Risk & Return theories II

CAPM (Capital Asset Pricing Model)

APT(Arbitrage Price Theory)

These Asset pricing models are equilibrium models. These models provide
the return that an investor should require on a capital asset given the
assumptions about the investor behavior and assumptions about the capital
markets.
Portfolio Theory
In constructing a portfolio investors seeks to maximize the expected return
from their investment given some level of risk they are willing to accept.
the portfolios that satisfy this requirement are called efficient portfolios.
Portfolio theory tells us how to achieve efficient portfolios Markowitz
efficient portfolio
A reasonable assumption is that investors are risk averse.

Portfolio Risk (
p
)
Achievable Set of
Risky Portfolio
Combinations
ER
p

Achievable Portfolio Combinations
Efficient Frontier (Set)
E
Efficient
frontier is the
set of
achievable
portfolio
combinations
that offer the
highest rate
of return for a
given level of
risk.
CAPM
The model which is used to calculate required rate of return for pricing
risky securities.
Was introduced by William Sharpe. John Lintner and Jan Mossin.
CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 4
Assumptions about the investor behavior
Investors are risk averse. Means an investor who faces a choice between
two portfolios with the same expected return will select the portfolio with
the lower risk.
The investors have reduced portfolio risk by combining assets with
counterbalancing correlations.
All investors make investment decisions over some single period
investment horizon.
Investors have homogenous expectations about asset returns, variances and
correlations
Assumptions about Capital Markets

Capital market is perfectly competitive. Or investors are price takers.
Markets are frictionless. Or there is no transaction cost like taxes,
brokerage fee, bid ask spread etc.
Investors can borrow and lend unlimited funds at Risk free rate of return.
Risk-free Investing
When we introduce the presence of a risk-free investment, a whole new set
of portfolio combinations becomes possible.
We can estimate the return on a portfolio made up of RF asset and a risky
asset A letting the weight w invested in the risky asset and the weight
invested in RF as (1 w).
The New Efficient Frontier
Efficient Portfolios using the Tangent Portfolio T
Risk
ER
RF
A
T
Clearly RF with
T (the tangent
portfolio) offers
a series of
portfolio
combinations
that dominate
those produced
by RF and A.
Further, they
dominate all but
one portfolio on
the efficient
frontier!
The New Efficient Frontier
Lending Portfolios
Risk
ER
RF
A
T
Portfolios
between RF
and T are
lending
portfolios,
because they
are achieved by
investing in the
Tangent
Portfolio and
lending funds to
the government
(purchasing a
T-bill, the RF).
Lending Portfolios
The New Efficient Frontier

Risk
ER
RF
A
T
The line can be
extended to risk
levels beyond
T by
borrowing at RF
and investing it
in T. This is a
levered
investment that
increases both
risk and
expected return
of the portfolio.
Lending Portfolios Borrowing Portfolios

ER
RF
A2
T
A
B
B2
Capital Market Line
The New Efficient Frontier

The optimal
risky portfolio
(the market
portfolio M)
Clearly RF with
T (the market
portfolio) offers
a series of
portfolio
combinations
that dominate
those produced
by RF and A.
Further, they
dominate all but
one portfolio on
the efficient
frontier!
This is now
called the new
(or super)
efficient frontier
of risky
portfolios.
Investors can
achieve any
one of these
portfolio
combinations
by borrowing or
investing in RF
in combination
with the market
portfolio.
The assumptions have the following implications:
1. The optimal risky portfolio is the one that is
tangent to the efficient frontier on a line that is drawn
from RF. This portfolio will be the same for all
investors.
2. This optimal risky portfolio will be the market
portfolio (M) which contains all risky securities.


The Market Portfolio and the Capital Market Line (CML)
The slope of the CML is the incremental expected
return divided by the incremental risk.






This is called the market price for risk. Or
The equilibrium price of risk in the capital market.

RF - ER
CML the of Slope
M
M
o
=

The Market Portfolio and the Capital Market Line (CML)
Solving for the expected return on a portfolio in the presence of a
RF asset and given the market price for risk :





Where:
ER
M
= expected return on the market portfolio M

M
= the standard deviation of returns on the market portfolio

P
= the standard deviation of returns on the efficient portfolio being
considered

) (

- RF ER
RF R E
P
M
M
P
o
(

+ =
CAPM and Market Risk
Diversifiable and Non-Diversifiable Risk
Volatility (risk) of individual security returns are caused by two
different factors:

Non-diversifiable risk (system wide changes in the economy and
markets that affect all securities in varying degrees)
Diversifiable risk (company-specific factors that affect the returns
of only one security).
CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 17
Diversifiable Risk
(Non-systematic Risk)
Volatility in a securitys returns caused by company-specific factors (both
positive and negative) such as:
a single company strike
a spectacular innovation discovered through the companys R&D
program
equipment failure for that one company
management competence or management incompetence for that
particular firm
a jet carrying the senior management team of the firm crashes (this
could be either a positive or negative event, depending on the
competence of the management team)
the patented formula for a new drug discovered by the firm.
diversifiable risk is that unique factor that influences only the one firm.

The CAPM and Market Risk

9 - 7 FIGURE
Number of Securities
Total Risk ()
Unique (Non-systematic) Risk
Market (Systematic) Risk
Market or
systematic
risk is risk
that cannot
be eliminated
from the
portfolio by
investing the
portfolio into
more and
different
securities.
Relevant Risk

individual securities volatility of return comes from two factors:
Systematic factors
Company-specific factors
When combined into portfolios, company-specific risk is diversified
away.
Since all investors are diversified then in an efficient market, no-
one would be willing to pay a premium for company-specific risk.
Relevant risk to diversified investors then is systematic risk.
Systematic risk is measured using the Beta Coefficient.
The Formula for the Beta Coefficient
Beta is equal to the covariance of the returns of the
stock with the returns of the market, divided by the
variance of the returns of the market:

,
2
i
M
i M i
M
i,M

COV
o
o
| = =

How is the Beta Coefficient Interpreted?
The beta of the market portfolio is ALWAYS = 1.0

The beta of a security compares the volatility of its returns to the volatility of the
market returns:

s
= 1.0 - the security has the same volatility as the market as a whole

s
> 1.0 - aggressive investment with volatility of returns greater than
the market

s
< 1.0 - defensive investment with volatility of returns less than the
market

s
< 0.0 - an investment with returns that are negatively correlated with
the returns of the market




CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 22
The Beta of a Portfolio
The beta of a portfolio is simply the weighted average of the
betas of the individual asset betas that make up the portfolio.





Weights of individual assets are found by dividing the value of
the investment by the value of the total portfolio.
...
n n B B A A P
w w w | | | | + + + =
[9-8]
The Security Market Line
CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 24

The Security Market Line (SML)
The SML is the hypothesized relationship between return (the
dependent variable) and systematic risk (the beta coefficient).
It is a straight line relationship defined by the following formula:





Where:
k
i
= the required return on security i
ER
M
RF = market premium for risk

i
= the beta coefficient for security i

(See Figure 9 - 9 on the following slide for the graphical representation)
) (
i M i
RF ER RF k | + =
[9-9]

The Security Market Line (SML)

M
= 1
ER
RF

M
ER
M

i M i
RF ER RF k | ) ( + =
The SML is
used to
predict
required
returns for
individual
securities
The SML
uses the
beta
coefficient as
the measure
of relevant
risk.
Challenges to CAPM
Empirical tests suggest:
CAPM does not hold well in practice:
Beta possesses no explanatory power for predicting stock
returns (Fama and French, 1992)
CAPM remains in widespread use despite the foregoing.
Advantages include relative simplicity and intuitive logic.
Because of the problems with CAPM, other models have been
developed including:
Fama-French (FF) Model
Arbitrage Pricing Theory (APT)
The Arbitrage Pricing Theory
An alternative model to CAPM and the multifactor CAPM was developed
by Stephen Ross in 1976.
The model is purely based upon arbitrage arguments thats why it is called
as arbitrage price theory.
The model postulate that the expected return is influenced by a variety of
factors , as opposed to a single market index of CAPM.

The Arbitrage Pricing Theory
A pricing model that uses multiple factors to relate expected
returns to risk by assuming that asset returns are linearly related
to a set of indexes, which proxy risk factors that influence
security returns.




Underlying factors represent broad economic forces which are
inherently unpredictable.
...
1 1 1 1 0 n in i i i
F b F b F b a ER + + + + =

The Model
Underlying factors represent broad economic forces which are
inherently unpredictable.






Where:
ER
i
= the expected return on security i
a
0
= the expected return on a security with zero systematic risk
b
i
= the sensitivity of security i to a given risk factor
F
i
= the risk premium for a given risk factor

The model demonstrates that a securitys risk is based on its sensitivity
to broad economic forces.



...
1 1 1 1 0 n in i i i
F b F b F b a ER + + + + =

Challenges to The Arbitrage Pricing Theory
Underlying factors represent broad economic forces which are
inherently unpredictable.
Ross and Roll identify five systematic factors:
1. Changes in expected inflation
2. Unanticipated changes in inflation
3. Unanticipated changes in industrial production
4. Unanticipated changes in the default-risk premium
5. Unanticipated changes in the term structure of interest rates

Clearly, something that isnt forecast, cant be used to price securities
todaythey can only be used to explain prices after the fact.