INVESTMENT PORTFOLIO

MANAGEMENT:
THE CAPITAL ASSET PRICING MODEL

REPORTER: RODELIE P. GABATO

INTRODUCTION TO INVESTMENT
PORTFOLIO MANAGEMENT
A portfolio is a combination of various instruments of
investments. It is also a combination of securities with
different risk-return characteristics. The object of portfolio is
to reduce risk by diversification and maximize gains.
PORTFOLIO MANAGEMENT

• Portfolio management means selection of securities and

constant shifting of the portfolio in the light of varying
attractiveness of the constituents of the portfolio.
PORTFOLIO MANAGEMENT

Portfolio management includes portfolio planning, selection

and construction, review and evaluation of securities. The skill
in portfolio management lies in achieving a sound balance
between the objectives of safety, liquidity and profitability.
PORTFOLIO MANAGEMENT

Timing is an important aspect of portfolio revision. Ideally,

investors should sell at market tops and buy at market
bottoms. Investors may switch from bonds to share in a
bullish market and vice-versa in a bearish market.
PORTFOLIO MANAGEMENT

Portfolio management is all about strengths, weaknesses,

opportunities and threats in the choice of debt vs. equity,
domestic vs. international, growth vs. safety, and many other
tradeoffs encountered in the attempt to maximize return at a
given appetite for risk.
PORTFOLIO MANAGEMENT

Portfolio management is an art and science of making

decisions about investment mix and policy, matching
investments to objectives, asset allocation for individuals and
institutions, and balancing risk against performance.
OBJECTIVES OF PORTFOLIO
MANAGEMENT
1) Security / Safety of Principal
2) Stability of Income
3) Capital growth
4) Marketability
5) Liquidity
6) Diversification
7) Tax Incentives
 RISK AND RETURN

When there is only one asset involved, its risk and return
can be measured using expected return and variance of
return.

A portfolio is a combination of more than one asset.

FORMULA FOR VARIANCE

The variance of return is the measure of risk inherent in investing in

a single asset or portfolio. The higher the variance, the greater the
squared deviation of return from the expected rate of return. The
higher values indicate a greater amount of risk, and low values mean
a lower inherent risk.
• The variance of a perfect-certainty (risk-free) asset is zero.
 RISK AND RETURN

Two types of risk for individual assets

• Diversifiable / Nonsystematic / Idiosyncratic Risk

• Nondiversifiable / Systematic / Market risk

Diversifiable risk can be eliminated without cost by combining

assets into portfolios.
DIVERSIFIABLE / NONSYSTEMATIC RISK

Examples
• Firm discovers a gold mine beneath its property
• Lawsuits
• Technological innovations
• Labor strikes
The key is that these events are random and unrelated
across firms.
 NONDIVERSIFIABLE / SYSTEMATIC RISK
Examples:
• Business Cycle
• Inflation Shocks
• Productivity Shocks
• Interest Rate Changes
• Major Technological Change
• These are economic events that affect all assets. The risk
associated with these events is systematic (system wide),
and does not disappear in well diversified portfolios.
IMPLICATIONS OF DIVERSIFICATION

• Diversifiable / Nonsystematic / Idiosyncratic Risk

• Disappears in well diversified portfolios.
• It disappears without cost, i.e. you need not sacrifice expected return to reduce
this type of risk.

• Nondiversifiable / Systematic / Market risk

• Does not disappear in well diversified portfolios.
• Must trade expected return for systematic risk.
• Level of systematic risk in a portfolio is an important choice for an individual.
 MEASURING SYSTEMATIC RISK

The Beta Coefficient is the slope coefficient in an OLS regression of

stock returns on market returns:

Cov(R i , R M )
i 
Var(R M )

Beta is a measure of sensitivity: it describes how strongly the

stock return moves with the market return.
• Example: A Stock with  = 2 will on average go up 20% when the market
goes up 10%, and vice versa.
 BETAS AND PORTFOLIOS

The Beta of a portfolio is the weighted average of the

component assets’ Betas.
Example: You have 30% of your money in Asset X, which has X = 1.4 and
70% of your money in Asset Y, which has Y = 0.8.
Portfolio Beta is: P = .30(1.4) + .70(0.8) = 0.98.
RECAPP:

A beta
a. Is a measure of the sensitivity of a stock’s return to the
returns on the market portfolio.
b. A standardized measure of a stock’s contribution to the
risk of a well diversified portfolio.
c. A measure of a stock’s systematic risk (per unit risk or
relative to the risk of the market portfolio).
 HOW TO GET BETA

Beta is estimated using a regression equation.

• In practice, generally use last five years of monthly data. Some companies publish
beta estimates on a regular basis:
• Value Line, Merrill Lynch Beta Book, S&P

• What if the company is not publicly traded?

• Find a comparable company that is traded.
• Use accounting data (ROE) instead of stock returns.
What Determines Beta?
u Beta is a measure of sensitivity to the market.
u Companies with cyclical cash flows will tend to
have higher betas.
u Higher operating leverage implies higher betas.
u Operating leverage is the ratio of fixed costs to
variable costs.
u Higher financial leverage also means a higher
equity beta.
 THE CAPITAL ASSET PRICING
MODEL (CAPM)
CAPM is an investment theory that shows the relationship
between the expected return of an investment and the
market risk.
Formula:

Where Rf = risk free rate ß = beta

Rm = expected return of stock market Ra = return on assets
 THE CAPITAL ASSET PRICING
MODEL (CAPM)
Illustration:
Using 10-year treasury notes, the Rm is 9% (historical average)
Risk free rate = 3%

Apple Facebook
ß = 0.99 ß = 1.2
Ra = 3% + 0.99 (9% - 3%) Ra = 3% + 1.2 (9% - 3%)
= 8.9% = 10.2%
 HOW CAN WE USE CAPM

One way is to use CAPM to calculate WACC

 THE CAPITAL ASSET PRICING
MODEL (CAPM)
• Given that
• some risk can be diversified,
• diversification is easy and costless,
• rational investors diversify,
• There should be no premium associated with diversifiable risk.
• The question becomes: What is the equilibrium relation between
systematic risk and expected return in the capital markets?
• The CAPM is the best-known and most-widely used equilibrium
model of the risk/return (systematic risk/return) relation.
CAPM INTUITION: RECAP

• E[Ri] = RF (risk free rate) + Risk Premium

= Appropriate Discount Rate
• Risk free assets earn the risk-free rate
• If the asset is risky, we need to add a risk premium.
• The size of the risk premium depends on the amount of systematic
risk for the asset (stock, bond, or investment project) and the price
per unit risk.

• Could a risk premium ever be negative?

 THE CAPM

Cov(R i , R M )
E[R i ]  R F  [E[R M ]  R F ]
Var(R M )
or, E[R i ]  R F   i [E[R M ]  R F ]

Number of units of
systematic risk () Market Risk Premium
or the price per unit risk

• The expression above is referred to as the “Security

Market Line” (SML).
USING THE CAPM TO SELECT A
DISCOUNT RATE
• Three inputs are required:
(i) An estimate of the risk free interest rate.
• The current yield on short term treasury bills is one proxy.
• Practitioners tend to favor the current yield on longer-term treasury
bonds but this may be a fix for a problem we don’t fully understand.
• Remember to adjust the market risk premium accordingly.

(ii) An estimate of the market risk premium, E(Rm) - Rf.

• Expectations are not observable.
• Generally use a historically estimated value.

(iii) An estimate of beta. Is the project or a surrogate for it traded in

financial markets? If so, gather data and run an OLS regression. If not,
you enter a very fuzzy area.
 The Market Risk Premium
n The market is defined as a portfolio of all wealth including real
estate, human capital, etc.
n In practice, a broad based stock index, such as the S&P 500 or
the portfolio of all NYSE stocks, is generally used.
The Market Risk Premium Is Defined As:
[E[R M ]  R F ]
n Historically, the market risk premium has been about 8.5% - 9%
above the return on treasury bills.
n The market risk premium has been about 6.5% - 7% above the
return on treasury bonds.
PROBLEMS
• The current risk-free rate is 4% and the expected
risk premium on the market portfolio is 7%.
• An asset has a beta of 1.2. What is the expected return
on this asset? Interpret the number 1.2.

• Ra = 4% + 1.2 (7% - 4%)

• = 7.6%
PROBLEMS

• The current risk-free rate is 4% and the expected

risk premium on the market portfolio is 7%.
• An asset has a beta of 0.6. What is the expected
return on this asset?

• Ra = 4% + 0.6 (7% - 4%)

• = 5.8%
PROBLEMS

• The current risk-free rate is 4% and the expected risk premium on

the market portfolio is 7%.
• Ra = [0.5(4% + 1.2 (7% - 4%))+ (0.5(4% + 0.6 (7% - 4%)]
= 3.8% + 2.9%
= 6.7%
• If we invest ½ of our money in the first asset and ½ of our money in the
second, what is our portfolio beta and what is its expected return?
• Relative to the first asset our portfolio has a smaller expected return, why?
• Does this mean the first asset is better than the portfolio?