Chapter Brealey, Myers, and Allen Principles of Corporate Finance 11th Edition PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL 8 Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY Combining stocks into portfolios can reduce standard deviation below simple weighted- average calculation Correlation coefficients make possible Various weighted combinations of stocks that create specific standard deviation constitute set of efficient portfolios

8-3 FIGURE 8.1 DAILY PRICE CHANGES, IBM

8-4 FIGURE 8.2A STANDARD DEVIATION VERSUS EXPECTED RETURN

8-5 FIGURE 8.2B STANDARD DEVIATION VERSUS EXPECTED RETURN

8-6 FIGURE 8.2C STANDARD DEVIATION VERSUS EXPECTED RETURN

8-7 FIGURE 8.3 EXPECTED RETURN AND STANDARD DEVIATION, HEINZ, AND EXXON MOBIL

8-8 TABLE 8.1 EXAMPLES OF EFFICIENT PORTFOLIOS Efficient Portfolios—Percentages Allocated to Each Stock Stock Expected Return Standard Deviation A B C Dow Chemical 16.4% 40.2% Bank of America Ford Heinz IBM Newmont Mining Pfizer Starbucks Walmart ExxonMobil Expected portfolio return Portfolio standard deviation

8-9 FIGURE 8.4 FOUR EFFICIENT PORTFOLIOS FROM TEN STOCKS

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY Efficient Frontier Each half-ellipse represents possible weighted combinations for two stocks Composite of all stock sets constitutes efficient frontier Expected return (%) Standard deviation

8-11 FIGURE 8.5 LENDING AND BORROWING

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY Example Correlation Coefficient =.18 Stocks  % of Portfolio Average Return Heinz14.660% 6.0% ExxonMobil % 10.0% Standard deviation = weighted average = Standard deviation = portfolio = 15.1 Return = weighted average = portfolio = 7.6% Higher return, lower risk through diversification

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY Example Correlation Coefficient =.4 Stocks  % of Portfolio Average Return ABC Corp2860% 15% Big Corp42 40% 21% Standard deviation = weighted average = 33.6 Standard deviation = portfolio = 28.1 Return = weighted average = portfolio = 17.4%

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY Example, continued Correlation Coefficient =.3 Add new stock to portfolio Stocks  % of PortfolioAverage Return Portfolio28.150% 17.4% New Corp30 50% 19% Standard deviation = weighted average = Standard deviation = portfolio = Return = weighted average = portfolio = 18.20%

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY A B Return Risk (measured as  )

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY A Return Risk B AB

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY A B N Return Risk AB

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY A B N Return Risk AB ABN

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY A B N Return Risk AB ABN Goal is to move up and left—less risk, more return

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY Sharpe Ratio Ratio of risk premium to standard deviation

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return

HARRY MARKOWITZ AND THE BIRTH OF PORTFOLIO THEORY Return Risk A B N AB ABN

THE RELATIONSHIP BETWEEN RISK AND RETURN Return Risk. rfrf Market portfolio Market return = r m

8-25 FIGURE 8.6 SECURITY MARKET LINE Return. rfrf Market portfolio Market return = r m BETA1.0 Security market line (SML)

THE RELATIONSHIP BETWEEN RISK AND RETURN SML Equation: r f + β(r m − r f ) Return BETA rfrf 1.0 SML

THE RELATIONSHIP BETWEEN RISK AND RETURN Capital Asset Pricing Model (CAPM)

8-28 TABLE 8.2 ESTIMATES OF RETURNS Returns estimates in January 2012 based on capital asset pricing model. Assume 2% for interest rate r f and 7% for expected risk premium r m − r f. StockBetaExpected Return Dow Chemical Bank of America Ford ExxonMobil Starbucks IBM Newmont Mining Pfizer Walmart Heinz

8-29 FIGURE 8.7 SECURITY MARKET LINE EQUILIBRIUM In equilibrium, no stock can lie below the security market line

8-30 FIGURE 8.8 CAPITAL ASSET PRICING MODEL

8-31 FIGURE 8.9B BETA VERSUS AVERAGE RETURN

8-32 FIGURE 8.10 RETURN VERSUS BOOK-TO-MARKET

ALTERNATIVE THEORIES Alternative to CAPM

ALTERNATIVE THEORIES Estimated risk premiums ( )

ALTERNATIVE THEORIES Three-Factor Model Identify macroeconomic factors that could affect stock returns Estimate expected risk premium on each factor ( r factor1 − r f, etc.) Measure sensitivity of each stock to factors ( b 1, b 2, etc.)

8-36 TABLE 8.3 EXPECTED EQUITY RETURNS