Introduction to Corporate Finance

7: Risk, Return and the Capital Asset Pricing Model

In Figure 7.4, the investor’s portfolio lies up and to the right of the market portfolio at point B.

At this point, we must stop and make a crucial observation. If it is true, as the preceding example

shows, that a portfolio with a beta of 0.5 offers an expected return of 7%, then, in equilibrium, it must

also be true that any individual security with a beta of 0.5 offers the same return. To understand this

claim, examine point C in Figure 7.4. This point represents a share with a beta of 0.5 and an expected

return of less than 7%. Rational investors who own C will sell it, because they can create an equally risky

portfolio that offers a higher return, by combining Treasury notes and the market portfolio. As investors

sell asset C, its price will fall. We know that prices and returns of financial assets move in opposite

directions (for example, if a bond’s price falls, its yield rises), so as the price of C falls, its expected return

rises until it reaches 7%.

Similarly, consider point D in the figure. Point D represents an asset with a beta of 0.5 but an

expected return greater than 7%. This asset is a true bargain, because it offers investors a higher rate of

return than they can earn on a 50–50 portfolio of Treasury notes and shares, without requiring them to

take on extra risk. Investors will rush to buy share D, and their buying pressure will drive up the price

and push down the return of share D. As soon as the expected return on D reaches 7%, the market once

again reaches equilibrium.

Figure 7.4 therefore plots the relationship between betas and expected returns for individual

securities as well as for portfolios. This relationship is called the security market line, and the equation of

this line is the fundamental risk and return relationship predicted by the capital asset pricing model (CAPM).

The CAPM says that the expected return on any asset (i), denoted by E(ri), depends on the risk-free rate(rf),

the asset’s beta (bi) and the market risk premium (given by the excess expected return of the market (E(rm))

compared to the risk free rate.^11

Eq. 7.5 E(ri) = rf + bi(E(rm) – rf)

11 ‘i ’ is standard notation to suggest any asset, rather than a specific asset. ‘ri ’ refers to the return of this asset i. ‘E(ri)’ refers to the expected
return of the asset i.

William Sharpe, Stanford

University, Co-founder,

Financial Engines

‘To the extent that there

is a premium for bearing

risk, it is a premium for

bearing the risk of doing

badly in bad times.’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

COURSEMATE

SMART VIDEO

finance in practice

CFO FORECASTS OF THE MARKET RISK PREMIUM

The expected risk premium on the market is an

important component of the CAPM, but how does

one know what the expected market risk premium

is? One way to estimate that premium is to ask

CFOs what return they expect shares to earn

relative to safe assets such as Treasury notes or, in

the US, Treasury bonds or bills. The chart below

shows the market risk premium that American

CFOs said they expected (looking 10 years into

the future) when they responded to the quarterly

Duke University CFO Survey. From 2001 to 2011

(1st quarter), CFOs’ estimates of the market risk

premium averaged about 3.5%, but their forecasts

fluctuated over time, ranging from a low of about

2.4% to a high of 4.75%. In general, these forecasts

suggest that CFOs expect a lower market risk

premium than the long-run historical average of

7.5% presented in Chapter 6.

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capital asset pricing

model (CAPM)

States that the expected

return on a specific asset

equals the risk-free rate plus a

premium that depends on the

asset’s beta and the expected

risk premium on the market

portfolio