FF6121 Investments: Week 7

Week 7
FF6121 Investments
Capital Market Line & Optimal Risky P
E(rC) CAL (P) = CML
Buy P on margin Efficient

E(rC,P) Frontier
P o P is called the Optimal

E(rP) Risky Portfolio or Tangency
Portfolio.
o The optimal CAL is called
the Capital Market Line
(CML).
o Includes Maximum Sharpe
ratio portfolio
rf
sP sHIGH VOL = sC,P s

FF6121 W7-2 Nanyang Business School
Investments
EXTRA Materials: not required for exams
Optimization Problem using Math

Conclusion: there is only one optimal risky portfolio.

Big Picture
• Elements of investments
– Introduction to investments (seminar 1)
– Asset classes and financial instruments (seminar 2)
Background
– Bonds (seminars 3)
– Securities markets and trading (seminar 4)
• Modern portfolio theory

– Risk and return (seminar 5)
– Efficient diversification (seminar 6)
– CAPM and APT (seminars 7 & 8)
– Efficient market hypothesis (seminars 9 & 11)
• Other investments
– Mutual funds and performance evaluation (seminar 12)
W7 Index Model & Capital Asset Pricing
• Index Model systematic risk

firm-specific
– Two Components of Stock Risk σi2 = bi2σ2m + σ2(ei); R2 = bi2σ2m / σ2i
• Capital Asset Pricing Model E(ri) = rf + βi[E(rM) – rf]

– CAPM and Capital Market Line E(rs ) - r M
M
f = Mkt Sharpe Ratio = CML Slope
= Maximum Sharpe Ratio
– Understanding Beta 𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑀 )
𝛽𝑖 =
• Beta by Industry 2
𝜎𝑀
– Securities Market Line

– Understanding Alpha α = E(ri) - rf - βi[E(rM) - rf]
• Arbitrage Pricing Theory
– Assumptions

Chapter 6 & 7
Index Model &

Capital Asset Pricing
Two Components of Stock Risk
Variance (Ri) = Variance (ai +biRm + ei) Ri,t = ai + biRm,t + εi,t
=0
σi2 = σ2(ai) + σ2 (bi Rm) + σ2(ei) = σ2ei =Var (ei)
= σ2bi Rm
= bi 2 σ 2 m
=Var (b R )
i m
= bi2σ2m + σ2(ei)
Total Risk = Systematic risk + Firm-specific risk
Systematic risk of each stock depends on σ2m and the sensitivity bi.
Firm-specific risk is measured by σ2(ei).
• E(ei )=0 ?
 A: ei has an expected value of zero as the impact of unanticipated events must average
out to zero. By regression, we get the best fit line set by minimizing the error term. In real
life, good news and bad news cancel out on average.
• var(ei)=0 ? Not necessarily in index model, but yes in CAPM.

Variance (ai) is zero. Why?
R2 = bi2σ2m / σ2i systematic risk/total risk
In the index model, R2 measures how much of the variation of Ri is
explained by variation in market returns, Rm. Fitness of the model.
7.1 The Capital Asset Pricing Model

Capital Asset Pricing Model
The CAPM shows how risk and expected returns relate in
equilibrium, and what type of investment risk matters.
If the model assumptions are true: take the market prevailing price
• Individual investors are “price takers.”
• Investments are limited to traded financial assets.
• No taxes and no transaction costs.
• People only care about mean and variance of returns.
• People all have the same expectations, and the mean and
variance of returns are known (Homogeneous expectations).
identical
Then in equilibrium all investors will hold some combination of the
Market Portfolio (M) and the risk-free asset.
CAPM:
Overview of Implications
All investors will hold some combination of the

Market Portfolio (M) and the risk-rate.
Market Portfolio:
• All assets of the security universe.
• Market-value weighted.
• Is the optimal risky portfolio and on efficient
frontier. well-diversified
In Class: CAPM, Capital Market Line
E(rC,M) =yM*E(rM) + (1-yM)*rf = rf + yM*(E(rM)-rf)
Market Portfolio (M) is: 1) market-value weighted of all assets
of the security universe; 2) the optimal risky portfolio on efficient
frontier of all risky assets with the maximum Sharpe ratio.
0 ≤yM<1 yM = 1 yM> 1 E(rM) - rf
E(rM)
sM
= Slope of the CML
The market risk premium is:
E(rM) - rf = A* σM2
e.g., when the average investor is fully invested in the market

portfolio, so yM = 1
sM =sC,M=yMsM
CAPM: ONLY systematic risk
determines Expected Returns
When the average investor is fully invested in the
market portfolio,
Using the CML, y = 1
➔The market risk premium is E(rM) - rf = A* σM2, Why?

CAPM: ONLY systematic risk
determines Expected Returns
Since investors hold the market portfolio, the
unsystematic risk of an investment doesn’t affect
expected returns.
• Why?
because idiosyncratic (unsystematic risk) is fully diversified
• A:
• ➔ only systematic risk matters.
measure systematic risk,how sensitive excess return
• CAPM: E(ri) = rf + bi [E(rM) – rf]

excess return/ market risk premium

Investments EXTRA Materials (not required for exam)
How to Derive CAPM (1)? • We also observe that the contribution of GE to the
risk premium of the market portfolio is .
• The CAPM is built on the insight that the • Therefore, the reward-to-risk ratio for investments in
appropriate risk premium on an asset will be GE can be expressed as
determined by its contribution to the risk of
investors’ overall
Q Q
portfolios.
2
σp =  [W I W J Cov(rI , rJ )] • On the other hand, the market portfolio is the
I=1 J=1 tangency (efficient mean-variance) portfolio. The
• Thus, the contribution of GE’s stock to the reward-to-risk ratio for investment in the market
variance of the market portfolio is portfolio is
• This can be written as • A basic principle of equilibrium is that all

investments should offer the same reward-to-risk
• (1)
ratio. If the ratio were better for one investment than
another, investors would rearrange their portfolios,
• But because , tilting toward the alternative with the better trade-off
and shying away from the other. Such activity would
• Equation (1) implies that, impart pressure on security prices until the ratios
were equalized. Non-arbitrage principle.
• Therefore:
• and therefore, GE’s contribution to the

• Rearrange to:
variance of the market portfolio may be more
simply stated as • measures the contribution of GE
stock to the variance of the market portfolio.
• If the covariance between GE and the rest of
The ratio is called beta and is denoted by β.
the market is negative, then GE makes a
“negative contribution” to portfolio risk. • Therefore:
How to Derive CAPM (2)? • Old Traditional Derivation

Consider a portfolio with a fraction 1-α of wealth
• CAPM with Quadratic Expected Utility invested in an arbitrary security j and a fraction of α
in the market portfolio

Understanding Beta
BETA measures an asset’s systematic risk relative to the market.
𝛽𝑖 for each individual security:
𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑀 )
𝛽𝑖 = 2
𝜎𝑀
Beta is the sensitivity of a security’s excess return to the systematic
factor (mkt risk premium).
𝑛
𝛽𝑝 for a portfolio: σ
𝛽𝑝 = 𝑖=1 𝑤𝑖 𝛽𝑖
𝑤𝑖 = proportion of portfolio wealth invested in stock “i”
• β > 1 indicates a stock with greater sensitivity to the economy
than the average stock in the market.
• β < 1 indicates a stock with below-average sensitivity to the

economy.
• β = 1. By definition, the market portfolio has a beta of 1.

In Class: Beta by Industry
The following industries are likely to have LOW
betas:
The following industries are likely to have HIGH

betas:
The following industries are likely to have betas

around one:

Real- Beta by Industry
World Industry Beta
Examples Low Beta Stocks

Utility (General) 0.29
Utility (Water) 0.34
Beverage (Soft) 0.70
Real Estate (General/Diversified) 0.75
High Beta Stocks

Beverage (Alcoholic) 1.33
Shipbuilding & Marine 1.79
Steel 1.82
Chemical (Diversified) 2.03
Beta Near One

Investments & Asset Management 0.99
Household Products 1.00
Air Transport 1.01
Publishing & Newspapers 1.02
Source: Aswath Damodaran: http://pages.stern.nyu.edu/~adamodar/. In

spreadsheet labeled “Beta, Unlevered beta and other risk measures”.
Collected Q.1, 2018.
CAPM: Securities Market Line
If the CAPM is correct: E(ri) = rf + bi[E(rM) – rf]
SML
• β determines the risk Securities Market Line
premium of all individual
E(r)
stocks. Idiosyncratic risk
does not change expected
returns Slope
• All stocks should have the E(𝑟 ) – rf

= 𝑖
same risk-return trade off, as βi
E(𝑟𝑀 ) – rf
E(𝑟 ) – rf
measured by 𝑖 E(𝑟 ) = βM
βi = 𝑀
rf =E(𝑟𝑀 ) – rf
– rf
• All stocks {E(ri),bi} pairs ß
should be on the SML.
SML and CAPM Equation
E(𝑟𝑖 ) – rf E(𝑟𝑀 ) – rf
SML Slope = = = E(𝑟𝑀 ) – rf
βi βM
=1
➔E(𝑟𝑖 ) – rf = βi * (E(𝑟𝑀 ) – rf)
➔ E(𝑟𝑖 ) = rf + βi * (E(𝑟𝑀 ) – rf)

SML: Example
E(ri) = rf + bi[E(rM) - rf]
rf =0.03 E(rm) - rf = 0.08
Return due risk-free rate = 3% & return per unit of
systematic risk = 8%
What is the security’s expected return?

• If bx = 1.25 E(rx) = 0.03 + 1.25(0.08) = .13 or 13%
• If by = .6 E(ry) = 0.03 + 0.6(0.08) = 0.078 or 7.8%
• If b = 1 E(r) = 0.03 + 1(0.08) = 0.11 or 11%
• If b = 0 E(r) = 0.03 + 0*(0.08) = 0.03 or 3%

Security Market Line
E(ri) = rf + bi[E(rM) – rf]
E(r)
SML Slope=
E(𝑟𝑀 ) – rf
βM
rx=13% .08
rM=11%
If the CAPM is correct, only β
ry=7.8% risk matters in determining the
risk premium for a given slope
3% of the SML.
ß
.6 1.0 1.25
ßy ßM ßx
Understanding α
Alpha measures how much expected returns
differ from CAPM-implied expected returns.
CAPM: E(ri) = rf + bi [E(rM) – rf]
• In an CAPM equilibrium, alpha=0:
Index model: Ri,t = ai + bi RM + εi,t
E(ri) = (α =0) + rf + bi[E(rM) - rf]
where RM= E(rM), -rf ; Ri,t= E(ri) - rf
E(εi,t) =0
• In a dis-equilibrium, alpha ≠ 0. In this case, asset is mispriced.
E(ri) - rf: Ex-ante risk premium
Ex-post average excess returns
rf - bi[E(rM) - rf]: CAPM-predicted return
capm model give a higher return than expected
If alpha: α = E(ri) - rf - bi[E(rM) - rf] <0, asset is overvalued;

α >0, undervalued. Which one to buy? sicking-alpha
Alpha is the expected excess returns (E(ri) - rf ) adjusted for
compensation for systematic risk (bi[E(rM) - rf]).
“Risk-adjusted ” expected (or ex post: average) excess
FF6121 W7-23
returns.
Nanyang Business School
Alpha: Example
An analyst estimates
Disequilibrium Example
that for stock A Inc.:
E(r)
SML
E(r): 15%
15% b : 1.25
a
Rm=11% 13%
rf=3%
According to the SML:
E(r)=0.03 + 1.25(.08)=13%
ß
1.0 1.25
Overvalued or α = E(ri) - rf - bi[E(rM) - rf]

undervalued?
undervalued = 15% - 13% = 2%

α (Abnormal returns):
Implications
Positive Alpha implies that the stock has
positive risk adjusted expected excess
returns.
• The stock is UNDERPRICED: It offers too high
of expected rate of return for its level of risk
• A negative Alpha implies negative positive risk
adjusted expected excess returns and over-
pricing.

William F. Sharpe
• William Forsyth Sharpe is the winner of the I am a professor of
1990 Nobel Memorial Prize in Economic Sciences, finance @Stanford, and a
shared with Harry Markowitz. recipient of 1990 Nobel
• Sharpe was one of the originators of the capital Prize in Economics. Thx!
asset pricing model. He created the Sharpe ratio for
risk-adjusted investment performance analysis, and
he contributed to the development of the binomial
method for the valuation of options, and returns-
based style analysis for evaluating the style and
performance of investment funds.
• In 1961 he started research on an equilibrium theory

of asset pricing, work that yielded the Capital asset
pricing model. He submitted the paper describing
CAPM to the Journal of Finance in 1962. However,
ironically, the paper which would become one of the
foundations of financial economics was initially
considered irrelevant and rejected from
publication. Sharpe had to wait for the editorial
staff to change until finally getting the paper
published in 1964.
• At the same time, the CAPM was independently
developed by John Lintner, Jan Mossin, and Jack
Treynor.

Chapter 7
Arbitrage Pricing
Theory
Review: Single Factor Index Models
𝑅𝑖 = 𝛼𝑖 + 𝛽𝑖 𝑅𝑚 + 𝜀𝑖
Use actual historical returns of asset 𝑖 and 𝑚

to separate total risk into systematic and
idiosyncratic risk components.
• 𝛽𝑖 is an estimate of security 𝑖 ′ 𝑠 sensitivity to the
(systematic) factor portfolio 𝒎
We will discuss what “factor portfolio”
means in this lecture and in class.
• 𝜀𝑖 represent unanticipated firm-specific events.

Review Question 1
An analyst estimates the index model using holding
period returns for the market (M) and XYZ Corp.:
rXYZ,t – rf,t = αXYZ + βXYZ,M(rM,t – rf,t) + eXYZ,t
In month t, you observe the following information:

βXYZ,M 1.5 Pm,t $100
αXYZ 0 PXYZ,t $25
rf,t+1 = 5% is the risk-free rate of return from t to t+1. This

is known at time t. If you forecast that next period, Pm,t+1
= $108, what is your best estimate of rXYZ,t+1 and
PXYZ,t+1?
Question 1: Answer
Step 1: Calculate the forecasted return for the market:
Forecasted rM,t+1 = (108 – 100) / 100 = 0.08
Step 2: Calculate the forecasted return for XYZ in t+1:

Forecasted rXYZ,t+1 - rf,t+1 = αXYZ + βXYZ,M(rM,t+1 – rf,t+1)
= 0 + 1.5*(0.08 – 0.05) = 0.045
Forecasted rXYZ,t+1 = rf,t+1 + 0.045 = 0.05 + 0.045 = 0.095
Step 3: Calculate the forecasted price.

Forecasted PXYZ,t+1 = PXYZ,t(1+ Forecasted rXYZ,t+1)
= 25*(1+0.095) = 27.375
If you do not know PXYZ,t+1, your best estimate of the price GIVEN
Pm,t+1= $108 is $27.375.

Question 1: Answer (continued)
IF et+1 is zero, the forecasted price equals the realized

price.
IF et+1 = 0, the ONLY factor that drives changes in PXYZ

is changes in the price of the market portfolio.

Review Question 2
An analyst estimates the index model using holding
period returns for the market (M) and XYZ Corp.:
rXYZ,t – rf,t = αXYZ + βXYZ,M(rM,t – rf,t) + eXYZ,t
In month t+1, you observe the following information:

βXYZ,M 1.5 Pm,t $100
αXYZ 0 Pm,t+1 $108
rf,t+1 5% PXYZ,t $25
You observe that PXYZ,t+1 is 26. Calculate eXYZ,t+1.

Based on your analysis, was there good or bad news
about XYZ Corp.?
Question 2: Answer
rXYZ,t+1 – rf,t+1 = αXYZ + βXYZ,M(rM,t+1 – rf,t+1) + eXYZ,t+1

eXYZ,t+1 = rXYZ,t+1 – rf,t+1 - αXYZ - βXYZ,M(rM,t+1 – rf,t+1)
= (26 – 25)/25 – 0.05 – 0 – 1.5(0.08 – 0.05)
= -0.055 < 0
Since eXYZ,t+1 < 0, there was bad news about XYZ

Corp.
Even though there was bad news, the stock price
went UP. This is because there was a positive
systematic shock.

In Class Review Question 1,2: Answer
If you do not know PXYZ,t+1, your best estimate of the
price GIVEN Pm,t+1= $108 and forecasted returns the
index model.
IF et+1 is zero, the forecasted price equals the realized

price, and the ONLY factor that drives changes in PXYZ
is changes in the price of the market portfolio.
Since eXYZ,t+1 < 0, there was bad news about XYZ Corp.
Even though there was bad news, the stock price went
UP. This is because there was a positive systematic
shock.
7.5 Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT):
Motivation
The CAPM has only one source of systematic risk: Unexpected
changes in the market portfolio.
In reality, other sources of risk may also cause stock prices to

unexpectedly change: Real-world examples include:
1. Unexpected changes (shocks) in interest rates.
2. Unexpected changes (shocks) in inflation.
3. Unexpected changes in aggregate corporate default risk (e.g., the financial
crisis 2007-2009).
4. Unexpected changes in industrial production
Systematic risk must be:

1. Pervasive
2. Undiversifiable
Arbitrage Pricing Theory:
Describes the relation between expected
returns and risk when there are ONE or
MORE sources of systematic risk.
Systematic risk must be:
1. Pervasive – The source of risk must potentially impact most
companies, leading the stock prices to unexpectedly
change.
2. Undiversifiable - The source of risk can not be diversified
away in a large portfolio.

APT: Assumptions
1. No taxes, no transaction costs
2. Investors can form well-diversified portfolios.
• Well-diversified portfolios only contain systematic risk.
• All idiosyncratic risk is diversified away.
3. No arbitrage opportunities exist.

• Two securities that always have the same payoff must always have
the same price.
• A portfolio that requires NO initial investment should produce a zero

payout in the future.

APT: Assumptions
What is an arbitrage opportunity?
• An arbitrage opportunity exists when two securities always
have the same payoff but DO NOT have the same price.
• Arbitrage is the act of exploiting mispricing of two or more

securities to achieve a risk-free profit.
• Profitable arbitrage opportunities quickly disappear in an

efficient market.
• In other words, there is No free lunch.

In Class Summary APT: Assumptions
1. No taxes, no transaction costs
2. Investors can form well-diversified portfolios.
• Well-diversified portfolios only contain systematic risk.
• All idiosyncratic risk is diversified away.

• Two securities that always have the same payoff must always have
the same price.
• An arbitrage opportunity exists when two securities always have the

same payoff but DO NOT have the same price.
• A portfolio that requires NO initial investment should produce a zero

payout in the future.
• Profitable arbitrage opportunities quickly disappear in an efficient

market.
Presentation Questions
Notes: 1) During or after presentations, other groups
are encouraged to ask questions. Q&A.
2) It will be credited.

Q1. You estimate the index model, For A and B:
ri – rf = αi + βi,M(rM – rf,) + ei
For stocks A and B and find the following:

βi,M St.Dev(ri) St.Dev(ei)
Stock A: 1.5 0.3 ?
Stock B: 2 0.2 ?
M: 1 0.1 0
1. The R2 of the regression of A’s excess returns on the

market excess returns is higher than the R2 of the
regression of excess returns for B on market excess
returns.
2. St.Dev(eA) will be larger than St.Dev(eB).
3. A. and B. are both true.
4. A. and B. are both NOT true

Q2: Which of these statements are true?
A. Stocks with a beta of zero offer an expected rate of

return of zero.
B. The CAPM implies that investors require a higher return

to hold highly volatile securities.
1. A
2. B
3. A and B
4. None of the above

Q3: If the CAPM is valid, then which of these
situations is possible? Consider each situation
independently.
Situation A Situation B
Portfolio E(Return) Beta Portfolio E(Return) Standard
ABC 20% 1.4 Deviation
XYZ 25% 1.2 ABC 30% 35%

XYZ 40% 25%
1. A only
2. B only
3. A&B
4. Neither

Q4: If the CAPM is valid, then which of these
situations is possible? Consider each situation
independently.
Situation A Situation B
Portfolio E(Return) Std Dev. Portfolio E(Return) Std Dev.
Risk-free 10% 0% Risk-free 10% 0%
Market 18% 24% Market 18% 24%
ABC 16% 12% XYZ 20% 22%
1. A only
2. B only
3. A&B
4. Neither

Q5
Ken invests 100% of his wealth in Fund XYZ, which
perfectly tracks the market portfolio. Ken’s financial
advisor comments that Ken’s portfolio can improve by
purchasing a second ETF, called ABC. The beta of ABC
with respect to the market is negative. In other words,
βABC,M < 0.
Ken’s financial advisor states that adding ABC with XYZ
will gain benefits of diversification.
Is Ken’s advisor correct?

Answer yes or no, and explain why you think so in three
sentences or less.
Critical thinking 1
• Is it right to say that a well-diversified

portfolio must be on the efficient frontier?

Critical thinking 2
• The difference between CML and SML?

Extra Practice

Investments
Question 1
Suppose the yield on short-term government securities (perceived to be

risk-free) is about 4%. Suppose also that the expected return required by
the market for a portfolio with a beta of 1 is 12%. According to the capital
asset pricing model:
a) What is the expected return on the market portfolio?
b) What would be the expected return on a zero-beta stock?
c) Suppose you consider buying a share of stock at a price of $40. The
stock is expected to pay a dividend of $3 next year and to sell then for
$41. The stock risk has been evaluated at β = − .5. Is the stock
overpriced or underpriced?

Q2. The tangency portfolio has an expected return of
10 % and standard deviation of 30 %. The risk-free
rate is 2 %. You can borrow or lend at the risk-free
rate. You want an expected return of 15%. How
much do you invest in the tangency portfolio?
1. Greater than 0 and less than 1

2. Greater than 1 and less than 1.5
3. Greater than 1.5
4. None of the above.

W7 Index Model & Capital Asset Pricing
• Index Model
– Two Components of Stock Risk σi2 = bi2σ2m + σ2(ei); R2 = bi2σ2m / σ2i
• Capital Asset Pricing Model E(ri) = rf + βi[E(rM) – rf]

– CAPM and Capital Market Line E(rs ) - r M
M
f = Mkt Sharpe Ratio = CML Slope
= Maximum Sharpe Ratio
– Understanding Beta 𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑀 )
𝛽𝑖 =
• Beta by Industry 2
𝜎𝑀
– Securities Market Line

– Understanding Alpha α = E(ri) - rf - βi[E(rM) - rf]
• Arbitrage Pricing Theory
– Assumptions

Homework
• You can practice after-chapter questions in BKM (the
textbook);
– Note: Those not covered neither in the lecture notes nor in-
class are not required for the final exam.
• the extra materials I give in-class will not be covered in the final
exam either, but they are helpful for your learning.
• Read lecture notes for Week 8.
• Presentation questions for Week 8.

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Week 7

Buy P on margin Efficient

P o P is called the Optimal

sP sHIGH VOL = sC,P s

Optimization Problem using Math

FF6121 W7-3 Nanyang Business School

• Modern portfolio theory

• Index Model systematic risk

– Two Components of Stock Risk σi2 = bi2σ2m + σ2(ei); R2 = bi2σ2m / σ2i

• Capital Asset Pricing Model E(ri) = rf + βi[E(rM) – rf]

– Securities Market Line

FF6121 W7-5 Nanyang Business School

Index Model &

• var(ei)=0 ? Not necessarily in index model, but yes in CAPM.

FF6121 W7-8 Nanyang Business School

All investors will hold some combination of the

0 ≤yM<1 yM = 1 yM> 1 E(rM) - rf

e.g., when the average investor is fully invested in the market

FF6121 W7-12 Nanyang Business School

• CAPM: E(ri) = rf + bi [E(rM) – rf]

FF6121 W7-13 Nanyang Business School

• This can be written as • A basic principle of equilibrium is that all

• and therefore, GE’s contribution to the

How to Derive CAPM (2)? • Old Traditional Derivation

FF6121 W7-15 Nanyang Business School

• β < 1 indicates a stock with below-average sensitivity to the

• β = 1. By definition, the market portfolio has a beta of 1.

The following industries are likely to have HIGH

The following industries are likely to have betas

FF6121 W7-17 Nanyang Business School

Examples Low Beta Stocks

High Beta Stocks

Beta Near One

Source: Aswath Damodaran: http://pages.stern.nyu.edu/~adamodar/. In

• All stocks should have the E(𝑟 ) – rf

➔E(𝑟𝑖 ) – rf = βi * (E(𝑟𝑀 ) – rf)

➔ E(𝑟𝑖 ) = rf + βi * (E(𝑟𝑀 ) – rf)

FF6121 W7-20 Nanyang Business School

What is the security’s expected return?

FF6121 W7-21 Nanyang Business School

If alpha: α = E(ri) - rf - bi[E(rM) - rf] <0, asset is overvalued;

Overvalued or α = E(ri) - rf - bi[E(rM) - rf]

FF6121 W7-24 Nanyang Business School

FF6121 W7-25 Nanyang Business School

• In 1961 he started research on an equilibrium theory

FF6121 W7-26 Nanyang Business School

Use actual historical returns of asset 𝑖 and 𝑚

FF6121 W7-28 Nanyang Business School

In month t, you observe the following information:

rf,t+1 = 5% is the risk-free rate of return from t to t+1. This

Step 2: Calculate the forecasted return for XYZ in t+1:

Step 3: Calculate the forecasted price.

FF6121 W7-30 Nanyang Business School

IF et+1 is zero, the forecasted price equals the realized

IF et+1 = 0, the ONLY factor that drives changes in PXYZ

FF6121 W7-31 Nanyang Business School

In month t+1, you observe the following information:

You observe that PXYZ,t+1 is 26. Calculate eXYZ,t+1.

rXYZ,t+1 – rf,t+1 = αXYZ + βXYZ,M(rM,t+1 – rf,t+1) + eXYZ,t+1