Analysis of Investments and Management of Portfolios

by Keith C. Brown & Frank K. Reilly

An Introduction to Asset Pricing Models

Capital Market Theory: An Overview

Chapter 8

The Capital Asset Pricing Model Empirical Tests of the CAPM

Capital Market Theory: An Overview

Capital market theory extends portfolio theory and develops a model for pricing all risky assets, while capital asset pricing model (CAPM) will allow you to determine the required rate of return for any risky asset

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 Relationship between risk and return

Return SML

Return i

The higher the Risk i Risk , The higher the required return. SML can be used to generate risk-adjusted discount rates to be used in Financial decisions.

Risk

Risk and Rate of Return

Portfolio Rate of Return : Average weighted return on the portfolio as a whole. Standard deviation : reflection of risk inherent in the portfolio. It measures the extent of possible outcomes are likely to be different from the mean outcome

The correlation coefficient , the covariance

Direct way to find portfolio risk by dealing with the interrelatedness of Assets returns. It is a number that can take values from -1 (perfect negative relatedness) to +1 ( perfect positive relatedness). *The more positively related securities in portfolio, the less gain from diversification.

Risk, Diversification & the Market Portfolio

Systematic Risk
Only systematic risk remains in the market portfolio Systematic risk is the variability in all risky assets caused by macroeconomic variables
Variability in growth of money supply Interest rate volatility Variability in factors like (1) industrial production (2) corporate earnings (3) cash flow

Systematic risk can be measured by the standard deviation of returns of the market portfolio and can change over time

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Risk, Diversification & the Market Portfolio

Diversification and the Elimination of Unsystematic Risk
The purpose of diversification is to reduce the standard deviation of the total portfolio This assumes that imperfect correlations exist among securities As you add securities, you expect the average covariance for the portfolio to decline How many securities must you add to obtain a completely diversified portfolio? See Exhibit 8.3
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Exhibit 8.3

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Beta Coefficient ( Regression coefficient) B coefficient express relationship between the return expected from security and that expected from the market as whole j=
Standard deviation Correlation of j

of return j

with the Market

Standard deviation of Market Return

i.e = j Pjm m Same as j m Pjm 2m

Covariance j with Market
variance of Market

j = j m 2m

The Capital Asset Pricing Model

Calculating Systematic Risk
The formula

si Cov ( Ri , RM ) bi = riM = 2 sM sM

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The Capital Asset Pricing Model

Let i=(i riM) / M be the asset beta measuring the relative risk with the market, the systematic risk The CAPM indicates what should be the expected or required rates of return on risky assets

This helps to value an asset by providing an appropriate discount rate to use in dividend valuation models
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E(Ri ) = RFR bi [E(RM ) RFR ]

The Capital Asset Pricing Model

The Security Market Line (SML)
The SML is a graphical form of the CAPM Exhibit 8.5 shows the relationship between the expected or required rate of return and the systematic risk on a risky asset The expected rate of return of a risk asset is determined by the RFR plus a risk premium for the individual asset The risk premium is determined by the systematic risk of the asset (beta) and the prevailing market risk premium (RM-RFR)
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Exhibit 8.5

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 Example:

If Market return move from 12% to 14% a security with return of 15% and of 1.3 will move to 15% +1.3 (14%-12%) = 17.6%

The Capital Asset Pricing Model

Determining the Expected Rate of Return
Risk-free rate is 5% and the market return is 9%
Stock
Beta

A
0.70

B
1.00

C
1.15

D
1.40

E
-0.30

Applying E(Ri ) = RFR bi [E(RM ) RFR ]

E(RA) = 0.05 + 0.70 (0.09-0.05) = 0.078 = 7.8% E(RB) = 0.05 + 1.00 (0.09-0.05) = 0.090 = 09.0% E(RC) = 0.05 + 1.15 (0.09-0.05) = 0.096 = 09.6% E(RD) = 0.05 + 1.40 (0.09-0.05) = 0.106 = 10.6% E(RE) = 0.05 + -0.30 (0.09-0.05) = 0.038 = 03.8%
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The Capital Asset Pricing Model

Identifying Undervalued & Overvalued Assets
In equilibrium, all assets and all portfolios of assets should plot on the SML Any security with an estimated return that plots above the SML is underpriced

Any security with an estimated return that plots below the SML is overpriced

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The Capital Asset Pricing Model

Compare the required rate of return to the estimated rate of return for a specific risky asset using the SML over a specific investment horizon to determine if it is an appropriate investment Exhibit 8.8 shows A, C and E are underpriced but B and D are over priced because Stock Required Return Estimated Return
A B C D E
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7.8% 9.0% 9.6% 10.6% 3.8%

8.0% 6.2% 15.15% 5.15% 6.0%

Exhibit 8.8

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Empirical Tests of the CAPM

Stability of Beta
Betas for individual stocks are not stable Portfolio betas are reasonably stable The larger the portfolio of stocks and longer the period, the more stable the beta of the portfolio

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Summary
The relevant risk measure for an individual risky asset is its systematic risk or covariance with the market portfolio SML is derived to show the relationship between the required return and its systematic risk for any risky asset Assuming security markets are not always completely efficient, you can identify undervalued and overvalued securities by comparing your estimate of the rate of return on an investment to its required rate of return
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The Internet Investments Online

http://www.valueline.com http://www.wsharpe.com http://gsb.uchicago.edu/fac/eugene.fama/ http://www.moneychimp.com

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