11-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Eleven Return, Risk and the Security Market Line

11-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 11.1Expected Returns and Variances 11.2 Portfolios 11.3 Announcements, Surprises and Expected Returns 11.4 Risk: Systematic and Non-systematic 11.5 Diversification and Portfolio Risk 11.6 Systematic Risk and Beta 11.7 The Security Market Line 11.8 The Capital Market Line 11.9 Portfolio Characteristics The SML and the Cost of Capital: A Preview 11.11Problems with the CAPM Summary and Conclusions Chapter Organisation

11-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Calculate the expected return and risk (standard deviation) of both a single asset and a portfolio. Distinguish between systematic and non-systematic risk. Explain the principle of diversification. Explain the capital asset pricing model (CAPM). Distinguish between the security market line (SML) and the capital market line (CML).

11-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Expected Return and Variance Expected return—the weighted average of the distribution of possible returns in the future. Variance of returns—a measure of the dispersion of the distribution of possible returns. Rational investors like return and dislike risk.

11-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Calculating Expected Return

11-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Calculating Variance

11-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Expected Return and Variance Expected Returns:

11-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Expected Return and Variance Variances: Standard deviations:

11-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Portfolios A portfolio is a collection of assets. Portfolio weight is the percentage of a portfolio’s total value in a particular asset. An asset’s risk and return is important in how it affects the risk and return of the portfolio. The risk–return trade-off for a portfolio is measured by the portfolio’s expected return and standard deviation, just as with individual assets.

11-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Portfolio Expected Returns The expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolio. m E(R p ) = ∑ w j E (R j ) j=1 You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities.

11-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Portfolio Return and Variance Assume 50 per cent of portfolio in asset A and 50 per cent in asset B.

11-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Portfolio Return and Variance Var(R p )  (0.50 x Var(R A )) + (0.50 x Var(R B )). By combining assets in a portfolio, the risks faced by the investor can significantly change.

11-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Asset A returns Asset B returns Portfolio returns: 50% A and 50% B The Effect of Diversification on Portfolio Variance

11-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Announcements, Surprises and Expected Returns Key Issues –What are the components of the total return? –What are the different types of risk? Expected and Unexpected Returns –Total return (R) = expected return (E(R)) + unexpected return (U). Announcements and News –Announcement = expected part + surprise = E(R) + U –It is the surprise component that affects a stock’s price and, therefore, its return.

11-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Risk Systematic risk is the component of total risk which is due to economy-wide factors. Also known as market risk. Influences a large number of assets, each to a greater or lesser extent. Non-systematic risk is the component of total risk which is unique to an asset or firm. Affects a single asset or a small group of assets.

11-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Risk The distinction between systematic and non-systematic risk means can be applied to break down the surprise portion of returns:

11-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Diversification Diversification is the process of spreading investments across different assets, industries and countries to reduce risk. Total risk = systematic risk + non-systematic risk Non-systematic risk can be eliminated by diversification. Systematic risk affects all assets and cannot be diversified away.

11-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Standard Deviations of Monthly Portfolio Returns

11-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Principle of Diversification Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns. This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another. However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion or market risk.

11-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Portfolio Diversification

11-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Systematic Risk and Beta The systematic risk principle states that the expected return on a risky asset depends only on the asset’s systematic risk. The amount of systematic risk in an asset relative to an average risky asset is measured by the beta coefficient. Since assets with larger betas have greater systematic risks, they will have greater expected returns.

11-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Systematic Risk and Beta Example: Std Deviation Beta Security A30%0.60 Security B10%1.20 Security B will have a higher risk premium and a greater expected return, despite the fact that it has less total risk than Security A.

11-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Measuring Systemic Risk What does beta tell us? - A beta of 1 implies the asset has the same systematic risk as the overall market. -A beta < 1 implies the asset has less systematic risk than the overall market. -A beta > 1 implies the asset has more systematic risk than the overall market.

11-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Beta Coefficients for Selected Companies

11-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Portfolio Beta Calculations AmountPortfolio ShareInvestedWeightsBeta (1)(2) (3) (4) (3)  (4) ABC Company $ % LMN Company % XYZ Company % Portfolio$ % 1.034

11-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Portfolio Expected Returns and Betas Assume you wish to hold a portfolio consisting of asset A and a riskless asset. Given the following information, calculate portfolio expected returns and portfolio betas, letting the proportion of funds invested in asset A range from 0 to 125 per cent. Asset A has a beta of 1.2 and an expected return of 18 per cent. The risk-free rate is 7 per cent. Asset A weights: 0 per cent, 25 per cent, 50 per cent, 75 per cent, 100 per cent and 125 per cent.

11-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Portfolio Expected Returns and Betas Proportion Portfolio Invested in ExpectedPortfolio Asset A (%)Risk-free Asset (%) Return (%) Beta –

11-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Return, Risk and Equilibrium Key issues: –What is the relationship between risk and return? –What does security market equilibrium look like? The ratio of the risk premium to beta is the same for every asset. In other words, the reward-to-risk ratio for the market is constant and equal to:

11-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Asset Pricing Asset A has an expected return of 12 per cent and a beta of Asset B has an expected return of 8 per cent and a beta of Are these two assets valued correctly relative to each other if the risk-free rate is 5 per cent? Asset B offers insufficient return for its level of risk, relative to A. B’s price is too high; therefore, it is overvalued (or A is undervalued).

11-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Security Market Line The security market line (SML) is the representation of market equilibrium. The slope of the SML is the reward-to-risk ratio: (E(R M ) – R f )/ß M. But since the beta for the market is ALWAYS equal to one, the slope can be rewritten. Slope = E(R M ) – R f = market risk premium.

11-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Security Market Line (SML) Asset expected return (E (R i )) Asset beta (  i ) = E (R M ) – R f E (R M ) RfRf M = 1.0

11-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Capital Asset Pricing Model (CAPM) An equilibrium model of the relationship between risk and return. What determines an asset’s expected return? –The risk-free rate—the pure time value of money –The market risk premium—the reward for bearing systematic risk –The beta coefficient—a measure of the amount of systematic risk present in a particular asset.

11-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Calculation of Systematic Risk Where:Cov = covariance i = random distribution of return for asset i M = random distribution of return for the market  M = standard deviation of market return

11-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Covariance and Correlation The covariance term measures how returns change together—measured in absolute terms. The correlation coefficient measures how returns change together—measured in relative terms. Correlation coefficient ranges between –1.0 and Where  i = standard deviation of the return on asset i.

11-35 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Security Market Line versus Capital Market Line SML explains the expected return for all assets. CML explains the expected return for efficient portfolios.

11-36 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Risk of a Portfolio Variance of a two-asset portfolio is calculated as: weighted variance of the expected return for each asset in the portfolio + twice the weighted covariance of the expected return on the first asset with the expected return on the second

11-37 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Risk of a Portfolio WeightingStd Deviation Asset A Asset B The covariance of the expected returns between A and B is

11-38 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Problems with CAPM Difficulties in estimating beta - thin trading - non-constant beta. Using CAPM - adding explanatory variables - measure of market return. Where are we? - Despite its limitations, CAPM is still highly regarded - To discard the CAPM is to surely ‘throw the baby out with the bath water.’

11-39 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions The reward for bearing risk is the risk premium on an asset. The total risk associated with an asset has two parts: systematic risk and non-systematic risk. Non-systematic risk can be eliminated by diversification. The risk premium on an asset is determined by its systematic risk. The SML tells us the reward offered in financial markets for bearing risk. The SML is a benchmark for which we can compare the returns expected from real asset investments to determine if they are desirable.