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BF Lecture Notes Topic 5 Part 2-2-2
BF Lecture Notes Topic 5 Part 2-2-2
Expected
Return Portfolio (M)
Rm
Risk
sm sP
The straight line connecting Rf with M, the tangency point between Rf and the old
Efficient Frontier, becomes the new Efficient Frontier – called the Capital Market Line
(CML).
High
M
B
Expected Return
RB
RA Rc A
Rf
Low
Low High
σA
σC
σB Risk (σi)
Introducing a risk-free asset enlarges the opportunity set - many more risk/return
combinations are possible.
The risk-free asset increases the return for each level of risk or, alternatively
expressed, it reduces the risk for every given level of return
The Capital Market Line (CML) is all linear combinations of the risk-free asset (R f ) and
the market portfolio (M)
With the CML all investors will hold some combination of the risk-free asset and the
market portfolio M. All investors will choose a portfolio on the CML – where on the CML
will depend on their risk preferences, i.e. on their attitude towards risk.
A – low
Rf risk & low
expected
return
Low
Low High
Risk
Each asset weight in the portfolio will reflect its relative importance in the economy
as a whole. Example – if the retail sector makes up 60% of the national economy,
retail sector assets will make up 60% of the market portfolio M.
Expected
Return NG CML
W I
RRO
BO
M
DING
L EN
Rf To the right of M - Borrowing
σp
i.e. Portfolio Return = Risk-Free Return + ((Market Risk Premium) x Measure of Relative Risk)
Where:
Rp = Portfolio Return
Rf = Risk-Free Return
Rm = Market Return
(Rm - Rf) = Market Risk Premium
σp = Market Risk
σm = Portfolio Risk
σp/σM = Measure of Relative Risk
By borrowing funds the investor increases the risk on his/her portfolio and is able to increase
the expected return on the portfolio to 13.50%.
In this example the investor borrows 75% of the required funds and invests the total funds in
the market portfolio Rm and this increases the total risk on the investor’s portfolio σp by 75%
above that of the market portfolio σm i.e. increases the standard deviation on the investor’s
portfolio σp = σm x 1.75 = 0.08 x 1.75 = 0.14 = 14%.
Security A has greater total risk (as it has a higher standard deviation) but less
systematic risk than Security B (because Security A has a lower βeta).
Boral 0.84
Coca-Cola Amatil (CCA) 1.05
CSR 0.90
Mayne Nickless 0.80 Mayne Nickless is 20% less risk than the market
NAB 1.09
R i R f R M R f i
Example
Given a risk free rate (Rf) of 5% and an expected market return (Rm) of 10%, what
is the required return ( R ) for Share Z with a beta of 1.5?
i
The Capital Market Line (CML), which we covered earlier, gives the risk return
relationship for portfolios consisting of some combination of the market portfolio
and the risk free asset, where risk is total risk (as measured by standard deviation
σp).
The Security Market Line (SML) is used for working out the risk and return
relationship for individual assets and portfolios other than those comprised of a
combination of the market portfolio and the risk free asset, and where risk is
measured only by systematic risk (βeta βi).
i ,m i m cov i ,m
i
m 2
m2
where:
ρi,m = correlation coefficient between the return on the Asset i and the market return;
σi = standard deviation of returns on Asset i;
σm = standard deviation of returns on the market;
σm2 = variance of returns on the market.
βp = W1 β1 + W2 β2 + W3 β3 + ... + Wn βn
If the actual/expected/forecast return on an asset is less than its required rate
of return the asset is over-priced. Investors will sell the asset - the price will be
forced down.
Buying and selling will continue until a state of equilibrium is achieved, i.e.
actual/expected/forecast return equals required return.
R i R f ( RM R f ) i
R x 0.05 (0.10 0.05)0.8 0.09 9%
R y 0.05 (0.10 0.05)1.2 0.11 11 %
R z 0.05 (0.10 0.05)1.8 0.14 14%
% R SML
14
FY Z FZ
RM
11
10
9
. Y
FX = actual/forecast return on Asset X (7%)
X M
X = required return on Asset A (9%)
FX FY = actual/forecast return on Asset Y (12.5%)
5
Y = required return on Asset Y (11%)
FZ = actual/forecast return on Asset Z (14%)
Z = required return on Asset Z (14%)
0.
8 1.8 b
1.
1.
0
2
βM
Y Share Y is underpriced. The share is forecast to generate an actual return (12.5%) that
is higher than the required/equilibrium return predicted by CAPM (11%).
Y Investors will buy Share Y causing its price to rise until the actual return decreases to
equal the required return.
Z Share Z is fairly priced (actual return 14% equals required return 14%).
The type of market efficiency we are most interested in (and what you may be
examined on) is Informational Efficiency.
If a financial market is efficient an investor cannot consistently earn abnormal profits
because prices of securities adjust instantaneously to fully reflect all relevant
information.
Consistently - other than by chance.
Abnormal profits - a return greater than a risk-adjusted return (as estimated using
CAPM).
− *2
Technical Analysis: Also known as ‘Charting’, is the study of historical chart patterns and trends of publicly traded
stocks using tools such as bar or candlestick charts and trading volumes to determine the future behaviour of a stock.
Much of this practice involves discovering the overall trend line of a stock's movement.
*1 http://www.investopedia.com/terms/w/weakform.asp, 19/09/13.
*2
http://www.investopedia.com/terms/t/technical-analysis-of-stocks-and-trends.asp, 19/09/13.
*1
http://www.investopedia.com/terms/s/strongform.aspardless of the amount of research or information investors have access to., 19/09/13.
Also: ‘It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater efficiency to
occur, the following criteria must be met:
1. Universal access to high-speed and advanced systems of pricing analysis,
2. A universally accepted analysis system of pricing stocks,
3. An absolute absence of human emotion in investment decision-making,
4. The willingness of all investors to accept that their returns or losses will be exactly identical to all other market
participants. It is hard to imagine even one of these criteria of market efficiency ever being met.
*1
http://www.investopedia.com/articles/basics/04/022004.asp, 19/09/13.
*2
Warren Buffet: Known as "the Oracle of Omaha", Buffett is Chairman of Berkshire Hathaway and arguably the greatest investor of all time. His wealth fluctuates with the
performance of the market but as of 2008 his net worth was estimated at $62 billion, making him the richest man in the world. Buffett is a value investor. His company Berkshire
Hathaway is basically a holding company for his investments. Major holdings he has had at some point include Coca-Cola, American Express and Gillette. Critics predicted an end
to his success when his conservative investing style meant missing out on the dotcom bull market. Of course, he had the last laugh after the dotcom crash because, once again,
Buffett's time tested strategy proved successful. http://www.investopedia.com/terms/w/warrenbuffet.asp, 19/09/13.
• *1 For those interested in learning more about the EMH and empirical evidence on its validity the
Peirson et. al textbook has a good summary (note: current (prescribed text) edition is Ed. 11).