Professional Documents
Culture Documents
Chapter 9
Charles P. Jones, Investments: Principles and Concepts,
Twelfth Edition, John Wiley & Sons
9-1
Positive rather than normative
◦ Describes how investors could behave not how
they should be have
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
9-2
Assumes all No transaction costs,
investors: no personal income
◦ Use the same taxes, no inflation
information to generate No single investor
an efficient frontier
can affect the price
◦ Have the same one-
period time horizon of a stock
◦ Can borrow or lend Capital markets are
money at the risk-free in equilibrium
rate of return
9-3
Risk-Free Assets, Borrowing, Lending
Risk free assets
◦ No correlation with risky assets
◦ Usually proxied by a Treasury security
Adding a risk-free asset extends and changes
the efficient frontier
“Lending” because investor lends money to
issuer
With borrowing, investor no longer restricted
to own wealth
9-4
Riskless assets can
L be combined with
any portfolio in the
B
efficient set AB
E(R) T ◦ Z implies lending
Z X Set of portfolios on
RF line RF to T
A dominates all
portfolios below it
Risk
9-5
Risk-free investing and borrowing creates a
new set of expected return-risk possibilities
Addition of risk-free asset results in
9-6
Line from RF to L is
L capital market line
M (CML)
E(RM) x = risk premium
=E(RM) - RF
x y =risk =M
RF Slope =x/y
y =[E(RM) - RF]/M
y-intercept = RF
M
Risk
9-7
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
9-8
Most important implication of the CAPM
◦ The portfolio of all risky assets is the optimal risky
portfolio (called the market portfolio)
◦ The expected price of risk is always positive
◦ The optimal portfolio is at the highest point of
tangency between RF and the efficient frontier
◦ All investors hold the same optimal portfolio of
risky assets
9-9
All risky assets must be in portfolio, so it is
completely diversified
◦ Includes only systematic risk
Unobservable but approximated with
portfolio of all common stocks
◦ In turn approximated with S&P 500
All securities included in proportion to their
market value
9-
10
Investors use their preferences (reflected in an
indifference curve) to determine optimal
portfolio
Separation Theorem
9-
11
CML Equation only applies to markets in
equilibrium and efficient portfolios
The Security Market Line depicts tradeoff
portfolio
◦ Relevant risk of any security is therefore its
covariance with the market portfolio
9-
12
Beta
Standardized measure of systematic risk
Relative measure of risk: risk of an individual
9-
13
Beta
9-14
Required rate of return on an asset (ki) is
composed of
◦ risk-free rate (RF)
◦ risk premium (i [ E(RM) - RF ])
Market risk premium adjusted for specific security
ki = RF +i [ E(RM) - RF ]
◦ The greater the systematic risk, the greater the
required return
9-
15
Treasury Bill rate used to estimate RF
Expected market return unobservable
9-
16
Market model
◦ Relates the return on each stock to the return on
the market, assuming a linear relationship
◦ Produces an estimate of return for any stock
Ri =i +i RM +ei
Characteristic line
◦ Line fit to total returns for a security relative to
total returns for the market index
9-
17
Betas change with a company’s situation
Estimating a future beta
9-
18
No one correct number of observations and
time periods for calculating beta
◦ Therefore, estimates of beta vary
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-
19
Tests of CAPM
Assumptions are mostly unrealistic
Empirical evidence has not led to consensus
However, some points are widely agreed upon
9-
20
9-
21
CML SML
It measures total risk It measures systematic
(S.D) on the X-axis. risk only (beta) on the X-
axis.
Y axis measures E(R) Y axis measures E(R)
The CML line shows the It can be plotted for
relationship of risk and portfolios as well as for
return only for diversified an individual stock.
portfolios.
Only efficient portfolios Both efficient and
inefficient portfolios
the market portfolio and all security factors are
risk free assets are determined by the SML.
determined by the CML.
9-
22
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, APT does not assume
◦ single-period investment horizon, absence of
personal taxes, riskless borrowing or lending,
mean-variance decisions
9-
23
APT assumes returns generated by a factor
model
Factor Characteristics
9-
24
Most important are the deviations of the
factors from their expected values
◦ Expected return is directly related to sensitivity
◦ CAPM assumes risk is only sensitivity to market
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-
25
Factors are not well specified ex ante
◦ To implement the APT model, need the factors that
account for the differences among security returns
CAPM identifies market portfolio as single factor
Studies suggest certain factors are reflected
in market
◦ Focus on cash flows and discount rate
Both CAPM and APT rely on unobservable
expectations
9-
26