Sikkim Manipal University 3rd Semester Fall 2010

MBA – III SEM

Security Analysis & Portfolio Management – MF0001

SET - 2

Q. 1. With the help of examples explain what is systematic (also called

systemic) and unsystematic risk? All said and done CAPM is not perfect,
do you agree?

Answer: Systematic Risk:-

In finance, systematic risk, sometimes called market risk, aggregate risk, or

undiversifiable risk, is the risk associated with aggregate market returns.
Systematic risk should not be confused with systemic risk, the risk of loss from some
catastrophic event that collapses the entire financial system. It is the risk which is due
to the factors which are beyond the control of the people working in the market and
that's why risk free rate of return in used to just compensate this type of risk in
market. Interest rates, recession and wars all represent sources of systematic risk
because they affect the entire market and cannot be avoided through diversification.
Whereas this type of risk affects a broad range of securities, unsystematic risk affects
a very specific group of securities or an individual security. Systematic risk can be
mitigated only by being hedged. Even a portfolio of well-diversified assets cannot
escape all risk.

Example
Examples of systematic risk include uncertainty about general economic conditions,
such as GNP, interest rates or inflation. For example, consider an individual investor
who purchases $10,000 of stock in 10 biotechnology companies. If unforeseen
events cause a catastrophic setback and one or two companies' stock prices drop,
the investor incurs a loss. On the other hand, an investor who purchases $100,000 in
a single biotechnology company would incur ten times the loss from such an event.
The second investor's portfolio has more unsystematic risk than the diversified
portfolio. Finally, if the setback were to affect the entire industry instead, the investors
would incur similar losses, due to systematic risk. Systematic risk is essentially
dependent on macroeconomic factors such as inflation, interest rates and so on. It
may also derive from the structure and dynamics of the market.

Systematic Risk and Portfolio Management:-

Given diversified holdings of assets, an investor's exposure to unsystematic risk from
any particular asset is small and uncorrelated with the rest of the portfolio. Hence, the
contribution of unsystematic risk to the riskiness of the portfolio as a whole may
become negligible. In the capital asset pricing model, the rate of return required for
an asset in market equilibrium depends on the systematic risk associated with
returns on the asset, that is, on the covariance of the returns on the asset and the
aggregate returns to the market. Lenders to small numbers of borrowers (or kinds of

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borrowers) face unsystematic risk of default. Their loss due to default is credit risk,
the unsystematic portion of which is concentration risk.

Unsystematic Risk:-
By contrast, unsystematic risk, sometimes called specific risk, idiosyncratic risk,
residual risk, or diversifiable risk, is the company-specific or industry-specific risk in a
portfolio, which is uncorrelated with aggregate market returns.

Unsystematic risk can be mitigated through diversification, and systematic risk

cannot be.
This is the risk other than systematic risk and which is due to the factors which are
controllable by the people working in market and market risk premium is used to
compensate this type of risk.

Total Risk = Systematic risk + Unsystematic Risk

The risk that is specific to an industry or firm. Examples of unsystematic risk include
losses caused by labour problems, nationalization of assets, or weather conditions.
This type of risk can be reduced by assembling a portfolio with significant
diversification so that a single event affects only a limited number of the assets.
Company- or industry-specific risk as opposed to overall market risk; unsystematic
risk can be reduced through diversification. As the saying goes, “Don't put all of your
eggs in one basket.” Also known as specific risk, diversifiable risk, and residual risk.

Example
On the other hand, announcements specific to a company, such as a gold mining
company striking gold, are examples of unsystematic risk.

Risk: Systematic and Unsystematic:-

We can break down the risk, U, of holding a stock into two components: systematic
risk and unsystematic risk:

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CAPM is not perfect:-

 The model assumes that either asset returns are (jointly) normally distributed
random variables or that investor’s employ a quadratic form of utility. It is
however frequently observed that returns in equity and other markets are not
normally distributed. As a result, large swings (3 to 6 standard deviations from
the mean) occur in the market more frequently than the normal distribution
assumption would expect.

 The model assumes that the variance of returns is an adequate measurement

of risk. This might be justified under the assumption of normally distributed
returns, but for general return distributions other risk measures (like coherent
risk measures) will likely reflect the investors' preferences more adequately.
Indeed risk in financial investments is not variance in itself rather it is the
probability of losing: it is asymmetric in nature.

 The model assumes that all investors have access to the same information
and agree about the risk and expected return of all assets (homogeneous
expectations assumption).

 The model assumes that the probability beliefs of investors match the true
distribution of returns. A different possibility is that investors' expectations are
biased, causing market prices to be informationally inefficient. This possibility
is studied in the field of behavioral finance, which uses psychological
assumptions to provide alternatives to the CAPM such as the overconfidence-
based asset pricing model of Kent Daniel, David Hirshleifer, and Avanidhar
Subramanyam (2001).

 The model does not appear to adequately explain the variation in stock
returns. Empirical studies show that low beta stocks may offer higher returns
than the model would predict. Some data to this effect was presented as early
as a 1969 conference in Buffalo, New York in a paper by Fischer Black,
Michael Jensen, and Myron Scholes. Either that fact is itself rational (which
saves the efficient-market hypothesis but makes CAPM wrong), or it is
irrational (which saves CAPM, but makes the EMH wrong – indeed, this
possibility makes volatility arbitrage a strategy for reliably beating the market).

 The model assumes that given a certain expected return investors will prefer
lower risk (lower variance) to higher risk and conversely given a certain level
of risk will prefer higher returns to lower ones. It does not allow for investors
who will accept lower returns for higher risk. Casino gamblers clearly pay for
risk, and it is possible that some stock traders will pay for risk as well.

 The model assumes that there are no taxes or transaction costs, although this
assumption may be relaxed with more complicated versions of the model.

 The market portfolio consists of all assets in all markets, where each asset is
weighted by its market capitalization. This assumes no preference between
markets and assets for individual investors, and that investors choose assets

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solely as a function of their risk-return profile. It also assumes that all assets
are infinitely divisible as to the amount which may be held or transacted.

 The market portfolio should in theory include all types of assets that are held
by anyone as an investment (including works of art, real estate, human
capital...) In practice, such a market portfolio is unobservable and people
usually substitute a stock index as a proxy for the true market portfolio.
Unfortunately, it has been shown that this substitution is not innocuous and
can lead to false inferences as to the validity of the CAPM, and it has been
said that due to the inobservability of the true market portfolio, the CAPM
might not be empirically testable. This was presented in greater depth in a
paper by Richard Roll in 1977, and is generally referred to as Roll's critique.

 The model assumes just two dates, so that there is no opportunity to consume
and rebalance portfolios repeatedly over time. The basic insights of the model
are extended and generalized in the intertemporal CAPM (ICAPM) of Robert
Merton, and the consumption CAPM (CCAPM) of Douglas Breeden and Mark
Rubinstein.

 CAPM assumes that all investors will consider all of their assets and optimize
one portfolio. This is in sharp contradiction with portfolios that are held by
individual investors: humans tend to have fragmented portfolios or, rather,
multiple portfolios: for each goal one portfolio.

Q. 2. What do you understand by arbitrage? Make a critical comparison

between APT & CAPM.
Answer: In economics and finance, arbitrage is the practice of taking advantage of a
price difference between two or more markets: striking a combination of matching
deals that capitalize upon the imbalance, the profit being the difference between the
market prices. When used by academics, an arbitrage is a transaction that involves
no negative cash flow at any probabilistic or temporal state and a positive cash flow
in at least one state; in simple terms, it is the possibility of a risk-free profit at zero
cost.

In principle and in academic use, an arbitrage is risk-free; in common use, as in

statistical arbitrage, it may refer to expected profit, though losses may occur, and in
practice, there are always risks in arbitrage, some minor (such as fluctuation of prices
decreasing profit margins), some major (such as devaluation of a currency or
derivative). In academic use, an arbitrage involves taking advantage of differences in
price of a single asset or identical cash-flows; in common use, it is also used to refer
to differences between similar assets (relative value or convergence trades), as in
merger arbitrage.

People who engage in arbitrage are called arbitrageurs (IPA: /ˌɑrbɨtrɑːˈʒɜr/)—such

as a bank or brokerage firm. The term is mainly applied to trading in financial
instruments, such as bonds, stocks, derivatives, commodities and currencies.

Conditions for arbitrage:-

Arbitrage is possible when one of three conditions is met:

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1. The same asset does not trade at the same price on all markets ("the law of
one price").

2. Two assets with identical cash flows do not trade at the same price.

3. An asset with a known price in the future does not today trade at its future
price discounted at the risk-free interest rate (or, the asset does not have
negligible costs of storage; as such, for example, this condition holds for grain
but not for securities).

Arbitrage is not simply the act of buying a product in one market and selling it in
another for a higher price at some later time. The transactions must occur
simultaneously to avoid exposure to market risk, or the risk that prices may change
on one market before both transactions are complete. In practical terms, this is
generally only possible with securities and financial products which can be traded
electronically, and even then, when each leg of the trade is executed the prices in the
market may have moved. Missing one of the legs of the trade (and subsequently
having to trade it soon after at a worse price) is called 'execution risk' or more
specifically 'leg risk'.

In the simplest example, any good sold in one market should sell for the same price
in another. Traders may, for example, find that the price of wheat is lower in
agricultural regions than in cities, purchase the good, and transport it to another
region to sell at a higher price. This type of price arbitrage is the most common, but
this simple example ignores the cost of transport, storage, risk, and other factors.
"True" arbitrage requires that there be no market risk involved. Where securities are
traded on more than one exchange, arbitrage occurs by simultaneously buying in one
and selling on the other.

See rational pricing, particularly arbitrage mechanics, for further discussion.

Mathematically it is defined as follows:

and ...

where Vt means a portfolio at time t.

Examples
• Suppose that the exchange rates (after taking out the fees for making the
exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo
are ¥1000 = $12 = £6. Converting ¥1000 to $12 in Tokyo and converting that
$12 into ¥1200 in London, for a profit of ¥200, would be arbitrage. In reality,
this "triangle arbitrage" is so simple that it almost never occurs. But more
complicated foreign exchange arbitrages, such as the spot-forward arbitrage
(see interest rate parity) are much more common.

• One example of arbitrage involves the New York Stock Exchange and the
Chicago Mercantile Exchange. When the price of a stock on the NYSE and its
corresponding futures contract on the CME are out of sync, one can buy the
less expensive one and sell it to the more expensive market. Because the
differences between the prices are likely to be small (and not to last very long),

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this can only be done profitably with computers examining a large number of
prices and automatically exercising a trade when the prices are far enough out
of balance. The activity of other arbitrageurs can make this risky. Those with
the fastest computers and the most expertise take advantage of series of
small differences that would not be profitable if taken individually.

• Economists use the term "global labor arbitrage" to refer to the tendency of
manufacturing jobs to flow towards whichever country has the lowest wages
per unit output at present and has reached the minimum requisite level of
political and economic development to support industrialization. At present,
many such jobs appear to be flowing towards China, though some which
require command of English are going to India and the Philippines. In popular
terms, this is referred to as offshoring. (Note that "offshoring" is not
synonymous with "outsourcing", which means "to subcontract from an outside
supplier or source", such as when a business outsources its bookkeeping to
an accounting firm. Unlike offshoring, outsourcing always involves
subcontracting jobs to a different company, and that company can be in the
same country as the outsourcing company.)

• Sports arbitrage – numerous internet bookmakers offer odds on the outcome

of the same event. Any given bookmaker will weight their odds so that no one
customer can cover all outcomes at a profit against their books. However, in
order to remain competitive their margins are usually quite low. Different
bookmakers may offer different odds on the same outcome of a given event;
by taking the best odds offered by each bookmaker, a customer can under
some circumstances cover all possible outcomes of the event and lock a small
risk-free profit, known as a Dutch book. This profit would typically be between
1% and 5% but can be much higher. One problem with sports arbitrage is that
bookmakers sometimes make mistakes and this can lead to an invocation of
the 'palpable error' rule, which most bookmakers invoke when they have made
a mistake by offering or posting incorrect odds. As bookmakers become more
proficient, the odds of making an 'arb' usually last for less than an hour and
typically only a few minutes. Furthermore, huge bets on one side of the market
also alert the bookies to correct the market.

• Exchange-traded fund arbitrage – Exchange Traded Funds allow authorized

participants to exchange back and forth between shares in underlying
securities held by the fund and shares in the fund itself, rather than allowing
the buying and selling of shares in the ETF directly with the fund sponsor.
ETFs trade in the open market, with prices set by market demand. An ETF
may trade at a premium or discount to the value of the underlying assets.
When a significant enough premium appears, an arbitrageur will buy the
underlying securities, convert them to shares in the ETF, and sell them in the
open market. When a discount appears, an arbitrageur will do the reverse. In
this way, the arbitrageur makes a low-risk profit, while fulfilling a useful
function in the ETF marketplace by keeping ETF prices in line with their
underlying value.

• Some types of hedge funds make use of a modified form of arbitrage to profit.
Rather than exploiting price differences between identical assets, they will

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purchase and sell securities, assets and derivatives with similar

characteristics, and hedge any significant differences between the two assets.
Any difference between the hedged positions represents any remaining risk
(such as basis risk) plus profit; the belief is that there remains some difference
which, even after hedging most risk, represents pure profit. For example, a
fund may see that there is a substantial difference between U.S. dollar debt
and local currency debt of a foreign country, and enter into a series of
matching trades (including currency swaps) to arbitrage the difference, while
simultaneously entering into credit default swaps to protect against country
risk and other types of specific risk.

Comparison between APT & CAPM:-

• APT applies to well diversified portfolios and not necessarily to individual
stocks.

• With APT it is possible for some individual stocks to be mispriced - not lie on
the SML.

• APT is more general in that it gets to an expected return and beta relationship
without the assumption of the market portfolio.

• APT can be extended to multifactor models.

• Both the CAPM and APT are risk-based models. There are alternatives.

• Empirical methods are based less on theory and more on looking for some
regularities in the historical record.

• Be aware that correlation does not imply causality.

• Related to empirical methods is the practice of classifying portfolios by style

e.g.
 Value portfolio

 Growth portfolio

• The APT assumes that stock returns are generated according to factor models
such as:

R = R + β F + β GD F GD + β F + ε
I I S S
P P

• As securities are added to the portfolio, the unsystematic risks of the individual
securities offset each other. A fully diversified portfolio has no unsystematic
risk.

• The CAPM can be viewed as a special case of the APT.

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• Empirical models try to capture the relations between returns and stock
attributes that can be measured directly from the data without appeal to
theory.

• Difference in Methodology:

 CAPM is an equilibrium model and derived from individual portfolio

optimization.

 APT is a statistical model which tries to capture sources of systematic risk.

Relation between sources determined by no Arbitrage condition.

• Difference in Application:

 APT difficult to identify appropriate factors.

 CAPM difficult to find good proxy for market returns.

 APT shows sensitivity to different sources. Important for hedging in

portfolio formation.

 CAPM is simpler to communicate, since everybody agrees upon.

Q. 3. Explain in brief APT with single factor model.

Answer: Arbitrage pricing theory (APT), in finance, is a general theory of asset
pricing, that has become influential in the pricing of stocks.

APT holds that the expected return of a financial asset can be modeled as a linear
function of various macro-economic factors or theoretical market indices, where
sensitivity to changes in each factor is represented by a factor-specific beta
coefficient. The model-derived rate of return will then be used to price the asset
correctly - the asset price should equal the expected end of period price discounted
at the rate implied by model. If the price diverges, arbitrage should bring it back into
line.
The theory was initiated by the economist Stephen Ross in 1976.

The APT model:-

Risky asset returns are said to follow a factor structure if they can be expressed as:

where
• E(rj) is the jth asset's expected return,

• Fk is a systematic factor (assumed to have mean zero),

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• bjk is the sensitivity of the jth asset to factor k, also called factor loading,

• and εj is the risky asset's idiosyncratic random shock with mean zero.

Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated

with the factors.

The APT states that if asset returns follow a factor structure then the following
relation exists between expected returns and the factor sensitivities:

where
• RP is the risk premium of the factor,

• rf is the risk-free rate,

That is, the expected return of an asset j is a linear function of the assets sensitivities
to the n factors.

Note that there are some assumptions and requirements that have to be fulfilled for
the latter to be correct: There must be perfect competition in the market, and the total
number of factors may never surpass the total number of assets (in order to avoid the
problem of matrix singularity).

Using the APT:-

Identifying the factors:-

As with the CAPM, the factor-specific Betas are found via a linear regression
of historical security returns on the factor in question. Unlike the CAPM, the APT,
however, does not itself reveal the identity of its priced factors - the number and
nature of these factors is likely to change over time and between economies. As a
result, this issue is essentially empirical in nature. Several a priori guidelines as to the
characteristics required of potential factors are, however, suggested:

1. Their impact on asset prices manifests in their unexpected movements.

2. They should represent undiversifiable influences (these are, clearly, more

likely to be macroeconomic rather than firm-specific in nature).

3. Timely and accurate information on these variables is required.

4. the relationship should be theoretically justifiable on economic grounds

Chen, Roll and Ross (1986) identified the following macro-economic factors as
significant in explaining security returns:

• surprises in inflation;

• Surprises in GNP as indicated by an industrial production index;

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• Surprises in investor confidence due to changes in default premium in

corporate bonds;

• Surprise shifts in the yield curve.

As a practical matter, indices or spot or futures market prices may be used in place of
macro-economic factors, which are reported at low frequency (e.g. monthly) and
often with significant estimation errors. Market indices are sometimes derived by
means of factor analysis. More direct "indices" that might be used are:

 short term interest rates;

 the difference in long-term and short-term interest rates;

 a diversified stock index such as the S&P 500 or NYSE Composite Index;

 oil prices

 gold or other precious metal prices

 Currency exchange rates

Single factor model:-

rj = bj0 + bj1F1 + €j ; j = 1; 2; : : : ; n

where
rj is the rate of return on asset (or portfolio) j,

F1 denotes the factor’s value,

bj0 and bj1 are parameters, and

j denotes an unobserved random error. It is assumed that

E[€j l F1] = 0, that is, the expected value of the random error, conditional upon the
value of the factor, is zero.

APT prediction, single factor model:-

The weight λ1 is interpreted as the risk premium associated with the factor, that is,
the risk premium corresponds to the source of the systematic risk.

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