Introduction to Corporate Finance

7: Risk, Return and the Capital Asset Pricing Model

However, diversification does not eliminate systematic risk. Therefore, if we redefine portfolio risk

and focus on systematic risk only, not on the standard deviation – which includes both systematic and

unsystematic risk – then the simple weighted average formula works. For example, suppose an ADM

share has a beta of 0.8 and AMR’s beta equals 1.4. The beta of a portfolio with equal investments in each

share is:

Portfolio beta = βp = (0.50)(0.8) + (0.50)(1.4) = 1.1

We can write a more general expression describing a portfolio’s beta. Suppose a portfolio contains

different assets. The betas of these assets are β 1 , β 2 ,...., βn. The portfolio weights are w 1 , w 2 , ....wn. The

portfolio beta (βp) is given by this equation:

Eq. 7.4 βp = w 1 β 1 + w 2 β 2 + ... + wnβn

where w 1 + w 2 + ... + wn = 1

The chapter-opening ‘What companies do’ box illustrates why distinguishing between systematic

and unsystematic risk is important, not just for investors who buy shares and bonds, but also for global

corporations that build factories, invest in distribution networks and make other kinds of investments in

physical assets.

Andrew Karolyi, Cornell

University

‘Investors who seek to

diversify internationally

to reduce their global

risk can leave money

on the table if they

ignore the unique

industrial compositions

of markets.’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

COURSEMATE

SMART VIDEO

finance in practice

HOW RISKY ARE EMERGING MARKETS?

In recent decades, many developing countries

adopted market-oriented reforms and opened

their economies to foreign capital. Despite the

success these countries have enjoyed in attracting

new investors, a report by McKinsey & Company

argues that most multinational corporations

overestimate the risk of investing in emerging

markets. According to McKinsey, companies

routinely assign a risk premium to projects in

emerging markets that is more than double the

risk premium that they assign to similar projects

in the United States and Europe. By overstating

the risks, multinational companies understate

the value of investments in emerging markets.

McKinsey & Company believes that this leads

companies to pass up profitable investment

opportunities in these countries.

If it is true that companies overstate the risks of

investing in emerging markets, what is the cause of

that error? McKinsey proposes that companies do

not take the proper portfolio view of the businesses

they engage in around the world. Rather than

looking at each business unit’s contribution

to overall company risk – the contribution of each

unit to the company’s portfolio of businesses –

companies place too much emphasis on the

unsystematic risks associated with individual

countries.

To demonstrate that point, McKinsey calculates

a beta for each emerging market relative to a world

market index. By definition, the world market’s beta

equals 1.0. Especially risky countries should have

betas much greater than 1.0, while supposedly

‘safe’ countries like the US should have betas

below 1.0. The bar chart below shows betas for

the US, Europe and 22 emerging markets. Ten

emerging markets have a beta below that of the

US market, and in only one country, Russia, does

the market beta justify a risk premium double that

of the US. Investments that seem to be very risky

when considered in isolation look much less risky

as part of a portfolio. That’s a lesson that applies

to individual investors as well as to multinational

corporations.

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