ASSET PRICING

The basic issue is

how to determine
the price of a financial
asset?
REAL
ASSETS
FINANCIAL
ASSETS
There are broadly two approaches for
asset pricing in Theory of Finance
One approach is EQUILIBRIUM
APPROACH; and


Another approach is ARBITRAGE
APPROACH.
The Story of Asset Pricing started
with
Markowitz
Portfolio Theory
Therefore, we start with
HARRY MARKOWITZ MODEL
MARKOWITZ MODEL
Markowitz is called father of Modern Portfolio Theory.
He gave for the very first time a quantitative
measurement of risk and return of a security as well as
of a portfolio.
He also suggested a methodology for constructing an
optimum portfolio.
He changed the whole character and the nature of the
theory of Finance.
HOW TO CALCULATE RETURN ??
4 Return on an equity share consists of
dividend income; and
capital gain/loss
4 Under uncertainty situation, it is measured in terms
of EXPECTED RETURN.
4 And, expected return is defined as -

j
n
1 j
j i
p r ) R ( E

=
=
How to estimate RETURN from the
past data?
4 Return may be defined as
(P
1
- P
0
)/P
0
assuming that the compounding is discrete (one may
include any other cash flow that may arise during the period.).
Ln(P
1
/P
0
) assuming that the compounding is continuous (one
may include any other cash flow that may arise during the
period.).
4 The mean of the return can be taken as a proxy for
the Expected Return.

HOW TO CALCULATE RISK ??
4 Risk on equity is understood in the sense of variation;
higher the variation higher the risk; lower the
variation lower the risk.
4 Under certainty situation, there is no risk.
4 Under uncertainty situation, it is measured in terms
of STANDARD DEVIATION/VARIANCE/ COEFFICIENT OF
VARIATION.
4 And, variance is defined as -
2
i
i
2
j
n
1 j
2
i j i
)] R ( E [ ) R ( E
p )] R ( E r [( ) R ( Var
=
=

=
How to estimate RISK from the
past data?
4The Standard Deviation of the returns
can be taken as a proxy for Risk of a
security.

Markowitz said that since a security is
evaluated in terms of Risk and Return
parameters, a portfolio should also be
evaluated in terms of Risk and Return.
Return and Risk of a Portfolio
j i

) , ( ) (
) ( ) (
=
= = =
=

+ =
=
n
i
n
i
n
j
j i j i i i P
n
i
i i P
R R Cov R
R E R E
1 1 1
2 2
1
o o o o o
o
Where
E(R
P
) = Expected Return of the Portfolio
s(R
P
) = Standard Deviation of return on a portfolio
a
i
= Proportion of i
th
security in the portfolio
s
i
2
= Variance of i
th
security
E(R
i
) = Return on i
th
security
Cov(R
i
,R
j
) = Covariance between the return of i
th
security and the return of the j
th

security
Portfolio DIVERSIFY AWAY Risk ????!!!!!
Markowitz questioned NAVE
DIVERSIFICATION - a diversification that is
obtained by just adding a number of different
securities into a portfolio.
Can we really conclude that adding too many
securities simply into a portfolio reduce risk?
Markowitz said - not Necessarily.
It may be or may not be.
Then, what determines whether risk in a
portfolio can be reduced?
Markowitz said - it is the nature and the
degree of covariances existing among
securities that determine whether risk in a
portfolio could be reduced.
Diversification pays when the securities are
having less degree of correlation and negative
correlation.
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n


r = 1
r = -1
Markowitz Model of Portfolio
(Journal of Finance : 1952)
Assumptions:
The investor is rational.
The investor is risk averter.
Securities and portfolios can be evaluated only in terms of
two parameters - Mean and Variance.
Security Market is perfectly competitive.
Securities are perfectly divisible.
Investors have complete information about Mean,
Variance and Correlation of all securities.
Investors have one period as holding period.
Investors are not E(R) maximiser but E(U) maximiser and
U = f(Risk and Return)
Either Utility Function is quadratic or the returns are
following normal probability distribution.
Are you searching for an OPTIMUM
PORTFOLIO ???
If YES!? Then, first, look for an efficient set of portfolios.
A set of portfolios is called an efficient set if all the portfolios in it
are non-dominated portfolios in the sense of mean-variance
dominance principle.
MEAN - VARIANCE DOMINANCE PRINCIPLE says that a
portfolio is a dominating over the other portfolio if
for the same or more expected return a portfolio is having
same or less risk.
for the same or less risk a portfolio is having more expected
return.
MINIMUM VARIANCE SET OF
PORTFOLIOS?
It is a set of those portfolios which have minimum variance for a
given expected return on a portfolio.
It is usually referred as a BULLET because of its shape.
Standard Deviation O
If two or more portfolios
from minimum variance
set are combined, then the
resultant portfolio also has
minimum variance.
MINIMUM VARIANCE PORTFOLIOS -
SOME THEOREMS
=A portfolio with two shares will have minimum variance
if the weight of one of the shares in the portfolio will
be


=A portfolio of a group of shares that minimises the
return variance is the portfolio that has an equal
covariance with every share return.
2 1
2
2
1
2
2 1
2
2
2
x
o o o o
o o o
+

=
CHART SHOWING HOW TO FIND MINIMUM VARIANCE
PORTFOLIO
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.18
1
0
.
9
5
0
.
9
0
.
8
5
0
.
8
0
.
7
5
0
.
7
0
.
6
5
0
.
6
0
.
5
5
0
.
5
0
.
4
5
0
.
4
0
.
3
5
0
.
3
0
.
2
5
0
.
2
0
.
1
5
0
.
1
0
.
0
5 0
PROPORTION OF X AND (1-X) PROPORTION OF Y
V
A
R
I
A
N
C
E

A
N
D

C
O
V
A
R
I
A
N
C
E
S
COV(P,X)
COV(P,Y)
PORTFOLIO
VARIANCE
Can we have a zero risk portfolio???
Yes! We can have it if we can find
two securities having between them
perfect negative correlation.
And now, we start with
EFFICIENT FRONTIER
EFFICIENT FRONTIER ???
+ A curve that shows non-dominated
portfolios in terms of mean-variance
dominance is called EFFICIENT
FRONTIER.
+ No portfolio on it is dominated by
any one.
+ It always have positive slope.
+ It steepnees depends upon the
degree of correlation that exists
between portfolios.
+ It is concave with respect to risk
and convex with respect to
expected return.
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n


F
E
A B
C
X
Y
TWO - FUND SEPARATION
THEOREM
+This theorem says that-
+all portfolios on the mean - variance efficient
frontier can be formed as a weighted average of
any two portfolios(or funds) on the efficient
frontier.
OPTIMUM SELECTION OF A PORTFOLIO
DEPENDS UPON RISK - RETURN TRADE - OFF!!!
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n


F
E
OPTIMUM
PORTFOLIO
P
What is the most important
contribution of Markowitz model?
It is the concept of
Efficient Portfolio!!!
Is there
anything in the
Markowitz
Model at which
you would like to
ATTACK?
Limitations of Markowitz Model
+Large Volume of data required
+No consideration of risk free rate
+It does not explain how securities are priced in market.
+It is a normative model.
+It does not explain the market behaviour.
+It is not a multi-period model.
+It suggest that different persons can have different
portfolios of risk assets which is unlikely a case in a
perfectly competitive market.
+It shows that risk of a portfolio can be reduced to zero
that is again unrealistic conclusion in the real world.
One of the serious limitation of
the Markowitz Model is
+Huge data requirement!!!!



+Can we overcome this
problem?
Have you ever
wondered why
returns of shares
of companies from
various industries
are correlated?
Scatter Diagram
R = 0.289
-6
-4
-2
0
2
4
6
-10 -5 0 5 10 15
ACC (Return%)
R
I
L

(
R
e
t
u
r
n
%
)
SCATTER DIAGRAM OF RETURNS
-4
-2
0
2
4
6
8
10
-3 -2 -1 0 1 2 3 4
RANBAXY LABORATORIES LTD.(%)
S
T
A
T
E

B
A
N
K

O
F

I
N
D
I
A
(
%
)
R = 0.3027
SBI AND SAIL
R
2
= 0.208
-15
-10
-5
0
5
10
15
20
-10 -8 -6 -4 -2 0 2 4 6 8 10
RETURN OF SBI
R
E
T
U
R
N

O
F

S
A
I
L
ONGC & Ranbaxy Laboratories Ltd.
R
2
= 0.1468
-10
-5
0
5
10
15
-8 -6 -4 -2 0 2 4 6 8
RETURN OF ONGC
R
E
T
U
R
N

O
F

R
A
N
B
A
X
Y
What makes shares
return to have
correlation across
the companies from
the different
industries?
THINK!!!
Is there some
underlying
FACTOR
which makes
these
correlations
to exist?
If that factor exists, then your
data requirement will also be
considerably reduced!!!!
But, are we in a position
to identify that factor?
Yes!!!! We can identify that
factor...
And, this takes us to ...
c + | + o = Rm R
i
SHARPES SINGLE
FACTOR/INDEX MODEL



It is ex-post relationship.
It shows how a factor leads to generation of returns in
a security.
Its intercept represents unique return of a security
which is independent of Market Index.
The slope of the Single Index Model represents | which
is a measure of SYSTEMATIC RISK.
c + | + o = Rm R
i
+It is a linear relation between the return of a security
and the underlying factor which is the MARKET
INDEX.

Systematic Risk
Vs. Unsystematic Risk
Systematic Risk: Return on an asset is systemically influenced
by return on market portfolio; hence if any variation in the return of an
asset is explained by the variation in the market return, then such a
variation is called SYSTEMATIC RISK.
+Such a risk is caused mainly by the macro factors; and
+it is non-diversifiable risk.
Unsystematic Risk: Any variation in the return of an asset that
is not explained by the variation in the market return and is
independent of the market risk, or that resides within the asset itself
is called UNSYSTEMATIC RISK.
+Such a risk is caused mainly by the micro factors; and
+it is diversifiable risk.
CHARACTERISTIC LINE
A regression line fitted to the scatter plot of returns from the
market portfolio and a security is called CHARACTERISTIC
LINE.
This is also a line that gives us the estimates of the parameters of
the Single Factor Model.
The slope of the characteristic line is called | that represents
SYSTEMATIC RISK.
It is called a characteristic line as its slope showing the risk
characteristics of a security which is different for different
securities.
CHARACTERISTICS LINE
y = 0.4619x - 0.2251
R
2
= 0.1813
-3
-2
-1
0
1
2
3
-1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3
COMPONENTS OF TOTAL RISK OF A
SECURITY
Total Risk of a security is determined by the variance of the
returns.
It is equal to Unsystematic Risk and Systematic Risk. That is---
TOTAL RISK = UNSYSTEMATIC RISK + SYSTEMATIC
RISK.
Where
Total Risk of i
th
security = o
i
2
;
Systematic Risk = |
i
2
o
m
2
; and
Unsystematic Risk = Total Risk - Systematic Risk = o
i
2
|
i
2
o
m
2
.
R
2
represents proportion of total risk which is SYSTEMATI C.

Is there any statistical measure that can tell us -
out of total variation, how much per cent
variation is due to systematic part and how
much is due to unsystematic part?
YES!!!
It is R
2
. It represents proportion of total risk which is
SYSTEMATIC.


In what way, the information of R
2
is useful for an
investment manager?
ESTIMATION OF
The estimation of | of a security needs the following
steps:
First, identify a suitable MARKET INDEX.
Collect information about the prices of the security and
the Index.
Fit the regression equation on the returns of the security
and the Index where the security return will be taken as a
dependent variable and the return on the Index will be
taken as an independent variable.
What next?
Dr. Vibha Jain
WHATS THE
WORTH OF A
CAPITAL
ASSETS???
CAPITAL ASSET PRICING MODEL
It is a model that tries to answer the following questions:
=What is the relevant CHOICE SET OF SECURITIES/PORTFOLIOS given
the risk free asset and risky assets?
=How investors select the final OPTIMAL PORTFOLIO?
=What risk is considered by the market in pricing a security?
=What should be the equilibrium return and price?
It makes use of the foundations built by the Markowitz
Model and the Single Factor Model of Sharpe.
Its main contribution is LINEARITY and SIMPLICITY.
Assumptions of Capital Assets Pricing
Model
Investments are judged on the basis of risk and return
associated with them.
Returns are visualized in stochastic manner by investors.
Investors maximise their expected utility function which is
determined by return and risk.
Investors are rational investors.
Investors are risk averse.
Market is perfectly competitive.
Market is frictionless i.e. it has no transaction cost and
information is also cost free.
Assumptions of Capital Assets Pricing
Model(continued)
Capital assets are perfectly divisible.
Investors can have unlimited borrowing and lending at risk
free rate.
All investors have homogenous probability distributions and
expected returns for future returns.
All investors have same one holding period time horizon.
All investors are Markowitz efficient.
None is expecting any unanticipated inflation.
All assets are available in fixed quantities.
Capital market is in equilibrium.
WHAT HAPPENS TO EFFICIENT
FRONTIER WHEN A RISK FREE ASSET IS
INTRODUCED INTO CAPITAL MARKET???
Will it be a non-linear
or
linear ???
EFFICIENT FRONTIER
becomes a straight line that is
tangent to Markowitz Efficient
Frontier and it is called
CAPITAL MARKET LINE.
Capital Market Line (CML)
=CML is a line rising from the risk free rate, R
f
, on the vertical axis and
tangential to the Markowitz Efficient Frontier at M, which is market
portfolio.
=It consists of efficient portfolios constructed by combing risk free security
and market portfolio.
=It represents equilibrium in the capital market.
M
R
f

Lending
Borrowing
Risk
o
M

Capital Market Line (CML)
(continued)
=All risky assets are included in the market portfolio to extent of their
supply.
=All portfolios on CML are perfectly correlated with the market portfolio
and it implies that they are completely diversified and hence, possesses no
unsystematic risk.
=CML relates the expected rate of return of an efficient portfolio to its
standard deviation.
=The equation of CML is -

P
M
F M
F P
R R E
R R E o
o

+ =
) (
) (
E The slope of CML represents the price per unit of risk.
E It does not show how the expected rate of return of an asset relates to
its individual risk.
E Every portfolio on the efficient frontier has perfectly positive correlation
with the market portfolio and hence, all variations in it are explained by
the market portfolio. Thus, they have no diversifiable risk.
E Therefore, in an equilibrium situation, the market will price only
systematic risk and |eta measures the systematic risk. This is known as
the SYSTEMATIC RISK PRINCIPLE which states that the expected
return on an asset depends only on its systematic risk.
Capital Market Line (CML)
(continued)
Why is the portfolio at which the
new efficient frontier is tangent to
the Markowitz Efficient Frontier
called MARKET PORTFOLIO?
ONE - FUND THEOREM
It says that
one can generate an Efficient Portfolio by taking
only ONE FUND and that is, the Market Portfolio
and combine it with a risk free asset.
WHICH PORTFOLIO FROM CML SHOULD
BE SELECTED BY AN INVESTOR???
Depending upon an investors return - risk trade-off which is
reflected in his indifference map, he selects an optimum
portfolio for himself.
M
R
f

Risk
A
B
o
M

ARE Investment Decisions and


Financing Decisions



independent ???
TOBINS SEPARATION THEOREM
* Decision to invest in a capital asset has two
stages:
How to find the proportion of optimal portfolio of
risky assets? [I nvestment Decision ] and
How to finance the portfolio of risky assets?
[Financing Decision ]
TOBINS SEPARATION THEOREM
(continued)
* Investment Decision is same for all investors as every one
selects the market portfolio of risky assets.
* Financing Decision is left for the individual investor. He/she
can decide how much to borrow or to lend at risk free rate
depending upon his/her degree of risk averseness.
* Thus, investment decision and financing decision of each
investor are totally independent
=investment decisions are same for all; and
=financing decisions are different and independent of investment decisions.
qSML is a line drawn in E(R) and | space.
qIt shows a linear relation between a securitys expected
return and its |.
qSecurity lying above SML is under-priced while security
below SML is over-priced.
qSecurity lying to the right of | = 1 is aggressive while
security on the left of | = 1 is defensive.
qThe equation of SML is:
E(R
i
) = R
F
+ ( E(R
M
) - R
F
) |
i

SECURITY MARKET LINE (SML)
qThe equation of SML is called CAPITAL ASSET
PRICING MODEL.
qE(R
M
)

- R
F
is called risk premium per unit of systematic
risk.
SECURITY MARKET LINE (SML)
R
f

SML
M
| =1
|
Aggressive Security
Defensive Security
What should be the price of a
security in an equilibrium capital
market ???
CAPM directly does not provide price of a security. However,
indirectly through expected return, it provides price as return
and price are inversely related.
Let P
1
and P
0
represent price of a security at time 1 and time 0
respectively. Also, if P
1
is the expected price, then by definition,
the expected return, E(R), would be:
} ) ) ( ( {
) ) ( (
) (
|
|
F M F
F M F
R R E R
P
P
P
P P
R R E R
P
P P
R E
+ +
=

= +

=
1
1
0
0
0 1
0
0 1
CAPM and
its IMPLICATIONS
CAPM makes investment decision simple. J ust buy market portfolio.
CAPM helps in identifying over - and under - priced securities.
CAPM helps in the performance evaluation of an investment portfolio. A
number of measures are developed to evaluate a portfolio. They are:
6 Jensens Index
6 Sharpes Index
6 Treynors Index
CAPM says Simplified diversification works .
CAPM is very useful in capital budgeting decisions. It helps in finding:
6 Certainty Equivalent; and
6 Risk Adjusted Discount Rate
SFM - a linear relation between the return of a security and the underlying factor.
CAPM - a linear relation between the return of a security and its |.
SFM - represents ex-post relationship while CAPM represents ex-ante relationship.
SFM - shows how a factor leads to generation of returns in a security, i.e. it shows return generating
process while CAPM shows how the market price a security and how much risk premium, the
market is willing to pay for one unit of systematic risk.
SFM - its intercept represents unique return of a security when the return on the factor is zero while
the intercept of CAPM represents risk free rate.
The slope of SFM represents | while the slope of CAPM represents the risk premium.
CAPM
vs.
SINGLE FACTOR MODEL
What next?
References ...
1. Investments Analysis and Management Charles P. Jones; John Wiley & Sons, Inc. (CPJ)
2. Investments: Analysis and Management - Jack Clark Francis; McGraw Hill International Editions,
McGraw-Hill, Inc. New York. (CF)
3. Security Analysis and Portfolio Management - Donald E. Fischer and Ronald J. Jordan; Prentice
- Hall of India Private Limited; New Delhi. (FJ)
4. Modern Portfolio Theory and Investment Analysis - Edwin J Elton and Martin J Gruber; John
Wiley, New York. (EG)
5. Portfolio Construction, Management and Protection - Robert A. Strong; South-Western College
Publishing, Thomson Learning, USA. (RS)
6. Introduction to Investments - Haim Levy; South-Western College Publishing, Thomson Learning,
USA. (HL)
7. Investments-An introduction - Herbert B. Mayo; The Dryden Press, Harcourt College Publishers,
USA. (MA)
8. Quantitative Analysis for Investment Management - Robert A. Taggart; Prentice-Hall, New
Jersey, USA. (RT)
9. Investment Science - D. G. Luenberger; Oxford University Press, 1998
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