + 𝛽× 𝐸 𝑟Z − 𝑅Y
𝐸 𝑅 − 𝑅Y 0.25 − 0.05
𝛽= = = 1.33
𝐸 𝑟Z − 𝑅Y 0.20 − 0.05

FINA1310 Lecture 6: Return, Risk and the Capital Market 88

The Security Market Line

Expected Return Slope: 𝐸 𝑅; − 𝑅9

𝑅;

𝑅9

𝛽; = 1 Beta

FINA1310 Lecture 6: Return, Risk and the Capital Market 89

The Security Market Line
• Example:

Expected Return
Slope:
𝐸 𝑅; − 𝑅9 = 12%
𝑅; = 15%

𝑅9 = 3%

𝛽; = 1 Beta

FINA1310 Lecture 6: Return, Risk and the Capital Market 90

The Security Market Line
• Example:

Expected Return
Slope:
𝐸 𝑅; − 𝑅9 = 12%
𝑅; = 15%
Stock A:
𝐸(𝑅$ ) = 15%; 𝛽$ = 1.5
𝑅9 = 3%

𝛽; = 1 Beta

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The Security Market Line
• Example:
Slope:

Expected Return
𝐸 𝑅; − 𝑅9 = 12%

Slope:
𝐸 𝑅$ − 𝑅9
= 8%
𝑅; = 15% 𝛽$
Stock A:
𝐸(𝑅$ ) = 15%; 𝛽$ = 1.5
𝑅9 = 3%

𝛽; = 1 Beta

FINA1310 Lecture 6: Return, Risk and the Capital Market 92

The Security Market Line
• Example
If you have $1,000, think about the following two investment:
• Investment I:
Buy $1,000 worth of Stock A
• Investment II:
Borrow $500 at the risk-free rate and invest $1,500 worth of the market
portfolio

• Which one should you choose?

FINA1310 Lecture 6: Return, Risk and the Capital Market 93

The Security Market Line
• Example
If you have $1,000, think about the following two investment:
• Investment I:
Buy $1,000 worth of Stock A
§ 𝑅@ = 15%
§ 𝛽@ = 1.5
• Investment II:
Borrow $500 at the risk-free rate and invest $1,500 worth of the market
portfolio
§ 𝑤> = −0.5; 𝑤= = 1.5
§ 𝑅@@ = 𝑤> ×𝑅> + 𝑤= ×𝑅= = 21%
§ 𝛽@@ = 𝑤> ×𝛽> + 𝑤= ×𝛽= = 1.5

FINA1310 Lecture 6: Return, Risk and the Capital Market 94

The Security Market Line
• Example:

Expected Return
The new return of A:
𝑅9 + 𝛽$ ×[𝐸 𝑅; − 𝑅9 ] = 21%
Slope:
𝐸 𝑅; − 𝑅9 = 12%
𝑅; = 15%
Stock A

𝑅9 = 3%

𝛽; = 1 Beta

FINA1310 Lecture 6: Return, Risk and the Capital Market 95

The Security Market Line
• Example:
Stock B:

Expected Return
𝐸(𝑅% ) = 24%; 𝛽% = 1.5

Slope:
𝐸 𝑅; − 𝑅9 = 12%
𝑅; = 15%

𝑅9 = 3%

𝛽; = 1 Beta

FINA1310 Lecture 6: Return, Risk and the Capital Market 96

The Security Market Line
• Example:
Slope:
Stock B: 𝐸 𝑅% − 𝑅9

Expected Return
𝐸(𝑅% ) = 24%; 𝛽% = 1.5 = 14%
𝛽%

Slope:
𝐸 𝑅; − 𝑅9 = 12%
𝑅; = 15%

𝑅9 = 3%

𝛽; = 1 Beta

FINA1310 Lecture 6: Return, Risk and the Capital Market 97

The Security Market Line
• Example
If you have $1,000, think about the following two investment:
• Investment I:
Buy $1,000 worth of the market portfolio
• Investment II:
Buy $667 worth of Stock B and $333 worth of the risk-free asset

• Which one should you choose?

FINA1310 Lecture 6: Return, Risk and the Capital Market 98

The Security Market Line
• Example
If you have $1,000, think about the following two investment:
• Investment I:
Buy $1,000 worth of the market portfolio
§ 𝑅@ = 15%
§ 𝛽@ = 1
• Investment II:
Buy $667 worth of Stock B and $333 worth of the risk-free asset
§ 𝑤> = 1/3; 𝑤3 = 2/3
§ 𝑅@@ = 𝑤> ×𝑅> + 𝑤3 ×𝑅3 = 17%
§ 𝛽@@ = 𝑤> ×𝛽> + 𝑤3 ×𝛽3 = 1

FINA1310 Lecture 6: Return, Risk and the Capital Market 99

The Security Market Line
• Example:
Stock B:

Expected Return
𝐸(𝑅% ) = 24%; 𝛽% = 1.5

Slope:
𝐸 𝑅; − 𝑅9 = 12%
𝑅; = 15% The new return of B:
𝑅9 + 𝛽% ×[𝐸 𝑅; − 𝑅9 ] = 21%

𝑅9 = 3%

𝛽; = 1 Beta

FINA1310 Lecture 6: Return, Risk and the Capital Market 100

The Security Market Line

Expected Return
Slope:
𝐸 𝑅; − 𝑅9
Asset j
𝑅;

Asset i
𝑅9

𝛽; = 1 Beta

FINA1310 Lecture 6: Return, Risk and the Capital Market 101

Fundamental Risk-Return Relationship
• Reward-to-Risk Ratio:
Risk premium for every unit of systematic risk

𝑬 𝑹 − 𝑹𝒇
𝜷
• For any asset 𝑖:
The reward-to-risk ratio equals to the market risk premium
(The slope of the Security Market Line)

𝑬 𝑹𝒊 − 𝑹𝒇
= 𝑬 𝑹𝑴 − 𝑹𝒇
𝜷𝒊

FINA1310 Lecture 6: Return, Risk and the Capital Market 102

Capital Asset Pricing Model (CAPM)
• CAPM:
𝑬 𝑹 𝒊 = 𝑹 𝒇 + 𝜷𝒊 × 𝑬 𝑹 𝑴 − 𝑹 𝒇

What E(R) tells us?

• For investors:
‒ The required return
§ The minimum rate of return that is sufficient to compensate the systematic risk of this asset
§ The minimum rate of return that makes investors willing to invest in this asset relative to other
assets in the market
• For businesses (security issuers):
‒ The cost of capital
§ The minimum cost they need to spend to raise money from investors

FINA1310 Lecture 6: Return, Risk and the Capital Market 103

Next Lecture

• Capital Budgeting
‒ Textbook reading: Chapter 9
(Net Present Value and Other Investment Criteria)

FINA1310 Lecture 6: Return, Risk and the Capital Market 104