Models for the Pricing of Assets

Chapter 9 Charles P. Jones, Investments: Analysis and Management, Tenth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University

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Capital Asset Pricing Model

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

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CAPM Assumptions

All investors:

Use the same information to generate an efficient frontier Have the same oneperiod time horizon Can borrow or lend money at the risk-free rate of return

No transaction costs, no personal income taxes, no inflation No single investor can affect the price of a stock Capital markets are in equilibrium

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Borrowing and Lending Possibilities

Risk free assets

Certain-to-be-earned expected return and a variance of return of zero No correlation with risky assets Usually proxied by a Treasury security

Amount to be received at maturity is free of default risk, known with certainty

Adding a risk-free asset extends and changes the efficient frontier

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Risk-Free Lending
Riskless assets can be combined with L any portfolio in the B efficient set AB

E(R) Z RF A X

Z implies lending

Set of portfolios on line RF to T dominates all portfolios below it

Risk
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Impact of Risk-Free Lending

If wRF placed in a risk-free asset

Expected portfolio return

Risk of the portfolio

E(Rp ) w RF RF ( 1-w RF )E(RX ) p ( 1-w RF ) X

Expected return and risk of the portfolio with lending is a weighted average

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Borrowing Possibilities

Investor no longer restricted to own wealth Interest paid on borrowed money

Higher returns sought to cover expense Assume borrowing at RF

Risk will increase as the amount of borrowing increases

Financial leverage

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The New Efficient Set

Risk-free investing and borrowing creates a new set of expected returnrisk 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 investors riskreturn preferences
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Portfolio Choice

The more conservative the investor the more is placed in risk-free lending and the less borrowing The more aggressive the investor the less is placed in risk-free lending and the more borrowing

Most aggressive investors would use leverage to invest more in portfolio T

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Market Portfolio

Most important implication of the CAPM

All investors hold the same optimal portfolio of risky assets The optimal portfolio is at the highest point of tangency between RF and the efficient frontier The portfolio of all risky assets is the optimal risky portfolio

Called the market portfolio

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Characteristics of the Market Portfolio

All risky assets must be in portfolio, so it is completely diversified

Includes only systematic risk

All securities included in proportion to their market value Unobservable but proxied by S&P 500 Contains worldwide assets

Financial and real assets

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Capital Market Line

L
E(RM) M

x
RF y M Risk

Line from RF to L is capital market line (CML) x = risk premium =E(RM) - RF y =risk =M Slope =x/y =[E(RM) - RF]/M y-intercept = RF

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The Separation Theorem

Investors use their preferences (reflected in an indifference curve) to determine their optimal portfolio Separation Theorem:

The investment decision, which risky portfolio to hold, is separate from the financing decision Allocation between risk-free asset and risky portfolio separate from choice of risky portfolio, T
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Separation Theorem

All investors

Invest in the same portfolio Attain any point on the straight line RF-T-L by by either borrowing or lending at the rate RF, depending on their preferences

Risky portfolios are not tailored to each individuals taste

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Capital Market Line

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
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Security Market Line

CML Equation only applies to markets in equilibrium and efficient portfolios The Security Market Line depicts the tradeoff between risk and expected return for individual securities Under CAPM, all investors hold the market portfolio

How does an individual security contribute to the risk of the market portfolio?
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Security Market Line

A securitys contribution to the risk of the market portfolio is based on beta Equation for expected return for an individual stock

E(Ri ) RF i E(RM ) RF

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Security Market Line

SML E(R) kM A B C

Beta = 1.0 implies as risky as market Securities A and B are more risky than the market

kRF

Beta >1.0

0.5

1.0 1.5 BetaM

Security C is less risky than the 2.0 market

Beta <1.0
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Security Market Line

Beta measures systematic risk

Measures relative risk compared to the market portfolio of all stocks Volatility different than market
The expected return on the security should be only that return needed to compensate for systematic risk

All securities should lie on the SML

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CAPMs Expected Return-Beta Relationship

Required rate of return on an asset (ki) is composed of

risk-free rate (RF) risk premium (i [ E(RM) - RF ])

Market risk premium adjusted for specific security

The greater the systematic risk, the greater the required return

ki = RF +i [ E(RM) - RF ]

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Estimating the SML

Treasury Bill rate used to estimate RF Expected market return unobservable

Estimated using past market returns and taking an expected value

Estimating individual security betas difficult

Only company-specific factor in CAPM Requires asset-specific forecast

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Estimating Beta

Market model

Relates the return on each stock to the return on the market, assuming a linear relationship Ri =i +i RM +ei
Line fit to total returns for a security relative to total returns for the market index
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Characteristic line

How Accurate Are Beta Estimates?

Betas change with a companys situation

Not stationary over time

Estimating a future beta

May differ from the historical beta

RM represents the total of all marketable assets in the economy

Approximated with a stock market index Approximates return on all common stocks
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How Accurate Are Beta Estimates?

No one correct number of observations and time periods for calculating beta The regression calculations of the true and from the characteristic line are subject to estimation error Portfolio betas more reliable than individual security betas

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Arbitrage Pricing Theory

Based on the Law of One Price

Two otherwise identical assets cannot sell at different prices Equilibrium prices adjust to eliminate all arbitrage opportunities
single-period investment horizon, absence of personal taxes, riskless borrowing or lending, mean-variance decisions

Unlike CAPM, APT does not assume

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Factors

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 nonzero prices Risk factors must be unpredictable to the market
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APT Model

Most important are the deviations of the factors from their expected values 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)

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Problems with APT

Factors are not well specified ex ante

To implement the APT model, need the factors that account for the differences among security returns

CAPM identifies market portfolio as single factor

Neither CAPM or APT has been proven superior

Both rely on unobservable expectations

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