Asset Pricing Principles

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

her portfolio according to the Markowitz

model

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

◦ 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

9-6
  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
 Assume that expected return on portfolio M
is 13%, with a standard deviation of 20%, and
that RF is 5% .
 Find the slope of the CML

9-8
 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  p
M

 9-9
 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 risky 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-
10
 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
 All securities included in proportion to their

market value

9-
11
 Investors use their preferences (reflected in an
indifference curve) to determine optimal
portfolio
 Separation Theorem

◦ The investment decision about which risky portfolio

to hold is separate from the financing decision
 Investment decision does not involve investor
 Financing decision depends on investor’s preferences

9-
12
 CML Equation only applies to markets in
equilibrium and efficient portfolios
 The Security Market Line depicts tradeoff

between risk and expected return for

individual securities
 Under CAPM, all investors hold the market

portfolio
◦ Relevant risk of any security is therefore its
covariance with the market portfolio

9-
13
Beta
 Standardized measure of systematic risk
 Relative measure of risk: risk of an individual

stock relative to the market portfolio of all

stocks
 Relates covariance of an asset with the

market portfolio to the variance of the market

portfolio Covi, M

 2
M

 9-
14
Beta

SML  Beta = 1.0 implies as

E(R) risky as market
 Securities A and B are
A
kM B more risky than the
market
C
kRF ◦ Beta >1.0
 Security C is less
risky than the market
0 0.5 1.0 1.5 2.0 ◦ Beta <1.0
BetaM

9-15
 Required rate of return on an asset (ki) is
composed of
◦ risk-free rate (RF)
◦ risk premium for security i (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-
16
 Assume that the beta for IBM is 1.15
 Also assume that RF is 0.05 and that the

expected return on the market is 0.12

 The required return for IBM can be calculated

as

9-
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9-
18
stock Beta E(R)
1 0.9 12
2 1.3 13
3 0.5 11
4 1.1 12.5
5 1.0 12

9-
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9-
20
Use the above table to answer the following questions:
a. Compute the market risk premium
 
b.Compute the required Rate of Return for stock A.
 
c. Compute the risk for a portfolio contains stock A and stock B.

9-
21
9-2 Assume that Exxon is priced in
equilibrium. Its expected return next year is
14 percent, and its beta is 1.1. The risk free
rate is 6 percent.
 Calculate the slope of SML
 Calculate the expected return on the market.

9-
22
9-3 Given the following information:
 Expected return for the market 12 %

 Standard deviation of the market 21 %

 Risk free rate 8 %

 Correlation coefficient between

 Stock A and the market 0.8

 Stock B and the market 0.6
 Standard deviation of the Stock A 25 %

 Standard deviation of the stock B 30 %

a.  Calculate the beta for stock A and Stock B

b. Calculate the required rate of return for each stock.

9-
23
9-4 The expected return for the market is 12%, with a standard
deviation of 21%. The expected risk-free rate is 8% . Information is
available for five mutual funds, all assumed to be efficient, as follows:

Mutual SD( % )
Funds
a) calculate the slope of the CML
Affiliated 14
b) Calculate the expected return for each portfolio
Omega 16
a) Lvy 21

9-
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 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-
25
 The expected risk-return relationship of individual securities
may deviate from that suggested by the SML, and that
difference is the asset’s alpha. Alpha is the difference between
the expected (estimated) rate of return for a stock and its
required rate of return based on its systematic risk Alpha is
computed as
 
 ALPHA (α )  = E(ri) - [rf + b(E(rM) - rf)]
where
E(ri) = expected return on Security i
rf = risk-free rate
bi = beta for Security i
E(rM) = expected return on the market

9-
26
9-6 Within the context of the capital asset pricing model
(CAPM), assume:
 Expected return on the market = 15 percent

 Risk-free rate = 8 percent

 Expected rate of return on XYZ security = 17 percent

 Beta of XYZ security = 1.25

Which one of the following is correct?

a. XYZ is overpriced.
b. XYZ is fairly priced.
c. XYZ’s alpha is −0.25 percent.
d. XYZ’s alpha is 0.25 percent.

9-
27
 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-
28
 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 non-zero prices
◦ Risk factors must be unpredictable to the market

9-
29
 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-
30
 Factors are not well specified ex
 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-
31
 Northeast Airlines has a market beta of 1.2 and a
T-bond beta of 0.7. Suppose the risk premium of
the market index is 6%, while that of T-bond
portfolio is 3%. If the risk-free rate is 4%, the
expected return on the portfolio should be

 E(r)= 4%+1.2%X6%+0.7X3%= 13.3%

9-
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 Suppose the market can be described by the following three sources of
systematic risk. Each factor in the following table has mean value of zero (so
factor values represent realized surprises relative to prior expectation), and
the risk premium associated with each source of systematic risk are given in
the last column.

Systematic factor risk premium

Industrial production, IP 6%
Interest rates, INT 2
Credit risk CRED 4
 The excess return, R, on a particular stock is described by the following
equation that relates realized return to surprises in the three systematic
factors:
 R=6%+1.0IP+0.5INT+0.75 CRED +e
 Find the equilibrium expected excess return on this stock using the APT. Is
the stock overpriced or underpriced?

9-
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 Suppose there are two independent economic
factors,M1and M2 . The risk-free rate is 7%, and all
stocks have independent firm-specific components
with a standard deviation of 50%. Portfolios A and B
are both well diversified.
Portfolio Beta on M1` Beta on M2 Expected return
A 1.8 2.1 40
B 2.0 -0.5 10

 What is the expected return-beta relationship in

this economy?

9-
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