Risk, Return, and CAPM

1. Risk, Return, and CAPM Professor Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics and Law Fußzeile

2. Expected Returns Methods used to estimate expected return Decisions must be based on expected returns Historical approach Probabilistic approach Risk-based approach Fußzeile

3. Using 1900-2003 annual returns, the average risk premium for U.S. stocks relative to Treasury bills is 7.6%. Treasury bills currently offer a 2% yield to maturity Expected return on U.S. stocks: 7.6% + 2% = 9.6% Historical Approach for Estimating Expected Returns Assume that distribution of expected returns will be similar to historical distribution of returns. Can historical approach be used to estimate the expected return of an individual stock? Fußzeile

4. Historical Approach for Estimating Expected Returns Assume General Motors long-run average return is 17.0%. Treasury bills average return over same period was 4.1% GM historical risk premium: 17.0% - 4.1% = 12.9% GM expected return = Current Tbill rate + GM historical risk premium = 2% + 12.9% = 14.9% May reflect GM’s past more than its future Limitations of historical approach for individual stocks Many stocks have a long history to forecast expected return Fußzeile

5. For example, assign probabilities for possible states of economy: boom, expansion, recession and project the returns of GM stock for the three states Outcome Probability GM Return Recession 20% -30% Expansion 70% 15% Boom 10% 55% Probabilistic Approach for Estimating Expected Returns Identify all possible outcomes of returns and assign a probability to each possible outcome: GM Expected Return = 0.20(-30%) + 0.70(15%) +0.10(55%) = 10% Fußzeile

6. Risk-Based Approach for Estimating Expected Returns 1. Measure the risk of the asset 2. Use the risk measure to estimate the expected return 1. Measure the risk of the asset • Systematic risks simultaneously affect many different assets • Investors can diversify away the unsystematic risk • Market rewards only the systematic risk: only systematic risk should be related to the expected return How can we capture the systematic risk component of a stock’s volatility? Fußzeile

7. Risk-Based Approach for Estimating Expected Returns • Collect data on a stock’s returns and returns on a market index • Plot the points on a scatter plot graph • Y–axis measures stock’s return • X-axis measures market’s return • Plot a line (using linear regression) throughthe points Slope of line equals beta, the sensitivity of a stock’s returns relative to changes in overall market returns Beta is a measure of systematic risk for a particular security. Fußzeile

8. Sharper Image weekly returns S&P 500 weekly returns Scatter Plot for Returns on Sharper Image and S&P 500 Fußzeile

9. ConAgra weekly returns S&P 500 weekly returns Scatter Plot for Returns ConAgra and S&P 500 Fußzeile

10. Risk-Based Approach for Estimating Expected Returns Capital Average Market Line Return Individual Stock A: rM CAPM R f Slope CML: s2M Risk Fußzeile

11. E(RP) SML A - Undervalued • • A Slope = E(Rm) - RF = MarketRisk Premium RM • • B • • RF B - Overvalued •  =1.0 i The Security Market Line Fußzeile

12. Risk-Based Approach for Estimating Expected Returns 2. Use the risk measure to estimate the expected return: • Plot beta against expected return for two assets: • A risk-free asset that pays 4% with certainty, with zero systematic risk and • An “average stock”, with beta equal to 1, with an expected return of 10%. • Draw a straight line connecting the two points. • Investors holding a stock with beta of 0.5 or 1.5, for example, can find the expected return on the line. Beta measures systematic risk and links the risk and expected return of an asset. Fußzeile

13. Expected returns • 18% • 14% • ß = 1.5 • • 10% “average” stock • 4% Risk-free asset • • • • • • • • • • 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 Beta Risk and Expected ReturnsSecurity Market Line What is the expected return for stock with beta = 1.5 ? Fußzeile

14. Estimating the Risk Free Rate Extract of UK interest rate data from the Financial Times (17 February, 2005)

15. The Steps Towards the Estimation of Beta Using Ordinary Least Squares Regression

16. The Security Market Line

17. Arbitrage Drivers and the Linearity of the Security Market Line

18. Portfolio Expected Returns How does the expected return of a portfolio relate to the expected returns of the securities in the portfolio? Expected return of a portfolio with N securities The portfolio expected return equals the weighted average of the portfolio assets’ expected returns E(Rp) = w1E(R1)+ w2E(R2)+…+wnE(Rn) • w1, w2 , … , wn : portfolio weights • E(R1), E(R2), …, E(RN): expected returns of securities Fußzeile

19. Portfolio Expected Returns E (Rp) = w1 E (R1)+ w2 E (R2)+…+wn E (Rn) E (Rp) = (0.125) (10%) + (0.25) (12%) + (0.125) (8%) + (0.5) (14%) = 12.25% Fußzeile

20. Portfolio Risk Portfolio risk is the weighted average of systematic risk (beta) of the portfolio constituent securities. ß P = (0.125) (1.00) + (0.25) (1.33) + (0.125) (0.67) + (0.50) (1.67) = 1.38 But portfolio volatility is not the same as the weighted average of all portfolio security volatilities Fußzeile

21. Portfolio composed of the following two assets: • An asset that pays a risk-free return Rf, , and • A market portfolio that contains some of every risky asset in the market. Security Market Line Security market line: The line connecting the risk-free asset and the market portfolio Fußzeile

22. The Security Market Line • In equilibrium, all assets lie on this line. • If individual stock or portfolio lies above the line: • Expected return is too high. • Investors bid up price until expected return falls. • If individual stock or portfolio lies below SML: • Expected return is too low. • Investors sell stock driving down price until expected return rises. Plots relationship between expected return and betas Fußzeile

23. Efficient Markets Efficient market hypothesis (EMH): in an efficient market, prices rapidly incorporate all relevant information Financial markets much larger, more competitive, more transparent, more homogeneous than product markets Much harder to create value through financial activities Changes in asset price respond only to new information. This implies that asset prices move almost randomly. Fußzeile

24. Efficient Markets If asset prices unpredictable, then what is the use of CAPM? CAPM gives analyst a model to measure the systematic risk of any asset. On average, assets with high systematic risk should earn higher returns than assets with low systematic risk. CAPM offers a way to compare risk and return on investments alternatives. Fußzeile

25. Risk, Return, and CAPM • Decisions should be made based on expected returns. • Expected returns can be estimated using historical, probabilistic, or risk approaches. • Portfolio expected return/beta equals weighted average of the expected returns/beta of theassets in the portfolio. • CAPM predicts that the expected return on a stock depends on the stock’s beta, the risk-free rate and the market premium. Fußzeile