Chapter 10
Capital Markets and the Pricing of Risk
I. Chapter Outline
The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides
are referenced in bold. Alternative Examples to selected textbook examples are also available in the
PowerPoint Lecture Slides and are also referenced in bold.
10.1 Risk and Return: Insights from 89 Years of Investor History (Slides 7-12)
12)
10.2 Common Measures of Risk and Return (Slide 13)
• Probability Distributions (Slide 13)
• Table 10.1 Probability Distribution of Returns for BFI (Slide 14)
• Figure 10.3 Probability Distribution of Returns for BFI (Slide 15)
• Expected Return (Slide 16)
• Variance and Standard Deviation (Slides 17–18)
• Example 10.1 Calculating the Expected Return and Volatility (Slides 19–20)
10.3 Historical Returns of Stocks and Bonds (Slide 24)
• Computing Historical Returns (Slides 24–26, 33–34)
– Calculating Realized Annual Returns (Slide 24)
• Example 10.2 Realized Returns for Microsoft Stock (Slides 27–28)
• PowerPoint Alternative Example 10.2 (Slides 29–32)
• Table 10.2 Realized Return for the S&P 500, Microsoft, and Treasury Bills, 2002-2014
(Slide 33)
• Table 10.3 Average Annual Returns for U.S. Small Stocks, Large Stocks (S&P 500),
Corporate Bonds, and Treasury Bills, 1926-2014 (Slide 36)
• Average Annual Returns (Slide 37)
• The Variance and Volatility of Returns (Slide 38)
Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition 41
• Table 10.4 Volatility of U.S. Small Stocks, Large Stocks, Corporate Bonds, and Treasury
Bills, 1926–2014 (Slide 44)
• Estimation Error: Using Past Returns to Predict the Future (Slides 45–46)
– Standard Error (Slides 45-46)
– Limitations of Expected Return Estimates
• Example 10.4 The Accuracy of Expected Return Estimates (Slides 47–48)
• PowerPoint Alternative Example 10.4 (Slides 49–50)
10.4 The Historical Trade-Off Between Risk and Return (Slide 51)
500), Corporate Bonds, and Treasury Bills, 1926–2014 (Slide 52)
• Figure 10.6 The Historical Trade-Off Between Risk and Return in Large Portfolios (Slide
53)
10.5 Common Versus Independent Risk (Slide 56)
• Theft Versus Earthquake Insurance: An Example
10.6 Diversification in Stock Portfolios (Slide 59)
• Firm-Specific Versus Systematic Risk (Slides 59–65)
10.7 Measuring Systematic Risk (Slides 75–76)
• Identifying Systematic Risk: The Market Portfolio (Slide 76)
• Sensitivity to Systematic Risk: Beta (Slide 77)
10.8 Beta and the Cost of Capital (Slide 86)
• Estimating the Risk Premium (Slides 86–87)
– The Market Risk Premium (Slide 86)
42 Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition
• PowerPoint Alternative Example 10.9 (Slides 90–91)
• The Capital Asset Pricing Model (Slide 92)
II. Learning Objectives
10-2 Compute the realized or total return for an investment.
10-4 Use the standard error of the estimate to gauge the amount of estimation error in the average.
10-6 Describe the relationship between volatility and return on individual stocks.
10-8 Define an efficient portfolio and a market portfolio.
10-10 Use the Capital Asset Pricing Model to calculate the expected return for a risky security.
10-12 Explain why, in an efficient capital market, the cost of capital depends on systematic risk
rather than diversifiable risk.
III. Chapter Overview
This chapter begins the discussion of risk and return. The authors begin with probability distributions
and realized returns. They show that the expected return of individual stocks is higher for the amount
of risk taken than it is for the portfolios typically examined. They then describe idiosyncratic and
systematic risk. The CAPM is also introduced. Throughout the discussion the authors emphasize no-
arbitrage conditions to explain idiosyncratic and systematic risk.
10.1 Risk and Return: Insights from 86 Years of Investor History
This section compares returns on several types of investment. Figure 10.1 shows the returns from a
10.2 Common Measures of Risk and Return
This section introduces the probability distribution of returns and describes how mean, variance, and
