Key Questions:

 In equilibrium:
 Which portfolios should investors hold?
 Which securities should investors hold?
Portfolio Variance and SD

 With 2 securities, portfolio variance is:

        212 12 1 2
2
p
2
1
2
1
2
2
2
2
 In general, the portfolio variance is:
N N N
    2    
2
p i
2
i
2
i j ij i j
i 1 i 1 j i

 The standard deviation of the portfolio is:

p   2
p
Risk Reduction in Equally-Weighted
Portfolios: Independent Returns
 Suppose we have an equally weighted portfolio
(holding weights 1/N) of N independent stocks.
 The variance of the portfolio return is
N
1 1 1 N
 2
p 
N2

i 1
i
2
 { {  i2 }}
N N i 1

1 average 
  variance 
N  
Risk Reduction in Equally-Weighted
Portfolios: The General Case
 Suppose we have an equally weighted portfolio
(holding weights 1/N) of N stocks.
 The variance of the portfolio return is:
N N N
1 2
  2
2
p
N

i 1

i
2

N 2  cov(R , R )
i 1 ji
i j

1  1 N 2  1   1 N N 
    i   1     cov(R i , R j )
N  N i 1   N   N(N - 1)/2 i 1 ji 
1 average   1  average 
   1   
N  variance   N  covariance 

Risk in Equally-Weighted Portfolios:
The General Case

What happens when N goes to infinity?

Illustrating Diversification Effects of a Stock
Portfolio
Systematic Risk Principle

 The expected return on a risky asset depends

only on that asset’s systematic risk.
 This is because idiosyncratic risk can be
diversified away.
 There is a reward for bearing risk.
 There is not a reward for bearing risk
unnecessarily.
 How do we measure systematic risk?
Measuring Risk

 Total Risk = stand-alone risk

 Standard deviation measures total risk
 Some of this risk can be diversified away – so
investors do not need to be compensated for
all of it.
Idiosyncratic Risk

 only affects one (or a few) assets

 eliminated through proper diversification
 Investors should NOT be compensated for
this type of risk
 Also called: diversifiable, unique, asset-
specific, unsystematic, firm-specific, non-
systematic risk
Systematic Risk

 influences the entire market

 NOT eliminated through diversification
 Investors should be compensated for this risk
 Also called: market risk, covariance risk, non-
diversifiable risk
Types or Risk

 Which type of risk is each of the following,

Systematic or Idiosyncratic?
 Drought that destroys tobacco crop
 Inflation
 Actors guild strike
 Fire in paper manufacturing plant
 Change in interest rates by Federal Reserve Bank
Beta

 Beta measures: (all of these are the same!)

 For stock i, its beta is: βi = (i,M i) / M

Beta - β

 By definition if an asset has a beta of 1 then

it has the same amount of risk as the overall
market.
 A beta < 1 implies the asset has less
systematic risk than the overall market.
 A beta > 1 implies the asset has more
systematic risk than the overall market.
 If beta is negative then the asset has risk
opposite of the market.
Beta

 Specifically, beta measures the % change in

the expected return on a risky asset for every
% change in the expected return of a well-
diversified portfolio
 EX: Stock has β = 1.2
 If the “market” moves up by 1% then the expected
return on the stock is 1.2%.
 If the “market” falls by 1% than the stock’s returns
would be expected to fall by 1.2%.
Return

Time
Return

Time
Total versus Systematic Risk
 Consider the following information:
Standard Deviation Beta
 Security C 20% 1.25
 Security K 30% 0.95
 Which security has more total risk?

 Which security has more systematic risk?

 Which security should have the higher

expected return?
Beta: Examples

 What is a reasonable estimate of β for:

 Disney World?
 Pathmark?
 Revlon?
 The S&P500?
 A treasury bill?
β for Selected Companies
Separating Risk – Single Index Model

 Market Index return: RM = Σ wi Ri

 Regression analysis: Ri = αi+βiRM+ei
 ei: Idiosyncratic component of the return,
idiosyncratic risk (variance risk) = σ e.
2

 βiRM: Systematic component of the return,

systematic risk (covariance risk) = (βi)2 σ2M .
 Total variance is: var(Ri) = (βi)2 σ2M + σ2e
 Definition: βi = Cov(RM, Ri) / σ2M
 Cov(ei ,ej)=0, for 2 risky assets i and j
Calculating Beta

 Run a regression with returns on the stock

in question plotted on the Y axis and returns
on the market portfolio plotted on the X
axis.
 The slope of the regression line, which
measures relative volatility, is defined as the
stock’s beta coefficient, or β.
Illustrating the Calculation of Beta

_
ri

.
.
20 Year rM ri
1 15% 18%
15
2 -5 -10
10 3 12 16
5

-5 0 5 10 15 20 rM
Regression line:

.
-5 ^ ^
ri = -2.59 + 1.44 rM
-10
 Finding Beta in Excel

Calculating Coca-Cola's Stock Beta

Created by Jennifer Itzkowitz - 8/1/2014*

Coca-Cola Historic Stock Data S&P 500 Historic Stock Data There are 2 ways to calculate Coca-Cola's Beta in Excel:
Date Adj Close Return Date Adj Close Return
7/28/2014 69.82 -0.01147 7/28/2014 1930.67 -0.0241 1. The Excel Slope function can be used to find beta.
7/21/2014 70.63 -0.02283 7/21/2014 1978.34 6.07E-05 Beta 0.69 =SLOPE(C6:C57,H6:H57)
7/14/2014 72.28 -0.00138 7/14/2014 1978.22 0.005413
7/7/2014 72.38 -0.03929 7/7/2014 1967.57 -0.009 2. Run a regression analysis to find beta.
6/30/2014 75.34 0.013997 6/30/2014 1985.44 0.012484 The output is shown in the next tab.
6/23/2014 74.3 -0.00575 6/23/2014 1960.96 -0.00097
6/16/2014 74.73 0.003087 6/16/2014 1962.87 0.013795
6/9/2014 74.5 -0.02051 6/9/2014 1936.16 -0.00681
6/2/2014 76.06 0.014269 6/2/2014 1949.44 0.013449
5/27/2014 74.99 -0.01575 5/27/2014 1923.57 0.012123
5/19/2014 76.19 0.002104 5/19/2014 1900.53 0.012072
5/12/2014 76.03 -0.01541 5/12/2014 1877.86 -0.00033
5/5/2014 77.22 -0.06626 5/5/2014 1878.48 -0.00141
4/28/2014 82.7 0.010138 4/28/2014 1881.14 0.00952
4/21/2014 81.87 0.021078 4/21/2014 1863.4 -0.00078
4/14/2014 80.18 -0.00435 4/14/2014 1864.85 0.027075
4/7/2014 80.53 0.024164 4/7/2014 1815.69 -0.02649
3/31/2014 78.63 -0.07156 3/31/2014 1865.09 0.004021
3/24/2014 84.69 -0.03178 3/24/2014 1857.62 -0.00477
3/17/2014 87.47 -0.00421 3/17/2014 1866.52 0.01379
3/10/2014 87.84 0.021277 3/10/2014 1841.13 -0.01965
3/3/2014 86.01 0.144511 3/3/2014 1878.04 0.009998
2/24/2014 75.15 0.01335 2/24/2014 1859.45 0.012634
2/18/2014 74.16 0.032869 2/18/2014 1836.25 -0.00129
2/10/2014 71.8 0.063704 2/10/2014 1838.63 0.023155
2/3/2014 67.5 -0.00487 2/3/2014 1797.02 0.008095
What is Coca-Cola’s (KO) Beta?

 Yahoo.finance.com:
 Reuters.com/finance:
 Google.com/finance:
 Beta and the Risk Premium

 Required Stock Return

= Risk-free rate + Premium for the stock’s risk
 The higher the beta, the greater the risk
premium should be.
Market Risk Premium

 Definition: Additional return over the risk-free

rate needed to compensate investors for
assuming an average amount of risk.

 Its size depends on the perceived risk of the

stock market and investors’ degree of risk
aversion.
 Varies from year to year, but most estimates
suggest that it ranges between 4% and 8%
per year.
Risk and Return

 Treasury Bills have a fixed return.

 Fully diversified portfolio

 Security Market Line

Return

Risk Free Return = Rf

β
Security Market Line Equation
 The Capital Market Line and
the Security Market Line

E[rM ] E[rM ]
E[rQ ]  E[rK ]
E[rQ ]  E[rK ]
fr
rf

σM 1

E[ rM ]  rf
σM E[rM ]  rf
Capital Asset Pricing Model (CAPM)

 Model linking risk and required returns.

 CAPM suggests that there is a Security Market
Line (SML) that states that a stock’s required
return equals the risk-free return plus a risk
premium that reflects the stock’s risk after
diversification.
ri = rRF + βi (rM – rRF)
 Primary conclusion: The relevant riskiness of
a stock is its contribution to the riskiness of a
well-diversified portfolio.
Factors Affecting Return

 Investors are compensated for holding systematic

risk in form of higher returns.
 The size of the compensation depends on the
equilibrium risk premium, [ E(RM) - Rf ].
 The equilibrium risk premium is increasing in:
1. the variance of the market portfolio (volatile times)
2. the degree of risk aversion of average investor
Calculating Return

 Assume that the risk-free rate is 3% and the

required return on the market is 7%. What is
the required return of a stock with a beta of
1.5?
 Security Market Line
Return

Market Return = Rm = 7% .

Risk Free Return = Rf = 3%

1.0 β
Alpha

 The abnormal rate of return on a security in

excess of what would be predicted by an
equilibrium model
 The difference between fair and actual
expected rates of return on a stock
 The expected return of a mispriced security:
E(rs) = αs + rf + βs[E(rM) – rf ]
 Security Market Line
Return

Market Return = Rm = 7% .

Risk Free Return = Rf = 3%

1.0 β
Creating a Portfolio

 If you have $25,000 invested in a stock with

a beta of 1.2 and $75,000 invested in a stock
with a beta of 0.8 and these are your only 2
investments, what is your portfolio beta?
Systematic and Idiosyncratic Risk

 ABC Internet stock has a volatility of 90%

and a beta of 3. The market portfolio has an
expected return of 14% and a volatility of
15%. The risk-free rate is 7%.
 What is the equilibrium expected return on
ABC stock?
 What is the proportion of ABC Internet’s
variance which is diversified away in the
market portfolio?
Factors That Change the SML

 What if investors raise inflation expectations

by 3%, what would happen to the SML?
ri (%)

SML1
10.5

5.5
Risk, βi

0 0.5 1.0 1.5

Factors That Change the SML

 What if investors’ risk aversion increased,

causing the market risk premium to increase
by 3%, what would happen to the SML?
ri (%)

SML1
10.5

5.5
Risk, β i

0 0.5 1.0 1.5

Applications of the CAPM

1. Portfolio choice in equilibrium

2. Shows what a “fair” security return is
3. Gives benchmark for security analysis
4. Required return used in capital budgeting
Active and Passive Strategies
 An “active” strategy tries to beat the market
by stock picking, by timing, or other methods
 But, CAPM implies that
 security analysis is not necessary
 every investor should just buy a mix of the risk-
free security and the market portfolio, a
“passive” strategy.
 Grossman-Stiglitz paradox: How can market
be efficient if everyone uses a passive
strategy?
The Passive Strategy is Efficient

 CAPM implies that a passive strategy is a

powerful alternative to an active strategy
CAPM Assumptions
 Assumptions:
 The market is in a competitive equilibrium;
 Common single-period investment horizon;
 All assets are tradable (market portfolio);
 No transaction costs, no taxes;
 Investors are rational mean-variance optimizers with
 homogeneous expectations
 Some assumptions can be relaxed
 If many assumptions are relaxed - Topic of
ongoing research
Limitations of CAPM

 Theoretical market portfolio

 Expected as opposed to actual returns
Verifying the CAPM Empirically

 The CAPM has not been verified completely.

 Statistical tests have problems that make
verification almost impossible.
 Some argue that there are additional risk
factors, other than the market risk premium,
that must be considered.
More Thoughts on the CAPM

 Investors seem to be concerned with both

market risk and total risk. Therefore, the
SML may not produce a correct estimate of ri.
ri = rRF + (rM – rRF)βi + ???
 CAPM/SML concepts are based upon
expectations.
 Betas are calculated using historical data.
 A company’s historical data may not reflect
investors’ expectations about future riskiness.
Summary

 The CAPM follows from equilibrium conditions

in a frictionless mean-variance economy with
rational investors.
 Prediction 1: Everyone should hold a mix of
the market portfolio and the risk-free asset.
 Prediction 2: The expected return on an
individual stock is a linear function of its beta.
(That is, stocks should be on SML.)
 A stock’s beta can be estimated using
historical data by linear regression.