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    1. 1. Chapter 11 <ul><li>Measuring Market Risk and beta </li></ul><ul><li>Portfolio Betas </li></ul><ul><li>CAPM and Expected Return </li></ul><ul><li>Security Market Line </li></ul><ul><li>Capital Budgeting and Project Risk </li></ul>
    2. 2. Measuring Market Risk <ul><li>Market risk: Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.” </li></ul><ul><li>Market risk of an individual stock represents part of its total risk. </li></ul><ul><ul><li>Total risk = market risk + unique risk </li></ul></ul><ul><ul><li>Total risk is measured by variance (or Std.Dev.) </li></ul></ul><ul><ul><li>For well-diversified investors, only market risk matters, since unique risk has been eliminated through diversification. </li></ul></ul>
    3. 3. Total Risk, Unique Risk and Market Risk
    4. 4. Measuring Market Risk <ul><li>Beta: Sensitivity of a stock's return to fluctuations in returns on the market portfolio. </li></ul><ul><ul><li>Market Portfolio – An ultimate well-diversified portfolio with all assets (stocks) in the economy. In practice a broad stock market index, is used to represent the market. </li></ul></ul><ul><ul><li>In terms of numbers, beta gives the size and sign of change in the return of an investment when there is one unit change in return on market portfolio. </li></ul></ul><ul><li>Beta describes the size of an investment’s market risk relative to that of market portfolio, but it does not give us the exact size of the market risk. </li></ul>
    5. 5. Measuring Market Risk
    6. 6. More on Beta <ul><li>Market portfolio’s beta is 1.0 </li></ul><ul><ul><li>A portfolio that replicates a market index has beta of 1.0 </li></ul></ul><ul><li>Beta for a riskless investment is zero </li></ul><ul><ul><li>Treasury bills </li></ul></ul><ul><li>Most stocks have betas in the range of 0.5 to 1.5. </li></ul><ul><ul><li>If beta = 1.0, stock has as much market risk as the market portfolio. </li></ul></ul><ul><ul><li>If beta > 1.0, stock has larger market risk than the market. </li></ul></ul><ul><ul><li>If beta < 1.0, stock has less market risk than the market. </li></ul></ul><ul><ul><li>Most stocks have betas in the range of 0.5 to 1.5. </li></ul></ul><ul><li>Beta can be negative, but very unlikely. </li></ul>
    7. 7. Estimating Beta <ul><li>Beta can be estimated using past return data </li></ul><ul><li>Regression analysis </li></ul><ul><ul><li>Find the fitted line for the plot of a stock’s returns against market portfolio’s returns. </li></ul></ul><ul><ul><li>The slope is the estimate of beta. </li></ul></ul>
    8. 8. Estimating Beta
    9. 9. Portfolio Betas <ul><li>Diversification decreases unique risk, but not market risk. </li></ul><ul><li>The beta of your portfolio will be an weighted average of the betas of the securities in the portfolio. </li></ul>
    10. 10. Example: Portfolio beta Calculate beta for a portfolio with 50% HP and 50% Wal-Mart. Assume beta for HP and Wal-Mart are 1.29 and 0.61, respectively
    11. 11. Capital Asset Pricing Model <ul><ul><li>Expected risk premium on a stock/portfolio is proportional to its beta. </li></ul></ul><ul><ul><li>Expected return on a security depends on the risk free rate and an risk premium. </li></ul></ul><ul><ul><ul><li>Difference in expected return across securities arises from difference in risk premium which can be fully explained by beta. </li></ul></ul></ul>
    12. 12. Example: CAPM and Expected Return <ul><li>Assume r f = 8% and r M =15%. </li></ul><ul><li>How much is the market risk premium? </li></ul><ul><li>Use CAPM to compute the expected rate of return on a stock with beta=1.25 </li></ul>
    13. 13. Capital Asset Pricing Model <ul><li>The CAPM world assumes that stock market is dominated by well-diversified investors, i.e. every investor holds an two-asset portfolio consisting of the market portfolio and/or the risk free asset. </li></ul><ul><li>Investors are concerned with only market risk in individual stocks. </li></ul><ul><li>An investor’s risk preference determines how he/she allocates funds between market portfolio and risk free asset. </li></ul>
    14. 14. Example: Two Fund Separation <ul><li>Jessica and John both has $10,000 to invest in stock market and T-bills, but they have very different risk preference. Jessica believes that life is full of adventures and she is ready to take risks; while John thinks that stability builds a peaceful mind and he always tries to avoid risk. Therefore, Jessica puts 80% of her money in market portfolio but John only puts 20%. Now assume market portfolio return is 10% and T-bill rate is 4%. If CAPM is turn, please answer the following question: </li></ul><ul><li>What will be Jessica’s and John’s expected return on their investment? </li></ul><ul><li>Is Jessica’s investment strategy superior to John’s? (Hint: Sharpe ratio) </li></ul><ul><li>What happens when Jessica stead borrow $2,000 and invest the total of $12,000 in market portfolio? </li></ul>
    15. 15. Security Market Line <ul><li>Security Market Line </li></ul><ul><li>Plot the expected return against beta according to CAPM. </li></ul><ul><li>We only need two benchmark securities (each with expected rate of return and beta) to specify the security market line. (e.g. T-bill and market portfolio) </li></ul>
    16. 16. Over-pricing and Under-pricing <ul><li>Asset A is under-priced; asset B is over-priced. </li></ul>
    17. 17. CAPM and Investment Projects <ul><li>Company cost of capital and project cost of capital are different. </li></ul><ul><li>We can find a matched company for a project so that they have similar risk, and then use the beta for this company to estimate expected return for the project. </li></ul><ul><ul><li>Pure-play method </li></ul></ul>
    18. 18. Beyond CAPM <ul><li>Three factor model </li></ul><ul><ul><li>Two other risk factors related to firm size and book to market ratio help explain the difference in expected return on stocks </li></ul></ul>