Investment Analysis and Portfolio Management

An Introduction to Portfolio Management

Questions to be answered: What do we mean by risk aversion and what evidence indicates that investors are generally risk averse? What are the basic assumptions behind the Markowitz portfolio theory? What is meant by risk and what are some of the alternative measures of risk used in investments?

An Introduction to Portfolio Management

How do you compute the expected rate of return for an individual risky asset or a portfolio of assets? How do you compute the standard deviation of rates of return for an individual risky asset? What is meant by the covariance between rates of return and how do you compute covariance?

An Introduction to Portfolio Management

What is the relationship between covariance and correlation? What is the formula for the standard deviation for a portfolio of risky assets and how does it differ from the standard deviation of an individual risky asset? Given the formula for the standard deviation of a portfolio, why and how do you diversify a portfolio?

An Introduction to Portfolio Management

What happens to the standard deviation of a portfolio when you change the correlation between the assets in the portfolio? What is the risk-return efficient frontier? Is it reasonable for alternative investors to select different portfolios from the portfolios on the efficient frontier? What determines which portfolio on the efficient frontier is selected by an individual investor?

Background Assumptions
As an investor you want to maximize the returns for a given level of risk. Your portfolio includes all of your assets and liabilities The relationship between the returns for assets in the portfolio is important. A good portfolio is not simply a collection of individually good investments.

Risk Aversion
Given a choice between two assets with equal rates of return, most investors will select the asset with the lower level of risk.

Evidence That Investors are Risk Averse

Many investors purchase insurance for: Life, Automobile, Health, and Disability Income. The purchaser trades known costs for unknown risk of loss Yield on bonds increases with risk classifications from AAA to AA to A.

Not all Investors are Risk Averse

Risk preference may have to do with amount of money involved - risking small amounts, but insuring large losses

Definition of Risk
1. Uncertainty of future outcomes or 2. Probability of an adverse outcome

Markowitz Portfolio Theory

Quantifies risk Derives the expected rate of return for a portfolio of assets and an expected risk measure Shows that the variance of the rate of return is a meaningful measure of portfolio risk Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a portfolio

Assumptions of Markowitz Portfolio Theory

1. Investors consider each investment alternative as being presented by a probability distribution of expected returns over some holding period.

Assumptions of Markowitz Portfolio Theory

2. Investors maximize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth.

Assumptions of Markowitz Portfolio Theory

3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.

Assumptions of Markowitz Portfolio Theory

4. Investors base decisions solely on expected return and risk, so their utility curves are a function of expected return and the expected variance (or standard deviation) of returns only.

Assumptions of Markowitz Portfolio Theory

5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of expected returns, investors prefer less risk to more risk.

Markowitz Portfolio Theory

Using these five assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return.

Alternative Measures of Risk

Variance or standard deviation of expected return Range of returns Returns below expectations
Semivariance a measure that only considers deviations below the mean These measures of risk implicitly assume that investors want to minimize the damage from returns less than some target rate

Expected Rates of Return

For an individual asset - sum of the potential returns multiplied with the corresponding probability of the returns For a portfolio of investments - weighted average of the expected rates of return for the individual investments in the portfolio

Computation of Expected Return for an Individual Risky Investment

Exhibit 7.1

Probability 0.35 0.30 0.20 0.15

Possible Rate of Return (Percent) 0.08 0.10 0.12 0.14

Expected Return (Percent) 0.0280 0.0300 0.0240 0.0210 E(R) = 0.1030

Computation of the Expected Return for a Portfolio of Risky Assets

Weight (Wi ) (Percent of Portfolio) 0.20 0.30 0.30 0.20 Expected Security Return (R i ) 0.10 0.11 0.12 0.13
n

Expected Portfolio Return (Wi X Ri ) 0.0200 0.0330 0.0360 0.0260 E(Rport) 0.1150
Exhibit 7.2

E(R port) Wi R i
i 1

where : Wi the percent of the portfolio in asset i E(R i ) the expected rate of return for asset i

Variance (Standard Deviation) of Returns for an Individual Investment

Variance is a measure of the variation of possible rates of return Ri, from the expected rate of return [E(Ri)] Standard deviation is the square root of the variance

Variance (Standard Deviation) of Returns for an Individual Investment

Variance ( ) [R i - E(R i )] Pi
2 2 i 1

where Pi is the probability of the possible rate of return, Ri

Variance (Standard Deviation) of Returns for an Individual Investment

Standard Deviation

( )

[R
i 1

- E(R i )] Pi

Variance (Standard Deviation) of Returns for an Individual Investment

Exhibit 7.3
Possible Rate of Return (R i ) 0.08 0.10 0.12 0.14 Expected Return E(R i ) 0.103 0.103 0.103 0.103 Ri - E(R i ) -0.023 -0.003 0.017 0.037 [Ri - E(Ri )] 0.0005 0.0000 0.0003 0.0014
2

Pi 0.35 0.30 0.20 0.15

[Ri - E(R i )] Pi 0.000185 0.000003 0.000058 0.000205 0.000451

Variance ( 2) = .000451 Standard Deviation ( ) = .021237

Covariance of Returns
A measure of the degree to which two variables move together relative to their individual mean values over time

Covariance of Returns
For two assets, i and j, the covariance of rates of return is defined as: Covij = E{[Ri - E(Ri)] [Rj - E(Rj)]}

Covariance and Correlation

The correlation coefficient is obtained by standardizing (dividing) the covariance by the product of the individual standard deviations

Covariance and Correlation

Correlation coefficient varies from -1 to +1 Cov ij rij

i j

where : rij the correlatio n coefficien t of returns

i the standard deviation of R it j the standard deviation of R jt

Correlation Coefficient
It can vary only in the range +1 to -1. A value of +1 would indicate perfect positive correlation. This means that returns for the two assets move together in a completely linear manner. A value of 1 would indicate perfect correlation. This means that the returns for two assets have the same percentage movement, but in opposite directions

Portfolio Standard Deviation Formula

port
where :

w
i 1 2 i

2 i

w i w j Cov ij
i 1 i 1

port the standard deviation of the portfolio

Wi the weights of the individual assets in the portfolio, where weights are determined by the proportion of value in the portfolio

i2 the variance of rates of return for asset i

Cov ij the covariance between th e rates of return for assets i and j, where Cov ij rij i j

Portfolio Standard Deviation Calculation

Any asset of a portfolio may be described by two characteristics:
The expected rate of return The expected standard deviations of returns

The correlation, measured by covariance, affects the portfolio standard deviation Low correlation reduces portfolio risk while not affecting the expected return

Combining Stocks with Different Returns and Risk

Asset
1
2

E(R i )
.10
.20

.50

Wi

2i
.0049
.0100

.07
.10

.50

Case a b c d e

Correlation Coefficient +1.00 +0.50 0.00 -0.50 -1.00

Covariance .0070 .0035 .0000 -.0035 -.0070

Combining Stocks with Different Returns and Risk

Assets may differ in expected rates of return and individual standard deviations Negative correlation reduces portfolio risk Combining two assets with -1.0 correlation reduces the portfolio standard deviation to zero only when individual standard deviations are equal

Constant Correlation with Changing Weights

Asset
1
2

E(R i )
.10
.20

rij = 0.00

Case f g h i j k l

W1 0.00 0.20 0.40 0.50 0.60 0.80 1.00

W2 1.00 0.80 0.60 0.50 0.40 0.20 0.00

E(Ri ) 0.20 0.18 0.16 0.15 0.14 0.12 0.10

Constant Correlation with Changing Weights

Case f g h i j k l W1 0.00 0.20 0.40 0.50 0.60 0.80 1.00 W2 1.00 0.80 0.60 0.50 0.40 0.20 0.00 E(Ri ) 0.20 0.18 0.16 0.15 0.14 0.12 0.10 E(F ) port 0.1000 0.0812 0.0662 0.0610 0.0580 0.0595 0.0700

Portfolio Risk-Return Plots for Different Weights

E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

With two perfectly correlated assets, it is only possible to create a two asset portfolio with riskreturn along a line between either single asset

Rij = +1.00 1

Standard Deviation of Return

Portfolio Risk-Return Plots for Different Weights

E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

f With uncorrelated h assets it is possible i j to create a two Rij = +1.00 asset portfolio with k lower risk than 1 either single asset Rij = 0.00 g

Standard Deviation of Return

Portfolio Risk-Return Plots for Different Weights

E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

f With correlated h assets it is possible i j to create a two Rij = +1.00 asset portfolio k Rij = +0.50 between the first 1 two curves Rij = 0.00 g

Standard Deviation of Return

Portfolio Risk-Return Plots for Different Weights

E(R) With 0.20 negatively correlated assets it is 0.15 possible to create a two 0.10 asset portfolio with much 0.05 lower risk than either single asset
-

Rij = -0.50 g h j k i

Rij = +1.00 1 Rij = 0.00 Rij = +0.50

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

Portfolio Risk-Return Plots for Exhibit 7.13 Different Weights

E(R)
0.20 0.15 0.10 0.05 -

Rij = -0.50

f g

Rij = -1.00
h j k i

Rij = +1.00 Rij = +0.50

1 Rij = 0.00 With perfectly negatively correlated assets it is possible to create a two asset portfolio with almost no risk

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

Estimation Issues
Results of portfolio allocation depend on accurate statistical inputs Estimates of
Expected returns Standard deviation Correlation coefficient
Among entire set of assets With 100 assets, 4,950 correlation estimates

Estimation risk refers to potential errors

Estimation Issues
With assumption that stock returns can be described by a single market model, the number of correlations required reduces to the number of assets Single index market model:

R i a i bi R m i

bi = the slope coefficient that relates the returns for security i to the returns for the aggregate stock market Rm = the returns for the aggregate stock market

Estimation Issues
If all the securities are similarly related to the market and a bi derived for each one, it can be shown that the correlation coefficient between two securities i and j is given as: 2 m rij b i b j i j
2 where m the variance of returns for the

aggregate stock market

The Efficient Frontier

The efficient frontier represents that set of portfolios with the maximum rate of return for every given level of risk, or the minimum risk for every level of return Frontier will be portfolios of investments rather than individual securities
Exceptions being the asset with the highest return and the asset with the lowest risk

Efficient Frontier for Alternative Portfolios Exhibit 7.15

E(R)

Efficient Frontier

Standard Deviation of Return

The Efficient Frontier and Investor Utility

An individual investors utility curve specifies the trade-offs he is willing to make between expected return and risk The slope of the efficient frontier curve decreases steadily as you move upward These two interactions will determine the particular portfolio selected by an individual investor

The Efficient Frontier and Investor Utility

The optimal portfolio has the highest utility for a given investor It lies at the point of tangency between the efficient frontier and the utility curve with the highest possible utility

Selecting an Optimal Risky Portfolio Exhibit 7.16

E(R port )
U3 U2
U1

Y U3 X U1

U2

E( port )

An Introduction to Asset Pricing Models

Questions to be answered: What are the assumptions of the capital asset pricing model? What is a risk-free asset and what are its risk-return characteristics? What is the covariance and correlation between the risk-free asset and a risky asset or portfolio of risky assets?

An Introduction to Asset Pricing Models

What is the expected return when you combine the risk-free asset and a portfolio of risky assets? What is the standard deviation when you combine the risk-free asset and a portfolio of risky assets? When you combine the risk-free asset and a portfolio of risky assets on the Markowitz efficient frontier, what does the set of possible portfolios look like?

An Introduction to Asset Pricing Models

Given the initial set of portfolio possibilities with a risk-free asset, what happens when you add financial leverage (that is, borrow)? What is the market portfolio, what assets are included in this portfolio, and what are the relative weights for the alternative assets included? What is the capital market line (CML)? What do we mean by complete diversification?

An Introduction to Asset Pricing Models

How do we measure diversification for an individual portfolio? What are systematic and unsystematic risk? Given the capital market line (CML), what is the separation theorem? Given the CML, what is the relevant risk measure for an individual risky asset? What is the security market line (SML) and how does it differ from the CML?

An Introduction to Asset Pricing Models

What is beta and why is it referred to as a standardized measure of systematic risk? How can you use the SML to determine the expected (required) rate of return for a risky asset? Using the SML, what do we mean by an undervalued and overvalued security, and how do we determine whether an asset is undervalued or overvalued?

An Introduction to Asset Pricing Models

What is an assets characteristic line and how do you compute the characteristic line for an asset? What is the impact on the characteristic line when you compute it using different return intervals (e.g., weekly versus monthly) and when you employ different proxies (i.e., benchmarks) for the market portfolio (e.g., the S&P 500 versus a global stock index)?

An Introduction to Asset Pricing Models

What happens to the capital market line (CML) when you assume there are differences in the riskfree borrowing and lending rates? What is a zero-beta asset and how does its use impact the CML? What happens to the security line (SML) when you assume transaction costs, heterogeneous expectations, different planning periods, and taxes?

An Introduction to Asset Pricing Models

What are the major questions considered when empirically testing the CAPM? What are the empirical results from tests that examine the stability of beta? How do alternative published estimates of beta compare? What are the results of studies that examine the relationship between systematic risk and return?

An Introduction to Asset Pricing Models

What other variables besides beta have had a significant impact on returns? What is the theory regarding the market portfolio and how does this differ from the market proxy used for the market portfolio? Assuming there is a benchmark problem, what variables are affected by it?

Capital Market Theory: An Overview

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

Assumptions of Capital Market Theory

1. All investors are Markowitz efficient investors who want to target points on the efficient frontier.
The exact location on the efficient frontier and, therefore, the specific portfolio selected, will depend on the individual investors risk-return utility function.

Assumptions of Capital Market Theory

2. Investors can borrow or lend any amount of

money at the risk-free rate of return (RFR).

Clearly it is always possible to lend money at the nominal risk-free rate by buying risk-free securities such as government T-bills. It is not always possible to borrow at this risk-free rate, but we will see that assuming a higher borrowing rate does not change the general results.

Assumptions of Capital Market Theory

3. All investors have homogeneous expectations; that is, they estimate identical probability distributions for future rates of return.
Again, this assumption can be relaxed. As long as the differences in expectations are not vast, their effects are minor.

Assumptions of Capital Market Theory

4. All investors have the same one-period time horizon such as one-month, six months, or one year.
The model will be developed for a single hypothetical period, and its results could be affected by a different assumption. A difference in the time horizon would require investors to derive risk measures and risk-free assets that are consistent with their time horizons.

Assumptions of Capital Market Theory

5. All investments are infinitely divisible, which means that it is possible to buy or sell fractional shares of any asset or portfolio.
This assumption allows us to discuss investment alternatives as continuous curves. Changing it would have little impact on the theory.

Assumptions of Capital Market Theory

6. There are no taxes or transaction costs involved in buying or selling assets.
This is a reasonable assumption in many instances. Neither pension funds nor religious groups have to pay taxes, and the transaction costs for most financial institutions are less than 1 percent on most financial instruments. Again, relaxing this assumption modifies the results, but does not change the basic thrust.

Assumptions of Capital Market Theory

7. There is no inflation or any change in interest rates, or inflation is fully anticipated.
This is a reasonable initial assumption, and it can be modified.

Assumptions of Capital Market Theory

8. Capital markets are in equilibrium.
This means that we begin with all investments properly priced in line with their risk levels.

Assumptions of Capital Market Theory

Some of these assumptions are unrealistic Relaxing many of these assumptions would have only minor influence on the model and would not change its main implications or conclusions. A theory should be judged on how well it explains and helps predict behavior, not on its assumptions.

Risk-Free Asset
An asset with zero standard deviation Zero correlation with all other risky assets Provides the risk-free rate of return (RFR) Will lie on the vertical axis of a portfolio graph

Covariance with a Risk-Free Asset

Covariance between two sets of returns is n
i 1

Cov ij [R i - E(R i )][R j - E(R j )]/n

Because the returns for the risk free asset are certain,

RF 0

Thus Ri = E(Ri), and Ri - E(Ri) = 0

Consequently, the covariance of the risk-free asset with any risky asset or portfolio will always equal zero. Similarly the correlation between any risky asset and the risk-free asset would be zero.

Combining a Risk-Free Asset with a Risky Portfolio

Expected return the weighted average of the two returns

E(R port ) WRF (RFR) (1 - WRF )E(R i )

This is a linear relationship

Combining a Risk-Free Asset with a Risky Portfolio

Standard deviation
The expected variance for a two-asset portfolio is

E(

2 port

) w w 2w 1 w 2 r1,2 1 2
2 1 2 1 2 2 2 2

Substituting the risk-free asset for Security 1, and the risky asset for Security 2, this formula would become
2 2 E( port ) w 2 RF (1 w RF ) 2 i2 2w RF (1 - w RF )rRF,i RF i RF

Since we know that the variance of the risk-free asset is zero and the correlation between the risk-free asset and any risky asset i is zero we can adjust the formula
2 E( port ) (1 w RF ) 2 i2

Combining a Risk-Free Asset with a Risky Portfolio

Given the variance formula
the standard deviation is
2 E( port ) (1 w RF ) 2 i2

E( port ) (1 w RF ) 2 i2

(1 w RF ) i
Therefore, the standard deviation of a portfolio that combines the risk-free asset with risky assets is the linear proportion of the standard deviation of the risky asset portfolio.

Combining a Risk-Free Asset with a Risky Portfolio

Since both the expected return and the standard deviation of return for such a portfolio are linear combinations, a graph of possible portfolio returns and risks looks like a straight line between the two assets.

Portfolio Possibilities Combining the Risk-Free Asset and Risky Portfolios on the Efficient Frontier

E(R port )

Exhibit 8.1

D M C B

RFR

E( port )

Risk-Return Possibilities with Leverage

To attain a higher expected return than is available at point M (in exchange for accepting higher risk) Either invest along the efficient frontier beyond point M, such as point D Or, add leverage to the portfolio by borrowing money at the risk-free rate and investing in the risky portfolio at point M

Portfolio Possibilities Combining the Risk-Free Asset and Risky Portfolios on the Efficient Frontier

E(R port )

Exhibit 8.2

RFR

E( port )

The Market Portfolio

Because portfolio M lies at the point of tangency, it has the highest portfolio possibility line Everybody will want to invest in Portfolio M and borrow or lend to be somewhere on the CML Therefore this portfolio must include ALL RISKY ASSETS

The Market Portfolio

Because the market is in equilibrium, all assets are included in this portfolio in proportion to their market value

The Market Portfolio

Because it contains all risky assets, it is a completely diversified portfolio, which means that all the unique risk of individual assets (unsystematic risk) is diversified away

Systematic Risk
Only systematic risk remains in the market portfolio Systematic risk is the variability in all risky assets caused by macroeconomic variables Systematic risk can be measured by the standard deviation of returns of the market portfolio and can change over time

Examples of Macroeconomic Factors Affecting Systematic Risk

Variability in growth of money supply Interest rate volatility Variability in
industrial production corporate earnings cash flow

How to Measure Diversification

All portfolios on the CML are perfectly positively correlated with each other and with the completely diversified market Portfolio M A completely diversified portfolio would have a correlation with the market portfolio of +1.00

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?

Diversification and the Elimination of Unsystematic Risk

Observe what happens as you increase the sample size of the portfolio by adding securities that have some positive correlation

Number of Stocks in a Portfolio and the Standard Deviation of Portfolio Return

Standard Deviation of Return Unsystematic (diversifiable) Risk

Exhibit 8.3

Total Risk

Standard Deviation of the Market Portfolio (systematic risk)

Systematic Risk

Number of Stocks in the Portfolio

The CML and the Separation Theorem

The CML leads all investors to invest in the M portfolio Individual investors should differ in position on the CML depending on risk preferences How an investor gets to a point on the CML is based on financing decisions Risk averse investors will lend part of the portfolio at the risk-free rate and invest the remainder in the market portfolio

The CML and the Separation Theorem

Investors preferring more risk might borrow funds at the RFR and invest everything in the market portfolio

The CML and the Separation Theorem

The decision of both investors is to invest in portfolio M along the CML (the investment decision)
E ( R port )
B CML

A PFR

port

The CML and the Separation Theorem

The decision to borrow or lend to obtain a point on the CML is a separate decision based on risk preferences (financing decision)

The CML and the Separation Theorem

Tobin refers to this separation of the investment decision from the financing decision, the separation theorem

A Risk Measure for the CML

Covariance with the M portfolio is the systematic risk of an asset The Markowitz portfolio model considers the average covariance with all other assets in the portfolio The only relevant portfolio is the M portfolio

A Risk Measure for the CML

Together, this means the only important consideration is the assets covariance with the market portfolio

A Risk Measure for the CML

Because all individual risky assets are part of the M portfolio, an assets rate of return in relation to the return for the M portfolio may be described using the following linear model: where:

R it a i b i R Mi

Rit = return for asset i during period t ai = constant term for asset i

bi = slope coefficient for asset i

RMt = return for the M portfolio during period t

= random error term

Variance of Returns for a Risky Asset

Var(R it ) Var (a i b i R Mi ) Var (a i ) Var (b i R Mi ) Var ( ) 0 Var (b i R Mi ) Var ( )

Note that Var (b i R Mi ) is variance related to market return or systematic risk Var ( ) is the residual return not related to the market portfolio or unsystemat ic risk

The Capital Asset Pricing Model: Expected Return and Risk

The existence of a risk-free asset resulted in deriving a capital market line (CML) that became the relevant frontier An assets covariance with the market portfolio is the relevant risk measure This can be used to determine an appropriate expected rate of return on a risky asset - the capital asset pricing model (CAPM)

The Capital Asset Pricing Model: Expected Return and Risk

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 You can compare an estimated rate of return to the required rate of return implied by CAPM - over/under valued ?

The Security Market Line (SML)

The relevant risk measure for an individual risky asset is its covariance with the market portfolio (Covi,m) This is shown as the risk measure The return for the market portfolio should be consistent with its own risk, which is the covariance of the market with itself - or its 2 variance: m

Exhibit 8.5

Graph of Security Market Line (SML)

E(R i )
SML

Rm

RFR

2 m

Cov im

The Security Market Line (SML)

The equation for the risk-return line is R M - RFR E(R i ) RFR (Cov i,M ) 2

M Cov i,M RFR (R M - RFR) 2 M Cov i,M as beta ( ) We then define i 2 M

E(R i ) RFR i (R M - RFR)

Exhibit 8.6

Graph of SML with Normalized Systematic Risk

E(R i )
SML

Rm
Negative Beta

RFR

1.0

Beta(Cov im/ 2 )
M

Determining the Expected Rate of Return for a Risky Asset

E(R i ) RFR i (R M - RFR)
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)

Determining the Expected Rate of Return for a Risky Asset

Stock A B C D E Beta 0.70 1.00 1.15 1.40 -0.30

RFR = 5% (0.05) RM = 9% (0.09) Implied market risk premium = 4% (0.04)

Assume:

E(R i ) RFR i (R M - 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%

Determining the Expected Rate of Return for a Risky Asset

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 A superior investor must derive value estimates for assets that are consistently superior to the consensus market evaluation to earn better risk-adjusted rates of return than the average investor

Identifying Undervalued and Overvalued Assets

Compare the required rate of return to the expected rate of return for a specific risky asset using the SML over a specific investment horizon to determine if it is an appropriate investment Independent estimates of return for the securities provide price and dividend outlooks

Calculating Systematic Risk: The Characteristic Line

The systematic risk input of an individual asset is derived from a regression model, referred to as the assets characteristic line with the model portfolio: where: Ri,t = the rate of return for asset i during period t RM,t = the rate of return for the market portfolio M during t

R i,t i i R M, t

i R i - i R m i Cov i,M
2 M

the random error term

The Impact of the Time Interval

Number of observations and time interval used in regression vary Value Line Investment Services (VL) uses weekly rates of return over five years Merrill Lynch, Pierce, Fenner & Smith (ML) uses monthly return over five years There is no correct interval for analysis Weak relationship between VL & ML betas due to difference in intervals used The return time interval makes a difference, and its impact increases as the firms size declines

The Effect of the Market Proxy

The market portfolio of all risky assets must be represented in computing an assets characteristic line Standard & Poors 500 Composite Index is most often used
Large proportion of the total market value of U.S. stocks Value weighted series

Weaknesses of Using S&P 500 as the Market Proxy

Includes only U.S. stocks The theoretical market portfolio should include U.S. and non-U.S. stocks and bonds, real estate, coins, stamps, art, antiques, and any other marketable risky asset from around the world

Relaxing the Assumptions

Differential Borrowing and Lending Rates
Heterogeneous Expectations and Planning Periods

Zero Beta Model

does not require a risk-free asset

Transaction Costs
with transactions costs, the SML will be a band of securities, rather than a straight line

Relaxing the Assumptions

Heterogeneous Expectations and Planning Periods
will have an impact on the CML and SML

Taxes
could cause major differences in the CML and SML among investors

Empirical Tests of the CAPM

Stability of Beta
betas for individual stocks are not stable, but portfolio betas are reasonably stable. Further, the larger the portfolio of stocks and longer the period, the more stable the beta of the portfolio

Comparability of Published Estimates of Beta

differences exist. Hence, consider the return interval used and the firms relative size

Relationship Between Systematic Risk and Return

Effect of Skewness on Relationship
investors prefer stocks with high positive skewness that provide an opportunity for very large returns

Effect of Size, P/E, and Leverage

size, and P/E have an inverse impact on returns after considering the CAPM. Financial Leverage also helps explain cross-section of returns

Relationship Between Systematic Risk and Return

Effect of Book-to-Market Value
Fama and French questioned the relationship between returns and beta in their seminal 1992 study. They found the BV/MV ratio to be a key determinant of returns

Summary of CAPM Risk-Return Empirical Results

the relationship between beta and rates of return is a moot point

The Market Portfolio: Theory versus Practice

There is a controversy over the market portfolio. Hence, proxies are used There is no unanimity about which proxy to use An incorrect market proxy will affect both the beta risk measures and the position and slope of the SML that is used to evaluate portfolio performance

Summary
The assumption of capital market theory expand on those of the Markowitz portfolio model and include consideration of the riskfree rate of return

Summary
The dominant line is tangent to the efficient frontier
Referred to as the capital market line (CML) All investors should target points along this line depending on their risk preferences

Summary
All investors want to invest in the risky portfolio, so this market portfolio must contain all risky assets
The investment decision and financing decision can be separated Everyone wants to invest in the market portfolio Investors finance based on risk preferences

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The relevant risk measure for an individual risky asset is its systematic risk or covariance with the market portfolio
Once you have determined this Beta measure and a security market line, you can determine the required return on a security based on its systematic risk

Summary
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

Summary
When we relax several of the major assumptions of the CAPM, the required modifications are relatively minor and do not change the overall concept of the model.

Summary
Betas of individual stocks are not stable while portfolio betas are stable There is a controversy about the relationship between beta and rate of return on stocks Changing the proxy for the market portfolio results in significant differences in betas, SMLs, and expected returns

Summary
It is not possible to empirically derive a true market portfolio, so it is not possible to test the CAPM model properly or to use model to evaluate portfolio performance