Capital Markets 1

Expected Return for Individual Stocks Probability x Return = ___% Probability x Return = ___% Expected Return = ___

Capital Markets 2

Expected Return

Stock A Stock B

Probability Return Probability Return10% -15% -1.5% 20% -50% -10%

40% 10% 4% 30% 0% 0%

50% 25% 12.5% 50% 50% 25%

Expected Return 15% Expected Return 15%

Calculating Expected Return

Capital Markets 3

Expected Return for Portfolio

Portfolio Weight x Return = ___% Portfolio Weight x Return = ___% Expected Return = ___

Capital Markets 4

Portfolio Expected Return

ReturnStock X 60% 12% 7.20%Stock Y 25% 16% 4.00%Stock Z 15% 19% 2.85%

100% 14.05%

Capital Markets 5

Portfolio Beta

Investment BetaStock Q: 20% of portfolioStock R: 20% of portfolio

1.4 .6

.28

.12

Stock S: 10% of portfolioStock T: 50% of portfolio

1.51.8

.15

.90

Portfolio Beta 1.45

Capital Markets 6

Standard Deviation of Portfolio

Not the average of standard deviation for portfolio componentsCalculation

Calculate expected return for portfolio under each condition

Then determine deviation from expected return from portfolio, square it, multiply times probability, sum it, and take the square root…which sounds familiar…

Capital Markets 7

Risk

Unsystematic: impacts a single stock or industryDole recalls spinach

Systematic: impacts most, if not all, stocksFed leaves interest rates unchanged

Capital Markets 8

Diversification

Create a portfolio of 20 stocks with a low correlation: chart on Page 338This would eliminate almost all

unsystematic riskUnsystematic risk is not rewarded

Investing 90% of your portfolio in one stockLow correlation: stocks that don’t tend

to move in the same direction Airline and oil stocks, for example

Capital Markets 9

CAPM and SML

SML: reflects risk-reward ratio for an individual securityRisk is measured by betaAssumes security is in a diversified

portfolioHow much risk does a security add to a

diversified portfolio?

Capital Markets 10

CAPM

ER = RF + (MR – RF) x B RF = “Risk-free” rate of return on T-

billsCurrently __%

MR = Expected Return for the MarketApproximately 12% for large-cap stocks

B = Beta

What happens to Expected Return if the Market has

additional risk? If the asset’s beta increases?

Capital Markets 11

Beta

Measures systematic riskNot total risk since it doesn’t include

unsystematic risk Market = 1.0 Can beta be negative? Can betas be different if you look at

different sources?Generally based on 5-year moving average

Capital Markets 12

CAPM

Capital Markets 13

Coefficient of variation

Expected Return

Standard Deviation

Coefficient Variation

Stock A 12.00% 14.96% 0.80 Stock B 11.50% 25.50% 0.45 Stock C 14.00% 15.29% 0.92

Capital Markets 14

Reward/Risk Relationship

Coefficient of variation = Reward / Risk= Expected return / Standard deviation

or BetaTextbook: Reward-to-risk ratio

In an efficient market, should be the same for all assets

Capital Markets 15

News and Expected Returns

Surprise news: impacts stock priceMSFT earnings are below estimates Inflation is higher than expected

What the market already knows is discounted into current stock price