 Risk and Return Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 8 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 8- 2 Topics Covered  Markowitz Portfolio Theory  Risk and Return Relationship  Testing the CAPM  CAPM Alternatives

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 8- 3 Markowitz Portfolio Theory  Markowitz was the first person to observe that there are no securities that are perfectly positively or negatively correlated.  Thus, all stocks fall in the middle range and the risk of a PF will always be less than the simple weighted average of the individual risks of the stocks in the PF.  Correlation coefficients make this possible.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 8- 4 Markowitz Portfolio Theory Bristol-Myers Squibb McDonald’s Standard Deviation Expected Return (%) 45% McDonald’s  Expected Returns and Standard Deviations vary given different weighted combinations of the stocks.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 8- 5 Efficient Frontier Standard Deviation Expected Return (%) Each half egg shell represents the possible weighted combinations for two stocks. The composite of all stock sets constitutes the efficient frontier.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 8- 6  The efficient frontier represents the set of portfolios that will give you the highest return at each level of risk. Portfolios on the efficient frontier are efficient in that there is no other combination of stocks that offer that high a return for the risk taken.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 8- 7 Efficient Frontier Example Correlation Coefficient =.4 Stocks  % of PortfolioAvg Return ABC Corp2860% 15% Big Corp42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Return = weighted avg = Portfolio = 17.4%

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 8- 8 Efficient Frontier Example Correlation Coefficient =.4 Stocks  % of PortfolioAvg Return ABC Corp2860% 15% Big Corp42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Return = weighted avg = Portfolio = 17.4% Let’s Add stock New Corp to the portfolio

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 8- 9 Efficient Frontier Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20%

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier A B Return Risk (measured as  )

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier A B Return Risk AB

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier A B N Return Risk AB

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier A B N Return Risk AB ABN

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier A B N Return Risk AB Goal is to move up and left. WHY? ABN

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier Return Risk Low Risk High Return

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier Return Risk Low Risk High Return High Risk High Return

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier Return Risk Low Risk High Return High Risk High Return Low Risk Low Return

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Efficient Frontier Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill So far, we assume that all the securities on the efficient set are risky. Alternatively, an investor could easily combine a risky investment with an investment in a riskless security. The combination of the riskless asset and the risky asset produces a liner risk/return line. The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line (Capital Market Line). That is, CML can be viewed as the efficient set of all assets, both risky and riskless.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Capital Market Line Return Risk. rfrf Risk Free Return = Market Return = r m Market Portfolio

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill  With riskless borrowing and lending, the PF of risky assets held by any investor would always be point A. Regardless of the investor’s tolerance for risk, he would never choose any other point on the efficient set of risk assets nor any point in the interior of the feasible region.  Rather, he would combine the securities of A with the riskless assets if he had high aversion to risk.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill  Notice that the standard deviation of returns is on the X-axis of the CML graph. Is this the relevant measure of risk?  The standard deviation of expected returns measures a stock’s total risk. However, the risk that can be easily diversified should not be compensated for.  If you want to plot return again risk, the risk measure must be the measure of risk influencing return. So, the proper relationship is return vs. systematic risk.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Security Market Line Return BETA. rfrf Risk Free Return = Market Return = r m Efficient Portfolio 1.0

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Security Market Line Return BETA rfrf Risk Free Return = Market Return = r m 1.0 Security Market Line (SML)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill  The relationship between expected return and beta can be represented by the capital asset pricing model. Expected return on a security = rf + Beta of the security * [E(Rm)-rf ]

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Testing the CAPM Avg Risk Premium Portfolio Beta 1.0 SML Investors Market Portfolio Beta vs. Average Risk Premium

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Testing the CAPM Avg Risk Premium Portfolio Beta 1.0 SML Investors Market Portfolio Beta vs. Average Risk Premium