# The Risk of Individual Assets

Capital Market Equilibrium and the Capital Asset Pricing Model
Econ 422 Investment, Capital & Finance Summer 2006 August 15, 2006

Investors require compensation for bearing risk. We have seen that the standard deviation of the rate of return is an appropriate measure of risk for one’s portfolio. Standard deviation is not the best measure of risk for individual assets when investors hold diversified portfolios.
ECON 422:CAPM © 2006 R.W.Parks/E. Zivot

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

1

2

The Risk of Individual Assets (continued) For people holding a diversified portfolio it is the contribution of the individual asset to the portfolio’s standard deviation that matters. [If your portfolio involved only one asset, e.g. young Bill Gates, the portfolio standard deviation would be the standard deviation of the single asset.]
ECON 422:CAPM © 2006 R.W.Parks/E. Zivot

The contribution of an individual asset to the portfolio’s standard deviation: Beta
Beta measures the sensitivity of an asset’s rate of return to variation in the market portfolio’s return. Beta for asset i can be computed as

βi =

cov(ri , rm ) σ im = 2 V (rm ) σm

3

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

4

1

Beta as a Measure of Portfolio Risk: Class Example
Suppose you hold an equally weighted portfolio with 99 assets What happens to the portfolio variance if a new asset, say IBM, is added to the portfolio?

Measuring Betas The Market Model
Beta can be interpreted as the slope coefficient in a regression of the return on the ith security, ri, on the return for the market portfolio, rm. The interpretation rests on the market model:

rit = α i + β i rmt + ε it
rm represents “market risk” and εi represents “firm specific” risk independent of the market. See Spreadsheet example

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

5

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

6

Beta as a Measure of Risk for Individual Assets
Asset i’s Return ri
+10%

The Capital Asset Pricing Model (CAPM)
CAPM describes the relationship between an asset’s beta risk and its expected return as follows:

The slope is given by β=cov(ri,rm)/V(rm)

The intercept is given by α
-10% +10%

E ( ri ) = rf + β i E ( rm ) − rf
-10%

Market return rm

= riskfree rate + beta x market risk premium.

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

7

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

8

2

The Security Market Line (SML) Describes the CAPM Relationship
E(ri)
E(rm)
rf

The Capital Asset Pricing Model Example
If T-bill yield = 2% The beta for Microsoft = 1.61 (from Yahoo! See link for key statistics) The historical market risk premium =7.5% Then

Security Market Line (SML)

Slope is the market risk premium = E(rm)-rf

1.0

β

E[rmsft ] = rf + βmsft (E[Rmt ] − rf ) = 2% +1.61*(7.5%) = 14.075%
Note: the return predicted from the CAPM is sometimes called the “risk-adjusted” return
9 ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 10

E ( ri ) = rf + β i E ( rm ) − rf
ECON 422:CAPM © 2006 R.W.Parks/E. Zivot

The Market Model and the Measures of Risk
The total risk of an asset, held alone, i.e. not as part of a diversified portfolio, would be measured by its variance, V(ri). According to the market model

The Market Model and the Measures of Risk
R2 measures proportion of an asset’s total risk that is market risk:

rit = α i + β irmt + ε it
2 i

and

1=

Var (rit ) βi2Var (rmt ) Var (ε it ) = + Var (rit ) Var (rit ) Var (rit )

V(rit ) = β V (rmt ) + V (ε it )
Total risk = systematic market risk + unique risk The unique risk can be eliminated through diversification.
ECON 422:CAPM © 2006 R.W.Parks/E. Zivot ECON 422:CAPM

= R2 + 1 − R2 R2 =

βi2Var (rmt )
Var (rit )

, 1 − R2 =

Var (ε it ) Var (rit )

See spreadsheet for examples
11 © 2006 R.W.Parks/E. Zivot 12

3

Portfolio Beta
The beta of a portfolio is a weighted average of the individual asset betas

Testing the CAPM
Key CAPM prediction: stocks with high betas should have high average returns; stocks with low betas should have low average returns Simple test: compute average returns and betas for a bunch of stocks and see if the high beta stocks have higher average returns than the low beta stocks CAPM predicts a straight line relationship between average return and beta
13 ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 14

β p = x1 β 1 + x 2 β 2 + β i = beta for asset i
ECON 422:CAPM

+ xn β n

x i = portfolio share for asset i

© 2006 R.W.Parks/E. Zivot

Testing the CAPM
Testing involves a number of measurement problems: » for expected returns » for beta » for the market portfolio

Some Approaches Used to Address the Measurement Problems
Early studies by Black Jensen & Scholes (1972) and by Fama and McBeth (1973) Measurement of betas: data from period 1 used to estimate individual stock betas. These betas used to construct “decile portfolios”: stocks with betas in the lowest 10% grouped as the first portfolio. Stocks with betas in the next lowest 10% grouped as the second portfolio etc. » Portfolio betas are more accurate than single asset betas Data from period 2 used to re-estimate betas and average returns for the 10 portfolios Look at the regression of average return on betas for the 10 portfolios
15 ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 16

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

4

Black, Jensen & Scholes CAPM Test (1972)
Average Monthly Return

Validity of the CAPM
Evidence is mixed: » Long-run average returns are significantly related to betas. » Beta is probably not a complete explanation. – Low beta stocks have earned higher rates of return than predicted by the model. » Recent results by Fama and French (1992) – Small company stocks stocks have earned higher rates of return than predicted by the model. (Size Effect) – Value company stocks have earned higher rates of return than predicted by the model. (Style Effect)
© 2006 R.W.Parks/E. Zivot 18

Theoretical SML Fitted SML

rf

Low Beta

High Beta

Beta

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

17

ECON 422:CAPM

What is a Value Stock?
A stock that tends to trade at a lower price relative to it's fundamentals (i.e. dividends, earnings, sales, etc.) and thus considered undervalued by a value investor. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio.

The CAPM Remains Attractive
It is simple and gives sensible answers. It distinguishes between diversifiable and non-diversifiable risk.

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

19

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

20

5

Applying the CAPM to Valuation The CAPM Remains Controversial
It is difficult to devise a definitive test » We don’t know how to define and measure the market portfolio. If we use the wrong market index the resulting betas are mismeasured Fama & French results cast doubt on the CAPM although their study is also subject to criticisms. Multi-factor models have been developed to compete with the CAPM e.g. the Arbitrage Pricing Model. Ch 11
ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 21

Recall the one-period holding period rate of return: r= P − P + D1 1 0 P 0

At time t = 0, P is known, but P and D1 are not known; they are random variables. 0 1 Take expectations: E(P ) − P + E(D1) 1 0 E(r) = P 0 Solve for P : 0 P= 0 E(P ) + E(D1) E(P ) + E(D1) 1 1 = 1+ E(r) 1+ rf + β[E(rM ) − rf ]

using the CAPM relation: E(r) = rf + β[E(rM ) − rf ]
ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 22

Applying the CAPM to Valuation (continued)
P0 = E ( P ) + E ( D1 ) 1 1 + rf + β [ E (rM ) − rf ]

Example: Stock valuation using CAPM
E[D1] = 5, g = 0.10, rf = 0.03 β = 1.5, E[rm] – rf = 0.075

To value a future risky cash flow, discount the expected value of the cash flow to present value using the risk-adjusted expected return based on the CAPM.

E[r] = rf + β(E[rM ] − rf ) = 0.03+1.5(0.075) = 0.1425 Constant growth: P = 0 E[D1] 5 5 = = =117.64 (E[r] − g) 0.1425−0.1 0.0425

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

23

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

24

6

Using the CAPM to Determine the Discount Rate for Risky Projects
For risk-free projects you would use a riskfree interest rate for discounting a project’s cash flow. For risky projects you discount the expected cash flow by a risk adjusted interest rate, using the CAPM.

The Company Cost of Capital
The average rate of return for the entire company’s assets is called the company cost of capital. If the project under consideration has the same risk as these assets, then the company cost of capital is an appropriate discount rate. But the project may have a different risk. We would then use a discount rate matching the project’s risk.
25 ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 26

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

Project Discount Rate and the Company Cost of Capital
Required return

Determining Project Risk E[r] = 2% + β*(7.5%)
Category Speculative ventures New Products Project Beta 3.73 2.4 Discount Rate 30% 20% 15% (company cost of capital) 10%

S ecurity market line, CAPM

Company Cost of Capital
Rf

P roject B eta

Expansion of 1.73 = estimated existing business beta from data Cost 1.06 improvement
27 ECON 422:CAPM © 2006 R.W.Parks/E. Zivot

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

28

7

Estimating the Cost of Capital for an All-Equity Firm
For an all-equity firm the riskiness of the stock is the same as the riskiness of the company’s assets. Stock betas are easy to obtain or estimate. Use the CAPM to estimate the company cost of capital: E (rA ) = rf + β E [ E (rM ) − rf ] This is the discount rate for project with the same riskiness as the firm’s current assets.
ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 29

Estimating the Cost of Capital for an All-Equity Firm: Example
For Microsoft MSFT I found the following information: (From Yahoo Finance, key statistics) Microsoft is an all equity firm, i.e. it has essentially no debt, debt/equity ratio is 0. Its stock beta is 1.61 rf= 1.75%=current T-Bill yield [E(rM) - rf]=expected market risk premium=7.5%, E(re)=rf + β[E(rM) - rf] =1.75%+1.61[7.5%]=13.825%

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

30

A Firm’s Capital Structure: Relative Amounts of Debt and Equity
Assets Cash Receivables Buildings Equipment Patents V= Total Assets Total Liabilities =V=D+E Equity E Liabilities Debt D

The Risk of A Company’s Assets is Shared by Its Owners
If the risk of the company's current assets is β A then D E D E βD + βE = βD + βE D+E D+E V V D E Note that since D + E = V , + = 1. V V If we apply the CAPM to the three components, it must be the case that

βA =

E(rA ) =

D E E (rD ) + E (rE ). V V

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

31

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

32

8

Examples of Asset Betas
All equity firm: D/V = 0, E/V =1

The Riskiness of the Equity Owners Rises When There is Debt
Consider the special case when the debt is risk-free:
D E βD + βE V V If β D = 0,

βA = 0 ⋅βD + 1⋅βE = βE
Firm with small debt: D/V = 0.1, E/V =0.9

βA =

β

A

= 0 .1 ⋅ β D + 0 .9 ⋅ β E

Note: Equity beta, βE, is estimated from stock returns (easy); Debt beta, βD, may be estimated from returns on corporate debt (not so easy)
ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 33 ECON 422:CAPM

βE = βA

V E+D D = βA = βA + βA E E E

© 2006 R.W.Parks/E. Zivot

34

The Riskiness of the Equity Owners Rises When There is Debt (continued)

The Discount Rate for a Project in a Leveraged Firm
Equity beta are easy to determine. Asset betas would not be easy to estimate directly. Use the equity beta, and undo the effect of the leverage. Estimate or look up the equity beta, estimate the debt beta if it is not zero. Then use the beta relationship to get the asset beta:
D E βD + βE D+E D+E Then use the CAPM to determine the corresponding expected return.

BE

βE = βA +

D βA E

BA
Debt is risk free D/E

βA =

E (rA ) = rf + β A [ E (rM ) − rf ] Use this rate as the discount when project has same risk as company's existing assets.
ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 35 ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 36

9

The Discount Rate for a Project in a Leveraged Firm: Example
Sea Star Inc. has a debt/equity ratio of 0.1, an equity beta of 1.21 and a debt beta of 0.11. The current risk-free interest rate is 4%. The expected market risk premium is 8.5%. Find the discount rate for a project with the same risk as the company’s current assets.

The Discount Rate for a Project in a Leveraged Firm: Example
Note:

D = 0.1 ⇒ D = 0.1 × E E 0.1 × E 0.1 × E 1 D = = = D + E 0.1 × E + E 1.1 × E 11 1 10 E D = 1− = 1− = D+E D+E 11 11
37 ECON 422:CAPM © 2006 R.W.Parks/E. Zivot 38

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

The Discount Rate for a Project in a Leveraged Firm: Example
Therefore,

1 10 1 10 βD + βE = .11+ 1.21 = .01+1.10 = 1.11 11 11 11 11 Then use the CAPM:

βA =

E(rA ) = rf + β A ⎡E(rM ) − rf ⎤ = 4% +1.11*8.5% = 13.435% ⎣ ⎦

ECON 422:CAPM

© 2006 R.W.Parks/E. Zivot

39

10

Sign up to vote on this title