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Principles

Chapter 9

Charles P. Jones, Investments: Principles and Concepts,

Eleventh Edition, John Wiley & Sons

9-

1

**Capital Asset Pricing
**

Model

Focus on the equilibrium relationship

between the risk and expected return on

risky assets

Builds on Markowitz portfolio theory

Each investor is assumed to diversify his or

**her portfolio according to the Markowitz
**

model

9-

2

CAPM Assumptions

All investors:

◦ Use the same

information to

generate an efficient No transaction costs,

frontier

no personal income

◦ Have the same one-

period time horizon

taxes, no inflation

◦ Can borrow or lend No single investor

money at the risk-free can affect the price

rate of return of a stock

Capital markets are

in equilibrium

9-

3

known with certainty Adding a risk-free asset extends and changes the efficient frontier 9- 4 .Borrowing and Lending Possibilities Risk free assets ◦ Certain-to-be-earned expected return and a variance of return of zero ◦ No correlation with risky assets ◦ Usually proxied by a Treasury security Amount to be received at maturity is free of default risk.

Risk-Free Lending L Riskless assets can be combined with B any portfolio in the E(R) T efficient set AB Z X ◦ Z implies lending RF Set of portfolios on A line RF to T dominates all portfolios below it Risk 9-5 .

Impact of Risk-Free Lending If wRF placed in a risk-free asset ◦ Expected portfolio return E(R p ) w RF RF ( 1-w RF )E(R X ) ◦ Risk of the portfolio σ p ( 1-w RF )σ X Expected return and risk of the portfolio with lending is a weighted average 9- 6 .

Borrowing Possibilities Investor no longer restricted to own wealth Interest paid on borrowed money ◦ Higher returns sought to cover expense ◦ Assume borrowing at RF Risk will increase as the amount of borrowing increases ◦ Financial leverage 9- 7 .

The New Efficient Set Risk-free investing and borrowing creates a new set of expected return-risk possibilities Addition of risk-free asset results in ◦ A change in the efficient set from an arc to a straight line tangent to the feasible set without the riskless asset ◦ Chosen portfolio depends on investor’s risk-return preferences 9- 8 .

Portfolio Choice The more conservative the investor the more is placed in risk-free lending and the less borrowing The more aggressive the investor the less is placed in risk-free lending and the more borrowing ◦ Most aggressive investors would use leverage to invest more in portfolio T 9- 9 .

Market Portfolio Most important implication of the CAPM ◦ All investors hold the same optimal portfolio of risky assets ◦ The optimal portfolio is at the highest point of tangency between RF and the efficient frontier ◦ The portfolio of all risky assets is the optimal risky portfolio Called the market portfolio 9- 10 .

so it is completely diversified ◦ Includes only systematic risk All securities included in proportion to their market value Unobservable but proxied by S&P 500 Contains worldwide assets ◦ Financial and real assets 9- 11 .Characteristics of the Market Portfolio All risky assets must be in portfolio.

Capital Market Line L M Line from RF to L is E(RM) capital market line (CML) x x = risk premium =E(RM) .RF RF y y =risk =M Slope =x/y M =[E(RM) .RF]/M Risk y-intercept = RF 9-12 .

T 9- 13 .The Separation Theorem Investors use their preferences (reflected in an indifference curve) to determine their optimal portfolio Separation Theorem: ◦ The investment decision. is separate from the financing decision ◦ Allocation between risk-free asset and risky portfolio separate from choice of risky portfolio. which risky portfolio to hold.

depending on their preferences Risky portfolios are not tailored to each individual’s taste 9- 14 .Separation Theorem All investors ◦ Invest in the same portfolio ◦ Attain any point on the straight line RF-T-L by by either borrowing or lending at the rate RF.

Capital Market Line Slope of the CML is the market price of risk for efficient portfolios. or the equilibrium price of risk in the market Relationship between risk and expected return for portfolio P (Equation for CML): E(RM ) RF E(R p ) RF σp σM 9- 15 .

Security Market Line CML Equation only applies to markets in equilibrium and efficient portfolios The Security Market Line depicts the tradeoff between risk and expected return for individual securities Under CAPM. all investors hold the market portfolio ◦ How does an individual security contribute to the risk of the market portfolio? 9- 16 .

Security Market Line A security’s contribution to the risk of the market portfolio is based on beta Equation for expected return for an individual stock E(Ri ) RF βi E(RM ) RF 9- 17 .

Security Market Line SM E(R) L Beta = 1.0 implies as risky as market A kM B Securities A and B are more risky than C kRF the market ◦ Beta >1.0 Security C is less 0 0.0 risky than the BetaM market ◦ Beta <1.5 2.0 1.0 9-18 .5 1.

Security Market Line Beta measures systematic risk ◦ Measures relative risk compared to the market portfolio of all stocks ◦ Volatility different than market All securities should lie on the SML ◦ The expected return on the security should be only that return needed to compensate for systematic risk 9- 19 .

CAPM’s Expected Return-Beta Relationship Required rate of return on an asset (ki) is composed of ◦ risk-free rate (RF) ◦ risk premium (i [ E(RM) .RF ] ◦ The greater the systematic risk.RF ]) Market risk premium adjusted for specific security ki = RF +i [ E(RM) . the greater the required return 9- 20 .

Estimating the SML Treasury Bill rate used to estimate RF Expected market return unobservable ◦ Estimated using past market returns and taking an expected value Estimating individual security betas difficult ◦ Only company-specific factor in CAPM ◦ Requires asset-specific forecast 9- 21 .

assuming a linear relationship Ri = i + i RM +ei Characteristic line ◦ Line fit to total returns for a security relative to total returns for the market index 9- 22 .Estimating Beta Market model ◦ Relates the return on each stock to the return on the market.

How Accurate Are Beta Estimates? Betas change with a company’s situation ◦ Not stationary over time Estimating a future beta ◦ May differ from the historical beta RM represents the total of all marketable assets in the economy ◦ Approximated with a stock market index ◦ Approximates return on all common stocks 9- 23 .

How Accurate Are Beta Estimates? No one correct number of observations and time periods for calculating beta The regression calculations of the true and from the characteristic line are subject to estimation error Portfolio betas more reliable than individual security betas 9- 24 .

absence of personal taxes. riskless borrowing or lending.Arbitrage Pricing Theory Based on the Law of One Price ◦ Two otherwise identical assets cannot sell at different prices ◦ Equilibrium prices adjust to eliminate all arbitrage opportunities Unlike CAPM. mean-variance decisions 9- 25 . APT does not assume ◦ single-period investment horizon.

Factors APT assumes returns generated by a factor model Factor Characteristics ◦ Each risk must have a pervasive influence on stock returns ◦ Risk factors must influence expected return and have nonzero prices ◦ Risk factors must be unpredictable to the market 9- 26 .

APT Model Most important are the deviations of the factors from their expected values The expected return-risk relationship for the APT can be described as: E(Ri) =RF +bi1 (risk premium for factor 1) +bi2 (risk premium for factor 2) +… +bin (risk premium for factor n) 9- 27 .

need the factors that account for the differences among security returns CAPM identifies market portfolio as single factor Neither CAPM or APT has been proven superior ◦ Both rely on unobservable expectations 9- 28 .Problems with APT Factors are not well specified ex ante ◦ To implement the APT model.

Coeficient Beta : Contoh i = Cov(rirM 1) / M² Expected Return : E(ri)= RF + i [E(rM).648 % C 15 Cov (rCrM) 1.215 % D 16 Cov (rDrM) 0.RF] = Ri – E(r) Sto Return Covariance antara ck Realisasi Saham i dgn index pasar A 17 Cov (rArM) 0.972 % B 14 Cov (rBrM) 0.6075 % .

000 1) Beta saham () 0.2 1.8 1.000 Rp 1. B dan C adalah sebagai berikut : Saham A Saham B Saham C Harga periode Rp 1.400 sekarang (Pt) Harga periode lalu (Pt. Rp 1. Data untuk tiga saham A.RF] = Ri – E(r) . Contoh 2 Diketahui expected return dari index pasar adalah 11%. Suku bunga SBI sebesar 8%.500 Rp 1.5 Return Realisasi : Ri= (Pt .Pt-1) / Pt-1 Expected Return : E(ri)= RF + i [E(rM).350 Rp 5.000 Rp 5.

caused by the use of these programs or from the use of the information contained herein. Inc. Request for further information should be addressed to the Permissions department.Copyright 2010 John Wiley & Sons. omissions. 9- 31 . John Wiley & Sons. The Publisher assumes no responsibility for errors. All rights reserved. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. or damages. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United states Copyright Act without the express written permission of the copyright owner is unlawful. Inc.

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