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© 2012 McGraw-Hill Ryerson Limited Chapter 12 -1
Market Risk Premium: ◦ The risk premium of the market portfolio. It is the difference
between market return and the return on risk free asset.
Benchmark Betas◦ Since the return on a t-bill is fixed and unaffected by what
happens in the market; the beta of the risk-free asset is zero.
◦ By definition, the beta of the market portfolio is 1.
◦ Given these benchmarks and the market risk premium, we can calculate the expected return on any asset.
LO3
© 2012 McGraw-Hill Ryerson Limited Chapter 12 -2
Measuring return with given beta: The Capital Asset Pricing Model (CAPM):
Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium
According to the CAPM:
fr-mrj+fr=)jE(r
LO3
© 2012 McGraw-Hill Ryerson Limited Chapter 12 -3
An example of measuring return with CAPM:
Calculate the expected return on a stock with a beta of 0.5 if T-bills return 4% and the market returns 11%.
Expected Return =rj = rf + ×[rm – rf] = 4% + 0.5 × [11% -
4%] = 7.5%
LO3
© 2012 McGraw-Hill Ryerson Limited Chapter 12 -4
CAPM
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
0 0.5 1 1.5 2 2.5Beta of Asset
Exp
ecte
d R
etu
rn (
%)
Market Portfolio
T-bill
LO3
© 2012 McGraw-Hill Ryerson Limited Chapter 12 -5
Security Market Line (SML)◦The graph showing the relationship between
the market risk of the security and its expected return is called the Security Market Line (SML).
◦According to the CAPM, expected rates of return for all securities and all portfolios lie on the SML.
LO3
© 2012 McGraw-Hill Ryerson Limited Chapter 12 -6
CAPM
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
0 0.5 1 1.5 2
Beta of Asset
Exp
ecte
d R
etu
rn (
%)
SML
2.3
Proposed Holding
LO3
© 2012 McGraw-Hill Ryerson Limited Chapter 12 -7
How Well Does the CAPM Work?◦ Studies have found the CAPM is too simple to capture
exactly how stock markets work
◦ However, the CAPM does capture two fundamental financial principles: Investors require extra return for taking on risk Investors are primarily concerned with the market risk they
cannot eliminate by diversification
◦ Thus, the CAPM is a good rule of thumb for pricing assets.◦ Example: IMAX has a beta of 1.25Expected Return = 4% + 1.25× (11% - 4%) = 12.75%
◦ Thus, if IMAX were proposing an expansion project, you would discount its estimated cash flows at 12.75%
LO3, LO4
