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Attribution Non-Commercial (BY-NC)

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I. Portfolio Theory

group of assets? assume: investors are risk averse additional compensation for risk tradeoff between risk and expected return

goal

for a given risk, maximize exp. return OR for a given exp. return, minimize the risk

tools

Measuring Return

change in asset value + income

return = R = initial value

R is ex post

example 1

Tbill, 1 month holding period buy for $9488, sell for $9528 1 month R:

9528 - 9488 9488 = .0042 = .42%

annualized R:

(1.0042)12 - 1 = .052 = 5.2%

example 2

100 shares IBM, 9 months buy for $62, sell for $101.50 $.80 dividends 9 month R:

101.50 - 62 + .80 62 = .65 =65%

annualized R:

(1.65)12/9 - 1 = .95 = 95%

Expected Return

E(R) = SUM(Ri x Prob(Ri))

example 1

R 10% 5% -5% Prob(R) .2 .4 .4

= 2%

example 2

R 1% 2% 3% Prob(R) .3 .4 .3

= 2%

examples 1 & 2

returns in example 1 are more variable

Risk

how much will R vary from E(R) how likely is actual R to vary from E(R) measured by variance (s2) standard deviation (s)

s = SQRT(s2)

example 1

s2 =

(.2)(10%-2%)2 + (.4)(5%-2%)2

+ (.4)(-5%-2%)2

= .0039 s = 6.24%

example 2

s2 =

(.3)(1%-2%)2 + (.4)(2%-2%)2

+ (.3)(3%-2%)2

= .00006 s = .77%

preferred by risk averse investors variance works best with symmetric distributions

prob(R)

prob(R)

E(R)

E(R)

symmetric

asymmetric

Diversification

holding a group of assets lower risk w/out lowering E(R)

Why?

individual assets do not have same return pattern combining assets reduces overall return variation

unsystematic risk

specific to a firm can be eliminated through diversification examples: -- Safeway and a strike -- Microsoft and antitrust cases

systematic risk

market risk cannot be eliminated through diversification due to factors affecting all assets -- energy prices, interest rates, inflation, business cycles

example

reduce risk by 40-50%

then s is not the best measure of risk is an absolute measure of risk need a measure just for the systematic component

Beta, b

relative to return of market portfolio mkt. portfolio = mkt. index -- S&P 500 or NYSE index

% change in asset return b= % change in market return

interpreting b if b = 0

asset is risk free if b = 1 asset return = market return if b > 1 asset is riskier than market index b<1 asset is less risky than market index

Sample betas

Amazon Anheuser Busch Microsoft Ford General Electric Wal Mart 2.23 -.107 1.62 1.31 1.10 .80

measuring b

estimated by regression

data on returns of assets data on returns of market index estimate

R = bR m

problems

weekly? monthly? annually? choice of market index? NYSE, S&P 500 survivor bias

5 years? 50 years? time period? 1970-1980? 1990-2000?

CAPM

Capital Asset Pricing Model 1964, Sharpe, Linter quantifies the risk/return tradeoff

assume

asset no transactions costs, taxes same expectations, time horizon risk averse investors

implication

beta risk free return market return

E( R ) = R f b[ E( R m ) R f ]

or

E( R ) R f = b[ E( R m ) R f ]

where

E( R m ) R f

so if b >1,

E( R ) R f

>

E( R m ) R f

E( R )

> E( R m )

so if b <1,

E( R ) R f

<

E( R m ) R f

E( R )

< E( R m )

exp. market return less risky portfolio has smaller exp. return

so if b =1,

E( R ) R f

E( R m ) R f

E( R )

= E( R m )

exp. market return equal risk portfolio means equal exp. return

so if b = 0,

E( R ) R f

=0 =

Rf

E( R )

free return

example

E( R ) = R f b[ E( R m ) R f ]

tradeoff CAPM tells use the price of risk

return under CAPM > actual return relationship between and return? some studies it is positive some recent studies argue no relationship (1992 Fama & French)

determining returns January effect firm size effect day-of-the-week effect ratio of book value to market value

CAPM not testable do not observe E(R), only R do not observe true Rm do not observe true Rf results are sensitive to the sample period

APT

several factors affect E(R) does not specify factors

implications

E(R) is a function of several factors, F each with its own b

many factors unspecified factors CAPM is a special case of the APT 1 factor factor is market risk premium

how many factors? what are the factors? 1980 Chen, Roll, and Ross

industrial production inflation yield curve slope other yield spreads

summary

how to measure risk? how to price risk? neither CAPM or APT are perfect or free of testing problems both have shown value in asset pricing

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