CHAPTER 8 ever kee co Cent ees ‘After you read this chapter, you should be able to answer the following questions: How does capital market theory extend Markowitz portfolio theory with the addition of a risk-free asset? ‘What ae the other critical assumptions underlying captial market theory? ‘What is the capital market line (CML), and how does it enhance our understanding of the ‘eclationship between risk and expected return? ‘What is the market portfolio, and what role does it play in the investment process implied by the CML? Under what conditions does the CML recommend the use of leverage in forming an investor's preferted strategy? ‘What is the difference between systematic and unsystematic risk, and how does that relate to the concept of diversification? How does the capital asset pricing model (CAPM) extend the results of captial market theory? ‘What special role does beta play inthe CAPM, and how do investors calculate a security's characteristic ine in practice? ‘Whats the security market line (SML}, and what are the similarities and diferences between the SML and CML? How can the SML be used to evaluate whether securities are properly priced? What assumptions are necessary for the CAPM, and what impact does relaxing those assump- tions have? What do the various empirical tests of the CAPM allow us to conclude? Does the selection of a proxy for the market portfolio matter? Following the development of portfolio theory by Markowitz, two major theories have been derived for the valuation of risky assets. In this chapter, we introduce the first ofthese model — the capital asset pricing model (CAPM), The background on the CAPM is important at this point in the book because the risk measure it implies is a necessary input for much of our subsequent discussion. The presentation concems capital market theory and the capital asset pricing model that was developed almost concurrently by three individuals. An alternative asset valuation model—the arbitrage pricing theory (APT)-has led to the development of ‘numerous other multifactor models and is the subject of Chapter 9 “8.1 Capital Market Theory: An Overview Because capital market theory builds directly on the portfolio theory we developed in Chapter 7, ‘his chapter begins where our discussion of the Markowitz efficient frontier ended, in particu- lar, capital market theory extends portfolio theory by developing model for pricing all risky assets. The final product, the capital asset pricing model (CAPM), will allow you to deter- sine the required rate of return for any risky asset. As we will sce, this development depends 205206 PART 2 (HVLLOMANISN NALSIAENT TORY ritically on the existence of @ risk-free asset, which in turn will lead to the designation of the market portfolio a collection of ll ofthe risky assets inthe marketplace that assures 2 special role in asset pricing theory. 8.1.1 Background for Capitat Market Theory With any theory itis necessary to articulate a set of assumptions tha specify how the world s expected to act. This allows ene to concentrate on developing an explanation for how market potticipants wil respond to changes in the environment. n this scion, we consider the mai "scumptions that under the development of epitl market theory ‘Assumptions of Capital Market Theory Because capital market theory builds on the Markowitz portfolio model, it requires the same assumptions, along with some additional 1. Albinvestors are Markowitzeffcient in that they seek to invest in tangent points on the efficient frontier. The exact location of this tangent point and, therefore, the specific portfolio selected will depend on the individual investor's risk-return utility function, 2. Investors can borrow or lend any amount of money at the risk-free rate of return (RR). (Clearly, itis always possible to lend money at the nominal risk-free rate by buying risk- free securities such as government T-bills, It i not always possible to borrow at this risk free rat, but we will see that assuming a higher borrowing rate does not change the general results) 3. Allinvestors have homogeneous expectations; that i, they estimate identical probability distributions for future rates of return. Again, thisassumption can be relaxed with minimal effect. 4. Allinvestors have the same one-period time horizon such as one month or one year. The model wil be developed for single hypothetical period, and its results could be affected by a different assumption, since it requires investors to derive risk measures and risk-free assets that are consistent with ther investment horizons. 5. All investments are infinitely divisible, which means that it is possible to buy or sell fractional shares of any asset or portfolio, "is assumption allows us to discuss investment alternatives as continuous curves. Changing it would have little impact on the theory. 6, There areno taxes or transaction costsinvolved in buyingoo selling assets. This isa reasonable assumption in many instances. Neither pension funds nor charitable foundationshave to pay taxes, and the transaction costs for most financial institutions are less than 1 percent on most financial instruments. Again, relaxing this assumption does not change the bast result, 7. ‘There is no inflation or any change in interest rates, or inflation is fully anticipated, This isa reasonable initial assumption, and it can be modified. 8. Capital markets are in equilibrium. This means that we begin with al investments properly priced inline with their rsk levels. Some of these assumptions may seem unrealistic, but keep in mind two things. Fist, as men- tioned, relaxing them would have only a minor effect on the model and would not change its main implications or conclusions. Second, a theory should never be judged on the bass ofits assumptions but rather on how well it explains and helps us predict behavior inthe real world If this theory and the model it implies help us explain the rates of return on a wide variety of risky assets, itis useful, even if some of its assumptions are unrealistic. Development of Capital Market Theory ‘The major factor that allowed portfolio theory {o develop into capital market theory is the concept of a risk-free asset, Following the develop- ment of the Markowitz portfolio model, several authors considered the implications of assumm- ing the existence of a risk-free aset, that is, an asset with zero variance. As we will how, such an asset would have zero correlation with al other risky assets and would provide the risk-free ‘ate of return (RFR) pri rete for: vail alwe RE, Cor rate ofr. Port whe:e its ats a of oy a m ach (CHAPTER - AN INTRODUCTION TO ASSET MCN MODELS. 207 ‘This assumption of a risk-free axsct allows us to derive a generalized theory of capital asset pricing under conditions of uncertainty from the Markowitz portfolio theory. This achieve: ment is generally attributed to William Sharpe (1964), who received a Nobel Prize for it, but ner (1965) and Mossin (1966) derived similar theories independently. Consequently, you may see references to the Sharpe-Lininer-Mossin capital asset pricing model 8.1.2 Developing the Capital Market Line We have defined a risky asset as one from which fatuce returns are uncertain, and we have meastted this uncertainty by the variance, or slandard deviation, of expected returns. Because the expected return on arsk-frce asst is entirely certain, the standard deviation ofits expected return is zero (a4, = 0). ‘Phe rate of return earned on such an asset should be the risk-free rate of retuen (RER), which, as we discussed in Chapter 1, should equal the expected long-run growth rate of the economy with an adjusiment for short-run liquidity. We now shove what happens when we introduce this risk-free asset into the risky world of the Markowitz portfolio model Covariance with a Risk-Free Asset Recall that the covariance between two sets of returns is Cov, = F(R, ~ E(RIIR, ~ HR))n ‘Assume for the moment that Asset iin this formula is the risk-free asset, Because the returns for the risk-free asset are certain, (typ = 0) R, = E(R,) during all periods. Thus, R, ~ £{R) will equal 2eF0, and the product of this expression with any other expression will equal zero. ‘Consequently, the covariance ofthe risk-free asset with any risky asset or portfolio of assets will always equal zero. Similarly, the correlation between any risky asset j, and the risk-free asset, RF, would be zero because it is equal to Fans OM eI u80, Combining a Risk-Free Asset with a Risky Portfolio What happens o the expected rate of return and the standard deviation of returns when you combine a risk-free asset with a portfolio of risky assets such as those that exist on the Markowitz efficient frontier? Expected Return Like the expected return for a portfolio of two risky assets, the expected rate fof return for a portfolio that includes a risk-free asset with a collection of risky assets (call it Portfolio M) is the weighted average ofthe two returns: EAR yg) = My(RER) + (= Hyg ECR) where: ‘ty, ~ the proportion of the portfolio invested in the risk-free asset (R,.) = the expected rate of return on risky Portfolio M Standard Deviation Recall {rom Chapter 7 that the expected variance fora two-asset portfolio is hay = wha? + Who} + ww 20.0% Substituting the rsk free asset for Security 1, and the risky asset portfolio for Security 2, this formula would become hag = Why Oke + (1 ~ Wye)? OK + Dye ~ weedeat Tero ‘We know that the variance of the risk-free asset is zero, that i, 0}, ~ 0, Because the correlation between the risk-free asst and any rsky asset, M, is also zero, the factor ran in the preceding208 PART 2~ (HV 4M NTS IV NESTA THEY equation also equals ze70, Therefore, any component ofthe variance formul that has either of these terms will equal zero. When you make these adjustments, the formula hecomes igh = (1 ~ wy Fed sii Foon = we Pe that ‘The standaed deviation is your ea = VO Wg ty Noti (0 wl rela that Therefore. the standard deviation of a portfolio that combines the risk-free asset with risky tem assets isthe lincar proportion af the sanclard deviation ofthe risky aset portfolio iin the The Risk-Return Combination With these results, we can develop the risk-return relationship ¥ between F(R) and gb) ts few algebraic manipulations isk. (irq MRER) + (1-H) ECR) + ARFR — RER) ne RER— (Iw )RFR + (1 — Wg h(E) asthe = RFR + (IW, MECR,) ~ RFR] fee 5 = RER + (LW) fy / Oy LER) ~ RFR) porth sothat 4 E(Ry) — RER te FR eg) = BER Og] on thy Equation 8.1 is the primary result of capital market theory. It can be interpreted as follows: Investors who allocate their money between a riskless security and the risky Portfolio M can expect a return equal fo the risk-free rate plus compensation forthe numberof risk units (,,) they accept This outcome is consistent with the concept underlying ll of investment theory that inves tors perform two functions in the capital markets for which they can expect to be rewarded. First, they allow someone else to use their money, for which they receive the risk-free rate of interest. Second, they beat the risk that the returns they have been promised in exchange for their invested capital will not be repaid. The term, [E(R,.) — RFR]/0yq is the expected compensa- tion per unit of risk taken, which is more commonly referred to as the investor's expected isk premium per unit of risk ‘The Capital Market Line ‘The risk-retum relationship shown in Equation 8.1 holds for ‘every combination of the risk-free asset with any collection of risky assets, However, inves- tors would obviously like to maximize their expected compensation for bearing risk (ie. they would ike to maximize the risk premium they receive). Let us now assume that Portfolio M ls the single collection of risky assets that happens to maximize this risk premium, With this assumption, Portfolio M is called the market portfolio and, by definition, it contains all risky assets held anywhere in the marketplace, It has the property of receiving the highest level of ‘expected return (in excess of the risk-frce rate) per unit of risk for any available portfolio of risky assets, Under these conditions, Equation 8. i called the capital market line (CML) Exhibit 8.1 shows the various possibilities when a rsk-fre asset is combined with alteena- tive risky combinations of assets along the Markowitz efficient frontier. Each of the straight tines depicted represents mixtures of a risky portfolio with the riskless asset. For instance, the risk-free asset cold be combined in various weights with Portfolio A, as shown by the straight line RFR — A. Any combination on this line would dominate portfolio possibilities that fall below it because it would have a higher expected return for the same level of risk. Similarly, any combination ofthe risk-free asset and Portfolio A is dominated by some mixture of the risk-free asset and Portfolio B,CHAPTER ANINTAODUCTON TO ASSET BLING MIEN, 209 ‘You can continue to draw lines from RFR to the efficient frontier with increasingly ‘higher slopes until you reach the point of tangency at Portfolio M. The set of portfolio pos- sibilities along Line RER-M—which is the CML—dominates ail other feasible combinations that investors could form. For example, Point C could be established by investing half of your assets in the riskless security (12, lending at RFR) and the other half in Portfolio M. [Notice in Exhibit 4.1 that there is no way to invest your money and achieve a higher expected ceturn Jor the same level of risk (9). In this sense, the CML represents a ncw efficient frontier that results from combining the Markowitz efficient frontier of risky assets with the ability tw invest in the risk-free security. Finally, the stope of the CML is [/(R,) ~ RFRI/a,,. which is the maximum risk premium compensation that investors can expect for each unit of risk they bear Fisk-Returo Possibilities with Leverage An investor may want to attain a higher expected ‘return than is available at Foint M in exchange for accepting higher risk. One alternative would be to invest in one of the risky asset portfolios on the efficient frontier beyond Point M such as the portfolio at Point D. A second alternative isto add leverage to the portfolio by borrow ing money al the risk-free rate andl investing the proceeds in the risky asset portfolio at Point (Mi; this is depicted as Point E. What effect would this have on the return and risk for your portfolio? If you borrow an amount equal to 50 percent of your original wealth atthe risk-free rate, Wg Will not be a positive fraction but, rather, a negative 50 percent (Ww, = -0.50). The effect ‘on the expected return for your portfolio is: ghRER) + (1 = yg ECR) 0.50(RER) + [1 = (-0.50)16(R,.) 0.50(RFR) + 1.50(Ry) ELByoq)290 PART2» DIVILCEMENTS INEST ‘The return will increase n a linear fashion along the CML because the gross return increases bby 50 percent but you must pay interest atthe RFR on the money borrowed. If (RFR) = 0.06 and FXR,y) = 0.12, the return on your leveraged poetflio would be: =0.50(0.06) + 1.5(0.12) 0.03 + 0.18 = 05 tthe effect an the standard deviation ofthe leveraged portfolio is similar. Oey 1 = We) Oy = [1 = 050)} 44 = 1.505, where: {4 ~ the standard deviation of Portfolio M Therefore, both return and risk increase in a linear fashion along the CML. This is shown in hibit 8.2 Our discussion of portfolio theory stated that, when two assets are perfectly correlated, the set of portfolio possibilities falls long a straight line. Therefore, because the CML isa straight line, it implies that all the portfolios on the CML are perfectly positively cortlated. This posi- tive corrdation occurs because all portfolios on the CML combine the risky asset Portfolio M and the risk-free asset. You either invest part of your money in the risk-free asset (Le, you lend at the RFR) and the rest in the risky asset Portfolio M, or you borrow atthe risk-free rate and fnvest these funds im the risky asset portfolio. In either case, all the variability comes from the risky asset M portfolio. The only difference between the alternative portfolios on the CML is the magnitude ofthat variability, which is caused by the proportion of the risky asset portfolio held in the total portfolio. 8.1.3 Risk, Diversification, and the Market Portfolio ‘The investment prescription that emerges from capital market theory is clear-cut: Investors should only invest their funds in two types of assets—the risk-free security and risky asset Portfolio M—with the weights of these two holdings determined by the invéstors' tolerance for risk. Because ofthe special place that the market Portfolio M holds to al investors, it must contain all risky assets for which there fs any value in the marketplace. This includes not justUS. common stocks, but also non-US. stocks, USS. and non-U.S. bonds, real estate, private equity, options and futures contracts art, antiques, and so on. Further, these assets should be represented in Portfolio M in proportion to ther relative market values. Since the market portfolio contains all risky assets it isa completely diversified portfolio, ‘which means that all risk unique to individual assets in the portfolio is diversified away. Specifically. the unique risk—which is often called unsystematic risk—of any single asset is ‘offset by the unique variability ofall of the other holdings in the portfolio. This implies that cooly systematic risk, defined as the variability in all risky assets caused by macroeconomic variables, remains in Portfolio M, Systematic risk can he measured by the standard deviation ‘of returns to the market porifolio and it changes overtime whenever there are changes inthe “underlying economie forces that affect the valuation of all risky assets? Such economic forces ‘would be variability of money supply growth, interest rate voatlity, and variability in indus- ‘rial produetion oF corporate earnings. How to Measure Diversification Asnoted carlir, ll portfolios on the CML are perfectly positively correlated, which means tha al portfolis on the CME are perfectly correlated with the completely diversified market Portfolio M. Lorie (1975) suggests a measure of diversifica- Lion. Specifically, a completely diversified portfolio would have a correlation with the market portfolio of + 1.00, ‘This is logical because complete diversification means the elimination of all the unsystematic or unique risk. Once you have eliminated all unsystematic risk, only system atic risk is lef, which cannot be diversified away. Therefore. completely diversified portfolios ‘would correlate perfectly with the market portfolio, which has only systematic risk, Diversification and the Elimination of Unsystematic Risk: As discussed in Chapter, the purpose of diversification is to reduce the standard deviation of the total portfolio. This, assumes imperfect correlations among securities. Ideally, you add securities, the average ‘covariance for the portfolio declines. How many securities must be included to arrive at @ completely diversified portfolio? To discover the answer, you must observe what happens as you increase the sample sizeof the portfolio by adding securities that have some positive cor- relation. The typical correlation between U.S. securities ranges from 0.20 to 0.60. ‘One set of studies examined the average standard deviation for numerous portfolios of randomly selected stocks of different sample sizes Evans and Archer (1968) and Tole (1982) computed the standard deviation for portfolios of increasing size up to 20 stocks. The results indicated that the major benefits of diversification were achieved rather quickly, with about 90 percent of the maximum benefit of diversification derived from portfolios of 12 to 18 stocks. Exhibit 8.3 shows a stylized depiction of this effect. ‘Two subsequent studies have modified this finding. Statmen (1987) considered the trade-off between the diversification benefits and additional transaction costs involved with increasing the sie of a portfolio. He concluded that ¢ well-dversified portfolio must contain at least 30-40 stocks. Campbell, Leta, Malkiel, and Xu (2001) demonstrated that because the idiosyncratic portion of an individual stock's total risk has been increasing in recent years, it snow takes more stocks in a portfolio to achieve the same level of diversification, For instance, they showed that the level of diversification that was possible with only 20 stocks in the 1960s ‘would require about 50 stocks by the late 1990s. ‘The important point to remember is that, by adding stocks to the portfolio that are not perfectly correlated with stocks in the portfolio, you can reduce the overall standard deviation cof the portfolio, which will eventually reach the level of the market portfolio, At that point, you will have diversified avay all unsystematic risk, but you sill have market or systematic risk You cannot climinate the variability and uncertainty of macroeconomic factors that affect all risky assets. Further, you can attain a lower level of systematic risk by diversifying globally ° Fr anaes of changes in she standatd deviton (vay) of returns or stocks an bond in he United Slates sce Schwer ({995),Iechen (2000), Rly, Weight and Chan (2000), and Ang Hodeck. Xing ard Zhang (2000) AM NDRODUCTION TO A28E1FHMLING MODELS 200292. PART?2- «VE LOPHLNISIN LSTA THEORY Standord Deviatlon of Retun 0% Unsystemanic (Onersifable Fisk ‘Standard Deviation of the Market Portoio (Systematics) Number of Stocks in te Portola versus only diversifying within the United States because some of the systematic risk factors in the U.S. market (such as U.S. monetary policy) are not perfectly correlated with systematic risk variables in other countries such as Germany and Japan. As a result, if you diversify globally, you eventually get down to a world systematic risk level, The CML and the Separation Theorem As we have seen, the CML leads all investors to invest in the same risky asset Portfolio M. Individual investors should only differ regard- ing their position on the CML, which depends on their risk preferences. In turn, how they get to. point on the CML is based on their financing decisions. If you ate relatively risk averse, you will lend some part of your portfolio at the RFR by buying some risk-free securities and Jnvesting the remainder in the market portfolio of risky assets (eg, Point C in Exhibit 8.1). In contrast, if you prefer more risk, you might borrow funds at the RFR and invest everything (all ‘of your capital plus what you borrowed) in the market portfolio (Point Ein Exhibit 8.1), This financing decision provides more risk but greater expected returns than the market portfolio, Because portfolios on the CML, dominate other portfolio possibilities, the CMI. becomes the efficient frontier of portfolios, and investors decide where they want to be along this efficient frontier. Tobin (1958) called this division of the investment decision from the financing d sion the separation theorem. Specifically, to be somewhere on the CML efficient frontier, you {initially decide to invest i the market Portfolio M, which means that you will be on the CML. ‘This is your investment decision, Subsequently, based on your risk preferences, you make a separate financing decision either to borrow or to lend to attain your preferred risk position fon the CML. ‘ARisk Measure for the CML In discussing the Markowitz portfolio model, we noted that ‘he relevant rsk to consider when adding a security to a portfolio is its average covariance with ail other assets in the portfolio, in this chapter, we have shown that the only relevant portfolio is the market Portfolio M. Together, this means thatthe only important consideration for any ‘individual risky asset is its average covariance with all the risky assets in Portfolio M or the asse's covariance with the market portfolio, This covariance, then, isthe relevant risk measure for an individual risky asset. Because all individual risky asets are a part of the market portfolio, one can describe their rates of return in relation to the returns to Portfolio M using the following linear model: 82 Ry=a,t bRy +e wh The 83 Not ret for vari ance bece atle itis Afte inve expe syste the Whi. Bac port! Port: com high. retur ofex shou you Fiskl. ofa usingure where: R,, = return for asset { during period 1 14, = constant term for asset 8, = slope coefficient for asset # suc = Feturn for Portfolio M during period “¢= random error term R, The variance of returns for a rishy asset can similarly be described as 83 VarlR,) = Varla, + bRy, + Var(a) + Var(by,) + Varte) = 0+ VarlbRy) + Varle) Note that Var(b,R) isthe variance of return for an asset related to the variance of the market return, or the asset's systematic variance or risk, Also, Var(e) isthe residual variance of return for the individuat asset that is not related 10 the market portfolio. This residual variance is the ‘variability that we have referred to as the unsystematic or unique risk because it arises from the ‘unique features of the asset. Therefore: ‘Var(R,,) = Systematic Variance + Unsystematic Variance ‘We know that a completely diversified portfolio has had all ofits unsystematic vari- ance eliminated. Therefore, the unsystematic variance of an asset is not relevant to investors, because they can eliminate it when holding an asset as part of a broad-based portfolio. As @ ‘consequence, investors should not expect to receive compensation for bearing this unsystem- atic risk. Only the systematic variance ig relevant because it cannot be diversified away, because itis caused by economic forces that afect all risky assets. 8.1.4 Investing with the CML: An Example ‘After doing considerable research on current capital market conditions, you have estimated the investment characteristics for six diferent combinations of risky asets. Exhibit 8.4 lists your expected return and standard deviation forecasts for these portfolios. You have also established that each of these portfolios is completely diversified so that its volatility estimate represents systematic risk only. The risk-free rate atthe time of your analysis is 4 percent. Based on your forecasts for E(R) and o alone, none of these portfolios clearly dominates the others since higher levels of expected return always come atthe cost of higher levels of risk Which portfolio offers the best trade-off between risk and return? The last column in Exhibit 8.4 calculates the ratio of the expected risk premium (F(R)—RFR) to volatility (0) for each portfolio. As explained earlier, this ratio can be interpreted asthe ammount of compensation that investors can expect for each unit of risk they assume in a particular portfolio, For example, Portfolio 2 offers investors 0.429 =[7 — 4/7) units of compensation per unit of risk while the comparable ratio for Portfolio 6 is lower at 0.393 (=[15 — 4]/28) despite promising a much higher overall return By this measure, it is clear that Portfolio 3 offers investors the best combination of riskand return, No other feasible collection of risky assets inthis comparison cen match the 0.500 units of expected risk premium per unit of risk promised by Portfolio 3. Consequently Portfolio 3 should be considered as the market portfolio, Capital market theory would recommend that you only consider two alternatives when investing you funds: (i) lending or borrowing inthe riskless security at 4 percent and (i) buying Portfolio 3. Suppose now thet given your risk tolerance you are willing to assume a standard deviation (of 85 percent. How should you go about investing your money, according to the CML? First, using Equation 8.1, the return you can expect is: 49% + (8.5%)(0.500) = 8.25% CHAPTER 8. AUINTRODACIION FO ASSET PINCMG MODUS 243‘As we have seen, there is ne way for you to obtain a higher expected return under the current conditions without assuming more risk. Second, the investment strategy necessary to achieve this return can be found by solving: RSH omy (46) + (1 — my )(9%) oF Wy = (9 — 8.25)49 ~ 4) = 0.15. This means that you would need to invest 15 percent of your funds in the riskless asset and the remaining 85 percent in Portfolio 3. Finally, notice that the expected risk premium per unit of risk for this postion is 0.500 (=[8.25 — 4/8). the same 48 Portfolio 3. Infact, all points along the CML will ave the same risk-return trade-off asthe ‘market portfolio since ths ratio i the slope ofthe CML. ‘Asa lat extension, consider what would happen if you were willing to take on a risk level of o = 15 percent. From Exhibit 84, you could realize an expected retuen of 11 percent if you placed 100 percent of funds in Portfolio 4. However, you can do better than this by following the investment prescription of the CML. Specifically for a risk level of £5 percent, you ean obtain an expected return of: 4% + (15%)(0,500) = 11.5%, ‘This goal is greater than the expected return offered by @ 100 percent investment in the market portfolio (ie. 9 percent), so you will have to use leverage to achieve it. Specifically, solving for the investment weights along the CML. leaves w,, = (9 —11.5/(9 ~ 4) = -0.50 and (1 ~ w,,) = 1.50, Thus, for each dollar you currently have to invest, you will need to borrow an additional 50 cents and place all of these funds in Portfolio 3 8.2 The Capital Asset Pricing Model Capital market theory represented a major step forward in how investors should think about the investment process The formula for the CML (Equation 8.1) offers a precise way of calculating the return that investors can expect for (1) providing their financial capital (RFR), and (2) bear- ing ¢,, units of risk ([E(R,) ~ RERIf0y). This last expression is especially significant because it offers a tangible measurement forthe expected risk premium prevailing in the marketplace. Unfortunately, capital market theory is an incomplete explanation for the relationship that exists between risk end return, To understand why, recall that the CML defined the risk ‘an investor beats by the total volatility (0) ofthe investment. However, since we have seen that investors cannot expect to be compensated for any portion of risk that they could have diver- sified away (ie. tnsystematic risk), the CML must be based on the assumption that investors only hold fully diversified portfolio, for which total risk and systematic risk are the same thing. ‘The limitation is that the CML cannot provide an explanation forthe risk-return trade-off for individual risky assets because the standard deviation measures for these securities will ontain a substantial amount of unique risk ‘The capital asset pricing model (CAPM) extends capital market theory in away that allows Investors to evaluate the risk-return trade-off for both diversified portfolios and individual Asn car ets, the » folio follo: thet of th ofris inves this ¢ is sys byth Inser! leaves This asecu the rs isk 10 abeta marke marke as vel! for an rather statesing. for ‘ain dual securities, To do this, the CAPM redefines the relevant measure of risk from total volati to just the nondiversiable portion of that total volatility (ie. systematic risk). This mew risk ‘measure is called the beta coefficient and it calculates the levet of a security's systematic risk ‘compared to that of the market portfatio, Using beta asthe relevant measure of risk, the CAPM then redefines the expected risk premium per unit of risk in a commensurate fashion. This in ‘urn leads once again to an expression of the expected return that can be decomposed into (1) she risk-free rate and (2) the expected risk premium 8.2.1 A Conceptual Development of the CAPM {As noted earlier, Sharpe (1964), along with Lintner (1965) and Mossin (1966), developed the CAPM ina formal way. In addition to the assumptions listed before, the CAPM requires oth cers, such a8 that asset returns come from a Normal probability distribution. Rather than repeat the mathematical derivation of the CAPM, we will present a conceptual development of the smodel that emphasizes its role in the natural progression that began with the Markowitz port folio theory, Recall that the CML expressed the risk-return trade-off for fully diversified portfolios as follows: 1g) = OR 22 = BF] ‘When tying to extend this expression to allow forthe evaluation of any individual risky asset the logical temptation is to simply replace the standard deviation of the patflio (with th of the single security (¢). However, as explained above, this would overstate the relevant level ‘of risk inthe ith seeurty because it doesnot take into account how much ofthat volallity the investor could diversify away by combining that asset with other holdings. One way to address this concern is to “shrink” the level of go include only the portion of risk in Security éthat is systematically related to the risk in the market portfolio, This can be done by maliplying o, by the correlation coefficient between the returns to Security and the market portfolio Inserting this product into the CML and adapting the notation forthe -th individual asset leaves: [st] ELR) = RFR + (oyu) This expression can be rearranged a: F(R) = RER + (2) [2(R,) — RFR} 4 B(R) = RER + BIE(R,) — RER]. [Equation & is the CAPM. Notice in particular that the CAPM redefines risk in terms of «security's beta (B,), which captures the nondiversfiable portion ofthat stock's risk relative to the market as a whole. Because ofthis, beta can be thought of as indexing the asset's systematic risk to that of the market portfolio. This leads toa very convenient interpretation A stock with 1 beta of 1.20 has a level of systematic risk that is 20% greater than the average forthe entire market while a stock with a beta of 0.70 is 30% less risky than the market. By definition, the vatket portfolio itself will always have a beta of 1.00. Indexing the systematic risk of an individual security to the market hasanother nice feature as well From Equation 84 itis clear that the CAPM once again expresses the expected return for an investment as the sum of the risk-free rate and the expected risk premium, However, rather than calculate a eifferent risk premium for every separate security that exists the CAPM. states that only the overall market risk premium (£(R,,) ~ RER) matters and that this quantity TORE FING MNCOUS 215aie pant? INVESTMENT Tek ‘an then be adapted to any risky asset by scaling t up or down according to that asset's riskiness ‘clative to the market (B}). As we will se, this substantially reduces the number of calculations that investors must make when evaluating potential investments for their portfolios. 8.2.2 The Security Market Line ‘The CAPM can also be illustrated in graphical form as the security market fine (SM. This is bit 85, Like the CML. the SML expresses the trade-off between risk and expected return as. straight line intersecting the vertical axis (i, 2ero-rsk point) atthe risk-free rate. However. there are two important differences between the CMI and the SML. First the CMI. measures risk by the standard deviation (ie. total risk) of the investment while the SME. explic- itly considers only the systematic component of an investments volatility. Second, as 4 conse- {quence ofthe first point, the CMIL.can only be applied to portfolio holdings that are already fully diversified, whereas the SML. can be applied to any individual asset or collection of assets, shown in Ex Determining the Expected Rate of Return for a Risky Asset To demonstrate how you would compute expected or required rates of return, consider the following example stocks ‘assuming you have already computed betas: ‘Sock__Beta * 020 6 100) < ag 6 140 E 030 Assume that we expect the economy's RFR to be $ percent (0.05) and the expected return plies a market risk premium of 4 percent (0.04). With these inputs, the SML would yield the following required rates of return on the market portfolio (E(R,,) to be 9 percent (0.09). This for these five stocks: E(R) = RFR + B(E(R,) ~ RFR) B(R,) © 0.05 + 0.70 (0.09 ~ 0.05) = 0.078 = 780% EAR) = 005 + 1,00 (0.09 - 0405) 0.09 = 9.00% a) sm tor req Stow Sp peri Any ond vith poss req effi info desi Asa adju ide SM spec ny subs prec ric. cpr eatin base alph. stoc! vithCHAPTERS. AN INTRODUCTION TO ASSET RLING MODS 297 IR.) = 0.05 + 1.15 (0.09 — 0.05) = 0.096 = 9.60% 0.05 + 1.40 (0.09 ~ 0.05) 106 = 10.60% FR) = 0105 + (=0.30) (0.09 ~ 0.05) ~ 08 = 0012 = 0.038 8 Stock A has lower risk than the aggregate market, so you should not expect its return to bbe as high as the return on the market portfolio of risky assets. You should expect Stock A to return 7.80 percent, Stock B has systematic risk equal to the market's (beta = 1.00), so its required rate of return should likewise be equal to the expected market return (9 percent) ‘Stocks C and D have systematic risk greater than the market's, so they should provide returns ‘consistent with their risk. Finally, Stock F has a negative beta (which is quite rare in practice), 430 its required rate of returo, if such a stock could be found, would be below the RFR of 5 percent. In equilibrium, af asets and all portfolios of assets should plot on the SML. Thetis all assets should be priced so that their estimated rates of return, which are the actual holding period rates of return that you anticipate, are consistent with their levels of systematic risk. ‘Any security with an estimated rate of return that plots above the SML would be considered ‘undervalued because it implies that you estimated you would receive a rate of return on the security that is above its required rate of return based on its systematic risk, In contrast, assets with estimated rates of return that plot below the SMI would be considered overvalued. This position relative to the SMI. implies that your estimated rate of return is below what you should require based on the asset’ systematic risk, In a completely efficient market, you would not expect any assets to plot off the SML ‘because, in equilibrium, all stocks should provide holding period returns that are equal to theie required rates of return, Alternatively, a market tha is fairly efficient but not completely efficient may misprice certain assets because not everyone will be aware ofall the relevant Information for an asset. As we discussed in Chapter 6, 2 superior investor has the ability to derive value estimates for assets that consistently outperform the consensus market evaluation. ‘As a result, such an investor wil earn better rates of return than the average investor on atisk- adjusted bass Identifying Undervalued and Overvalued Assets Now that we understand how to compute the rate of return one should expect or require for a specific risky asset using the SML, we can compare this required rate of return to the asset’ estimated rate of return over a specific investment horizon to determine whether it would be an appropriate investment, To ‘make this comparison, you need an independent estimate ofthe return outlook for the secu- rity based on either fundamental or technical analysis techniques, which will be discussed in subsequent chapters. ‘Assume that analysts at a major brokerage firm have been following the five stocks in the preceding example. Based on extensive fondamental analysis, they provide you with expected price and dividend information for the next year, as shown in Exhibit 86, Given these projec- fions, you can compute an estimated rate of return for each stock by summing the expected capital gain (P,,~,/P,) and the expected dividend yield (D,, P), For example, the analysts’ estimated future retuta for Stock A is 8.00 percent (= [26 ~ 25]125+ 1/25) Exhibit 8.7 summarizes the relationship between the required rate of return for each stock based on its systematic riskas computed earlier, nd its estimated rate of return. This diference between estimated return and expected return is sometimes referred to as 4 stock's expected ‘alpha oc its excess return. This alpha can be positive (the stock is undervalued) or negative (the stock is overvalued). Ifthe alpha is zero, the stock is on the SML and is properly valued inline swith its systematic risk,Currant Pica stodk e * 25 8 a c 2 9 os € So prea Expected Price 2% a 2 3 Required Return Estimated Stock Beta Fi) Return a 070 780 800 8 10 300 62 © ous 960 SIs Bsa 1060 516 — 030 380 600 Plotting these estimated rates of return and stock betas on the SML gives Exhibit 8.8. Stock A is almost exactly on the line, so i is considered properly valued because is estimated rate of return is almost equal to its required rate of return, Stocks B and D are considered, ‘overvalued because their estimated rates of return during the coming period are substantially less than what an investor should expect for the risk involved. As a result they plot below the SML. In contrast, Stocks C and E are expected to provide rates of return greater than we would require based on their systematic risk. Therefore, both stocks plot above the SML, indicating ‘that they are undervalued, -80 ~60 40-20 00 20 #0 60 10 1.00 1201.40 140 180 200 220 240 be iny Ste c pr as wh lio eq por 86 fac an pre est use co Re. vat all tio rat. ys hel Ha pre ter Mc po val, KyCHAPTER. AVINTREDUCTON 10 ASSET MBEING MODUS 219 If you trusted these analysts to forecast estimated returns, you would take no action regard- {ng Stock A, but you would buy Stocks C and E and sell Stocks B and D. You might even sel Stocks B and D short if you favored such aggressive tactics Calculating Systematic Risk ‘There arc two ways that a stock’s beta can be calculated in practice. Fest, given our conceptual discussion of the CAPM. a beta coefficient for Security é ‘sin be calculated directly from the following formula: os ve( 2: )irgd = ete? whore, in addition to the tems defined earlier 0, isthe return variance for the market partfo lio and Cov(R, R,) is the covariance between returns to the Security i and the market. ‘Alternatively, security betas can also be estimated as the slope coeficient in a regression equation etiveen the returns to the security (R,) over time and the returns (R,) to the market portfolio, as x, a+ BURY) te, ‘where, isthe intercept ofthe regression and ¢, ithe random error tert that agcounts forthe fact that notall of Security isk is systematically related tothe market. Equation 86 is known asthe security's characteristic line with the market portfolio. Equations 85 and 8.6 will produce the same estimate of B, for any given sample of security and market portfolio returns. However, the regression-based method in Equation 86 is often prefered because its a formal estimation process, meaning that the statistical reliability ofthe estimate can be assessed (ie, a t-statistic on the, estimate can be evaluated). ‘The Impact ofthe Time interval In practice, the number of observations and the time interval cused in the regression vary widely. For example, Morningstar derives characteristic lines for ‘common stocks using monthly returns for the most recent five-year period (60 obscrvations). ‘Reuters Analytics calculates stock betas using daily returns over the prior two years (504 obser- -vations) Bloomberg uses two years of weekly returns (104 observations) in its basic calculations, although its system allows the user to select daily, weekly, monthly, quarterly, or annual returns ‘over other time horizons. Because there is no theoretically correct time interval for this estima- tion, we must make a trade-off between enough observations to eliminate the impact of random tates of return and an excessive length of time, such as 15 or 20 years, aver which the subject company may have changed dramatically, Remember that what you really want fs the expected systematic risk forthe potential investment. In this process, you are analyzing historical data to Tielp you derive a reasonable estimate ofthe asst’ future level of systematic risk. Reillyand Wright (1988) analyzed the differential effects of return computation, market inde, and the time interval and showed that the major cause of the differences in beta was the use of ‘monthly versus weekly return interval. Also, the interval effect depended on the sizes ofthe firms. ‘The shorter weekly interval caused a larger beta for large firms and a smaller beta for small firms Handa, Kothari, and Wasley (1989) concurred with this conclusion and showed thatthe reason was that an asse's covariance with the market and the market's return Variance did not change proportionally with the retuen intervat They also confirmed that firm size influenced the effoct. The Effect ofthe Market Proxy Another significant decision when computing an asset's charac- teristic line is which indicator series to use asa proxy forthe market portfolio of ll risky assets, “Most investigators use the Standard & Poor's 5H) Composite Index asa proxy for the market portfolio, because the stocks in this index encompass a large proportion ofthe total market value of US. stocks and it is a value-weighted series, which is consistent with the theoretical _market series till, this series is dominated by large-cap U.S. stocks, most of them listed on the NYSE. Previously it was noted that the market portfolio ofall risky assets should include U.S.w wr MySay AMY ay — MEY ny hy Dé (OMX PHOMDSW Kas) 0O5 ans 220 PART2.-Monthy Returns 01 PS 8 =200 Monthly Reruns for SPX. CHAPTERS. ANSVTROUXICHON ASSET PRICNG MODELS. 221 stocks and bonds, non-US. stocks and bonds, real estate, coins, stamps, att, antiques, and any ‘other marketable risky asset from around the world? ‘Computing a Characteristic Line: An Example The following example shows how ‘you would estimate a characteristic line for Procter & Gamble (PG) using monthly return data from July 2006 to June 2007. Twelve monthly rates are not typically considered sufficient for statistical purposes, but they are adequate for demonstration purposes. We calculate betas for PG using two different proxies for the market portfolio: (1) the S&P 500 (SPX), an index of stocks mostly domiciled in the United States, and (2) the MSCI World Equity (MXWO) index, ‘which represents a global portfolio of stocks. ‘Exhibit 89 lists monthly price changes for PG, SPX, and MXWO, which are computed sing month-end closing prices. Exhibit 8.10 shows a scatterplo ofthese return data for PG and ‘SPX, while Exhibit 8.11 contains ¢ similar display for PG and MXWO. During this 12-month period, there was only one month when the PG return diverged greatly from the S&P 500 index series. As a result, the calculation in Exhibit 89 shows that the covariance between PG and SPX was positive (2.72). The covatiance divided by the variance of SPX (3.39) equals PG's ‘beta compared to the S&P 500. For this period, the beta was 0.80, indicating that PG was less risky than the aggregate market. The intercept for this characteristic line is -0.29, calculated as the average monthly retura for PG (0.85) less the product of the average monthly return for SPX (1.43) and the beta coefficient. The fact that most of the observations plotted in Exhibit 8.10 are reasonably close to the characteristic line is consistent with the correlation coefficient between PG and SPX of O44, *sabtana dacutsionsurounds the mate! proxy wed ad is impact om the empirical results and useless ofthe ‘CAPM."This concern te decreed forthe and demonstrated inthe mubeguent secon on computing an ats chet {teristic tine. The fet ofthe matket proxy ie aso considered when we dics te afblage pring theory (APT) fe ‘Ghapter 9 and in Chapter 25 who we discuss be evaluation of poole periormance. Dre retro used thiexarpl ar based sly on monthly Pic changes fr PG and two indexes (S&P 500 and MSC ‘World Equtys they do no inode ddende Tis done frumpy but «also base on Sharpe and Cooper (Goraa} finding that beta derived rors ree wth and witout dividends havea cvtltinncoeiient of 033,222. PART2- 01 0008 ONT Standatd Eror = 00 008 stone 9.003 008 | stops =-0001 Standard noe = 8.001 Standard Enor = 00005 006 004 02 [wena 000 99g ss ‘0505 184330 000s 10 15 20 Systematic Risk Systematic Risk Keaus and Litzenberger (1976) tested a CAPM with a skewness term and confirmed that investors are wiling to pay for positive skewness. The importance of skewness was supported in studies by Sears and Wei (1988) and subsequently by Lim (1989). Effect of Size, P/E, and Leverage In the efficient markets hypothesis (EMH} chapter, we discussed the size effec (the small-firm anomaly) and the P/E eflect and showed that these vari ables have an inverse impact on retums after considering the CAPM. These results imply that size and P/E are additional risk factors that nced to be considered along with beta. Specifically, expected returns area positive function of beta, but investors also require higher returns from ‘elatively small firms and for stocks with relatively low P/E ratios. ‘Bhandari (1988) found that financial leverage aso helps explain the cross section of aver~ age returns after both beta and size are considered, This implies « multivatiate CAPM with three risk variable: beta, size, and financial leverage. Effect of Book-to-Market Value Fama and French (1992) evaluated the joint roles of rmatket bela size, E/P, financial leverage, and the book-to-market equity ratio in the cross- section of average returns on the NYSE, AMEX, and NASDAQ stocks. While some catlerstud- ies found a significant positive relationship between returns and beta, this study finds thatthe relationship between beta and the average rate of return disappears during the recent period226 PART 2» PYULLOPaF NTS INVEST WED 1963 to 1990, even when beta I sed alone to explain average eturns. In contrast, univariate forsi tests hetween average returns and size, leverage, E/P, and book-to-market equity (BF/ME) inat indicate that all of these variables are significant and have the expected sign. ‘or bi In the multivariate tess, the results showed thatthe negative relationship between sixe us. [ln (ME)] and average returns is robust to the inclusion of other variables. Purther, the posi- itiet tie relation between BEIM and average returns also persists when the other variables are corre include. Interestingly. when bot ofthese variables see included, the book: 10-market valu : ratio (BEME) has the consis stronger toe in explaining average returns seri ¥amaand French concluded thatsizeandbook-to-markel equity epturetheerss-sectional these ‘ariation in average stock retuzns associated wih size, HP, Bookto-markel equity. and lever cap. aye. Moncver, ofthe two variables, the book-o-marketequly ratio appeae to subse F7P tots and leverage. Following thee results, Fama and French (1993) suggested the use of three por factor CAPM model. This model was used by Fama and French (1996) to explain a number of port the anomalies from prior studies.* incor 8.4.3 Summary of CAPM Risk-Return Empirical Results mie ‘Most of the early evidence regarding the relationship between rates of return and systematic syste: risk of portfolios supported the CAPM; there was evidence that the intercepts were generally from higher than implied by the RFR that prevailed, which is either consistent with a zero-beta where ‘model or the existence of higher borrowing rates. To explain these unusual returns, additional pont les were considered including the third moment of the distribution (skewness). The appee results indicated that positive skewness and high betas were correlated. truer “The literature provided extensive evidence that site, the P/E ratio, financial leverage, and SM. the book-to-market value ratio have explanatory power regarding returns beyond bela. The E Fama-Erench study concluded that the two dominant variables were size and the book-wale select to marketvalue sai. mewn Ta contrast to Famaand French, who messure beta with monthly returns, Kothari, Shanken, Spon and Sloan (1995) measured beta with annual returns to avoid trading problems and found meas. substantial compensation for beta risk. They suggested that the results obtained by Fama and the tn French may have beea time pesiod-specific and might not be sigifcant over a longer period. R Pettengill, Dundaram, and Matthur (1995) noted that empirical studies typically use realized sepres reluens to teat the CAPM model whea theory specifies expected returns. When they adjusted inde for negative markt excess returns, they found a consistent and significant relationship between beta and rates of return. When Jagannathan and Wang (1996) employed 2 conditional CAPM that allows for changes in betas and in the market risk premium, this model performed well in explaining the cross section of returns. Grundy and Malkiel (1996) also contend that beta 4s a very useful measure of risk during declining markets, which is when itis most important, Finally, when Reilly and Wright (2004) examined the risk-adjusted performance for 31 differ- cent asst classes utilizing betas computed using a very broad proxy for the market portfolio, the risk-return relationship was significant and as expected in theory. ‘8.5 The Market Portfolio: Theory versus Practice. “Throughout our presentation of the CAPM, we noted that the market portfotio included aif the risky assets in the economy. Further, in equilibrium, the various asets would be included in the portfolio in proportion to their market value, Therefore, this market portfolio should contain rot only U.S. stocks and bonds but also real estate, options, art, foreign stocks and bonds, and s0 on, with weights equal to their relative market value, Although this concept of a market portfolio is reasonable in theory. it is dficu to imple- ‘ment when testing or using the CAPM. The easy partis getting an index series for U.S, and “This thee factor model by Fama and French ie decused farther and demonstrate fo Chaps 8, which deals with smulsctr model of rik aod ear,forcign stocks and bonds. Because ofthe difficulty in deriving series that are available monthly ina timely fashion for numerous other assets, most studies have been limited to using a stock ‘or bond series alone. Infact, the vast majority of studies have chosen an index limited to onty US. stocks, which constitutes less than 20 percent ofa truly global risky asset portfolio, At hes, its then assumed thatthe particular series used as a proxy forthe market portfolio was highly correlated with the true market pariflio. ‘Mast researchers recognize this potential problem but assume that the defieency is not serious. Several articles by Itoll (19772, 1978, 1980, L9K1), however, concluded that the use of indexes asa proxy for the market portfolio had very serious implications for tests of the PM and especially for using the model wien evaluating portfolio performance. Rel referred to this problem asa benchmark error because the practice is to compare the performance of « portfolio manager tothe seturn of an unmanaged portfolio of equal risk--that i, the market portfolio adjusted for tisk would be the benchmark. Roll’ point is that, ifthe benchmark is incorrectly specified, you cannot measure the performance of a portfolio manager properly. A ‘mistakenly specified market portfolio can have two effects. First, the beta computed for alter- native portfolios would be wrong because the market portfolio used to compute the portfolios systematic risk is inappropriate, Second, the SMI. derived would be wrong because it goes from the RFR through the improperly specified M portfolio. Exhibit 8.16 shows an example where the true portfolio risk (f,) is underestimated (f.), possibly because ofthe proxy market portfolio used in computing the estimated beta. As show the portfolio being evaluated may appear to be above the SML using 8, which would imply superior management, If, in fact, the true risk (f,) is greater the portfolio being evaluated will shift to the right and be below the SML, which would indicate inferior performance. Exhibit 8.17 indicates that the intercept and slope will differ if (1) there is an error in selecting a proper risk-free asset and (2) if the market portfolio selected is not the correct ‘mean-variance efficient portfolio. Obviously, it is very possible that under these conditions, a portfolio judged to be superior relative tothe first SMI. (ie, the portfolio plotted above the ‘measured SML) could be inferior relative tothe true SMI. (i.e, the portfolio would plot below the true SML}. Roll contends that atest of the CAPM requires an analysis of whether the proxy used to represent the market portfolio is mean-variance efficient (on the Markowitz efficient frontier) and whether itis the true optimum market portfolio. Roll showed that if the proxy market230 PART 2» 1: (DENIS N SO STMENT 1 08 True M Ponto Measured SM, Portoto portfolio (eg. the S&P 500 index) is mean-variance efficient, it is mathematically possible to show a linear relationship between returns and belas derived with this portfolio. ‘A demonstration of the impact othe benchmark problem is provided ina study by Reily and Akhtar (1995), Exhibit &.18 shows the substantial difference in average beta forthe 30 stocks in the DJIA during three alternative periods using two diferent proxies forthe market portfolio: (1) the ‘S&P 500 Index, and (2) the Brinson Partners Global Security Market Index (GSMD. The GSML includes not only US. and international stocks but also U.S, and international bonds, The results are as expected because, as we know from earlier discussions, beta for Security iis equal t: Cov oie Consequently, as we change from an all-U'S. stock index toa world stock and bond index (GSMD, we would expect the covariance with US. stocks to decline. The other component of beta is the variance for the market portfolio. As shown in Exhibit 8.18, although the covariance between the US. stocks and the GSMI is lower, the variance of the GSMI market portfolio, sthich i highly diversified with stocks and bonds from around the world, is substantially lower (about 25 to 33 percent), As 2 result, the beta is substantially larger (about 27 to 48 percent +6 larger) when the Brinson GSMI is used rather than the S&P 500 Index. Notably, the Brinson be GSMI has a composition of assets that is substantially closer to the true M portfolio than the th S&P 500 proxy that contsins only US. stocks. * ‘There also was a difference in the SMLs implied by each of the market proxies. Exhibit 8.19 in contains the average RFR, the market returns, and the slope of the SML during three time peri- « ‘ds for the two indexes. Clearly, the slopes differ dramatically among the alternative indexes “4 and over time, Needless to say, the benchmark used does make a difference. * In summary, an incorrect market proxy will affect both the beta risk measures and the on position and slope of the SML that is used to evaluate portfolio performance. In general, the be errors will end to overestimate the performance of portfolio managers because the proxy used é for the market portfolio is probably not as efficient as the true market portfolio, so the slope i of the SML will be underestimated. Also, the beta measure generally will be underestimated w‘CHAPTERS. ANINTRGDUCHION ASSET RACING MODELS 331 Pree ALTERNATIVE MARKET PROXIES, ‘Tims Perlod Sap 500 nson GSM 22000-2004 fverage beta 961 1305 ‘Mean nde cur 0006 001 Standard deviation 08 ost ‘findes enne 1989-1994 Average bet> oat 1268 Mean ine retura oor 1008. Standard deviation 0036 9026 ‘finden tue 1903-1968 ‘Average beta onz0 ras ‘Mean index return ora oor Standard deviation 3.0K9 oon lindas rete eae Fans Ronn a hah a Rae oh ada Ha hele (Uineen nownduattey Tcongmemaen vei ingeronie romsutnotoe oun punch vast Doe 1909-1996 1903-1988, BAF anmrn) AER m= AFR)__R RFR (hy AR) ser s00 “201305 50613077738 1820 950 BrnsonGsmi 302-305-0308 ATS 8H wo22 Sac: ain a yi kM Bo ecm Capa re orapw Fa ERA ‘Suloonepordsso ee tytn rcanspees an prion om rr oonetonpen tbh nee because the true market portfolio will have a lower variance than the typical market proxy because the true market portfolio is more diversified. However, recognize that benchmark problems do not invalidate the CAPM as a normative model of asset pricing they only indicate 1 problem in measurement when attempting to test the theory and when using this model for evaluating portfolio performance. +26 © SUMMARY # + -- ‘+ Capital market theory expanded the concepts introduced bby Markowitz portfolio theory by introducing the notion that investors could borrow or lend atthe riskefre rae in addition to forming efficient portfolios of risky assets. This {insight led to the development of the capital market line (CML), which can be viewed as a new efficient frontier that ‘emanates fom the risk-free rate and is tangent 10 the okd Markowitz efficient frontier. The point of tangencyiscalled the market portflio. +The CML's main contribution isthe relationship it specifies berwcen the risk and expected return of a wel-dversified portfolio, The CML makes it clear thatthe market portfolio ‘8 the single collection of risky astets that maximizes the ‘of expected risk premium to portalia volatility. The investment prescription of the CML is that investors cat not do bette, on average, than when they divide theic investment funds between (1) the riskess asset and (2) the market portflio. ‘The CML is a model of the risk-reture trade-off that only applies to porefolios that have diversified away all ‘unsystematic tisk, The capital asset pricing model (CAPM) seneralizes this relationship to individual securities as well as entire portfolios. To make this extension, the CAPM redefines the relevant measure of risk as beta, which i the ‘systematic component ofa secuticy’s voltiity relative to that of the market ponfalio. Like the CML, the security ‘marke ine (SME) shows thatthe relationship between sk and expected retor isa straight line with a positive slope.282 PART2+ OC IOPMUNES IN INSTA MT THLOHY “The SMI provides investors with tool fr Judging whether securities are undervalued or overvalued glven thelr level of systematic (beta risk. +The CAPM hasheen subjected to extensive empirical testing with mised findings, Fary teats substantiated the potive relationship between ftuens and measures of systematic Wack, Fischer, 1972. “Capital Market Equilibrium with Restricted Borrowing.” Journal of Busines 45, 00.3 (July): 444-455, ‘Camphell John ¥, and Job, Ammer. 1993. “What Moves the ‘Stock and Hond Markets? A Variance Decomposition for Long-Term Asset Returns." Journal of Finance 48. no. t (March): 3-38, tisk although subsequent studies indicated tha the single beta model needed to be supplemented with additional dimensiontof rik (eg, skewness. fim sie, PE. book vale! market value). Another challenge confronting the CAPM in fpractive 8 the benchmark ettoe prblem that rests front improper specifying a proxy forthe market portflio. * SUGGESTED READINGS * +-- Elton, Edwin J, Martin |. Gruber, Stephen J. Brown, aud ‘William N.Goctzmann, 2006. Modern Porsfolio Theory and Investnent Analysis, 7h ed. New York: Wiley Shaepe, William F. 2007, Fnvettors and Markets: Portflio ‘Choices, Asset Prices, and Investment Advice. Princeton, Ni: Princeton University Press. QUESTIONS + +++ 1, Draws graph that shows what happens to the Markowitz efficient frontier when you combinea riskfee asset wth alternative risky aset portfolios on the Markowitz efficent frontier. Explain wy the line from the RFR that s tangent to theeficient frontier defines the dominant set of portolo posibiies, 2, What changes would you expect in the standard deviation for a portfolio of between 4 nd 10 stacks, ‘erween 10 and 20 stocks, and between £0 and 100 stocks? 13. ‘The capital aset pricing model (CAPM) contends that there is systematic and unsystematic risk for an individval security. Which is the relevant sk variable and why is it relevant? Why isthe other risk variable not relevant? 4. What are the similarities and differences between the CML. and SML as models of the risk-retuon trade off CFA EXAMINATION LEVEL I Identify and brelly discuss three criticisms of b asst pricing model (CAPM). [6 minutes] 6 CEAEXAMINATION LEVEL Briefly explain whether Investors should expecta higher return from hold- Ing Portfolio A versus Portfolio B under capital asset pricing theory (CAPM). Assume that both 48 used in the capital, portfolios are lly diversified, (6 minutes) erfolleA___—Porfoto Syptemaic isk beta) Spee tk foreach nda securty 19 10 gh tow (CFA EXAMINATION LEVEL I! You have recently been appointed chief javestment officer of « major charitable foundation Its large endowment fund is currently invested in a broadly diversified port: folio of stocks (60 percent) and bonds (40 percent) The foundation's board of trustees isa group of prominent individuals whose knowledge of modern investment theory and practice is superficie You decide a discussion of basic investment principles would be helpful a, Explain the concepts of specific risk, systematic risk, variance, covariance, standard deviation, at deta as they relate to investment management. (12 minutes] ‘You believe thatthe addition of other asst classes to the endowment portfolio would improve the portfolio by reduc ak and enhancing return, You ate swate that depressed conditions in US. real ‘estate markets are providing opportunities for property acquisition at levels of expected retwen that ‘are unusually high by historical standards. You believe that an investment in US. rea estate would ‘be both appropriate and timely, and have decided to recommend a 20 percent position be established ‘with funds taken equally from stocks and bonds,a of and the real ‘hat val shed ANINTRODUCLON TO ASSLT PHN MODUS 233 Preliminaty discussions revealed tha several tetee believe tcl cate stow risky to include in ‘the portfolio. The buard chuirman, however, has scheduled a special meeting for further discussion of the matter and hes oxked you to provide beckground information that wil clarify the esk sue “To assist you, the following expectational dats have been developed: ‘CORRELATION MATROE us. us. us. Us. Asset clase Return Stocks Bonds RealEstate T-ily 5 sts ow va i Ret oem ise Pte bus -att 1 b. lxplatn the effect on both portfolio risk and return that would result feoa the addition uf US. el ‘estate, Include in your answer 1wo reasons for any change you expect in portflia risk, (Note It is mot necessary to compute expected risk and return) {8 rirutes] Your understanding of capital market theory causes you to doubt the validity f the expected feturn and risk for US, rel estate Justify our skepticism, [5 minutes} Draw an ideal SML. Based on the early empirical sesults, what did the actual rsk-return relationship Tock ike relative tothe ides relationship implied by the CAPM? According to the CAPM, what asses ae included inthe market portfolio, and what are the eltive ‘ecightings In empirical studies ofthe CAPM. what are the typical proxies used forthe market port: {oliot Assuming that the empirical proxy forthe market portfolio is not a good proxy, what factors related to the CAPM will be affected? ‘Some studies elated 10 the efficent market hypothesis generated results that implied aitional fac- tors beyond beta should be considered to estimate expected returns, Wht are these other variables and why should they be considered? +++ © PROBLEMS * + +> Dra the secur mart ine fo ah of he flowing condions 2) RAR = 005: Bram) = O12 2) R, = 0.06; R(true) = 0.15 b, Rader Ter as hollowing el fr the at sx perads, Cleat and compare the betas ung cach inde. RATES OF RETURN Taderte "Proxy specific nder True Generalindex etlod 1 oo) 1 2 2 1s 2 2 0 2 3 “2 3 ‘5 4 a « is 5 2 % 2 6 5 ao 0 & I the current period return for the market is 12 percent and for Rader Tice iis 11 percent, are superior results being obtained for either index beta? ‘You are an analyst fora large public pension fund and you have been asigned the task of evaluating two different external portfolio managers (¥ and Z). You consider the fllowing historical average teturn, standard deviation, and CAPM beta estimates for these two managers ove the pas five years Aewsl Standard Portfotig _Ave. Return _Devioton_fatn tearagerY 102% 120% 120 veanagel 2 B50 95% ObBee eager es 2234 PART 2 = O1VELONML RISEN ONLS INA NT Hot ‘Additionally, your estimate for the ris premium for the market portflio Is 5.00% and the risk-free rate is currently 450%, 4. Forboth Manager ¥ and Manager Z, celculete the expected return using the CAPM. Express your answers (the nearest bass point (it, 4.X8%, 1, Calculate each fund manaer's average “alpha” (Le, actual return minus expected return} over Five-year holding pore. Show graphically ehere these alpha statistics wold plot on the security rest line (SME) Explain whether you cam conclude from the information in Pat i (either manager ontper formed the other om a risk-adjusted as. and (Hither manager ontperformed market expecta sin ena the fllowing results, indicate what wil happen to the beta for Sophie Fashion Ci, relative to the market proxy, compared to the beta realve tothe tue market portobo: YEARLY RATES OF RETURN Jophterashion Market Proxy True Market Year oH) ow) 4) 1 9 f © 2 2» 4 0 3 “a = 7 ‘ 2 ae 2 5 2 0 [Discus the reason forthe differences in the measured betas for Sophie Fashion Co. Does the sug- gested relationship appear reasonable? Why or why not? Based on five years of monthly date, you derive the following information forthe companies liste inet om Tae 072 Fo! 010 Mo 0 Anheuser such BIT 750 8s merce 005 10% 00 3500 00 sso 1m ‘Compute the beta coeficent foreach stock. D. Assuming a risk-free rate of 8 percent and an expected return for the market portfolio of 15 percent, compute the expected (required) return for all the stocks and plot them on the SML. «. Plot the following estimated returns for the next year on the SML and indicate which stocks are ‘undervalued or overvalued. + Intel-20 percent + Ford—15 perent + Anheuser Busch—19 percent + Merck—10 percent 5. CFRENAMINATION LEVEL 'An analyst expects risk-free return of45 percent, a market return of 145 percent, and the returns for Stocks A and B that are shown inthe following table, STOCKINFORMATION. a 16% e 08 1 44 Show on the graph provided inthe snswer book: (1) Where Stocks A and B would plot on the security market line (SML) if hey were fairy valued using the capital asset pricing model (CAPM) 2) Where Stocks A snd B actually plot on the same graph according tothe returns estimated by the analyst and shown in dhe table (6 minutes] ». State whether Stocks A and B are undervalued or overvalued ifthe analyst uses the SML for stra topic investment decisions, [6 minutes} You are evaluating various investment opportunities currently available and you have calculated eapected returns and standard deviations fr five different well-diversfid portfolios of risky assets:(CHAPTER 8 ANINTRODUCTION TO ASSET PRIING MODUS 295 Portfalio Return ‘Standard Deviation 9 7a 105% « 100 140 5 46 50 7 7 185, u 42 7 4 For cach porto, caleolate the risk premium per unit of risk that you expect to roccive ([E(R) — RFRWo). Assume thatthe risk-free rte Bs 3.0%, b. Using your computations in Part a, explain which of these five portals is mos likely te be the ‘market portfolio, Use your calculations to draw the capital market line (CML © you areas 7.0% isi pansible for yn te earn a return of 7082 48. What (the minimun level of tisk thot would be necestary for an investment to earn 7.0%2 What isthe composition ofthe portflig along the CML that will generate that expected return? © Suppose you are now welling to make an investment with o = 182%. What would be the invest: ‘ment proportions inthe riskless asset and the market portfolio for this portfolio? What is the ‘expected return for this portfliot (CFA EXAMMNUATION LEVEL The following informatio ship forthe stocks of two of WAH's competitors. _—____Epectedneturn standard Deviation _Betz lescribes the expected return and risk relation Stock 1206 0m 3 Stock? 90 is or Maret nde veo a we Rekieoris so Using only the data shown inthe preceding table: 1 Draw and label a graph showing the security market line and position Stocks X and ¥ relative to 5 [5 minutes} 1. Compute the alphas both for Stock X and for Stock V. Show your work. [4 minutes] ‘& Assume thatthe rskfee rate increases to 7 percent, wit the other datz inthe preceding matrix remaining unchanged. Select the stock providing the higher expected risk-adjusted return and. justify your selection, Show your calculations. [6 minutes] ‘You expect an RER of 10 percent and the market return (Ry) of 14 percent, Compute the expected return forthe following stocks, and plot them on an SML graph, Stock pew uv 8s Nn 15 D 0% ‘You atk a stockbroker what the firm's research department expects for these three stocks. The broker responds withthe following information: stock current Price Pee Expected Dividend v 2 2% 078 " “ st 200 D a rd us Plot your estimated returns on the graph from Part sand indicate what actions you would take with regard to these stocks Explin your decisions, “The allowing are the historic returns for the Chelle Computer Company Year ‘chete Computer General index 1 » 15 2 9 8 3 a Me 4 & 4 5 u a 8 « °10, Assume that you expect the eon 236 PART2- DVI LOMALNTS RU MISTMET THLOHY ‘Based om this information, compute the following: 8. The correlation coeffcint between Chelle Computer and the General Index bh The tandard deviation forthe company und the inde. ©. Thebeta forthe Chelle Computer C wy ‘and a market retuen (Ry) of 12 percent 3. Drave the SML- under these assumptions 1. Subsequently, you expect the rate of inflation fo increase from 3 percent taf percent, What fect ‘would thishave on the RFR and the d,? Draw another SMI. on the graph from Part 3 Drawan SMLu the same graph te rect an RER of 9 percent and an Ro 17 percent How das this SME difler feos tbat derived in Pat b? Explain what has tanspited pany. «af Inflation tbe 3 percent, giving an REK of 6 percent You want to evaluate the recent investment performance for two stocks—Walgreen and Exxon ‘Mobil—relatve tothe S&P 500 index. 1. Under the “Companies” ta, laok up the ticker symbols for Walgreen and Exxon Mobil '. For each firm, as well as forthe SAP 500 index, download daily price information forthe past year using the menu options available under the "Prices" ab fr each company. «For each frm, calculate the set of daily returns that correspond to these daly price seis. 4, Using daily retuens forthe past year, caleylate the beta coefficient for Walgreen and Exxon Mobil compared to the S&P 500 index. (Note: You can ether buld your own spreadsheet modelo per form these calculations of use Excel’ built-in functions for “Slope” ox “Regression.") «Based an your results in Part d, which stock appears to he the rishiest” ‘To evaluate how sensitive beta estimates are to the period over which returns are measured, ou now ‘want to repeat the analysis inthe last problem using weekly data over the past year. 4. For each firm, as well a for the S&P 500 index. download weekly price information for the past year using the menu options available in the Prices tab fr each company. b. Foreach firm, calculate the set of weekly returns that correspond to these daily price series, ‘© Using work returns for te past year, calculate the beta for Walgreen and Exxon Mobil compared tothe S&P 500 index 44, How do your bera estimates for Walgreen and Exxon Mobil difer when using daly versus weekly data in the estimation process? Does your conclusion change about which stock i the iskiest? ‘You would now like to evaluate the impact that the choice of index used for the market portfolio proxy has on the beta estimation process, 8. Collect monthly price dats for Walgreen and Exxon Mobil for the past five years and use this information to compute monthly relurns over that period. ». Collect montly price data forthe S&P 500 index and MSCI World index (based in U.S. dollars) forthe past five years and compute monthly returns for both series. (Note: You can access the information for «wide variety of diferent indexes under the main “Indices” tab) Calculate betas for both stocks compared to the SBP 500 index, 4, Calculate betas for bath stocks compared to the MSCI World index Compare the (wo beta estimates for each stock and explain why they would differ from one another.