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Running head: ASSIGNMENT UNIT 1

FERNANDO LUZERNO AUGUSTO CARLOS LICHUCHA

This assignment is submitted in partial fulfilment of the requirements for


5522S2091 DF Derivative Instruments & Markets R2

Assignment Unit 1

School of Management

Dr. Igor Gvozdanovic

March 29, 2016

ASSIGNMENT UNIT 1

Table of Contents
List of Abbreviations.......................................................................................................................3
List of Figures..................................................................................................................................3
List of Tables...................................................................................................................................3
Introduction......................................................................................................................................4
PART A............................................................................................................................................4
Derivative contract...........................................................................................................................4
Major forms of derivatives and their differences.............................................................................5
Major forms of derivatives...........................................................................................................5
Differences between major forms of derivatives.........................................................................5
Main attributes of exchange-traded derivatives...............................................................................6
Difference between OTC market traded derivatives and exchange-traded derivatives...................7
PART B............................................................................................................................................7
Valuation..........................................................................................................................................7
Some applications of valuation approaches.....................................................................................8
Reference.......................................................................................................................................22

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List of Abbreviations
CAPM.
CML...
ER..
MPT
OTC....
RF..
SML...
VNM..

Capital Asset Pricing Market


Capital Market Line
Expected return
Modern Portfolio Theory
over- the-counter
Risk free
The Security Market Line
Von Neumann & Morgenstern

List of Figures
Figure 1 Impact of Correlation Coefficient...................................................................................12
Figure 2 Minimum Variance Portfolio...........................................................................................13
Figure 3 Minimum variance portfolio for four assets....................................................................14
Figure 4 New set of portfolio combinations..................................................................................14
Figure 5 Tangent Portfolio T.........................................................................................................15
Figure 6 The New (Super) Efficient Frontier................................................................................16
Figure 7 The Capital Market Line.................................................................................................17
Figure 8 Security Market Line.......................................................................................................19

List of Tables
Table 1 Forwards versus Futures....................................................................................................6

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Introduction
This short essay is divided into two parts: a) part A presents derivative basics and b) part B
presents financial assets valuation basics.
Part A is about basics of derivatives contracts and markets, specifically, it defines the concept of
derivatives, provides the reasons for their existence, their major forms and differences, attributes
of exchange-traded derivatives, OTC market traded derivatives and exchange-traded derivatives.
Part B presents valuation assumptions, Discount and Coupon-Bearing bonds, valuation of
stocks, differences between utility and portfolio theories, CAPM and measurement of
portfolio performance.

PART A
Derivative contract
(Whaley, 2007) defines a derivative as a contract to execute an exchange at some future date and
its value derives from the price of an underlying asset such as a stock, bond, currency, or
commodity and the key feature of the transaction specified in a derivative contract is that it will
be executed in the future than today. (Drake & Fabozzi, 2010) distinguishes two sources of
derivative value; a) the value derived from the underlying asset, and b) the value derived from
the features of the derivative itself.
(Campolieti & Makarov, 2014; Whaley, 2007) affirm that derivatives are needed for risk
management, improving market efficiency and transactions costs reduction.
According to (Campolieti & Makarov, 2014), derivatives help to manage the risk and improve
market efficiency in the following ways:
Speculation - Speculators use derivatives to bet on the future price direction of an
underlying asset and in doing so they provide liquidity and depth to the market.
Speculation increases risk and hence increases expected return (Whaley, 2007, p. 10).
Hedging - Hedgers use derivatives to reduce the risk that they face from potential future
price movements in an underlying asset providing economic balance to the market.
Hedging reduces risk and hence reduces expected return (Whaley, 2007, p. 10).
Arbitrage - Arbitrageurs take offsetting positions in two or more instruments to lock in
a profit which help to make markets liquid, ensure accurate and uniform pricing, and
enhance price stability. They use derivatives to take advantage of a discrepancy between
prices in two different markets.
Leveraging Investors use derivative contracts for risk allocation because of the cheap
leverage opportunities they provide (Sill, 1997).
And, (Whaley, 2007) affirms that derivatives help improve market efficiency and reduce
transactions costs by:
Reducing trading costs trading costs are costs incurred in trading the underlying asset
or derivative contract. Because, the trading costs for derivative contracts are less than the

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trading costs for the underlying asset, managers, investors and others who are conscious
of return versus risk prefer to trade derivatives rather than the underlying asset.
Circumventing trading restrictions/regulations. Derivative contracts can be used as an
effective substitute when the underlying an asset cannot be traded or if regulation limits
the types of trades that can be placed.

Major forms of derivatives and their differences


Major forms of derivatives
According to (Chui1, 2012), there are four main types of derivatives contracts: forwards, futures,
options and swaps.
A forward is a contract to buy or sell an underlying asset at some pre-specified future date at a
price agreed upon today. No money changes hands until the expiration date, at which time the
buyer pays the amount of cash specified in the contract and the seller delivers the underlying
asset (Whaley, 2007). A forward contract is a private agreement between two parties or a
customised contract traded in the over-the-counter market, in the sense that the terms of the
contract are agreed upon by the individual parties and may include:
(a) the price per unit of the asset that the byer will pay the seller of the asset,
(b) the number of units of the asset that will be delivered,
(c) the date on which the delivery will take place, and
(d) the delivery settlement or cash settlement or moot method of settlement
A futures contract is a standardised forward contract between two parties to buy or sell an asset
at a certain time in the future for a certain price, normally traded on an exchange (Booth &
Cleary, 2008). A futures contract is virtually identical to a forward contract (Whaley, 2007).
Options are contracts that gives its owner the right, but not the obligation, to buy or sell a
specified asset at a stipulated price, called the strike price. Contracts that give owners the right to
buy are referred to as call options and contracts that give the owner the right to sell are called put
options. Options include both standardized products that trade on organized exchanges and
customized contracts between private parties (Sill, 1997). American options can be exercised at
any time up to the expiration date while European options can be exercised only on the
expiration date itself.
Swaps are agreements between two counterparties to exchange a series of cash payments for a
stated period of time. The periodic payments can be charged on fixed or floating interest rates,
depending on contract terms (Chui1, 2012). Most swaps are traded Over The Counter and
some are also traded on futures exchange market. There are two common types of swap: a)
plain vanilla interest rate swap and b) currency swap.

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Differences between major forms of derivatives


According to (Chui1, 2012), forward and futures contracts are share similar features except the
following differences:
the gains and/or losses on futures contracts are posted each day while forwards
transaction requires cash settlement at delivery,
futures contracts are standardized while forwards are customised to meet the special
needs of the counterparties,
futures contracts are settled through established clearing house while forwards are
settled between the counterparties, and
futures contracts have to be regulated in order to be traded in on exchange market,
whereas forwards are loosely regulated and traded in on over-the-counter market.
And, (Booth & Cleary, 2008) summarises the differences between forward and futures in the
(Table 1)
Table 1
Forwards versus Futures
Forwards
Contracts
customized
trading
Dealer or OTC market
Default (credit) risk
important
Initial deposit
Not required

Futures
standardized
Exchanges market
Unimportant-guaranteed by clearing house
Initial margin and maintenance margin
required
settlement
On maturity
Marked to market daily
Source: Table 11-3 (Booth & Cleary, 2008, p. 430)
An important difference between options contracts and futures and forwards contracts is that
options do not require the purchaser to buy or sell the underlying asset under all circumstances
(Chui1, 2012). A swap contract has multiple payments in the futures while a forward has only a
single payment.

Main attributes of exchange-traded derivatives


According to (Chui1, 2012), the main attributes of exchange-traded derivatives are:
Standardised derivatives contracts - in exchange-traded markets, derivatives contracts
are standardised with specific quantity of underlying asset, quality of underlying asset
(not required in financial futures), delivery dates, price quotes and delivery or settlement
terms.
Derivatives contracts negotiation from open outcry system to electronic trading negotiation between traders traditionally was conducted by shouting on the trading floor
(open outcry). But electronic trading system has become increasingly popular in many
major exchanges.
Market Transparency and Clearinghouse - exchange-traded derivative trades are
publicly reported and cleared in a clearing house. The clearing house is obliged to honour
the trade if the seller defaults.

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Margining system in the exchange-traded derivatives the buyer and seller are both
required to deposit good-faith collateral designed to show that they can fulfill the terms of
the contract (Whaley, 2007).

Difference between OTC market traded derivatives and


exchange-traded derivatives
Over-the-counter (OTC) market is a secondary market that does not have a physical location and
consist of a network of dealers who trade directly with one another (Booth & Cleary, 2008).
According to (Chui1, 2012), derivatives traded in OTC markets differ from exchange-traded
derivatives for the following reasons:
the trade is bilateral, that is all contract terms such as delivery quality, quantity, location,
date and prices are negotiated between the two parties,
the contract can be tailor-made to the two parties liking
transactions can be arranged by telephone or other communication means,
prices are not reported publicly,
there is usually some credit risk in an over-the-counter trade,
Over-the-counter markets are uncontrolled, unregulated and have very few laws, and
OTC markets perform the role as an incubator for new financial products.

PART B
Valuation
Valuation is a process of determining the value of financial or real asset. According to (Whaley,
2007), the value of an asset can be determined using three factors, namely: risk, return, and
timing of cash flows. (Damodaran, 2002) points out that in general terms, there are three
approaches to valuation and (Ferris & Petitt, 2013) add one more.
Discounted cash flow valuation - relates the value of an asset to the present value of
expected future cash flows on that asset.
Relative valuation - estimates the value of an asset by looking at the pricing of
'comparable' assets relative to a common variable such as earnings, cash flows, book
value or sales.
Contingent claim valuation - uses option pricing models to measure the value of assets
that share option characteristics.
Economic income models - valuation methods that rely on a financial variable other than
cash flows (Ferris & Petitt, 2013, p. 6)
(Ferris & Petitt, 2013) list five types of value: book value, break-up value, liquidation value,
fundamental value, and market value that can be determined by these valuation models.
(Whaley, 2007) states to build a valuation model requires making assumptions, namely:

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a) the absence of costless arbitrage opportunities or non arbitrage principle, that is, two
investments with the same risk, return, and timing of cash flows should have exactly the
same price otherwise someone will immediately step in to earn a risk-free profit by
simultaneously buying the cheaper asset and selling the more expensive one.
b) frictionless markets, that is, in the economy where the assets are being valuated there are
or is:
No trading costs.
No taxes.
Unlimited borrowing and lending at the risk-free rate of interest.
Freedom to sell (short) with full use of any proceeds.
The possibility to trade at any time.
(Damodaran, 2002) states that valuation is useful in a wide range of tasks such as portfolio
management, acquisition analysis and corporate finance. In addition these applications of
valuation can be used in economics and business analysis.

Some applications of valuation approaches


In corporate finance, discounted cash flow valuation approach can be used to determine the
value of bonds and stocks. Bonds are long-term debt instruments that promise fixed payments
and have maturities of longer than seven years (Booth & Cleary, 2008). There are two types of
bonds: discount bonds and coupon-bearing bonds. A discount bond or zero-coupon bond is a debt
security with a single future cash payment, that is the bond holder receives no cash payment until
the maturity while in a coupon-bearing bond, the holder receives periodic coupons payments
throughout the bonds life plus a coupon payment and repayment of the bonds par value at
maturity (Whaley, 2007). The values of a discount bond, (Equation 1) and coupon-bearing bond,
(equation 2) can be determined using the following formulae, respectively (Whaley, 2007).
B = FerT
(1)
n

Bc

Bd ,i =
=
i=1

CF i er

iT i

i=1

(2)

where B discount bond, Bc coupon bond, F face value , r an annualized yield, T time to
maturity, i the ith discount bond, Bd,i the value of ith discount bond, CFi the amount of the cash
flow received at the maturity of the ith discount bond, ri is the zero-coupon discount rate, and Ti
time until the cash flow i occurs.
A valuation of a share of stock can be determined in the same way as bond valuation in sense
that its value is equal to the sum of the discounted future cash flows. However, the expected
future cash flows called dividends are not specified in the contract (Whaley, 2007).

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S=

Di ek t

(3)

i=1

Where, S value of share, Di ith cash dividend, ti time from now until the ith dividend is received
and k required rate of return on the stock. (Equation 3) is called generic stock valuation formula,
that is, it calculates the value of a share as the present value of an infinite series of expected
dividend payments. In addition to the generic model, there are at least three variations of this
generic stock valuation formula: zero dividend growth model, constant dividend growth model,
and variable dividend growth model.
(Whaley, 2007) presents the following formula for constant growth model.
D0
S=

ek g1

(4)

where D0 dividend just paid, g constant growth rate.


Economic income models such as utility functions derived from utility theory can be used in
portfolio management. (Norstad, 2011) defines utility theory as a way to measure investor's
preferences for wealth and the amount of risk they are willing to undertake in the hope of
attaining greater wealth (p. 1).
According to (Lee, Finnerty, & Chen, 2010), the utility theory primarily used in finance is that
developed by (Von Neumann & Morgenstern, 1947) as cited in (Lee, Finnerty, & Chen, 2010)
that defines the investor utility as a function of rates of return or wealth. The utility function
associated with the VNMs utility theory in terms of wealth can be defined (Equation 5):
U = f(w,w)
(5)
where w indicates expected future wealth and w represents the predicted standard deviation
of the possible divergence of actual future wealth from w.
So, rational investors are expected to prefer a higher expected future wealth to a lower value, and
are generally risk averse. That is, they prefere a lower value of w to higher value, given the
level of w. The more risk averse investors will claim more premium when the face risk.
The expected utility can be calculated in terms of the probabilities of occurrence associated with
each of the possible returns(Equation 6):
n

E(U) =

U(Wi)Pi

(6)

where E(U) indicates expected utility, U(Wi) represents the utility of the ith outcome and Pi is
the probability of the ith outcome.

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According to (Whaley, 2007), the expected utility framework is weak because the utility function
(Equation 5) has to be defined for each individual preferences and the specification mechanics of
the individuals utility function are not clear and portfolio theory uses a generic model for two,
three and n assets combination.
According to (Lee, Finnerty, & Chen, 2010), risk-averse investors hold portfolios rather
individual assets as a means of eliminating unsystematic risk, so, the discussion of the utility
function will move on to portfolio theory. (Whaley, 2007) states that there is no need to specify
functions for individuals portfolio allocation decision.
A portfolio is a collection of different securities such as stocks and bonds, that are combined and
considered a single asset (Booth & Cleary, 2008).
The expected return on a portfolio is simply the weighted average of the returns of the individual
assets that make up the portfolio:
n

ERp ( wi ERi )
i 1

(7)

Where, ERp is the expected return of the portfolio, wi represents the portfolio weight of a
particular security, that is the percentage of the portfolios total wealth that is invested in that
security, and ERi is the expected return of the individual asset i.
(Booth & Cleary, 2008) use the following example to illustrate the calculation of the expected
return on a portfolio of two assets A e B.
Total wealth = $2,000 + $5,000 = $7,000
Portion of wealth invested in asset A: wA = weight of security A = $2,000 / $7,000 = 28.6%
Portion of wealth invested in asset B: wB = weight of security B = $5,000 / $7,000 = 71.4%
Expected return of the individual asset A e B:rA = 14%, rB = 6%,
n

ER p ( wi ERi ) (.286 14%) (.714 6% ) 4.004% 4.284% 8.288%


i 1

The range of returns in a two asset portfolio can be produced simply by changing the weight of
the constituent assets, different portfolio returns can be achieved the returns ranging from the
lowest asset return to the highest in this case from 6% to 14%. The range of returns represents
the range of possible expected utilities.
(Booth & Cleary, 2008) states that prior to the establishment of MPT, most people only focused
upon investment returnsthey ignored risk. The risk-return characteristics of the portfolio is
demonstrably different than the characteristics of the assets that make up that portfolio,
especially with regard to risk. The combination of different assets into portfolios rely upon
diversification, that is, the selection of assets that can only be combined if the final risk is

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reduced so that the lost in one asset can mitigated with gains in other asset. Therefore, with
MPT, investors had a tool that they could use to dramatically reduce the risk of the portfolio
without a significant reduction in the expected return of the portfolio.
The risk or the standard deviation of a two-asset portfolio using covariance can be estimated
as follows:

P wA2 A2 wB2 B2 2wA wB COV AB


(8)
where:
P = portfolio standard deviation
( wA ) 2 ( A ) 2

= weighted risk of asset A


2
2
( wB ) ( B )

= weighted risk of asset B


2( wA )( wB )(COV A,B )

= Factor that takes into account the degree of co-movement of


returns. It can have a negative value if correlation is negative
COVAB = covariance of the returns of securities A and B
The covariance is calculated:
n

COV AB Prob (rA,i rA )( rB ,i rB )


i 1

(9)
The risk or the standard deviation of a two-asset portfolio using correlation coefficient can be
estimated by Markowitz model:

p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )( wB )( A, B )( A )( B )
(10)
Where:

2( wA )( wB )( A, B )( A )( B )

2( wA )( wB )(COV A,B )

=
= Factor that takes into account the
degree of co-movement of returns. It can have a negative value if correlation is negative
COV AB
COV AB AB A B AB
A B
= the correlation coefficient is a statistical
measure that identifies how security returns move in relation to one another

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Therefore, according to (Booth & Cleary, 2008), the correlation coefficient will range between -1
and +1, meaning that (Figure 1):
Securities that have -1 correlation are perfectly negatively correlated (as one goes up, the
other goes down)
Securities that have +1 correlation are perfectly positively correlated (both go up
together)
Securities that have zero correlation have no relationship
The closer the absolute value of the correlation is to 1, the stronger the relationship
between the securities

Figure 1 Impact of Correlation Coefficient


Source: The author
The MPT not only can associate returns to risk but also can help to identify efficient portfolios,
that is, portfolios with the highest expected return for a given level of risk and/or with lowest risk
for a given level of expected return (Whaley, 2007). In each curve from (Figure 2Figure 1) there
is a combination that produces minimum variance portfolio. Therefore, every combination with a
return higher than the minimum variance portfolio that lies on the curve section from minimum
variance portfolio upwards called efficient frontier is considered an efficient portfolio.

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Figure 2 Minimum Variance Portfolio


Source: Author
The proportion of asset A that yields a minimum variance portfolio is given by (Equation 11)
A ^ 2 ( R A , RB ) * A * B
A ^ 2 B ^ ^ 2 2 ( RA , RB ) * A * B
WA =
(11)
Furthermore, the minimum variance portfolio can be calculated with n assets. For example, a
portfolio with four assets: A(=31.62%,=6%), B(=54.77%,=8%), C(=63.25%,=10%) and
D(=70.71%, =15%) and proportions varying from 0 to 1 gives the following minimum
variance portfolio (Figure 3)

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Figure 3 Minimum variance portfolio for four assets


Source: The Author
Notwithstanding the major difference between utility theory and portfolio theory that hinges on
the fact that individuals utility function must be specified for every investment decision,
portfolio theory has a lot calculation.
So far, the portfolios introduced only combine risky assets although in the market there are risk
free assets such as treasury bills. When risk portfolios are combined with free risk assets a new
set of portfolio combinations becomes possible (Figure 4)

Figure 4 New set of portfolio combinations


Source: (Booth & Cleary, 2008)

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15

The expected return on a portfolio made up of risk free asset and a risky asset A letting the
weight w invested in the risky asset and the weight invested in RF as (1 w), is:
ERP = RF + w (E(RA) RF)

(12)

The (Equation 12) can be rewritten to reflect the risky asset A in the portfolio as follows:
The risk of the portfolio made up of risk free asset and a risky asset A is
2
p A2 w2 RF
(1 w) 2 2(1 w) w A, RF A RF

. As the risk of the risk free asset is zero,

p A2 w2
then risk of the portfolio made up of risk free asset and a risky asset A becomes
p w A
p A
which is the risk of asset A,
. The weight, w, can be written as w =
/ and
(Equation 12) become:

E(R A ) - RF
P
A

ER P RF

(13)
With efficient set of risky portfolios over the efficient frontier starting from the minimum
variance portfolio (Figure 3), a number of combinations can be attained with a risk free asset
until a Tangent Portfolio T is found (Figure 5).

Figure 5 Tangent Portfolio T


Source: (Booth & Cleary, 2008)

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The line from RF stopping at Tangent Portfolio T can be extended to risk levels beyond T
(Figure 6). The extended line is called the new (or super) efficient frontier to distinguish it from
efficient frontier of risky portfolios.

Figure 6 The New (Super) Efficient Frontier


Source: (Booth & Cleary, 2008)
In the New Efficient Frontier all investors will only hold individually-determined combinations
of the risk free asset (RF) and the tangent portfolio that offer the highest expected rate of return
for any given level of risk.
So far, the discussion about portfolio revolved around return and risk and no mention about the
price of the assets being combined into portfolios. There is a need to find a model to price the
assets and that model is Capital Asset Pricing Model.
CAPM formalizes the relationships between the expected rate of a security and its risk and have
three results (Whaley, 2007):
1. The capital market line
2. The composition of the market portfolio
3. The security market line.
From (Figure 6), it can be observed that if all investors coincide in their decisions about expected
rates of return and the risk attached to each security, they will have the same efficient frontier for
risky assets. If the investors have the same efficient frontier for risky assets it may also be
possible to produce the same portfolio made up of risk free asset and risky portfolio that offers
the highest expected rate of return for any given level of risk. Instead of, each investor having its
own tangent portfolio, since they agree to hold the same portfolio made up of risk free asset and
risky portfolio, the individual tangent portfolios which are also the same they became a market
portfolio of all risky securities in the market. So the individual Tangent Portfolio T which is
common to all investors became Market Portfolio M and the New Efficient Frontier became
CML (Figure 7). The composition of the market portfolio M comprehends all risky securities and
every security has to be held by someone. Formally, (Whaley, 2007) defines composition of the
market portfolio as follows:

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Xi =

Vi
VM

17

for all i

Where Xi is the proportion of risky security wealth invested in the market portfolio, and V i and
VM are the market values of risk security market portfolio, respectively.

Figure 7 The Capital Market Line


Source: (Booth & Cleary, 2008)
The CML is that set of superior portfolio combinations that are achievable in the presence of the
equilibrium condition, that is, supply equals demand for all risk assets (Booth & Cleary, 2008).
The CML formula is
ERM - RF
E ( RP ) RF
P
M

(14)
Where:

ERM = 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

The slope of the CML is the incremental expected return divided by the incremental risk
R - RF
Slope of the CML M
M
(15)
This is called the market price for risk or the equilibrium price of risk in the capital market. The
market price of risk indicates the additional expected return that the market demands for an
increase in risk. So, in an efficient capital market investors will require a return on a portfolio

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18

that compensates them for the risk-free return as well as the market price for risk, that is, the
portfolios should offer returns along the CML (Booth & Cleary, 2008)
The CML provides a method of estimating the required return on equity securities relative to
their risk, but it applies only to efficient portfolios and not to individual securities. In addition,
the risk premium is based on portfolio risk as measured by standard deviation of the return on the
portfolio. However, the risk of individual security returns are caused by two different factors: a)
non-diversifiable risk (system wide changes in the economy and markets that affect all
securities), and b) diversifiable risk (company-specific factors that affect the returns of only one
security) (Booth & Cleary, 2008).
When individual securities are combined into portfolios, company-specific risk is diversified
away leaving out systematic risk. So investors do not get compensated for systematic risk
because it is not captured by CML (Equation 14). Systematic (non-diversifiable) risk is
measured using the beta coefficient. Beta coefficient is a pure number and has no units of
measure (Booth & Cleary, 2008).
There are two basic approaches to estimating the beta coefficient:
1. Using a formula (and subjective forecasts)
2. Use of regression (using past holding period returns)
The formula for the beta coefficient:

COVi,M i , M i

M2
M
(16)

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.
The beta of the market portfolio is = 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 (Booth & Cleary, 2008).
The beta of a portfolio is simply the weighted average of the betas of the individual asset betas
that make up the portfolio.

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19

P wA A wB B ... wn n
(17)
Based on the argument that investors should be compensated for market risk, as measured by
beta, it is easy to use the CML to derive the SML (Equation 18). The SML is the hypothesized
relationship between return (the dependent variable) and systematic risk (the beta coefficient)
(Booth & Cleary, 2008). It is a straight line relationship (Figure 8) defined by the following
formula.

ki RF ( ERM RF ) i
(18)
Where:
ki = the required return on security i
ERM RF = market premium for risk
i = the beta coefficient for security i

Figure 8 Security Market Line


Source: (Booth & Cleary, 2008)
The SML is a single factor model because it based on the hypothesis that required rate of return
can be predicted using one factor systematic risk and is used to price individual investments
and uses the beta coefficient as the measure of risk.
CAPM not only develop capital market line, composition of the market portfolio, and security
market line, can also be used to measure the performance of portfolios, that is, to evaluate the
historical performance of security portfolios on a risk-adjusted basis. The most commonly
applied measures are: Sharpe ratio, M-squared, Treynor ratio and Jensen alpha (Whaley, 2007).
Sharpe ratio (Equation 19) and M2 (Equation 20) are based on the total risk of the portfolio being

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20

evaluated. Treynor ratio (Equation 21) and Jensen alpha (Equation 22) are based on systematic
risk of the portfolio being evaluated.

Total risk based measures


(19)

(20)
Systematic risk based measures
(21)
(22)
Where,

are the means returns of a risk-free asset, the market, and the portfolio
being evaluated

are the standard deviations of the returns (total risks) of the market and
the portfolio

is the portfolio systematic risk, beta.

Sharpe ratio (Equation 19) is a measure of portfolio performance that describes how well an
assets returns compensate investors for the risk taken Its value is the premium earned over the
RF divided by portfolio risk so it is measuring value added per unit of risk (Booth & Cleary,
2008).

ASSIGNMENT UNIT 1

21

The M2 (Equation 20) examines the difference between the excess returns of the portfolio and the
market caused by the degree of leverage
embedded in (Equation 20). Whenever M was
2
greater than P according to M (Equation 20), the excess return of the portfolios were levered
up in order to match the total risk of the market, that is, P (M/P) = M. In the case of M being
less than P he excess return of the portfolios were levered down in order to match the total risk
of the market. So, the realized abnormal performance of the portfolio, as measured by M 2, is
(Equation 23). In the case of M2 being greater than zero, the portfolio P outperformed the market
on risk-adjusted basis. With M2 less than zero, the portfolio lacked behind the market on riskadjusted basis.

(23)

Treynor ratio (Equation 21) is similar to Sharpe ratio (Equation 19) its value is the premium
earned over the RF divided by portfolio risk (systematic risk measured by beta) so it is
measuring value added per unit of systematic risk.
Last, if the estimated value of Jensen alpha (Equation 22) is greater than zero, the portfolio
outperformed the market on a risk-adjusted basis (Whaley, 2007).

ASSIGNMENT UNIT 1

22

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