ChapterMcGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.12Return, Risk, and the Security Market Line12-2Expected and Unexpected Returns• The return on any stock traded in a financial market is composed of two parts.– The normal, or expected, part of the return is the return that investors predict or expect.– The uncertain, or risky, part of the return comes from unexpected information revealed during the year.E(R) -R UReturn Expected - Return Total Return UnexpectedReturn Unexpected Return Expected Return Total12-3Announcements and News• Firms make periodic announcements about events that may significantly impact the profits of the firm.– Earnings– Product development– Personnel• The impact of an announcement depends on how much of the announcement represents new information.– When the situation is not as bad as previously thought, what seems to be bad news is actually good news.– When the situation is not as good as previously thought, what seems to be good news is actually bad news.• News about the future is what really matters.– Market participants factor predictions about the future into the expected part of the stock return.– Announcement = Expected News + Surprise News12-4Systematic and Unsystematic Risk• Systematic risk is risk that influences a large number of assets. Also called market risk.• Unsystematic risk is risk that influences a single company or a small group of companies. Also called unique risk or firm-specific risk.Total risk = Systematic risk + Unsystematic risk12-5Diversification and Risk• In a large portfolio:– Some stocks will go up in value because of positive company-specific events, while – Others will go down in value because of negative company-specific events.• Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.• Unsystematic risk is also called diversifiable risk.• Systematic risk is also called non-diversifiable risk.12-6The Systematic Risk Principle• What determines the size of the risk premium on a risky asset?• The systematic risk principle states:The expected return on an asset depends only on its systematic risk.• So, no matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset.12-7Measuring Systematic Risk• To be compensated for risk, the risk has to be special.– Unsystematic risk is not special.– Systematic risk is special.• The Beta coefficient () measures the relative systematic risk of an asset. – Assets with Betas larger than 1.0 have more systematic risk than average.– Assets with Betas smaller than 1.0 have less systematic risk than average.• Because assets with larger betas have greater systematic risks, they will have greater expected returns.Note that not all Betas are created equally.12-8Portfolio Expected Returns and Betas for Asset A12-9The Reward-to-Risk Ratio• Notice that all the combinations of portfolio expected returns and betas fall on a straight line.• Slope (Rise over Run): • What this tells us is that asset A offers a reward-to-risk ratio of 7.50%. In other words, asset A has a risk premium of 7.50% per “unit” of systematic risk. 7.50%1.64%16%βRREAfA12-10The Fundamental ResultIn general …• The reward-to-risk ratio must be the same for all assets in a competitive financial market.• If one asset has twice as much systematic risk as another asset, its risk premium will simply be twice as large.• Because the reward-to-risk ratio must be the same, all assets in the market must plot on the same line.12-11The Security Market Line (SML)• The Security market line (SML) is a graphical representation of the linear relationship between systematic risk and expected return in financial markets.• For a market portfolio,    fMfMMfMRRE1RREβRRE12-12The Security Market Line, II.• The term E(RM) – Rfis often called the market riskpremium because it is the risk premium on a market portfolio.• For any asset i in the market:• Setting the reward-to-risk ratio for all assets equal to the market risk premium results in an equation known as the capital asset pricing model.  fMifiRREβRRE    ifMfiβRRERRE 12-13The Security Market Line, III.• The Capital Asset Pricing Model (CAPM) is a theory of risk and return for securities in a competitive capital market.• The CAPM shows that E(Ri) depends on: – Rf, the pure time value of money.– E(RM) – Rf, the reward for bearing systematic risk.– i, the amount of systematic risk.    ifMfiβRRERRE 12-14The Security Market Line, IV.12-15Risk and Return Summary, I.12-16Risk and Return Summary, II.12-17A Closer Look at Beta• R – E(R) = m + , where m is the systematic portion of the unexpected return.• m =   [RM– E(RM)]• So, R – E(R) =   [RM– E(RM)] + • In other words:– A high-Beta security is simply one that is relatively sensitive to overall market movements– A low-Beta security is one that is relatively insensitive to overall market movements.12-18Where Do Betas Come From?• A security’s Beta depends on:– How closely correlated the security’s return is with the overall market’s return, and– How volatile the security is relative to the market.• A security’s Beta is equal to the correlation multiplied by the ratio of the standard deviations. miMiiσσR,RCorrβ 12-19Why Do Betas Differ?• Betas are estimated from actual data. Different sources estimate differently, possibly using different data.– For data, the most common choices are three to five years of monthly data, or a single year of weekly data.– To measure the overall market, the S&P 500 stock market index is commonly used.– The calculated betas may be adjusted for various statistical reasons.12-20Extending CAPM• The CAPM has a stunning implication: – What you earn on your portfolio depends only on the level of systematic risk that you bear– As a diversified investor, you do not need to worry about total risk, only systematic risk.• But, does expected return depend only on Beta? Or, do other factors come into play?• The above bullet point is a hotly debated question.12-21Important General