Introduction to Corporate Finance

7: Risk, Return and the Capital Asset Pricing Model

FIGURE 7.3 BETA AND EXPECTED RETURNS

An investor willing to accept an average level of systematic risk, by holding a share with a beta of 1.0, expects a return of
10%. By holding only the risk-free asset, an investor can earn 4% without having to accept any systematic risk at all.

2%

1%

0%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

14%

13%

16%

15%

17%

0 0.25 0.5 0.75 1 1.25 1.5 1.75 2

Beta

Expected return

Risk-free asset

'average' stock

HOW DO AUSTRALIAN COMPANIES ESTIMATE THE RISK-FREE RATE?

The risk-free rate can never be known with certainty.

However, we can use the yields on observable

instruments that are expected to behave in a similar

fashion to risk-free assets, because they themselves

are very low-risk assets. This is the logic behind

using triple A-rated treasury bonds and notes issued

by the Australian government as proxies for risk-free

assets.

Companies typically make long-term

investment decisions, and so often use the 10-

year government bond as a default proxy for a

risk-free asset. However, to be more accurate,

we should match the duration of our risk-free

asset to the expected duration of our investment.

Thus, for short-term investments, it might be

more appropriate to use the yield on short-dated

instruments such as treasury notes as our proxy for

the risk-free rate.

Another issue to consider is that investors

investing in a triple A-rated coupon-paying

treasury bond will bear more risk than those

investing in zero-coupon triple A-rated treasury

bonds. This is because the coupons will be

exposed to reinvestment risk; the rate at which

they can be invested could be different from

the yield on the zero-coupon bonds. Thus, zero-

coupon treasury instruments will be better proxies

for risk-free assets.

finance in practice