Slides by

1
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Risk and Return

• Slides by
• Matthew Will

Chapter 8

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
2
Topics Covered

• Markowitz Portfolio Theory
• Risk and Return Relationship
• Testing the CAPM
• CAPM Alternatives

3
Markowitz Portfolio Theory

• Combining stocks into portfolios can reduce
  standard deviation below the level obtained from
  a simple weighted average calculation.
• Correlation coefficients make this possible.
• The various weighted combinations of stocks that
  create this standard deviations constitute the
  set of efficient portfolios.

4
Markowitz Portfolio Theory

• Price changes vs. Normal distribution
• Microsoft - Daily change 1986-1997

of Days (frequency)
Daily Change
5
Markowitz Portfolio Theory

• Price changes vs. Normal distribution
• Microsoft - Daily change 1986-1997

of Days (frequency)
Daily Change
6
Markowitz Portfolio Theory

• Standard Deviation VS. Expected Return
• Investment C

probability
return
7
Markowitz Portfolio Theory

• Standard Deviation VS. Expected Return
• Investment D

probability
return
8
Markowitz Portfolio Theory

• Expected Returns and Standard Deviations
  vary given different weighted combinations of
  the stocks.

Expected Return ()
McDonalds
45 McDonalds
Bristol-Myers Squibb
Standard Deviation
9
Efficient Frontier

• Each half egg shell represents the possible
  weighted combinations for two stocks.
• The composite of all stock sets constitutes the
  efficient frontier.

Expected Return ()
Standard Deviation
10
Efficient Frontier

• Lending or Borrowing at the risk free rate (rf)
  allows us to exist outside the efficient frontier.

Expected Return ()
T
Lending Borrowing
rf
S
Standard Deviation
11
Efficient Frontier

• Example Correlation
  Coefficient .4
• Stocks s of Portfolio Avg Return
• ABC Corp 28 60 15
• Big Corp 42 40 21
• Standard Deviation weighted avg 33.6
• Standard Deviation Portfolio 28.1
• Return weighted avg Portfolio 17.4

12
Efficient Frontier

• Example Correlation
  Coefficient .4
• Stocks s of Portfolio Avg Return
• ABC Corp 28 60 15
• Big Corp 42 40 21
• Standard Deviation weighted avg 33.6
• Standard Deviation Portfolio 28.1
• Return weighted avg Portfolio 17.4
• Lets Add stock New Corp to the portfolio

13
Efficient Frontier

• Example Correlation
  Coefficient .3
• Stocks s of Portfolio Avg Return
• Portfolio 28.1 50 17.4
• New Corp 30 50 19
• NEW Standard Deviation weighted avg 31.80
• NEW Standard Deviation Portfolio 23.43
• NEW Return weighted avg Portfolio 18.20

14
Efficient Frontier

• Example Correlation
  Coefficient .3
• Stocks s of Portfolio Avg Return
• Portfolio 28.1 50 17.4
• New Corp 30 50 19
• NEW Standard Deviation weighted avg 31.80
• NEW Standard Deviation Portfolio 23.43
• NEW Return weighted avg Portfolio 18.20
• NOTE Higher return Lower risk

15
Efficient Frontier

• Example Correlation
  Coefficient .3
• Stocks s of Portfolio Avg Return
• Portfolio 28.1 50 17.4
• New Corp 30 50 19
• NEW Standard Deviation weighted avg 31.80
• NEW Standard Deviation Portfolio 23.43
• NEW Return weighted avg Portfolio 18.20
• NOTE Higher return Lower risk
• How did we do that?

16
Efficient Frontier

• Example Correlation
  Coefficient .3
• Stocks s of Portfolio Avg Return
• Portfolio 28.1 50 17.4
• New Corp 30 50 19
• NEW Standard Deviation weighted avg 31.80
• NEW Standard Deviation Portfolio 23.43
• NEW Return weighted avg Portfolio 18.20
• NOTE Higher return Lower risk
• How did we do that? DIVERSIFICATION

17
Efficient Frontier
Return
B
A
Risk (measured as s)
18
Efficient Frontier
Return
B
AB
A
Risk
19
Efficient Frontier
Return
B
N
AB
A
Risk
20
Efficient Frontier
Return
B
N
ABN
AB
A
Risk
21
Efficient Frontier
Goal is to move up and left. WHY?
Return
B
N
ABN
AB
A
Risk
22
Efficient Frontier
Return
Low Risk High Return
Risk
23
Efficient Frontier
Return
Low Risk High Return
High Risk High Return
Risk
24
Efficient Frontier
Return
Low Risk High Return
High Risk High Return
Low Risk Low Return
Risk
25
Efficient Frontier
Return
Low Risk High Return
High Risk High Return
Low Risk Low Return
High Risk Low Return
Risk
26
Efficient Frontier
Return
Low Risk High Return
High Risk High Return
Low Risk Low Return
High Risk Low Return
Risk
27
Efficient Frontier
Return
B
N
ABN
AB
A
Risk
28
Security Market Line
Return
.
Efficient Portfolio
Risk Free Return
rf
Risk
29
Security Market Line
Return
.
Market Return rm
Efficient Portfolio
Risk Free Return
rf
Risk
30
Security Market Line
Return
.
Market Return rm
Efficient Portfolio
Risk Free Return
rf
Risk
31
Security Market Line
Return
.
Market Return rm
Efficient Portfolio
Risk Free Return
rf
BETA
1.0
32
Security Market Line
Return
Market Return rm
Security Market Line (SML)
Risk Free Return
rf
BETA
1.0
33
Security Market Line
Return
SML
rf
BETA
1.0
SML Equation rf B ( rm - rf )
34
Capital Asset Pricing Model
R rf B ( rm - rf )
CAPM
35
Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium 1931-65
SML
30 20 10 0
Investors
Market Portfolio
Portfolio Beta
1.0
36
Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium 1966-91
30 20 10 0
SML
Investors
Market Portfolio
Portfolio Beta
1.0
37
Testing the CAPM
Company Size vs. Average Return
Average Return ()
Company size
Smallest
Largest
38
Testing the CAPM
Book-Market vs. Average Return
Average Return ()
Book-Market Ratio
Highest
Lowest
39
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth market portfolio
40
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Market risk makes wealth uncertain.
Wealth market portfolio
41
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Market risk makes wealth uncertain.
Standard CAPM
Wealth market portfolio
42
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Stocks (and other risky assets)
Market risk makes wealth uncertain.
Standard CAPM
Wealth market portfolio
Consumption
43
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Stocks (and other risky assets)
Wealth is uncertain
Market risk makes wealth uncertain.
Standard CAPM
Wealth
Consumption is uncertain
Wealth market portfolio
Consumption
44
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Stocks (and other risky assets)
Wealth is uncertain
Market risk makes wealth uncertain.
Consumption CAPM
Standard CAPM
Wealth
Consumption is uncertain
Wealth market portfolio
Consumption
45
Arbitrage Pricing Theory

• Alternative to CAPM
• Expected Risk
• Premium r - rf
• Bfactor1(rfactor1 - rf) Bf2(rf2 - rf)
  

46
Arbitrage Pricing Theory

• Alternative to CAPM
• Expected Risk
• Premium r - rf
• Bfactor1(rfactor1 - rf) Bf2(rf2 - rf)
  
• Return a bfactor1(rfactor1)
  bf2(rf2)

47
Arbitrage Pricing Theory

• Estimated risk premiums for taking on risk
  factors
• (1978-1990)