Ch 07 10e

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CHAPTER 7 Risk and Return: Portfolio Theory and Asset Pricing Models:

CHAPTER 7 Risk and Return: Portfolio Theory and Asset Pricing Models Capital Asset Pricing Model (CAPM) Efficient frontier Capital Market Line (CML) Security Market Line (SML) Beta calculation Arbitrage pricing theory Fama-French 3-factor model

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What is the CAPM? The CAPM is an equilibrium model that specifies the relationship between risk and required rate of return for assets held in well-diversified portfolios . It is based on the premise that only one factor affects risk. What is that factor?

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Investors all think in terms of a single holding period . All investors have identical expectations . Investors can borrow or lend unlimited amounts at the risk-free rate . What are the assumptions of the CAPM? (More...)

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All assets are perfectly divisible . There are no taxes and no transactions costs . All investors are price takers , that is, investors’ buying and selling won’t influence stock prices. Quantities of all assets are given and fixed.

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The feasible set of portfolios represents all portfolios that can be constructed from a given set of stocks. An efficient portfolio is one that offers: the most return for a given amount of risk, or the least risk for a give amount of return. The collection of efficient portfolios is called the efficient set or efficient frontier .

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Indifference curves reflect an investor’s attitude toward risk as reflected in his or her risk/return tradeoff function. They differ among investors because of differences in risk aversion. An investor’s optimal portfolio is defined by the tangency point between the efficient set and the investor’s indifference curve.

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When a risk-free asset is added to the feasible set, investors can create portfolios that combine this asset with a portfolio of risky assets. The straight line connecting k RF with M, the tangency point between the line and the old efficient set, becomes the new efficient frontier . What impact does k RF have on the efficient frontier?

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M Z . A k RF  M Risk,  p Efficient Set with a Risk-Free Asset The Capital Market Line (CML): New Efficient Set . . B k M ^ Expected Return, k p

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The Capital Market Line (CML) is all linear combinations of the risk-free asset and Portfolio M. Portfolios below the CML are inferior. The CML defines the new efficient set. All investors will choose a portfolio on the CML. What is the Capital Market Line?

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The expected rate of return on any efficient portfolio is equal to the risk-free rate plus a risk premium . The optimal portfolio for any investor is the point of tangency between the CML and the investor’s indifference curves. What does the CML tell us?

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The CML gives the risk/return relationship for efficient portfolios . The Security Market Line (SML), also part of the CAPM, gives the risk/return relationship for individual stocks . What is the Security Market Line (SML)?

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The measure of risk used in the SML is the beta coefficient of company i, b i . The SML equation: The SML Equation

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Run a regression line of past returns on Stock i versus returns on the market. The regression line is called the characteristic line . The slope coefficient of the characteristic line is defined as the beta coefficient . How are betas calculated?

Method of Calculation:

(More...) Method of Calculation Analysts use a computer with statistical or spreadsheet software to perform the regression. At least 3 year’s of monthly returns or 1 year’s of weekly returns are used. Many analysts use 5 years of monthly returns.

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If beta = 1.0, stock is average risk. If beta > 1.0, stock is riskier than average. If beta < 1.0, stock is less risky than average. Most stocks have betas in the range of 0.5 to 1.5.

Interpreting Regression Results:

Interpreting Regression Results The R 2 measures the percent of a stock’s variance that is explained by the market. The typical R 2 is: 0.3 for an individual stock over 0.9 for a well diversified portfolio

Interpreting Regression Results (Continued):

Interpreting Regression Results (Continued) The 95% confidence interval shows the range in which we are 95% sure that the true value of beta lies. The typical range is: from about 0.5 to 1.5 for an individual stock from about .92 to 1.08 for a well diversified portfolio

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 2 = b 2  2 +  e 2 .  2 = variance = stand-alone risk of Stock j. b 2  2 = market risk of Stock j.  e 2 = variance of error term = diversifiable risk of Stock j. What is the relationship between stand-alone, market, and diversifiable risk. j j M j j j j M

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Beta stability tests Tests based on the slope of the SML What are two potential tests that can be conducted to verify the CAPM?

Tests of the SML indicate::

Tests of the SML indicate: A more-or-less linear relationship between realized returns and market risk. Slope is less than predicted. Irrelevance of diversifiable risk specified in the CAPM model can be questioned. (More...)

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Betas of individual securities are not good estimators of future risk. Betas of portfolios of 10 or more randomly selected stocks are reasonably stable. Past portfolio betas are good estimates of future portfolio volatility.

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CAPM/SML concepts are based on expectations , yet betas are calculated using historical data. A company’s historical data may not reflect investors’ expectations about future riskiness . Other models are being developed that will one day replace the CAPM, but it still provides a good framework for thinking about risk and return.

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The CAPM is a single factor model. The APT proposes that the relationship between risk and return is more complex and may be due to multiple factors such as GDP growth, expected inflation, tax rate changes, and dividend yield. What is the difference between the CAPM and the Arbitrage Pricing Theory (APT)?

Required Return for Stock i under the APT:

k i = k RF + (k 1 - k RF )b 1 + (k 2 - k RF )b 2 + ... + (k j - k RF )b j . b j = sensitivity of Stock i to economic Factor j. k j = required rate of return on a portfolio sensitive only to economic Factor j. Required Return for Stock i under the APT

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The APT is being used for some real world applications. Its acceptance has been slow because the model does not specify what factors influence stock returns. More research on risk and return models is needed to find a model that is theoretically sound, empirically verified, and easy to use. What is the status of the APT?

CAPM Required Return for Stock i:

CAPM: k i = k RF + (k M - k RF )b i k i = 6.8% + (6.3%)(0.9) = 12.47% Fama-French (previous slide): k i = 8.97% CAPM Required Return for Stock i

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