Chapter 3
Market Risk and Returns
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Efficient Financial Markets
• Market efficiency
– Market uses all information
• Economy
• Financial markets
• Specific company
– Price movements follow a random walk
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Stages of Efficiency
• Weak-form market efficiency
– Historical information
• Semistrong-form market efficiency
– Publicly available information
• Strong-form market efficiency
– Publicly available and private information
• Arbitrage opportunities do not exist
• Security prices are in equilibrium
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Does Market Efficiency Always
Hold?
• Stock market crash 10/19/87
– Down 20% in hours
• Efficient Market Hypothesis (EMH)
– Evidence suggests exceptions
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Security Portfolios
• Expected return for a portfolio is a weighted
average of expected returns for securities in the
m
portfolio
rp  r j A j

j 1
– Where rj is expected return on security j and Aj
is proportion of total funds invested in security j
• Diversification
– Combining securities to reduce relative risk
– Individual returns do not move in concert
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Covariance of Returns
• Measures how closely returns move together
• Standard deviation for a portfolio
– Variances
– Covariances
• Range of correlation
– -1 to +1
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Two-Security Efficient Set
• Opportunity set
– Risk-return tradeoff
• Diversification properties
– Diversification effect
– Reduce the standard deviation
– Minimum variance portfolio
– Efficient set
– Position on the line
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Different Correlations
• Diversifying one’s holdings
• Include securities with less than perfect
positive correlation
• Risk is lowered relative to expected return
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Multiple Security Portfolio
Analysis and Selection
• Efficient set
– Highest expected return for a given standard
deviation
– Determined on the basis of dominance
• Utility functions and investor choice
– Risk-averse investor
– Indifference curves
– Slope
• Risk-free asset
• Optimal selection
• Market portfolio
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Separation Theorem
• Borrow and lend at risk-free rate
• Optimal portfolio of risky assets
– Independent of individual’s risk preference
• Two phased approach to investing
– Determine an optimal portfolio of risky assets
– Determine the most desirable combination
• Risk-free asset
• Portfolio of risky assets
• Depends on utility preferences
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Global Diversification
•
•
•
•
Can achieve greater diversification
American Depository Receipts (ADRs)
Mutual funds
Caveats
– Higher foreign-stock returns may not
occur in the future
– Integrated financial markets lessen
diversification
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CAPM
•
•
•
•
•
•
Equilibrium model
Unavoidable risk
Tradeoff
Simple in concept
Has real world applications
Types of investment opportunities
– Risk-free security
– Market portfolio
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CAPM
Expected Return
Tradeoff
Unavoidable Risk
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CAPM Assumptions
•
•
•
•
•
•
•
•
Capital markets are highly efficient
Investors are well informed
Zero transaction costs
Negligible restrictions on investment
No taxes
No investor can affect market price
General agreement about performance and risk
Common holding period
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The Characteristic Line
• Excess returns
• Historical data
• Future return estimates from security analysts
– Conditional on a specific market return
– Pessimistic estimate
– Most likely estimate
– Optimistic estimate
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Characteristic Line
Excess Returns for Stock
Relationship
Excess Returns for Market Portfolio
Measurements
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Alpha
Beta
Unsystematic Risk
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A Security Alpha
• In theory, the characteristic line should
intercept the y-axis at 0
– If intercept is < 0  avoid the stock
– If intercept is > 0  buy the stock
• Equilibration process
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The Systematic Risk as
Measures by Beta
• Most important measurement of risk
– Depicts the sensitivity of the security’s excess
return to that of the market portfolio
• Slope of the characteristic line
– Slope is 1 excess returns very proportionally
– Slope > 1 excess return varies more
• Aggressive investment
– Slope < 1 excess return varies less
• Defensive investment
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Beta
• Amplification of risk
• Represents a stock’s contribution to the risk
of a portfolio
• Past betas useful in predicting future betas
• Obtaining beta
– Organizations compute and publish
– Regression analysis
– Comparable firms
• Adjusting historical betas
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Unsystematic Risk
• Variability of the stock’s excess return not
associated with the market
• As dispersion increases, unsystematic risk
increases
• Diversification reduces unsystematic risk
• Total risk = systematic + unsystematic
risk
risk
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Diversification
• Moderate amount of diversification
– 15-20 stocks
• Efficient diversification
– Only systematic risk remains
• CAPM assumes diversification
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Expected Return for Individual
Securities
• Expected rate of return


R j  R f  Rm  R f  j
– Risk-free rate R f 
 
– Return for the market return R m
– Beta  j
• Risk premium
– (Expected market return) - (risk-free rate)
• Beta of a portfolio
– Weighted average of the betas of the securities
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 
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The Security Market Line
• Describes the market price of risk in the capital
markets
• Linear relationship between expected rate of
return and systematic risk
• No reward for unsystematic risk
• Important to differentiate systematic risk from
total risk
• Equilibrium
– Undervalued
– Overvalued
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Implications for the Valuation
of the firm
• Decisions of the firm can be judged by their
effect on valuation
• Unsystematic risk may become a factor
– CAPM assumptions
– Market imperfections
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Certain Issues with the CAPM
• Maturity of risk-free security
– Short-term rate
– Intermediate-term rate
– Long-term rate
• Equity risk premium
– Larger when interest rates are lower
– Smaller when they are high
– Can change over time
• Faulty use of the market index
• Fama-French and beta as a risk measure
– Small stock effect
– Low P/E and market-to-book-value ratios
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Some Final Observations
• CAPM is widely used because of its simplicity
• CAPM has a number of challenges
• Alternative models are being developed
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