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Investors are rational and seek to maximize their expected utility functions All investment is for the same time period All investors can borrow or lend at the risk-free rate
Portfolio separation theorem allows investors to separate the decision of selecting the risky portfolio from the investors risk preference
Market Portfolio
The Market Portfolio (point M) must be the only risky portfolio chosen by all risk-averse investors. Because it is demanded by all investors, it must contain all the securities and other traded assets
Relative Risk
Relative risk contribution of security i
Total risk contribution of security i divided by Total risk of market portfolio, M
Known as beta, , it measures security risk, or volatility relative to the market portfolio Beta greater than 1.0 is riskier than the market
Understanding Beta
All security betas are measured relative to the market portfolio beta, which equals 1.0 A beta greater than 1.0 means the security contributes more than the average risk to the well-diversified market portfolio The value of beta implies something about returns relative to the market
The index used to approximate the market portfolio can affect the beta estimate
Risk recap
Market risk Firm-specific risk Securitys total risk is market risk plus firm-specific risk Relative market risk for a security is its beta Securitys total risk is beta plus firm-specific risk Beta is the systematic or nondiversifiable risk Diversifiable risk is irrelevant in a well diversified portfolio Decisions made by total risk (standard deviations) instead of beta ignore the systematic risk and diversifiable risk components of total risk
Risk/return relationships
Security systematic risk, beta, can be defined as a ratio to the market return ERi = RF + i (ERM - RF) Security market line (SML) shows the risk/return relationship for securities and a graphical representation of the CAPM Equation of a line is Y = a + bX
a is the y-intercept and b is the slope
The y-intercept is the risk-free rate The slope is (ERM - RF) The equation of the SML is
we can estimate the required return for a security, on an SML graph Calculate the predicted return for the security based on todays price, a predicted price a year from today, and expected dividends in the coming year Predict a holding period return and compare to the SML expected return If a security seems likely to have a higher return than its risk level justifies, then it is undervalued (good investment) A lower expected return than its risk would justify suggests a security is overvalued (not a good investment)
Estimating Beta
A beta estimate measures the changes of a securitys return relative to the market return A security characteristic line graphs the relationship between the return on the market portfolio and a security return The market model uses linear regression to estimate the relationship between the market return and the security return
! * Security Return M o * .
f Market Return
The beta value for the SML comes from the slope estimate of the SCL
Research has shown little correlation between a security returns and market portfolio returns Historical betas can be better predictors of future betas for large portfolios than it is for individual securities The more securities in the portfolio, the better predictor the portfolio beta is Other strategies can be more successful than strictly investing in beta based strategies Some choose to ignore beta - Beta is dead Beta isnt perfect, but risk must be measured in making risk/return decisions The assumptions of the CAPM were stringent, and not realistic and will be relaxed in the next chapter in developing a general risk/return relationship