08 Zutter Smart PMF 16e ch08

Principles of Managerial Finance
Sixteenth Edition, Global Edition
Chapter 8
Risk and Return
Copyright © 2022 Pearson Education, Ltd.

Learning Goals (1 of 2)
L G 1 Understand the meaning and fundamentals of risk,
return, and risk preferences.
L G 2 Describe procedures for assessing and measuring the
risk of a single asset.
L G 3 Discuss the measurement of return and standard
deviation for a portfolio and the concept of correlation.

Learning Goals (2 of 2)
L G 4 Understand the role that correlation plays in
constructing an efficient portfolio.
L G 5 Review the two types of risk and the derivation and
role of beta in measuring the relevant risk of both a
security and a portfolio.
L G 6 Explain the capital asset pricing model (CAPM), its
relationship to the security market line (SML), and the
major forces causing shifts in the SML.

8.1 Risk and Return Fundamentals
(1 of 4)
• Portfolio
– A collection or group of assets
• What Is Risk?
– Risk
 A measure of the uncertainty surrounding the return that
an investment will earn
• What Is Return?
– Total Rate of Return
 The total gain or loss experienced on an investment over
a given period expressed as a percentage of the
investment’s value; calculated by dividing the asset’s
change in value, plus cash distributions during the
period, by its beginning-of-period value
(2 of 4)
• What Is Return?
Pt  Pt 1  Ct
rt  (8.1)
Pt 1
 Where:
– rt = Total return during period t
– Pt = Price of asset at time t
– Pt − 1 = Price of asset at time t − 1
– Ct = Cash flow received from the asset during period
t Copyright © 2022 Pearson Education, Ltd.
Example 8.1 (1 of 2)
Robin wishes to determine the return on two stocks she
owned during 2019, McDonald’s and Walmart. At the
beginning of the year, McDonald’s stock traded for $170.84
per share, and Walmart stock was valued at $90.69. During
the year, McDonald’s paid $4.73 per share in dividends, and
Walmart shareholders received dividends of $2.12 per share.
At the end of the year, McDonald’s stock was worth $196.38,
and Walmart stock sold for $117.80.

Substituting into Equation 8.1, we can calculate the annual
rate of return for each stock:
McDonald’s: ($196.38 − $170.84 + $4.73) ÷ 170.84 = 17.7%
Walmart: ($117.80 − $90.69 + $2.12) ÷ $90.69 = 32.2%
Robin made money on both stocks in 2019. On a
percentage basis, her return was higher on Walmart stock,
though her profit in dollar terms was $30.27 on McDonald’s
stock versus $29.23 for Walmart.

(3 of 4)
• What Is Return?
 Realized Return
– Historical return
 Expected Return
– The return that an asset is expected to generate
in future, composed of a risk-free rate plus a risk
premium

Table 8.1 Historical Returns on
Selected Investments (1900–2019)
Investment Average nominal return Average real return
Treasury bills 3.7% 0.9%
Treasury bonds 5.3 2.5
Common stocks 11.5 8.5
Source: Elroy Dimson, Paul Marsh, Mike Staunton, Credit Suisse Global
Investment Returns Yearbook 2020.
(4 of 4)
• Risk Preferences
– Risk Seeking
 The attitude toward risk in which investors prefer
investments with greater risk, perhaps even if they
have lower expected returns
– Risk Neutral
 The attitude toward risk in which investors choose the
investment with the higher expected return regardless
of its risk
– Risk Averse
 The attitude toward risk in which investors require an
increased expected return as compensation for an
increase in risk
8.2 Risk of a Single Asset (1 of 10)
• Risk Assessment
– Scenario Analysis
 An approach for assessing risk that uses several
possible alternative outcomes (scenarios) to obtain
a sense of the variability among returns
– Range
 A measure of an asset’s risk, which is found by
subtracting the return associated with the
pessimistic (worst) outcome from the return
associated with the optimistic (best) outcome

Example 8.2
Norman Company, a manufacturer of custom golf equipment,
wants to choose the better of two investments, A and B. Each
requires an initial outlay of $10,000, and each has a most
likely annual rate of return of 15%. Management has
estimated returns associated with each investment’s
pessimistic and optimistic outcomes. Table 8.2 lists the three
return estimates for each asset and the range between the
best and worst outcomes. Asset A appears to be less risky
than asset B; its range of 4% (17% −13%) is less than the
range of 16% (23% − 7%) for asset B. The risk-averse
decision maker would prefer asset A over asset B, because A
offers the same most likely return as B (15%), with lower risk
(smaller range).

Table 8.2 Norman Company Assets A
and B
Asset A Asset B
Initial investment $10,000 $10,000
Annual rate of return
Pessimistic 13% 7%
Most likely 15% 15%
Optimistic 17% 23%
Range 4% 16%

• Risk Assessment
– Probability Distributions
 Probability
– The chance that a given outcome will occur
 Discrete Probability Distribution
– Lists every possible value of some random variable
along with the probability of each outcome
 Bar Chart
– A visual representation of a discrete probability
distribution
 Histogram
– A graph that puts historical data into bins and shows
the relative frequency of data points in each bin

Figure 8.1 Bar Charts

Example 8.3
Norman Company’s past estimates indicate that the
probabilities of the pessimistic, most likely, and optimistic
outcomes are 25%, 50%, and 25%, respectively. Note that
the sum of these probabilities must equal 100%; that is, the
probability distribution must assign a probability to every
possible outcome such that no other outcomes are possible.

Figure 8.2 Histograms for Coca-Cola
and Google (1 of 2)

Figure 8.2 Histograms for Coca-Cola
and Google (2 of 2)

Matter of Fact (1 of 2)
Beware of the Black Swan
Is it ever possible to know for sure that a particular outcome
can never happen—that the chance of its occurrence is 0%?
In the 2007 bestseller The Black Swan: The Impact of the
Highly Improbable, Nassim Nicholas Taleb argues that
seemingly improbable or even impossible events are more
likely to occur than most people think, especially in the area
of finance. The book’s title refers to a long-held belief that all
swans were white, a belief held by many people until a black
variety was discovered in Australia. Taleb reportedly earned
a large fortune during the 2007–2008 financial crisis by
betting that financial markets would plummet.

• Risk Assessment
– Probability Distributions
 Continuous Probability Distribution
– A probability distribution showing all the possible
outcomes and associated probabilities for a given
event

• Risk Measurement
– Variance and Standard Deviation
 Variance (σ2)
– A measure of the dispersion or volatility of an
investment’s return about its average return
 Standard Deviation (σ)
– The square root of variance

 Average return (r̅ )
n
r   rj  Pr j (8.2)
j 1
– where
 rj = Return for the jth outcome
 Prj = Probability of occurrence of the jth
outcome
 n = Number of outcomes considered

 An investment’s average return can be estimated by
taking the arithmetic mean from a series of n
historical returns
n
r
j 1
j
r (8.2a)
n

Example 8.4
Table 8.3 presents the average returns for Norman
Company’s assets A and B. Column one gives the
probability of each outcome, Prj , and column two
gives the return associated with each outcome, rj.
Each asset’s average return is 15%.

Table 8.3 Average Returns for
Norman Company Assets A and B
Possible outcomes Probability Prj Returns rj Prj × rj
Asset A
Pessimistic 0.25 13% 3.25%
Most likely 0.50 15 7.50
Optimistic 0.25 17 4.25
Total 1.00 Average return
15.00%
Asset B
Pessimistic 0.25 7% 1.75%
Most likely 0.50 15 7.50
Optimistic 0.25 23 5.75
Total 1.00 Average 15.00%

– With an estimate of the average return in hand, we can
calculate the variance and its square root, the standard
deviation
– When the j outcomes and their probabilities are known, the
expressions for variance and standard deviation are
 Variance σ2
 
n
   rj  r  Prj 
 2
2
  8.3
j 1 
 Standard Deviation of Returns (σ)
 
n
   rj  r  Prj 
 2
(8.3a)

j 1 


– In the more common situation of knowing neither the
full list of possible outcomes nor their associated
probabilities, we estimate the variance and standard
deviation using n observations of historical data, using
the following formulas:
2
 r 
n
j r
2  j 1
8.4 
n 1
 r 
n 2
j r
 j 1
8.4 a 
n 1
Example 8.5
Table 8.4 presents the standard deviations for Norman
Company’s assets A and B, based on the data in Table 8.3.
The standard deviation for asset A is 1.41%, and the
standard deviation for asset B is 5.66%, clearly reflecting B’s
higher volatility.

Table 8.4 Calculating the Standard
Deviation of the Returns for Norman
Company Assets A and B

 Historical Returns and Risk
– Investments with higher returns have higher
standard deviations
 Normal Probability Distribution
– A symmetrical probability distribution that
resembles a “bell-shaped” curve

Matter of Fact (2 of 2)
All Stocks Are Not Created Equal
Table 8.5 shows that stocks are riskier than bonds, but are
some stocks riskier than others? The answer is emphatically
yes. A recent study examined the historical returns of large
stocks and small stocks and found that the average annual
return on large stocks over the previous century was 12.0%,
while small stocks earned 16.6% per year on average. The
higher returns on small stocks came with a cost, however.
The standard deviation of small stock returns was a
whopping 31.9%, whereas the standard deviation on large
stocks was just 19.9%.

Table 8.5 Historical Returns and
Standard Deviations on Selected
Investments (1900–2019)
Investment Average nominal return Standard deviation Coefficient of variation
Treasury bills 3.7% 2.9% 0.78
Treasury 5.3 8.9 1.68

bonds
Common 11.5 19.7 1.71
stocks
Source: Elroy Dimson, Paul Marsh, Mike Staunton, Credit Suisse Global
Investment Returns Yearbook 2020.

Figure 8.3 Bell-Shaped Curve

Example 8.6
Using the data in Table 8.5 and assuming that the probability
distributions of returns for common stocks and bonds are
normal, we can surmise that 68% of the possible outcomes
would have a return ranging between −8.2% and 31.2% for
stocks and between −3.6% and 14.2% for bonds; 95% of the
possible return outcomes would range between −27.9% and
50.9% for stocks and between −12.5% and 23.1% for bonds.
The greater volatility of stock returns is clearly reflected in
the much wider range of possible returns for each level of
confidence (68% or 95%).

– Coefficient of Variation: Trading Off Risk and Return
 Coefficient of Variation (C V)
– A measure of relative dispersion that is useful in
comparing assets with different average, or
expected, returns

CV  (8.5)
r
– A higher coefficient of variation means that an
investment has more volatility relative to its
expected return.

Example 8.7
Substituting the standard deviations (from Table 8.4) and the
expected returns (from Table 8.3) for assets A and B into
Equation 8.5, we find that the coefficients of variation for A
and B are 0.094 (1.41% ÷ 15%) and 0.377 (5.66% ÷ 15%),
respectively. Asset B has the higher coefficient of variation.

Personal Finance Example 8.8 (1 of 4)
Marilyn Ansbro is reviewing stocks for inclusion in her
investment portfolio. The stock she wishes to analyze is
Danhaus Industries Inc. (DI I), a diversified manufacturer of
pet products. One of her key concerns is risk; as a rule, she
will invest only in stocks with a coefficient of variation below
0.75. She has gathered price and dividend data (shown in
the accompanying table) for DI I over the past three years,
and she plans to calculate DI I’s coefficient of variation using
this admittedly limited historical sample.

Substituting the price and dividend data for each year into
Equation 8.1, we calculate the return on DI I stock in each
year.
Year Returns
1 ($36.50 − $35.00 + $3.50) ÷ $35.00 = 14.3%
2 ($34.50 − $36.50 + $3.50) ÷ $36.50 = 4.1%
3 ($35.00 − $34.50 + $4.00) ÷ $34.50 = 13.0%
Substituting into Equation 8.2a we get the average return, r̅ :

r̅ = (14.3% + 4.1% + 13.0% ) ÷ 3 = 10.5%

Substituting the average return and annual returns into
Equation 8.4a, we get the standard deviation, σ:
  14.3%  10.5%    4.1%  10.5%   13.0%  10.5%   3  1

 2 2 2
 
 14.44%  40.96%  6.25%   30.825%  5.6%
Finally, substituting the standard deviation of returns and the

average return into Equation 8.5, we get the coefficient of
variation, CV:
CV = 5.6% ÷ 10.5% = 0.53

Because the coefficient of variation of returns on the DI I
stock over this period of 0.53 is well below Marilyn’s
maximum coefficient of variation of 0.75, she concludes that
the DI I stock would be an acceptable investment.

8.3 Risk of a Portfolio (1 of 8)
• Risk of a Portfolio
– Efficient Portfolio
 A portfolio that maximizes return for a given level of risk
– Return on a Portfolio (rp)
 Weighted average of the returns on the individual assets
from which it is formed
n
rp  ( w1  r1 )  ( w2  r2 )  ...  ( wn  rn )   w j  rj (8.6)
j 1
where
– wj = percentage of the portfolio’s total dollar value
invested in asset j
– rj = return on asset j
Example 8.9
James purchases 10 shares of JPMorgan at a price of $90 per
share, so his total investment in JPMorgan is $900. He also
buys 27 shares of Medtronic at $100 per share, so the total
investment in Medtronic is $2,700. Combining these two
holdings, James’s total portfolio is worth $3,600. Of the total,
25% is invested in JPMorgan ($900 ÷ $3,600), and 75% is
invested in Medtronic ($2,700 ÷ $3,600). Thus, w1 = 0.25,
w2 = 0.75, and w1 + w2 = 1.0.

• Risk of a Portfolio
– Average Return on a Portfolio (r̅ p)
r p  ( w1  r1 )  ( w2  r 2 )  ...  ( wn  r n )   j 1 w j r j
n
(8.7)

Table 8.6 Panel C applies the monthly return series in Panel
A and the average returns in Panel B to Equation 8.4a to find
the respective standard deviations, which tell us about the
month-to-month fluctuations in the return series. Intuitively,
you might guess that the portfolio’s standard deviation equals
a weighted average of the standard deviations of JPMorgan
and Medtronic. In this case, that intuition is flawed.
JPMorgan’s standard deviation is 6.5% and Medtronic’s is
2.8%. A simple weighted average of these two values, using
25% weight for JPMorgan and 75% for Medtronic, would say
that the portfolio’s standard deviation is 3.7% (0.25 × 6.5% +
0.75 × 2.8%), but that is incorrect.

Panel C shows the step-by-step standard deviation
calculation, which indicates that the portfolio’s standard
deviation is just 1.7%! That’s remarkable because the
portfolio is less volatile than either asset in the portfolio. To
say that differently, of the two stocks, Medtronic has less
volatility (2.8% vs. 6.5% for JPMorgan). You might guess that
the safest way to form a portfolio of these two assets is to not
form a portfolio at all and just invest everything in Medtronic.
That would be wrong, because the portfolio that invests 25%
in JPMorgan is less volatile than Medtronic is all by itself.

Carefully scanning the numbers in the last column of Table
8.6 makes this point clear. The portfolio’s highest and lowest
returns are 5.3% and –0.4% respectively. In seven out of 10
months the portfolio’s return is between 2% and 3.2%, and in
only one month does the portfolio return go negative. The
individual stock returns vary a great deal more.

Table 8.6 Individual and Portfolio
Returns and Standard Deviation of
Returns for JPMorgan (JPM) and
Medtronic (MDT) (1 of 3)
A. Individual and Portfolio Monthly Returns6

B. Individual and Portfolio Average Returns7

C. Individual and Portfolio Standard Deviations8

• Correlation
– A statistical measure of the relationship between any
two series of numbers
– Positively Correlated
 Describes two series that move in the same
direction
– Negatively Correlated
 Describes two series that move in opposite
directions

Figure 8.4 Part A: Monthly Returns on
JPMorgan Chase and Medtronic

Figure 8.4 Part B: Monthly Returns on
JPMorgan Chase and Morgan Stanley

• Correlation
– Correlation Coefficient
 A measure of the degree of correlation between two
series
– Perfectly Positively Correlated
 Describes two positively correlated series that have
a correlation coefficient of +1
– Perfectly Negatively Correlated
 Describes two negatively correlated series that have
a correlation coefficient of −1
– Uncorrelated
 Describes two series that lack any interaction and
therefore have a correlation coefficient of zero
• Correlation
– Mathematically, the correlation coefficient between two
stocks i and j, pij, calculated using n historical
observations, equals
ij   
n 
 rt ,i  ri

 
rt , j  rj     n  1 (8.8)
t 1  i j 
 
r
1i  ri   r
1j rj   r
2i  ri   r
2j rj   ...   r
ni  ri   r
nj rj 
i j i j i j
ij  (8.8a)
 n  1

• Diversification and Efficient Portfolios
– To reduce portfolio risk, it is best to diversify by
combining, or adding to the portfolio, assets that have
the lowest possible correlation
– Combining assets that have a low correlation with each
can sometimes simultaneously increase a portfolio’s
return while decreasing its standard deviation
– Whenever assets are perfectly negatively correlated,
some combination of the two assets exists such that
the resulting portfolio’s returns are risk free

Table 8.7 Correlation Coefficient for
JPMorgan (JPM) and Medtronic
(MDT) (1 of 2)

Table 8.7 Correlation Coefficient for
JPMorgan (JPM) and Medtronic
(MDT) (2 of 2)

• Diversification and Efficient Portfolios
– We have already seen that the average return on a
portfolio depends on the average returns of the stocks
in the portfolio
– A portfolio’s standard deviation depends not only on the
standard deviations of the stocks in the portfolio but
also on how those stocks are correlated with each
other
– If the portfolio consists of just two stocks, the formula
for the standard deviation of a portfolio is
 p  w12 12  w22 22  2w1w2 1 2 12 (8.9)

Table 8.6 walked through the calculation of the standard
deviation of a portfolio consisting of 25% JPMorgan and 75%
Medtronic, but we can do that using Equation 8.9 instead.
Summarizing what we know about the two stocks already:

Plugging the relevant numbers into Equation 8.9 we have
 p  0.252  (6.5%) 2  0.752  (2.8%) 2  2  0.25  0.75  6.5%  2.8%  0.62  1.7%
Confirming the result in Example 8.10, the standard

deviation of a portfolio that invests 25% in JPMorgan and
75% in Medtronic is just 1.7%, which is less than the
standard deviation of either stock on its own.

Table 8.8 Average Return and
Standard Deviation for Portfolios of
JPMorgan and Medtronic (1 of 2)

Table 8.8 Average Return and
Standard Deviation for Portfolios of
JPMorgan and Medtronic (2 of 2)

Figure 8.5 Average Return and
Standard Deviation of Portfolios of
JPMorgan and Medtronic

Table 8.9 presents historical returns from three different
assets—X, Y, and Z—from 2017 to 2021, along with their
average returns and standard deviations. The assets are
similar in that they each have the same average return of
12% and the same standard deviation of 3.16%. The returns
of X and Y are perfectly negatively correlated. When X
enjoys its highest return, Y experiences its lowest return and
vice versa. Alternatively, the returns of X and Z are perfectly
positively correlated. They move in precisely the same
direction, so when the return on X is high, so is the return on
Z. (Note: The returns for X and Z are identical.) Now let’s
consider what happens when we combine these assets in
different ways to form portfolios.

Portfolio X Y Portfolio X Y combines equal portions of assets
X and Y, the perfectly negatively correlated assets. The
return on this portfolio, rxy, is 12% all the time. Thus,
portfolio X Y completely eliminates risk because in each and
every year the portfolio earns a 12% return. Whenever
assets are perfectly negatively correlated, some combination
of the two assets exists such that the resulting portfolio’s
returns are risk free.

Portfolio XZ Portfolio XZ combines equal portions of assets
X and Z, the perfectly positively correlated assets.
Individually, assets X and Z have the same standard
deviation, 3.16%, and because they always move together,
the standard deviation of a portfolio of X and Z will be a
simple weighted average of the standard deviation of X and
the standard deviation of Z. As was the case with portfolio
XY, the average return of portfolio XZ is 12%.
Because both portfolios provide the same average return,
but portfolio XY achieves that expected return with no risk,
portfolio XY is clearly preferred by risk-averse investors over
portfolio XZ.

Table 8.9 Average Returns and
Standard Deviations for Portfolios
X Y and X Z

• Summary of the Effect of Correlation on Risk and Return
– In general, the lower the correlation between asset
returns, the greater the risk reduction that investors can
achieve by diversifying

Consider two assets—Lo and Hi—with the characteristics
described in the following table.
Clearly, asset Lo offers a lower average return than Hi does,

but Lo is also less volatile than Hi. We have seen that a
portfolio of these two assets will always have an average
return that falls between 6% and 8%. The correlation
between them does not affect the portfolio’s average return.
However, the correlation does affect the portfolios’ standard
deviation.
Figure 8.6 illustrates three specific scenarios: (1) returns on
Lo and Hi are perfectly positively correlated, (2) returns on
Lo and Hi are uncorrelated, and (3) returns on Lo and Hi are
perfectly negatively correlated.
Whether the correlation between Lo and Hi is +1, 0, or -1, a
portfolio of those two assets must have an average return
between 6% and 8%. That is why the line segments at the
left in Figure 8.6 all range between 6% and 8%. If a portfolio
is mostly invested in Lo with only a little money invested in
Hi, the portfolio’s return will be close to 6%. If more money is
invested in Hi, the portfolio return will be closer to 8%.

However, the standard deviation of a portfolio depends
critically on the correlation between Lo and Hi. Only when Lo
and Hi are perfectly positively correlated can it be said that
the portfolio standard deviation must fall between 3% (Lo’s
standard deviation) and 8% (Hi’s standard deviation). As the
correlation between Lo and Hi becomes weaker (i.e., as the
correlation coefficient falls), investors may find they can form
portfolios of Lo and Hi with standard deviations that are even
less than 3% (i.e., portfolios that are less risky than holding
asset Lo by itself). That is why the line segments at the right
in Figure 8.6 vary. In the special case when Lo and Hi are
perfectly negatively correlated, it is possible to diversify away
all the risk and form a portfolio that is risk free.

Figure 8.6 Possible Correlations

8.4 Risk and Return: The Capital
Asset Pricing Model (CAP M) (1 of 14)
• Capital Asset Pricing Model (CAP M)
– The classic theory that links risk and return for all assets
• Types of Risk
– Total Risk
 The combination of a security’s nondiversifiable risk and
diversifiable risk
Total security risk = Nondiversifiable risk + Diversifiable risk (8.10)
– Diversifiable Risk
 The portion of an asset’s risk that is unique to that asset and
can be eliminated through diversification
 Also called unsystematic risk, idiosyncratic risk, unique risk, or
firm-specific risk

Asset Pricing Model (CAP M) (2 of 14)
– Nondiversifiable Risk
 The relevant portion of an asset’s risk attributable to
market factors that affect most if not all firms
 Cannot be eliminated through diversification
 Also called systematic risk or market risk

Figure 8.7 Risk Reduction

Asset Pricing Model (C A P M) (3 of 14)
• The Model: CAP M
– The capital asset pricing model (CAP M) links
nondiversifiable risk to expected returns
– Beta Coefficient (β)
 A relative measure of nondiversifiable risk
 An index of the degree of movement of an asset’s
return in response to a change in the market return
– Market Return
 The return on the market portfolio of all traded
securities
 Analysts often use the S&P 500 or similar stock index
as the market return
 Deriving Beta from Return Data
– Estimate the “characteristic line”
• The slope of this line is beta, (β)

Figure 8.8 Beta Derivation

 Interpreting Betas
– The beta coefficient for the entire market (and
the average beta across all stocks) equals 1.0
– All other betas are viewed in relation to this
value
– Asset betas may be positive or negative, but
positive betas are the norm
– The majority of beta coefficients fall between 0.5
and 2.0
 Portfolio Betas
– Portfolio betas are interpreted in the same way
as the betas of individual assets
n
 p  ( w1  1 )  ( w2   2 )  ...  ( wn   n )   w j   j (8.11)
j 1

Table 8.10 Selected Beta Coefficients
and Their Interpretations

Table 8.11 Beta Coefficients for
Selected Stocks (April 2020)
Source: Data from Yahoo Finance, www.finance.yahoo.com

Mario Austino, an individual investor, wishes to assess the
risk of two small portfolios he is considering. The first is a
portfolio that Mario called “the necessities,” which includes
investments in five stocks listed in Table 8.11: Costco,
Exxon, PepsiCo, Starbucks, and Walmart. Mario’s “high-
tech” portfolio also contains five stocks: Amazon, Apple,
Intel, Microsoft, and Qualcomm.

In each portfolio, Mario invests the same proportion (20%) in

each of the five stocks. Using Equation 8.11 and the betas
from Table 8.11, Mario calculates the beta of each of his
portfolios:
βnecessities = (0.20 × 0.70) + (0.20× 1.36) + (0.20 × 0.66)
+ (0.20 × 0.80) + (0.20 × 0.32) = 0.77
Βhigh-tech = (0.20 × 1.35) + (0.20 × 1.17) + (0.20 × 0.82)

+ (0.20 × 0.95) + (0.20 × 1.38) = 1.13

The necessities portfolio beta is 0.77 compared with the
1.13 beta of the tech portfolio. Those numbers may not
seem very different, but the tech portfolio is almost 47%
more risky than the necessities portfolio (i.e., (1.13 - 0.77) ÷
0.77 = 47%). Next, Mario needs a way to assess how much
extra return he should anticipate if he chooses to hold the
riskier portfolio.

– The Equation
rj  RF   j   rm  RF  (8.12)
– where
 rj = Expected return or required return on asset j
 RF = Risk-free rate of return, commonly measured
by the return on a U.S. Treasury bill
 βj = Beta coefficient or index of nondiversifiable risk
for asset j
 rm = expected return on the market portfolio of
assets Copyright © 2022 Pearson Education, Ltd.
– The Equation
 Risk-Free Rate of Return (RF)
– The required return on a risk-free asset, typically
a 3-month U.S. Treasury bill
 U.S. Treasury bills (T-bills)
– Short-term IOUs issued by the U.S. Treasury
– Considered the risk-free asset

– The Equation
 Historical Risk Premiums
– The calculation involves merely subtracting the
historical U.S. Treasury bill’s average return from the
historical average return for a given investment:
a
Historical average returns obtained from Table 8.1.
Mario Austino wants to know what return he should expect
from the high-tech portfolio with a beta of 1.13. The risk-free
rate of return is 2%, and Mario expects that the risk premium
on the market portfolio will be just 4%, much lower than its
long-run historical average. This means the expected return
on the market portfolio is 6%. After substituting that
information into Equation 8.12, the expected return on the
high-tech portfolio is
r = 2% + 1.13 (6% − 2%) = 6.5%

The market risk premium of 4% (6% − 2%), when adjusted
for the asset’s index of risk (beta) of 1.13, results in a risk
premium for the high-tech portfolio of 4.5% (6.5% − 2%).
That risk premium, when added to the 2% risk-free rate,
results in an 6.5% required return.
Other things being equal, the higher the beta, the higher the
required return, and the lower the beta, the lower the
required return.

– The Graph: The Security Market Line (S M L)
 Security Market Line (S M L)
– The graphical depiction of the capital asset
pricing model (CAP M), which shows how the
expected or required return in the marketplace
depends on nondiversifiable risk (beta)

We can plot the S M L by connecting two points for which we
already know the expected return (from the previous
example) and the beta. The first point is the risk-free asset,
which has a return of 2% and a beta of 0.0 (because it has
no risk and does not move when the market moves). The
second point is the market portfolio, which has a return of
6% and a beta of 1.0. Plotting those two points on a graph
and connecting them with a straight line yields the SML
shown in Figure 8.9. The line has an intercept of 2%,
meaning that a security with no risk earns a 2% return. The
slope of the line is 4%, equal to the risk premium on the
market portfolio (6% − 2%).

The figure highlights that there is a tradeoff between a
security’s nondiversifiable risk and its required return, and
for any beta the figure makes it easy to find the associated
expected return. For example, an asset, Z, that has a beta of
1.5, has a required return of 8%. Thus, asset Z’s risk
premium is 6% (8% − 2%), which is higher than the market’s
risk premium. The general principle illustrated in the figure is
that the risk premium for an asset with a beta greater than
1.0 will be greater than the risk premium of the market,
whereas an asset with a beta below 1.0 will have a risk
premium that is less than the market’s risk premium.

Figure 8.9 Security Market Line

– The Graph: The Security Market Line (SM L)
 Shifts in the Security Market Line
– Changes in Inflationary Expectations
• Changes in inflationary expectations affect
the risk-free rate of return, RF
RF = r* + i (8.13)
• Changes in inflationary expectations result in

parallel shifts in the SML in direct response to
the magnitude and direction of2022
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Pearson Education, Ltd.
In the preceding example, using the CAP M, the required
return for asset Z, rZ, was 8%. Assuming that the risk-free
rate of 2% includes a 1% real rate of interest and a 1%
inflation premium, IP, then Equation 8.13 confirms that
RF = 1% + 1% = 2%
Now assume that recent economic events have resulted in
an increase of 3% in inflationary expectations, raising the
inflation premium to 4%. As a result, all returns likewise rise
by 3%. In this case, the new returns (noted by subscript 1)
are
RF1 = 5% (rises from 2% to 5%)
rm1 = 9% (rises from 6% to 9%)
Substituting these values, along with asset Z’s beta (βZ) of
1.5, into the CAP M (Equation 8.12), we find that asset Z’s
new required return (rZ1) also increases by 3%:
rZ1 = 5% + 1.5 × (9% − 5%) = 5% + 6% = 11%
Comparing rZ1 of 11% to rZ of 8%, we see that the change of
3% in asset Z’s required return exactly equals the change in
the inflation premium. The same 3% increase results for all
assets.

Figure 8.10 depicts this situation. It shows that the 3%
increase in inflationary expectations results in a parallel shift
upward of 3% in the S M L, which means that the required
returns on all assets rise by 3%. Note that the rise in the
inflation premium from 1% to 4% causes the risk-free rate to
rise from 2% to 5% (RF to RF1) and the market return to
increase from 6% to 9% (rm to rm1). The important lesson
here is that a change in inflationary expectations will cause
a corresponding change in the returns of all assets, as
reflected graphically in a parallel shift of the S M L.

Figure 8.10 Inflation Shifts SML

– The Graph: The Security Market Line (S M L)
 Changes in Risk Aversion
– The slope of the security market line reflects the general
risk preferences of investors in the marketplace
– Most investors are risk averse
– If investors become more risk averse, then the slope of
the SML becomes steeper, as they demand a higher
return for any risk level
– Changes in risk aversion and the slope of the SML result
from changing preferences of investors, which generally
stem form economic, political, or social events.

The S M L in Figure 8.9 reflected a risk-free rate (RF) of 2%,
a market return (rm) of 6%, a market risk premium (rm − RF)
of 4%, and a required return on asset Z (rZ) of 8% with a
beta (βZ) of 1.5. Assume that recent economic events have
made investors more risk averse, causing them to demand
a higher risk premium on the market portfolio. Assume that
the risk premium rises to 7%, so that the market return (rm1)
increases to 9%. Graphically, this change would cause the
SM L to pivot upward as shown in Figure 8.11. The required
return on all risky assets will increase.

We can calculate the new required return for asset Z, with a
beta of 1.5, by using the CAP M (Equation 8.12):
rZ1 = 2% + 1.5 × (9% − 2%) = 2% + 10.5% = 12.5%
This value appears on the new security market line (S M L1)
in Figure 8.11. Note that although asset Z’s risk, as
measured by beta, did not change, its required return has
increased because of the increased risk aversion reflected in
the market risk premium. To summarize, greater risk
aversion results in higher required returns for each level of
risk. Similarly, a reduction in risk aversion causes the
required return for each level of risk to decline.

Figure 8.11 Risk Aversion Shifts S M L

– Some Comments on the CAP M
 To estimate a stock’s beta, analysts generally use
historical data
 The estimated beta may or may not actually indicate
the future variability of returns
 Users of betas commonly make subjective
adjustments to the historically determined betas to
reflect their expectations of the future
 Studies have supported the CAP M’s main
prediction that stocks with higher betas should have
higher returns on average
– Some Comments on the CAP M
 Studies have uncovered other characteristics that appear to
influence returns, besides beta only as the CAP M predicts
– Over time, small firms, for example, tend to earn higher
returns than large firms do, even after taking into account
that smaller firms often have higher betas.
 Despite its limitations, the CAP M sees widespread application
in corporations that use the model to assess the required
returns their shareholders demand
 Most large firms rely on CAP M to estimate their cost of capital,
which in turn has a major impact on the investments the firm
chooses to undertake

Review of Learning Goals (1 of 9)
• LG1
– Understand the meaning and fundamentals of risk,
 Risk is the uncertainty surrounding the return that
an investment will produce
 The total rate of return is the sum of cash
distributions, such as interest or dividends, plus the
change in the asset’s value, divided by the
investment’s beginning-of-period value
 Returns vary both over time and between different
types of investments
 Investors may be risk averse, risk neutral, or risk
seeking
• L G 1 (Cont.)
– Understand the meaning and fundamentals of risk,
 Most financial decision makers are risk averse
 A risk-averse decision maker requires a higher
expected return on a more risky investment

• LG2
– Describe procedures for assessing and measuring the
risk of a single asset.
 Risk is related to uncertainty about the return that
an investment will provide
 Scenario analysis and probability distributions can
be used to assess risk
 The range, the standard deviation, and the
coefficient of variation can measure risk
quantitatively

• LG3
– Discuss the measurement of return and standard deviation
for a portfolio and the concept of correlation.
 The return of a portfolio is calculated as the weighted
average of returns on the individual assets from which it
is formed
 The portfolio standard deviation depends on the
standard deviation of the returns on each asset in the
portfolio as well as on the correlation between those
returns
 Correlation—the statistical relationship between any two
series of numbers—can be positively correlated,
negatively correlated, or uncorrelated
 At the extremes, the series can be perfectly positively
correlated or perfectly negatively correlated
• LG4
– Understand the role that correlation plays in constructing an
efficient portfolio
 Diversification involves combining assets that are less
than perfectly correlated to reduce the risk of the
portfolio
 The range of risk in a two-asset portfolio depends on the
correlation between the two assets
 If they are perfectly positively correlated, the portfolio’s
risk will be between the individual assets’ risks
 If they are perfectly negatively correlated, the portfolio’s
risk will be between the risk of the riskier asset and zero
 An efficient portfolio is one that provides the highest
expected return for any risk level

• LG5
– Review the two types of risk and the derivation and
 The total risk of a security consists of
nondiversifiable and diversifiable risk
 Diversifiable risk can be eliminated through
diversification
 Nondiversifiable risk is the only risk that the market
rewards with higher returns
 Nondiversifiable risk is measured by the beta
coefficient, a relative measure of the relationship
between an asset’s return and the market return
• L G 5 (Cont.)
– Review the two types of risk and the derivation and
 Beta is derived by finding the slope of the
“characteristic line” that best explains the historical
relationship between the asset’s return and the
market return
 The beta of a portfolio is a weighted average of the
betas of the individual assets that it includes

• LG6
– Explain the capital asset pricing model (CAP M), its
relationship to the security market line (S M L), and the major
forces causing shifts in the S M L.
 In the CAP M, beta relates an asset’s risk relative to the
market to the asset’s required return
 The graphical depiction of the CAP M is the S M L, which
shifts over time in response to changing inflationary
expectations and/or changes in investor risk aversion
 Changes in inflationary expectations result in parallel
shifts in the S M L
 Increasing risk aversion results in the slope of the S M L
becoming steeper

• L G 6 (Cont.)
– Explain the capital asset pricing model (C A P M), its
relationship to the security market line (S M L), and the
major forces causing shifts in the S M L.
 Decreasing risk aversion reduces the slope of the
SM L
 Although it has some shortcomings, the C A P M
provides a useful conceptual framework for
evaluating and linking risk and return

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Principles of Managerial Finance

Sixteenth Edition, Global Edition

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Treasury bills 3.7% 0.9%

Treasury bonds 5.3 2.5

Common stocks 11.5 8.5

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 Standard Deviation of Returns (σ)

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Treasury bills 3.7% 2.9% 0.78

Treasury 5.3 8.9 1.68

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Substituting into Equation 8.2a we get the average return, r̅ :

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  14.3%  10.5%    4.1%  10.5%   13.0%  10.5%   3  1

Finally, substituting the standard deviation of returns and the

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