Capital market theory

EQUILIBRIUM PRICING MODELS

ICM-JJ

1

Portfolio theory and Capital markets theory
• depict the theoretical relationship between the risk and expected return of an asset • Portfolio theory
– A selection of portfolios that maximizes expected returns consistently within acceptable levels of risk

• Capital markets theory
– Deals with the effects of investor’s decisions on security prices
ICM-JJ 2

Lintner and Mossin are researchers credited with its development E ( Ri )  R f   i [ E ( Rm )  R f ] ICM-JJ 3 . Sharpe.Capital Asset Pricing Model (CAPM) • Equilibrium model that underlies all modern financial theory • Derived using the principles of diversification (portfolio theory) with simplified assumptions (capital market theory) • Markowitz.

Assumptions • Individual investors are price takers • Single-period investment horizon • Investments are limited to traded financial assets (risk-free asset exists) • No taxes. and transaction costs • Information is costless and available to all investors • Homogeneous expectations • Investors are rational mean-variance optimisers ICM-JJ 4 .

Components of Risk • Specific risk – The variability in return due to factors unique to the individual firm – Usually eliminated by diversifying the portfolio • Systematic risk – The variability in return due to dependence on factors which influence the return on all securities – Not diversifiable – Often called market risk (Beta) • Total risk = Systematic + Unsystematic ICM-JJ 5 .

e.Beta (Market risk) Beta indicates how the return of a particular share is expected to vary for given variations in the return on the overall stock market i.m   i m 6 . how E(Ri) and E(Rm) are systematically related Individual securities: [COV (ri .m   i   m m 2  Corri . rm )] i   m2 i  ICM-JJ Corri .

The Security Market Line (SML) E(Ri) Market portfolio M Security market line E(Rm) Rf E ( Ri )  R f   i [ E ( Rm )  R f ] βm = 1 Beta SML describes the relationship between risk and return when all securities are correctly priced i. ICM-JJ 7 .e. SML indicates the ‘appropriate’ required return on individual assets and inefficient portfolios. when the capital market is in equilibrium.

0 B 19% 1. over.or correctly priced? Estimated (Ri) Beta A 21% 2.Example (I) The expected return on the market portfolio is 15% and the risk-free rate is 7%. In light of this info. determine whether the following securities are under-.5 ICM-JJ 8 .3 C 11% 0.

Example (I) E ( Ri )  R f  i [ E ( Rm )  R f ] E ( Ri )  7  i (15  7)  7  8i For share A: E(R) β ICM-JJ 9 .

Example (I) E ( Ri )  R f  i [ E ( Rm )  R f ] E ( Ri )  7  i (15  7)  7  8i For share B: E(R) β ICM-JJ 10 .

Example (I) E ( Ri )  R f  i [ E ( Rm )  R f ] E ( Ri )  7  i (15  7)  7  8i For share C: E(R) β ICM-JJ 11 .

shares with lower beta gained lower returns relative to shares with higher beta which gained higher returns ICM-JJ 12 .e.Empirical evidence (I) • Sharpe & Cooper (1972) – Examined whether there is a positive relationship between expected return and beta (as stated by CAPM) – Data of shares on the NYSE from 1931 to 1967 – Shares were ranked according to their betas and grouped into 10 deciles Findings – CAPM does apply i.

Empirical evidence (II) • Fama & MacBeth (1973) – Investigated the relationship between risk and return using a regression analysis Findings – Statistics failed to reject the hypotheses that the relationship between risk and return is linear and beta is the relevant measure of portfolio risk – Positive risk & return trade-off – CAPM does apply ICM-JJ 13 .

book to market value ratios (BV/MV). negative coefficient. coefficient was small and not significantly different from zero – Size was important. E/P ratios.Empirical evidence (III) • Fama & French (1992) – Examined the relationship of returns to size. large companies earned lower returns than their smaller counterparts – Book to market was also important. gearing (D/E) and beta Findings – β did not explain returns. lower market to book companies earned higher returns – Low P/E companies earned higher returns ICM-JJ 14 .

Empirical evidence (IV) • Basu (1983) • Banz (1981) ICM-JJ 15 .

1976) • A security’s expected return is influenced by a variety of factors as opposed to the single market index of CAPM • Based on purely arbitrage arguments (where an investor can construct a zero investment portfolio with sure profit) ICM-JJ 16 .Arbitrage Pricing Theory (APT) • An alternative model to the CAPM (Ross.

g.APT formula E ( Ri )  R f  1bi1  2bi 2   where: E(Ri) = expected return. inflation. etc b1 = the sensitivity of the asset to each of the common factors ICM-JJ 17 . Rf = the risk-free rate λ1 = the risk premium related to each of the common factors e.

Individuals will arbitrage away the difference (very profitable opportunities) . Actual(Ri) E(Ri) 20% 15% .Using returns generating formula as follows: Ri  E ( Ri )  bi1 F1  bi 2 F2   bik Fk  ei where Ri is the actual return on asset i E(Ri) is the expected return on asset i Fk is the kth shock to factors common to all assets bik is the sensitivity of asset i to changes in factor k ICM-JJ 18 .g.• Ross (1976) APT – Actual returns differ from expected returns because of shocks to macroeconomic variables e.

75 ICM-JJ 19 . risk free rate • The two stocks have the following sensitivities to these factors: bX1 = 0.50 bY1 = 2. bY2 = 1. bX2 = 1.00. percent growth in real GDP Rf = 0. in a twofactor model environment: λ1 = 0.01. changes in the rate of inflation λ2 = 0. X and Y.03.50.Example II • Consider the following stocks.02.

Example II (a) What are their respective expected returns? (b) Which is the riskier stock? E ( Ri )  R f  1bi1  2bi 2  E(R X )   E(R Y )   (a) (b) ICM-JJ 20 .

75%.2 0.75%? (b) Contrast portfolio E against a portfolio constructed of 1/3 of funds in A.Example III Suppose that the following two factor model describes returns: Ri = E(Ri) + bi1 F1 + bi2 F2 The following data is available: Portfolio A B Estimated (r%) 17 14 bi1 1.6 1.5 bi2 0. ICM-JJ 21 .3 0.0 C E 8 15 0. B & C. λ1=5% and λ2=3. B and C are correctly priced if Rf =7.6 0.6 (a) Determine which of A.0 0.

75  5 b  3.75 b i i1 i2 A Alpha   B Alpha  C Alpha  ICM-JJ 22 .Example III (a) APT : E(R )  7.

Example III (b) New portfolio: 1/3 funds in each A. B & C E(Rn) = 1/3 (15) + 1/3 (14) + 1/3 (10) = 13 Type b1 risk = = Type b2 risk = = E(R) 15% b1 0.6 23 Portfolio E Portfolio N ICM-JJ .6 b2 0.

Beta did not affect price – Support APT and not CAPM ICM-JJ 24 .Empirical evidence (V) • Roll & Ross (1980) – Tested for factors which explained returns using factor analysis technique – Investigated whether sensitivity to these factors are priced Findings – In over 38% of the groups. there was a less than 10% chance that a sixth factor had explanatory power – Over 50% chance that the 5 factors were significant – About 3 out of 5 appeared to be priced by the market and helped explain returns earned by securities – When Beta was added to the equation.

term structure of interest rates. Roll & Ross (1986) – Argued that the return on shares should be influenced by any factor that affects either the future cashflow from holding these shares or the present value of these cashflows – Tested 5 factors. risk premia. inflation. unexpected inflation. industrial production – Examined whether the sensitivity to these factors are priced by the market ICM-JJ 25 .Empirical evidence (VI) • Chen.

it was not significant • Cochrane (1999a. which persisted over several periods – The sensitivities to these factors are significant – When Beta was introduced as another variable.Empirical evidence (VI) Findings – A strong relationship existed between the factors examined and returns.b) • Carhart (1997) ICM-JJ 26 .

APT v CAPM v Multifactors? • • • • • Assumptions Models Risks Empirical evidence and tests Implications for portfolio management and security analysis ICM-JJ 27 .

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