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Specific
Risk
As the number of risky assets increases ( typically > 15 random securities) the risk of
the portfolio tends to the average covariance, or how the return on the stocks move with
respect to each other (the majority of stocks have positive covariance with each other).
Beyond a point, therefore adding new securities to the portfolio does not result in
further risk reduction.
The risk which can be diversified away by increasing the number of securities is the
Specific risk.
The portfolio which has the highest excess return per unit of risk or Sharpe ratio is the
Market portfolio. By implication it is clear that the risk of the Market Portfolio is made
up only of market risk.
Equivalent terms
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The Beta of a stock
The total risk on a stock can be expressed as the sum of the squares of
the systematic risk and its unsystematic risk
The systematic part of the risk is the portion which is related to the market.
Beta is the sensitivity of the expected return on the stock to the expected return on the
Market portfolio. It is the covariance of the return on the security i with the return on
the market portfolio divided by the variance of the market portfolio.
So when ρim2 = R2 is close to 1; the stock’s risk is almost entirely systematic risk,
and it has very little specific or unsystematic risk.
The Capital Asset Pricing Model (CAPM), gives us the Security Market Line as a basis
to price assets by the amount of market risk (or systematic risk) which comprises the
total risk of returns on the asset.
The CAPM implies that there is no premium for the nonmarket related risks that an
asset may have (also called specific risk), as all specific risk can be diversified away.
ERi = Rf + βi ( ERm-Rf )
Rm overpriced securities
Rf
β=1 β
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Relationship between the CML and the SML
The Capital Market Line (CML) shows us portfolios of different risk made up
only of the riskfree asset and the Market portfolio with the highest excess return per
unit of risk (Sharpe ratio).
The relationship between the CML and the SML are as below:
CML SML
ERi M
rf rf
0 σm σj = β j σm β=1 βj
σ β
Note
(i) how the SML prices only the market (systematic) component of a security
and
(ii) the CML shows how an equivalent portfolio with only market risk can be made
from a combination of the risk free asset and market portfolio.
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Finding Beta by the Market Model
In practice the β of an asset can be found by regressing the returns on the asset against
the returns on the market portfolio over a suitable period of time: such a model is called
the market model of the CAPM.
Rai = α + β Rmi
( ie Rai = α + β Rmi + e )
Rai = predicted return on share `a’ when return on the market index is Rmi
where `e’ is an error term representing the difference between the actual
return and the return predicted by the model. ( e = Rai- Rai)
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Tests of the CAPM
According to CAPM theory, the market portfolio is mean variance efficient and the
SML equation is a correct predictor of returns on various securities:
Rp = Rf + (Rm-Rf)βp
Empirical tests of the CAPM are based on testing expost data through reclassifying the
CAPM equation as below:
Rp-Rf = γo + γ1 βp + ε p
The betas of stocks or portfolios of stocks are ascertained over a period in the first
stage; then in the second stage, these betas are plotted regressed against the excess
return on the share/portfolio.
(i) the intercept must be zero; beta should be the only factor fully able to explain the
excess return on the share.
(ii) the slope of the empirical market line so obtained must equal the market risk
premium.
When γo is significantly different from zero, and the empirical line is flatter, it implies
there are possibly other variables which can also explain the returns of an asset and not
only the market portfolio ( eg P/E; M/B; Size, D/Y).
Roll’s basic critique is that a share index is not the market portfolio, which has to
include all the risky assets in the market and not only securities ( coins, property etc… ).
Hence, Roll developed an alternative theory the Arbitrage Pricing Model, according to
which security returns are sensitive to a set of factors ( hence this a multiple beta
model.)
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Arbitrage pricing theory
The APT assumes that individuals believe that security returns are determined by a K-
factor generating model
Rj = E(Rj) + Σ bjk Fk + εj
where
bjk is the sensitivity of the jth asset’s return to the kth factor
Fk is the kth factor common to the returns of all assets under consideration.
εj is the noise term for the jth asset ( random, zero mean)
Like the CAPM, the APT assumes that risk is composed of a diversifiable(non-
systematic) and systematic components. In APT the systematic components are
measureable through the sensitivity of the asset’s return to various factors which affect
all assets.
E(Rj) = Rf + Σ ( δ k - Rf) bj k
`δ k’ is the expected return on a portfolio which has a sensitivity of 1 to the kth factor
and zero sensitivity to all other factors.
`Rf’ is the return on a riskfree asset which has no sensitivity to any factor.
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According to APT at Market equilibrium no (riskless) arbitrage profits are available by
holding different combinations of securities. ( In efficient markets correct pricing of
various assets takes place through elimination of arbitrage opportunities.)
In equilibrium, the factor sensitivities `bjk’ can be likened to `β’ in the CAPM.
Research by Chen, Roll and Ross in the US has shown that the following five
macroeconomic variables are significant `factors’–
1. Industrial production
2. Changes in the default risk premium
3. Return on short-term and long-term government bonds
4. Inflation
5. Changes in the real rate of interest
The factors found significant in APT tests are in the manner of economy wide risks
affecting the returns of all assets to different degrees. The CAPM, however, is thus a
special case of the APT where one factor, the expected return on the market portfolio
explains the return on an asset.
CAPM is thus not as effective as the APT, for predicting returns on assets not properly
represented in the reference index. ( commodities, savings and loans, electric utilities).
Earlier, it was also stated that empirical tests have found that the empirical market
line is flatter, with an intercept possibly explainable in terms of
P/E, MTBR, Dividend yield, Size.
On the other hand the CAPM conveniently prices assets on the basis of a single factor
which encapsulates economy wide variables. It is useful for determining the cost of
capital required for valuation and for capital budgeting, for the majority of stocks.
Compared to the DVM, the CAPM is a single period model, dependent on past Betas,
whereas the DVM is forward looking, based on expectations of Dividends in several
future periods. The DVM however is also dependent on past growth rates of dividends..
A good discussion on the CAPM versus the Dividend Valuation Model appears in Steve
Lumby’s Investment Appraisal and Financial Decisions, 5th ed. Note also that the DVM
in its bare form is a total risk model.
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