Different Types of Rate of Return Expected return = best guess of what

return will be if we invest in a security Required return = minimum return that

we will accept on the investment; minimum acceptable return

Actual return = not known until after we buy and then sell the security some time later

Using Expected vs Required to Make Investment Decisions If expected return > required return,

BUY If expected return < required return,

SELL If expected return = required return,

HOLD (stock is in equilibrium)

Capital Asset Pricing Model

Model that relates risk to rate of return Tells investors how much they should

require as a rate of return, given a stock’s level of market risk

(Remember, no reward for bearing company-specific risk. Investors should diversify!)

Kc = Rf + (Km - Rf)

Kc= Common stockholders’ required rate of return

Rf = Risk-free rate of return

Km = Expected return on portfolio of all stocks; expected return on the stock market

= Beta, measure of market risk

Risk-free Rate of Return

Rf has two components: 1) A true, or real, rate of return that

would be earned in a perfect world 2) An inflation premium (points to cover

investors for rate of inflation) Rf can be estimated using return on T

bills

Market Rate of Return

Km is an estimate of what investing in the whole stock market would provide as a rate of return

Estimate Km by looking at predictions for market index like S&P 500

Difficult to forecast; easier to evaluate using past data

(Km - Rf) = Market Risk Premium

Difference between return on whole market and risk-free rate of return

Extra reward (points) to investors for exposure to average market risk

Size of market risk premium reflects investors’ degree of risk aversion (how investors feel about investing in the stock market – safe or scared?)

(Km - Rf)

Market risk premium tailored for how much market risk a given company has

Average market risk ( = 1.0): Required return = Market return Km

Above average market risk ( > 1.0): Required return > Market return Km

Below average market risk ( < 1.0): Required return < Market return Km

Graphing CAPM

X axis = (Market Risk) Y axis = Kc (Required Rate of Return) Relationship is linear - just need two

points to graph CAPM:– 1) If = 0, Kc = Rf

– 2) If = 1.0, Kc = Km

Security Market Line (SML)

Graphically shows relationship between market risk and required rate of return

Locate firm on X axis using its beta Go up to intersection with SML and over

to Y axis to see firm’s required rate of return

Slope of SML

Slope of SML:– Rise/Run

– (Y1 - Y0)/(X1 - X0)

– Change in Kc/Change in

– Market risk premium (Km - Rf)

What Slope of SML indicates:

The slope of the SML reflects investors’ degree of Risk Aversion

When slope is steep (high market risk premium, high required rates of return), this indicates that investors are nervous (worried, concerned) about investing in the stock market and want higher returns on every stock.

When slope of SML is flatter (lower market risk premium, lower required rates of return for every stock), this reflects that investors are more comfortable investing in the stock market and don’t perceive market risk as being such a danger.

Changes in slope reflect changes in investors’ perceptions about market risk.

SML and Changes in Inflation

When inflation changes, the risk-free rate of return changes (inflation is one of its components)

Y intercept changes Slope remains constant (assuming

investors’ perceptions about market risk are unchanged), so Km must also change to preserve constant slope!

Changes in Inflation

When Rf increases, Kc increases by the same amount

Higher inflation leads to higher required rates of return for all stocks

When Rf decreases, Kc decreases by the same amount

Lower inflation leads to lower required rates of return for all stocks

Relationship of Inflation and Stock Prices When inflation is high, stock prices are

NOT high Required rates of return on stocks are

high to cover for increase in inflation Higher required returns lead to lower

stock prices When inflation is high, stock prices are

LOW! (And vice versa.)