Expected Return for Individual
Stocks
Probability x Return = ___%
 Probability x Return = ___%
 Expected Return
= ___

Capital Markets
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Calculating
Expected Return
Expected Return
Stock A
Probability
Return
10%
-15%
40%
50%
Expected Return
Stock B
Probability
Return
-1.5%
20%
-50%
10%
4%
30%
0%
0%
25%
12.5%
50%
50%
25%
15%
Expected Return
Capital Markets
-10%
15%
2
Expected Return for Portfolio
Portfolio Weight x Return = ___%
 Portfolio Weight x Return = ___%
 Expected Return
= ___

Capital Markets
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Portfolio Expected Return
Return
Stock X 60%
12% 7.20%
Stock Y 25%
16% 4.00%
Stock Z 15%
19% 2.85%
100%
14.05%
Capital Markets
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Portfolio Beta
Investment
Beta
Stock Q: 20% of portfolio
Stock R: 20% of portfolio
1.4
.6
.28
.12
Stock S: 10% of portfolio
Stock T: 50% of portfolio
1.5
1.8
.15
.90
Portfolio Beta
1.45
Capital Markets
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Standard Deviation of Portfolio

Not the average of standard deviation for
portfolio components
 Calculation
Calculate expected return for portfolio under each
condition
 Then determine deviation from expected return
from portfolio, square it, multiply times probability,
sum it, and take the square root…which sounds
familiar…

Capital Markets
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Risk

Unsystematic: impacts a single stock or
industry
 Dole

recalls spinach
Systematic: impacts most, if not all, stocks
 Fed
leaves interest rates unchanged
Capital Markets
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Diversification

Create a portfolio of 20 stocks with a low
correlation: chart on Page 338
 This
would eliminate almost all unsystematic
risk
 Unsystematic risk is not rewarded

Investing 90% of your portfolio in one stock
 Low
correlation: stocks that don’t tend to
move in the same direction

Airline and oil stocks, for example
Capital Markets
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CAPM and SML

SML: reflects risk-reward ratio for an
individual security
 Risk
is measured by beta
 Assumes security is in a diversified portfolio
 How much risk does a security add to a
diversified portfolio?
Capital Markets
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CAPM
ER = RF + (MR – RF) x B
 RF = “Risk-free” rate of return on T-bills

 Currently

__%
MR = Expected Return for the Market
 Approximately

B = Beta
12% for large-cap stocks
What happens to Expected
Return if the Market has
additional risk? If the
asset’s beta increases?
Capital Markets
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Beta

Measures systematic risk
 Not
total risk since it doesn’t include
unsystematic risk
Market = 1.0
 Can beta be negative?
 Can betas be different if you look at
different sources?

 Generally
based on 5-year moving average
Capital Markets
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CAPM
Capital Markets
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Coefficient of variation
Expected
Return
Stock A
12.00%
Stock B
11.50%
Stock C
14.00%
Standard
Deviation
14.96%
25.50%
15.29%
Capital Markets
Coefficient
Variation
0.80
0.45
0.92
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Reward/Risk Relationship

Coefficient of variation = Reward / Risk
=
Expected return / Standard deviation or
Beta
 Textbook: Reward-to-risk ratio

In an efficient market, should be the
same for all assets
Capital Markets
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News and Expected Returns

Surprise news: impacts stock price
 MSFT
earnings are below estimates
 Inflation is higher than expected

What the market already knows is
discounted into current stock price
Capital Markets
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