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CORPORATE FINANCE

Laurence Booth • W. Sean Cleary

Model

Prepared by

Ken Hartviksen

CHAPTER 9

The Capital Asset Pricing

Model (CAPM)

Lecture Agenda

• Learning Objectives

• Important Terms

• The New Efficient Frontier

• The Capital Asset Pricing Model

• The CAPM and Market Risk

• Alternative Asset Pricing Models

• Summary and Conclusions

– Concept Review Questions

– Appendix 1 – Calculating the Ex Ante Beta

– Appendix 2 – Calculating the Ex Post Beta

Learning Objectives

2. How modern portfolio theory is extended to develop the

capital market line, which determines how expected

returns on portfolios are determined.

3. How to assess the performance of mutual fund managers

4. How the Capital Asset Pricing Model’s (CAPM) security

market line is developed from the capital market line.

5. How the CAPM has been extended to include other risk-

based pricing models.

Important Chapter Terms

(APT) • New (or super) efficient

frontier

• Capital Asset Pricing • No-arbitrage principle

Model (CAPM) • Required rate of return

• Capital market line • Risk premium

(CML) • Security market line

• Characteristic line (SML)

• Fama-French (FF) model • Separation theorum

• Sharpe ratio

• Insurance premium • Short position

• Market portfolio • Tangent portfolio

• Market price of risk

Achievable Portfolio Combinations

(CAPM)

Achievable Portfolio Combinations

The Two-Asset Case

different risk/return characteristics just by varying the

weights of the two assets in the portfolio.

• Assets A and B are assumed to have a correlation

coefficient of -0.379 and the following individual

return/risk characteristics

Asset A 8% 8.72%

Asset B 10% 22.69%

100 different weighting schemes for just these two

securities:

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9-7

Example of Portfolio Combinations and

Correlation

You repeat this

procedure Expected Standard Correlation

down until you Asset Return Deviation Coefficient

have determine A 8.0% 8.7% -0.379

the portfolio B 10.0% 22.7%

characteristics

The first Portfolio Components Portfolio Characteristics

for all

The 100

second Expected Standard

combination

portfolios.

portfolio Weight of A Weight of B Return Deviation

simply99%

assumes 100% 0% 8.00% 8.7%

99% 1% 8.02% 8.5%

inNext

assumes plot1%

A and the

you

in 98% 2% 8.04% 8.4%

returns

B. Notice onthe

a

invest

graph

solely

(see in

increase the

97%

96%

3%

4%

8.06%

8.08%

8.2%

8.1%

innext

Asset

return slide)

and A

the 95% 5% 8.10% 7.9%

94% 6% 8.12% 7.8%

decrease in 93% 7% 8.14% 7.7%

portfolio risk! 92% 8% 8.16% 7.5%

91% 9% 8.18% 7.4%

90% 10% 8.20% 7.3%

89% 11% 8.22% 7.2%

Attainable Portfolio Combinations for a

Example of Portfolio Combinations and

Two Asset Portfolio

12.00%

Correlation

Expected Return of the

10.00%

8.00%

Portfolio

6.00%

4.00%

2.00%

0.00%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

Standard Deviation of Returns

Two Asset Efficient Frontier

portfolios (A,B,C,D and E in reference to the

attainable set of portfolio combinations of this

two asset portfolio.

Efficient Frontier

The Two-Asset Portfolio Combinations

8 - 10 FIGURE

A is not attainable

B,E lie on the

efficient frontier and

are attainable

A B E is the minimum

variance portfolio

C (lowest risk

combination)

C, D are

E attainable but are

%nr ut e R det ce px E

D dominated by

superior portfolios

that line on the line

above E

Standard Deviation (%)

Achievable Set of Portfolio Combinations

Getting to the ‘n’ Asset Case

investment alternatives (stocks, bonds, money market

securities, hybrid instruments, gold real estate, etc.) it

is possible to construct many different alternative

portfolios out of risky securities.

• Each portfolio will have its own unique expected return

and risk.

• Whenever you construct a portfolio, you can measure

two fundamental characteristics of the portfolio:

– Portfolio expected return (ERp)

– Portfolio risk (σp)

The Achievable Set of Portfolio

Combinations

risky portfolios.

• The results (in terms of ER p and σp )might look

like the graph on the following page:

Achievable Portfolio Combinations

The First Ten Combinations Created

ERp

10 Achievable

Risky Portfolio

Combinations

The Achievable Set of Portfolio

Combinations

more portfolios.

• Thirty risky portfolios might look like the

graph on the following slide:

Achievable Portfolio Combinations

Thirty Combinations Naively Created

ERp

30 Risky Portfolio

Combinations

Achievable Set of Portfolio Combinations

All Securities – Many Hundreds of Different Combinations

different portfolios naively varying the weight

of the individual assets and the number of

types of assets themselves, you get a set of

achievable portfolio combinations as

indicated on the following slide:

Achievable Portfolio Combinations

More Possible Combinations Created

The highlighted

portfolios are

ERp ‘efficient’ in that

they offer the

highest rate of

E is the return for a given

minimum level of risk.

variance Rationale investors

portfolio Achievable Set of will choose only

Risky Portfolio from this efficient

Combinations set.

The Efficient Frontier

(CAPM)

Achievable Portfolio Combinations

Efficient Frontier (Set)

Efficient

ERp frontier is the

set of

achievable

portfolio

combinations

Achievable Set of that offer the

Risky Portfolio

Combinations

highest rate

of return for a

given level of

E

risk.

The New Efficient Frontier

Efficient Portfolios

9 - 1 FIGURE

Figure 9 – 1

illustrates

Efficient Frontier three

ER

achievable

portfolio

combinations

B

that are

A ‘efficient’ (no

other

achievable

MVP portfolio that

offers the

same risk,

Risk offers a higher

return.)

Underlying Assumption

Investors are Rational and Risk-Averse

• This means they will not willingly undertake fair gamble.

– A risk-averse investor prefers the risk-free situation.

– The corollary of this is that the investor needs a risk premium to be

induced into a risky situation.

– Evidence of this is the willingness of investors to pay insurance

premiums to get out of risky situations.

• The implication of this, is that investors will only choose

portfolios that are members of the efficient set (frontier).

The New Efficient Frontier and

Separation Theorem

(CAPM)

Risk-free Investing

investment, a whole new set of portfolio

combinations becomes possible.

• We can estimate the return on a portfolio

made up of RF asset and a risky asset A

letting the weight w invested in the risky

asset and the weight invested in RF as (1 – w)

The New Efficient Frontier

Risk-Free Investing

asset A and RF:

slide.

The New Efficient Frontier

Attainable Portfolios Using RF and A

9 - 2 FIGURE

This means

you can 9 – 2

Equation

Rearranging 9

ER achieve

illustrates any

-2 where w=σ

portfolio

what you can

p / σA and

combination

see…portfolio

substituting in

σ pA =) - w

E(R RFσA along

risk the blue

increases

[9-3] ER P[9-2]

= RF + σ P Equation 1 we

σ coloured

in line

A A getdirect

an

simply

proportionby to

equation for a

changing

the amount the

RF straight line

relative

invested weight

with a in the

of RFasset.

risky and A in

constant

the two asset

slope.

portfolio.

Risk

The New Efficient Frontier

Attainable Portfolios using the RF and A, and RF and T

9 - 3 FIGURE

Which risky

portfolio

ER would a

rational risk-

T

averse

investor

A choose in the

presence of a

RF

RF investment?

Portfolio A?

Tangent

Risk Portfolio T?

The New Efficient Frontier

Efficient Portfolios using the Tangent Portfolio T

9 - 3 FIGURE

Clearly RF with

T (the tangent

portfolio) offers

ER a series of

portfolio

combinations

T

that dominate

A those produced

by RF and A.

Further, they

RF

dominate all but

one portfolio on

the efficient

Risk frontier!

The New Efficient Frontier

Lending Portfolios

9 - 3 FIGURE

Portfolios

between RF

and T are

Lending Portfolios ‘lending’

ER

portfolios,

because they

T

are achieved by

A investing in the

Tangent

Portfolio and

RF lending funds to

the government

(purchasing a

T-bill, the RF).

Risk

The New Efficient Frontier

Borrowing Portfolios

9 - 3 FIGURE

The line can be

extended to risk

levels beyond

Lending Portfolios Borrowing Portfolios ‘T’ by

ER

borrowing at RF

and investing it

T

in T. This is a

A levered

investment that

increases both

RF risk and

expected return

of the portfolio.

Risk

The New Efficient Frontier

The New (Super) Efficient Frontier

called

Clearlythe RFnewwith

Capital Market Line (or super)

T (the market

The optimal

efficient

portfolio) frontier

offers

ER risky portfolio

B2 of risky

a series of

(the market

portfolios.

portfolio

portfolio ‘M’)

T B

combinations

Investors can

that dominate

A2 achieve any

those produced

one of these

by RF and A.

A portfolio

RF

combinations

Further, they by

borrowing

dominate all or but

σρ investing

one portfolio in RF

on

in

thecombination

efficient

with the market

frontier!

portfolio.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 31

The New Efficient Frontier

The Implications – Separation Theorem – Market Portfolio

combinations of:

– The risk free asset (RF) and

– The model portfolio (market portfolio)

• The separation theorem

– The investment decision (how to construct the portfolio of risky

assets) is separate from the financing decision (how much

should be invested or borrowed in the risk-free asset)

– The tangent portfolio T is optimal for every investor regardless of

his/her degree of risk aversion.

• The Equilibrium Condition

– The market portfolio must be the tangent portfolio T if everyone

holds the same portfolio

– Therefore the market portfolio (M) is the tangent portfolio (T)

The New Efficient Frontier

The Capital Market Line

CML set of superior

The optimal

portfolio

ER risky portfolio

combinations

(the market

that are ‘M’)

portfolio

M achievable in

the presence of

the equilibrium

condition.

RF

σρ

The Capital Asset Pricing Model

between Risk and Return

The Capital Asset Pricing Model

What is it?

• Hypothesizes that investors require higher rates of return for greater levels of

relevant risk.

• There are no prices on the model, instead it hypothesizes the relationship

between risk and return for individual securities.

• It is often used, however, the price securities and investments.

The Capital Asset Pricing Model

How is it Used?

– Uses include:

• Determining the cost of equity capital.

• The relevant risk in the dividend discount model to estimate a stock’s intrinsic

(inherent economic worth) value. (As illustrated below)

Risk (Beta Coefficient) Required Return Investment’s Intrinsic stock price in the

Value market

COVi,M D1

βi =

σ M2

ki = RF + ( ERM − RF ) β i P0 = Is the stock

kc − g fairly priced?

The Capital Asset Pricing Model

Assumptions

1. All investors have identical expectations about expected returns,

standard deviations, and correlation coefficients for all securities.

2. All investors have the same one-period investment time horizon.

3. All investors can borrow or lend money at the risk-free rate of

return (RF).

4. There are no transaction costs.

5. There are no personal income taxes so that investors are

indifferent between capital gains an dividends.

6. There are many investors, and no single investor can affect the

price of a stock through his or her buying and selling decisions.

Therefore, investors are price-takers.

7. Capital markets are in equilibrium.

Market Portfolio and Capital Market Line

implications:

1. The “optimal” risky portfolio is the one that is

tangent to the efficient frontier on a line that is drawn

from RF. This portfolio will be the same for all

investors.

2. This optimal risky portfolio will be the market

portfolio (M) which contains all risky securities.

The Capital Market Line

9 - 5 FIGURE

ER

CML

ERM − RF setThe

of achievable

market

k P = RF + σ P

ERM M portfolio

Theportfolio

CMLishasthe

σM combinations

optimal

standardrisky

thatdeviation

portfolio,

are possible

of

it

contains

portfolio

when investing

all

returns

risky

in as

only

the

securities twoand

RF lies

independent

assets

tangent

(the(T)

market

on variable.

the efficient

portfolio

and frontier.

the risk-free

σρ asset (RF).

σM

The Capital Asset Pricing Model

The Market Portfolio and the Capital Market Line (CML)

return divided by the incremental risk.

ER M - RF

[9-4] Slope of the CML =

σM

– The equilibrium price of risk in the capital market.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 40

The Capital Asset Pricing Model

The Market Portfolio and the Capital Market Line (CML)

RF asset and given the market price for risk :

ERM - RF

[9-5] E ( RP ) = RF + σ P

σM

– Where:

• ERM = expected return on the market portfolio M

• σM = the standard deviation of returns on the market portfolio

• σP = the standard deviation of returns on the efficient portfolio being

considered

The Capital Market Line

Using the CML – Expected versus Required Returns

return on a portfolio that compensates them for the

risk-free return as well as the market price for risk.

– This means that portfolios should offer returns along

the CML.

The Capital Asset Pricing Model

Expected and Required Rates of Return

9 - 6 FIGURE

C is an

A

B a portfolio

overvalued

that

undervalued

offers

portfolio.

andExpected

expected

Required portfolio.

return equal

is less

Expected

tothan

the

Return on C

ER CML return

required

the required

is greater

return.

return.

than the required

Expected

A Selling pressure

return on A return.

will cause the price

Demand

to fall andfor

the yield

C Portfolio

to rise until

A will

Required increase driving

expected equalsup

return on A

B the required

price, andreturn.

therefore the

Expected

Return on C expected return will

RF

fall until expected

equals required

(market equilibrium

condition is

achieved.)

σρ

The Capital Asset Pricing Model

Risk-Adjusted Performance and the Sharpe Ratios

– William Sharpe identified a ratio that can be used to assess the risk-adjusted

performance of managed funds (such as mutual funds and pension plans).

– It is called the Sharpe ratio:

ER P - RF

[9-6] Sharpe ratio =

σP

an asset’s returns compensate investors for the risk taken.

– It’s value is the premium earned over the RF divided by portfolio risk…so it is

measuring valued added per unit of risk.

– Sharpe ratios are calculated ex post (after-the-fact) and are used to rank

portfolios or assess the effectiveness of the portfolio manager in adding

value to the portfolio over and above a benchmark.

The Capital Asset Pricing Model

Sharpe Ratios and Income Trusts

standard deviation, Sharpe and beta coefficient for

four very different portfolios from 2002 to 2004.

– Income Trusts did exceedingly well during this time,

however, the recent announcement of Finance

Minister Flaherty and the subsequent drop in Income

Trust values has done much to eliminate this

historical performance.

Income Trust Estimated Values

Return σP Sharpe β

Equally weighted trust portfolio 29.97% 8.02% 3.44 0.28

S&P/TSX Composite Index 8.97% 13.31% 0.49 1.00

Scotia Capital government bond index 9.55% 6.57% 1.08 20.02

Source: Adapted from L. Kryzanowski, S. Lazrak, and I. Ratika, " The True

Cost of Income Trusts," Canadian Investment Review19, no. 5 (Spring

2006), Table 3, p. 15.

CAPM and Market Risk

Diversifiable and Non-Diversifiable Risk

• Volatility (risk) of individual security returns are

caused by two different factors:

– Non-diversifiable risk (system wide changes in the economy and

markets that affect all securities in varying degrees)

– Diversifiable risk (company-specific factors that affect the returns

of only one security)

• Figure 9 – 7 illustrates what happens to portfolio risk

as the portfolio is first invested in only one

investment, and then slowly invested, naively, in more

and more securities.

The CAPM and Market Risk

Portfolio Risk and Diversification

9 - 7 FIGURE

Market or

systematic

Unique (Non-systematic) Risk

risk is risk

that cannot

be eliminated

from the

portfolio by

investing the

Market (Systematic) Risk

portfolio into

more and

different

securities.

Number of Securities

Relevant Risk

Drawing a Conclusion from Figure 9 - 7

volatility of return comes from two factors:

– Systematic factors

– Company-specific factors

• When combined into portfolios, company-specific risk is

diversified away.

• Since all investors are ‘diversified’ then in an efficient

market, no-one would be willing to pay a ‘premium’ for

company-specific risk.

• Relevant risk to diversified investors then is systematic

risk.

• Systematic risk is measured using the Beta Coefficient.

Measuring Systematic Risk

The Beta Coefficient

(CAPM)

The Beta Coefficient

What is the Beta Coefficient?

risk

• As a ‘coefficient’ the beta is a pure number

and has no units of measure.

The Beta Coefficient

How Can We Estimate the Value of the Beta Coefficient?

estimating the beta coefficient:

2. Use of regression (using past holding period returns)

to estimate the beta coefficient)

The CAPM and Market Risk

The Characteristic Line for Security A

9 - 8 FIGURE

4 The

Theslope

plotted of

the

points

regression

are the

line

coincident

is beta.

2

rates of return

earned

The lineon of

the

0 investment

best fit is

-6 -4 -2 0 2 4 6 8 andknown

the market

in

( s nr ut e Rt ekr a M

-2 finance

portfolioasover

the

characteristic

past periods.

line.

-4

-6

) %

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 54

The Formula for the Beta Coefficient

returns of the stock with the returns of the

market, divided by the variance of the

returns of the market:

COVi,M ρ i , M σ i

[9-7] βi = =

2

σM σM

The Beta Coefficient

How is the Beta Coefficient Interpreted?

• The beta of a security compares the volatility of its returns to the volatility of the

market returns:

whole

than the market

the market

with the returns of the market

Canadian BETAS

Selected

Algoma Steel Inc. Materials - Steel 1.92

Bank of Montreal Financials - Banks 0.50

Bank of Nova Scotia Financials - Banks 0.54

Barrick Gold Corp. Materials - Precious Metals & Minerals 0.74

BCE Inc. Communications - Telecommunications 0.39

Bema Gold Corp. Materials - Precious Metals & Minerals 0.26

CIBC Financials - Banks 0.66

Cogeco Cable Inc. Consumer Discretionary - Cable 0.67

Gammon Lake Resources Inc. Materials - Precious Metals & Minerals 2.52

Imperial Oil Ltd. Energy - Oil & Gas: Integrated Oils 0.80

Source: Res earch Insight, Com pustat North Am erican database, June 2006.

The Beta of a Portfolio

the betas of the individual asset betas that make up the

portfolio.

[9-8] β P = wA β A + wB β B + ... + wn β n

value of the investment by the value of the total

portfolio.

The Security Market Line

(CAPM)

The CAPM and Market Risk

The Security Market Line (SML)

dependent variable) and systematic risk (the beta coefficient).

– It is a straight line relationship defined by the following formula:

[9-9] ki = RF + ( ERM − RF ) β i

– Where:

ki = the required return on security ‘i’

ERM – RF = market premium for risk

Βi = the beta coefficient for security ‘i’

The CAPM and Market Risk

The Security Market Line (SML)

9 - 9 FIGURE

ER ki = RF + ( ER M − RF ) βi

M TheSML

The SMLis

ERM uses

usedtheto

beta

predict

coefficient

required as

the measure

returns for

of relevant

individual

RF

risk.

securities

βM = 1 β

The CAPM and Market Risk

The SML and Security Valuation

9 - 10 FIGURE

Similarly,

Required

A is an returns

B is an

ER ki = RF + ( ER M − RF ) βi are forecast using

undervalued

overvalued

this equation.

security

security. because

SML its expected return

You can see

Investor’s willthat

sell

is greater than the

thelock

to required

in gains,return

required return.

Expected A on any

but the security

selling is

Return A

a functionwill

Investors

pressure will

of its

Required

Return A B

systematic

‘flock’

cause to

theA market

and

risk bid

(β)

RF andthe

up

price market

toprice

fall,

factors the

causing (RF and

expected

market

return

expected to fallreturn

till itto

premium

equals

rise untilthe for

it equals

βA βB β risk)

required

the requiredreturn.

return.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 62

The CAPM in Summary

The SML and CML

investors, managers and financial institutions.

– It is a single factor model because it based on the

hypothesis that required rate of return can be

predicted using one factor – systematic risk

– The SML is used to price individual investments and

uses the beta coefficient as the measure of risk.

– The CML is used with diversified portfolios and uses

the standard deviation as the measure of risk.

Alternative Pricing Models

(CAPM)

Challenges to CAPM

• Empirical tests suggest:

– CAPM does not hold well in practice:

• Ex post SML is an upward sloping line

• Ex ante y (vertical) – intercept is higher that RF

• Slope is less than what is predicted by theory

– Beta possesses no explanatory power for predicting stock returns

(Fama and French, 1992)

• CAPM remains in widespread use despite the foregoing.

– Advantages include – relative simplicity and intuitive logic.

• Because of the problems with CAPM, other models have

been developed including:

– Fama-French (FF) Model

– Abitrage Pricing Theory (APT)

Alternative Asset Pricing Models

The Fama – French Model

expected returns to risk including:

1. A market factor related to firm size.

2. The market value of a firm’s common equity (MVE)

3. Ratio of a firm’s book equity value to its market value of equity.

(BE/MVE)

– This model has become popular, and many think it

does a better job than the CAPM in explaining ex

ante stock returns.

Alternative Asset Pricing Models

The Arbitrage Pricing Theory

returns to risk by assuming that asset returns are linearly related

to a set of indexes, which proxy risk factors that influence

security returns.

otherwise identical assets cannot sell at different prices.

– Underlying factors represent broad economic forces which are

inherently unpredictable.

Alternative Asset Pricing Models

The Arbitrage Pricing Theory – the Model

– Underlying factors represent broad economic forces which are inherently unpredictable.

– Where:

• ERi = the expected return on security i

• a0 = the expected return on a security with zero systematic risk

• bi = the sensitivity of security i to a given risk factor

• Fi = the risk premium for a given risk factor

– The model demonstrates that a security’s risk is based on its sensitivity to broad

economic forces.

Alternative Asset Pricing Models

The Arbitrage Pricing Theory – Challenges

which are inherently unpredictable.

– Ross and Roll identify five systematic factors:

1. Changes in expected inflation

2. Unanticipated changes in inflation

3. Unanticipated changes in industrial production

4. Unanticipated changes in the default-risk premium

5. Unanticipated changes in the term structure of interest rates

to price securities today…they can only be used to

explain prices after the fact.

Summary and Conclusions

free borrowing and lending leading to a super efficient frontier

called the Capital Market Line (CML)

– The Security Market Line can be derived from the CML and

provides a way to estimate a market-based, required return for

any security or portfolio based on market risk as measured by

the beta.

– That alternative asset pricing models exist including the Fama-

French Model and the Arbitrage Pricing Theory.

Concept Review Questions

Concept Review Question 1

Risk Aversion

investors are risk averse?

Estimating the Ex Ante (Forecast) Beta

APPENDIX 1

Calculating a Beta Coefficient Using Ex Ante

Returns

• You would use ex ante return data if historical rates of

return are somehow not indicative of the kinds of

returns the company will produce in the future.

• A good example of this is Air Canada or American

Airlines, before and after September 11, 2001. After

the World Trade Centre terrorist attacks, a

fundamental shift in demand for air travel occurred.

The historical returns on airlines are not useful in

estimating future returns.

Appendix 1 Agenda

• The formula approach to beta measurement

using ex ante returns

– Ex ante returns

– Finding the expected return

– Determining variance and standard deviation

– Finding covariance

– Calculating and interpreting the beta coefficient

The Beta Coefficient

total risk is partitioned into two parts:

– Systematic risk

– Unsystematic risk – diversifiable risk

• Systematic risk is the only relevant risk to the

diversified investor

• The beta coefficient measures systematic risk

The Beta Coefficient

The Formula

Covariance of Returns between stock ' i' returns and the market

Beta =

Variance of the Market Returns

COVi,M ρ i , M σ i

[9-7] βi = =

2

σM σM

The Term – “Relevant Risk”

• What does the term “relevant risk” mean in the context of the CAPM?

– It is generally assumed that all investors are wealth maximizing risk

averse people

– It is also assumed that the markets where these people trade are highly

efficient

– In a highly efficient market, the prices of all the securities adjust instantly

to cause the expected return of the investment to equal the required

return

– When E(r) = R(r) then the market price of the stock equals its inherent

worth (intrinsic value)

– In this perfect world, the R(r) then will justly and appropriately

compensate the investor only for the risk that they perceive as

relevant…

– Hence investors are only rewarded for systematic risk.

NOTE: The amount of systematic risk varies by investment. High systematic risk

occurs when R-square is high, and the beta coefficient is greater than 1.0

The Proportion of Total Risk that is Systematic

respect to the percentage of total risk that is

systematic.

– Such stocks are not influenced by the health of the economy in

general…their financial results are predominantly influenced by

company-specific factors.

– An example is cigarette companies…people consume cigarettes

because they are addicted…so it doesn’t matter whether the

economy is healthy or not…they just continue to smoke.

• Some stocks have a high proportion of their total risk

that is systematic

– Returns on these stocks are strongly influenced by the health of

the economy.

– Durable goods manufacturers tend to have a high degree of

systematic risk.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 79

The Formula Approach to Measuring the Beta

Cov(k i k M )

Beta =

Var(k M )

You need to calculate the covariance of the returns between the

stock and the market…as well as the variance of the market

returns. To do this you must follow these steps:

• Calculate the expected returns for the stock and the market

• Using the expected returns for each, measure the variance

and standard deviation of both return distributions

• Now calculate the covariance

• Use the results to calculate the beta

Ex ante Return Data

A Sample

probabilities looks as follows:

Future State Possible Possible relates the stock

By observation

returns to the

of the Returns on Returns on market

you can returns,

see the

Economy Probability the Stock the Market the

rangegreater range

is much

of stock returns

Boom 25.0% 28.0% 20.0% greater for the

changing in the

stock than theas

same direction

Normal 50.0% 17.0% 11.0% market

the market and they

Recession 25.0% -14.0% -4.0% indicates

move in the the beta

will

same be direction.

greater

than 1 and will be

positive.

(Positively

correlated to the

market returns.)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 81

The Total of the Probabilities must Equal 100%

in this discrete probability distribution

Possible

Future State Possible Possible

of the Returns on Returns on

Economy Probability the Stock the Market

Boom 25.0% 28.0% 20.0%

Normal 50.0% 17.0% 11.0%

Recession 25.0% -14.0% -4.0%

100.0%

Measuring Expected Return on the Stock

From Ex Ante Return Data

The expected return is weighted average returns from

the given ex ante data

Possible

Future State Possible

of the Returns on

Economy Probability the Stock (4) = (2)*(3)

Boom 25.0% 28.0% 0.07

Normal 50.0% 17.0% 0.085

Recession 25.0% -14.0% -0.035

Expected return on the Stock = 12.0%

Measuring Expected Return on the Market

From Ex Ante Return Data

The expected return is weighted average returns from

the given ex ante data

Possible

Future State Possible

of the Returns on

Economy Probability the Market (4) = (2)*(3)

Boom 25.0% 20.0% 0.05

Norm al 50.0% 11.0% 0.055

Recession 25.0% -4.0% -0.01

Expected return on the Market = 9.5%

Measuring Variances, Standard Deviations of

the Forecast Stock Returns

Using the expected return, calculate the deviations away from the mean, square

those deviations and then weight the squared deviations by the probability of

their occurrence. Add up the weighted and squared deviations from the mean

and you have found the variance!

Possible Weighted

Future State Possible and

of the Returns on Squared Squared

Economy Probability the Stock (4) = (2)*(3) Deviations Deviations Deviations

Boom 25.0% 0.28 0.16

0.07 0.0256 0.0064

Norm al 50.0% 0.17 0.05

0.085 0.0025 0.00125

Reces sion 25.0% -0.14 -0.26

-0.035 0.0676 0.0169

Expected return (stock) = 12.0% Variance (stock)= 0.02455

Standard Deviation (stock) = 15.67%

Measuring Variances, Standard Deviations of

the Forecast Market Returns

Now do this for the possible returns on the market

Possible Weighted

Future State Possible and

of the Returns on Squared Squared

Economy Probability the Market (4) = (2)*(3) Deviations Deviations Deviations

Boom 25.0% 0.2 0.05 0.105 0.011025 0.002756

Norm al 50.0% 0.11 0.055 0.015 0.000225 0.000113

Recession 25.0% -0.04 -0.01 -0.135 0.018225 0.004556

Expected return (market) = 9.5% Variance (market) = 0.007425

Standard Deviation (market)= 8.62%

Covariance

between the returns on the stock and the returns on the

market is:

n _ _

[8-12] COV AB = ∑ Prob i (k A,i − ki )(k B ,i - k B )

i =1

movement’ of returns.

Correlation Coefficient

Correlation is covariance normalized by the product of the standard deviations

of both securities. It is a ‘relative measure’ of co-movement of returns on a

scale from -1 to +1.

The formula for the correlation coefficient between the returns on the stock

and the returns on the market is:

COV AB

[8-13] ρAB =

σ AσB

The correlation coefficient will always have a value in the range of +1 to -1.

+1 – is perfect positive correlation (there is no diversification potential when combining

these two securities together in a two-asset portfolio.)

- 1 - is perfect negative correlation (there should be a relative weighting mix of these two

securities in a two-asset portfolio that will eliminate all portfolio risk)

Measuring Covariance

from Ex Ante Return Data

Using the expected return (mean return) and given data measure the

deviations for both the market and the stock and multiply them

together with the probability of occurrence…then add the products

up.

Future Returns Possible from the from the

State of the on the (4) = Returns on mean for mean for

Economy Prob. Stock (2)*(3) the Market (6)=(2)*(5) the stock the market (8)=(2)(6)(7)

Boom 25.0% 28.0% 0.07 20.0% 0.05 16.0% 10.5% 0.0042

Normal 50.0% 17.0% 0.085 11.0% 0.055 5.0% 1.5% 0.000375

Recession 25.0% -14.0% -0.035 -4.0% -0.01 -26.0% -13.5% 0.008775

E(kstock) = 12.0% E(kmarket ) = 9.5% Covariance = 0.01335

The Beta Measured

Using Ex Ante Covariance (stock, market) and Market Variance

Now you can substitute the values for covariance and the

variance of the returns on the market to find the beta of

the stock:

CovS,M .01335

Beta = = = 1.8

VarM .007425

returns are more volatile than the market as a whole.

• If the market returns were expected to go up by 10%, then the stock

returns are expected to rise by 18%. If the market returns are expected

to fall by 10%, then the stock returns are expected to fall by 18%.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 90

Lets Prove the Beta of the Market is 1.0

returns against itself…what will the beta be?

(1) (2) (3) (4) (5) (6) (6) (7) (8)

Future Returns Cov Returns .007425 from the from the

State of the Beta =(4) =

on the

`M, M

on the = = 1.0

mean for mean for (8)=(2)(6)(7

Economy Prob. Market Var

(2)*(3) Market

M .007425

(6)=(2)*(5) the stock the market )

Boom 25.0% 20.0% 0.05 20.0% 0.05 10.5% 10.5% 0.002756

Normal 50.0% 11.0% 0.055 11.0% 0.055 1.5% 1.5% 0.000113

Recession 25.0% -4.0% -0.01 -4.0% -0.01 -13.5% -13.5% 0.004556

E(kM) = 9.5% E(kM) = 9.5% Covariance = 0.007425

Since the variance of the returns on the market is = .007425 …the beta for

the market is indeed equal to 1.0 !!!

Proving the Beta of Market = 1

value in the beta formula you get:

Cov MM .007425

Beta = = = 1 .0

Var(R M ) .007425

1.0 because you are measuring the market returns

against market returns.

Using the Security Market Line

How Do We use Expected and Required

Rates of Return?

Once you have estimated the expected and required rates of return, you can plot them on the

SML and see if the stock is under or overpriced.

% Return

E(Rs) = 5.0%

R(ks) = 4.76%

SML

E(kM)= 4.2%

Risk-free Rate = 3%

How Do We use Expected and Required

Rates of Return?

• The stock is fairly priced if the expected return = the required return.

• This is what we would expect to see ‘normally’ or most of the time in an efficient

market where securities are properly priced.

% Return

SML

E(RM)= 4.2%

Risk-free Rate = 3%

B M= BS = 1.464

1.0

Use of the Forecast Beta

• We can use the forecast beta, together with an estimate of the

risk-free rate and the market premium for risk to calculate the

investor’s required return on the stock using the CAPM:

free rate (RF) as measured by the 91-day, government of Canada

T-bill yield, and a current estimate of the market premium for risk

(kM – RF)

Conclusions

returns on stock and returns on the market portfolio.

• Those forecasts can be analyzed to estimate the beta

coefficient for the stock.

• The required return on a stock can then be calculated

using the CAPM – but you will need the stock’s beta

coefficient, the expected return on the market

portfolio and the risk-free rate.

• The required return is then using in Dividend Discount

Models to estimate the ‘intrinsic value’ (inherent

worth) of the stock.

Calculating the Beta using Trailing

Holding Period Returns

APPENDIX 2

The Regression Approach to Measuring the

Beta

• You need to gather historical data about the stock and the market

• You can use annual data, monthly data, weekly data or daily data.

However, monthly holding period returns are most commonly used.

• Daily data is too ‘noisy’ (short-term random volatility)

• Annual data will extend too far back in to time

• You need at least thirty (30) observations of historical data.

• Hopefully, the period over which you study the historical returns of the

stock is representative of the normal condition of the firm and its

relationship to the market.

• If the firm has changed fundamentally since these data were produced

(for example, the firm may have merged with another firm or have

divested itself of a major subsidiary) there is good reason to believe

that future returns will not reflect the past…and this approach to beta

estimation SHOULD NOT be used….rather, use the ex ante approach.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 99

Historical Beta Estimation

The Approach Used to Create the Characteristic Line

In this example, we have regressed the quarterly returns on the stock against the

quarterly returns of a surrogate for the market (TSE 300 total return composite

index) and then using Excel…used the charting feature to plot the historical

points and add a regression trend line.

The ‘cloud’ of plotted points

Period HPR(Stock) HPR(TSE 300)

represents

2006.4

‘diversifiable

-4.0% 1.2%

or company C harac teristic L ine (Regression)

30.0%

specific’ -16.0%

2006.3 risk in the securities

-7.0% returns

25.0%

that can be

2006.2 eliminated

32.0% from a portfolio

12.0%

20.0%

2006.1 through diversification.

16.0% 8.0% Since

Returns on Stock

15.0%

2005.4 company-specific

-22.0% risk can be

-11.0%

2005.3 15.0%investors16.0% 10.0%

eliminated, don’t require

2005.2 28.0%

compensation for 13.0%

it according to 5.0%

2005.1 19.0% 7.0% 0.0%

Markowitz Portfolio Theory.

2004.4 -16.0% -4.0% -40.0% -20.0% -5.0%0.0% 20.0% 40.0%

2004.3 8.0% 16.0%

-10.0%

2004.2 -3.0% -11.0%

The regression

2004.1 34.0%

line 25.0%

is a line of ‘best -15.0%

fit’ that describes the inherent Returns on TSE 300

relationship between the returns on

the stock and the returns on the

market. The slope is the beta

coefficient.

Characteristic Line

• The characteristic line is a regression line that represents the

relationship between the returns on the stock and the returns on the

market over a past period of time. (It will be used to forecast the

future, assuming the future will be similar to the past.)

the dependent variable (returns on the stock) is measured by the

coefficient of determination. (also known as the R2 (r-squared or

coefficient of determination)).

all of the points of observation would lie on the line. This would

mean that the characteristic line would explain 100% of the

variability of the dependent variable.

line). Many stock analysts search out stocks with high alphas.

Low R2

characteristic (regression) line explains virtually none of the

variability in the dependent variable.

• This means that virtually of the risk of the security is

‘company-specific’.

• This also means that the regression model has virtually no

predictive ability.

• In this case, you should use other approaches to value the

stock…do not use the estimated beta coefficient.

Characteristic Line for Imperial Tobacco

An Example of Volatility that is Primarily Company-Specific

Characteristic

Returns on

Line for Imperial

Imperial

Tobacco

Tobacco %

• High alpha

• R-square is very

low ≈ 0.02

• Beta is largely

irrelevant

Returns on

the Market %

(S&P TSX)

High R2

characteristic (regression) line explains virtually all of the

variability in the dependent variable.

• This means that virtually of the risk of the security is

‘systematic’.

• This also means that the regression model has a strong

predictive ability. … if you can predict what the market will

do…then you can predict the returns on the stock itself with

a great deal of accuracy.

Characteristic Line General Motors

A Positive Beta with Predictive Power

Characteristic

Returns on

Line for GM

General

Motors % (high R2)

• Positive alpha

• R-square is

very high ≈ 0.9

• Beta is positive

and close to 1.0

Returns on

the Market %

(S&P TSX)

An Unusual Characteristic Line

A Negative Beta with Predictive Power

Stock % that will provide excellent

portfolio diversification

• Positive alpha

(high R2) • R-square is

very high

• Beta is negative

<0.0 and > -1.0

Returns on

the Market %

(S&P TSX)

Diversifiable Risk

(Non-systematic Risk)

factors (both positive and negative) such as:

– a single company strike

– a spectacular innovation discovered through the company’s R&D program

– equipment failure for that one company

– management competence or management incompetence for that particular firm

– a jet carrying the senior management team of the firm crashes (this could be either a

positive or negative event, depending on the competence of the management team)

– the patented formula for a new drug discovered by the firm.

• Obviously, diversifiable risk is that unique factor that influences only

the one firm.

OK – lets go back and look at raw data

gathering and data normalization

• You will also need to go to the library a use the TSX Review

(a monthly periodical) – to obtain:

– Number of shares outstanding for the firm each month

– Ending values for the total return composite index (surrogate for the

market)

• You want data for at least 30 months.

• For each month you will need:

– Ending stock price

– Number of shares outstanding for the stock

– Dividend per share paid during the month for the stock

– Ending value of the market indicator series you plan to use (ie. TSE

300 total return composite index)

Demonstration Through Example

Alcan Aluminum (AL.TO)

Five Year Stock Price Chart for AL.TO

Spreadsheet Data From Yahoo

Process:

– Go to http://ca.finance.yahoo.com

– Use the symbol lookup function to search for the

company you are interested in studying.

– Use the historical quotes button…and get 30 months

of historical data.

– Use the download in spreadsheet format feature to

save the data to your hard drive.

Spreadsheet Data From Yahoo

Alcan Example

01-May-02 57.46 62.39 56.61 59.22 753874

01-Apr-02 62.9 63.61 56.25 57.9 879210

01-Mar-02 64.9 66.81 61.68 63.03 974368

01-Feb-02 61.65 65.67 58.75 64.86 836373

02-Jan-02 57.15 62.37 54.93 61.85 989030

03-Dec-01 56.6 60.49 55.2 57.15 833280

01-Nov-01 49 58.02 47.08 56.69 779509

Spreadsheet Data From Yahoo

Alcan Example

01-May-02 57.46 62.39 56.61 59.22 753874

01-Apr-02 62.9 63.61 56.25 57.9 879210

Volume of

Opening price per share, the trading done

The day, highest price per share during the in the stock on

month and month, the lowest price per share the TSE in the

year achieved during the month and the month in

closing price per share at the end numbers of

of the

CHAPTER 9 – month

The Capital Asset Pricing Model (CAPM) board 9lots

- 113

Spreadsheet Data From Yahoo

Alcan Example

closing price per share and the date. Just delete the

other columns.

Da te Close

01-M ay-02 59.22

01-A pr-02 57.9

01-M ar-02 63.03

01-Feb-02 64.86

02-Jan-02 61.85

Acquiring the Additional Information You Need

Alcan Example

basis, you will need to find out how many shares were

outstanding at the end of the month and whether any

dividends were paid during the month.

S&P/TSX Total Return Composite Index (look in the green

pages of the TSX Review)

Raw Company Data

Alcan Example

Closing P rice Ca sh

Issue d for Alca n Divide nds

Da te Ca pita l AL.TO pe r S ha re

01-M ay-02 321,400,589 $59.22 $0.00

01-A pr-02 321,400,589 $57.90 $0.15

01-M ar-02 321,400,589 $63.03 $0.00

01-Feb-02 321,400,589 $64.86 $0.00

02-Jan-02 160,700,295 $123.70 $0.30

01-Dec -01 160,700,295 $119.30 $0.00

Number of shares doubled and share price fell by half between

January and February 2002 – this is indicative of a 2 for 1 stock split.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 116

Normalizing the Raw Company Data

Alcan Example

Closing

Price for Cash

Issued Alcan Dividends Adjustment Normalized Normalized

Date Capital AL.TO per Share Factor Stock Price Dividend

01-May-02 321,400,589 $59.22 $0.00 1.00 $59.22 $0.00

01-Apr-02 321,400,589 $57.90 $0.15 1.00 $57.90 $0.15

01-Mar-02 321,400,589 $63.03 $0.00 1.00 $63.03 $0.00

01-Feb-02 321,400,589 $64.86 $0.00 1.00 $64.86 $0.00

02-Jan-02 160,700,295 $123.70 $0.30 0.50 $61.85 $0.15

01-Dec-01 145,000,500 $111.40 $0.00 0.45 $50.26 $0.00

capital cell divided by 321,400,589.

Calculating the HPR on the stock from the

Normalized Data

Normalized Normalized ( P1 − P0 ) + D1

HPR =

Date Stock Price Dividend HPR P0

$59.22 - $57.90 + $0.00

01-May-02 $59.22 $0.00 2.28% =

$57.90

01-Apr-02 $57.90 $0.15 -7.90%

= 2.28%

01-Mar-02 $63.03 $0.00 -2.82%

01-Feb-02 $64.86 $0.00 4.87%

02-Jan-02 $61.85 $0.15 23.36%

01-Dec-01 $50.26 $0.00

beginning price and during the month of May, no

dividend was declared.

Now Put the data from the S&P/TSX Total

Return Composite Index in

Ending

Norm a lize d Norm a lize d TS X

Da te S tock P rice Divide nd HP R V a lue

01-M ay-02 $59.22 $0.00 2.28% 16911.33

01-A pr-02 $57.90 $0.15 -7.90% 16903.36

01-M ar-02 $63.03 $0.00 -2.82% 17308.41

01-Feb-02 $64.86 $0.00 4.87% 16801.82

02-Jan-02 $61.85 $0.15 23.36% 16908.11

01-Dec-01 $50.26 $0.00 16881.75

Index values in TSX Review found in the library.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 119

Now Calculate the HPR on the Market Index

( P1 − P0 )

HPR =

P0

16,911.33 - 16,903.36

Ending

=

Norm a lize d Norm a liz e d 16,903.36 TS X HP R on

= 0.05%

Da te S tock P rice Divide nd HP R V a lue the TS X

01-M ay-02 $59.22 $0.00 2.28% 16911.33 0.05%

01-A pr-02 $57.90 $0.15 -7.90% 16903.36 -2.34%

01-M ar-02 $63.03 $0.00 -2.82% 17308.41 3.02%

01-Feb-02 $64.86 $0.00 4.87% 16801.82 -0.63%

02-Jan-02 $61.85 $0.15 23.36% 16908.11 0.16%

01-Dec-01 $50.26 $0.00 16881.75

ending values for the total return composite index.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 120

Regression In Excel

menu…down to add-ins and check off the VBA

Analysis Pac

• When you go back to the tools menu, you

should now find the Data Analysis bar, under

that find regression, define your dependent

and independent variable ranges, your output

range and run the regression.

Regression

Defining the Data Ranges

Ending

Norm a lize d Norm a liz e d TS X HP R on

Da te S tock P rice Divide nd HP R V a lue the TS X

01-M ay-02 $59.22 $0.00 2.28% 16911.33 0.05%

01-A pr-02 $57.90 $0.15 -7.90% 16903.36 -2.34%

01-M ar-02 $63.03 $0.00 -2.82% 17308.41 3.02%

01-Feb-02 $64.86 $0.00 4.87% 16801.82 -0.63%

02-Jan-02 $61.85 $0.15 23.36% 16908.11 0.16%

01-Dec-01 $50.26 $0.00 16881.75

The dependent

independentvariable

variableis isthe

thereturns

returnsononthe

theStock.

Market.

Now Use the Regression Function in Excel to

regress the returns of the stock against the

returns of the market

SUMMARY OUTPUT

Multiple R 0.05300947

R Square 0.00281 coefficient of

Adjusted R Square

Standard Error

-0.2464875

5.79609628

determination =

Observations 6 0.0028=.3%

ANOVA

df SS MS F Significance F

Regression 1 0.3786694 0.37866937 0.011271689 0.920560274

Residual 4 134.37893 33.5947321

Total 5 134.7576

CoefficientsStandard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%

Intercept 59.3420816 2.8980481 20.4765686 3.3593E-05 51.29579335 67.38836984 51.2957934 67.38837

X Variable 1 3.55278937 33.463777 0.10616821 0.920560274 -89.35774428 96.46332302 -89.3577443 96.46332

Coefficient vertical intercept.

is the X-

Variable 1

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 123

Finalize Your Chart

Alcan Example

scatter plot of the points and to put a line of best fit

(the characteristic line) through the points.

• In Excel, you can edit the chart after it is created by

placing the cursor over the chart and ‘right-clicking’

your mouse.

• In this edit mode, you can ask it to add a trendline

(regression line)

• Finally, you will want to interpret the Beta (X-

coefficient) the alpha (vertical intercept) and the

coefficient of determination.

The Beta

Alcan Example

be read from the regression output.

– In this case it was 3.56 making Alcan’s returns more

than 3 times as volatile as the market as a whole.

– Of course, in this simple example with only 5

observations, you wouldn’t want to draw any serious

conclusions from this estimate.

Copyright

Copyright © 2007 John Wiley &

Sons Canada, Ltd. All rights

reserved. Reproduction or

translation of this work beyond that

permitted by Access Copyright (the

Canadian copyright licensing

agency) is unlawful. Requests for

further information should be

addressed to the Permissions

Department, John Wiley & Sons

Canada, Ltd. The purchaser may

make back-up copies for his or her

own use only and not for distribution

or resale. The author and the

publisher assume no responsibility

for errors, omissions, or damages

caused by the use of these files or

programs or from the use of the

information contained herein.

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