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PRICING MODELS

INTRODUCTION

CHAP 7 Markowtiz portfolio theory

First to quantify risk

How investors should select optimal portfolio

CHAP 8 CAPM If investors follow Markowtiz

rules, how will securities be priced in

equilibrium ? Beta relevant measure of risk

CHAP 9 APT Allows for multiple sources of

market risk

Malkiel chapters 9 and 10

consider

Model for financial assets

Only expected return, risk drives decisions

How to measure risk: Volatility of returns

(standard deviation)

Correlation coefficient, covariance in portfolio

context

How to estimate Expected returns

Model for investor

Efficient portfolio

Optimal portfolio selection

Tangency between efficient frontier and utility

curve with highest possible utility

Depends on risk preferences

RETURN

EXPECTED RETURNS DETERMINED BY:

_-Range of possible outcomes

-Probability of every outcome

RISK DETERMINED BY:

-Standard deviation of individual asset

-Correlation (measured by covariance)

between returns of individual assets

-Weights of different assets in the portfolio

NB low/ negative correlation reduces

portfolio risk while not affecting the

expected return

The efficient frontier represents that set

of portfolios with the maximum rate of

return for every given level of risk, or

the minimum risk for every level of

return

Frontier will be portfolios of investments

rather than individual securities

Exceptions being the asset with the highest

return and the asset with the lowest risk

Efficient Frontier

for Alternative Portfolios

Exhibit 7.15

E(R)

Efficient

Frontier

and Investor Utility

Investors utility curve specifies the tradeoff between expected return and risk

The slope of the efficient frontier curve

decreases steadily as you move upward

Choosing an optimal portfolio:

Has the highest utility for a given investor

Lies at point of tangency between efficient

frontier, utility curve with highest possible

utility

E

(R

port)

E

(port)

Portfolio

Exhibit 7.16

U3

U2

U3

U2

U1

U1

INTRODUCTION TO CAPITAL

MARKET THEORY

REILLY AND BROWN CHAP 8

Portfolio theory

Normative- how investors should select

optimal portfolio

Capital market theory

Positive

If investors follow these strategies, how will

security prices, returns be determined in

equilibrium ?

CAPM builds on portfolio theory, determine

required rate of return for any risky asset

Risk-free asset

An asset with zero standard deviation

Zero correlation with all other risky assets

Introduction changes Markowitz efficient frontier

into straight line, CML

Dominates all portfolios below it

Market portfolio

Include all risky assets, completely diversified, no

unsystematic risk

Diversification

Purpose: lower standard deviation of portfolio

HOW: add securities with negative/ low correlation

Completely diversified portfolio

Correlation with market portfolio of +1

E

(R

port)

E

(port)

Portfolio Possibilities Combining the RiskFree Asset and Risky Portfolios on the

Efficient Frontier p.242

Exhibit 8.1

RFR

E

(R

port)

E

(port)

Portfolio Possibilities Combining the RiskFree Asset and Risky Portfolios on the

Efficient Frontier p.243

g

n

i

ow

r

r

Bo

g

n

i

nd

e

L

RFR

L

M

C

Exhibit 8.2

Systematic Risk

Systematic risk is the variability in all

risky assets caused by macroeconomic

variables (eg. Interest rate variability,

changes in economic growth)

Systematic risk can be measured by

the standard deviation of returns of

the market portfolio and can change

over time

Investment decision separate from

financing decision

Choice of optimal risky portfolio

same for all investors but Choice of

risk exposure NOT the same for all

investors

(All investors on the CML, but

position on CML differ)

OPTIMAL PORTFOLIO IN

PRACTICE

Implication of separation principle:

portfolio manager will offer same

risky portfolio to all clients

In practice, different managers focus

on different subsets of the whole

universe of financial assets, derive

different efficient frontiers and offer

different optimal portfolios to their

clients.

E

(mR

i)

2

ovim

mC

Line8.5

(SML)

SML

RFR

E

(m0

R

i)

eta(C

ovim/M2)

1.0B

Normalized Systematic Risk

SML

Negative

Beta

RFR

SOME CONCEPTS

SML

relationship between expected return, Beta

Individual securities, efficient and inefficient

portfolios

Can be used to identify over and undervalued

securities

CML

Tangent line: risk-free asset, Markowtiz efficient

frontier

relationship between expected return, standard

deviation (total risk)

E(R

)FR

(M-R

F)

ii

Rate of Return for a Risky

Asset

Stock

Beta

Assume:

RFR = 6%

A

B

C

D

E

(0.06)

RM = 12% (0.12)

0.70

1.00 Implied market risk premium =

1.15

1.40

-0.30

E(RB) = 0.06 + 1.00 (0.12-0.06) = 0.120 = 12.0%

E(RC) = 0.06 + 1.15 (0.12-0.06) = 0.129 = 12.9%

6% (0.06)

undervalued assets

Compare required rate of return with

expected rate of return

Any security with an estimated return

that plots above the SML is underpriced

(estimated return > required return)

Any security with an estimated return

that plots below the SML is overpriced

Required return: from formula: K = riskfree rate + risk premium based on Beta

Expected return: expectations regarding

price appreciation, dividends

Wide acceptance of CAPM makes it

important to tests predictions

empirically

Hard to test empirically: theory

formulated on ex ante basis, can only

be tested ex post

Expected returns, volatility not directly

observable, can be time varying

What does CAPM tell us ?

Expected return, beta linear relation

Only beta necessary to explain

differences in returns among securities

Expected return of zero beta asset is rf

Expected return on asset with beta of 1

is market return

CONCLUSION/ SUMMARY

Markowtiz portfolio theory : how

investors select optimal risky portfolio

Adding risk-free asset to Markowtiz

portfolio construction process allows

portfolio theory to develop into capital

market theory

Risk free-asset: zero variance of return,

zero correlation with other assets

Borrowing possibilities: no longer

restricted to own wealth when investing.

Borrow- higher risk, higher return

SUMMARY

CML- tangent line between risk-free asset

and Markowtiz efficient frontier

Plot expected return against total risk

Complete diversification occurs when all

unsystematic risk has been diversified

away

Completely diversified portfolio will be on

the SML and CML

Use SML to identify undervalued,

overvalued securities

Undervalued- offer returns in excess of

what is required. Plot above SML

Summary

All investors should target points along the

CML depending on their risk preferences

All investors want to invest in the risky

portfolio, so this market portfolio must

contain all risky assets

The investment decision and financing

decision can be separated :Everyone

wants to invest in the market portfolio

BUT

Investors finance decision based on risk

preferences

Summary

The relevant risk measure for an

individual risky asset is its

systematic risk or covariance with

the market portfolio

Once you have determined this

Beta measure and a security

market line, you can determine

the required return on a security

based on its systematic risk

return (APT)

APT an alternative pricing theory with

fewer assumptions than CAPM

TWO IMPORTANT CONCEPTS

Common factors- eg inflation,

economic growth, interest rates should

have influence on returns of all stocks

Factor loadings: how sensitive specific

stocks is for specific factor

CAPM VS APT

CAPM: Beta only relevant factor

THE REAL WORLD

MPT dominant academic framework.

But does it offer any solutions to real

world investors ?

SOME CRITICISM:

Volatility as risk measure

But investors care about loosing money!

(negative returns, risk below benchmark/

underperformance, failing meet goals)

GOAL OF DIVERSIFICATION

General common sense viewpoint:

response to uncertainty about the future,

to the unavoidable risk that any expected

profit may turn out to be a loss

Reduce expected return while protection

against unexpected loss

Goal in MPT: Fine-tune balance between

expected return and expected volatility

Goal is creation of efficient portfolios

DIVERSIFICATION

The alternative viewpoint

JM Keynes best investment strategy

you put all your money in the few

stocks about which you felt

favourably, without any regard to

diversification

Once you obtain confidence,

diversification is undesirable

Diversification is an admission of not

knowing what to do in an effort to

strike the average

POST-MODERN PORTFOLIO

THEORY (PMPT)

MPT

Use mean-variance optimization model for

asset allocation, thus optimize return versus

standard deviation

Not originally created for task of asset

allocation

Efficient frontier software: what is best return

investor can get for given level of risk ? /least

risk investor can take for given level of return ?

PMPT

Downside risk optimization

Goal still optimum mix of risk and reward,

but use downside risk instead of standard

deviation

SPECIFIC PREPARATIONS/

HOMEWORK

Exhibit

Exhibit

Exhibit

Exhibit

7.13

7. 15, 7.16

8.1, 8. 2

8.5

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