Professional Documents
Culture Documents
Models
Business Finance 722
Investment Management
Professor Karl B. Diether
The Ohio State University
Fisher College of Business
E(r)
riskfree rate
(r)
The CAPM & Multifactor Models
SR =
E(rT ) r f
(rT )
E(ri) r f
E(r j ) r f
=
for all i and j
cov(ri, rT ) cov(r j , rT )
Implications:
u We find the tangency portfolio by picking the weights so the
E(rT ) r f
E(ri) r f
=
cov(ri, rT ) cov(rT , rT )
But remember that cov(rT , rT ) = 2(rT ). Therefore,
E(ri) r f
E(rT ) r f
=
cov(ri, rT )
2(rT )
We can use the above expression to derive a relation between
an assets expected return and risk.
cov(ri, rT )
2(rT )
Typically people call cov(ri, rT )/ 2(rT ), Beta ( ).
The CAPM & Multifactor Models
cov(ri, rT )
2(rT )
E(ri)
E(rT) - rf
rf
iT
The CAPM & Multifactor Models
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cov(ri, rT )
2(rT )
return or risk?
u What is missing or lacking?
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that silly?
Implication: M = T:
u In equilibrium, prices must be set so that the market
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rM = viri
i
where
vi =
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Market Equilibrium
Complete agreement and M = T:
u Given the assumption what can we say about investors
portfolio choices?
u How are their allocations different from each other?
u What is the commonality across different investors
holdings?
u Why does this assumption imply that M=T?
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Finally
Finally, we have identified the tangency portfolio (after we
made a few assumptions).
Prices must be set so that the market portfolio (M) is the
tangency portfolio.
u The market portfolio contains all assets we can invest in:
portfolio:
l
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E(r)
CML
riskfree rate
(r)
The CAPM & Multifactor Models
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The CAPM
Since the market portfolio (M) is the tangency portfolio, mean
variance mathematics implies the following:
cov(ri, rM )
2(rM )
iM .
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E(ri)
E(rM) - rf
rf
iM
The CAPM & Multifactor Models
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Some Examples
Q: Suppose the risk free rate is 5%, and the expected return
on the market portfolio is 11%, the standard deviation 20%,
and the covariance of IBM with the market is 0.05. What is
IBMs beta and expected return?
cov(ribm, rM )
2(rM )
0.05
= 1.25
=
0.202
ibmM =
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Some Examples
Q: Suppose the risk free rate is 4%, the expected return on the
market portfolio is 12%, and its standard deviation is 20%.
Stock Z has a standard deviation of 50%, but is uncorrelated
with the market. What is Zs beta and expected return?
cov(rz, rM )
2(rM )
0.00
=
=0
0.202
E(rz) = r f + zM [E(rM ) r f ]
= 0.04 + 0(0.12 0.04) = 4%
zM =
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Some Examples
Q: You invest 20% percent of your money in T-bills, and 80%
percent in the market portfolio. What is the beta of your
portfolio?
Statistical Fact: The beta of a portfolio is the weighted sum of
the component assets betas.
n
pM = wiiM
i=1
pM = 0.2 f M + 0.8MM
= 0.2 cov(r f , rM )/ 2(rM ) + 0.8 cov(rM , rM )/ 2(rM )
= 0 + 0.8 2(rM )/ 2(rM ) = 0.8
The CAPM & Multifactor Models
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CAPM Intuition
High beta stocks are risky, and therefore investors will only buy
them if they offer higher returns on average.
Why are high beta stocks risky?
u High beta stocks tend to have good returns when when the
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Other Models
The CAPM is a model.
u No model is perfect.
u We will find that the CAPM has some significant
weaknesses.
Other Models
u We need to consider other models if the CAPM is an
empirical failure.
u All our other models will build on the economic theory and
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E(rit ) r f t = iM [E(rMt ) r f t ]
u Stocks have high expected returns if they have high
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portfolio is a factor
u Debate: is that enough or are there other factors?
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Types of Factors
Factors can be tradeable portfolios.
u They must be zero cost portfolios (weights add up to zero).
u For example, in the CAPM the portfolio is 100% in the
We will focus on the case where the factors are zero cost
portfolios.
The CAPM & Multifactor Models
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Multifactor Models
In general multifactor models will look like the following:
K
E(r p) r f =
p jE(Fj)
j=1
p1, p2, . . ., pK
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rg r j
and the multifactor model is,
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guns, locks and security guards will see their returns go up.
u Returns go down for luxury car and jewelry companies.
u A stock that pays off more money when crime is high is
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is no general consensus.
u Risk and reward usually go together. If you want high
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