CF Risk Return(2)

7/27/2019 CF Risk Return(2)

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Corporate Financial Policy:Risk, Return and the CAPM

Jide Wintoki

Fall 2013

Jide Wintoki (University of Kansas) Business Investment (FIN 468) Fall 2013 1 / 13

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Lecture Outline

The Relationship Between Risk and Return

The Security Market Line

Calculating Individual Stock Betas

Validity and the Role of the CAPM

Some Alternative Theories


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Risk and Return

The return earned on investments represents the marginal benefit of investing.

Risk represents the marginal cost of investing.

For any project to create value, the marginal benefit must exceed themarginal cost of investing.


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Project or asset risk

In general, the risk of investing in any project or holding any asset consistsof two components:

Undiversifiable risk (systematic risk, market risk)

Only systematic risk is priced in the market.

This is the only type of risk that is relevant for capital budgeting orasset valuation.

Beta is one way to measure the systematic risk of an asset.

Diversifiable risk (unsystematic risk, idiosyncratic risk, or unique risk)

Investors do not care about unsystematic risk because it can bediversified away very cheaply.


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Capital Asset Pricing Model (CAPM)

E (R i ) = R f + β i [E (R m − R f )]

Only beta changes from one security to the next. For that reason, analystsclassify the CAPM as a single-factor model, meaning that just one variableexplains differences in returns across securities.


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Plots the relationship between expected return and betas

In equilibrium, all assets lie on this line

If stock lies above the line:

Expected return is too high

Investors bid up price until expected return falls

If stock lies below the line:

Expected return is too low

Investors sell stock, driving down price until expected return rises


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β i

E(RP)

RF

SML

Slope = E(Rm) - RF = Market Risk

Premium (MRP)

•

A - Undervalued

•

•

•RM

β =1.0

•

B

• A

• B - Overvalued


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Beta

β i =σim

σ2m

The numerator is the covariance of the stock with the market.

The denominator is the market’s variance.

In the CAPM, a stock’s systematic risk is captured by beta.

The higher the beta, the higher the expected return on the stock.


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Beta And Expected Return

Beta measures a stock’s exposure to market riskThe market risk premium is the reward for bearing market risk:R m − R f

E(R i) = R f + ß [E(R m) – R f ]

• Return forbearing nomarket risk (risk-free rate)

• Stock’sexposure tomarket risk (beta)

• Reward forbearing marketrisk (marketpremium)


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Calculating Expected Returns

E (R i ) =

R f + β i [

E (R m− R

f )]

Assume

Riskfree rate = 2%

Market risk premium = 6%

If Stock’s Beta Is Then Expected Return Is0 2%

0.5 5%

1 8%2 14%

When Beta = 0, The Return Equals The Risk-Free Return

When Beta = 1, The Return Equals The Expected Market Return


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Using The Security Market Line

r%

β

12.4%

10

5

Rf = 2%

1 2GEP&G

SML

6.8%

15

•

slope = E(Rm) – RF =

MRP = 10% - 2% = 8%= ΔY ÷ ΔX

The SML and where P&G and GE place on it


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Alternatives To CAPM

Arbitrage Pricing Theory

R i −R f = β i 1(R 1−R f )+β i 2(R 2−R f )+β i 3(R 3−R f )+. . .+β in(R n−R f )

Fama-French Model

R i − R f = α + β i 1(R m − R f ) + β i 2(R small − R big ) + β i 3(R high − R low )

Betas represent sensitivities to each source of risk. Terms inparentheses are the rewards for bearing each type of risk.


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The Current State of APT

Investors demand compensation for taking risk because they are riskaverse.

There is widespread agreement that systematic risk drives returns.

You can measure systematic risk in several different ways dependingon the asset pricing model you choose.

The CAPM is still widely used in practice in both corporate finance

and investment-oriented professions.


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CF Risk Return(2)