Chapter 13 – Return, Risk, and the Security Market Line
Chapter 13
RETURN, RISK, AND THE SECURITY MARKET LINE
CHAPTER WEB SITES
Section
Web Address
CHAPTER ORGANIZATION
13.1 Expected Returns and Variances
13.2 Portfolios
13.3 Announcements, Surprises, and Expected Returns
13.4 Risk: Systematic and Unsystematic
13.5 Diversification and Portfolio Risk
13.6 Systematic Risk and Beta
Chapter 13 – Return, Risk, and the Security Market Line
13-2
13.7 The Security Market Line
13.8 The SML and the Cost of Capital: A Preview
13.9 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
Lecture Tip: You may find it useful to emphasize the economic
foundations of the material in this chapter. Specifically, we
assume:
13.1. Expected Returns and Variances
A. Expected Return
Chapter 13 – Return, Risk, and the Security Market Line
13-3
State of economy
Probability
Return (%)
Product
B. Calculating the Variance
State of Economy
Probability
Return (%)
Squared
Deviation
Product
+1% change in GDP
+2% change in GDP
+3% change in GDP
Lecture Tip: Some students experience confusion in understanding
+1% change in GDP
+2% change in GDP
+3% change in GDP
Sums
E(R) = 15%
Chapter 13 – Return, Risk, and the Security Market Line
13-4
13.2. Portfolios
A. Portfolio Weights
B. Portfolio Expected Returns
The expected return on a portfolio is the sum of the product of the
C. Portfolio Variance
Unlike expected return, the variance of a portfolio is NOT the
Chapter 13 – Return, Risk, and the Security Market Line
13-5
State of
Probability
Return on
Return on
Return on
Return on
Variances and standard deviations:
Notice that the portfolio variance is less than any of the individual
variances.
Lecture Tip: In most business programs, a course in elementary
+1% change in
.25
-5
0
20
5
+2% change in
.50
15
10
10
11.7
+3% change in
.25
35
20
0
18.3
Expected
15
10
10
11.7
Chapter 13 – Return, Risk, and the Security Market Line
13-6
Reconsider the previous example.
The following covariances can be computed:
This is just as we computed earlier, with a slight difference due to
rounding portfolio returns.
Lecture Tip: Here are a few tips to pass along to students suffering
from “statistics overload”:
13.3. Announcements, Surprises, and Expected Returns
A. Expected and Unexpected Returns
Chapter 13 – Return, Risk, and the Security Market Line
13-7
B. Announcements and News
Announcement – The release of information not previously
Lecture Tip: It is easy to see the effect of unexpected news on stock
prices and returns. Consider the following two cases: (1) On
13.4. Risk: Systematic and Unsystematic
A. Systematic and Unsystematic Risk
Chapter 13 – Return, Risk, and the Security Market Line
13-8
Lecture Tip: You can expand the discussion of the difference
B. Systematic and Unsystematic Components of Return
13.5. Diversification and Portfolio Risk
A. The Effect of Diversification: Another Lesson from Market
History
Video Note: “Portfolio Management” looks at the value of diversification.
B. The Principle of Diversification
Chapter 13 – Return, Risk, and the Security Market Line
13-9
International Note: Common sense suggests that, to the extent that
C. Diversification and Unsystematic Risk
When securities are combined into portfolios, their unique or
D. Diversification and Systematic Risk
Systematic risk cannot be eliminated by diversification since it
13.6. Systematic Risk and Beta
A. The Systematic Risk Principle
Chapter 13 – Return, Risk, and the Security Market Line
13–10
Lecture Tip: Exchange Traded Funds (ETFs) are essentially
B. Measuring Systematic Risk
Beta coefficient – measures how much systematic risk an asset has
relative to an asset of average risk.
Lecture Tip: Students sometimes wonder just how high a stock’s
of at least 2.00 turns up 1,330 stocks.
Lecture Tip: The point that “the market does not reward risks that
C. Portfolio Betas
Portfolio betas are a weighted average of the individual asset betas.
Chapter 13 – Return, Risk, and the Security Market Line
13–11
Example:
Lecture Tip: Remember that the cost of equity depends on both the
13.7. The Security Market Line
A. Beta and the Risk Premium
A riskless asset has a beta of 0.When a risky asset with >0 is
Chapter 13 – Return, Risk, and the Security Market Line
13–12
Lecture Tip: The example in the book illustrates a greater than
100% investment in asset A. This means that the investor has
B. The Security Market Line
Chapter 13 – Return, Risk, and the Security Market Line
13–13
Lecture Tip: Although the realized market risk premium has on
average been approximately 8.2%, the historical average should
Market Portfolios: Consider a portfolio of all the assets in the
market and call it the market portfolio. This portfolio, by
13.8. The SML and the Cost of Capital: A Preview
A. The Basic Idea
Chapter 13 – Return, Risk, and the Security Market Line
13–14
Lecture Tip: Students should remember that in an efficient market,
B. The Cost of Capital
13.9. Summary and Conclusions
APPENDIX A: CALCULATING BETA COEFFICIENTS
In the chapter we noted that a beta coefficient measures the amount of systematic risk
present in a particular risky asset relative to the average risky asset. (Later, it was
Chapter 13 – Return, Risk, and the Security Market Line
13–15
Although, it is beyond the scope of this book, it is possible to show that, given certain
Consider the following monthly stock return data.
Month
Rj
RM
Finally, it should be noted that most people need not bother to calculate betas for stocks