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Chapter 8: Securities and portfolios - risk and return - Learning outcomes

Chapter 8: Securities and portfolios -


risk and return
Table of Contents
Learning outcomes .................................................................................................................... 2
Essential reading........................................................................................................................ 2
1. Introduction ........................................................................................................................... 3
2. Risk and return of a single financial security ........................................................................ 4
2a. Empirical evidence on risk, return and their relationship ................................................ 7
3. Risk and return of a portfolio: portfolio analysis ................................................................ 11
4. Benefits of diversification ................................................................................................... 14
5. Mean-standard deviation portfolio theory ........................................................................... 17
5a. Efficient frontier and optimal portfolio with no risk-free asset ..................................... 18
5b. Mean-standard deviation frontier with arbitrary correlation (ρ).................................... 25
5c. The introduction of a risk-free asset: the capital market line......................................... 26
6. Asset pricing models ........................................................................................................... 29
7. Capital Asset Pricing Model (CAPM) ................................................................................. 30
7a. Security market line ....................................................................................................... 36
7b. Diversifiable risk and market risk ................................................................................. 38
7c. Theoretical and practical limitations of the CAPM ....................................................... 40
8. Arbitrage Pricing Theory (APT) ......................................................................................... 43
8a. Factor models ................................................................................................................ 43
8b. Arbitrage Pricing Theory ............................................................................................... 46
8c. Theoretical and empirical validation of the APT........................................................... 49

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Chapter 8: Securities and portfolios - risk and return - Learning outcomes

Learning outcomes
By the end of this chapter, and having completed the essential readings and activities, you
should be able to:
 explain how risk affects the return of a risky asset, and hence how risk affects the value of
the asset in equilibrium
 calculate risk and return for individual securities and portfolios, and understand the basic
statistical tools of expected returns, standard deviations and covariances
 explain the mean-standard deviation portfolio theory, and the meaning of its key concepts
(efficient frontier, feasible region, capital market line, and optimal portfolio)
 illustrate the effects of diversification
 explain the main assumptions and results of the CAPM
 illustrate the key concepts of the CAPM (beta and security market line)
 explain the main assumptions and results of the APT
 compare the theoretical and empirical validation of the CAPM and APT.

Essential reading
 Brealey, Myers and Allen 2010. Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate
Finance. (Boston, London: McGraw-Hill/Irwin, 2010) tenth edition Chapters 7 and 8.
 Mishkin and Eakins 2009. Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston,
London: Addison Wesley, 2009) Chapter 4.

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Chapter 8: Securities and portfolios - risk and return - 1. Introduction

1. Introduction
 Study Guide, pp. 160

Required return of saver-lender


In light of the main function performed by financial markets – to channel funds from saver-
lenders to spender-borrowers (as discussed in Chapter 2) – we now turn to the pay-off
required by saver-lenders when they invest in the financial assets (securities) issued on the
financial markets by the spender-borrowers (such as industrial firms) to finance their
investments in real assets (discussed earlier in Chapter 7).

Security attributes: Risk and Return


Two main attributes characterise the pay-off of a security: return and risk.
But thus far we have said little about where the expected return used in the valuation methods
(as explained in Chapter 7) comes from, or about the relationship between the two attributes.

Risk and return relationship


The objective of this chapter is to demonstrate how the risk of a security affects the return
required for it, and hence how risk affects the value assigned to the security in equilibrium.

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Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security

2. Risk and return of a single financial security


 Study Guide, pp. 160 – 161
 Mishkin and Eakins 2009, pp. 72 – 74
 Brealey, Myers and Allen 2010, pp. 191 - 194

Risk and return are the two main attributes of a financial security.

Actual return = amount received / amount invested


The actual return of a security is the amount received divided by the amount invested.

Uncertain return
However, when securities are originally acquired, their returns are usually uncertain because
their prices are subject to changes.

Example of uncertain return


For instance, say I bought shares in XYZ company in 2000 expecting a return of 10 per cent
per annum for 7 years.
Instead, my return was –20 per cent. Can you see that the actual return is –20 per cent, not
what I had hoped to get?
This implies that a variety of return outcomes are likely to exist, each occurring with a
specific probability.

Return modeled as random variable


Accordingly, the return measure of a risky asset is considered to be a random variable.
For analytical purposes the uncertainty of the return is measured by the expected (average)
return.

Expected return = probability weighted average of all possible returns


To provide a quantitative measure of the expected return we normally use the weighted average of all
possible returns, where the weights are the probabilities of occurrence of that return.
Formally, this is (Eqn 8.1):

E ( R)  p1 R1  p2 R2  ...  pn Rn (8.1)
where:
E(R) = expected return
Ri = return of the state of nature i
n = number of possible states of nature (outcomes)
pi = probability of occurrence of the return Ri.

 Notation of expected return in study guide is (E) R instead of E(R).


Note that returns and their probabilities are not usually known.

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Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security

Historical average return as proxies


However, in practice, historical average returns and number of past observations are often used as
proxies.

Figure 8.1: distribution of historical returns


Figure 8.1 shows a typical distribution for historical returns on stocks in major corporations. Each point
of the curve represents a stock.
Based on past performance in the overall market, we estimate that the expected return is 13 per cent.
We recognise that there can be significant deviations from the mean (13 per cent).
In fact it is quite possible that return could be –10 per cent in one year and +35 per cent in the next year.
(Note that the return can become arbitrarily large, but can never be less than –1, which represents the
complete loss of the original investment in the stock.)

Measure of risk: variation around E(R) - Variance


The variation around the expected return is a measure of the risk of a security. This is a measure of
how far the actual return differs from the expected return.
To provide a quantitative measure of the degree of possible deviations from the expected return we
normally use a measure of dispersion of a distribution of historical returns: the variance.

Standard Deviation (SD)


We frequently use the square root of the variance, called standard deviation. The standard deviation
is a statistical measure of how variable the returns are around the average return.

Deviation = Ri - E(R)
More formally, to calculate the standard deviation of returns we need to calculate the expected return
E(R), then to subtract the expected return from each return to get a deviation.
Then we square each deviation and multiply it by the probability of occurrence of that outcome.
Finally we add up all these weighted squared deviations and take the square root, that is:
  p1 ( R1  E ( R)) 2  p2 ( R2  E ( R)) 2  ...  pn ( Rn  E ( R)) 2 (8.2)

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Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security

Standard Deviation, variability and risk


The higher the standard deviation, the greater the variability, and hence the higher the risk.

Example of measure S.D.


Example: Consider First Class, a stock with a return of 24 per cent one-half of the time and 10 per cent
one-half of the time.
The expected return is 17 per cent (=0.5*0.24+0.5*0.10).
The standard deviation is 7 per cent:

Activity 8.1
Consider Second Class, a stock with a return of 16 per cent two-thirds of the time and 9 per cent one-
third of the time. Then answer the following questions:

 What is the expected return of the stock?

 What is the standard deviation of the returns on the stock?

 Is the Second Class stock more or less risky than the First Class stock?

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Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security

2a. Empirical evidence on risk, return and their


relationship
 Study guide, pp. 162 - 164

What are the levels of risk and return of financial securities around the world? The next activity enables
you to find out some empirical evidence on risk and average returns associated with different classes of
securities (stocks and bonds) for different countries.

Activity 8.2
Download the Credit Suisse Global Investment Returns Yearbook 2010, available at:
http://tinyurl.com/DMS2010
Carefully read the country profiles for the 19 countries focusing on figure 3 in each profile which shows
the returns and risks of major asset classes from 1900 to 2009.

Real return = Nominal return - inflation


The empirical evidence provided in the ‘Global Investment Returns Yearbook 2010’ shows both real and
nominal returns.
(Note that the difference between nominal and real performance rates arises because the purchasing
power of income is reduced by inflation.)

Stock market performance


Among the 19 countries under investigation over 110 years, the best performer for stocks over the very
long term is Australia, with an annualised percentage real return of 7.5 per cent since 1900, compared
to a world average of 5.4 per cent.
The worst performer for stocks is Italy with an annualised percentage real return of about 2.1 per cent
since 1900.

Bond market performance


The best performer for bonds is Denmark, with an annualised percentage real return of 3.0 per cent
since 1900, compared to a world average of 1.7 per cent.
The worst performer for bonds is Germany, with an annualised percentage real return of about –2.0 per
cent since 1900.

Let us now focus on the USA. To find out the risk and average returns associated with different classes
of securities in the US market, move to the next activity.

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Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security

Activity 8.3
Visit the Morningstar website at
http://corporate.morningstar.com/ib/documents/SampleContent/MktChartsImages.pdf and analyse the
figure ‘Stock, Bonds, Bills and Inflation’.

Stock, Bonds, Bills and Inflation


This Morningstar’s figure shows the amount available in 2006 by investing $1 at the start of 1926 in
each of the four security classes (small companies’ stocks, large companies’ stocks, government bonds
and Treasury bills). Values take into account inflation (i.e. real returns).
By 2006, the performances in real terms are (in increasing order):

 Treasury bills (a money market debt instrument) grew to $18,


 long-term government bonds grew to $71,
 large stocks grew to $5658, and
 small stocks grew to $13796.

The performance of each security class coincides with the intuitive risk ranking.

Relationship between risk and return


Following on, we turn our attention to the relationship between risk and return.
Figure 8.2 shows the risk and return of US financial instruments over the period 1926–2000.

 risk is measured as risk premium, i.e. the extra return versus Treasury bills
 return is measured by the average nominal and real annual rate of return

 Treasury bills were the least profitable (3.9 per cent nominal annual rate of return), but
were also virtually risk-free (0 per cent risk premium).
 Common stocks obtained the highest average return (13 per cent nominal annual return),
but also experienced the highest risk (9.1 per cent risk premium).

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Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security

Fact 1. Positive relationship between risk and return


A first interesting fact about the relationship between risk and return emerges: this relationship is
positive. In other words, the performance of each security class increases with the risk ranking.

Return as compensation for bearing risk


This occurs because investors require compensation for bearing risk.
The higher the risk associated with a financial instrument, the higher the return investors require to hold
a financial asset.

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Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security

Risk and return varies over time


Moreover the relationship between risk and return varies over time, as shown in the next activity.

Activity 8.4
Visit the Morningstar website at
http://corporate.morningstar.com/ib/documents/SampleContent/MktChartsImages.pdf and analyse the
figure on ‘Reduction of risk over time’.

Risk reduces over time


This Morningstar’s figure provides evidence on how risk reduces over time.
In the US market (with reference to the years 1926–2006), the level of risk (measured in terms of
variability of returns) decreases by holding financial securities over longer periods of time.

Returns of 1 year holding period


When the holding period is one year only, the level of dispersion of returns is very high:

 between –50 per cent and +135 per cent for small company stocks, and
 between 0 per cent and +20 per cent for Treasury bills.

Returns of 20 years holding period


When the holding period is up to 20 years, the level of variability of returns is much more limited:

 between +5 per cent and +20 per cent for small company stocks, and
 between 0 per cent and +7 per cent for Treasury bills.

Note that when the holding period is up to 20 years, the average returns of different security class
converge towards the average nominal values analysed above. Specifically, they are:
 12.6 per cent for small company stocks,
 10.4 per cent for large company stocks,
 5.5 per cent for government bonds and
 3.7 per cent for Treasury bills.

Fact 2: relationship between risk and return changes over time


A second interesting fact about the relationship between risk and return emerges: the relationship
changes over different holding periods. Specifically, the level of risk tends to reduce over longer
holding periods.

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Chapter 8: Securities and portfolios - risk and return - 3. Risk and return of a portfolio:
portfolio analysis

3. Risk and return of a portfolio: portfolio analysis


 Study Guide, pp 164 – 165
 Brealey, Myers and Allen 2010, pp. 198 - 202

Portfolio
A portfolio is a combination of different assets held by an investor.

Portfolio weight
The share of the value of each individual asset over the total value of the portfolio is referred to as the
weight of the asset in the portfolio.
Obviously the sum of the weights of all the assets of the portfolio must be one (unity).

Example of 2 stock portfolio


Example: Consider an investor with a portfolio composed of two stocks: 75 The Coca Cola Company
stocks and 50 Microsoft stocks.
On 28 February 2008 the market prices of the two stocks were: The Coca Cola Company $41.16,
Microsoft $26.67.
The total value of the portfolio is $4,420. The portfolio weight for The Coca Cola Company is therefore
69.8 per cent.

Activity 8.5*
Calculate the portfolio weight for Microsoft.

 The solution to this activity can be found at the end of the subject guide in Appendix 1.

Expected return of a portfolio E(Rp)


The expected return of a portfolio – E(Rp) – is simply the weighted average of the expected returns of
the individual stocks of which the portfolio is composed, where the weights are the portfolio weights.
Formally, this is:

E ( R p )  w1 E ( R1 )  w2 E ( R2 )  ...  wn E ( Rn ) (8.3)
where: wi = portfolio weight for stock i.

Example of E(Rp)
Going back to our example, assume that the expected return over the coming year will be 10 per cent
for The Coca Cola Company and 15 per cent for Microsoft.
The expected return of the portfolio of the investor is 11.5 per cent = (0.698 × 0.10 + 0.301 × 0.15).

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Chapter 8: Securities and portfolios - risk and return - 3. Risk and return of a portfolio:
portfolio analysis

Risk of portfolio: correlation


The calculation of the risk of the portfolio is much more complex.
We need to understand the statistical concept of correlation, which measures the degree to which two
returns tend to move together.

 A positive correlation means that the two returns tend to move together;
 a negative correlation implies that the two returns tend to move in opposite directions;
 a zero correlation indicates that the returns of the stocks are wholly unrelated.

Correlation coefficient
A statistical measure of correlation is known as the correlation coefficient.
It is simply the covariance divided by the product of the respective standard deviations.
Formally the correlation coefficient is defined as follows:

 1, 2
1, 2  (8.4)
 1 2
where: σ1,2 = covariance between stocks 1 and 2, which is a measure of the degree to which
the two stocks move together over time (covary).

Portfolio variance
The portfolio variance is the weighted average of several components:

 a) the variance of the returns on each stock (σi2 with i = 1,2) multiplied by the square of its portfolio
weight (wi2);
 b) the covariance between stocks 1 and 2. Formally, this is:

 p2  w12 12  w22 22  2w1 w2 1, 2 1 2 (8.5)

Portfolio SD
The portfolio standard deviation is of course the square root of the variance.
Note that the standard deviation of a portfolio is simply the weighted average of uncorrelated
(i.e. ρ1,2= 0).

Expected return and variance of a portfolio


Now, given the expected returns, return variances and correlation coefficient for any set of assets, we
should be able to calculate the expected return and variance of a portfolio composed of these assets.

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Chapter 8: Securities and portfolios - risk and return - 3. Risk and return of a portfolio:
portfolio analysis

Example of E(Rp) & σp


Example: Recalling our portfolio composed of The Coca Cola Company and Microsoft, let us calculate
its variance.
In the past the standard deviations were 35 per cent for The Coca Cola Company and 50 per cent for
Microsoft.
Assume that the two stocks are positively – but not perfectly – correlated (i.e. ρ1,2= 0.5).
The variance of the portfolio is 11.9 per cent = [(0.698)2 × (0.35)2] + [(0.302)2 × (0.50)2] + 2 (0.698 ×
0.302 × 0.5 × 0.35 × 0.50).
Therefore the standard deviation is 34.5 per cent.

Activity 8.6
Using the same weights and standard deviations given above, calculate the portfolio return variance in
these three cases:
1. Negative correlation between returns, ρ1,2 = – 0.3.

2. Perfect positive correlation between returns, ρ1,2 = 1.

3. Uncorrelated returns, ρ1,2 = 0.

 The solution to this activity can be found at the end of the subject guide in Appendix 1

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Chapter 8: Securities and portfolios - risk and return - 4. Benefits of diversification

4. Benefits of diversification
 Study Guide, pp. 165 – 166
 Brealey, Myers and Allen 2010, pp. 196 - 198

Variance of portfolio < Variance of individual asset


From most of the above calculations, you can note that the variance of the portfolio return is lower than
that of any individual asset.

Reduce risk by diversification


This suggests that by forming portfolios (or by including additional assets in the portfolio), risk-averse
investors are able to reduce risk.
This process is referred to as diversification.

Reason: -1< correlation <1


The reason this works is that, in real stock return data, the correlations between returns are less than
perfect.

 Note that diversification does not work in the extremely rare cases where returns move
perfectly together.
 Conversely, if returns are uncorrelated, it is possible through diversification to reduce risk to zero.

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Chapter 8: Securities and portfolios - risk and return - 4. Benefits of diversification

Figure 8.3: benefits of diversification


As shown in Figure 8.3 diversification can significantly reduce risk. The portfolio variance falls as the
number of assets held increases.
This benefit can be achieved even with a relatively small number of stocks (around 20 stocks).

Activity 8.7
Read Mishkin and Eakins (2009), p.75 (footnote 2) and summarise their example of how diversification
works.

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Chapter 8: Securities and portfolios - risk and return - 4. Benefits of diversification

Figure 8.4: Empirical evidence of diversification


The effectiveness of diversification in reducing the risk of a portfolio varies from country to country as
shown in Figure 8.4.
In Switzerland, Germany and Italy stocks tend to move together (high covariance), and thus
diversification is less effective.
Instead, in Belgium and the Netherlands, much more of the risk of holding individual stocks can be
diversified away because of the low covariance.

Activity 8.8
Now think about what an investor in say, Germany, can do to achive greater risk reduction.

Diversification by global investment


The investor could invest some of their wealth in stocks listed outside of Germany. In fact many
investors and investment funds diversify their portfolios internationally.

Exchange rate risk in global investment


However, this brings an additional risk – exchange rate risk. That is, the value of the foreign investments
may decline due to changes in the exchange rate.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

5. Mean-standard deviation portfolio theory


 Study Guide, pp. 166
 Brealey, Myers and Allen 2010, pp. 213 - 220

The aim of this section is to identify the optimal holding of risky assets for a risk-averse agent, since
the investor seeks to minimise risk.
This is known as the mean-standard deviation portfolio theory, and was developed by Markowitz (1952).

Assumption: preference only involve expected return and SD


The assumption is that agents have preferences that only involve expected portfolio returns and
return standard deviations.

Utility function
The utility function is increasing in expected portfolio returns, and decreasing in return standard
deviation.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

5a. Efficient frontier and optimal portfolio with no


risk-free asset
 Study Guide, pp. 166 - 169

Figure 8.5 Mean-Standard deviation frontier with 2 risky assets


Let us first consider two risky assets named X and Y. (We thus assume that there is no risk-free asset.)
The two assets can be combined, according to some weights, to form a portfolio (a new asset).

The diagram shown in Figure 8.5 describes the mean (Y-axis) and the standard deviation (X-axis) of
any risky asset, and each point in this diagram represents an asset.
As the portfolio weights for the two assets vary from 0 to 1,

 the portfolio goes from one that contains only asset X,


 to one that contains a mixture of assets X and Y, and then
 to one that contains only asset Y.

As the portfolio weights vary, the new portfolios trace out a curve that includes assets X and Y.

Mean-standard deviation frontier


This curve, which looks something like the curved shape in Figure 8.5, is named the mean-standard
deviation frontier.
It shows the expected return and risk that could be achieved by different combinations (portfolios)
of the two risky assets, and

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

Trade-off between mean (return) and SD (risk)


Trade-off between mean (return) and SD (risk) enables understanding of how investors view the trade-
offs between means and standard deviations when they choose the portfolio weights of the assets to
include in their portfolios.

Implicit assumption: no short selling


Note that an implicit assumption is made that investors are prohibited from short selling the assets (and
thus borrowing the required money).

Optimal portfolio: right of point V


As the investor’s preferences are increasing in return and decreasing in standard deviation (the investor
wants to go up and to the right within the area of the diagram), the optimal portfolio will always lie on
the frontier and to the right of the point labelled V.

Minimum variance portfolio (V)


This point V represents the minimum-variance portfolio (i.e. a portfolio that offers the minimum risk).
The minimum variance portfolio is found by differentiating the equation for the portfolio variance
(equation 8.5) with respect to one of the weights, say, w1.
The derivative of this equation is then set to zero and solved for w1.
w1  ( 22   1 2 1, 2 ) /( 12   22  2 1 2 1, 2 )

Derivation of the minimum variance portfolio (V) (Out of Syllabus)

σp2 = w12 σ12 + w22 σ22 + 2 w1 w2 ρ1,2 σ1 σ2


Put w2 = 1 - w1, σp2 = w12 σ12 + (1 - w1)2 σ22 + 2 w1 (1- w1) ρ1,2 σ1 σ2
Differentiate σp with respect to w1,
2 σp (d/dw1(σp)) = 2 σ12 w1 -2 σ22 + 2 w1 σ22 + 2 ρ1,2 σ1 σ2 - 4 w1 ρ1,2 σ1 σ2

Divide both sides by 2,


σp (d/dw1(σp)) = (σ12 + σ22 - 2 σ1σ2ρ1,2)w1 -σ22 + σ1σ2 ρ1,2

Set d/dw1(σp) = 0,
w1 = (σ22 - σ1σ2 ρ1,2) / (σ12 + σ22 - 2 σ1σ2ρ1,2)

The weight of the other asset (w2) in the minimum variance portfolio is found from: w2 = 1 – w1
Using the two calculated weights in equations 8.3 and 8.5 will give us the expected return and standard
deviation of the minimum variance portfolio.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

Upper part of the frontier


Only the upper part of the mean-standard deviation frontier will be of interest to risk-averse investors.
In fact only the portfolios on the frontier and to the right of V maximise the expected return for a given
standard deviation.

Efficient frontier
In the absence of a risk-free asset, this set of portfolios (on the frontier and to the right of V) is termed
the efficient frontier (as shown in Figure 8.6).

Minimise risk or maxmise return


This is the group of portfolios that both minimise risk for a given level of expected return, and
maximise expected return for a given level of risk.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

Activity 8.9*
Risky asset A has an expected return of 15% and a standard deviation of 25%
Risky asset B has an expected return of 35% and a standard deviation of 40%. If the
correlation between the returns on assets A and B is 0.25 and the assets are combined in
the following proportions:
A B

1 1 0

2 .75 .25

3 .5 .5

4 .25 .75

5 0 1

Calculate
i. the expected return and standard deviation for the 5 portfolios

ii. the expected return and standard deviation for the minimum risk portfolio

iii. plot all the portfolios calculated in (i) and (ii) on a graph and identify the efficient frontier.

 The solution to this activity can be found at the end of the subject guide in Appendix 1.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

Preference of investor
In order to identify the optimal portfolio (of two risky assets) for a given investor, we need to identify a
set of preferences for this investor.

Indifference curve
This set of preferences towards risk and return can be represented by an indifference curve. Figure
8.6 shows two indifference curves for investors A and B respectively.

Risk-averse investor (A)


The quite steep indifference curve on the left represents a relatively risk-averse investor (investor A),

Less risk-averse investor (B)


while the flatter indifference curve on the right represents a less risk-averse investor (investor B).

Optimal portfolio: tangent to efficient frontier


The optimal portfolio is the portfolio where the investor’s indifference curve is tangent to the mean-
standard deviation frontier.
These two optimal portfolios (for the two different investors) are identified on Figure 8.6 at points A and
B.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

Figure 8.7: Mean-standard deviation frontier for N risky assets


In Figure 8.7 we draw the mean-standard deviation frontier for N risky assets using every possible
weighting scheme.

Feasible region
The set of all points representing portfolios made from N assets is called the feasible set or feasible
region.

Same shape
The shape of the frontier is the same as in the case of two risky assets (as drawn in Figure 8.5).

More feasible but inefficient portfolios


The difference is that the shaded area represents feasible but inefficient portfolios, which do not
maximise the expected return for a given standard deviation.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

Activity 8.10*
Consider a rational investor who has to choose one portfolio. Which portfolio would always be preferred
for each of the following pairs of portfolios?
1. Portfolio A E(R) = 17% σ = 16%
Portfolio B E(R) = 17% σ = 6%
2. Portfolio C E(R) = 15% σ = 16%
Portfolio D E(R) = 12% σ = 16%

 The solution to this activity can be found at the end of the subject guide in Appendix 1.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

5b. Mean-standard deviation frontier with arbitrary


correlation (ρ)
 Study guide, pp. 169 - 170

In the last section, the mean-standard deviation frontier has been identified by assuming that the return
correlation coefficient was between plus and minus one.
Figure 8.8 shows the locus of the return-standard deviation frontier assuming different correlation
coefficients.

Perfect correlation (ρ = +1)


When there is perfect correlation (ρ = +1), the return–risk combinations are represented by a straight
line.

Less than perfect correlation (ρ <+1)


When the risky assets have less than perfect correlation (ρ <+1), the investor can reduce the portfolio
risk by diversification.

Reduce the portfolio risk (SD)


(As previously discussed, the standard deviation of this portfolio is less than the weighted average of the
two standard deviations.) This gives the curvature to the left. The correlation determines the degree of
curvature: the lower the correlation, the more distended the curvature.

Perfectly negatively correlated (ρ = –1) asset


Finally, when the investor can include in the portfolio a risk-free asset with a return perfectly negatively
correlated (ρ = –1), the return-risk combinations are represented by a pair of lines.

The figure 8.8 and 8.9 is misplaced in the study guide.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

5c. The introduction of a risk-free asset: the capital


market line
 Study guide, pp. 170 - 171

Risk-free asset, E(R) = Rf, SD = 0


Let us now introduce a risk-free asset, with expected return Rf and zero standard deviation.
(As discussed in Chapter 2, in the USA the least risky asset is a US Treasury bill.)

Fig 8.9 Mean-SD frontier with risk-free asset and N risky assets
In Figure 8.9 we have plotted the expected return and risk of a portfolio composed by the risk-free asset
and a combination of risky assets.

Capital market line (CML)


A range of combinations of the risk-free asset and a portfolio of risky assets exist and two possible
combinations (labelled CML1 and CML2) are shown in Figure 8.9.
Note that CML stands for capital market line.

We now need to identify the optimal portfolio for an investor who wants to hold a risk-free asset in
addition to N risky assets.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

Optimal portfolio: point K


What is the optimal portfolio of risky assets for the investor?
The optimal portfolio is represented by point K in Figure 8.8. The reason for this is that an investor will
prefer to be somewhere on CML1 rather than any other CML (joining the risk-free asset to the efficient
frontier (such as CML2).

 As all points along CML1 are superior (in terms of return for a given risk) to points on
say, CML2.

Efficient set = CML1


In presence of a risk-free asset and N risky assets, the efficient set becomes the optimal capital market
line (CML1).

Two-fund separation
We have achieved a very important result known as two-fund separation. Any risk-averse investor
can form the optimal portfolio by combining two funds.

1. The first is the risk-free asset,


2. the second is the risky asset portfolio K.

Degree of risk-aversion
The degree of risk-aversion determines the portfolio weights placed on the two funds.

Example of different risk-aversion


For example, in Figure 8.9, investor A is more risk-averse than investor B, and thus A puts more
weight on the risk-free asset.

Optimal portfolio (K): all investor invest in it.


This result allows us to identify the optimal portfolio of risky assets, K, that all investors who invest in
risky assets will choose to hold irrespective of their risk preference.

Relationship of Two-fund separation and CAPM


The two-fund separation theorem forms the starting point for the important Capital Asset Pricing Model,
discussed in the next section.

Lending and borrowing on CML1


Optimal portfolios of the risk-free asset and the risky portfolio, K, lie along
CML1 such that

 points to the left of K represent lending portfolios where the investor invests positive amounts in
the risk-free asset.

 Points to the right of K represent borrowing portfolios where the investor borrows at the risk-free
rate to increase the amount of funds they can invest in the optimal risk assets portfolio K.

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Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory

Example of lending
An example will help to illustrate this. Suppose an investor has $10,000 to invest. The expected return
on portfolio K is 15 per cent and the standard deviation of returns is 20 per cent. The risk-free rate of
interest is 5 per cent.
A risk-averse investor may wish to invest half of his/her wealth ($5,000) in the risk-free asset and half
($5,000) in portfolio K.
What is the expected return and risk for this efficient portfolio, say, A?

Answer:
E(RA) = 0.5 × 5% + 0.5 × 15% = 10%; σA = 0.5 × 0 + 0.5 × 20% = 10%

SD of portfolio on CML1: linear weighted average of Rf and K


Note that the standard deviation of portfolio A is simply a linear weighted average of the individual risks
of the two funds.
Of course, the standard deviation of the risk-free asset is zero so the risk of this efficient lending portfolio
is simply the weight assigned to portfolio K multiplied by the
risk of portfolio K.

Example of borrowing
A more risk-seeking investor may choose to borrow, at the risk-free rate, an amount of $5,000 giving
him/her a total of $15,000 to invest in portfolio K.
The expected return and risk of this borrowing portfolio, say B, is given by:

Answer:
E(RB) = −0.5 × 5% + 1.5 × 15% = 20%; σB = −0.5 × 0 + 1.5 × 20% = 30%

Activity 8.11
How can investors identify the best set of efficient portfolios of common stocks?
What does ‘best’ mean?

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Chapter 8: Securities and portfolios - risk and return - 6. Asset pricing models

6. Asset pricing models


Goal: equilibrium asset price
The problem we want to solve in this section is to determine the correct, arbitrage-free, or fair price
of an asset in equilibrium. In order to do so, it is necessary to identify theories that enable us to deduce
this equilibrium price of a risky asset.

CAPM: mean-SD frontier


We analyse first the Capital Asset Pricing Model (CAPM), which identifies the equilibrium price within
the framework of the mean-standard deviation frontier.

APT: same asset cannot sell at different prices


We then move to the Arbitrage Pricing Theory (APT),

 which does not require the assumption that investors choose their portfolios on the basis of
means and standard deviations,

 but rather on the basis that two assets that are the same cannot sell at different prices.

Reference of CAPM & APT


The CAPM model has been developed primarily by Sharpe (1964) and Lintner (1965), and the APT by
Ross (1976).

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

7. Capital Asset Pricing Model (CAPM)


 Study Guide, pp. 172 – 174
 Beta: Brealey, Myers and Allen 2010, pp. 202 – 205
 CAPM: Brealey, Myers and Allen 2010, pp. 220 - 223

Optimal portfolio (K) = tangent portfolio


To implement the mean-standard deviation frontier requires observing the optimal portfolio, which is the
tangent portfolio (as discussed in the previous section).

Problem: finding tangent portfolio for a large number of risky assets.


However, it is impossible to derive the tangent portfolio simply from observed returns on large
numbers of risky assets.

CAPM: Theory to identify the tangent portfolio


We thus need a theory that identifies the tangent portfolio from sound theoretical assumptions. This
section develops one such theory, the Capital Asset Pricing Model (CAPM).

Assumptions of CAPM
To begin our discussion of the CAPM, let us first present the assumptions that underlie the theory:

1. Investors maximise their utility only on the basis of expected portfolio returns and return
standard deviations.

2. Unlimited amounts can be borrowed or loaned at the risk-free rate.

3. Markets are perfect and frictionless. (i.e. no taxes on sales or purchases, no transaction costs
and no short sales restrictions).

4. Investors have homogeneous beliefs regarding future returns, which means that all investors
have the same information and assessment about expected returns, standard deviations and
correlations of all feasible portfolios.

 assumptions 1–3 were implicit in the mean-standard deviation analysis


 assumption 4 is an additional one needed to develop the CAPM

Conclusion of CAPM: tangent portfolio = market portfolio


From these assumptions, the main conclusion of the CAPM is that in equilibrium the tangent portfolio
of risky assets must be the market portfolio.

Derive from two-fund separation


From the two-fund separation theorem everybody will hold a risk-free asset and a combination of risky
assets.

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

From assumption 4, everyone hold the same market portfolio.


Furthermore, as everybody shares the same beliefs, everybody will use the same efficient fund of risky
assets. This fund must be the market portfolio. Each investor will hold the same portfolio as everybody
else; in other words, everybody will hold the market portfolio.

Market portfolio: includes all assets


The market portfolio is the portfolio comprising all assets, where the weight on each asset is the
market capitalisation (also called market value) of that asset divided by the total market capitalisation
of all risky assets. These weights are termed capitalisation weights.

All risky assets


The market portfolio should include all risky assets and therefore

 all stocks and bonds listed on all exchanges and

 those traded over-the-counter as well as

 non-financial assets (such as real estate and durable goods).

Market portfolio is unobservable

Therefore, the exact composition of the market portfolio is unobservable.

Proxies: broad-based equity index


Consequently, the implementation of the CAPM requires using proxies for the market portfolio. A
frequently used proxy is a broad-based equity index

 such as the S&P500 (500 typically larger market capitalisation stocks traded on the NYSE and
Nasdaq).

Equilibrium: supply = demand


Capital market equilibrium requires that the demand for risky assets be identical to their supply.

 The demand for risky assets is represented by the optimal portfolio chosen by investors, whereas

 their supply is given by the market portfolio.

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Equilibrium equation under CAPM


Under the CAPM assumptions, the equilibrium between risk and return can be expressed as (Eqn 8.6):

E ( Ri* )  R f   i [ E ( RM )  R f (8.6)

where:

 βi = the covariance of the returns on asset i with the return on a market portfolio, divided by the
variance of the market return. Formally, this is: βi = σiM / σ2M

 E(RM) = expected return on the market portfolio

 [E(RM) – Rf] = market risk premium, which is the amount by which the return of the market
portfolio is expected to exceed the risk-free rate.

Usage of Eqn 8.6: finding expected return = risk-free rate + market risk premium *
beta

The CAPM enables us to figure out what returns investors are looking for from particular security.
Specifically, under the CAPM framework, the expected return of a given risky asset (or portfolio of
assets) is equal to the risk-free rate plus a market risk premium multiplied by the asset or portfolio
beta.

Estimate of 3 elements (risk-free rate, beta and market risk premium)


To calculate this, we need three elements: risk-free rate, beta and market risk premium.

We showed estimates of the risk-free rate in the paragraph on ‘Empirical evidence on risk, return and
their relationship’; and we will do the same for beta and market risk premium in the next paragraphs.

Beta
βi = the covariance of the returns on asset i with the return on a market portfolio, divided
by the variance of the market return. Formally, this is: βi = σiM / σ2M

From SD to Beta
Under the CAPM framework, the standard deviation of an asset by itself is no longer an important
determinant of the expected return of that asset.

Beta measures sensitivity


What is important is the beta of the risky asset (βi), which measures the sensitivity of an individual
security to the market movements.

E(R) increase linearly with β


The expected returns increase linearly with beta.

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Aggressive companies: β > 1


Stocks with betas greater than 1.0 tend to amplify the overall movement of the market: generally
speaking we expect aggressive companies or highly leveraged companies to have high betas.

Conservative companies: 0 < β < 1


Conversely, stocks with betas between 0 and 1 tend to move less than the market: and therefore are
typically conservative companies.

Mimic the market (β = 1)


A stock with a beta equal to one will mimic the market.

Example of Beta
Example: Consider the beta of Microsoft stock, which is equal to 1.527 (this estimate is provided by
various data service organisations such as Bloomberg, and it is calculated by using a record of past
stock values).

 This β value means that on average, when the market return increases by an extra 1 per cent,
Microsoft’s return will rise by an extra 1.527 per cent.

 When the market decreases by an extra 2 per cent, Microsoft stock return will fall an extra 2
×1.572 = 3.144 per cent.

Activity 8.13
Decide whether each of the following statements is true or false.
 The expected return of an asset with a beta of 0.5 is half the expected return of the market.
(True / False)
 If the beta of an asset is lower than 0, the CAPM implies that its expected return will be lower
than the interest rate. (True / False)

Beta of a portfolio
The beta of a portfolio (βp) is simply the weighted average of the betas of the individual assets in the
portfolio (βi), where the weights are the portfolio weights (wi). Formally this is:

 p   wi  i (8.7)

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Market risk premium


What about the value of the market risk premium? The market risk premium cannot be measured with
precision, and practitioners and scholars are still debating about its magnitude and the method to be
used for the estimation.

Arithmetic average / geometric average


Specifically, it can be estimated either by using an arithmetic average or a geometric average of
historical returns.

Fig 8.10: Market risk around the world


With regard to the magnitude, some recent empirical evidence, as summarised in Figure 8.10, shows
that the annualised arithmetic equity risk premium relative to bills was 7.05 per cent for the USA,
6.02 per cent for the UK and 5.09 per cent for the world index for the years from 1990–2001.

These values are somewhat lower than the historical average risk premium over the longer period
1926–2000: for example, for the USA the risk premium over 1926–2000 was equal to 9.1 per cent (=
0.13 – 0.039; see Figure 8.2).

Different market, different market risk premium


The value of the market risk premium varies internationally: over the period 1990–2001, the risk
premium in Denmark was only 3.02 per cent (bottom end), whereas in Germany it was up to 10.0 per
cent and in Italy to 10.06 per cent.

Some of these variations may reflect differences in risk (i.e. Italian stocks may have been particularly
variable and investors may have required a higher return to compensate).

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Geometric averages < Arithmetic averages


As regard to the method to be used for the estimation, Figure 8.10 reveals that the risk premium
measured by geometric averages is much lower than the premium based on arithmetic averages.

Example of geometry equity risk premium


For example, the annualised geometric equity risk premium relative to bills was 5.06 per cent for the
USA (instead of 7.05 per cent).
Accordingly, the Global Investment Returns Yearbook 2005 (LBS/ABN Amro) estimates that the
plausible forward-looking risk premium for the world’s major markets would be of the order of 3 per cent
relative to bills on a geometric mean basis, whereas the corresponding arithmetic mean risk premium
would be around 5 per cent.

Norm for the estimation: arithmetic average


Which method should be preferred? The arithmetic average is the norm for the estimation, but the
debate is still open. (for example Jacquier et al., (2003) show that the correct estimation requires
compounding at a weighted average of the arithmetic and geometric historical averages).

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

7a. Security market line


 Study Guide, pp. 175

Graphical representation of CAPM: Security Market Line (SML)


The CAPM equilibrium relationship between risk and return has a very simple graphical representation.
The CAPM formula can be seen as a linear relationship between the expected return and β, which is
known as the security market line (SML).
As shown in Figure 8.11, beta is on the horizontal axis, while the expected return is on the vertical
axis.
The expected return on a risk-free asset is Rf.

Market portfolio (M): β = 1, E(Rp) = E(RM)


An asset with β of unity has an expected return equal to that of the market E(RM): this asset is the
market portfolio (M).

SML
Therefore the security market line is a straight line emanating from the risk-free point and passing
through the market portfolio.

Equilibrium on SML
In equilibrium every stock must lie on the security market line: no stock can lie below or above the
security market line.
This happens because any investor can always obtain a market risk premium of βi[E(RM) – Rf]
by holding a combination of the market portfolio and the risk-free asset.

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Example of market risk premium


Example: Consider Microsoft stock. Given a beta equal to 1.527, a market risk premium of 9 per cent,
and a risk-free rate of 3.5 per cent, the expected return for Microsoft must be

Answer: 0.035 + 1.527 × (0.09 – 0.035) = 11.9%

Activity 8.14*
Assume that the return on US Treasury bills is 3 per cent, the expected return on the market portfolio is
12 per cent. On the basis of the CAPM:
1. Draw a graph showing the relationship between the expected return and beta.

2. What is the risk premium on the market?

3. What is the required return on a stock with a beta of 1.5?

4. What is the beta of a stock if the market return is expected to be 12.5 per cent?

The solution to part of this activity can be found at the end of the subject guide in Appendix 1.

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

7b. Diversifiable risk and market risk


 Study Guide, pp. 175 - 176

Identical E(R), identical β; may have different S.D. (σ)


In equilibrium two assets with identical expected returns must have identical betas, although their
standard deviations can differ.

Reason: Reduce some risk by diversification


The reason for the difference in the standard deviation is that a portion of risk can be eliminated
through diversification (as discussed before).

Diversifiable risk
The risk that can be eliminated by diversification is known as diversifiable risk (or unique, specific,
non-systematic risk), which is the risk peculiar to a company or its immediate competitors.

Bearing diversifiable risk does not increase E(R)


Investors do not need any reward to bear such risk, and hence diversifiable risk does not affect
expected returns.

Market risk
However, there is some risk that cannot be avoided, regardless of how much investors diversify. This
risk is known as market risk (or systematic, undiversifiable risk), which can be thought of as the risk
of the market as a whole.

Beta summarise market risk exposure


The exposure of an asset to such risk can be summarised by beta. For a reasonably well diversified
portfolio only market risk matters.

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Fig 8.12 Diversifiable risk and market risk


Recall Figure 8.3, which shows that the portfolio standard deviation depends on the number of securities
in the portfolio.
Following on, as shown in Figure 8.12, by adding securities, and therefore by diversification, portfolio
standard deviation decreases until all diversifiable risk is eliminated, and only market risk
remains.

 If you have only one stock, diversifiable risk is very important; however,

 if you hold a portfolio of 20 or more stocks, only market risk matters.)

The magnitude of market risk depends on the average betas of the securities included in the portfolio.

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

7c. Theoretical and practical limitations of the CAPM


 Study Guide, pp. 176 – 177
 Brealey, Myers and Allen 2010, pp. 223 - 227. Validity and role of the CAPM

The tests of the CAPM investigate how well it describes reality.


However, even before we examine these tests, it is useful to develop an asset pricing model based on
more realistic assumptions.

Standard CAPM
The CAPM developed in the previous section is termed the standard CAPM because it provides a
complete description of the behaviour of capital markets if each of the underlying assumptions are held.

Non-standard forms of the CAPM


A wide literature examines the effects of modifying these assumptions, with a special
emphasis on two of them:
1. the ability to lend and borrow infinite sums of money at the risk-free rate (in the real world,
generally the risk-free rate is not a real rate because of uncertainty about inflation, and
borrowing rates are higher than lending rates), and
2. the absence of personal taxes.

The removal of these assumptions leads to the development of the non-standard forms of the CAPM.
(Note that in practice none of these modified versions is as widely used as the standard CAPM.)

Limit on the use of proxies


From a theoretical perspective, the implementation of the CAPM requires the use of proxies for the
market portfolio because the exact composition of the market portfolio is unobservable (as explained
earlier).

Roll's critics: CAPM is untestable


As argued by Roll (1977), the unobservability of the market portfolio makes the CAPM untestable.
Given that the quality of the proxies used for the market portfolio cannot be guaranteed, it is not
possible to test the CAPM.
There could be two alternative situations.

1. Incorrect reject: market portfolio is efficient, but proxy is inefficient


First, it might be the case that the market portfolio is efficient (and hence the CAPM is valid),
but the proxy chosen is inefficient (and hence the empirical tests incorrectly reject the CAPM).

2. False validation: Proxy is efficient, but market portfolio is not.


Second, the proxy for the market portfolio might be efficient (and hence the empirical tests
validate the CAPM), but the market portfolio itself is not efficient (and hence the validation is
false).

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

No consensus of testability of CAPM


Academics have been debating whether the CAPM is testable for many years without arriving
at a consensus; nevertheless the model is widely applied by practitioners and largely tested by
researchers by using several proxies for the market portfolio.
These tests provide valuable – but not conclusive – insights on the appropriateness of the
CAPM.

Tests support for the CAPM, but less rapidly than predicted
Overall, these tests provide broad support for the CAPM by showing that the expected return
increased with beta over the period 1931–91, even if less rapidly than the CAPM has
predicted.

Critics of the CAPM from empirical evidence


However, critics of the CAPM pointed out two problematic pieces of empirical evidence.

1. Slope of SML is flatter then expected from CAPM.


First, in recent years the slope of the security market line has been much flatter than one would expect
from the CAPM.

 This means that high-beta stocks performed better than low-beta stocks,
 but the difference in their actual returns was not as great as the CAPM would predict.

This evidence is against the CAPM.

Counter argument: test only use actual return, but not E(R)
However, the supporters of the CAPM argue that the evidence could be due to the fact that the CAPM
itself is concerned with expected returns, whereas the tests only use actual returns.
Actual returns do reflect expectations, but they are also largely affected by noise.

2. Factors other than beta also helps


Second, factors other than beta have all been found in empirical studies to explain ex-post realised
returns (after controlling for beta).

 Factors such as firm size, book-to-market ratio, price-to-earnings ratio and dividend yield

This contrasts with the CAPM, which predicts that beta is the only factor that explains expected
returns.

Small-cap works better than beta prediction


For example, small capitalisation stocks (known as small-cap) did better than large capitalisation stocks
over the period 1932–97.
Although they have higher betas, the difference in betas is not enough to explain the difference in
returns.
It seems that investors saw risks in small-cap that were not captured in their beta.

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Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Reason: data mining / snooping


One explanation for this result could be ‘data-snooping’ or ‘data mining’.
(This refers to the fact that many researchers look at past sample returns, and they are bound to find
a strategy that, just by pure chance, has worked in the past.)

Counter argument: Market efficiency eliminate the small-large cap result.


Actually, the supporters of the CAPM proved that the small–large cap results vanished once they
were discovered.

Empirical evidence may not prove anything


This empirical evidence can suggest either that the CAPM does not hold or that tests do not prove
anything about the CAPM because of Roll’s insights.

Result: Arbitrage Pricing Theory (APT)


The controversial nature of the evidence and the difficulties in interpreting this evidence have led to
other asset pricing theories, such as the Arbitrage Pricing Theory (discussed in the next section).

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Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

8. Arbitrage Pricing Theory (APT)


 Brealey, Myers and Allen 2010, pp. 227 - 231. Some Alternative Theories

The alternative asset pricing paradigm, known as Arbitrage Pricing Theory (APT) is, in some ways, less
complicated than the CAPM.

Requirement of APT: linear factor model


It simply requires that the returns on any stock be linearly related to one factor (or a set of factors), as
with factor models (discussed below).

8a. Factor models


 Study guide, pp. 178

The basic idea of factor models is that all common variations in stock returns are generated by
movements in one factor (or a set of factors).

One-factor model
The simplest factor model is a one-factor model, which assumes that there is only one factor.
Formally, it can be written as (8.8):

Ri a i bi1 F1   i , E ( i )  0 (8.8)

where:

ai = E(R) when Fi = 0
ai = expected level of return for stock i if all factors have a value of zero.

F1 = Value of Factor 1

F1 = value of the factor 1 that affects the returns on stock i. The factor is posited to affect all stock
returns, although different stocks can have different sensitivities.
The factor can be represented by macroeconomic conditions, financial conditions or political events.
Examples are:

 market index (e.g. S&P500),


 yield spread (return on long-term government bonds less return on 30-day Treasury bills),
 interest rate (change in Treasury bill return),
 change in the forecast of real GNP (Gross National Product), and
 change in forecast of inflation.

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Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

bi1 = Factor sensitivity


bi1 = sensitivity of the returns on stock i to factor 1. High values of bi1 imply that variations in F cause
very large movements in the return on stock i; whereas small values indicate that stock i reacts only
slightly to changes in F.

εi = Random Error Term


εi = random error term. This random stock return is termed the idiosyncratic return component for
stock i.
It has a mean equal to zero and variance equal to σ2ei.
Moreover, it is uncorrelated across stocks and with F; thus Cov (εi, εj)= 0, and Cov (εi, F)= 0.
The idiosyncratic return comes from events that are unique to the firm.

 Examples of the idiosyncratic return can be a legal action against the company of stock i,
or the unexpected departure of a company’s CEO.

Multi-factor model
A generalisation of equation (8.8) represents a multi-factor model, where a set of j factors affects the
returns on stock i (8.9):

Ri a i bi1 F1  bi 2 F2  ...  ( i ) , E ( i )  0 (8.9)

Find E(Rp) by finding weighted average factor sensitivities (bp)


To determine the return on a portfolio, given the above factor structure, we need to calculate the
portfolio weighted averages of the individual factor sensitivities.

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Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

Example of Multi-factor model


An example could clarify this simple calculation.
Example: Consider two stocks (X and Y), whose returns are determined by the following one-factor
model:

Rx = 0.03 + 0.9F1 + εx;


RY = 0.06 + 0.8F1 + εY

Example of portfolio under multi-factor model


To determine the return of an equally weighted portfolio of the two assets (½ stock X and ½ stock Y), we
simply need to form a weighted average of the stock sensitivities of individual factors:

Thus the portfolio return can be written as:

Thus the portfolio return can be written as:

RP = 0.045 + 0.85F1 + εP

Activity 8.15*
Assume that the portfolio weights of the above stocks (X and Y) are 0.25 and 0.75. Using the data of the
previous example, compute the portfolio return representation.

The solution to this activity can be found at the end of the subject guide in Appendix 1.

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Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

8b. Arbitrage Pricing Theory


 Study Guide, pp. 178 - 179

APT main assumption: prefer greater returns.


The Arbitrage Pricing Theory (APT) is based on the primary – simple – assumption that when returns
are certain, investors prefer greater returns to lesser returns.

Use of arbitrage portfolio & 4 assumptions


The mechanism for doing so involves the use of arbitrage portfolios, and thus the following four
assumptions:

1. No arbitrage opportunities
1. There are no arbitrage opportunities. Arbitrage opportunities represent the possibility of earning
riskless profits by taking advantage of differential pricing for the same asset.
There are two possible ways to define arbitrage strategies.

1. First, to invest in a set of assets that yield positive immediate cash inflow (obtained by the sale
of assets at a
relatively high price and the simultaneous purchase of the same assets at a relatively low price),
with no loss in the future.

2. Second, to invest today in costless investment strategy, and to obtain positive future cash
inflows (as described above). In both cases, when returns are certain, any investor who prefers
greater returns to lesser returns would invest as much as possible. Under the APT, these
investment strategies should not be permitted in properly functioning financial markets.

2. E(Ra) can be described as a factor model


2. Returns of risky assets can be described by a factor model, as described in the previous subsection.

3. Frictionless financial markets


3. Financial markets are frictionless (i.e. there are no transaction costs or related market frictions).

4. Can hold well-diversified portfolios


4. There is a large number of securities and so investors hold well-diversified portfolios.
This implies that diversifiable risk does not exist.
(Note that the sources of risk for any individual stock are: risk arising from macroeconomic factors,
which cannot be eliminated by diversification; and diversifiable risk associated with events that are
unique to the firm, which can be totally eliminated by diversification.)

Under the APT, the absence of arbitrage opportunities places restrictions on the relationship between
the expected returns on individual assets (and hence on a well-diversified portfolio) given the factor
structure underlying returns.

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Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

Key of APT
The key to the APT is that a factor model with no arbitrage opportunities implies that assets with the
same factor sensitivities must offer the same expected returns in financial market equilibrium.

Expected risk premium {E(Rx)* - Rf} depends on sum of expected risk premiums
of each factor (λj) * factor sensitivity (bj)
Therefore the expected risk premium on an individual asset (equal to the expected return on
an individual asset minus the risk-free rate) depends on the sum of the expected risk
premiums associated with each factor multiplied by the asset sensitivity to each of these
factors.
Thus the expected return on an individual asset can be written as:

E ( R X* )  R f  b1x 1  b2 x 2  ...  b1 j  j (8.10)

where:
λj = (RFj– Rf), which is the risk premium over the risk-free rate associated with factor j.

Risk premium (λj)


The risk premium is affected only by macroeconomic factors, and not by unique risk (note the
similarity with the CAPM).

Moreover, it varies in direct proportion to the asset’s sensitivity to the factor.

Example of positive Risk premium (λj > 0)


For example, consider a risk premium equal to 5 per cent for the real GNP factor. It means that stocks
with a positive average sensitivity to changes in real GNP (i.e. with b = 1) give an additional return of 5
per cent a year compared with stocks completely unaffected by real GNP.

Example of negative Risk premium (λj < 0)


Conversely a risk premium equal to –1 per cent for the inflation factor means that stocks with average
exposure to inflation give a 1 per cent less return than stocks with no exposure to inflation.

Zero sensitivity (bj = 0 for all j)


(Note that an asset with zero sensitivity to each factor is essentially risk-free, and thus must be priced to
offer the risk-free rate.)

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Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

Activity 8.16*
Consider a two-factor APT model. The factors and associated risk premiums are:

Factor Risk premium

Change in GNP 6%

Change in long-term interest rates 1.5%

Assuming a risk-free rate equal to 6 per cent, calculate the expected rates of return on the following
stocks:
a. A stock whose return is uncorrelated with all the two factors.

b. A stock with a positive average exposure to each factor.

 The solution to this activity can be found at the end of the subject guide in Appendix 1.

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Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

8c. Theoretical and empirical validation of the APT


 Study guide, pp. 180

The APT provides an interesting alternative perspective to that of the CAPM on the nature of equilibrium.
From a theoretical point of view, however, the theory is far from easy to implement.

Advantage of APT: no market portfolio


The advantage of the APT is that it does not require us to identify and measure the market portfolio

 (solving most of the problems presented in the previous subsection on the theoretical limitations
of the CAPM).

Disadvantage of AP: unknown factors


The disadvantage is that it does not tell us what the underlying factors are

 (unlike the CAPM, which collapses all the macroeconomic factors into the market portfolio).

Empirical research of APT


Empirical research is still in the early stages as regards the APT, and is not as well developed as the
literature on the CAPM.

Explain size effect


Many studies have been particularly interested in whether the APT explains the size effect discussed
about the CAPM.
Although the evidence is not conclusive, the majority of the studies (see among others: Chen, 1983;
Chan, Chen and Hsieh, 1985) find that the size effect becomes negligible in a multi-factor
framework.

Identifying of the factors


Other studies focused on the identification of the factors with significant effects on risk premiums. Chen,
Roll and Ross (1986) emphasise the relevance of

 growth in real GDP,


 interest spread and
 changes in default spreads.

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