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Capital Market Line (Rohit)

# Capital Market Line (Rohit)

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10/25/2012

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# Capital Market Line

 Line from RF to L is

L E(RM) M x RF y σ Risk
M

capital market line (CML)  x = risk premium = E(RM) - RF
 y = risk = σ  Slope = x/y
M

= [E(RM) - RF]/σ
 y-intercept = RF

M

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 + σp σM

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?

Security Market Line

Equation for expected return for an individual

stock similar to CML Equation

E(R M ) − RF σ i,M E(R i ) = RF + σM σM = RF + β i [ E(R M ) − RF]

Security Market Line
 Beta = 1.0 implies as

E(R) E(RM) RF C

SM L B A

risky as market  Securities A and B are more risky than the market

Beta > 1.0

 Security C is less risky

than the market

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 The expected return on the security should be only that return needed to compensate for systematic risk

All securities should lie on the SML

SML and Asset Values
Er
Underpriced SML: Er = rf + β (Erm – rf)

Overpriced

rf β
⇒ 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 Underpriced

CAPM’s Expected Return-Beta Relationship
Required rate of return on an asset (ki) is

composed of
 

risk-free rate (RF) risk premium (β i [ E(RM) - RF ])

ki = RF +β i [ E(RM) - RF ]

The greater the systematic risk, the greater the required return

Estimating the SML
Treasury Bill rate used to estimate RF Expected market return unobservable

Estimated using past market returns and taking an expected value Only company-specific factor in CAPM Requires asset-specific forecast

Estimating individual security betas difficult
 

Estimating Beta

Market model

Relates the return on each stock to the return on the market, assuming a linear relationship Rit =α i +β i RMt + eit

Test of CAPM
Empirical SML is “flatter” than predicted SML Fama and French (1992)
  

Market Size Book-to-market ratio True market portfolio is unobservable Tests of CAPM are merely tests of the mean-variance efficiency of the chosen market proxy

Roll’s Critique
 

Arbitrage Pricing Theory
Based on the Law of One Price  Two otherwise identical assets cannot sell at different prices  Equilibrium prices adjust to eliminate all arbitrage opportunities Unlike CAPM, APT does not assume  single-period investment horizon, absence of personal taxes, riskless borrowing or lending, mean-variance decisions

Factors
APT assumes returns generated by a factor model Factor Characteristics
 

Each risk must have a pervasive influence on stock returns Risk factors must influence expected return and have nonzero prices Risk factors must be unpredictable to the market

APT Model
Most important are the deviations of the factors

from their expected values The expected return-risk relationship for the APT can be described as: E(Rit) =a0+bi1 (risk premium for factor 1) +bi2 (risk premium for factor 2) +… +bin (risk premium for factor n)

APT Model
Reduces to CAPM if there is only one factor and

that factor is market risk Roll and Ross (1980) Factors:
    

Changes in expected inflation Unanticipated changes in inflation Unanticipated changes in industrial production Unanticipated changes in the default risk premium Unanticipated changes in the term structure of interest rates

Problems with APT
Factors are not well specified ex ante

To implement the APT model, the factors that account for the differences among security returns are required
 CAPM

identifies market portfolio as single factor

Neither CAPM or APT has been proven superior

Both rely on unobservable expectations

Two-Security Case
For a two-security portfolio containing Stock A and

Stock B, the variance is:

σ = x σ + x σ + 2 xA xB ρ ABσ Aσ B
2 p 2 A 2 A 2 B 2 B

17

Two Security Case (cont’d)
Example
Assume the following statistics for Stock A and Stock B:

Stock A Expected return Variance Standard deviation Weight Correlation coefficient .015 .050 .224 40% .50

Stock B .020 .060 .245 60%
18

Two Security Case (cont’d)
19

Example (cont’d)
What is the expected return and variance of this two-security portfolio?

Two Security Case (cont’d)
20

Example (cont’d)
Solution: The expected return of this two-security portfolio is:

% % E ( R p ) = ∑  xi E ( Ri )   
i =1

n

% % =  x A E ( RA )  +  xB E ( RB )      = 0.018 = 1.80%

= [ 0.4(0.015)] + [ 0.6(0.020) ]

Two Security Case (cont’d)
21

Example (cont’d)
Solution (cont’d): The variance of this two-security portfolio is:

2 2 2 2 σ 2 = x Aσ A + xBσ B + 2 xA xB ρ ABσ Aσ B p

= (.4) (.05) + (.6) (.06) + 2(.4)(.6)(.5)(.224)(.245) = .0080 + .0216 + .0132 = .0428
2 2

Minimum Variance Portfolio
22

The minimum variance portfolio is the particular

combination of securities that will result in the least possible variance
Solving for the minimum variance portfolio requires

basic calculus

Minimum Variance Portfolio (cont’d)
23

For a two-security minimum variance portfolio, the

proportions invested in stocks A and B are:

σ − σ Aσ B ρ AB xA = 2 2 σ A + σ B − 2σ Aσ B ρ AB
2 B

xB = 1 − x A

Minimum Variance Portfolio (cont’d)
24

Example (cont’d)
Assume the same statistics for Stocks A and B as in the previous example. What are the weights of the minimum variance portfolio in this case?

Minimum Variance Portfolio (cont’d)
25

Example (cont’d)
Solution: The weights of the minimum variance portfolios in this case are:

2 σ B − σ Aσ B ρ AB .06 − (.224)(.245)(.5) xA = 2 = = 59.07% 2 σ A + σ B − 2σ Aσ B ρ AB .05 + .06 − 2(.224)(.245)(.5)

xB = 1 − x A = 1 − .5907 = 40.93%

Minimum Variance Portfolio (cont’d)
26

Example (cont’d)
1.2 1 0.8 0.6

At hg e W i

0.4 0.2 0 0 0.01

Portfolio Variance

0.02

0.03

0.04

0.05

0.06

Correlation and Risk Reduction
27

Portfolio risk decreases as the correlation coefficient

in the returns of two securities decreases Risk reduction is greatest when the securities are perfectly negatively correlated If the securities are perfectly positively correlated, there is no risk reduction

The n-Security Case
28

For an n-security portfolio, the variance is:

σ = ∑∑ xi x j ρijσ iσ j
2 p i =1 j =1

n

n

where xi = proportion of total investment in Security i

ρij = correlation coefficient between
Security i and Security j

The n-Security Case (cont’d)
29

A covariance matrix is a tabular presentation of

the pairwise combinations of all portfolio components

The required number of covariances to compute a portfolio variance is (n2 – n)/2 Any portfolio construction technique using the full covariance matrix is called a Markowitz model

30

The single-index model compares all securities to

a single benchmark
 

An alternative to comparing a security to each of the others By observing how two independent securities behave relative to a third value, we learn something about how the securities are likely to behave relative to each other

31

A single index drastically reduces the number of

computations needed to determine portfolio variance

A security’s beta is an example:

%% COV ( Ri , Rm ) βi = 2 σm % where R = return on the market index
m 2 σ m = variance of the market returns % Ri = return on Security i

Portfolio Statistics With the Single-Index Model
32

Beta of a portfolio:

p Variance of a portfolio:

β = ∑ xi βi
i =1

n

2 2 2 σ 2 = β pσ m + σ ep p 2 2 ≈ β pσ m

Portfolio Statistics With the Single-Index Model (cont’d)
33

Variance of a portfolio component:

σ = β σ +σ
2 i 2 i 2 m

2 ei

Covariance of two portfolio components:

σ AB = β A β Bσ

2 m

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