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Lecture 5

Investment and Portfolio Analysis (Auckland University of Technology)

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Lecture 5

• Review of Lectures 1-4

• Capital Asset Pricing Model

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Lecture 1
 Key concepts
 Bid and ask prices
 Market orders and Price-contingent orders
 Limit order book
 Buying on margin
 Short sales
 Margin requirements
 Understand margin
 Be able to determine the conditions of a margin
call

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Lecture 2
 Key concepts
 Different types of investment companies
 Mutual funds, close-end funds, open-end funds
 ETF
 Relevant measures
 NAV
 Premium/discount to NAV
 Fee structure of mutual funds
 Return and turnover ratio of mutual funds

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Lecture 3
 Key concepts
 HPR
 Expected return and standard deviation of
returns
 Scenario analysis method
 Historical data method
 Risk premium and Sharpe ratio
 Asset allocation between risky and risk-
free assets
 Be able to determine investment opportunities
with these two assets
 Be able to draw CAL and use it

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Lecture 4
 Key concepts
 Market risk, firm specific risk, and beta
 Diversification and correlation of returns
 Efficient frontier
 Portfolio theory
 Optimal risky portfolio P forming CAL with the highest
Sharpe ratio
 Everyone invests in P, regardless of their degree of
risk aversion
 Be able to calculate the expected return and standard
deviation of a portfolio with two securities
 Be able to calculate portfolio beta
 Be able to determine minimum-variance and optimal
risky portfolios with two risky assets.

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Capital Asset Pricing Model (CAPM)

 Equilibrium model that underlies modern

financial theory

 Derived using principles of diversification with

simplified assumptions

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CAPM - Assumptions
 Individual investors  Information is
are price takers costless and
 Single-period available to all
investment horizon investors
 Investments are  Investors are
limited to traded rational mean-
financial assets variance optimizers
 No taxes and  There are
transaction costs homogeneous
expectations
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CAPM - Resulting Equilibrium Conditions

 All investors will hold the same portfolio of

risky assets – market portfolio
 Market portfolio contains all securities and the
proportion of each security is its market value
as a percentage of total market value
 Risk premium on the market will depend on
the average risk aversion of all market
participants
 The risk premium on individual assets will be
proportional to the market risk premium and
to the beta of the security in the market
portfolio.
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The Efficient Frontier and the

Capital Market Line
• M = The value weighted “Market”
E(r) Portfolio of all risky assets.
• Equilibrium conditions:
All investors will hold the M portfolio

CML
M
E(rM) Efficient
Frontier
rf


m
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Slope of CML and Market Risk Premium

M = Market portfolio
rf = Risk-free rate
E(rM)- rf = Excess return on the market portfolio
E (rM )  rf
M {
=Optimal Market price of risk
=Slope of the CML
Capital Market Line
M = The value weighted “Market”
Market”
E(r)
E(r) Portfolio of all risky assets.

CML
M
E(rM)
rf
→
 10
m

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Expected Return and Risk on

Individual Securities
 The risk premium on a security is a function of
the security’s contribution to the risk of the
market portfolio,
E (ri )  rf   i ( E (rM )  rf )
Cov(ri , rM )
 where  i 
 M2
 Does the firm-specific risk of a security matter to
investors holding a well-diversified portfolio? No!
 A security’s total risk (2i) can be partitioned into
systematic and unsystematic risk:
2i = i2 M2 + 2(ei)
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Individual Stocks: Security Market Line

E(r) Equation of the SML (CAPM)

E(ri) = rf + i[E(rM) - rf ]

SML
E(rM)
(E(rM) – rf )=SML Slope
rf =price of risk for market

ß
ß M = 1.0
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SML: Example
Beta is 1.25 for Stock X and 0.6 for stock Y. Find
the equilibrium expected returns for the stocks,
given the following information:
E(rm) - rf = 0.08, rf = 0.03

Stock X:
E(rx) = 0.03 + 1.25(0.08) = 0.13 or 13%
Stock Y:
E(ry) = 0.03 + 0.6(0.08) = 0.078 or 7.8%

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SML: Example (cont.)

E(r)
SML

E(rx)=13% .08
E(rM)=11%
If the CAPM is correct,
E(ry)=7.8%
only β risk matters in
determining the risk
3%
premium for a given
slope of the SML.
ß
.6 1.0 1.25
ßy ßM ßx
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SML: Example (cont.)

Suppose Stock Z has  = 1.25, and

offers an expected return of 15%
According to the SML, the
equilibrium expected return for the
stock should be 13%

E(rZ) = 0.03 + 1.25(.08) = 13%

Is Stock Z under or overpriced?

Underpriced: It is offering too high of a What is the  in this case?
rate of return for its level of risk.
Definition of   = +2%. Positive  is
The difference of the actual expected good, negative  is bad
return minus the equilibrium expected
return as measured by the CAPM is +  gives the buyer a +
called the stock’s alpha denoted by  . abnormal return
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Portfolio Betas
The beta of a portfolio with n securities is equal to the
weighted average of the betas of these securities, i.e.,
n
p  w i 1
i i

Example: If you put 50% of your money in a

stock with a beta of 1.5 and 30% of your money
in a stock with a beta of 0.9 and the rest in T-
bills, what is the portfolio beta?
βP =0.50(1.5) + 0.30(0.9) + 0.20(0) = 1.02

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The Single-Index Model and

Realized Returns
 Use historical data to estimate beta. As
such, move from expected to historical
realized returns, and use the index model
in excess return form:
Ri  i  i RM  ei
where Ri  ri  rf , RM  rM  rf , ei is an error term.
 Note: ri, rM, and rf are historical realized
returns on security i, market index M,
and risk-free rate for the same time
period t.
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Single-Index Model:
Security Characteristic Line (SCL)
 With the use of historical data on a
security, market index, and risk-free
rate (typically past 5 year data), obtain
the estimates of αi and βi, and define
SCL as
y  i  i x

 SCL is also called the regression line.

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Security Characteristic Line (SCL)

Excess Returns (i)
SCL

Dispersion of the
points around the

. . . . Slope = 
line measures
.
. . .
unsystematic risk. .
The statistic is
called (e)
. . . . .
. . .. . .
. .
. .
. . . Excess returns

. .. . . .
. . . .. . .
= 
on market index

. . .
What should  equal to?
.
.. . . . .
Ri =  i + ßiRM + ei
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GM’s beta: GM Excess Returns Jan 04 to Dec 08

SUMMARY OUTPUT
Excess Return
Regression Statistics
“True”  is between 0.28 and
Month GM Market
1.43!
Dec-08 22.93% -8.40% Multiple R 0.3641
Nov-08 -25.46% 0.95% R Square 0.1325 If rf = 5% and rm – rf = 6%,
Oct-08 -26.12% -7.12% Adjusted R Square 0.1176 then we would predict GM’s
Sep-08 -13.92% -16.82% Standard Error 0.0834 return (rGM) to be
Aug-08 -29.73% -9.66% Observations 60
Jul-08 -5.07% 1.25% 5% + 0.8554(6%) = 10.13%
Jun-08 -11.18% -1.24% ANOVA
May-08 -15.73% -8.69% df SS MS F Significance F
Apr-08 -6.65% 1.17% Regression 1 0.0617 0.0617 8.8622 0.0042
Mar-08 8.61% 4.43% Residual 58 0.4038 0.0070
Feb-08 -9.73% -1.16% Total 59 0.4655
. . .
. . . Coefficientstandard Erro t Stat P-value Lower 95% Upper 95%

. . . Intercept -0.0144 0.0110 -1.3062 0.1966 -0.0364 0.0077

Market 0.8554 0.2874 2.9769 0.0042 0.2802 1.4307
Sep-04 -0.03% 1.07%
Aug-04
Jul-04
1.40%
1.59%
0.78%
0.05%
Regression Results: rGM  rf     ( rS & P  rf )  e
Jun-04 2.31% -3.38%
May-04 -0.31% 1.73% Estimated α = -0.0144, Can we conclude α < 0?
Apr-04 -0.08% 1.54% Estimated β = 0.8554
R-Square = 13.25%, σ(e) = 8.34%, ρ = 0.3641
Mar-04 -3.28% -2.07%
Feb-04 -0.06% -1.44%
Jan-04 0.49% 1.21% Adjusted R-Square = 11.76%
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Evaluating the CAPM

 The CAPM is “false” based on the
validity of its assumptions
 The CAPM could still be a useful
predictor of expected returns. That is
an empirical question.
 Huge measurability problems because the
market portfolio is unobservable.
 Conclusion: As a theory the CAPM is
untestable.

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
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Evaluating the CAPM

 The principles we learn from the CAPM are
still entirely valid.
 Investors should diversify.
 Systematic risk is the risk that matters.

 A well diversified risky portfolio can be suitable

for a wide range of investors.
 The risky portfolio would have to be adjusted for tax
and liquidity differences.
 Differences in risk tolerances can be handled by
changing the asset allocation decisions in the
complete portfolio.
 Even if the CAPM is “false,” the markets can
still be “efficient.”
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