18 18 C h a p t e r Return, Risk, and the Security Market Line Return, Risk, and the Security Market Line second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 2 Return, Risk, & the Security Market Line Our goal in this chapter is to define risk more precisely, and discuss how to measure it. Then, we will quantify the relation between risk and return in financial markets. Goal © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 3 Expected and Unexpected Returns  The return on any stock traded in a financial market is composed of two parts. c The normal, or expected, part of the return is the return that investors predict or expect. d The uncertain, or risky, part of the return comes from unexpected information revealed during the year. Total return – Expected return = Unexpected return R – E(R) = U or © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 4 Announcements and News  The impact of an announcement depends on how much of it represents new information. Î When the situation is not as bad as previously thought, what seems to be bad news is actually good news.  News about the future is what matters. Î Market participants factor predictions into the expected part of the stock return. Announcement = Expected part + Surprise © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 5 Systematic and Unsystematic Risk Systematic risk Risk that influences a large number of assets. Also called market risk. Unsystematic risk Risk that influences a single company or a small group of companies. Also called unique or asset-specific risk. Total risk = Systematic risk + Unsystematic risk © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 6 Systematic & Unsystematic Components of Return  R – E(R) = U = Systematic portion + Unsystematic portion = m + ε R – E(R) = m + ε © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 7 Diversification and Risk  In a large portfolio, some stocks will go up in value because of positive company-specific events, while others will go down in value because of negative company-specific events.  Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.  Unsystematic risk is also called diversifiable risk, while systematic risk is also called nondiversifiable risk. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 8 The Systematic Risk Principle  The systematic risk principle states that the reward for bearing risk depends only on the systematic risk of an investment.  So, no matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset. What determines the size of the risk premium on a risky asset? © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 9 Measuring Systematic Risk  Because assets with larger betas have greater systematic risks, they will have greater expected returns.  Note that not all betas are created equal. Beta coefficient (β) Measure of the relative systematic risk of an asset. Assets with betas larger than 1.0 have more systematic risk than average, and vice versa. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 10 Measuring Systematic Risk [...]... All rights reserved 18 - 15 Beta and the Risk Premium McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 16 The Reward-to-Risk Ratio Notice that all the combinations of portfolio expected returns and betas fall on a straight line E (RA ) − R f 20% − 8% Slope = = = 7.50% βA 1.6 What this tells us is that asset A offers a reward-to-risk ratio of 7.50% In other words,... a risk premium of 7.50% per “unit” of systematic risk McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 17 The Basic Argument Consider a second asset, asset B, with E(RB) = 16% and βA = 1.2 Which investment is better, asset A or asset B? McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 18 The Basic Argument % of Portfolio Portfolio... 100 125 150 McGraw Hill / Irwin 8% 10 12 14 16 18 20 0 3 6 9 1.2 1.5 1.8 © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 19 The Basic Argument McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 20 The Basic Argument McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 21 The Fundamental Result The situation we have... Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 28 The Security Market Line McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 29 The Security Market Line McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 30 A Closer Look at Beta R – E(R) = m + ε, where m is the systematic portion of the unexpected return.. .18 - 11 Work the Web Beta coefficients are widely available online For example, check out: http://finance.yahoo.com McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 12 Portfolio Betas The riskiness of a portfolio has no simple relation to the risks of the assets in the portfolio In contrast, a portfolio beta can be calculated just like the expected return of. .. + ε In other words, a high-beta security is simply one that is relatively sensitive to overall market movements, whereas a low-beta security is one that is relatively insensitive McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 31 A Closer Look at Beta McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 32 A Closer Look at Beta... The McGraw-Hill Companies, Inc All rights reserved 18 - 34 Where Do Betas Come From? McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 35 Why Do Betas Differ? Betas are estimated from actual data Different sources estimate differently, possibly using different data For data, the most common choices are three to five years of monthly data, or a single year of weekly... then add the results to get the portfolio’s beta McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 13 Beta and the Risk Premium Consider a portfolio made up of asset A and a risk-free asset For asset A, E(RA) = 20% and βA = 1.6 The risk-free rate Rf = 8% Note that for a risk-free asset, β = 0 by definition We can calculate some different possible portfolio expected... The reward-to-risk ratio must be the same for all assets in a competitive financial market If one asset has twice as much systematic risk as another asset, its risk premium will simply be twice as large Because the reward-to-risk ratio must be the same, all assets in the market must plot on the same line McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 23 The Fundamental... McGraw-Hill Companies, Inc All rights reserved 18 - 24 The Security Market Line Security market line (SML) Graphical representation of the linear relationship between systematic risk and expected return in financial markets For a market portfolio, SML slope = E (RM ) − R f βM = E (RM ) − R f McGraw Hill / Irwin = E (RM ) − R f 1 © 2002 by The McGraw-Hill Companies, Inc All rights reserved 18 - 25 . Irwin Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 2 Return, Risk, & the Security Market Line Our goal in this chapter. McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 15 Beta and the Risk Premium © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 18 - 16 The. Reward-to-Risk Ratio  Notice that all the combinations of portfolio expected returns and betas fall on a straight line.  Slope  What this tells us is that asset A offers a reward-to-risk