Different Types of Rate of Return



Expected return = best guess of what
return will be if we invest in a security
Required return = minimum return that
we will accept on the investment;
minimum acceptable return
Actual return = not known until after we
buy and then sell the security some time
later
Using Expected vs Required to
Make Investment Decisions



If expected return > required return,
BUY
If expected return < required return,
SELL
If expected return = required return,
HOLD (stock is in equilibrium)
Capital Asset Pricing Model



Model that relates risk to rate of return
Tells investors how much they should
require as a rate of return, given a
stock’s level of market risk
(Remember, no reward for bearing
company-specific risk. Investors should
diversify!)
Kc = Rf + (Km - Rf)




Kc= Common stockholders’ required
rate of return
Rf = Risk-free rate of return
Km = Expected return on portfolio of all
stocks; expected return on the stock
market
 = Beta, measure of market risk
Risk-free Rate of Return




Rf has two components:
1) A true, or real, rate of return that
would be earned in a perfect world
2) An inflation premium (points to cover
investors for rate of inflation)
Rf can be estimated using return on T
bills
Market Rate of Return



Km is an estimate of what investing in
the whole stock market would provide
as a rate of return
Estimate Km by looking at predictions for
market index like S&P 500
Difficult to forecast; easier to evaluate
using past data
(Km - Rf) = Market Risk
Premium



Difference between return on whole
market and risk-free rate of return
Extra reward (points) to investors for
exposure to average market risk
Size of market risk premium reflects
investors’ degree of risk aversion (how
investors feel about investing in the
stock market – safe or scared?)
(Km - Rf)




Market risk premium tailored for how
much market risk a given company has
Average market risk ( = 1.0):
Required return = Market return Km
Above average market risk ( > 1.0):
Required return > Market return Km
Below average market risk ( < 1.0):
Required return < Market return Km
Graphing CAPM



X axis =  (Market Risk)
Y axis = Kc (Required Rate of Return)
Relationship is linear - just need two
points to graph CAPM:
– 1) If  = 0, Kc = Rf
– 2) If  = 1.0, Kc = Km
Security Market Line (SML)



Graphically shows relationship between
market risk and required rate of return
Locate firm on X axis using its beta
Go up to intersection with SML and over
to Y axis to see firm’s required rate of
return
Slope of SML

Slope of SML:
– Rise/Run
– (Y1 - Y0)/(X1 - X0)
– Change in Kc/Change in 
– Market risk premium (Km - Rf)
What Slope of SML indicates:


The slope of the SML reflects investors’
degree of Risk Aversion
When slope is steep (high market risk
premium, high required rates of return),
this indicates that investors are nervous
(worried, concerned) about investing in
the stock market and want higher
returns on every stock.


When slope of SML is flatter (lower
market risk premium, lower required
rates of return for every stock), this
reflects that investors are more
comfortable investing in the stock
market and don’t perceive market risk
as being such a danger.
Changes in slope reflect changes in
investors’ perceptions about market
SML and Changes in Inflation



When inflation changes, the risk-free
rate of return changes (inflation is one
of its components)
Y intercept changes
Slope remains constant (assuming
investors’ perceptions about market risk
are unchanged), so Km must also
change to preserve constant slope!
Changes in Inflation




When Rf increases, Kc increases by the
same amount
Higher inflation leads to higher required
rates of return for all stocks
When Rf decreases, Kc decreases by
the same amount
Lower inflation leads to lower required
rates of return for all stocks
Relationship of Inflation and
Stock Prices




When inflation is high, stock prices are
NOT high
Required rates of return on stocks are
high to cover for increase in inflation
Higher required returns lead to lower
stock prices
When inflation is high, stock prices are
LOW! (And vice versa.)