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Lecture 5
Investment and Portfolio Analysis (Auckland University of Technology)
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Lecture 5
• Review of Lectures 1-4
• Capital Asset Pricing Model
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Lecture 1
Key concepts
Bid and ask prices
Market orders and Price-contingent orders
Limit order book
Buying on margin
Short sales
Margin requirements
Understand margin
Be able to determine the conditions of a margin
call
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Lecture 2
Key concepts
Different types of investment companies
Mutual funds, close-end funds, open-end funds
ETF
Relevant measures
NAV
Premium/discount to NAV
Fee structure of mutual funds
Return and turnover ratio of mutual funds
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Lecture 3
Key concepts
HPR
Expected return and standard deviation of
returns
Scenario analysis method
Historical data method
Risk premium and Sharpe ratio
Asset allocation between risky and risk-
free assets
Be able to determine investment opportunities
with these two assets
Be able to draw CAL and use it
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Lecture 4
Key concepts
Market risk, firm specific risk, and beta
Diversification and correlation of returns
Efficient frontier
Portfolio theory
Optimal risky portfolio P forming CAL with the highest
Sharpe ratio
Everyone invests in P, regardless of their degree of
risk aversion
Be able to calculate the expected return and standard
deviation of a portfolio with two securities
Be able to calculate portfolio beta
Be able to determine minimum-variance and optimal
risky portfolios with two risky assets.
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Capital Asset Pricing Model (CAPM)
Equilibrium model that underlies modern
financial theory
Derived using principles of diversification with
simplified assumptions
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CAPM - Assumptions
Individual investors Information is
are price takers costless and
Single-period available to all
investment horizon investors
Investments are Investors are
limited to traded rational mean-
financial assets variance optimizers
No taxes and There are
transaction costs homogeneous
expectations
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CAPM - Resulting Equilibrium Conditions
All investors will hold the same portfolio of
risky assets – market portfolio
Market portfolio contains all securities and the
proportion of each security is its market value
as a percentage of total market value
Risk premium on the market will depend on
the average risk aversion of all market
participants
The risk premium on individual assets will be
proportional to the market risk premium and
to the beta of the security in the market
portfolio.
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The Efficient Frontier and the
Capital Market Line
• M = The value weighted “Market”
E(r) Portfolio of all risky assets.
• Equilibrium conditions:
All investors will hold the M portfolio
CML
M
E(rM) Efficient
Frontier
rf
m
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Slope of CML and Market Risk Premium
M = Market portfolio
rf = Risk-free rate
E(rM)- rf = Excess return on the market portfolio
E (rM ) rf
M {
=Optimal Market price of risk
=Slope of the CML
Capital Market Line
M = The value weighted “Market”
Market”
E(r)
E(r) Portfolio of all risky assets.
CML
M
E(rM)
rf
→
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m
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Expected Return and Risk on
Individual Securities
The risk premium on a security is a function of
the security’s contribution to the risk of the
market portfolio,
E (ri ) rf i ( E (rM ) rf )
Cov(ri , rM )
where i
M2
Does the firm-specific risk of a security matter to
investors holding a well-diversified portfolio? No!
A security’s total risk (2i) can be partitioned into
systematic and unsystematic risk:
2i = i2 M2 + 2(ei)
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Individual Stocks: Security Market Line
E(r) Equation of the SML (CAPM)
E(ri) = rf + i[E(rM) - rf ]
SML
E(rM)
(E(rM) – rf )=SML Slope
rf =price of risk for market
ß
ß M = 1.0
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SML: Example
Beta is 1.25 for Stock X and 0.6 for stock Y. Find
the equilibrium expected returns for the stocks,
given the following information:
E(rm) - rf = 0.08, rf = 0.03
Stock X:
E(rx) = 0.03 + 1.25(0.08) = 0.13 or 13%
Stock Y:
E(ry) = 0.03 + 0.6(0.08) = 0.078 or 7.8%
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SML: Example (cont.)
E(r)
SML
E(rx)=13% .08
E(rM)=11%
If the CAPM is correct,
E(ry)=7.8%
only β risk matters in
determining the risk
3%
premium for a given
slope of the SML.
ß
.6 1.0 1.25
ßy ßM ßx
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SML: Example (cont.)
Suppose Stock Z has = 1.25, and
offers an expected return of 15%
According to the SML, the
equilibrium expected return for the
stock should be 13%
E(rZ) = 0.03 + 1.25(.08) = 13%
Is Stock Z under or overpriced?
Underpriced: It is offering too high of a What is the in this case?
rate of return for its level of risk.
Definition of = +2%. Positive is
The difference of the actual expected good, negative is bad
return minus the equilibrium expected
return as measured by the CAPM is + gives the buyer a +
called the stock’s alpha denoted by . abnormal return
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Portfolio Betas
The beta of a portfolio with n securities is equal to the
weighted average of the betas of these securities, i.e.,
n
p w i 1
i i
Example: If you put 50% of your money in a
stock with a beta of 1.5 and 30% of your money
in a stock with a beta of 0.9 and the rest in T-
bills, what is the portfolio beta?
βP =0.50(1.5) + 0.30(0.9) + 0.20(0) = 1.02
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The Single-Index Model and
Realized Returns
Use historical data to estimate beta. As
such, move from expected to historical
realized returns, and use the index model
in excess return form:
Ri i i RM ei
where Ri ri rf , RM rM rf , ei is an error term.
Note: ri, rM, and rf are historical realized
returns on security i, market index M,
and risk-free rate for the same time
period t.
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Single-Index Model:
Security Characteristic Line (SCL)
With the use of historical data on a
security, market index, and risk-free
rate (typically past 5 year data), obtain
the estimates of αi and βi, and define
SCL as
y i i x
SCL is also called the regression line.
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Security Characteristic Line (SCL)
Excess Returns (i)
SCL
Dispersion of the
points around the
. . . . Slope =
line measures
.
. . .
unsystematic risk. .
The statistic is
called (e)
. . . . .
. . .. . .
. .
. .
. . . Excess returns
. .. . . .
. . . .. . .
=
on market index
. . .
What should equal to?
.
.. . . . .
Ri = i + ßiRM + ei
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GM’s beta: GM Excess Returns Jan 04 to Dec 08
SUMMARY OUTPUT
Excess Return
Regression Statistics
“True” is between 0.28 and
Month GM Market
1.43!
Dec-08 22.93% -8.40% Multiple R 0.3641
Nov-08 -25.46% 0.95% R Square 0.1325 If rf = 5% and rm – rf = 6%,
Oct-08 -26.12% -7.12% Adjusted R Square 0.1176 then we would predict GM’s
Sep-08 -13.92% -16.82% Standard Error 0.0834 return (rGM) to be
Aug-08 -29.73% -9.66% Observations 60
Jul-08 -5.07% 1.25% 5% + 0.8554(6%) = 10.13%
Jun-08 -11.18% -1.24% ANOVA
May-08 -15.73% -8.69% df SS MS F Significance F
Apr-08 -6.65% 1.17% Regression 1 0.0617 0.0617 8.8622 0.0042
Mar-08 8.61% 4.43% Residual 58 0.4038 0.0070
Feb-08 -9.73% -1.16% Total 59 0.4655
. . .
. . . Coefficientstandard Erro t Stat P-value Lower 95% Upper 95%
. . . Intercept -0.0144 0.0110 -1.3062 0.1966 -0.0364 0.0077
Market 0.8554 0.2874 2.9769 0.0042 0.2802 1.4307
Sep-04 -0.03% 1.07%
Aug-04
Jul-04
1.40%
1.59%
0.78%
0.05%
Regression Results: rGM rf ( rS & P rf ) e
Jun-04 2.31% -3.38%
May-04 -0.31% 1.73% Estimated α = -0.0144, Can we conclude α < 0?
Apr-04 -0.08% 1.54% Estimated β = 0.8554
R-Square = 13.25%, σ(e) = 8.34%, ρ = 0.3641
Mar-04 -3.28% -2.07%
Feb-04 -0.06% -1.44%
Jan-04 0.49% 1.21% Adjusted R-Square = 11.76%
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Evaluating the CAPM
The CAPM is “false” based on the
validity of its assumptions
The CAPM could still be a useful
predictor of expected returns. That is
an empirical question.
Huge measurability problems because the
market portfolio is unobservable.
Conclusion: As a theory the CAPM is
untestable.
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Evaluating the CAPM
The principles we learn from the CAPM are
still entirely valid.
Investors should diversify.
Systematic risk is the risk that matters.
A well diversified risky portfolio can be suitable
for a wide range of investors.
The risky portfolio would have to be adjusted for tax
and liquidity differences.
Differences in risk tolerances can be handled by
changing the asset allocation decisions in the
complete portfolio.
Even if the CAPM is “false,” the markets can
still be “efficient.”
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