1. Finance Lecture:
Risk, Return and the Cost of Equity
Brad Simon

2. Lecture Overview
 Risk and Return
 Measuring Returns
 Volatility
 Portfolios
 Diversification
 Risk Premium
 CAPM
 Summary
2

3. Motivating the topic: Risk and Return
3

4. Motivating the topic: Risk and Return
 The relationship between risk and return is
fundamental to finance theory
4

5. Motivating the topic: Risk and Return
 The relationship between risk and return is
fundamental to finance theory
 You can invest very safely in a bank or in
Treasury bills. Why would you invest in
risky stocks and bonds?
5

6. Motivating the topic: Risk and Return
 The relationship between risk and return is
fundamental to finance theory
 You can invest very safely in a bank or in
Treasury bills. Why would you invest in
risky stocks and bonds?
If you want the chance of earning higher
returns, it requires that you take on higher risk
investments
6

7. Motivating the topic: Risk and Return
 The relationship between risk and return is
fundamental to finance theory
 You can invest very safely in a bank or in
Treasury bills. Why would you invest in
risky stocks and bonds?
If you want the chance of earning higher
returns, it requires that you take on higher risk
investments
 There is a positive relationship between
risk and return
7

8. Historical Returns
8

9. Historical Returns
Ending Price - Beginning Price Dividend
Percentage Return
Beginning Price Beginning Price
9

10. Historical Returns
Ending Price - Beginning Price Dividend
Percentage Return
Beginning Price Beginning Price
Percentage Return Capital Gains Yield Dividend Yield
10

11. Historical Returns
Ending Price -Beginning Price Dividend
Percentage Return
Beginning Price Beginning Price
Percentage Return Capital Gains Yield Dividend Yield
 Example: You held 250 shares of Hilton Hotel‟s
common stock. The company‟s share price was
$24.11 at the beginning of the year. During the year,
the company paid a dividend of $0.16 per share, and
ended the year at a price of $34.90. What is the
dollar return, the percentage return, the capital gains
yield, and the dividend yield for Hilton?
11

12. Historical Returns
12

13. Historical Returns
 Percent return = Capital gains yield +
Dividend Yield
13

14. Historical Returns
 Percent return = Capital gains yield +
Dividend Yield
Capital gains yield = ($34.90 - $24.11)/$24.11
= 44.75%
14

15. Historical Returns
 Percent return = Capital gains yield +
Dividend Yield
Capital gains yield = ($34.90 - $24.11)/$24.11
= 44.75%
Dividend yield = $0.16/$24.11
= 0.66%
15

16. Historical Returns
 Percent return = Capital gains yield +
Dividend Yield
Capital gains yield = ($34.90 - $24.11)/$24.11
= 44.75%
Dividend yield = $0.16/$24.11
= 0.66%
Percent return = 44.75% + 0.66%
= 45.42%
16

17. Volatility
17

18. Volatility
 High volatility in historical returns are an
indication that future returns will be volatile
18

19. Volatility
 High volatility in historical returns are an
indication that future returns will be volatile
 One popular way of quantifying volatility is to
compute the standard deviation of percentage
returns
19

20. Volatility
 High volatility in historical returns are an
indication that future returns will be volatile
 One popular way of quantifying volatility is to
compute the standard deviation of percentage
returns
Standard deviation is a measure of total risk
20

21. Volatility
 High volatility in historical returns are an
indication that future returns will be volatile
 One popular way of quantifying volatility is to
compute the standard deviation of percentage
returns
Standard deviation is a measure of total risk
A large standard deviation indicates greater
return variability, or high risk
21

22. Volatility
 High volatility in historical returns are an
indication that future returns will be volatile
 One popular way of quantifying volatility is to
compute the standard deviation of percentage
returns
Standard deviation is a measure of total risk
A large standard deviation indicates greater
return variability, or high risk
N
2
(Return t
- Average Return)
t 1
Standard Deviation
N -1
22

23. Volatility - Example
23

24. Volatility - Example
 Example:
 Using the following returns, calculate the average
return, the variance, and the standard deviation for
Acme stock.
24

25. Volatility - Example
 Example:
 Using the following returns, calculate the average
return, the variance, and the standard deviation for
Acme stock.
Year Acme
1 10%
2 4
3 -8
4 13
5 5
25

26. Volatility - Example
Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 =
4.80%
26

27. Volatility - Example
Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 =
4.80%
σ2Acme = [(10 – 4.8)2 + (4 – 4.8)2 (- 8 – 4.8)2
+ (13 – 4.8)2 + (5 – 4.8)2 ] / (5 - 1)
27

28. Volatility - Example
Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 =
4.80%
σ2Acme = [(10 – 4.8)2 + (4 – 4.8)2 (- 8 – 4.8)2
+ (13 – 4.8)2 + (5 – 4.8)2 ] / (5 - 1)
σ2Acme = 258.8 / 4 = 64.70
28

29. Volatility - Example
Average Return = (10 + 4 - 8 + 13 + 5 ) / 5 =
4.80%
σ2Acme = [(10 – 4.8)2 + (4 – 4.8)2 (- 8 – 4.8)2
+ (13 – 4.8)2 + (5 – 4.8)2 ] / (5 - 1)
σ2Acme = 258.8 / 4 = 64.70
σAcme = (64.70)1/2 = 8.04%
29

30. Volatility - Application
30

31. Volatility - Application
31

32. Volatility - Application
 The volatility of stocks is much higher than the
volatility of bonds and T-bills
32

33. Volatility - Application
 The volatility of stocks is much higher than the
volatility of bonds and T-bills
 Different periods had differing levels of volatility
for the same asset class
33

34. Diversifying risk: Portfolios
34

35. Diversifying risk: Portfolios
 In the beginning of the lecture we saw that
higher risks must come with (the potential for)
higher returns.
35

36. Diversifying risk: Portfolios
 In the beginning of the lecture we saw that
higher risks must come with (the potential for)
higher returns.
 More volatile stocks should have, on average,
higher returns.
36

37. Diversifying risk: Portfolios
 In the beginning of the lecture we saw that
higher risks must come with (the potential for)
higher returns.
 More volatile stocks should have, on average,
higher returns.
 We can reduce volatility for a given level of
return by grouping assets into portfolios
37

38. Diversifying risk: Portfolios
 In the beginning of the lecture we saw that
higher risks must come with (the potential for)
higher returns.
 More volatile stocks should have, on average,
higher returns.
 We can reduce volatility for a given level of
return by grouping assets into portfolios
 This is known as “diversifying risk”
38

39. Diversifying risk: Example
39

40. Diversifying risk: Example
 In a given year a particular pharmaceutical
company may fail in getting approval of a new
drug, thus causing its stock price to drop.
40

41. Diversifying risk: Example
 In a given year a particular pharmaceutical
company may fail in getting approval of a new
drug, thus causing its stock price to drop.
 But it is unlikely that every pharmaceutical
company will fail major drug trials in the same
year.
41

42. Diversifying risk: Example
 In a given year a particular pharmaceutical
company may fail in getting approval of a new
drug, thus causing its stock price to drop.
 But it is unlikely that every pharmaceutical
company will fail major drug trials in the same
year.
 On average, some are likely to be successful
while others will fail.
42

43. Diversifying risk: Example
 In a given year a particular pharmaceutical
company may fail in getting approval of a new
drug, thus causing its stock price to drop.
 But it is unlikely that every pharmaceutical
company will fail major drug trials in the same
year.
 On average, some are likely to be successful
while others will fail.
 Therefore, the returns for a portfolio comprised of
all drug companies will have much less volatility
than that of a single drug company.
43

44. Diversifying risk: Example
(cont‟d)
44

45. Diversifying risk: Example
(cont‟d)
 By holding stock in the entire sector of
pharmaceuticals we have eliminated quite a bit of
risk as just described.
45

46. Diversifying risk: Example
(cont‟d)
 By holding stock in the entire sector of
pharmaceuticals we have eliminated quite a bit of
risk as just described.
 But it‟s possible there is sector-level risk that may
impact all drug companies.
46

47. Diversifying risk: Example
(cont‟d)
 By holding stock in the entire sector of
pharmaceuticals we have eliminated quite a bit of
risk as just described.
 But it‟s possible there is sector-level risk that may
impact all drug companies.
 For example, if the FDA changes its drug-
approval policy and requires all new drugs to go
through more strict testing we would expect the
entire sector – and our portfolio comprised of all
pharmaceutical companies – to suffer.
47

48. Diversifying risk: Example
(cont‟d)
 By holding stock in the entire sector of
pharmaceuticals we have eliminated quite a bit of
risk as just described.
 But it‟s possible there is sector-level risk that may
impact all drug companies.
 For example, if the FDA changes its drug-
approval policy and requires all new drugs to go
through more strict testing we would expect the
entire sector – and our portfolio comprised of all
pharmaceutical companies – to suffer.
 But what if we held a portfolio of not just
pharmaceuticals but also of computer companies,
48 manufacturing companies, service companies

49. Diversifying risk: Example
(cont‟d)
49

50. Diversifying risk: Example
(cont‟d)
 We would expect this expanded portfolio to be
even less risky than a portfolio comprised of
just one sector.
50

51. Diversifying risk: Example
(cont‟d)
 We would expect this expanded portfolio to be
even less risky than a portfolio comprised of
just one sector.
 In fact, we can imagine a market-level
portfolio comprised of all assets.
51

52. Diversifying risk: Example
(cont‟d)
 We would expect this expanded portfolio to be
even less risky than a portfolio comprised of
just one sector.
 In fact, we can imagine a market-level
portfolio comprised of all assets.
 Such a market portfolio would still have
uncertainty and risk but it would be greatly
reduced compared to just one asset or even a
group of related assets
52

53. Diversifying risk: Example
(cont‟d)
 We would expect this expanded portfolio to be
even less risky than a portfolio comprised of
just one sector.
 In fact, we can imagine a market-level
portfolio comprised of all assets.
 Such a market portfolio would still have
uncertainty and risk but it would be greatly
reduced compared to just one asset or even a
group of related assets
 We can then think of risk as having two
53
components:

54. Diversifying risk: Example
(cont‟d)
 We would expect this expanded portfolio to be
even less risky than a portfolio comprised of
just one sector.
 In fact, we can imagine a market-level
portfolio comprised of all assets.
 Such a market portfolio would still have
uncertainty and risk but it would be greatly
reduced compared to just one asset or even a
group of related assets
 We can then think of risk as having two
54
components:
 Firm-specific risk (or asset-specific risk)

55. Diversifying risk: Example
(cont‟d)
 We would expect this expanded portfolio to be
even less risky than a portfolio comprised of
just one sector.
 In fact, we can imagine a market-level
portfolio comprised of all assets.
 Such a market portfolio would still have
uncertainty and risk but it would be greatly
reduced compared to just one asset or even a
group of related assets
 We can then think of risk as having two
55
components:
 Firm-specific risk (or asset-specific risk)

56. Diversifying risk: Example
(cont‟d)
56

57. Diversifying risk: Example
(cont‟d)
 Firm-specific risk can be diversified away
57

58. Diversifying risk: Example
(cont‟d)
 Firm-specific risk can be diversified away
 Market-level risk cannot be eliminated
58

59. Diversifying risk: Naming
59

60. Diversifying risk: Naming
 Firm-specific risk is also called:
 Asset-specific risk
 Diversifiable risk
 Idiosyncratic risk
 Unsystematic risk
60

61. Diversifying risk: Naming
 Firm-specific risk is also called:
 Asset-specific risk
 Diversifiable risk
 Idiosyncratic risk
 Unsystematic risk
 Market-level risk is also called:
 Systematic Risk
 Market risk
 Non-diversifiable risk
61

62. Diversifying risk: Graph
62

63. Diversifying risk: Graph
63

64. Diversifying risk: Conclusions
64

65. Diversifying risk: Conclusions
 Investors are only compensated for risks their
bear.
65

66. Diversifying risk: Conclusions
 Investors are only compensated for risks their
bear.
 Any risks which can be diversified away will not
be compensated.
66

67. Diversifying risk: Conclusions
 Investors are only compensated for risks their
bear.
 Any risks which can be diversified away will not
be compensated.
 We want to understand how to create portfolios
which produce the maximum risk diversification.
67

68. Diversifying risk: Conclusions
 Investors are only compensated for risks their
bear.
 Any risks which can be diversified away will not
be compensated.
 We want to understand how to create portfolios
which produce the maximum risk diversification.
 We call such portfolios, “optimal portfolios”
68

69. Optimal Portfolios
69

70. Optimal Portfolios
 A portfolio is a collection of assets (stocks, bonds,
real estate, etc.)
70

71. Optimal Portfolios
 A portfolio is a collection of assets (stocks, bonds,
real estate, etc.)
 Holding different combinations of assets results in
different risk and return characteristics.
71

72. Optimal Portfolios
 A portfolio is a collection of assets (stocks, bonds,
real estate, etc.)
 Holding different combinations of assets results in
different risk and return characteristics.
 We can construct portfolios with “optimal” levels
of return for a given level of risk.
72

73. Optimal Portfolios
 A portfolio is a collection of assets (stocks, bonds,
real estate, etc.)
 Holding different combinations of assets results in
different risk and return characteristics.
 We can construct portfolios with “optimal” levels
of return for a given level of risk.
 We call such portfolios, “efficient portfolios”
73

74. Optimal Portfolios
74

75. Optimal Portfolios
75

76. Optimal Portfolios
 The curve drawn through all the efficient portfolios
is known as the “Efficiency Frontier”
76

77. Optimal Portfolios
 The curve drawn through all the efficient portfolios
is known as the “Efficiency Frontier”
 We will come back to this later.
77

78. How does diversification work?
78

79. How does diversification work?
 Diversification comes when stocks are subject to
different kinds of events such that their returns
differ over time, i.e. the stock‟s returns are not
perfectly correlated. Their price movements often
counteract each other
79

80. How does diversification work?
 Diversification comes when stocks are subject to
different kinds of events such that their returns
differ over time, i.e. the stock‟s returns are not
perfectly correlated. Their price movements often
counteract each other
 By contrast, if two stocks are perfectly positively
correlated, diversification has no effect on risk.
80

81. Risk Premium
81

82. Risk Premium
 We have previously said that the higher the
risk an investment is, the higher the return it
needs to offer.
82

83. Risk Premium
 We have previously said that the higher the
risk an investment is, the higher the return it
needs to offer.
 We can re-state this concept in the following
way:
83

84. Risk Premium
 We have previously said that the higher the
risk an investment is, the higher the return it
needs to offer.
 We can re-state this concept in the following
way:
 An investment in a risk-free US Treasury bill offers a
low return with no risk
84

85. Risk Premium
 We have previously said that the higher the
risk an investment is, the higher the return it
needs to offer.
 We can re-state this concept in the following
way:
 An investment in a risk-free US Treasury bill offers a
low return with no risk
 Investors who take on risk expect a higher return
compared to this risk-free opportunity, therefore:
85

86. Risk Premium
 We have previously said that the higher the
risk an investment is, the higher the return it
needs to offer.
 We can re-state this concept in the following
way:
 An investment in a risk-free US Treasury bill offers a
low return with no risk
 Investors who take on risk expect a higher return
compared to this risk-free opportunity, therefore:
Required Return = Risk-free Rate + Risk
Premium
86

87. Risk Premium
 We have previously said that the higher the
risk an investment is, the higher the return it
needs to offer.
 We can re-state this concept in the following
way:
 An investment in a risk-free US Treasury bill offers a
low return with no risk
 Investors who take on risk expect a higher return
compared to this risk-free opportunity, therefore:
Required Return = Risk-free Rate + Risk
Premium
87
 The risk-free rate equals the real interest rate and expected

88. Risk Premium
 We have previously said that the higher the
risk an investment is, the higher the return it
needs to offer.
 We can re-state this concept in the following
way:
 An investment in a risk-free US Treasury bill offers a
low return with no risk
 Investors who take on risk expect a higher return
compared to this risk-free opportunity, therefore:
Required Return = Risk-free Rate + Risk
Premium
 The risk-free rate equals the real interest rate and expected
inflation
88
 Typically considered the return on U.S. government

89. Risk Premium
89

90. Risk Premium
 The risk premium is the reward investors require
for taking risk
90

91. Risk Premium
 The risk premium is the reward investors require
for taking risk
 But the market doesn‟t reward all risks
91

92. Risk Premium
 The risk premium is the reward investors require
for taking risk
 But the market doesn‟t reward all risks
 Since the firm-specific portion of risk can be
diversified away, an efficient market will not
reward investors for taking this risk
92

93. Risk Premium
 The risk premium is the reward investors require
for taking risk
 But the market doesn‟t reward all risks
 Since the firm-specific portion of risk can be
diversified away, an efficient market will not
reward investors for taking this risk
 The market rewards only the remaining risk after
the firm-specific risk is diversified away: the
market risk
93

94. Risk Premium - Examples
94

95. Risk Premium - Examples
 Below are historical market-level risk premia over
different historical time periods:
95

96. CAPM
96

97. CAPM
 We can combine our concepts of optimal
portfolios, the efficiency frontier and risk premium
to create a theory seeking to relate an asset‟s risk
characteristics to its required risk premium (i.e.
it‟s return)
97

98. CAPM
 We can combine our concepts of optimal
portfolios, the efficiency frontier and risk premium
to create a theory seeking to relate an asset‟s risk
characteristics to its required risk premium (i.e.
it‟s return)
 Such a theory is called an “asset pricing theory”
98

99. CAPM
 We can combine our concepts of optimal
portfolios, the efficiency frontier and risk premium
to create a theory seeking to relate an asset‟s risk
characteristics to its required risk premium (i.e.
it‟s return)
 Such a theory is called an “asset pricing theory”
 The most famous asset pricing theory is the
Capital Asset Pricing Model (or CAPM)
99

100. CAPM
 We can combine our concepts of optimal
portfolios, the efficiency frontier and risk premium
to create a theory seeking to relate an asset‟s risk
characteristics to its required risk premium (i.e.
it‟s return)
 Such a theory is called an “asset pricing theory”
 The most famous asset pricing theory is the
Capital Asset Pricing Model (or CAPM)
100

101. CAPM
101

102. CAPM
 We saw how we can construct an efficiency
frontier comprised of „efficient portfolios.‟
102

103. CAPM
 We saw how we can construct an efficiency
frontier comprised of „efficient portfolios.‟
 Each portfolio combines a group of assets in such
a way that they provide the highest expected
return for a given level of risk.
103

104. CAPM
 We saw how we can construct an efficiency
frontier comprised of „efficient portfolios.‟
 Each portfolio combines a group of assets in such
a way that they provide the highest expected
return for a given level of risk.
104

105. CAPM
105

106. CAPM
 The horizontal axis in this example starts at 10%
risk (the standard deviation or volatility)
106

107. CAPM
 The horizontal axis in this example starts at 10%
risk (the standard deviation or volatility)
 But we could modify this graph – and our portfolio
– by including some amount of the risk-free asset.
107

108. CAPM
108

109. CAPM
109

110. CAPM
 The top graph is
simply the Efficiency
frontier from the prior
slide.
110

111. CAPM
 The top graph is
simply the Efficiency
frontier from the prior
slide.
 The bottom graph
now includes the risk-
free asset and the
efficiency frontier.
111

112. CAPM
 The top graph is
simply the Efficiency
frontier from the prior
slide.
 The bottom graph
now includes the risk-
free asset and the
efficiency frontier.
 We can imagine a line
being drawn that
starts at the risk-free
asset and running
tangent to the
112 efficiency frontier

113. CAPM
 The top graph is simply
the Efficiency frontier
from the prior slide.
 The bottom graph now
includes the risk-free
asset and the efficiency
frontier.
 We can imagine a line
being drawn that starts
at the risk-free asset
and running tangent to
the efficiency frontier
 Such a line is known as
the Capital Market Line
(CML).
113

114. CAPM
114

115. CAPM
115

116. CAPM
 By using holding some
combination of the risk-free
asset and an optimal portfolio
we can maximize our
expected return.
116

117. CAPM
 By using holding some
combination of the risk-free
asset and an optimal portfolio
we can maximize our
expected return.
 Such returns reside on the
Capital Market Line.
117

118. CAPM
 By using holding some
combination of the risk-free
asset and an optimal portfolio
we can maximize our
expected return.
 Such returns reside on the
Capital Market Line.
 The CML demonstrates that
an investor will hold the
market portfolio. Since such
an investor will be fully
diversified, the only relevant
risk is market risk.
118

119. CAPM
119

120. CAPM
 Since the investor has only market risk, it would be
desirable to have a measure of risk that measured
only market risk
120

121. CAPM
 Since the investor has only market risk, it would be
desirable to have a measure of risk that measured
only market risk
 Such as measure is called beta (β):
121

122. CAPM
 Since the investor has only market risk, it would be
desirable to have a measure of risk that measured
only market risk
 Such as measure is called beta (β):
Required Return = Rf + β(Risk PremuimMarket)
122

123. CAPM
 Since the investor has only market risk, it would be
desirable to have a measure of risk that measured
only market risk
 Such as measure is called beta (β):
Required Return = Rf + β(Risk PremuimMarket)
Required Return = Rf + β(RM – Rf)
123

124. CAPM
124

125. CAPM
 Beta measures the co-movement between a stock
and the market portfolio
125

126. CAPM
 Beta measures the co-movement between a stock
and the market portfolio
 The beta of the overall market is 1
126

127. CAPM
 Beta measures the co-movement between a stock
and the market portfolio
 The beta of the overall market is 1
 Stocks with betas greater than 1 are considered
riskier than the market portfolio and are called
aggressive stocks
127

128. CAPM
 Beta measures the co-movement between a stock
and the market portfolio
 The beta of the overall market is 1
 Stocks with betas greater than 1 are considered
riskier than the market portfolio and are called
aggressive stocks
 Stocks with betas less than 1 are less risky than the
market portfolio and are called defensive stocks
128

129. CAPM
129

130. CAPM
130

131. CAPM
 The CAPM equation allows us to estimate any stock‟s
required return once we have determined the stock‟s
beta, risk-free rate and market-risk premium.
131

132. CAPM
 The CAPM equation allows us to estimate any stock‟s
required return once we have determined the stock‟s
beta, risk-free rate and market-risk premium.
 CAPM Equation is:
Required Return = Rf + β(RM – Rf)
132

133. CAPM
 The CAPM equation allows us to estimate any stock‟s
required return once we have determined the stock‟s
beta, risk-free rate and market-risk premium.
 CAPM Equation is:
Required Return = Rf + β(RM – Rf)
 Example:
133

134. CAPM
 The CAPM equation allows us to estimate any stock‟s
required return once we have determined the stock‟s
beta, risk-free rate and market-risk premium.
 CAPM Equation is:
Required Return = Rf + β(RM – Rf)
 Example:
 Let‟s say we expect the market portfolio to earn 12%,
and T-bill yields are 5%. Home Depot has a beta of
1.08. Calculate Home Depot‟s required return
134

135. CAPM
 The CAPM equation allows us to estimate any stock‟s
required return once we have determined the stock‟s
beta, risk-free rate and market-risk premium.
 CAPM Equation is:
Required Return = Rf + β(RM – Rf)
 Example:
 Let‟s say we expect the market portfolio to earn 12%,
and T-bill yields are 5%. Home Depot has a beta of
1.08. Calculate Home Depot‟s required return
 Required Return = 5% + 1.08(12% - 5%) = 12.56%
135

136. CAPM
136

137. CAPM
 Finding Beta
137

138. CAPM
 Finding Beta
 The easiest way to find betas is to look them up.
Many companies provide betas:
138

139. CAPM
 Finding Beta
 The easiest way to find betas is to look them up.
Many companies provide betas:
 Value Line Investment Survey
 Hoovers
 MSN Money
 Yahoo! Finance
 Zacks
139

140. CAPM
 Finding Beta
 The easiest way to find betas is to look them up.
Many companies provide betas:
 Value Line Investment Survey
 Hoovers
 MSN Money
 Yahoo! Finance
 Zacks
 You can also calculate beta for yourself
140

141. Caveats
141

142. Caveats
 Measures of betas for a given asset can vary
depending on how it is calculated
142

143. Caveats
 Measures of betas for a given asset can vary
depending on how it is calculated
 The “risk / return” relationship rests on the
assumption that the stock (or asset) is priced
“correctly”
143

144. Caveats
 Measures of betas for a given asset can vary
depending on how it is calculated
 The “risk / return” relationship rests on the
assumption that the stock (or asset) is priced
“correctly”
 This in turn, requires that asset markets price
assets correctly
144

145. Caveats
 Measures of betas for a given asset can vary
depending on how it is calculated
 The “risk / return” relationship rests on the
assumption that the stock (or asset) is priced
“correctly”
 This in turn, requires that asset markets price
assets correctly
 Given historical events and other evidence, there
are reasons to question how “efficient” markets
are at pricing an asset at its true price
145

146. Summary
146

147. Summary
 We need the expectation of extra reward for
taking on more risk
147

148. Summary
 We need the expectation of extra reward for
taking on more risk
 An asset‟s risk premium is the additional
compensation required above the risk-free rate
for holding that asset
148

149. Summary
 We need the expectation of extra reward for
taking on more risk
 An asset‟s risk premium is the additional
compensation required above the risk-free rate
for holding that asset
 At the market level, the market risk premium is
the additional return above the risk-free rate to
hold the market portfolio
149

150. Summary
 We need the expectation of extra reward for
taking on more risk
 An asset‟s risk premium is the additional
compensation required above the risk-free rate
for holding that asset
 At the market level, the market risk premium is
the additional return above the risk-free rate to
hold the market portfolio
 For a given asset, the CAPM will tell us how much
return we will require for holding that asset relative to
the risk free rate and market portfolio
150

151. Summary
 We need the expectation of extra reward for
taking on more risk
 An asset‟s risk premium is the additional
compensation required above the risk-free rate
for holding that asset
 At the market level, the market risk premium is
the additional return above the risk-free rate to
hold the market portfolio
 For a given asset, the CAPM will tell us how much
return we will require for holding that asset relative to
the risk free rate and market portfolio
 Required Return = Rf + β(RM – Rf)
151

152. Summary
 We need the expectation of extra reward for
taking on more risk
 An asset‟s risk premium is the additional
compensation required above the risk-free rate
for holding that asset
 At the market level, the market risk premium is
the additional return above the risk-free rate to
hold the market portfolio
 For a given asset, the CAPM will tell us how much
return we will require for holding that asset relative to
the risk free rate and market portfolio
 Required Return = Rf + β(RM – Rf)
152