Capital Asset Pricing Model

(CAPM)

10/17/08 Capital Asset Pricing Model 1

Risk and Return
Company A Company B
State Probability Return Return
Boom .3 100% 20%
Normal .4 15% 15%
Recession .3 -70% 10%
1.0

1. Find the expected return for Company A and B.

2. Find the standard deviation for Company A and B.

10/17/08 Capital Asset Pricing Model 2

Find Expected Return
Company A Company B
State Probability Return Return
Boom .3 100% 20%
Normal .4 15% 15%
Recession .3 -70% 10%
1.0
E(R A ) = .3(100) + .4(15) + .3(-70)
= 15%
E(R B ) = .3(20) + .4(15) + .3(10)
= 15%

10/17/08 Capital Asset Pricing Model 3

 Find Standard Deviation
Company A Company B
State Probability Return Return
Boom .3 100% 20%
Normal .4 15% 15%
Recession .3 -70% 10%
1.0
[ ]
1
σA = .3(100 - 15) 2 + .4(15 - 15) 2 + .3(-70 - 15) 2 2
= 65%

[ ]
1
2 2 2 2
σ B = .3(20 - 15) + .4(15 - 15) + .3(10 - 15)
=3.8%

10/17/08 Capital Asset Pricing Model 4

Risk and Return
Expected
Return

15%

| | Standard
Deviation
4.0% Risk 65.8%

10/17/08 Capital Asset Pricing Model 5

Portfolio Risk and the Phantom
Egg Crusher

Your Portfolio Market

10/17/08 Capital Asset Pricing Model 6

Lessons from P.E.C.
1. Assets are not held in isolation; rather,
they are held as parts of portfolios.
2. Assets are priced according to their value
in a portfolio.
3. Investors are concerned about how the
portfolio of stocks perform--not individual
stocks.

10/17/08 Capital Asset Pricing Model 7

Risk and Return
Sun Tan Umbrella Probability
State Return Return of State
Sunny 33% -9% 1/3
Normal 12% 12% 1/3
Rainy -9% 33% 1/3

Expected return for Sun Tan Company = 12%

Expected return for Umbrella Company = 12%
Standard deviation for Sun Tan Company = 17.15%
Standard deviation for Umbrella Company = 17.15%
Find the expected return and standard deviation for a portfolio which invests
half its money in the Sun Tan and half its money in Umbrella Company.

10/17/08 Capital Asset Pricing Model 8

Portfolio Risk and Return
Sun Tan Umbrella Probability
State Return Return of State
Sunny 33% -9% 1/3
Normal 12% 12% 1/3
Rainy -9% 33% 1/3

E[ R 50/50 ] = .5(12%) + .5(12%)

= 12%
σ 50/50 ≠ .5(17.15%) + .5(17.15%)
Why not?

10/17/08 Capital Asset Pricing Model 9

Portfolio Risk and Return
Sun Tan Umbrella Probability
State Return Return of State
Sunny 33% -9% 1/3
Normal 12% 12% 1/3
Rainy -9% 33% 1/3

State Return
No deviation from 12%!
Sunny .5(33) + .5( - 9) = 12%
Normal .5(12) + .5(12) = 12% σ 50/50 = 0
Rainy .5( - 9) + .5(33) = 12%

10/17/08 Capital Asset Pricing Model 10

Lessons from Tahitian Island
1. Combining securities into portfolios reduces risk.
2. How? A portion of a stock’s variability in return is canceled by
complementary variations in the return of other securities
3. However, since to some extent stock prices (and returns) tend to move in
tandem, not all variability can be eliminated through diversification.
or
Even investors holding diversified portfolios are exposed to the risk
inherent in the overall performance of the stock market.
4. Therefore,
Total Risk = unsystematic + systematic
diversifiable nondiversifiable
firm specific market

10/17/08 Capital Asset Pricing Model 11

Portfolio Choice
U 2 U1 U 0
Expected
Return

Standard
Risk Deviation

10/17/08 Capital Asset Pricing Model 12

Risk and Return
Expected
Return

2
ρ=-1
ρ= 1
1

Standard
Deviation
Risk

10/17/08 Capital Asset Pricing Model 13

 Variability of Returns Compared
with Size of Portfolio
Average annual
standard deviation (%)

49% -

Unsystematic or diversifiable
risk (related to company-unique events)

24% -

19% -
Total Risk Systematic or nondiversifiable
risk (result of general market
influences)
Number of stocks
1 10 20 25 in portfolio

10/17/08 Capital Asset Pricing Model 14

Risk & Return
Expected
Return

X Efficient frontier
X X
X X X
X X X X

RF --

Risk Std dev

10/17/08 Capital Asset Pricing Model 15

Risk & Return
Expected
Return

wing
o
B orr

X Efficient frontier
RM --
g X X
e n din X X X
L
X X X X

RF --

Risk Std dev

10/17/08 Capital Asset Pricing Model 16

Security Market Line: Risk/Return
Trade-Off with CAPM
Expected
Return

SML

RF --

β
Systematic
Risk

10/17/08 Capital Asset Pricing Model 17

Security Market Line:
ke = RF + β(RM – RF)
Expected
Return

SML

RM --

RF --

| | β
Systematic 1 2
Risk

10/17/08 Capital Asset Pricing Model 18

CAPM
Provides a convenient measure of systematic risk of the volatility of an
asset relative to the markets volatility.

β is this measure--gauges the tendency of a security’s return to move in

tandem with the overall market’s return.

β =1 Average systematic risk

β >1 High systematic risk, more volatile than the market

β <1 Low systematic risk, less volatile than the market

10/17/08 Capital Asset Pricing Model 19

Betas for a Five-year Period
(1987-1992)
Company Name (1987-1992) Beta
Tucson Electric Power 0.65
California Power & Lighting 0.70
Litton Industries 0.75
Tootsie Roll 0.85 2006 Betas:
Quaker Oats 0.95
Standard & Poor’s 500 Stock 1.00
Index
Procter & Gamble 1.05
General Motors 1.15
Southwest Airlines 1.35
Merrill Lynch 1.65
Roberts Pharmaceutical 1.90

10/17/08 Capital Asset Pricing Model 20

 The SML and WACC
Expected
return
SML

= 8%
Incorrect
16% -- B acceptance
15% --
14% -- A WACC = 15%
Incorrect
rejection

R f = 7% --

β A = .60 β Firm = 1.0 β B = 1.2 Beta

If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency toward incorrectly
accepting risky projects and incorrectly rejecting less risky projects.

10/17/08 Capital Asset Pricing Model 21

 The SML and the Subjective Approach
Expected
return
SML

20% --
High risk
(+6%)
WACC = 14% --

10% --

R f = 7% -- Moderate risk
Low risk (+0%)
(-4%)

Beta

With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is
then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm’s WACC.

10/17/08 Capital Asset Pricing Model 22

Finding Beta for Three Companies:
High, Average, and Low Risk & Market

Year kH kA kL kM
1 10% 10% 10% 10%
2 20% 10% 0% 10%

3 25% 20% 15% 20%

10/17/08 Capital Asset Pricing Model 23

 The Concept of Beta (cont.)
Return on Stock i, k i (%)
Stock H, High Risk: β = 1.5
30 --
Stock A, Average Risk: β = 1.0
20 --
Stock L, Low Risk: β = 0.5
10 --

| | 0 | | |
-20 -10 10 20 30 Return on
-10 -- the
market,
-20 -- k i (%)

10/17/08 Capital Asset Pricing Model 24

Summary of
Relationship
Between Risk
and Return

10/17/08 Capital Asset Pricing Model 25