Principles of Managerial Finance

CHAPTER 5 Risk and Return 233

16. The initial development of this theory is generally attributed to William F. Sharpe, “Capital Asset Prices: A The-
    ory of Market Equilibrium Under Conditions of Risk,” Journal of Finance19 (September 1964), pp. 425–442, and
    John Lintner, “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital
    Budgets,” Review of Economics and Statistics47 (February 1965), pp 13–37. A number of authors subsequently
    advanced, refined, and tested this now widely accepted theory.

capital asset pricing model
(CAPM)
The basic theory that links risk
and return for all assets.

LG5 LG6

Even where governments do not impose exchange controls or seize assets,

international investors may suffer if a shortage of hard currency prevents payment

of dividends or interest to foreigners. When governments are forced to allocate

scarce foreign exchange, they rarely give top priority to the interests of foreign

investors. Instead, hard-currency reserves are typically used to pay for necessary

imports such as food, medicine, and industrial materials and to pay interest on the

government’s debt. Because most of the debt of developing countries is held by

banks rather than individuals, foreign investors are often badly harmed when a

country experiences political or economic problems.

Review Questions

5–8 What is an efficient portfolio?How can the return and standard deviation

of a portfolio be determined?

5–9 Why is the correlationbetween asset returns important? How does diver-

sification allow risky assets to be combined so that the risk of the portfolio

is less than the risk of the individual assets in it?

5–10 How does international diversification enhance risk reduction? When

might international diversification result in subpar returns? What are

political risks,and how do they affect international diversification?

5.4 Risk and Return: The Capital Asset

Pricing Model (CAPM)

The most important aspect of risk is the overall riskof the firm as viewed by

investors in the marketplace. Overall risk significantly affects investment oppor-

tunities and—even more important—the owners’ wealth. The basic theory that

links risk and return for all assets is the capital asset pricing model (CAPM).^16 We

will use CAPM to understand the basic risk–return tradeoffs involved in all types

of financial decisions.

Types of Risk

To understand the basic types of risk, consider what happens to the risk of a

portfolio consisting of a single security (asset), to which we add securities ran-

domly selected from, say, the population of all actively traded securities. Using