Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 8 McGraw Hill/Irwin Risk and Return

8- 2 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  Markowitz Portfolio Theory  Risk and Return Relationship  Testing the CAPM  CAPM Alternatives

8- 3 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Markowitz Portfolio Theory  Combining stocks into portfolios can reduce standard deviation, below the level obtained from a simple weighted average calculation.  Correlation coefficients make this possible. efficient portfolios  The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios.

8- 4 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Markowitz Portfolio Theory Price changes vs. Normal distribution Microsoft - Daily % change Proportion of Days Daily % Change

8- 5 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment A % probability % return

8- 6 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment B % probability % return

8- 7 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment C % probability % return

8- 8 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment D % probability % return

8- 9 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Markowitz Portfolio Theory Coca Cola Reebok Standard Deviation Expected Return (%) 35% in Reebok  Expected Returns and Standard Deviations vary given different weighted combinations of the stocks

8- 10 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

8- 11 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Frontier Standard Deviation Expected Return (%) Lending or Borrowing at the risk free rate ( r f ) allows us to exist outside the efficient frontier. rfrf Lending Borrowing T S

8- 12 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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%

8- 13 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

8- 14 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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%

8- 15 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

8- 16 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Frontier A B Return Risk (measured as  )

8- 17 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Frontier A B Return Risk AB

8- 18 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Frontier A B N Return Risk AB

8- 19 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Frontier A B N Return Risk AB ABN

8- 20 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Frontier A B N Return Risk AB Goal is to move up and left. WHY? ABN

8- 21 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Frontier Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return

8- 22 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Frontier Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return

8- 23 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Frontier Return Risk A B N AB ABN

8- 24 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Security Market Line Return Risk. rfrf Risk Free Return = Efficient Portfolio Market Return = r m

8- 25 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Security Market Line Return. rfrf Risk Free Return = Efficient Portfolio Market Return = r m BETA1.0

8- 26 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Security Market Line Return. rfrf Risk Free Return = BETA Security Market Line (SML)

8- 27 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Security Market Line Return BETA rfrf 1.0 SML SML Equation = r f + B ( r m - r f )

8- 28 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Capital Asset Pricing Model R = r f + B ( r m - r f ) CAPM

8- 29 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Testing the CAPM Avg Risk Premium Portfolio Beta 1.0 SML Investors Market Portfolio Beta vs. Average Risk Premium

8- 30 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Testing the CAPM Avg Risk Premium Portfolio Beta 1.0 SML Investors Market Portfolio Beta vs. Average Risk Premium

8- 31 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Testing the CAPM High-minus low book-to- market Return vs. Book-to-Market Dollars Low minus big

8- 32 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Consumption Betas vs Market Betas Stocks (and other risky assets) Wealth = market portfolio Market risk makes wealth uncertain. Stocks (and other risky assets) Consumption Wealth Wealth is uncertain Consumption is uncertain Standard CAPM Consumption CAPM

8- 33 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Arbitrage Pricing Theory Alternative to CAPM Expected Risk Premium = r - r f = B factor1 (r factor1 - r f ) + B f2 (r f2 - r f ) + … Return= a + b factor1 (r factor1 ) + b f2 (r f2 ) + …

8- 34 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Arbitrage Pricing Theory Estimated risk premiums for taking on risk factors ( )

8- 35 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Preparation for Next Class  Please read:  BM Chapter 9, P