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ri = E (ri ) + i m + ei
i = index of a securities particular return to the factor m = Unanticipated movement related to security returns ei = Assumption: a broad market index like the S&P 500 is the common factor.
Single-Index Model
Regression Equation:
Rt (t ) = i + t RM (t ) + ei (t )
Expected return-beta relationship:
E ( Ri ) = i + i E ( RM )
Concept check 1
Stock Capitalisation beta Mean excess returns Standard deviation A $ 3000 1 10% 40% B 1940 0.2 2% 30% C 360 1.7 17% 50% Standard deviation of the market portfolio is 25% a. What is the mean excess return of the index portfolio? b. What is the covariance between stock A and B? c. What is the covariance between stock B and the index? d. Break down the variance of stock B into its systematic and firm specific components. a. 3000/6300*10+1940/6300*2+1360/6300*17 =9.05% b. 1*0.2* 0.252 = .0125 c. 0.2 *0.252 = .0125 d. Systematic =0.22 *.252 = .0025 Firm specific = 0.302 - .0025 =.0875
Concept check 2
Suppose RA =1% +0.9 RM +eA RB = -2%+1.1 RM +eB (eA) =30% (eB) =10% M =20% Find the standard deviation of each stock and covariance between them. Stock A = 0.92 *(20)2 + 302 = 1224 SD = 35% Stock B =1.12 *(20)2 + 102 = 584 SD = 24% The covariance = .9* 1.1 * 202 = 396
Portfolios variance:
2 P 2 P
= + (eP )
2 M 2
Figure 8.1 The Variance of an Equally Weighted Portfolio with Risk Coefficient p in the Single-Factor Economy
Concept check 3
Reconsider the two stocks in concept check 2. Suppose we form an equally weighted portfolio of A and B. What will be the nonsystematic standard deviation of that portfolio? 2(ep) =0.52 [ .302 + .102 ]
= .0250 ep = .158 =15.8%
Figure 8.2 Excess Returns on HP and S&P 500 April 2001 March 2006
Figure 8.3 Scatter Diagram of HP, the S&P 500, and the Security Characteristic Line (SCL) for HP
H0: =0
Calculation of Risk
2HP = .7162/59 =.012 per month Monthly SD =11% Annualized standard deviation =38.17 (11 *sqrt 12) 2 HP2S&P500 =.3752 2eHP =.3410/58 =0.0057796 per month Monthly SD of HPs residual =7.67% Alternatively, Directly the square root of MS for residual Annualised residual SD = 7.67 *sqrt 12 =26.6%
A = 1, w = w
* A
0 A
A = + sP sM (eA )
2 2
Optimal risky portfolio now has weights W*M= 1-W*A Risk premium on of optimal risky portfolio E(Rp) =(W*M+W*A A) E(RM) +W*A A Compute the variance of the optimal risky portfolio 2p = (W*M+W*A A) 2 2M +[w*A (eA)]2
Question 17(a)
Alpha ()[extra market expected return] i = ri [rf + i(rM rf ) ] A = 20% [8% + 1.3(16% 8%)] = 1.6% B = 18% [8% + 1.8(16% 8%)] = 4.4% C = 17% [8% + 0.7(16% 8%)] = 3.4% D = 12% [8% + 1.0(16% 8%)] = 4.0% Expected excess return E(ri ) rf 20% 8% = 12% 18% 8% = 10% 17% 8% = 9% 12% 8% = 4%
Stocks A and C have positive alphas, where as stocks B and D have negative alphas. The residual variances are: 2(eA ) = 582 = 3,364 2(eB) = 712 = 5,041 2(eC) = 602 = 3,600 2(eD) = 552 = 3,025
With these weights, the forecast for the active portfolio is: = [0.6142 * 1.6] + [1.1265 * ( 4.4)] [1.2181 * 3.4] + [1.7058 * ( 4.0)] = 16.90% = [0.6142 * 1.3] + [1.1265 *1.8] [1.2181 * 0.70] + [1.7058 * 1] = 2.08 2(e) = [(0.6142)2 * 3364] + [1.12652 * 5041] + [(1.2181)2 *3600] + [1.70582 * 3025] = 21,809.6 (e) = 147.68%
Question 17(b)
The optimal risky portfolio has a proportion w* in the active portfolio, computed as follows:
The negative position is justified for the reason stated earlier. The adjustment for beta is:
w0 0.05124 w* = = = 0.0486 1 + (1 ) w 0 1 + (1 2.08)(0.05124)
Since w* is negative, the result is a positive position in stocks with positive alphas and a negative position in stocks with negative alphas. The position in the index portfolio is: 1 (0.0486) = 1.0486
Question 17(c)
The information ratio for the active portfolio is computed as follows: A = /(e)= 16.90/147.68 = 0.1144 A2 = 0.0131 Hence, the square of Sharpes measure (S) of the optimized risky portfolio is:
8 2 + = S2 = S2 A + 0.0131 = 0.1341 M 23
2
S = 0.3662 Compare this to the markets Sharpe measure: SM = 8/23 = 0.3478 The difference is: 0.0184
P = 23.00%
y= 8.42 = 0.5685 0.01 2.8 528.94
Question 17(d)
The final positions of the complete portfolio are:
Bills M A B C D 1 0.5685 = 0.5685 l.0486 = 0.5685 (0.0486) (0.6142) = 0.5685 (0.0486) 1.1265 = 0.5685 (0.0486) (1.2181) = 0.5685 (0.0486) 1.7058 = 43.15% 59.61% 1.70% 3.11% 3.37% 4.71% 100.00% [sum is subject to rounding error]
Assumptions
Individual investors are price takers Single-period investment horizon Investments are limited to traded financial assets No taxes and transaction costs
Assumptions Continued
Information is costless and available to all investors Investors are rational mean-variance optimizers There are homogeneous expectations
All assets have to be included in the market portfolio .The only issue is the price at which Investors will be willing to include a stock in their optimal risky portfolio
Y =E(rp) rf /A 2P
If Cov of GE with rest of the market is negativenegative contribution to the portfolio risk If Cov is positive then positive contribution to overall portfolio risk.
2 M
E (rM ) rf
P = wk k
E (rM ) = rf + M E ( r ) r M f
M =Cov(rM,rM) /2M =1 In an efficient market investors receive high expected returns only if they are willing to bear risk
Concept check
Suppose that the risk premium on the market portfolio is estimated at 8% with a standard deviation of 22%.What is the risk premium on a portfolio invested 25% in GM and 75% in Ford, if they have betas of 1.10 and 1.25 respectively?
p = .75*1.25+ .25* 1.10 = 1.2125 The portfolio risk premium = 1.2125 * 8 = 9.7%
Question
Stock XYZ has an expected return of 12% ,=1. Stock ABC has expected return of 13% and =1.5.The market expected return is 11% and rf = 5%. Acc. To CAPM which stock is a better buy? What is alpha of each stock? =E(r) { rf + [E(rm) rf] } XYZ =12-[5+ (11-5)] = 1% ABC = 13 [ 5+ 1.5(11-5)] =-1% ABC plots below SML ,while XYZ plots above
Question
The risk free rate is 8% and the expected return on market portfolio is 16%.A firm considers a project that is expected to have beta of 1.3.What is the required rate of return? If the expected IRR of the project is 19% , should it be accepted ?
=E(r) { rf + [E(rm) rf] }
= 8+1.3(16-8) =18.4%(Projects hurdle rate) Any project with an IRR equal to or less than 18.4 % should be rejected.
Ri = i + i RM + ei
Cov(Ri,Rm) = Cov (iRm+ei ,Rm) = i Cov(Rm,Rm)+ Cov (ei,Rm) =i 2M i = Cov(Ri,Rm) / 2M The index model beta coefficient turns out to be the same beta as that of the CAPM expected return-beta relationship
Var ( RM CM )