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You are on page 1of 54

Bodie, Kane, and Marcus

Essentials of Investments,

9th Edition

McGraw-Hill/Irwin

7-2

Assumptions

Markets are competitive, equally profitable

No investor is wealthy enough to individually affect

prices

All information publicly available; all securities public

No taxes on returns, no transaction costs

Unlimited borrowing/lending at risk-free rate

Investors are alike except for initial wealth, risk

aversion

Investors plan for single-period horizon; they are

Use same inputs, consider identical portfolio opportunity sets

7-3

Hypothetical Equilibrium

All investors choose to hold market portfolio

Market portfolio is on efficient frontier, optimal

risky portfolio

7-4

Hypothetical Equilibrium

Risk premium on market portfolio is proportional to

aversion

Risk premium on individual assets

Proportional to beta coefficient of security on

market portfolio

7-5

Line

7-6

Passive Strategy is Efficient

Mutual fund theorem: All investors desire same

single mutual fund composed of that portfolio

If passive strategy is costless and efficient, why

If no one does security analysis, what brings

7-7

Risk Premium of Market Portfolio

Demand drives prices, lowers expected rate of

return/risk premiums

When premiums fall, investors move funds into

risk-free asset

Equilibrium risk premium of market portfolio

proportional to

Risk of market

Risk aversion of average investor

7-8

7-9

The Security Market Line (SML)

Represents expected return-beta relationship of

CAPM

Graphs individual asset risk premiums as

Alpha

Abnormal rate of return on security in excess of

7-10

7-11

Applications of CAPM

Use SML as benchmark for fair return on risky

asset

SML provides hurdle rate for internal projects

7-12

7-13

7-14

Statistic (%)

T-Bills

S&P 500

0.184

0.239

1.125

0.055

0.941

Standard deviation*

0.177

5.11

10.40

Geometric average

0.180

0.107

0.600

11.65

6.60

43.17

9.04

27.45

70.42

2.29

-38.87

-40.99

0.10

36.83

42.36

7-15

7-16

7-17

7-18

Linear Regression

Regression Statistics

R

R-square

Adjusted R-square

SE of regression

Total number of observations

0.5914

0.3497

0.3385

8.4585

60

Regression equation: Google (excess return) = 0.8751 + 1.2031 S&P 500 (excess return)

ANOVA

df

1

58

59

Regression

Residual

Total

SS

2231.50

4149.65

6381.15

MS

2231.50

71.55

F

31.19

p-level

0.0000

Intercept

S&P 500

Coefficie

nts

0.8751

1.2031

t-Statistic (2%)

Standard

Error

1.0920

0.2154

tStatisti

c

0.8013

5.5848

pvalue

0.4262

0.0000

LCL

-1.7375

0.6877

UCL

3.4877

1.7185

2.3924

UCL - Upper confidence interval (95%)

7-19

Estimation results

Security Characteristic Line (SCL)

market

7-20

Predicting Betas

Mean reversion

To predict future betas, adjust estimates from

towards 1.0

7-21

CAPM is false based on validity of its

assumptions

Useful predictor of expected returns

Untestable as a theory

Principles still valid

Systematic risk is the risk that matters

Well-diversified risky portfolio can be suitable

7-22

7-23

7-24

Monthly Excess Return % *

Total Return

Average

Standard

Deviation

Geometric

Average

Cumulative

Return

0.18

11.65

Market index **

0.26

5.44

0.30

19.51

SMB

0.34

2.46

0.31

20.70

HML

0.01

2.97

-0.03

-2.06

0.94

10.40

0.60

43.17

Security

T-bill

** Includes all NYSE, NASDAQ, and AMEX stocks.

7-25

Specifications

Regression statistics for:

1.B Single index with broad market index (NYSE+NASDAQ+AMEX)

2. Fama French three-factor model (Broad Market+SMB+HML)

Monthly returns January 2006 - December 2010

Single Index Specification

Estimate

FF 3-Factor Specification

S&P 500

Correlation coefficient

0.59

0.61

0.70

Adjusted R-Square

0.34

0.36

0.47

8.46

8.33

7.61

0.88 (1.09)

0.64 (1.08)

0.62 (0.99)

Market beta

1.20 (0.21)

1.16 (0.20)

1.51 (0.21)

-0.20 (0.44)

-1.33 (0.37)

7-26

Arbitrage

Relative mispricing creates riskless profit

Risk-return relationships from no-arbitrage

Well-diversified portfolio

Nonsystematic risk is negligible

Arbitrage portfolio

Positive return, zero-net-investment, risk-free portfolio

7-27

Calculating APT

7-28

Steps to convert a well-diversified portfolio into

an arbitrage portfolio

*When alpha is negative, you would reverse the signs of each portfolio weight

to achieve a portfolio A with positive alpha and no net investment.

7-29

Stock

Weight Stock

Weight

7-30

on Benchmark Portfolio, 01/06-12/10

Linear Regression

Regression

Statistics

R

0.9933

R-square

0.9866

Adjusted R-square

0.9864

Annualiz

ed

Regression SE

0.5968

2.067

60

Standard

Coefficients

Error

t-stat

p-level

Intercept

-0.1909

0.0771

-2.4752

0.0163

Benchmark

0.9337

0.0143

65.3434

0.0000

7-31

Period

Real Rate

1.46

1.46

0.61

1/1/96 - 12/31/00

0.57

0.54

0.17

1/1/86 - 12/31/90

0.86

0.83

0.37

7-32

7-33

Multifactor Generalization of APT and CAPM

Factor portfolio

any other factor

Two-Factor Model for APT

7-34

Constructing an arbitrage portfolio with two

systemic factors

7-35

Selected Problems

7-36

Problem 1

CAPM: E(ri) = rf + (E(rM)-rf)

a.

E(rX)

X

E(rY)

Y

=

=

=

=

14% 12.2% = 1.8%

5% + 1.5(14% 5%) = 18.5%

17% 18.5% = 1.5%

7-37

Problem 1

X = 1.8%

Y = -1.5%

b. Which stock?

ii. Held alone:

i. Well diversified:

Relevant Risk Measure?

Relevant Risk Measure?

: CAPM Model

Best Choice?

Best Choice?

Calculate Sharpe

Stock X with the

ratios

positive alpha

b. Which stock?

7-38

Problem 1

b.

(continued)SharpeRatios

Sharpe Ratio

E(r) rf

HeldAlone:

Sharpe Ratio X = (0.14 0.05)/0.36 = 0.25

Better Sharpe Ratio Y = (0.17 0.05)/0.25 = 0.48

Sharpe Ratio Index = (0.14 0.05)/0.15 = 0.60

ii.

7-39

Problem 2

E(rP) = rf + [E(rM) rf]

20% = 5% + (15% 5%)

= 15/10 = 1.5

7-40

Problem 3

E(rP) = rf + [E(rM) rf]

If the stock pays a constant dividend in perpetuity, then we know from the

original data that the dividend (D) must satisfy the equation for a perpetuity:

Price = Dividend / E(r)

$40 = Dividend / 0.13 so the Dividend = $40 x 0.13 = $5.20

At the new discount rate of 19%, the stock would be worth:

$5.20 / 0.19 = $27.37

7-41

Problem 4

a. Depends on what one means by volatility. If one means the then

this statement is false. Investors require a risk premium for bearing

systematic (i.e., market or undiversifiable) risk.

b.

False. You should invest 0.75 of your portfolio in the market portfolio,

which has = 1, and the remainder in T-bills. Then:

= (0.75 x 1) + (0.25 x 0) = 0.75

P

7-42

Problems 5 & 6

5.

6.

5.

6.

Not possible. Portfolio A has a higher beta than Portfolio B, but the

expected return for Portfolio A is lower.

Possible.

Portfolio A's lower expected rate of return can be paired with a higher

standard deviation, as long as Portfolio A's beta is lower than that of

Portfolio B.

7-43

Problem 7

7.

Sharpe Ratio

7.

E(r) rf

Sharpe M

.18 .10

0.33

.24

Sharpe A

.16 .10

0.5

.12

than that of the market, which is not possible according to the CAPM,

since the CAPM predicts that the market portfolio is the portfolio with

the highest return per unit of risk.

7-44

Problem 8

8.

8.

Not possible. Portfolio A clearly dominates the market

portfolio. It has a lower standard deviation with a higher

expected return.

7-45

Problem 9

9.

9.

E(r) = 10% + (18% 10%)

A portfolio with beta of 1.5 should have an expected return of:

E(r) = 10% + 1.5(18% 10%) = 22%

Not Possible: The expected return for Portfolio A is 16% so that

Portfolio A plots below the SML (i.e., has an = 6%), and hence is

an overpriced portfolio. This is inconsistent with the CAPM.

7-46

Problem 10

10.

E(r) = 10% + (18% 10%)

10.

The SML is the same as in the prior problem. Here, the required

expected return for Portfolio A is:

10% + (0.9 8%) = 17.2%

overpriced, with = 1.2%.

7-47

Problem 11

11.

11.

Sharpe M = (18% - 10%) / 24% = .33

deviation is less attractive than the market's. This situation

is consistent with the CAPM. The market portfolio should

provide the highest reward-to-variability ratio.

7-48

Problem 12

12

12.

Since the stock's beta is equal to 1.0, its expected rate of return

the market return, or 18%

should be equal to ______________________.

E(r) =

D1 P1 P0

P0

0.18 = 9 P1 100

100

In Equilibrium :

or P1 = $109

D1 P1 P0

rf (E(rM ) rf )

P0

7-49

Problem 13

a.

r1=19%;r2=16%;1=1.5;2=1.0

We cant tell which adviser did the better job selecting stocks because

we cant calculate either the alpha or the return per unit of risk.

CAPM: ri = 6% + (14%-6%)

r1=19%;r2=16%;1=1.5;2=1.0,rf=6%;rM=14%

1=19% [6% + 1.5(14% 6%)] = 19% 18% = 1%

b.

2= 16% [6% + 1.0(14% 6%)] = 16% 14% = 2%

Thesecondadviserdidthebetterjobselectingstocks(bigger+alpha)

Part c?

7-50

Problem 13

c. CAPM: ri = 3% + (15%-3%)

r1 = 19%; r2 = 16%; 1 = 1.5; 2 = 1.0, rf = 3%; rM = 15%

1 = 19% [3% + 1.5(15% 3%)] = 19% 21% = 2%

2 = 16% [3%+ 1.0(15% 3%)] = 16% 15% = 1%

Here, not only does the second investment adviser appear to be a

better stock selector, but the first adviser's selections appear valueless

(or worse).

7-51

Problem 14

Murrays existing portfolio (i.e., buy more risky assets on margin).

In addition to increased expected return, the alternative portfolio on

the capital market line (CML) will also have increased variability (risk),

which is caused by the higher proportion of risky assets in the

total

portfolio.

b. McKay should substitute low beta stocks for high beta stocks in

order to reduce the overall beta of Yorks portfolio. Because York

does not permit borrowing or lending, McKay cannot reduce risk by

selling equities and using the proceeds to buy risk free assets (i.e.,

by lending part of the portfolio).

7-52

Problem 15

i. Since

the beta for Portfolio F is zero, the expected return for Portfolio

F equals the risk-free rate.

For Portfolio A, the ratio of risk premium to beta is: (10% - 4%)/1 = 6%

The ratio for Portfolio E is:

(9% - 4%)/(2/3) = 7.5%

ii.

Create Portfolio P by buying Portfolio E and shorting F in the

proportions to give p = A = 1, the same beta as A.

p =Wi i

1 = WE(E) + (1-WE)(F); WE = 1 / (2/3) or WE = 1.5 and WF = (1-WE) = -.5

E(rp) = 1.5(9) + -0.5(4) = 11.5%,

Buying Portfolio P and shorting A

p,-A = 11.5% - 10% = 1.5%

creates an arbitrage opportunity since

both have = 1

7-53

Problem 16

E(IP) = 4% &

E(IR) = 6%;

E(rstock) = 14%

IP = 1.0

&

IR = 0.4

Actual IP = 5%, so unexpected IP = 1%

Actual IR = 7%, so unexpected IR = 1%

The revised estimate of the expected rate of return of the stock would

be the old estimate plus the sum of the unexpected changes in the

factors times the sensitivity coefficients, as follows:

E(rstock) + due to unexpected Factors

Revised estimate = 14% + [(1 1%) + (0.4 1%)] = 15.4%

7-54

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