capm theory (rohit)

8/9/2019 Capm Theory (Rohit)

1/29

Chapter 13Chapter 13

Capital Asset PricingCapital Asset Pricing

TheoryTheory

Capital Asset PricingCapital Asset Pricing

TheoryTheory


2/29

CHAPTER 13 OVERVIEWCHAPTER 13 OVERVIEW

13.113.1 Portfolio TheoryPortfolio Theory

13.213.2 Capital Asset Pricing ModelCapital Asset Pricing Model

13.313.3 Expected Return and RiskExpected Return and Risk

13.413.4 Empirical Criticisms of BetaEmpirical Criticisms of Beta

13.513.5 Arbitrage Pricing TheoryArbitrage Pricing Theory


3/29

Portfolio TheoryPortfolio Theory

XX Investment Portfolio:Investment Portfolio:

collection of securities thatcollection of securities thattogether provide an investortogether provide an investor

with an attractive tradewith an attractive trade--offoff

between risk and returnbetween risk and return

XX Portfolio Theory:Portfolio Theory: concept ofconcept of

making security choices basedmaking security choices based

on portfolio expected returnson portfolio expected returns

and risksand risks


4/29

PORTFOLIO THEORY

Basic Assumptions

PORTFOLIO THEORY

Basic AssumptionsXX Expected Return:Expected Return: anticipated profit over some relevantanticipated profit over some relevant

holding periodholding period

XX Risk:Risk: return dispersion, usually measured by standardreturn dispersion, usually measured by standarddeviation of returnsdeviation of returns

XX Probability Distribution:Probability Distribution: apportionment of likelyapportionment of likely

occurrencesoccurrences

XX Utility:Utility:positive benefitpositive benefit

XX Disutility:Disutility:psychic losspsychic loss

XX Risk Averse:Risk Averse: desire to avoid riskdesire to avoid risk


5/29

PORTFOLIO THEORY

Three Fundamental Assertions

PORTFOLIO THEORY

Three Fundamental Assertions

XX Investors seek to maximize utility.Investors seek to maximize utility.

XX Investors are risk averse: Utility rises withInvestors are risk averse: Utility rises withexpected return and falls with an increase inexpected return and falls with an increase in

volatility.volatility.

XXThe optimal portfolio has the highest expectedThe optimal portfolio has the highest expectedreturn for a given level of risk, or the lowestreturn for a given level of risk, or the lowest

level of risk for a given expected return.level of risk for a given expected return.


6/29

Portfolio Expected Rate

of Return and Risk

Portfolio Expected Rate

of Return and RiskExpected rate of return:Expected rate of return:

Standard deviation (risk):Standard deviation (risk):

E R W E R p i ii

N!!

1

vvvN

i

N

j

jijii

N

i

p COVWWVASD W1 11

2

1


7/29

INVESTMENT OPPORTUNITY FUNDAMENTALSINVESTMENT OPPORTUNITY FUNDAMENTALS

Expected Rate of Return & RiskExpected Rate of Return & Risk

Figure 13.2 (c)Figure 13.2 (c)


8/29

Portfolio risk increases with thevolatility of individual holdings

and the extent to which holding

have high covariance.


9/29

Optimal Portfolio ChoiceOptimal Portfolio Choice

XX ZeroZero--Risk Portfolio:Risk Portfolio: constant return portfolioconstant return portfolio

XXEfficient Portfolio:Efficient Portfolio:portfolio with maximum expectedportfolio with maximum expectedreturn for a given level of risk, or minimum risk for areturn for a given level of risk, or minimum risk for a

given expected returngiven expected return

XX Efficient Frontier:Efficient Frontier: collection of all efficient portfolioscollection of all efficient portfolios

XX Optimal Portfolio:Optimal Portfolio: collection of securities that providescollection of securities that provides

an investor with the highest level of expected utilityan investor with the highest level of expected utility

XX Market Portfolio:Market Portfolio: all tradable assetsall tradable assets


10/29

Capital Asset Pricing Model

(C

APM)


(C

APM)

Method for predicting

how investment returnsare determined in an

efficient capital market


11/29

KEY TERMS


KEY TERMS


XX capital market line (CML)capital market line (CML)

XX security market line (SML)security market line (SML)

XX systematic risksystematic risk

XX unsystematic riskunsystematic risk

XX diversifiable riskdiversifiable risk

XX nondiversifiable risknondiversifiable risk

XX security characteristic linesecurity characteristic line

(SCL)(SCL)

XX positive abnormal returnspositive abnormal returns

XX negative abnormal returnnegative abnormal return

XX market index biasmarket index bias

XX model specification biasmodel specification bias

XX time interval biastime interval bias

XX nonstationary beta problemnonstationary beta problem

XX arbitrage pricing theory (APT)arbitrage pricing theory (APT)

XX arbitragearbitrage


12/29

CAPITAL ASSET PRICING MODEL

Basic Assumptions


Basic AssumptionsXX Investors hold efficient portfolios; higher expected returnsInvestors hold efficient portfolios; higher expected returns

involve higher risk.involve higher risk.

XXUnlimited borrowing and lending are available at the riskUnlimited borrowing and lending are available at the risk--free rate.free rate.

XX Investors have homogeneous expectations.Investors have homogeneous expectations.

XX There is a oneThere is a one--period time horizon.period time horizon.

XX Investments are infinitely divisible.Investments are infinitely divisible.

XX No taxes or transaction costs exist.No taxes or transaction costs exist.

XX Inflation is fully anticipated.Inflation is fully anticipated.

XX Capital markets are in equilibrium.Capital markets are in equilibrium.


13/29

CAPM & Market

Efficiency

CAPM & Market

Efficiency

XX CAPM can test Efficient Market Hypothesis.CAPM can test Efficient Market Hypothesis.

XX Market is efficient if only riskMarket is efficient if only risk--free assets give riskfree assets give risk--free rates of return (e.g., Treasury bills).free rates of return (e.g., Treasury bills).

XX Deviations may indicate opportunities.Deviations may indicate opportunities.

XX Modeling predictions can suggest improvements toModeling predictions can suggest improvements to

market functioning.market functioning.


14/29

Lending & Borrowing Under

the CPM

Lending & Borrowing Under

the CPM

XX Assumption of unlimited lending and borrowing atAssumption of unlimited lending and borrowing atriskrisk--free rate.free rate.

XX Lending if portion of portfolio held in riskLending if portion of portfolio held in risk--freefreeassets.assets.

XX Borrowing (leverage) if more than 100% ofBorrowing (leverage) if more than 100% ofportfolio is invested in risky assets.portfolio is invested in risky assets.

XX Superior returns made possible with lending andSuperior returns made possible with lending andborrowing; creates spectrum of risk preference forborrowing; creates spectrum of risk preference fordifferent investors.different investors.


15/29


Three Linear Relationships



XX Capital Market Line:Capital Market Line: linear risklinear risk--return tradereturn trade--off foroff for

all investment portfoliosall investment portfolios

XX Security Market Line:Security Market Line: linear risklinear risk--return tradereturn trade--offoff

for individual stocksfor individual stocks

XX Security Characteristic Line:Security Characteristic Line: linear relationlinear relation

between the return on individual securities and thebetween the return on individual securities and the

overall market at every point in timeoverall market at every point in time


16/29





XX Capital Market Line:Capital Market Line: linear risklinear risk--return tradereturn trade--off foroff for

all investment portfoliosall investment portfolios

Standard Deviation (total portfolio risk)

E(R)

M

Rf

W = market W


17/29

EXPECTED RETURN & RISK

TheC

apital Market Line (C

ML)


TheC


ML)

Linear riskLinear risk--return tradereturn trade--off for all investment portfolios given byoff for all investment portfolios given by

? A

E R R E R R

SD RSD R

R SDR

SD R E R R

P F

M F

M

P

FP

M

M F


18/29


TheC


ML)


TheC


ML)

Figure 13.4Figure 13.4


19/29

Security Market Line (SML)Security Market Line (SML)

XX Security Market Line:Security Market Line: linear risklinear risk--return tradereturn trade--off foroff for

individual stocksindividual stocks

XX Systematic Risk:Systematic Risk: return volatility tied to overallreturn volatility tied to overall

market; also called nondiversifiable riskmarket; also called nondiversifiable risk

XX Unsystematic Risk:Unsystematic Risk: return volatility tied specifically toreturn volatility tied specifically to

an individual company; also called diversifiable riskan individual company; also called diversifiable risk

XX Beta:Beta: sensitivity of a securitys returns to thesensitivity of a securitys returns to the

systematic market risk factorsystematic market risk factor


20/29





XX Security Market Line:Security Market Line: linear risklinear risk--return tradereturn trade--offoff

for all individual stocksfor all individual stocks

Systematic Risk

E(R)

M

Rf

F = 1


21/29

The BETA FactorThe BETA Factor

Figure 13.5Figure 13.5


22/29

The Security

Characteristic Line

The Security

Characteristic LineXX Linear relation between the return on individual securities andLinear relation between the return on individual securities and

the overall market at every point in time, given by:the overall market at every point in time, given by:

ZZ Positive Abnormal Returns:Positive Abnormal Returns: aboveabove--average returns that cantaverage returns that cantbe explained as compensation for added riskbe explained as compensation for added risk

ZZ Negative Abnormal Returns:Negative Abnormal Returns:belowbelow--average returns thataverage returns thatcannot be explained by belowcannot be explained by below--market riskmarket risk

R Rit i i Mt i! E F


23/29

Empirical Implications of

CAPM

Empirical Implications of

CAPM

XX Optimal portfolio choice depends on market riskOptimal portfolio choice depends on market risk--return tradereturn trade--

offs and individual investors differences in risk preferences.offs and individual investors differences in risk preferences.

XX Relation between expected return and risk is linear for allRelation between expected return and risk is linear for all

portfolios and individual assets.portfolios and individual assets.

XX Expected rate of return is riskExpected rate of return is risk--free rate plus relative risk (free rate plus relative risk (pp))

times market risk premium.times market risk premium.

ZZ High beta portfolios earn high risk premiums.High beta portfolios earn high risk premiums.

ZZ Low beta portfolios earn low risk premiums.Low beta portfolios earn low risk premiums.

XX Stock priceStock price FF measures relevant risk for all securities.measures relevant risk for all securities.


24/29

EMPIRICAL CRITICISMS OF BETA

MODEL SPECIFIC

ATION PROBLEMS

EMPIRICAL CRITICISMS OF BETA

MODEL SPECIFIC

ATION PROBLEMS

XX CAPM provides only incomplete description of returnCAPM provides only incomplete description of return

volatilityvolatilityvolatility in individual issues can only be describedvolatility in individual issues can only be described

as a function of overall market volatility.as a function of overall market volatility.

XX Overall market volatility very difficult to measureOverall market volatility very difficult to measure

ZZ Market Index Bias:Market Index Bias: distortion to beta estimates due to fact thatdistortion to beta estimates due to fact that

indexes are imperfect proxies for overall marketindexes are imperfect proxies for overall market

ZZ No single index includes all capital assets, including stocks,No single index includes all capital assets, including stocks,

bonds, real estate, collectibles, etc.bonds, real estate, collectibles, etc.

XX Model Specification Bias:Model Specification Bias: distortion to beta estimates becausedistortion to beta estimates because

SCL fails to include other important systematic influences onSCL fails to include other important systematic influences on

stock market volatilitystock market volatility


25/29

BETA

Data Interval & Nonstationary Beta

Problems

BETA

Data Interval & Nonstationary Beta

Problems

XX Data Interval Problem:Data Interval Problem:betabeta

estimation problem derivedestimation problem derived

from the fact that betafrom the fact that beta

estimates depend on dataestimates depend on data

interval studiedinterval studied

XX Nonstationary Beta Problem:Nonstationary Beta Problem:

difficulty tied to the fact thatdifficulty tied to the fact that

betas are inherently unstablebetas are inherently unstable


26/29

Testable Limitations Of

CAPM

Testable Limitations Of

CAPM

XX , the slope of the regression of a securitys return on, the slope of the regression of a securitys return on

the market return, is the only risk factor needed tothe market return, is the only risk factor needed to

explain expected return.explain expected return.

XX captures a positive expected return premium for risk. captures a positive expected return premium for risk.

XX Other risk factors emerge:Other risk factors emerge:

ZZ firm sizefirm size

ZZ low P/E, price/cash flow, P/B, and sales growthlow P/E, price/cash flow, P/B, and sales growth


27/29

Arbitrage Pricing Theory

(APT)

Arbitrage Pricing Theory

(APT)

XX Multifactor assetMultifactor asset--pricing model that allowspricing model that allows

market s to represent only one of the firmsmarket s to represent only one of the firmsmany risk factors.many risk factors.

XX Arbitrage:Arbitrage: simultaneous buying and selling ofsimultaneous buying and selling of

the same asset at different maturitiesthe same asset at different maturitiesXX APT suggests that asset returns might beAPT suggests that asset returns might be

affected by N risk factors.affected by N risk factors.


28/29

APT vs. CPMAPT vs. CPM

XX Volatile returns attributable to sixVolatile returns attributable to six--factor APTfactor APT

models are very unstablemodels are very unstableexplain very little ofexplain very little ofvariation in average returns.variation in average returns.

XX Though both CAPM and APT theory andThough both CAPM and APT theory and

evidence confirm relationship between risk andevidence confirm relationship between risk andreturn, neither approach gives precise estimates.return, neither approach gives precise estimates.

XX Neither provides foolproof test of EMF.Neither provides foolproof test of EMF.


29/29

KEY TERMS

Capital Asset Pricing

KEY TERMS

Capital Asset Pricing

XX investment portfolioinvestment portfolio

XX portfolio theoryportfolio theory

XX expected returnexpected return

XX riskrisk

XX probability distributionprobability distributionXX utilityutility

XX disutilitydisutility

XX risk averserisk averse

XX zerozero--risk portfoliorisk portfolio

XX efficient portfolioefficient portfolio

XX efficient frontierefficient frontier

XX optimal portfoliooptimal portfolio

XX market portfoliomarket portfolio

XX capital asset pricingcapital asset pricingmodelmodel

capm theory (rohit)

Documents