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INTRODUCTION TO

CORPORATE FINANCE
Laurence Booth • W. Sean Cleary

Chapter 9 – The Capital Asset Pricing


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9-3


Learning Objectives

1. What happens if all investors are rational and risk averse.


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9-4


Important Chapter Terms

• Arbitrage pricing theory • Market risk premium


(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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9-5


Achievable Portfolio Combinations

The Capital Asset Pricing Model


(CAPM)
Achievable Portfolio Combinations
The Two-Asset Case

• It is possible to construct a series of portfolios with


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

Expected Return Standard Deviation


Asset A 8% 8.72%
Asset B 10% 22.69%

The following table shows the portfolio characteristics for


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%

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9-8


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

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


Two Asset Efficient Frontier

• Figure 8 – 10 describes five different


portfolios (A,B,C,D and E in reference to the
attainable set of portfolio combinations of this
two asset portfolio.

(See Figure 8 -10 on the following slide)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 10


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 (%)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 11


Achievable Set of Portfolio Combinations
Getting to the ‘n’ Asset Case

• In a real world investment universe with all of the


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)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 12


The Achievable Set of Portfolio
Combinations

• You could start by randomly assembling ten


risky portfolios.
• The results (in terms of ER p and σp )might look
like the graph on the following page:

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 13


Achievable Portfolio Combinations
The First Ten Combinations Created

ERp

10 Achievable
Risky Portfolio
Combinations

Portfolio Risk (σp)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 14


The Achievable Set of Portfolio
Combinations

• You could continue randomly assembling


more portfolios.
• Thirty risky portfolios might look like the
graph on the following slide:

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 15


Achievable Portfolio Combinations
Thirty Combinations Naively Created

ERp

30 Risky Portfolio
Combinations

Portfolio Risk (σp)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 16


Achievable Set of Portfolio Combinations
All Securities – Many Hundreds of Different Combinations

• When you construct many hundreds of


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:

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 17


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.

Portfolio Risk (σp)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 18


The Efficient Frontier

The Capital Asset Pricing Model


(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.

Portfolio Risk (σp)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 20


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.)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 21


Underlying Assumption
Investors are Rational and Risk-Averse

• We assume investors are risk-averse wealth maximizers.


• 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).

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 22


The New Efficient Frontier and
Separation Theorem

The Capital Asset Pricing Model


(CAPM)
Risk-free Investing

• When we introduce the presence of a risk-free


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)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 24


The New Efficient Frontier
Risk-Free Investing

– Expected return on a two asset portfolio made up of risky


asset A and RF:

[9-1] ER p = RF + w (ER A - RF)

The possible combinations of A and RF are found graphed on the following


slide.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 25


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 RFσA 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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 26


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?

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 27


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!

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 28


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 29


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 30


The New Efficient Frontier
The New (Super) Efficient Frontier

9 - 4 FIGURE This is now


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

• All investors will only hold individually-determined


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)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 32


The New Efficient Frontier
The Capital Market Line

The CML is that


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 33


The Capital Asset Pricing Model

The Hypothesized Relationship


between Risk and Return
The Capital Asset Pricing Model
What is it?

– An hypothesis by Professor William Sharpe


• 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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 35


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)

Estimate Investment’s Determine Investment’s Estimate the Compare to the actual


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?

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 36


The Capital Asset Pricing Model
Assumptions

– CAPM is based on the following 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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 37


Market Portfolio and Capital Market Line

• The assumptions have the following


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.

(Figure 9 – 4 illustrates the Market Portfolio ‘M’)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 38


The Capital Market Line
9 - 5 FIGURE

ER
CML

The CML is that


 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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 39


The Capital Asset Pricing Model
The Market Portfolio and the Capital Market Line (CML)

– The slope of the CML is the incremental expected


return divided by the incremental risk.

ER M - RF
[9-4] Slope of the CML =
σM

– This is called the market price for risk. Or


– 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)

– Solving for the expected return on a portfolio in the presence of a


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 41


The Capital Market Line
Using the CML – Expected versus Required Returns

– In an efficient capital market investors will require a


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 42


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 43


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

– Sharpe ratio is a measure of portfolio performance that describes how well


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 44


The Capital Asset Pricing Model
Sharpe Ratios and Income Trusts

– Table 9 – 1 (on the following slide) illustrates return,


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 45


Income Trust Estimated Values

Table 9-1 Income Trusts Estimated Values

Return σP Sharpe β

Median income trusts 25.83% 18.66% 1.37 0.22


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 46


CAPM and Market Risk

The Capital Asset Pricing Model


Diversifiable and Non-Diversifiable Risk

• CML applies to efficient portfolios


• 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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 48


The CAPM and Market Risk
Portfolio Risk and Diversification

9 - 7 FIGURE

Total Risk (σ)

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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 49


Relevant Risk
Drawing a Conclusion from Figure 9 - 7

• Figure 9 – 7 demonstrates that an individual securities’


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 50


Measuring Systematic Risk
The Beta Coefficient

The Capital Asset Pricing Model


(CAPM)
The Beta Coefficient
What is the Beta Coefficient?

• A measure of systematic (non-diversifiable)


risk
• As a ‘coefficient’ the beta is a pure number
and has no units of measure.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 52


The Beta Coefficient
How Can We Estimate the Value of the Beta Coefficient?

• There are two basic approaches to


estimating the beta coefficient:

1. Using a formula (and subjective forecasts)


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

(Figure 9 – 8 on the following slide illustrates the characteristic line used


to estimate the beta coefficient)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 53


The CAPM and Market Risk
The Characteristic Line for Security A
9 - 8 FIGURE

Security A Returns (%)

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

Beta is equal to the covariance of the


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 55


The Beta Coefficient
How is the Beta Coefficient Interpreted?

• The beta of the market portfolio is ALWAYS = 1.0

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

βs = 1.0 - the security has the same volatility as the market as a


whole

βs > 1.0 - aggressive investment with volatility of returns greater


than the market

βs < 1.0 - defensive investment with volatility of returns less than


the market

βs < 0.0 - an investment with returns that are negatively correlated


with the returns of the market

Table 9 – 2 illustrates beta coefficients for a variety of Canadian Investments

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 56


Canadian BETAS
Selected

Table 9-2 Canadian BETAS

Company Industry Classification Beta

Abitibi Consolidated Inc. Materials - Paper & Forest 1.37


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 57


The Beta of a Portfolio

The beta of a portfolio is simply the weighted average of


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

Weights of individual assets are found by dividing the


value of the investment by the value of the total
portfolio.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 58


The Security Market Line

The Capital Asset Pricing Model


(CAPM)
The CAPM and Market Risk
The Security Market Line (SML)

– The SML is the hypothesized relationship between return (the


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’

(See Figure 9 - 9 on the following slide for the graphical representation)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 60


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 61


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

– The CAPM is well entrenched and widely used by


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 63


Alternative Pricing Models

The Capital Asset Pricing Model


(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)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 65


Alternative Asset Pricing Models
The Fama – French Model

– A pricing model that uses three factors to relate


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 66


Alternative Asset Pricing Models
The Arbitrage Pricing Theory

– A pricing model that uses multiple factors to relate expected


returns to risk by assuming that asset returns are linearly related
to a set of indexes, which proxy risk factors that influence
security returns.

[9-10] ER i = a0 + bi1 F1 + bi1 F1 +... + bin Fn

– It is based on the no-arbitrage principle which is the rule that two


otherwise identical assets cannot sell at different prices.
– Underlying factors represent broad economic forces which are
inherently unpredictable.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 67


Alternative Asset Pricing Models
The Arbitrage Pricing Theory – the Model

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

[9-10] ER i = a0 + bi1 F1 + bi1 F1 +... + bin Fn

– 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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 68


Alternative Asset Pricing Models
The Arbitrage Pricing Theory – Challenges

– Underlying factors represent broad economic forces


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

• Clearly, something that isn’t forecast, can’t be used


to price securities today…they can only be used to
explain prices after the fact.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 69


Summary and Conclusions

In this chapter you have learned:

– How the efficient frontier can be expanded by introducing risk-


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 70


Concept Review Questions

The Capital Asset Pricing Model


Concept Review Question 1
Risk Aversion

What is risk aversion and how do we know


investors are risk averse?

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 72


Estimating the Ex Ante (Forecast) Beta

APPENDIX 1
Calculating a Beta Coefficient Using Ex Ante
Returns

• Ex Ante means forecast…


• 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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 74


Appendix 1 Agenda

• The beta coefficient


• 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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 75


The Beta Coefficient

• Under the theory of the Capital Asset Pricing Model


total risk is partitioned into two parts:
– Systematic risk
– Unsystematic risk – diversifiable risk

Total Risk of the Investment

Systematic Risk Unsystematic Risk

• Systematic risk is non-diversifiable risk.


• Systematic risk is the only relevant risk to the
diversified investor
• The beta coefficient measures systematic risk

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 76


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 77


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 78


The Proportion of Total Risk that is Systematic

• Every investment in the financial markets vary with


respect to the percentage of total risk that is
systematic.

• Some stocks have virtually no systematic risk.


– 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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 80


Ex ante Return Data
A Sample

A set of estimates of possible returns and their respective


probabilities looks as follows:

Possible Since the beta


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%

This means that we have considered all of the possible outcomes


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%

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 82


Measuring Expected Return on the Stock
From Ex Ante Return Data
The expected return is weighted average returns from
the given ex ante data

(1) (2) (3) (4)


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%

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 83


Measuring Expected Return on the Market
From Ex Ante Return Data
The expected return is weighted average returns from
the given ex ante data

(1) (2) (3) (4)


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%

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 84


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!

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


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%

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 85


Measuring Variances, Standard Deviations of
the Forecast Market Returns
Now do this for the possible returns on the market

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


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%

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 86


Covariance

From Chapter 8 you know the formula for the 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

Covariance is an absolute measure of the degree of ‘co-


movement’ of returns.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 87


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)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 88


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.

(1) (2) (3) (4) (5) (6) (7) (8) "(9)

Possible Possible Deviations Deviations


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 89


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

• A beta that is greater than 1 means that the investment is aggressive…its


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

Let us assume we are comparing the possible market


returns against itself…what will the beta be?
(1) (2) (3) (4) (5) (6) (6) (7) (8)

Possible Possible Possible Deviations Deviations


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 !!!

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 91


Proving the Beta of Market = 1

If you now place the covariance of the market with itself


value in the beta formula you get:

Cov MM .007425
Beta = = = 1 .0
Var(R M ) .007425

The beta coefficient of the market will always be


1.0 because you are measuring the market returns
against market returns.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 92


Using the Security Market Line

Expected versus Required Return


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%

BM= 1.0 Bs = 1.464

Since E(r)>R(r) the stock is underpriced.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 94


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

E(Rs) = R(Rs) 4.76%


SML
E(RM)= 4.2%

Risk-free Rate = 3%

B M= BS = 1.464
1.0

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 95


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:

Required Return = RF + βi [E (k M ) − RF]

• This is a ‘market-determined’ return based on the current risk-


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)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 96


Conclusions

• Analysts can make estimates or forecasts for the


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 97


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 100


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 slope of the Characteristic Line is the Beta Coefficient.

• The degree to which the characteristic line explains the variability in


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)).

• If the coefficient of determination equals 1.00, this would mean that


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.

• The alpha is the vertical intercept of the regression (characteristic


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 101


Low R2

• An R2 that approaches 0.00 (or 0%) indicates that the


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.

(See the following slide for an illustration of a low r-square)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 102


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)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 103


High R2

• An R2 that approaches 1.00 (or 100%) indicates that the


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 104


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)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 105


An Unusual Characteristic Line
A Negative Beta with Predictive Power

Returns on a Characteristic Line for a stock


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)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 106


Diversifiable Risk
(Non-systematic Risk)

• Volatility in a security’s returns caused by company-specific


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 107


OK – lets go back and look at raw data
gathering and data normalization

• A common source for stock of information is Yahoo.com


• 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)

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 108


Demonstration Through Example

The following slides will be based on


Alcan Aluminum (AL.TO)
Five Year Stock Price Chart for AL.TO

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 110


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 111


Spreadsheet Data From Yahoo
Alcan Example

The raw downloaded data should look like this:

Date Open High Low Close Volume


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 112


Spreadsheet Data From Yahoo
Alcan Example

The raw downloaded data should look like this:

Date Open High Low Close Volume


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

From Yahoo, the only information you can use is the


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

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 114


Acquiring the Additional Information You Need
Alcan Example

In addition to the closing price of the stock on a per share


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.

You will also want to find the end-of-the-month value of the


S&P/TSX Total Return Composite Index (look in the green
pages of the TSX Review)

You can find all of this in The TSX Review periodical.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 115


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

The adjustment factor is just the value in the issued


capital cell divided by 321,400,589.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 117


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

Use $59.22 as the ending price, $57.90 as the


beginning price and during the month of May, no
dividend was declared.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 118


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

You will find the Total Return S&P/TSX Composite


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

Again, you simply use the HPR formula using the


ending values for the total return composite index.
CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 120
Regression In Excel

• If you haven’t already…go to the tools


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 121


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 122


Now Use the Regression Function in Excel to
regress the returns of the stock against the
returns of the market
SUMMARY OUTPUT

Regression Statistics R-square is the


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

Beta The alpha is the


Coefficient vertical intercept.
is the X-
Variable 1
CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 123
Finalize Your Chart
Alcan Example

• You can use the charting feature in Excel to create a


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 124


The Beta
Alcan Example

• Obviously the beta (X-coefficient) can simply


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 125


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.

CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 126