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Asset Pricing Principles

Chapter 9
Charles P. Jones, Investments: Principles and Concepts,
Twelfth Edition, John Wiley & Sons

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Positive rather than normative


Describes how investors could behave not how
they should be have

Focus on the equilibrium relationship


between the risk and expected return on
risky assets
Builds on Markowitz portfolio theory
Each investor is assumed to diversify his or
her portfolio according to the Markowitz
model

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Assumes all
investors:
Use the same
information to
generate an efficient
frontier
Have the same oneperiod time horizon
Can borrow or lend
money at the risk-free
rate of return

No transaction costs,
no personal income
taxes, no inflation
No single investor
can affect the price
of a stock
Capital markets are
in equilibrium

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Risk-Free Assets, Borrowing,


Lending

Risk free assets


No correlation with risky assets
Usually proxied by a Treasury security

Adding a risk-free asset extends and


changes the efficient frontier
Lending because investor lends money to
issuer
With borrowing, investor no longer
restricted to own wealth

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Riskless assets can


be combined with
L
any portfolio in the
B
efficient set AB

E(R)

Z implies lending

T
Z

RF
A

Set of portfolios on
line RF to T
dominates all
portfolios below it

Risk
9-5

Risk-free investing and borrowing creates a


new set of expected return-risk possibilities
Addition of risk-free asset results in

A change in the efficient set from an arc to a


straight line tangent to the feasible set without
the riskless asset
Chosen portfolio depends on investors risk-return
preferences

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L
M

E(RM)

x
RF

M
Risk

Line from RF to L is
capital market line
(CML)
x = risk premium
=E(RM) - RF
y =risk =M
Slope =x/y
=[E(RM) - RF]/M
y-intercept = RF

9-7

Slope of the CML is the market price of risk


for efficient portfolios, or the equilibrium
price of risk in the market
Relationship between risk and expected
return for portfolio P (Equation for CML):

E(RM ) RF
E(Rp ) RF
p
M

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Most important implication of the CAPM


The portfolio of all risky assets is the optimal risky
portfolio (called the market portfolio)
The expected price of risk is always positive
The optimal portfolio is at the highest point of
tangency between RF and the efficient frontier
All investors hold the same optimal portfolio of
risky assets

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All risky assets must be in portfolio, so it is


completely diversified
Includes only systematic risk

Unobservable but approximated with


portfolio of all common stocks
In turn approximated with S&P 500

All securities included in proportion to their


market value

910

Investors use their preferences (reflected in


an indifference curve) to determine optimal
portfolio
Separation Theorem

The investment decision about which risky portfolio


to hold is separate from the financing decision
Investment decision does not involve investor
Financing decision depends on investors preferences

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CML Equation only applies to markets in


equilibrium and efficient portfolios
The Security Market Line depicts tradeoff
between risk and expected return for
individual securities
Under CAPM, all investors hold the market
portfolio

Relevant risk of any security is therefore its


covariance with the market portfolio

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Beta
Standardized measure of systematic risk
Relative measure of risk: risk of an
individual stock relative to the market
portfolio of all stocks
Relates covariance of an asset with the
market portfolio to the variance of the
Covi, M
market portfolio

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Beta
SM
L

E(R)
kM

kRF

Beta = 1.0 implies


as risky as market
Securities A and B
are more risky than
the market
Beta >1.0

Security C is less
risky than the
0.5 1.0 1.5 2.0 market

BetaM

Beta <1.0
9-14

Required rate of return on an asset (ki) is


composed of
risk-free rate (RF)
risk premium (i [ E(RM) - RF ])

Market risk premium adjusted for specific security

ki = RF +i [ E(RM) - RF ]

The greater the systematic risk, the greater the


required return

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Treasury Bill rate used to estimate RF


Expected market return unobservable

Estimated using past market returns and taking


an expected value

Estimating individual security betas difficult


Only company-specific factor in CAPM
Requires asset-specific forecast

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Market model
Relates the return on each stock to the return on
the market, assuming a linear relationship
Produces an estimate of return for any stock
Ri = i + i RM +ei

Characteristic line
Line fit to total returns for a security relative to
total returns for the market index

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Betas change with a companys situation


Estimating a future beta

May differ from the historical beta

RM represents the total of all marketable


assets in the economy
Approximated with a stock market index
Approximates return on all common stocks

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No one correct number of observations and


time periods for calculating beta
Therefore, estimates of beta vary

The regression calculations of the true


and from the characteristic line are
subject to estimation error
Portfolio betas more reliable than individual
security betas

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Tests of CAPM
Assumptions are mostly unrealistic
Empirical evidence has not led to consensus
However, some points are widely agreed
upon

SML appears to be linear


Intercept is generally higher than RF
Slope of the CAPM is generally less than theory
predicts
Its likely that only systematic risk is rewarded

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Based on the Law of One Price

Two otherwise identical assets cannot sell at


different prices
Equilibrium prices adjust to eliminate all arbitrage
opportunities

Unlike CAPM, APT does not assume

single-period investment horizon, absence of


personal taxes, riskless borrowing or lending,
mean-variance decisions

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APT assumes returns generated by a factor


model
Factor Characteristics

Each risk must have a pervasive influence on


stock returns
Risk factors must influence expected return and
have non-zero prices
Risk factors must be unpredictable to the market

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Most important are the deviations of the


factors from their expected values
Expected return is directly related to sensitivity
CAPM assumes risk is only sensitivity to market

The expected return-risk relationship for the


APT can be described as:
E(Ri) =RF +bi1 (risk premium for factor 1)
+bi2 (risk premium for factor 2) +
+bin (risk premium for factor n)

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Factors are not well specified ex ante


To implement the APT model, need the factors
that account for the differences among security
returns
CAPM identifies market portfolio as single factor

Studies suggest certain factors are reflected


in market
Focus on cash flows and discount rate

Both CAPM and APT rely on unobservable


expectations

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