Two Types of Risk

• To summarize our discussion about risk, there are two

types of risk:
– Systematic Risk = Nondiversifiable Risk = Market Risk
– Diversifiable Risk = Idiosyncratic Risk = Firm-specific
Risk = Unsystematic risk
• Idiosyncratic risk can be easily eliminated by
diversification.
• Systematic risk is common to all stocks and cannot be
easily eliminated by diversification.

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 Risk and Risk Premium
• What determines the size of the risk premium on a
risky asset?
• The answer depends on the distinction between
systematic and idiosyncratic risk.
• Since idiosyncratic risk can be easily eliminated at
virtually no cost (by diversifying), there is no reward
for bearing idiosyncratic risk.
• Hence, the risk premium on a risky asset depends
only on the systematic risk, not the total risk. (The
systematic risk principle)

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 Adding a Risk-Free Asset
• The risk-free asset (riskless asset) (an example in the
real world would be the T-Bill) has zero risk and
would be shown on the vertical axis on the mean
variance graph (because of zero standard deviation by
assumption).
• Adding a risk free creates a new set of possible
portfolios. Now we can hold a portfolio of risk-free
asset and any portfolio on the efficient frontier.
• Adding a risk free also creates a new efficient
frontier.

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 Capital Market Line (CML)

Borrowing at rf

Less Risk
Averse Investor
Risk Averse
Investor

Tangent (or Market)

Portfolio

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 Market Portfolio
• With riskless borrowing and lending, the portfolio of
risky assets held by any investor would always be
point T.
• Regardless of an individual investor’s tolerance for
risk, she would never choose any other portfolio on
the efficient portfolio than portfolio T.
• All investors independent of their risk aversion would
be on the tangent line. Where on the tangent line
depends on individual investor’s risk tolerance.

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 Market Portfolio
• The tangent line is called the Capital Market Line.
• Furthermore, if we assume that individual investors
all have the same expectations about returns,
variances and correlations (the assumption of
homogenous expectations), then in the market
equilibrium the sum of everybody’s portfolio of risky
assets is the market portfolio (or tangency portfolio).

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 Measuring Systematic Risk and Beta
• We need a measure of systematic risk to analyze the
relation between risk and expected return.
• A measure of systematic risk should capture the
relation between the market return and the return on
an asset.
• Beta coefficient is an important measure of an asset’s
systematic risk, measured relative to the market
portfolio.
• Remember that the risk premium of an asset depends
only on the systematic risk of that asset, hence higher
the beta, higher the systematic risk and higher the
expected return on that asset.
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 Capital Asset Pricing Model (CAPM)
• Two important reference points
– What is the β of the market portfolio?
– What is the β of the risk-free asset?

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 Portfolio Beta
• Can the β of a portfolio be less than the β of all of its
components?
– Diversification can cancel out idiosyncratic risk, but not systematic risk
measured by β
• The β of a portfolio is simply the weighted average of
the βs of the component assets

 p  w   A  (1  w)   B

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 Example 1
• Suppose you have $1,000,000 to invest. You can
invest in three stocks, Stock A, B and C and the risk-
free asset. The betas of stocks are 0.7, 1.10 and 1.60.
Assume you have already invested $200,000 and
$250,000 in Stocks A and B respectively. How much
do you need to invest in Stock C and the risk-free
asset to create a portfolio equally as risky as the
market?

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 Security Market Line
• Consider possible portfolios formed by combining
Stock A (expected return of 20% and beta of 1.6) with
the risk-free asset (return of 8%). Remember that
risk-free asset has a beta of zero.

Weight of A Exp. Return Beta

0% 8.00% 0
25% 11.00% 0.4
50% 14.00% 0.8
75% 17.00% 1.2
100% 20.00% 1.6
125% 23.00% 2
150% 26.00% 2.4

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 Reward-to-Risk Ratio

Reward-to-Risk Ratio
or
Rf = 8%
Treynor Index

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 Security Market Line
• Now consider another stock with an expected return
of 16% and a beta of 1.2. (Reward-to-Risk for Stock
B is 6.67%=(16%-8%)/1.2.)
• Which stock is better, Stock A or Stock B?
• A is better because B offers inadequate compensation
for its level of systematic risk, i.e. 6.67%<7.50%.

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 Security Market Line

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 Security Market Line
• Everybody would prefer Stock A over Stock B since
Stock A provides a higher return for bearing a unit
systematic risk than Stock B.
• This cannot persist in a well-organized, active and
competitive market because investors would always
prefer Stock A.
• As a result, the price of Stock A will rise whereas the
price of Stock B will fall.
• Since prices and returns move in the opposite
direction, the expected return on Stock A will fall and
B’s will rise.

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 Fundamental Result
• In equilibrium, the reward-to-risk ratio of A and B
should be the same, i.e.

E[ RA ]  rf E[ RB ]  rf

A B

• The reward-to-risk ratio must be the same for all

assets in the market.

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 Capital Asset Pricing Model (CAPM)
• Then, we can write the excess expected return of
asset i as a function of the excess expected market
return

E[ Ri ]  rf   i ( E[ Rm ]  rf )
 im
where i  2
m

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 Calculating Beta
• The beta of a security measures the responsiveness of
that security’s return to the return on the market as a
whole.
• To calculate beta, we draw a line relating the expected
return on the security to different returns on the
market. This line is called the characteristic line and
its slope is the security’s beta.

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 Calculating Beta
• Do a scatter plot of returns on A versus return
on the market portfolio M
• Find a best fit line showing the relationship
• To find the best fit line, we perform a linear
regression (OLS)
RA     A Rm
where α is the intercept and β is the slope (the
measure of systematic risk).

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 Calculating Beta

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 Beta and R2
• In a regression of A on M, the slope coefficient on M
can be calculated as
cov( RA , Rm )
A 
var( Rm )
• The goodness of fit of the model can be calculated as

R  (corr ( RA , Rm ))
2 2

• R2 measures the proportion of total risk that is

systematic.
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 Intuition
• What is the expected return of a stock with β<0?
• What is the expected return of a stock with β=0?
• The intuition behind CAPM is the insurance motives
of risk averse investors.
• Holding a risky asset provides you insurance in
different states of the world that a risk-free asset
cannot do.
• Investors would prefer a stock that pays higher
returns in bad times but not in good times to a stock
that pays higher returns in good times but not in bad
times.

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 Putting it Together
The Price of Risk
• The risk-return relationship must be linear.
• β measures the market risk of a security.
• The Capital Asset Pricing Model (CAPM):

E[ RA ]  rf   A ( Rm  rf )
where
– Rf Risk-free rate (T-bills)
– RM Return on the market
– (RM – Rf)Equity premium

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 The Capital Asset Pricing Model (CAPM)

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 The Capital Asset Pricing Model (CAPM)
• According to CAPM, the expected return on an asset
depends on three things:
– The pure time value of money as measured by the risk-free
rate
– The reward for bearing systematic risk as measured by the
market risk premium
– The amount of systematic risk as measured by beta.

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 Predictions of the CAPM
• Everyone holds the risk free asset and the fully-
diversified market portfolio.

• Weights determined by preference for risk.

• Only market risk is relevant for predicting returns.

• The risk-return tradeoff is linear.

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 Problems With the CAPM
• Not everyone holds the full market portfolio
– Most diversification benefits can be obtained with
relatively few assets
– Mutual funds make diversification easy
• People hold assets that are not in the stock market
(real-estate, human capital).
• Other measures help to predict returns (firm size, time
of year, book-to-market ratios, P/E ratios).
• The measured β is not a very powerful predictor of
returns.
• Roll Critique: The market portfolio is unobservable
so we need to use a proxy. So CAPM is not testable.

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