CHAPTER 6
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Transcript of CHAPTER 6
1
CHAPTER 6
Risk, Return, and the Capital Asset Pricing
Model (CAPM)
2
Topics in Chapter 6
Basic return measurement Types of Risk addressed in Ch 6
Stand-alone (total) risk Portfolio (market) risk
Relationship between risk and return: CAPM/SML
3
Investment Returns
Returns may be: actual or expected.
Returns can be expressed in: dollars or percentage.
Returns include changes in asset value.
4
What is investment risk?
Risk exists any time returns are not known with certainty.
Why is risk important?
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Stand-Alone Risk
Stand-alone (total) risk is the risk facing an investor (firm) who owns only one asset.
Measures of stand-alone risk: Standard deviation Variance Coefficient of variation (CV)
6
Adding Stocks to a Portfolio
What happens to the risk of a one-stock portfolio as additional randomly selected stocks are included?
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stock ≈ 35%Many stocks ≈ 20%
-75 -60 -45 -30 -15 0 15 30 45 60 75 90 105
Returns (% )
1 stock2 stocksMany stocks
810 20 30 40 2,000 stocks
Company Specific (Diversifiable) Risk
Market Risk
20%
0
Stand-Alone Risk, p
p
35%
Risk vs. Number of Stock in Portfolio
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Stand-alone risk = Market risk + Diversifiable risk
Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification.
Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that can be eliminated by diversification.
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Beta
Market risk is measured by beta. Beta indicates:
A stock’s contribution to the risk of a diversified portfolio
The stock’s volatility relative to the market:
beta > 1.0 high risk beta = 1.0 average risk
beta < 1.0 low risk
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Using a Regression to Estimate Beta
To estimate a stock’s beta, plot the stock’s returns on the Y axis and market returns on the X axis.
The slope of the line of best fit as estimated through regression is the stock’s beta coefficient, or b.
12
Use the SML to calculate an asset’s required return.
The Security Market Line (SML) is part of CAPM. The equation for the SML is:
ri = rRF + (RPM)i ri is the required return on security i rRF is the risk-free interest rate RPM is the risk premium on the market i is the beta for security i