Chap 07_RiskreturnCAPM.pptVIP

Risk, Return, and theCapital Asset Pricing Model Chapter 7 Expected Returns Methods used to estimate expected return Expected Returns: The Historical Approach Expected Returns: The Historical Approach Assume General Motors’ long-run average return is 15.0%. Treasury bills’ average return over same period is 4%. Expected Returns: The Probabilistic Approach Expected Returns: The Probabilistic Approach Expected Returns: The Risk-Based Approach This approach is more theoretically sound and used in practice by most corporate finance professionals. Two-step process: Measure the risk of the asset. Translate that risk measure into an expected return estimate. Expected Returns: The Risk-Based Approach Expected Returns: The Risk-Based Approach Collect data on a stock’s returns and returns on a market index Plot the points on a scatter plot graph Y-axis: stock’s return X-axis: market’s return Plot a line (using linear regression) through the points Fig. 7.1A Scatter Plot of Weekly Returns on The Sharper Image vs. The SP 500 Stock Index High Beta By definition, the beta of the average stock equals 1.0. The return on a high-beta stock like The Sharper Image experiences dramatic up-and-down swings when the market return moves. Because The Sharper Image’s beta equals 1.44, we can say that the return on The Sharper Image’s shares moves, on average, 1.44 times as much as does the market return. Fig. 7.1B Scatter Plot of Weekly Returns on ConAgra vs. The SP 500 Stock Index Low Beta Because the ConAgra’s beta equals 0.11, we can say that the return on The ConAgra’s shares moves, on average, 0.11 times as much as does the market return. A stock that can gain or lose 12 percent in a week is volatile, but ConAgra’s volatility is only weakly related to fluctuations in the overall market. Most of ConAgra’s risk is unsystematic and can be eliminated through diversification. Expected Returns: The Risk-Based Approach Beta and Expected Returns Portfolio Expected Return Expected return of a