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Useful Concepts
Portfolio Portfolio return Portfolio risk Correlation > Risk Reduction Firm-specific risk Vs Market Risk Market Risk> Systematic Risk
Risk-free assets
Certain-to-be-earned expected return, zero variance No correlation with risky assets Usually proxied by a Treasury Bill
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
p = (1 - w RF ) X
All securities included in proportion to their market value Unobservable, but proxied by TSE 300 Index In theory, should contain all risky assets worldwide
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
E(R M ) RF E(R p ) = RF + p M
Beta = 1.0 implies as risky as market Securities A and B are more risky than the market
Beta > 1.0
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
ki = RF +i [ E(RM) - RF ]
The greater the systematic risk, the greater the required return
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 ]
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)
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
p =w 11 +w 2 2 + +w N N = j j w
j= 1 N
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