Risk Return & The Capital Asset Pricing Model (capm)

Risk Return & The Capital Asset Pricing Model (CAPM)

• To make “good” (i.e., value-maximizing) financial decisions, one must understands the relationship between risk and return

• We accept the notion that investors like returns and dislike risk

• Consider the following proxies for return and risk:

• Expected return - weighted average of the distribution of possible returns in the future.

• Variance of returns - a measure of the dispersion of the distribution of possible returns in the future.

Expected (Ex Ante) Return

• An Example

• Consider the following return figures for the following year on stock XYZ under three alternative states of the economy

• Pk Rk Probability Return in State of Economy of state k state k

• +1% change in GNP 0.25 -5%

• +2% change in GNP 0.50 15%

• +3% change in GNP 0.25 35%

• 1.00

Beta and Unique Risk

Efficient Sets and Diversification