CHAPTER 5 Risk and Return 245- A study by Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” Journal of
Finance47 (June 1992), pp. 427–465, raised serious questions about the validity of CAPM. The study failed to find
a significant relationship between the historicalbetas and historicalreturns on over 2,000 stocks during 1963–1990.
In other words, it found that the magnitude of a stock’s historicalbeta had no relationship to the level of its histori-
calreturn. Although Fama and French’s study continues to receive attention, CAPM has not been abandoned
because its rejection as a historicalmodel fails to discredit its validity as an expectationalmodel. Therefore, in spite
of this challenge, CAPM continues to be viewed as a logical and useful framework—both conceptually and opera-
tionally—for linking expectednondiversifiable risk and return.
described by CAPM in active markets such as the New York Stock Exchange.^23
In the case of real corporate assets, such as plant and equipment, research thus far
has failed to prove the general applicability of CAPM because of indivisibility,
relatively large size, limited number of transactions, and absence of an efficient
market for such assets.
Despite the limitations of CAPM, it provides a useful conceptual framework
for evaluating and linking risk and return. An awareness of this tradeoff and an
attempt to consider risk as well as return in financial decision making should help
financial managers achieve their goals.Review Questions
5–11 How are total risk, nondiversifiable risk, and diversifiable risk related?
Why is nondiversifiable risk the only relevant risk?
5–12 What risk does betameasure? How can you find the beta of a portfolio?
5–13 Explain the meaning of each variable in the capital asset pricing model
(CAPM)equation. What is the security market line (SML)?
5–14 What impact would the following changes have on the security market
line and therefore on the required return for a given level of risk? (a) An
increasein inflationary expectations. (b) Investors become lessrisk-averse.
5–15 Why do financial managers have some difficulty applying CAPM in finan-
cial decision making? Generally, what benefit does CAPM provide them?SUMMARY
FOCUS ON VALUE
A firm’s risk and expected return directly affect its share price. As we shall see in Chapter 7,
risk and return are the two key determinants of the firm’s value. It is therefore the financial
manager’s responsibility to assess carefully the risk and return of all major decisions in
order to make sure that the expected returns justify the level of risk being introduced.
The way the financial manager can expect to achieve the firm’s goal of increasing its
share price(and thereby benefiting its owners) is to take only those actions that earn returns
at least commensurate with their risk. Clearly, financial managers need to recognize, mea-
sure, and evaluate risk–return tradeoffs in order to ensure that their decisions contribute to
the creation of value for owners.