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Portfolio Management

Lecture 5

Instructor: Yong (Jimmy) JIN (jimmy.jin@polyu.edu.hk)

Office: M507D, Li Ka Shing Tower

Office Hour: Tuesday 17:20 to 18:20, 21:30 to 22:30; Friday 13:00 to 15:00

Agenda

• Capital Asset Pricing Model (CAPM)

• Security market line

• Arbitrage Pricing Theory (APT)

– Multifactor models

• Examples

What is CAPM?

• CAPM is capital asset pricing model, one of the most

fundamental concepts in investment theory.

stock

return on the market, the stock’s beta coefficient,

and the risk-free rate

CAPM assumptions

• Frictionless markets

– No trading costs

– No restrictions on short sales

• Investors care only about means and variances

CAPM assumptions

• Since everyone holds the same risky tangency portfolio and

since the supply of risky assets must equal the demand, this

implies

THE MARKET PORTFOLIO

• All investors will hold the same portfolio for risky assets –

market portfolio

• Market portfolio contains all securities and the proportion of

each security is its market value as a percentage of total

market value

The formula of CAPM

E[r ] r f

Cov(r , rM )

E[rM ] r f

Var (rM )

E[r ] r f E[rM ] r f

Beta

𝑐𝑜𝑣 𝑟 ,𝑟𝑀

• We refer to as beta,

𝑣𝑎𝑟 𝑟𝑀

E[r ] rf E[rM ] rf

individual assets

– For example, beta of an equal-weighted average

of the individual betas

p 0.5 X 0.5Y

Beta and expected return

• Assume risk-free rate of 3% and equity premium of

6%

• Expected return on GM assuming CAPM is true is

3%+1.269*6%= 10.61%

• In valuation applications, 10.61% would be the

discount rate in the present value formula

– Eg. If you expect GM’s price to be $50 in one year and

expect it to pay a dividend of $2, then the current fair price

is $(50+2)/(1+.1061)=$47.0

Beta and expected return

• A project has the following net after-tax cash flows ( in millions of dollars)

Year from now After-tax Cash Flow

0 -20

1 15

2 25

• What’s the NPV of the project?

Security Market Line

E(r)

SML

E(rM)

rf

M= 1.0

Capital Market Line

E(r)

CML

M

E(rM)

rf

m

CML vs. SML

• The CML plots the relation between expected

returns and standard deviation, while the SML is a

relationship between expected returns and

the SML. This is not true for the CML

– Investments with the same mean return can have different

standard deviations, but must have the same . In other

words, the only relevant measure of risk for pricing

securities is (a measure of covariance)

Sample calculations using CAPM

• E(rm) - rf = .08 rf = .03

• Two securities

– x = 1.25

• E(rx) = .03 + 1.25(.08) = .13 or 13%

– y = .6

• E(ry) = .03 + .6(.08) = .078 or 7.8%

Graph of sample calculations

E(r)

SML

Rx=13%

.08

Rm=11%

Ry=7.8%

3%

.6 1.0 1.25

y x

Disequilibrium example graph

E(r)

SML

15%

Rm=11%

rf=3%

1.0 1.25

Disequilibrium example calculations

• Suppose a security with a of 1.25 is offering

expected return of 15%

• According to SML, it should be 13%

• Since 15%>13%, this security is underpriced:

offering a high rate of return for its level of risk

Disequilibrium example calculations

• Suppose E(Rm)=12%, risk-free rate=5%

• Security A: beta=-0.5, offers an expected return of 3%

• Security B: beta=1.2, offer an expected return of 12%

• Which security is underpriced and which one is overpriced? Why?

Bottom-line

• Assumption of CAPM are restrictive

• But gives a simple and elegant relation for

expected returns

• Research shows that it is not very accurate

– Still widely used

Arbitrage Pricing Theory

• Given 𝑛 factors to determine the asset returns, as follows,

sensitivity to factor 𝑘, or the risk.

Factors

• What are the factors?

• For example, firm size?

– Choice 1: firm size, or other characteristics

• The relationship may be nonlinear

– Choice 2: constructed long-short portfolios

• Sort all the firms according to their size, using bottom 50% average return

minus top 50% average return

– Can capture the nonlinear relationship, especially the outliers

– Risk Premium is straightforward, simply average return of the

long short portfolios

Factors

• How does the factor affect the returns?

– Depends on the (risk) exposure to different factors

• Factors can capture the variation of the returns

• For example, the negative coefficient of size factor means the

firm is more likely to be a large firm

• Not prediction for the future return

• Mainly discover the alpha

Fama-French Three Factor Model

• Fama-French found that size and B/M do a better job of

explaining returns, so they said the model should be:

ri rf i i (rM rf ) si ( SMB) hi ( HML) ei

HML = high B/M minus low B/M = rvalue rgrowth

• Main criticism: No theory justifying why size and B/M

should be risk factors.

Fama-French Three Factor Model

HML = high B/M minus low B/M = rvalue rgrowth

Important Factors

• Market Excess Return: MRP

• Size Factor: SMB

• Value Factor: HML

• Momentum Factor: MOM

• Others:

• Share Issuance: McLean, Pontiff and Watanabe (2009)

• Profitability and Investment: Fama French (2016)

• Volatility: Ang, Hodrick, Xing and Zhang (2006)

• …

0

50

100

150

200

250

300

350

400

450

196306

196603

196812

197109

197406

197703

197912

198209

198506

198803

RMW

199012

199309

199606

199903

200112

200409

200706

• Size Factor: SMB

201003

201212

• Value Factor: HML

201509

0

100

300

400

600

700

200

500

800

196306

196603

196812

197109 • Investment Factor: CMA

• Profitability Factor: RMW

197406

197703

197912

198209

198506

198803

CMA

199012

199309

199606

199903

200112

200409

0

100

300

400

500

200

200706

0

200

400

600

800

1000

1200

201003 196306

201212 196306 196604

201509 196608 196902

196910 197112

197212 197410

197602 197708

197904 198006

198206 198304

198508 198602

Fama French 5 Factors

198810 198812

SMB

HML

199112 199110

199502 199408

199804 199706

200106 200004

200408 200302

200710 200512

201012 200810

201402 201108

201406

Factors

• How many factors do we have?

– In academic papers, there are more than 200….

– For example, “… and the Cross-Section of Expected

Returns”

– “Predicting Anomaly Performance with Politics, the

Weather, Global Warming, Sunspots and the Stars”

– One factor can be the noise version of the other factor

– One factor can be the linear combination of the other factors

0

5

10

15

20

25

1926

1930

1934

1938

1942

1946

1950

1954

1958

Mkt

1962

1966

1970

1974

1978

Ln(Total Wealth)

1982

1986

Selected Portfolio

1990

1994

1998

2002

2006

2010

2014

0

50

100

150

200

250

300

-100

-50

1926

1930

1934

1938

1942

1946

1950

1954

Mkt

1958

1962

1966

1970

1974

• Just based on SMB and HML two factors

1978

Annual Return (%)

1982

Stock Selection Example

1986

Selected Portfolio

1990

1994

1998

2002

2006

2010

2014

CAPM Example #1

• Given information: Assume CAPM holds

𝐸 𝑟𝐴 = 12%, 𝜎𝐴 = 25%

𝐸 𝑟𝐵 = 16%, 𝜎𝐵 = 45%

𝐸 𝑟𝐶 = 10%, 𝜎𝐶 = 30%

• Also given that stock C has a β of 0.6

• Find the β of stock B

CAPM Example #1

• Our objective: find the β of stock B

• 𝐸 𝑟𝑏 = 𝑟𝑓 + 𝛽𝑏 [𝐸 𝑟𝑚 − 𝑟𝑓 ]

• _____ = ____ + 𝛽𝑏 [𝐸 𝑟𝑚 − 𝑟𝑓 ]

• _____ = 𝛽𝑏 [𝐸 𝑟𝑚 − 𝑟𝑓 ]

• 𝐸 𝑟𝑐 = 𝑟𝑓 + 𝛽𝑐 [𝐸 𝑟𝑚 − 𝑟𝑓 ]

• ___ = ____ + ____ [𝐸 𝑟𝑚 − 𝑟𝑓 ]

• [𝐸 𝑟𝑚 − 𝑟𝑓 ]=____

• ____=𝛽𝑏 ∗ _______ 𝛽𝑏 =_____

CAPM Example #2

Assume CAPM holds and use the following information:

• Portfolio A has E(r) of 15% and β of 2

• Portfolio B has E(r) of 10% and β of 1

CAPM Example #2

• What information do we need?

– Risk-free rate and market risk premium

• What information do we have?

– Two CAPM equations for portfolio A and portfolio B

unknowns

CAPM Example #2

• Two equations:

𝐸 𝑟𝐴 = 𝑟𝑓 + 𝛽𝐴 𝐸 𝑟𝑚 − 𝑟𝑓

____= 𝑟𝑓 + _____ ∗ 𝐸 𝑟𝑚 − 𝑟𝑓 (1)

𝐸 𝑟𝐵 = 𝑟𝑓 + 𝛽𝐵 𝐸 𝑟𝑚 − 𝑟𝑓

____= 𝑟𝑓 + _____ ∗ 𝐸 𝑟𝑚 − 𝑟𝑓 (2)

____= 𝐸 𝑟𝑚 − 𝑟𝑓

CAPM Example #2

• Plug this into either of the equations

• Plug this into CAPM to find the return on a portfolio with a

β of 0.5

𝐸 𝑟𝑝 = ________________________

CAPM Example—Question

Assume CAPM holds and use the following information:

• Portfolio A has E(r) of 18% and β of 2.5

• Portfolio B has E(r) of 12% and β of 1.2

CAPM Example #3

• Given the following:

– Assume CAPM holds

– The expected return on the market is 14% with a SD of 20%

– The risk free rate of return is 4%

– The expected return on stock XYZ is 17% with a SD of 40%

– The covariance of XYZ with the market is 6%

– Question asks: Is XYZ fairly priced?

CAPM Example #3

• What do we need?

– Calculate expected return of stock XYZ, and then compare with the offered return

– Beta of XYZ

• What do we have?

– Covariance of the market with XYZ

– Formula to calculate beta using covariance and variance of the market

CAPM Example #3

𝐸 𝑟𝑋𝑌𝑍 = 𝑟𝑓 + 𝛽𝑋𝑌𝑍 𝐸 𝑟𝑚 − 𝑟𝑓

• Calculate 𝛽𝑋𝑌𝑍

𝜎𝑚,𝑋𝑌𝑍

𝛽𝑋𝑌𝑍 = =

𝑉𝑎𝑟(𝑚)

0.04+1.5*(0.14-0.04)=0.19 or 19% (remember this is the fair return)

17%<19%, future cash flows will be discounted at a lower discount

rate, therefore, the stock is overpriced.

CAPM Example --Question

• Given the following:

– Assume CAPM holds

– The expected return on the market is 14% with a variance of 8%

– The risk free rate of return is 4%

– The expected return on stock XYZ is 17% with a variance of 15%

– The covariance of XYZ with the market is 4%

– Question asks: Is XYZ fairly priced?

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