Capital Asset Pricing

Model (CAPM)

Arithmetic average return is the return earned in

an average year over a multiyear period.
Arithmetic Average Return of SR =
Arithmetic Average HR Return =

1
Historical variance and
standard deviation
• In general, if we have T historical returns, where T is
some number, we can write the historical variance as:

• Remember, standard deviation is the square root of

Var(R).

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Risk and Return
• Investment risk is related to the probability of
earning a low or negative actual return.
• Two types of investment risk
–Stand-alone risk
–Portfolio risk
• Investing in more than one security to reduce risk.
• Capital Asset Pricing Model (CAPM)
Security Market Line (SML)
Beta calculation

•If you owned a share of every stock

traded on the HOSE and HNE, would
you be diversified?

•Would you have eliminated all of your

risk?

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 p (%)
35 Diversifiable Risk

Total Risk, p

20
Non-diversifiable Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio

Some risk can be diversified

away and some cannot.

• Systematic risk is non-diversifiable.

This type of risk cannot be diversified
away.
• Unsystematic risk is diversifiable.
This type of risk can be reduced
through diversification.

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Systematic (Non-Diversifiable)
Risk
• Unexpected changes in interest
rates.
• Unexpected changes in cash flows
due to tax rate changes, foreign
competition, and the overall
business cycle.

Unsystematic (Diversifiable)
Risk
• A c m an lab f ce g e n ike
• A c m an managemen die in a lane
crash.
• A h ge il ank b and fl d a c m an
production area.

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Total Risk and systematic risk

• The total risk of an investment, as measured by the

standard deviation of its return, can be written as:

• Systematic risk is also called nondiversifiable risk or

market risk
• Unsystematic risk is also called diversifiable risk,
unique risk, or asset-specific risk

Do some firms have more non-

diversifiable risk than others?
For example:
Interest rate changes affect all firms, but which
would be more affected:

a) Retail food chain

b) Commercial bank

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Note
• As we know, the market
compensates investors for accepting
risk - but only for non-diversifiable
(Systematic) risk. Diversifiable risk
can and should be diversified away.
• So - we need to be able to measure
non-diversifiable (Systematic) risk.

This is why we have Beta.

Beta: a measure of market risk.

• Specifically, beta is a measure of how
an indi id al ck e n a ih
market returns.

• I a mea e f he en i i i of an
indi id al ck e n change in
the market.

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 Calculating Beta

XYZ Co. returns Beta = slope

15 .. .
= 1.20
.. . .
10 . . . .
.. . .
. . 5. .
S&P 500 .. . .
returns -15 -10 -5 -5. . . 5. 10 15
. . .. . .. -10.
.. . .
. . . -15.

The Ma e Be a i 1

• A firm that has a beta = 1 has average market risk.

The stock is no more or less volatile than the
market.
• A firm with a beta > 1 is more volatile than the
market.
(ex: technology firms)
• A firm with a beta < 1 is less volatile than the
market.
(ex: utilities)

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 How are betas calculated?

• Run a regression line of past returns

on Stock i versus returns on the
market.
• The regression line is called the
characteristic line.
• The slope coefficient of the
characteristic line is defined as the
beta coefficient.

How is beta calculated?

(y y )( x x)
=
(x x)2

=y x

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 Illustration of beta calculation:
_
Ri Regression line:
20 . Ri =

15
. Year RM Ri
10 1 15% 18%
2 -5 -10
5
3 12 16

-5 0 5 10 15 20
_
RM
-5

. -10

Scatter Plot of Weekly Returns on The

Sharper Image vs. The S&P 500 Stock Index

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Calculating Beta for SRE

0% R SRE

20%

0% RM
- 0% -20% 0% 20% 0%

-20%

R SRE =0.03 +0.83R

- 0% M

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 Summary:
• We know how to measure risk, using standard
deviation for overall risk and beta for non-
diversifiable (market) risk.
• We know how to reduce overall risk to only
systematic risk through diversification.
• We need to know how to price the risk so we will
know how much extra return we should require for
accepting extra risk.

What is the Required Rate of Return?

•It is the return on an investment

required by an investor given market
in e e a e and he in e men
risk.

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Required Risk-free Risk
rate of = rate of + premium
return return

Diversifiable risk
Non-diversifiable
risk

What is the Security Market Line

(SML)?
• The Security Market Line (SML), also known as the
Capital Asset Pricing Model (CAPM), gives the
risk/return relationship for individual stocks.
The SML
The measure of risk used in the SML is the beta
coefficient, .

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The Security Market Line and the CAPM

Given two points (risk-free asset and market portfolio asset) on

the security market line, the equation of the line is:

Return for Por folio s Reward for bearing

bearing no exposure to market risk
market risk market risk

The equation represents the risk and return relationship

predicted by the Capital Asset Pricing Model (CAPM).

Example:

•Suppose the Treasury bond rate is

6%, the average return on the S&P
500 index is 12%, and Walt Disney
has a beta of 1.2.
•According to the CAPM, what should
be the required rate of return on
Disney stock?

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 Rj = Rf + βj [E(RM)- Rf]
Rj =

The Security Market Line (SML)

E(RP)
A - Undervalued SML
•

•
A
RM • B • Slope = (y2-y1) / (x2-x1)
• = [RM Rf M-0)
= [RM Rf] / (1-0)
= RM Rf
Rf • • B - Overvalued = Market Risk Premium

•
M =1.0
i

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Calculate Beta for a portfolio with 50% in
GE (β=1.29) and 50% in RGLD (β=-0.86).

p= Weighted average
= 0.5( GE) + 0.5( RGLD)
=

SML:
Rp= Rf + E(RM) Rf) p
=

Change in inflation expectations

Required Rate
of Return (%)
D I = 3%
New SML
SML2

18 SML1
15
11 Original situation
8

0 0.5 1.0 1.5 Risk, βi

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 Change in risk aversion
Required
Rate of After increase
Return (%) in risk aversion
SML2
RM = 18%
RM = 15%
18 SML1
15 D RPM = 3%

8 Original situation
Risk, βi
1.0

More about average returns

Suppose you buy a particular stock for $100.
• Unfortunately, the first year you own it, it falls to $50.
The second year you own it, it rises back to $100,
leaving you where you started (no dividends were
paid). What was your average return on this
investment?

In this example, calculating the returns year-by-year, you

lost 50% the first year and you made 100% in the second
year, meaning your arithmetic average return is:
=

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Calculating Geometric Average
Returns
In general, if we have T years of returns, the geometric
average return over these T years is calculated using this
formula:

Geometric average return over this two-year period is:

=

Calculating Geometric Average

Returns

Geometric average return over this five-year period is:

=

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