The document discusses asset pricing theories and the Capital Asset Pricing Model (CAPM). It defines key concepts of CAPM such as the capital market line, market portfolio, beta, security market line, and the relationship between risk and expected return. It also provides the equations to calculate expected returns for efficient portfolios and individual securities based on their systematic risk (beta) as measured against the market portfolio.
The document discusses asset pricing theories and the Capital Asset Pricing Model (CAPM). It defines key concepts of CAPM such as the capital market line, market portfolio, beta, security market line, and the relationship between risk and expected return. It also provides the equations to calculate expected returns for efficient portfolios and individual securities based on their systematic risk (beta) as measured against the market portfolio.
The document discusses asset pricing theories and the Capital Asset Pricing Model (CAPM). It defines key concepts of CAPM such as the capital market line, market portfolio, beta, security market line, and the relationship between risk and expected return. It also provides the equations to calculate expected returns for efficient portfolios and individual securities based on their systematic risk (beta) as measured against the market portfolio.
The document discusses asset pricing theories and the Capital Asset Pricing Model (CAPM). It defines key concepts of CAPM such as the capital market line, market portfolio, beta, security market line, and the relationship between risk and expected return. It also provides the equations to calculate expected returns for efficient portfolios and individual securities based on their systematic risk (beta) as measured against the market portfolio.
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Asset Pricing Theories
• Asset pricing theories try to explain the expected
rates of return of assets and why they differ both among each other and over time.
• Equilibrium Rates of Return
A market is in equilibrium when all investors hold their optimal portfolio and hence there is no reason for further transactions. Capital Asset Pricing Model • Focus on the equilibrium relationship between the risk and expected return on risky assets
• It provides a way to calculate expected return based
on its level of systematic risk, as measured by beta.
• It is the equilibrium model that underlies all modern
financial theory.
• Derived using principles of diversification with
simplified assumptions. Characteristics of the Market Portfolio
• All risky assets must be in portfolio, so it is
completely diversified • Contains only systematic risk • All securities included in proportion to their market value • Unobservable, but proxied by Ghana All Share Composite Index • In theory, it should contain all risky assets worldwide Capital Market Line: slope and market risk premium
• Line from RF to L is capital
L market line (CML) • x = risk premium M E(RM) = E(RM) - RF • y = risk = M x • Slope = x/y RF = [E(RM) - RF]/M y • y-intercept = RF M Risk Capital Market Line • Slope of the CML is the market price of risk for efficient portfolios, or the equilibrium price of risk in the market • Relationship between risk and expected return for portfolio P (Equation for CML):
E(R M ) RF E(R p ) RF p M Question An analyst estimates that the expected returns on the market (S&P/TSX Composite Index) is 12 per cent, with a standard deviation of 15 per cent, and the risk-free rate of return (Treasury bill rate) is at 5 per cent. Using the following information about the variance of returns of some efficient portfolios, calculate their expected returns using the Capital Market Line approach. • Efficient Portfolio Variance • Portfolio A 121 • Portfolio B 144 • Portfolio C 196 Security Market Line • CML Equation only applies to markets in equilibrium and efficient portfolios • The Security Market Line depicts the tradeoff between risk and expected return for individual securities • Under CAPM, all investors hold the market portfolio • How does an individual security contribute to the risk of the market portfolio? The Capital Asset Pricing Model (CAPM) • RISK AVERSE INVESTORS • Risk averseness implies that investors Prefer sure return to same expected return which is uncertain. Demand risk premium if return is uncertain. Seek risk reduction through diversification.
• Assumptions of CAPM Investors are expected wealth maximizers who look at mean and standard deviation of portfolio returns. Investors can borrow or lend an unlimited amount at risk- free rate. Investors have homogeneous expectations about expected returns and risks. Frictionless markets with no taxes. Security Market Line
• Equation for expected return for an individual stock
similar to CML Equation
E(R M ) RF i,M E(R i ) RF M M RF i E(R M ) RF Security Market Line
• Beta = 1.0 implies as risky
as market SML • Securities A and B are E(R) more risky than the market A • Beta > 1.0 E(RM) B • Security C is less risky than C the market RF • Beta < 1.0
0 0.5 1.0 1.5 2.0
BetaM Security Market Line • Beta measures systematic risk • Measures relative risk compared to the market portfolio of all stocks • Volatility different than market • All securities should lie on the SML • The expected return on the security should be only that return needed to compensate for systematic risk SML and Asset Values Er Underpriced SML: Er = rf + (Erm – rf)
Overpriced
rf β
Underpriced expected return > required return according to CAPM
lie “above” SML Overpriced expected return < required return according to CAPM lie “below” SML Correctly priced expected return = required return according to CAPM lie along SML The SML and a Positive-Alpha Stock: Disequilibrium example
• Suppose a security with a
of 1.2 is offering expected return of 17% • According to SML, it should be 14.8% • Under-priced: offering too high of a rate of return for its level of risk • Its alpha is 17-14.8 = 2.2% CAPM’s Expected Return-Beta Relationship • Required rate of return on an asset (ki) is composed of • risk-free rate (RF) • risk premium (i [ E(RM) - RF ]) • Market risk premium adjusted for specific security
ki = RF +i [ E(RM) - RF ] • The greater the systematic risk, the greater the required return
