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Chapter 10Chapter 10 Estimating Risk and Return

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Expected Returns• Expected return is a forward-looking

calculation

• Includes risk measures

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Expected Return

• Multiply each possible return by the probability of that return occurring

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Risk Premiums

• Required return is the return that investors demand for the level of risk taken

• Risk premium is the reward investors require for taking risk

• Market risk premium is the reward for taking unsystematic stock market risk

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The Market Portfolio

• Capital Asset Pricing Model (CAPM)

– Best known capital asset pricing model

– Starts with modern portfolio theory

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Efficient Frontier• The efficient frontier demonstrates the

highest expected return for each level of risk

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Efficient Frontier• Adding a risk-free asset improves return for

each level of risk

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CAPM

• Calculate the Security Market Line for risk/return relationship

• Substituting into line equation results in CAPM

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Beta

• Measures the sensitivity of a stock or portfolio to market risk

– Beta greater than 1 = more risky than market (higher risk premium)

– Beta less than 1 = less risky (lower risk premium)

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Security Market Line

• Shows relationship between risk and return for any stock or portfolio

• Similar to capital market line– Risk is characterized by beta, not standard

deviation

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Security Market Line Uses Beta as Risk Measure

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Portfolio Beta

Weighted average of portfolio stocks’ betas

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Finding Beta

• Two ways

– Can compute with data from company’s and market portfolio returns

– Find in published data from financial outlets

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Capital Market Efficiency

• Efficient markets feature

– Many buyers and sellers

– No high barriers to entry

– Free and available information

– Low trading or transaction costs

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Efficient Market Hypothesis

• States that security prices fully reflect all available information

• Three levels– Weak form

– Semi-strong form

– Strong form

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Weak-form Efficiency

• Current prices reflect all information derived from trading– Includes current and past stock prices and

trading volume

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Semi-strong form Efficiency

• Current prices reflect all available public information– Includes information like financial statements,

news, analysts’ opinions

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Strong-form Efficiency

• Current prices reflect all information– Public

– Privately-held information

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Behavioral Finance

• People behave in “irrational” ways– Both optimism and pessimism can be

extreme

– Overconfidence is tendency to overestimate knowledge and underestimate risk

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Implications for Financial Managers

• Managers must...

– understand the risk/return relationship and implications

– address stockholders’ concerns and requirements

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Constant-Growth Model

• Assumes stock is efficiently priced• Uses dividend and price data and forward

estimate

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