Introduction to Corporate Finance

7: Risk, Return and the Capital Asset Pricing Model

example

Suppose you are wrong about these two shares, and
Rocket.com goes down by 10% during the year (to
$9), while BricksNMortar increases by 10% (to $11).
At the end of the year, your situation is as follows:

Sell Rocket.com shares $1,350 (150 shares @ $9.00)

Return borrowed shares $ 550 (50 shares @ $11.00)

Net cash earned $ 800

Rate of return = ($800 – $1,000)/$1,000 = –0.20 = 220%

The 150 shares of Rocket are worth just $1,350,

and you must return 50 BricksNMortar shares, which

are now worth $550, to the lender. That leaves you

with just $800 of your original $1,000 investment, a

loss of 20%.

7-2b PORTFOLIO RISK

Based on the calculation of a portfolio’s expected return, you may expect that a portfolio’s risk is equal

to a weighted average of the risks of the assets that comprise the portfolio. That statement is partly right

and partly wrong. When we shift our focus from expected return to risk, we must be very careful about

the measure of risk that we use in our calculations.

WHY PORTFOLIO WEIGHTS SHIFT

In Chapter 6 we looked at how your decision

to allocate funds between shares and bonds

would affect the amount of money you saved for

retirement. No matter how you allocate your savings

initially between shares and bonds, over time the

portfolio weights will shift toward the asset earning

the highest returns.

Repeating the example from page 201 of

Chapter 6, suppose you invest $4,000 each year for

35 years, and you invest half of each contribution in

bonds and half in shares. Assume that bonds earn

5.6% per year and shares earn 11.4%. The table

below shows how your portfolio weights tilt toward

ordinary shares, even though you divide your

contributions equally between shares and bonds.

Because shares earn a higher return than bonds, the

share portfolio grows faster each year, increasing the

portfolio weight invested in shares as time goes by.

finance in practice

Total amount invested

Year Bond portfolio Share portfolio % invested in shares

1 $ 2,000 $ 2,000 50.0%

2 4,112 4,228 50.7%

5 11,184 12,555 52.9%

10 25,872 34,095 56.9%

15 45,158 71,050 61.1%

30 147,416 429,841 74.5%