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)
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)
10.3 Historical Returns of Stocks and Bonds (Slide 24)
• Computing Historical Returns (Slides 24–26, 33–34)
– Calculating Realized Annual Returns (Slide 24)
500), Small Stocks, Corporate Bonds, and Treasury Bills, 1926–2014 (Slide 35)
• 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)
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
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.
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
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
10.3 Historical Returns of Stocks and Bonds
This section begins with an explanation of how to compute realized returns, including an explanation
of how those returns are annualized with equations 10.4 and 10.5. Example 10.2 shows how to
calculate returns using those equations for Microsoft stock for the years 2004 and 2008. Table 10.2
10.4 The Historical Trade-Off Between Risk and Return
The section begins by discussing the excess returns of large portfolios over Treasuries. Figure 10.6
10.5 Common Versus Independent Risk
This section explains why the risk of an individual security is different from that of a portfolio. The
authors explain this concept using an insurance company example. Suppose an insurance company
10.6 Diversification in Stock Portfolios
The authors begin with two extremes: companies (firm S) with no idiosyncratic risk and companies
(firm I) with no systematic risk. Figure 10.8 shows how volatility changes with the size of the
portfolio for type S and I firms. The volatility of the portfolio does not change with an increase in the
10.7 shows volatility for 10 type S firms versus 10 type I firms. A box describes diversification
benefits during market crashes.
10.7 Measuring Systematic Risk
In order to estimate the expected return, we must first measure the investment’s systematic risk, then
determine the risk premium required to compensate for that amount of systematic risk. The authors
10.8 Beta and the Cost of Capital
In this section, the authors show how the CAPM can be used to calculate the cost of capital for a firm
IV. Spreadsheet Solutions in Excel
The following Problems for Chapter 10 have spreadsheet versions of the problems available: 1, 2, 6,
8, 12, 13, 15, 17, 18, 19, 27, and 28.