CHAPTER NINE Capital Market Theory
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Transcript of CHAPTER NINE Capital Market Theory
CHAPTER NINE
Capital Market Theory
CHAPTER NINE
Capital Market Theory
Cleary / Jones
Investments: Analysis and Management
Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives
To explain capital market theory To explain capital market theory and the Capital Asset Pricing Modeland the Capital Asset Pricing Model
To discuss the importance and To discuss the importance and composition of the market portfoliocomposition of the market portfolio
To describe two important To describe two important relationships in CAPM as relationships in CAPM as represented by the capital market represented by the capital market line and the security market lineline and the security market line
Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives
To describe how betas are To describe how betas are estimated and how beta is usedestimated and how beta is used
To discuss the Arbitrage Pricing To discuss the Arbitrage Pricing Theory as an alternative to the Theory as an alternative to the Capital Asset Pricing ModelCapital Asset Pricing Model
Capital Asset Pricing Capital Asset Pricing ModelModel
Capital Asset Pricing Capital Asset Pricing ModelModel
Focus on the equilibrium Focus on the equilibrium relationship between the risk and relationship between the risk and expected return on risky assetsexpected return on risky assets
Builds on Markowitz portfolio Builds on Markowitz portfolio theorytheory
Each investor is assumed to Each investor is assumed to diversify his or her portfolio diversify his or her portfolio according to the Markowitz modelaccording to the Markowitz model
CAPM AssumptionsCAPM AssumptionsCAPM AssumptionsCAPM Assumptions
All investors:All investors:– Use the same Use the same
information to information to generate an generate an efficient frontier efficient frontier
– Have the same Have the same one-period time one-period time horizonhorizon
– Can borrow or lend Can borrow or lend money at the risk-money at the risk-free rate of returnfree rate of return
No transaction No transaction costs, no personal costs, no personal income taxes, no income taxes, no inflationinflation
No single investor No single investor can affect the can affect the price of a stockprice of a stock
Capital markets Capital markets are in equilibrium are in equilibrium
Market PortfolioMarket PortfolioMarket PortfolioMarket Portfolio
Most important implication of the CAPM Most important implication of the CAPM – All investors hold the same optimal All investors hold the same optimal
portfolio of risky assetsportfolio of risky assets– The optimal portfolio is at the highest point The optimal portfolio is at the highest point
of tangency between RF and the efficient of tangency between RF and the efficient frontier frontier
– The portfolio of The portfolio of allall risky assets is the risky assets is the optimal risky portfoliooptimal risky portfolio
Called the market portfolioCalled the market portfolio
Characteristics of the Characteristics of the Market PortfolioMarket Portfolio
Characteristics of the Characteristics of the Market PortfolioMarket Portfolio
All risky assets must be in portfolio, so All risky assets must be in portfolio, so it is completely diversifiedit is completely diversified– Contains only systematic riskContains only systematic risk
All securities included in proportion to All securities included in proportion to their market valuetheir market value
Unobservable, but proxied by TSE 300Unobservable, but proxied by TSE 300 In theory, should contain all risky In theory, should contain all risky
assets worldwideassets worldwide
Capital Market LineCapital Market LineCapital Market LineCapital Market Line
Line from RF to L is Line from RF to L is capital market line capital market line (CML)(CML)
x = risk premium x = risk premium = E(R = E(RMM) - RF) - RF
y = risk = y = risk = MM
Slope = x/ySlope = x/y
= [E(R= [E(RMM) - RF]/) - RF]/MM
y-intercept = RFy-intercept = RF
E(RM)
RF
RiskM
L
M
y
x
Capital Market LineCapital Market LineCapital Market LineCapital Market Line
Slope of the CML is the market Slope of the CML is the market price of risk for efficient portfolios, price of risk for efficient portfolios, or the equilibrium price of risk in or the equilibrium price of risk in the marketthe market
Relationship between risk and Relationship between risk and expected return for portfolio P expected return for portfolio P (Equation for CML):(Equation for CML):
pM
Mp
RF)R(ERF)R(E
Security Market LineSecurity Market LineSecurity Market LineSecurity Market Line
CML Equation only applies to markets in CML Equation only applies to markets in equilibrium and efficient portfoliosequilibrium and efficient portfolios
The Security Market Line depicts the The Security Market Line depicts the tradeoff between risk and expected tradeoff between risk and expected return for individual securitiesreturn for individual securities
Under CAPM, all investors hold the Under CAPM, all investors hold the market portfoliomarket portfolio– How does an individual security contribute to How does an individual security contribute to
the risk of the market portfolio? the risk of the market portfolio?
Security Market LineSecurity Market LineSecurity Market LineSecurity Market Line
Equation for expected return for an Equation for expected return for an individual stock similar to CML individual stock similar to CML EquationEquation
RF)R(ERF
RF)R(ERF)R(E
Mi
M
M,i
M
Mi
Security Market LineSecurity Market LineSecurity Market LineSecurity Market Line
Beta = 1.0 implies Beta = 1.0 implies as risky as marketas risky as market
Securities A and B Securities A and B are more risky than are more risky than the marketthe market– Beta > 1.0Beta > 1.0
Security C is less Security C is less risky than the risky than the marketmarket– Beta < 1.0Beta < 1.0
AB
C
E(RM)
RF
0 1.0 2.00.5 1.5
SML
BetaM
E(R)
Security Market LineSecurity Market LineSecurity Market LineSecurity Market Line
Beta measures systematic riskBeta measures systematic risk– Measures relative risk compared to Measures relative risk compared to
the market portfolio of all stocksthe market portfolio of all stocks– Volatility different than marketVolatility different than market
All securities should lie on the SMLAll securities should lie on the SML– The expected return on the security The expected return on the security
should be only that return needed to should be only that return needed to compensate for systematic riskcompensate for systematic risk
CAPM’s Expected Return-CAPM’s Expected Return-Beta RelationshipBeta Relationship
CAPM’s Expected Return-CAPM’s Expected Return-Beta RelationshipBeta Relationship
Required rate of return on an asset (kRequired rate of return on an asset (kii) ) is composed ofis composed of– risk-free rate (RF)risk-free rate (RF)
– risk premium (risk premium (ii [ E(R [ E(RMM) - RF ])) - RF ]) Market risk premium adjusted for specific Market risk premium adjusted for specific
securitysecurity
kkii = RF + = RF +ii [ E(R [ E(RMM) - RF ]) - RF ]– The greater the systematic risk, the The greater the systematic risk, the
greater the required returngreater the required return
Estimating the SMLEstimating the SMLEstimating the SMLEstimating the SML
Treasury Bill rate used to estimate RFTreasury Bill rate used to estimate RF Expected market return unobservableExpected market return unobservable
– Estimated using past market returns and Estimated using past market returns and taking an expected valuetaking an expected value
Estimating individual security betas Estimating individual security betas difficultdifficult– Only company-specific factor in CAPMOnly company-specific factor in CAPM– Requires asset-specific forecastRequires asset-specific forecast
Estimating BetaEstimating BetaEstimating BetaEstimating Beta
Market modelMarket model– Relates the return on each stock to the Relates the return on each stock to the
return on the market, assuming a linear return on the market, assuming a linear relationshiprelationship
RRii = =ii + +i i RRMM +e +eii
Characteristic lineCharacteristic line– Line fit to total returns for a security Line fit to total returns for a security
relative to total returns for the market relative to total returns for the market indexindex
How Accurate Are Beta How Accurate Are Beta Estimates?Estimates?
How Accurate Are Beta How Accurate Are Beta Estimates?Estimates?
Betas change with a company’s Betas change with a company’s situationsituation– Not stationary over time Not stationary over time
Estimating a Estimating a futurefuture beta beta– May differ from the historical betaMay differ from the historical beta
RRMM represents the total of all marketable represents the total of all marketable assets in the economyassets in the economy– Approximated with a stock market indexApproximated with a stock market index– Approximates return on all common stocksApproximates return on all common stocks
No one correct number of No one correct number of observations and time periods for observations and time periods for calculating betacalculating beta
The regression calculations of the The regression calculations of the true true and and from the characteristic from the characteristic line are subject to estimation errorline are subject to estimation error
Portfolio betas more reliable than Portfolio betas more reliable than individual security betasindividual security betas
How Accurate Are Beta How Accurate Are Beta Estimates?Estimates?
How Accurate Are Beta How Accurate Are Beta Estimates?Estimates?
Arbitrage Pricing TheoryArbitrage Pricing TheoryArbitrage Pricing TheoryArbitrage Pricing Theory
Based on the Law of One PriceBased on the Law of One Price– Two otherwise identical assets cannot Two otherwise identical assets cannot
sell at different pricessell at different prices– Equilibrium prices adjust to eliminate Equilibrium prices adjust to eliminate
all arbitrage opportunitiesall arbitrage opportunities Unlike CAPM, APT does Unlike CAPM, APT does notnot assume assume
– single-period investment horizon, single-period investment horizon, absence of personal taxes, riskless absence of personal taxes, riskless borrowing or lending, mean-variance borrowing or lending, mean-variance decisionsdecisions
FactorsFactorsFactorsFactors
APT assumes returns generated by a APT assumes returns generated by a factor modelfactor model
Factor CharacteristicsFactor Characteristics– Each risk must have a pervasive Each risk must have a pervasive
influence on stock returnsinfluence on stock returns– Risk factors must influence expected Risk factors must influence expected
return and have nonzero pricesreturn and have nonzero prices– Risk factors must be unpredictable to Risk factors must be unpredictable to
the marketthe market
APT ModelAPT ModelAPT ModelAPT Model
Most important are the deviations of Most important are the deviations of the factors from their expected valuesthe factors from their expected values
The expected return-risk relationship The expected return-risk relationship for the APT can be described as:for the APT can be described as:
E(RE(Rii) =RF +b) =RF +bi1 i1 (risk premium for factor 1) (risk premium for factor 1) +b+bi2i2 (risk premium for factor 2) +… (risk premium for factor 2) +… +b+binin (risk premium for factor n) (risk premium for factor n)
Problems with APTProblems with APTProblems with APTProblems with APT
Factors are not well specified ex anteFactors are not well specified ex ante– To implement the APT model, the To implement the APT model, the
factors that account for the differences factors that account for the differences among security returns are requiredamong security returns are required
CAPM identifies market portfolio as single CAPM identifies market portfolio as single factorfactor
Neither CAPM or APT has been Neither CAPM or APT has been proven superiorproven superior– Both rely on unobservable expectationsBoth rely on unobservable expectations