Class for bachelor students

Finance (10 ECTS)

Corporate Finance ( 5 ECTS)
Week 6: Capital Markets and the Pricing of Risk (Chapter 10 in Berk/DeMarzo)

Steffen Meyer
stme@[Link]

1
Chapter Outline

10.1 Risk and Return: Insights from 89 Years of Investor History

10.2 Common Measures of Risk and Return
10.3 Historical Returns of Stocks and Bonds
10.4 The Historical Trade-Off Between Risk and Return
10.5 Common Versus Independent Risk
10.6 Diversification in Stock Portfolios
10.7 Measuring Systematic Risk
10.8 Beta and the Cost of Capital

2
Learning Objectives

1. Define a probability distribution, the mean, the variance, the standard

deviation, and the volatility.
2. Compute the realized or total return for an investment.
3. Using the empirical distribution of realized returns, estimate expected
return, variance, and standard deviation (or volatility) of returns.
4. Use the standard error of the estimate to gauge the amount of
estimation error in the average.
5. Discuss the volatility and return characteristics of large stocks versus
large stocks and bonds.
6. Describe the relationship between volatility and return of individual
stocks.

3
Learning Objectives

7. Define and contrast idiosyncratic and systematic risk and the risk
premium required for taking each on.
8. Define an efficient portfolio and a market portfolio.
9. Discuss how beta can be used to measure the systematic risk of a
security.
10. Use the Capital Asset Pricing Model to calculate the expected return for
a risky security.
11. Use the Capital Asset Pricing Model to calculate the cost of capital for a
particular project.
12. Explain why in an efficient capital market the cost of capital depends on
systematic risk rather than diversifiable risk.

4
10.1 Risk and Return: Insights from 89 Years of
Investor History
▪ How would $100 have grown if it were placed in one of the following investments?
▪ Standard & Poor’s 500: 90 U.S. stocks up to 1957 and 500 after that. Leaders in
their industries and among the largest firms traded on U.S. Markets.
▪ Small stocks: Securities traded on the NYSE with market capitalizations in the
bottom 20%.

5
10.1 Risk and Return: Insights from 89 Years of
Investor History (cont’d)
▪ How would $100 have grown if it were placed in one of the following investments?
▪ World Portfolio: International stocks from all the world’s major stock markets in
North America, Europe, and Asia.
▪ Corporate Bonds: Long-term, AAA-rated U.S. corporate bonds with maturities of
approximately 20 years.
▪ Treasury Bills: An investment in three-month Treasury bills.

6
Figure 10.1 Value of $100 Invested at the End of 1925

Source: Chicago Center for Research in Security Prices, Standard and Poor’s, MSCI, and Global Financial Data.

7
10.1 Risk and Return: Insights from 89 Years of
Investor History (cont’d)
▪ Small stocks had the highest long-term returns, while T-Bills had the lowest long-term
returns.
▪ Small stocks had the largest fluctuations in price, while T-Bills had the lowest.
▪ Higher risk requires a higher return.
▪ Few people ever make an investment for 89 years.
▪ More realistic investment horizons and different initial investment dates can greatly
influence each investment's risk and return.

8
Figure 10.2 Value of $100 Invested in Alternative Investment
for Differing Horizons

Source: Chicago Center for Research in Security Prices, Standard and Poor’s, MSCI, and Global Financial Data.

9
10.2 Common Measures of Risk and Return

▪ Probability Distributions
▪ When an investment is risky, it may earn different returns. Each possible return has
some likelihood of occurring. This information is summarized with a probability
distribution, which assigns a probability, PR , that each possible return, R , will occur.
▪ Assume BFI stock currently trades for $100 per share.
In one year, there is a 25% chance the share price will be $140, a 50% chance it
will be $110, and a 25% chance it will be $80.

10
Table 10.1 Probability Distribution of Returns for BFI

11
Figure 10.3 Probability Distribution
of Returns for BFI

12
Expected Return

▪ Expected (Mean) Return

▪ Calculated as a weighted average of the
possible returns, where the weights correspond
to the probabilities.

Expected Return = E  R =  R
PR  R

E  RBFI  = 25%( − 0.20) + 50%(0.10) + 25%(0.40) = 10%

13
Variance and Standard Deviation

▪ Variance
▪ The expected squared deviation from the mean

Var (R) = E ( R − E  R )  =

 (R − E  R )
2 2
PR 
  R

▪ Standard Deviation
▪ The square root of the variance

▪ Both are measures of the risk of a probability distribution

SD( R) = Var ( R)

14
Variance and Standard Deviation (cont'd)

▪ For BFI, the variance and standard deviation are

Var  RBFI  = 25%  ( − 0.20 − 0.10)2 + 50%  (0.10 − 0.10)2

+ 25%  (0.40 − 0.10)2 = 0.045

SD( R) = Var ( R) = 0.045 = 21.2%

▪ In finance, the standard deviation of a return is also referred

to as its volatility. The standard deviation is easier to
interpret because it is in the same units as the returns
themselves.

15
Textbook Example 10.1

16
Textbook Example 10.1 (cont'd)

17
 Alternative Example 10.1

▪ Problem
▪ TXU stock is has the following probability distribution:

Probability Return
.25 8%
.55 10%
.20 12%

▪ What are its expected return and standard deviation?

18
Alternative Example 10.1 (cont’d)

▪ Solution
▪ Expected Return
▪ E[R] = (0.25)(0.08) + (0.55)(0.10) + (0.20)(0.12)
▪ E[R] = 0.020 + 0.055 + 0.024 = 0.099 = 9.9%
▪ Standard Deviation
▪ SD(R) = [(0.25)(0.08 – 0.099)2 + (0.55)(0.10 –
0.099)2 + (0.20)(0.12 – 0.099)2]1/2
▪ SD(R) = [0.00009025 + 0.00000055 + 0.0000882]1/2
▪ SD(R) = 0.0001791/2 = 0.01338 = 1.338%

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Figure 10.4 Probability Distributions for BFI and AMC
Returns

20
10.3 Historical Returns
of Stocks and Bonds
▪ Computing Historical Returns
▪ Realized Return
▪ The return that actually occurs over a particular time period.

Divt + 1 + Pt + 1 Divt + 1 Divt + 1 − Pt

Rt + 1 = − 1 = +
Pt Pt Pt
= Dividend Yield + Capital Gain Rate

21
10.3 Historical Returns
of Stocks and Bonds (cont'd)
▪ Computing Historical Returns
▪ If you hold the stock beyond the date of the first dividend, then to compute your
return you must specify how you invest any dividends you receive in the interim.
Let’s assume that all dividends are immediately reinvested and used to purchase
additional shares of the same stock or security.

22
10.3 Historical Returns
of Stocks and Bonds (cont'd)
▪ Computing Historical Returns
▪ If a stock pays dividends at the end of each quarter, with realized returns RQ1, . . .
,RQ4 each quarter, then its annual realized return, Rannual, is computed as follows:

1 + Rannual = (1 + RQ1 )(1 + RQ 2 )(1 + RQ3 )(1 + RQ 4 )

23
Textbook Example 10.2

24
Textbook Example 10.2 (cont'd)

25
Alternative Example 10.2

▪ Problem
▪ What were the realized annual returns for NRG stock in 2012 and in 2016?

26
Alternative Example 10.2 (cont’d)

▪ Solution
▪ First, we look up stock price data for NRG at the start and end of the year, as well as
dividend dates. From these data, we construct the following table:

Date Price ($) Dividend ($) Return Date Price ($) Dividend ($) Return
12/31/2011 58.69 12/31/2015 6.73 0
1/31/2012 61.44 0.26 5.13% 3/31/2016 5.72 0 -15.01%
4/30/2012 63.94 0.26 4.49% 6/30/2016 4.81 0 -15.91%
7/31/2012 48.5 0.26 -23.74% 9/30/2016 5.2 0 8.11%
10/31/2012 54.88 0.29 13.75% 12/31/2016 2.29 0 -55.96%
12/31/2012 53.31 -2.86%

27
Alternative Example 10.2 (cont’d)

▪ Solution
▪ We compute each period’s return using Equation 10.4. For example, the return from
December 31, 2011, to January 31, 2012, is

▪ We then determine annual returns using Eq. 10.5:

61.44 + 0.26
− 1 = 5.13%
58.69

R2012 = (1.0513)(1.0449)(0.7626)(1.1375)(0.9714) − 1 = −7.43%

R2016 = (0.8499)(0.8409)(1.0811)(0.440) − 1 = −66.0%

28
Alternative Example 10.2 (cont’d)

▪ Solution
▪ Note that, since NRG did not pay dividends during 2016, the return can also be
computed as follows:

2.29
− 1 = −66.0%
6.73

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Table 10.2 Realized Return for the S&P 500, Microsoft, and Treasury
Bills, 2002–2014

30
10.3 Historical Returns
of Stocks and Bonds (cont'd)
▪ Computing Historical Returns
▪ By counting the number of times a realized return falls within a particular range, we
can estimate the underlying probability distribution.
▪ Empirical Distribution
▪ When the probability distribution is plotted using
historical data

31
Figure 10.5 The Empirical Distribution of Annual
Returns for U.S. Large Stocks (S&P 500), Small Stocks, Corporate Bonds,
and Treasury Bills, 1926–2014

32
Table 10.3 Average Annual Returns for U.S. Small Stocks, Large
Stocks (S&P 500), Corporate Bonds, and Treasury Bills, 1926–2014

33
Average Annual Return

1 1 T
R =
T
( R1 + R2 + + RT ) = 
T t =1
Rt

▪ Where Rt is the realized return of a security in year t, for the years 1 through T
▪ Using the data from Table 10.2, the average annual return for the S&P 500
from 2002-2014 is as follows:

1
R = ( − 0.221 + 0.287 + 0.109 + 0.109 + 0.158 + 0.055 − 0.370
13
+ 0.265 + 0.151 + 0.021 + 0.160 + 0.324 + 0.137) = 8.7%

34
The Variance and Volatility of Returns

▪ Variance Estimate Using Realized Returns

T

 (R − R)
1 2
Var (R) =
T − 1
t
t =1
▪ The estimate of the standard deviation is the square root of the variance.

35
Textbook Example 10.3

36
Textbook Example 10.3 (cont'd)

37
Alternative Example 10.3

▪ Problem:
▪ Using the data from Table 10.2, what are the variance and standard deviation of
Microsoft’s returns from 2004 to 2014?

38
Alternative Example 10.3 (cont’d)

▪ Solution:
▪ First, we need to calculate the average return for Microsoft’s over that time period,
using equation 10.6:

1
R = (−0.9% + 15.8% + 20.8% − 44.4% + 60.5%
10
− 6.5% − 4.5% + 5.8% + 44.2% + 27.5%)
= 11.8%

39
Alternative Example 10.3 (cont’d)

Next, we calculate the variance using equation 10.7:

1
Var(R) =  t ( Rt -R)
2

T −1
1
= (−0.90% − 11.8%) 2 + (15.8% − 11.8%) 2 + ... + (27.5% − 11.8%) 2 
10 − 1
= 7.72%

The standard deviation is therefore

SD(R) = Var(R) = 7.72% = 27.79%

40
Table 10.4 Volatility of U.S. Small Stocks, Large
Stocks (S&P 500), Corporate Bonds, and Treasury
Bills, 1926–2014

41
Estimation Error: Using Past Returns to Predict the Future

▪ We can use a security’s historical average return to estimate its actual expected return.
However, the average return is just an estimate of the expected return.
▪ Standard Error
▪ A statistical measure of the degree of estimation error

42
Estimation Error: Using Past Returns to Predict the
Future (cont'd)
▪ Standard Error of the Estimate of the
Expected Return
SD(Individual Risk)
SD(Average of Independent, Identical Risks) =
Number of Observations
▪ 95% Confidence Interval

Historical Average Return  (2  Standard Error)

▪ For the S&P 500 (1926–2014)

 20.1% 
12.0%  2   = 12.0%  4.3%
 89 
▪ or a range from 7.7% to 16.3%

43
Textbook Example 10.4

44
Textbook Example 10.4 (cont'd)

45
Alternative Example 10.4

▪ Problem:
▪ Using the data from Alternative Example 10.3, what is the 95% confidence interval
you would estimate for Microsoft’s expected return?

46
Alternative Example 10.4 (cont’d)

▪ Solution:
▪ The 95% confidence interval for Microsoft’s expected return is calculated as follows:

 27.79% 
11.8%  2   = 11.8%  17.6%
 10 

▪ Or a range from -5.8% to 29.4%

47
10.4 The Historical Trade-Off
Between Risk and Return
▪ The Returns of Large Portfolios
▪ Excess Returns
▪ The difference between the average return for an investment and the average
return for T-Bills

48
Table 10.5 Volatility Versus Excess Return of U.S. Small
Stocks, Large Stocks (S&P 500), Corporate Bonds, and
Treasury Bills, 1926–2014

49
Figure 10.6 The Historical Trade-Off Between Risk
and Return in Large Portfolios

Source: CRSP, Morgan Stanley Capital International

50
The Returns of Individual Stocks

▪ Is there a positive relationship between volatility and average returns for individual
stocks?
▪ As shown on the next slide, there is no precise relationship between volatility and
average return for individual stocks.
▪ Larger stocks tend to have lower volatility than
smaller stocks.
▪ All stocks tend to have higher risk and lower returns than large portfolios.

51
Figure 10.7 Historical Volatility and Return for 500
Individual Stocks, Ranked Annually by Size

Source: CRSP

52
10.5 Common Versus Independent Risk

▪ Common Risk
▪ Risk that is perfectly correlated
▪ Risk that affects all securities
▪ Independent Risk
▪ Risk that is uncorrelated
▪ Risk that affects a particular security
▪ Diversification
▪ The averaging out of independent risks in a
large portfolio

53
Textbook Example 10.5

54
Textbook Example 10.5 (cont'd)

55
10.6 Diversification in Stock Portfolios

▪ Firm-Specific Versus Systematic Risk

▪ Firm Specific News
▪ Good or bad news about an individual company

▪ Market-Wide News
▪ News that affects all stocks, such as news about
the economy

56
10.6 Diversification
in Stock Portfolios (cont'd)
▪ Firm-Specific Versus Systematic Risk
▪ Independent Risks
▪ Due to firm-specific news
▪ Also known as
▪ Firm-Specific Risk
▪ Idiosyncratic Risk
▪ Unique Risk
▪ Unsystematic Risk
▪ Diversifiable Risk

57
10.6 Diversification
in Stock Portfolios (cont'd)
▪ Firm-Specific Versus Systematic Risk
▪ Common Risks
▪ Due to market-wide news
▪ Also known as
▪ Systematic Risk
▪ Undiversifiable Risk
▪ Market Risk

58
10.6 Diversification
in Stock Portfolios (cont'd)
▪ Firm-Specific Versus Systematic Risk
▪ When many stocks are combined in a large portfolio, the firm-specific risks for each
stock will average out and be diversified.
▪ The systematic risk, however, will affect all firms and will not be diversified.

59
10.6 Diversification
in Stock Portfolios (cont'd)
▪ Firm-Specific Versus Systematic Risk
▪ Consider two types of firms:
▪ Type S firms are affected only by systematic risk. There is a 50% chance the
economy will be strong and type S stocks will earn a return of 40%. There is a
50% change the economy will be weak and their return will be –20%. Because
all these firms face the same systematic risk, holding a large portfolio of type S
firms will not diversify the risk.

60
10.6 Diversification
in Stock Portfolios (cont'd)
▪ Firm-Specific Versus Systematic Risk
▪ Consider two types of firms:
▪ Type I firms are affected only by firm-specific risks. Their returns are equally
likely to be 35% or –25%, based on factors specific to each firm’s local market.
Because these risks are firm specific, if we hold a portfolio of the stocks of many
type I firms, the risk is diversified.

61
10.6 Diversification
in Stock Portfolios (cont'd)
▪ Firm-Specific Versus Systematic Risk
▪ Actual firms are affected by both market-wide risks and firm-specific risks. When
firms carry both types of risk, only the unsystematic risk will be diversified when
many firm’s stocks are combined into a portfolio. The volatility will therefore decline
until only the systematic risk remains.

62
Figure 10.8 Volatility of Portfolios
of Type S and I Stocks

63
Textbook Example 10.6

64
Textbook Example 10.6 (cont'd)

65
No Arbitrage and the Risk Premium

▪ The risk premium for diversifiable risk is zero, so investors are not compensated for
holding firm-specific risk.
▪ If the diversifiable risk of stocks were compensated with an additional risk premium,
then investors could buy the stocks, earn the additional premium, and
simultaneously diversify and eliminate the risk.
▪ By doing so, investors could earn an additional premium without taking on additional
risk. This opportunity to earn something for nothing would quickly be exploited and
eliminated. Because investors can eliminate firm-specific risk “for free” by
diversifying their portfolios, they will not require or earn a reward or risk premium for
holding it.
▪ This implies that a stock’s volatility, which is a measure of total risk (that is,
systematic risk plus diversifiable risk), is not especially useful in determining the risk
premium that investors will earn.

66
No Arbitrage
and the Risk Premium (cont'd)
▪ Standard deviation is not an appropriate measure of risk for an individual security. There
should be no clear relationship between volatility and average returns for individual
securities. Consequently, to estimate a security’s expected return, we need to find a
measure of a security’s systematic risk.

67
Textbook Example 10.7

68
Textbook Example 10.7 (cont'd)

69
10.7 Measuring Systematic Risk

▪ To measure the systematic risk of a stock, determine how much of the variability of its
return is due to systematic risk versus unsystematic risk.
▪ To determine how sensitive a stock is to systematic risk, look at the average change
in the return for each 1% change in the return of a portfolio that fluctuates solely due
to systematic risk.

70
10.7 Measuring Systematic Risk (cont'd)

▪ Efficient Portfolio
▪ A portfolio that contains only systematic risk. There is no way to reduce the volatility
of the portfolio without lowering its expected return.

▪ Market Portfolio
▪ An efficient portfolio that contains all shares and securities in the market
▪ The S&P 500 is often used as a proxy for the
market portfolio.

71
10.7 Measuring Systematic Risk (cont'd)

▪ Sensitivity to Systematic Risk: Beta (β)

▪ The expected percent change in the excess return of a security for a
1% change in the excess return of the market portfolio.
▪ Beta differs from volatility. Volatility measures total risk (systematic
plus unsystematic risk), while beta is a measure of only systematic
risk.

72
Textbook Example 10.8

73
Textbook Example 10.8 (cont'd)

74
Alternative Example 10.8

▪ Problem
▪ Suppose the market portfolio tends to increase by 52% when the economy is strong
and decline by 21% when the economy is weak.
▪ What is the beta of a type S firm whose return is 55% on average when the
economy is strong and -24% when the economy is weak?
▪ What is the beta of a type I firm that bears only idiosyncratic, firm-specific risk?

75
Alternative Example 10.8 (cont’d)

▪ Solution
▪ The systematic risk of the strength of the economy produces a 52% - (-21%) = 73%
change in the return of the market portfolio.
▪ The type S firm’s return changes by 55% -
(-24%) = 79% on average.
▪ Thus the firm’s beta is βS = 79%/73% = 1.082. That is, each 1% change in the return
of the market portfolio leads to a 1.082% change in the type S firm’s return on
average.

76
Alternative Example 10.8 (cont’d)

▪ Solution
▪ The return of a type I firm has only firm-specific risk, however, and so is not affected
by the strength of the economy. Its return is affected only by factors specific to the
firm.
▪ Because it will have the same expected return, whether the economy is strong or
weak, βI = 0%/72% = 0.

77
Table 10.6 Betas with Respect to the S&P 500 for Individual Stocks
(based on monthly data for 2010–2015)

78
Table 10.6 Betas with Respect to the S&P 500 for Individual Stocks
(based on monthly data for 2010–2015) (cont’d)

79
10.7 Measuring Systematic Risk (cont'd)

▪ Interpreting Beta (β)

▪ A security’s beta is related to how sensitive its underlying revenues and cash flows
are to general economic conditions. Stocks in cyclical industries are likely to be
more sensitive to systematic risk and have higher betas than stocks in less sensitive
industries.

80
10.8 Beta and the Cost of Capital

▪ Estimating the Risk Premium

▪ Market risk premium
▪ The market risk premium is the reward investors expect to earn for holding a
portfolio with a beta of 1.

Market Risk Premium = E  RMkt  − rf

81
10.8 Beta and Cost of Capital (cont'd)

▪ Adjusting for Beta

▪ Estimating a Traded Security’s Cost of Capital of an investment from Its Beta

E  R  = Risk-Free Interest Rate + Risk Premium

= rf +   (E  RMkt  − rf )

Equation10.11 is often referred to as the

Capital Asset Pricing Model (CAPM).

It is the most important method for estimating the cost of capital that is used in practice.

82
Textbook Example 10.9

83
Textbook Example 10.9 (cont'd)

84
Alternative Example 10.9

▪ Problem
▪ Assume the economy has a 60% chance of the market return will 15% next year and
a 40% chance the market return will be 5% next year.
▪ Assume the risk-free rate is 6%.
▪ If Microsoft’s beta is 1.18, what is its expected return next year?

85
Alternative Example 10.9 (cont’d)

▪ Solution
▪ E[RMkt] = (60% × 15%) + (40% × 5%) = 11%
▪ E[R] = rf + β ×(E[RMkt] − rf )
▪ E[R] = 6% + 1.18 × (11% − 6%)
▪ E[R] = 6% + 5.9% = 11.9%

86
Discussion of Data Case Key Topic

Find the betas for each of the 12 stocks listed in the data case. How do the
firms compare when ranked by beta as opposed to the standard deviations
you calculated?

Sources for betas available free on the web:

▪ Yahoo! Finance
▪ Value Line
▪ Google Finance

87
Chapter Quiz

1. From 1926 to 2014, which of the following investments had the highest
return: Standard & Poor’s 500, small stocks, world portfolio, corporate
bonds, or Treasury bills?
2. How do we calculate the expected return of a stock?
3. What are the two most common measures of risk, and how are they
related to each other?
4. We have 89 years of data on the S&P 500 returns, yet we cannot
estimate the expected return of the S&P 500 very accurately. Why?
5. Do expected returns of well-diversified large portfolios of stocks appear to
increase with volatility?

88
Chapter Quiz

6. Do expected returns for individual stocks appear to increase with

volatility?
7. What is the difference between common risk and independent risk?
8. Explain why the risk premium of diversifiable risk is zero.
9. Why is the risk premium of a security determined only by its systematic
risk?
[Link] the beta of a security.
[Link] can you use a security’s beta to estimate its cost of capital?
[Link] a risky investment has a beta of zero, what should its cost of capital be
according to the CAPM? How can you justify this?

89