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CHAPTER NINE CHAPTER NINE Capital Market Theory Capital Market Theory

Learning Objectives Learning Objectives


To explain capital market theory and the Capital Asset Pricing Model To discuss the importance and composition of the market portfolio To describe two important relationships in CAPM as represented by the capital market line and the security market line

Learning Objectives Learning Objectives


To describe how betas are estimated and how beta is used To discuss the Arbitrage Pricing Theory as an alternative to the Capital Asset Pricing Model

Capital Asset Pricing Model Capital Asset Pricing Model


CAPM A model based on the proposition that any stocks required rate of return is equal to the risk-free rate of return plus a risk premium, where risk reflects diversification 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

Useful Concepts
Portfolio Portfolio return Portfolio risk Correlation > Risk Reduction Firm-specific risk Vs Market Risk Market Risk> Systematic Risk

CAPM Assumptions CAPM Assumptions


All investors: No transaction costs, no personal Use the same information to income taxes, no generate an efficient inflation frontier No single investor Have the same onecan affect the price period time horizon of a stock Can borrow or lend money at the risk-free Capital markets are rate of return in equilibrium

Market Portfolio Market Portfolio


Most important implication of the CAPM
All investors hold the same optimal portfolio of risky assets The optimal portfolio is at the highest point of tangency between RF and the efficient frontier The portfolio of all risky assets is the optimal risky portfolio

Called the market portfolio

Risk-free assets
Certain-to-be-earned expected return, zero variance No correlation with risky assets Usually proxied by a Treasury Bill

Amount to be received at maturity is free of default risk, known with certainty

Adding a risk-free asset extends and changes the efficient frontier

L B E(R) Z RF A Risk X T

Riskless assets can be combined with any portfolio in the efficient set AB Set of portfolios on line RF to T dominates all portfolios below it

Impact Impact
If wRF placed in a risk-free asset
Expected portfolio return

E(R p ) = w RFRF + (1 - w RF )E(R X )


Risk of the portfolio

p = (1 - w RF ) X

Characteristics of the Characteristics of the Market Portfolio Market Portfolio


All risky assets must be in portfolio, so it is completely diversified
Contains only systematic risk

All securities included in proportion to their market value Unobservable, but proxied by TSE 300 Index In theory, should contain all risky assets worldwide

Capital Market Line Capital Market Line


L E(RM) M x RF y 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

Capital Market Line Capital Market Line


Slope of the CML = [E(RM) - RF]/M is the market price of risk for efficient portfolios, or the equilibrium price of risk in the market This is the risk premium: the excess return earned per unit of risk or standard deviation Relationship between risk and expected return for portfolio P (Equation for CML):

E(R M ) RF E(R p ) = RF + p M

Security Market Line Security Market Line


CML Equation only applies to markets in equilibrium and efficient portfolios The Security Market Line depicts the tradeoff between risk and expected return for individual securities Under CAPM, all investors hold the market portfolio
How does an individual security contribute to the risk of the market portfolio?

Security Market Line Security Market Line


Equation for expected return for an individual stock similar to CML Equation
E(R M ) RF i,M E(R i ) = RF + M M = RF + i [ E(R M ) RF]

Security Market Line Security Market Line


SML E(R) E(RM) RF C B A

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 market


0.5 1.0 1.5 2.0 BetaM Beta < 1.0

Security Market Line Security Market Line


Beta measures systematic risk
Measures relative risk compared to the market portfolio of all stocks Volatility different than market

All securities should lie on the SML


The expected return on the security should be only that return needed to compensate for systematic risk

CML vs SML
Both postulates a linear relationship between risk and return In CML, the risk is defined as total risk > measured by SD/ In SML, the risk is defined as systematic risk and is measured by beta. CML is valid only for efficient portfolios /SML is valid for all portfolios and all individual securities as well CML is the basis of the capital market theory/ SML is the basis of the CAPM model

CAPMs Expected ReturnCAPMs Expected ReturnBeta Relationship Beta Relationship


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

Over and Undervalued Securities


SML can be fitted to determine the expected (required) return-risk tradeoff Knowing the beta for any stock, we can determine the RRR from SML Estimating the ERR (fundamental analysis) > an investor can determine the under/over valued stock SML
E(Ry) E(Ry) E(RX) E(RX)

Z X Y

RF

Beta

X = undervalued > offering higher E(r) than required> Purchase X Y = overvalued > offering lower E(r) than required> Sell Y CAPM can be used to calculate ERR ki = RF +Bi [ E(RM) - RF ]

Pricing of Securities with CAPM


Securities plotted off the SML would be evidence of mispricing in the market place CAPM can identify underpriced and overpriced securities If E(R) calculated by CAPM is lower than the actual or estimated return offered> underpriced If E(R) calculated by CAPM is higher than the actual or estimated return offered> overpriced

Estimating Beta Estimating Beta


Beta coefficient,
a measure of the extent to which the returns on a given stock move with the stock market

Estimation of Company Beta


Theoretically, the calculation of the company beta is straightforward:

Cov( Ri , RM ) = = Var ( RM )

2 i 2 M

How Accurate Are Beta How Accurate Are Beta Estimates? Estimates?
Betas change with a companys situation
Not stationary over time (Cyclicality of Revenues)

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

How Accurate Are Beta How Accurate Are Beta Estimates? Estimates?
No one correct number of observations and time periods for calculating beta The regression calculations of the true and from the characteristic line are subject to estimation error Portfolio betas more reliable than individual security betas

Using an Industry Beta


It is frequently argued that one can better estimate a firms beta by involving the whole industry. If you believe that the operations of the firm are similar to the operations of the rest of the industry, you should use the industry beta. If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry, you should use the firms beta.

Portfolio Beta Coefficients


The beta of any set of securities is the weighted average of the individual securities betas

p =w 11 +w 2 2 + +w N N = j j w
j= 1 N

Arbitrage Pricing Theory Arbitrage Pricing Theory


CAPM is dependent on Market Portfolio> Market Risk APT> Several types of risk may affect security returns

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

Factors Factors
APT assumes returns generated by a factor model Factor Characteristics
Each risk must have a pervasive influence on stock returns: Firm-specific events are not considered Risk factors must influence expected return and have nonzero prices Risk factors must be unpredictable to the market>Rate of inflation

APT Model APT Model


Most important are the deviations of the factors from their expected values 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)

Problems with APT Problems with APT


Factors are not well specified ex ante
To implement the APT model, the factors that account for the differences among security returns are required

CAPM identifies market portfolio as single factor

Neither CAPM or APT has been proven superior


Both rely on unobservable expectations

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