13-0 Figure 13.8A – Portfolio Expected Returns and Betas RfRf LO4 © 2013 McGraw-Hill Ryerson Limited.

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13-0 Figure 13.8A – Portfolio Expected Returns and Betas RfRf LO4 © 2013 McGraw-Hill Ryerson Limited

13-1 Reward-to-Risk Ratio: Definition and Example The reward-to-risk ratio is the slope of the line illustrated in the previous example Slope = (E(R A ) – R f ) / (  A – 0) Reward-to-risk ratio for previous example = (20 – 8) / (1.6 – 0) = 7.5 What if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above the line)? What if an asset has a reward-to-risk ratio of 7 (implying that the asset plots below the line)? LO4 © 2013 McGraw-Hill Ryerson Limited

13-2 Market Equilibrium In equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal the reward-to-risk ratio for the market LO4 © 2013 McGraw-Hill Ryerson Limited

13-3 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 ) /  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 LO4 © 2013 McGraw-Hill Ryerson Limited

13-4 Figure – Security Market Line LO4 © 2013 McGraw-Hill Ryerson Limited

13-5 The Capital Asset Pricing Model (CAPM) The capital asset pricing model defines the relationship between risk and return E(R A ) = R f +  A (E(R M ) – R f ) If we know an asset’s systematic risk, we can use the CAPM to determine its expected return This is true whether we are talking about financial assets or physical assets LO4 © 2013 McGraw-Hill Ryerson Limited

13-6 Factors Affecting Expected Return Pure time value of money – measured by the risk-free rate Reward for bearing systematic risk – measured by the market risk premium Amount of systematic risk – measured by beta LO4 © 2013 McGraw-Hill Ryerson Limited

13-7 Example - CAPM Consider the betas for each of the assets given earlier. If the risk-free rate is 4.5% and the market risk premium is 8.5%, what is the expected return for each? SecurityBetaExpected Return ABC (8.5) = % DEF (8.5) = 9.940% GHI (8.5) = % JKL (8.5) = % LO4 © 2013 McGraw-Hill Ryerson Limited