Principles of Corporate Finance Brealey and Myers  Sixth Edition Risk and Return Slides by Matthew Will Irwin/McGraw Hill Chapter ©The McGraw-Hill Companies, Inc., 200 8- Topics Covered     Markowitz Portfolio Theory Risk and Return Relationship Testing the CAPM CAPM Alternatives Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- 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  The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios portfolios Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- Markowitz Portfolio Theory Price changes vs Normal distribution Microsoft - Daily % change 1986-1997 600 # of Days (frequency) 500 400 300 200 100 -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% Daily % Change Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- Markowitz Portfolio Theory Price changes vs Normal distribution Microsoft - Daily % change 1986-1997 600 # of Days (frequency) 500 400 300 200 100 -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% Daily % Change Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- Markowitz Portfolio Theory Standard Deviation VS Expected Return Investment C 20 18 16 % probability 14 12 10 -50 50 % return Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- Markowitz Portfolio Theory Standard Deviation VS Expected Return Investment D 20 18 16 % probability 14 12 10 -50 50 % return Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- Markowitz Portfolio Theory  Expected Returns and Standard Deviations vary given different weighted combinations of the stocks Expected Return (%) McDonald’s 45% McDonald’s Bristol-Myers Squibb Standard Deviation Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- Efficient Frontier •Each half egg shell represents the possible weighted combinations for two stocks •The composite of all stock sets constitutes the efficient frontier Expected Return (%) Standard Deviation Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- 10 Efficient Frontier •Lending or Borrowing at the risk free rate (rf) allows us to exist outside the efficient frontier Expected Return (%) T di n n Le wi o r r Bo ng g rf S Standard Deviation Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- 33 Security Market Line Return SML rf 1.0 BETA SML Equation = rf + B ( rm - rf ) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- 34 Capital Asset Pricing Model R = rf + B ( r m - r f ) CAPM Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- 35 Testing the CAPM Beta vs Average Risk Premium Avg Risk Premium 1931-65 SML 30 20 Investors Market Portfolio 10 1.0 Irwin/McGraw Hill Portfolio Beta ©The McGraw-Hill Companies, Inc., 200 8- 36 Testing the CAPM Beta vs Average Risk Premium Avg Risk Premium 1966-91 30 20 SML Investors 10 Market Portfolio 1.0 Irwin/McGraw Hill Portfolio Beta ©The McGraw-Hill Companies, Inc., 200 8- 37 Testing the CAPM Company Size vs Average Return Average Return (%) 25 20 15 10 Company size Smallest Irwin/McGraw Hill Largest ©The McGraw-Hill Companies, Inc., 200 8- 38 Testing the CAPM Book-Market vs Average Return Average Return (%) 25 20 15 10 Book-Market Ratio Highest Irwin/McGraw Hill Lowest ©The McGraw-Hill Companies, Inc., 200 8- 39 Consumption Betas vs Market Betas Stocks (and other risky assets) Wealth = market portfolio Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- 40 Consumption Betas vs Market Betas Stocks (and other risky assets) Market risk makes wealth uncertain Wealth = market portfolio Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- 41 Consumption Betas vs Market Betas Stocks (and other risky assets) Market risk makes wealth uncertain Standard CAPM Wealth = market portfolio Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- 42 Consumption Betas vs Market Betas Stocks (and other risky assets) Market risk makes wealth uncertain Wealth = market portfolio Irwin/McGraw Hill Stocks (and other risky assets) Standard CAPM Consumption ©The McGraw-Hill Companies, Inc., 200 8- 43 Consumption Betas vs Market Betas Stocks (and other risky assets) Stocks (and other risky assets) Wealth is uncertain Market risk makes wealth uncertain Standard Wealth CAPM Consumption is uncertain Wealth = market portfolio Irwin/McGraw Hill Consumption ©The McGraw-Hill Companies, Inc., 200 8- 44 Consumption Betas vs Market Betas Stocks (and other risky assets) Stocks (and other risky assets) Wealth is uncertain Market risk makes wealth uncertain Standard Wealth CAPM Consumption CAPM Consumption is uncertain Wealth = market portfolio Irwin/McGraw Hill Consumption ©The McGraw-Hill Companies, Inc., 200 8- 45 Arbitrage Pricing Theory Alternative to CAPM Expected Risk Premium = r - rf = Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + … Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 8- 46 Arbitrage Pricing Theory Alternative to CAPM Expected Risk Premium = r - rf = Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + … Return Irwin/McGraw Hill = a + bfactor1(rfactor1) + bf2(rf2) + … ©The McGraw-Hill Companies, Inc., 200 8- 47 Arbitrage Pricing Theory Estimated risk premiums for taking on risk factors (1978-1990) Yield spread Estimated Risk Premium (rfactor − rf ) 5.10% Interest rate Exchange rate Real GNP - 61 - 59 49 Inflation Mrket - 83 6.36 Factor Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 ... coefficients make this possible  The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios portfolios Irwin/McGraw Hill ©The McGraw-Hill... 200 8- Markowitz Portfolio Theory Price changes vs Normal distribution Microsoft - Daily % change 1986-1997 600 # of Days (frequency) 500 400 300 200 100 -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%... 200 8- Markowitz Portfolio Theory Price changes vs Normal distribution Microsoft - Daily % change 1986-1997 600 # of Days (frequency) 500 400 300 200 100 -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%