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Learning objectives
1. 2. 3. 4. 5. 6. 7.
8.
9.
Distinguish between systematic and unsystematic risk. Define the single index model and identify its components. Relate a securitys beta to its systematic risk. Describe the Capital Asset Pricing Model (CAPM) and list its assumptions. Identify the implications, applications and limitations of the CAPM. Use the CAPM to compute an assets expected return. Define the Security Market Line (SML). Understand the concepts of fairly priced, underpriced and overpriced. Describe the implementation of the CAPM.
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Concept Map
Portfolio Theory Foreign Exchange Asset Pricing
FINC4101
Derivatives Equity
Market Efficiency
Fixed Income
An asset pricing model allows us to figure out the required return of an asset. Required rate of return can be used for:
1. 2. 3.
understand the CAPM, we need to know the following: Systematic vs. unsystematic risk
Unsystematic risk
Unsystematic
risk: uncertainty or variability in returns that affects a specific asset without affecting other assets.
Also known as unique risk, firm-specific risk, diversifiable risk. Sources of unsystematic risk: litigation, patents, R&D,
Systematic risk
Systematic
Statistical model that estimates the systematic and unsystematic risk of a security or portfolio. Looks at excess return, denoted by R
Securitys HPR in excess of the risk free rate.
What is a securitys excess return Excess return of security i, Ri = security is HPR risk-free rate = ri rf
The following discussion focuses on excess returns.
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Uses a broad index of securities (e.g., S&P500) to represent systematic risk. This broad index is called, market index, market factor, or just market for short. Market excess return is denoted RM . The model says that a securitys excess return consists of 3 parts:
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ai b i RM
Ri = ai + biRM + ei
Stocks excess return if market factor is neutral, i.e., market excess return = 0 Excess return due to movements in the overall market. bi = responsiveness of securitys return to to market return. Excess return due to unexpected events relevant only to the security (firm-specific). On average, ei is assumed to be 0. That is, E(ei) = 0.
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ei
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As 2
1,
Systematic risk becomes a bigger part of total risk. Points on scatter diagram lie close to regression line.
As 2
0,
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Unsystematic risk becomes a bigger part of total risk. Points on scatter diagram lie away from regression line.
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model that underlies all modern financial theory Derived using principles of diversification with simplified assumptions Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development Theoretical model based on a list of simplifying assumptions
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2.
3.
4.
5.
6.
7.
Individual investors are price takers Single-period investment horizon Investments are limited to traded financial assets No taxes, and transaction costs Information is costless and available to all investors Investors are rational mean-variance optimizers Homogeneous expectations
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All investors will hold the same portfolio for risky assets market portfolio (M).
Market portfolio contains all securities. The proportion of each security is its market value as a percentage of total market value of all securities.
2.
Market portfolio will be on the efficient frontier and will be the tangency portfolio.
Capital Allocation Line is now called the Capital Market Line (CML).
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Average risk aversion of all market participants. Variance of the market portfolio.
4.
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Expected return:
E(rM) = rf + (A* x
2 sM )
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E(ri) rf = bi [ E(rM) rf ]
Security is expected return:
E(ri) = rf + bi [ E(rM) rf ]
Expected return-beta relationship Formulas also hold for a portfolio of securities.
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Portfolio beta, bP
The
beta of a portfolio, P,
Weighted average of the individual asset betas. Weights are the portfolio proportions.
Suppose the market risk premium is 8%. What is the risk premium of a portfolio invested 25% in Coca-Cola and 75% in BellSouth. Coca-Cola has a beta of 0.85 and BellSouth has a beta of 1.2.
Verify that portfolio beta is 1.1125 Verify that risk premium is 8.9%
Suppose you now invest 20% in the risk-free asset, 25% in Coca-Cola and the rest in BellSouth. What is the portfolio beta and risk premium?
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Questions
Are the following statements true or false? Explain. a) Stocks with a beta of zero offer an expected rate of return of zero. b) The CAPM implies that investors require a higher return to hold highly volatile securities. c) You can construct a portfolio with a beta of 0.75 by investing 0.75 of the budget in T-bills and the remainder in the market portfolio.
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More questions
1. What
is the beta of a portfolio with E(rP) = 20%, if rf = 5% and E(rM) = 15%. both portfolios A and B are well diversified, and E(rA) = 14% and E(rB) = 14.8%. If the economy has only one factor, and bA = 1.0 while bB = 1.1, what must be the risk-free rate?
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2. Assume
SML M
Rise
E(rM)
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Graphical representation of the expected return-beta relationship. Provides a benchmark for evaluating investment performance.
Given an investments beta, the SML tells us the return we should require or demand from this investment.
3.
Fairly priced assets plot exactly on the SML. Underpriced assets plot above the SML. Overpriced assets plot below the SML.
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Suppose stock A is currently priced at $45. Everyone agrees that its year-end price will be $50 and a dividend of $2.02 will be paid then. Stock As beta is 1.2, the market portfolios expected return is 14% and the risk-free rate is 6%. Given the stock price and future cash flows, expected HPR = (50 + 2.02 45)/45 = 0.156 or 15.6% CAPMs expected return = 6 + 1.2[14 6] = 15.6% ! Stock A is FAIRLY PRICED. Its current price leads to an expected return that is EXACTLY equal to the expected return indicated by the CAPM. So, CAPM says that $45 is the correct price for A given its risk. This stock plots exactly on the SML.
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Underpriced security
Now supposed everything stays the same, BUT stock A is now priced at $44.46. Given the stock price and future cash flows, expected HPR = (50 + 2.02 44.46)/44.46 = 0.17 or 17% But CAPM says stock A should provide 15.6% return and it should be worth $45. Stock A is UNDERPRICED. Its price of $44.46 is LESS than the CAPM price of $45. Also, As expected return given its price is 17% which is MORE than the CAPM expected return of 15.6% Stock A now plots ABOVE the SML.
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Overpriced security
Now supposed everything stays the same, BUT stock A is now priced at $46.04. Given the stock price and future cash flows, expected HPR = (50 + 2.02 46.04)/46.04 = 0.13 or 13% But CAPM says stock A should provide 15.6% return and it should be worth $45. Stock A is OVERPRICED. Its price of $46.04 is MORE than the CAPM price of $45. Also, As expected return given its price is 13% which is LESS than the CAPM expected return of 15.6% Stock A now plots BELOW the SML.
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a, Alpha
= (2) (3)
$45 $44.46
$46.04
15.6% 17%
13%
15.6% 15.6%
15.6%
0% 1.4%
-2.6%
Alpha: Difference between expected HPR and the return predicted by the CAPM.
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CAL becomes CML when the market portfolio is used as the risky portfolio
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SML Graphs expected return of individual asset against beta. Individual assets, portfolios Beta is the valid risk measure
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Questions
a)
b)
c)
d)
The SML depicts: A securitys expected return as a function of its systematic risk. The market portfolio as the optimal portfolio of risky securities. The relationship between a securitys return and the return on an index. The complete portfolio as a combination of the market portfolio and the risk-free asset.
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Valuation of assets.
3. 4.
Capital budgeting.
Karen Kay, a portfolio manager at Collins Asset Management, is using the CAPM for making recommendations to her clients. Her research department has developed the information shown in the following exhibit Forecasted return S.D. Beta Stock X Stock Y Market index Risk-free rate 14% 17 14 5
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36% 25 15
b)
Calculate expected return and alpha for each stock. Identify and justify which stock would be more appropriate for an investor who wants to:
Add this stock to a well-diversified equity portfolio. ii. Hold this stock as a single-stock portfolio.
i.
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market price of a security is $40. its expected rate of return is 13%. The riskfree rate is 7%, and the market risk premium is 8%. What will the market price of the security be if its beta doubles (and all other variables remain unchanged)? Assume the stock is expected to pay a constant dividend in perpetuity.
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The risk-free rate is 4%. Suppose that the expected return required by the market for a portfolio with a beta of 1.0 is 12%. According to the CAPM:
What is the expected return on the market portfolio? What would be the expected return on a zero-beta stock? Suppose you consider buying a share of stock at a price of $40. the stock is expected to pay a dividend of $3 next year and to sell then for $41. The stocks beta is -0.5. is the stock overpriced or underpriced?
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A.
B. C.
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You are an analyst at Goldman Sachs. You are covering a company which is considering a project with the following net after-tax cash flows : an outlay of $20 mil right now (t= 0), $10 mil at the end of each of the first nine years and $20 mil at the end of year 10. The project is terminated after 10 years. The projects beta is 1.7. Assuming rf = 9% and E(rM) = 19%, what is the projects NPV?
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Market portfolio of all assets is unobservable. The CAPM gives a relationship between expected return and beta. Expected returns are unobservable. How do we get round these problems?
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ri - rf = ai + bi(RM-rf) + ei
Excess return of stock i Excess return when index portfolio has 0 excess return. Excess return on stock index (e.g., S&P500).
Excess return due to firmspecific events.
E(ri) rf = ai + bi [ E(rM) rf ]
Recall the CAPM equation:
E(ri) rf = bi [ E(rM) rf ]
=> The CAPM predicts that ai = 0.
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Monthly prices of Coca-Cola (KO) Monthly index values of S&P 500 (^GSPC) Get monthly risk-free rate from Prof Ken Frenchs website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.fren ch/data_library.html Compute monthly excess returns of KO and ^GSPC.
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CAPM says that the market portfolio is the only source of systematic risk. But there can be multiple sources of systematic risk, e.g., fluctuation in interest rates, fluctuation in energy prices, uncertainty about inflation, etc. Multifactor asset pricing models try to do better than the CAPM by using more than one systematic risk factor to explain security returns.
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Summary
Asset pricing models tell us how to figure a risky assets expected return. The CAPM is such a model. It says that there is only one source of systematic risk the market. In the CAPM world, b is the measure of risk for individual securities. CAPM says that the riskier the security, the higher the required/expected return for holding that asset. SML depicts the relationship between b and expected return. CAPM can be used in a number of financial applications. Newer asset pricing models use more than one systematic risk factor.
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Practice 4
Chapter
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Homework 4
1.
2.
You already have a very well-diversified portfolio of common stock with a beta of 2, and you want to add stock AAA or BBB into the portfolio. AAAs standard deviation is 0.2300 and its beta is 4. BBBs standard deviation is 0.6500 and its beta is 0.5. How will the addition affect the portfolios risk? If we add more factors into the one-factor asset pricing model, what happens to the required returns, increase or decrease? If the expected future cash flows of the financial securities remain the same, will that increase or decrease the current market price? Why?
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Homework 5
Regression to find stock Beta.
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