®2002 Prentice Hall Publishing 1 Chapter 3 Market Risk and Returns.

1®2002 Prentice Hall Publishing

Chapter 3Market Risk and Returns


Efficient Financial Markets

• Market efficiencyMarket efficiency

– Market uses all informationMarket uses all information

• Economy Economy

• Financial marketsFinancial markets

• Specific companySpecific company

– Price movements follow a random walkPrice movements follow a random walk


Stages of Efficiency

• Weak-form market efficiencyWeak-form market efficiency– Historical informationHistorical information

• Semistrong-form market efficiencySemistrong-form market efficiency– Publicly available informationPublicly available information

• Strong-form market efficiencyStrong-form market efficiency– Publicly available and private informationPublicly available and private information

• Arbitrage opportunities do not existArbitrage opportunities do not exist• Security prices are in equilibriumSecurity prices are in equilibrium


Does Market Efficiency Always Hold?

• Stock market crash 10/19/87Stock market crash 10/19/87

– Down 20% in hoursDown 20% in hours

• Efficient Market Hypothesis (EMH)Efficient Market Hypothesis (EMH)

– Evidence suggests exceptionsEvidence suggests exceptions


Security Portfolios• Expected return for a portfolio is a weighted average of Expected return for a portfolio is a weighted average of

expected returns for securities in the portfolioexpected returns for securities in the portfolio

– Where rWhere rjj is expected return on security is expected return on security jj and A and Ajj is is

proportion of total funds invested in security proportion of total funds invested in security jj• DiversificationDiversification

– Combining securities to reduce relative riskCombining securities to reduce relative risk– Individual returns do not move in concertIndividual returns do not move in concert

m

jjjp Arr

1


Covariance of Returns

• Measures how closely returns move togetherMeasures how closely returns move together

• Standard deviation for a portfolioStandard deviation for a portfolio

– VariancesVariances

– CovariancesCovariances

• Range of correlationRange of correlation

– -1 to +1-1 to +1


Two-Security Efficient Set

• Opportunity setOpportunity set– Risk-return tradeoffRisk-return tradeoff

• Diversification propertiesDiversification properties– Diversification effectDiversification effect– Reduce the standard deviationReduce the standard deviation– Minimum variance portfolioMinimum variance portfolio– Efficient setEfficient set– Position on the linePosition on the line


Different Correlations

• Diversifying one’s holdingsDiversifying one’s holdings

• Include securities with less than perfect Include securities with less than perfect positive correlationpositive correlation

• Risk is lowered relative to expected returnRisk is lowered relative to expected return


Multiple Security Portfolio Analysis and Selection

• Efficient setEfficient set– Highest expected return for a given standard deviationHighest expected return for a given standard deviation– Determined on the basis of dominanceDetermined on the basis of dominance

• Utility functions and investor choiceUtility functions and investor choice– Risk-averse investorRisk-averse investor– Indifference curvesIndifference curves– Slope Slope

• Risk-free assetRisk-free asset• Optimal selectionOptimal selection• Market portfolioMarket portfolio


Separation Theorem• Borrow and lend at risk-free rateBorrow and lend at risk-free rate• Optimal portfolio of risky assetsOptimal portfolio of risky assets

– Independent of individual’s risk preferenceIndependent of individual’s risk preference• Two phased approach to investingTwo phased approach to investing

– Determine an optimal portfolio of risky assetsDetermine an optimal portfolio of risky assets– Determine the most desirable combinationDetermine the most desirable combination

• Risk-free assetRisk-free asset• Portfolio of risky assetsPortfolio of risky assets

• Depends on utility preferencesDepends on utility preferences


Global Diversification

• Can achieve greater diversificationCan achieve greater diversification

• American Depository Receipts (ADRs)American Depository Receipts (ADRs)

• Mutual fundsMutual funds

• CaveatsCaveats

– Higher foreign-stock returns may not occur Higher foreign-stock returns may not occur in the futurein the future

– Integrated financial markets lessen Integrated financial markets lessen diversificationdiversification


CAPM

• Equilibrium modelEquilibrium model• Unavoidable riskUnavoidable risk• Tradeoff Tradeoff • Simple in conceptSimple in concept• Has real world applicationsHas real world applications• Types of investment opportunitiesTypes of investment opportunities

– Risk-free securityRisk-free security– Market portfolioMarket portfolio


CAPM

Expected ReturnExpected Return

TradeoffTradeoff

Unavoidable RiskUnavoidable Risk


CAPM Assumptions

• Capital markets are highly efficientCapital markets are highly efficient• Investors are well informedInvestors are well informed• Zero transaction costsZero transaction costs• Negligible restrictions on investmentNegligible restrictions on investment• No taxesNo taxes• No investor can affect market priceNo investor can affect market price• General agreement about performance and riskGeneral agreement about performance and risk• Common holding periodCommon holding period


The Characteristic Line

• Excess returnsExcess returns

• Historical dataHistorical data

• Future return estimates from security analystsFuture return estimates from security analysts

– Conditional on a specific market returnConditional on a specific market return

– Pessimistic estimatePessimistic estimate

– Most likely estimateMost likely estimate

– Optimistic estimateOptimistic estimate


Characteristic Line

Excess Returns for StockExcess Returns for Stock

RelationshipRelationship

Excess Returns for Market PortfolioExcess Returns for Market Portfolio

Alpha Alpha

Measurements BetaMeasurements Beta

Unsystematic RiskUnsystematic Risk


A Security Alpha

• In theory, the characteristic line should In theory, the characteristic line should intercept the y-axis at 0intercept the y-axis at 0

– If intercept is < 0 If intercept is < 0 avoid the stock avoid the stock

– If intercept is > 0 If intercept is > 0 buy the stock buy the stock

• Equilibration processEquilibration process


The Systematic Risk as Measures by Beta

• Most important measurement of riskMost important measurement of risk– Depicts the sensitivity of the security’s excess Depicts the sensitivity of the security’s excess

return to that of the market portfolioreturn to that of the market portfolio• Slope of the characteristic lineSlope of the characteristic line

– Slope is 1Slope is 1 excess returns very proportionally excess returns very proportionally– Slope > 1Slope > 1 excess return varies more excess return varies more

• Aggressive investmentAggressive investment– Slope < 1Slope < 1 excess return varies less excess return varies less

• Defensive investmentDefensive investment


Beta• Amplification of riskAmplification of risk

• Represents a stock’s contribution to the risk of a Represents a stock’s contribution to the risk of a portfolioportfolio

• Past betas useful in predicting future betasPast betas useful in predicting future betas

• Obtaining betaObtaining beta

– Organizations compute and publishOrganizations compute and publish

– Regression analysisRegression analysis

– Comparable firms Comparable firms

• Adjusting historical betasAdjusting historical betas


Unsystematic Risk

• Variability of the stock’s excess return not Variability of the stock’s excess return not associated with the marketassociated with the market

• As dispersion increases, unsystematic risk As dispersion increases, unsystematic risk increasesincreases

• Diversification reduces unsystematic riskDiversification reduces unsystematic risk

• Total risk = systematic + unsystematicTotal risk = systematic + unsystematic risk riskrisk risk


Diversification

• Moderate amount of diversificationModerate amount of diversification

– 15-20 stocks15-20 stocks

• Efficient diversificationEfficient diversification

– Only systematic risk remainsOnly systematic risk remains

• CAPM assumes diversificationCAPM assumes diversification


Expected Return for Individual Securities

• Expected rate of returnExpected rate of return

– Risk-free rateRisk-free rate– Return for the market returnReturn for the market return– BetaBeta

• Risk premiumRisk premium– (Expected market return) - (risk-free rate)(Expected market return) - (risk-free rate)

• Beta of a portfolioBeta of a portfolio– Weighted average of the betas of the securitiesWeighted average of the betas of the securities

jfmfj RRRR

mR

j

fR


The Security Market Line

• Describes the market price of risk in the capital Describes the market price of risk in the capital marketsmarkets

• Linear relationship between expected rate of Linear relationship between expected rate of return and systematic riskreturn and systematic risk

• No reward for unsystematic riskNo reward for unsystematic risk• Important to differentiate systematic risk from Important to differentiate systematic risk from

total risktotal risk• EquilibriumEquilibrium

– UndervaluedUndervalued– OvervaluedOvervalued


Implications for the Valuation of the firm

• Decisions of the firm can be judged by their Decisions of the firm can be judged by their effect on valuationeffect on valuation

• Unsystematic risk may become a factorUnsystematic risk may become a factor

– CAPM assumptionsCAPM assumptions

– Market imperfectionsMarket imperfections


Certain Issues with the CAPM• Maturity of risk-free securityMaturity of risk-free security

– Short-term rateShort-term rate– Intermediate-term rateIntermediate-term rate– Long-term rateLong-term rate

• Equity risk premiumEquity risk premium– Larger when interest rates are lowerLarger when interest rates are lower– Smaller when they are highSmaller when they are high– Can change over timeCan change over time

• Faulty use of the market indexFaulty use of the market index• Fama-French and beta as a risk measureFama-French and beta as a risk measure

– Small stock effectSmall stock effect– Low P/E and market-to-book-value ratiosLow P/E and market-to-book-value ratios


Some Final Observations

• CAPM is widely used because of its simplicityCAPM is widely used because of its simplicity

• CAPM has a number of challengesCAPM has a number of challenges

• Alternative models are being developedAlternative models are being developed

®2002 Prentice Hall Publishing 1 Chapter 3 Market Risk and Returns.

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Transcript of ®2002 Prentice Hall Publishing 1 Chapter 3 Market Risk and Returns.