Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM)

1. Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) • 10.1 Individual Securities • 10.2 Expected Return, Variance, and Covariance • 10.3 The Return and Risk for Portfolios • 10.4 The Efficient Set for Two Assets • 10.5 The Efficient Set for Many Securities • 10.6 Diversification: An Example • 10.7 Riskless Borrowing and Lending • 10.8 Market Equilibrium • 10.9 Relationship between Risk and Expected Return (CAPM) • 10.10 Summary and Conclusions • Appendix 10A: Is Beta Dead?

2. Expected (Ex Ante) Return, Variance, and Covariance • Expected Return: E(R) = S (ps x Rs) • Variance: s2 = S {ps x [Rs - E(R)]2} • Standard Deviation = s • Covariance: sAB = S {ps x [Rs,A - E(RA)] x [Rs,B - E(RB)]} • Correlation Coefficient: rAB = sAB / (sAsB)

3. Return and Risk for Portfolios (2 Assets) • Expected Return of a Portfolio: E(Rp) = XAE(R)A + XB E(R)B • Variance of a Portfolio: sp2 = XA2sA2 + XB2sB2 + 2 XA XB sAB

4. An Example of Portfolio Return and Risk Stock Investment Xi E.(Ri) si2 IBM $5000 50% 0.09 0.01 HM $5000 50% 0.13 0.04 Total $10000 100% • sIBM,HM = 0 • E[Rp] = (0.5)(0.09) + (0.5)(0.13) = 11% • sp2 =(.5)2(.01) + (.5)2(.04) + 2(.5)(.5)(0) = 0.0125 • sp = (0.0125)(1/2) = 0.1118

5. Efficient Sets and Diversification r E(R) = -1 r < 1 -1 < r = 1 MV MV MV s

6. Capital Market Line Expected returnof portfolio Capital market line . 5 . Y M . 4 . Risk-freerate (Rf ) X Standarddeviation ofportfolio’s return.

7. Security Market Line Expected returnon security (%) Security market line (SML) . . Rm T M . S Rf Beta ofsecurity 0.8 1