1. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 10-1 Chapter 10 Return and Risk: The Capital- Asset-Pricing Model (CAPM)  10.1 Individual Securities  10.2 Expected Return, Variance, and Covariance  10.3 The Return and Risk for Portfolios  10.4 The Efficient Set for Two Assets  10.5 The Efficient Set for Many Securities  10.6 Diversification: An Example  10.7 Riskless Borrowing and Lending  10.8 Market Equilibrium  10.9 Relationship between Risk and Expected Return (CAPM)  10.10 Summary and Conclusions  Appendix 10A: Is Beta Dead?

2. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 10-2 Expected (Ex Ante) Return, Variance, and Covariance  Expected Return: E(R) =  (p s x R s )  Variance:  2 =  {p s x [R s - E(R)] 2 }  Standard Deviation =   Covariance:  AB =  {p s x [R s,A - E(R A )] x [R s,B - E(R B )]}  Correlation Coefficient:  AB =  AB / (  A  B )

3. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 10-3 Return and Risk for Portfolios (2 Assets)  Expected Return of a Portfolio: E(R p ) = X A E(R) A + X B E(R) B  Variance of a Portfolio:  p 2 = X A 2  A 2 + X B 2  B 2 + 2 X A X B  AB

4. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 10-4 An Example of Portfolio Return and Risk Stock InvestmentX i E.(Ri)  i 2 IBM$500050%0.090.01 HM$500050%0.130.04 Total$10000100%   IBM,HM = 0  E[R p ] = (0.5)(0.09) + (0.5)(0.13) = 11%   p 2 =(.5) 2 (.01) + (.5) 2 (.04) + 2(.5)(.5)(0) = 0.0125   p = (0.0125) (1/2) = 0.1118

5. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 10-5 Efficient Sets and Diversification  E(R)  = -1 -1 <   = 1 MV

6. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 10-6 Capital Market Line Expected return of portfolio Standard deviation of portfolio’s return. Risk-free rate (R f ) 4 M. 5.. Capital market line. X Y

7. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 10-7 Security Market Line Expected return on security (%) Beta of security RmRm RfRf 0.81 S M T... Security market line (SML)