Professional Documents
Culture Documents
Agenda
The Nature of Risk
The Capital Asset Pricing Model
How to Get a Discount Rate Using the CAPM
Std. Dev.
10
Sharpe-Ratio
A risk-free asset has zero variance and zero covariance with any
other asset.
Thus, a portfolio with one risky asset and one risk-free asset has an
expected return of:
and a portfolio standard deviation of:
The risk-return tradeoff is:
The CAPM
Assumptions
Financial Markets are efficient with no frictions.
Investors are risk averse.
Investors beliefs about correlations, returns, and risk are
identical.
The results:
All investors build their portfolios using the same risky asset:
The Value Weighted Market Portfolio
The Value Weighted Market Portfolio is efficient
The expected return on any security is determined by its beta.
The CAPM
Excess return on an asset:
Risk measure of the asset:
Excess return per unit of risk:
This should be the same for all:
Return
The CAPM
In equilibrium, any two assets with the same marginal contribution
to the risk of the market portfolio must have the same expected
return.
The relationship is of the specific functional form:
Example 1.
Consider a levered portfolio that consists of $1,200 invested in the
market portfolio, with $200 of that $1,200 borrowed at the riskless
rate of 5%. If the expected return on the market is 12%, what is the
expected return on your portfolio?
Recall:
Return:
Example 2
Aoife Kavanagh has invested 60% of her money in stock A with a
beta of 1.5. The rest is in stock B with a beta of 2.1. The risk free
rate is 5% and the expected market return is 12%.
Based on the CAPM, what is the expected return of each stock?
Risk premium is 7%.
What is the beta of her portfolio?
Based on the CAPM and given her portfolio beta, what is the
expected return on her portfolio?
Example 3
A stock is expected to pay no dividends for the first three years, i.e.,
D1 = $0, D2 = $0, and D3 = $0. The dividend for Year 4 is expected
to be $5.00 (i.e., D4 = $5.00), and it is anticipated that the dividend
will grow at a constant rate of 8% a year thereafter. The risk-free
rate is 4%, the market risk premium is 6%, and the stock's beta is
1.5. Assuming the stock is fairly priced, what is the current price of
the stock?
19
Beta: Intuition
Conceptually, the relative risk of an asset in the portfolio is:
i=cov(Ri,Rp)/2(Rp)
The beta of the stock is a measure of its relative risk in the market.
For a given stock market index, beta measures the assets relative
risk contribution to that index.
The beta of the market is 1. Beta measures a stocks relative
sensitivity to market movements. ><1?
Important in determining discount rates:
20
Measuring Beta
1. Total risk =
diversifiable risk +
market risk
2. Market risk is
measured by beta,
the sensitivity to
market changes.
Stock
Return
beta
Market
Return
21
22
Market Risk
How do we get a measure for market risk?
First, compute the stocks excess return over the risk free rate
and then regress that on the market return over the risk free rate!
Lets see how this works. The following page has a brief
introduction to the idea behind regression!
23
An Example
A regression is simply an estimation of a linear relationship between
2 or more variables. Lets review it by using a relevant example.
Find the realized RISK PREMIUM for both IBM and the S&P 500.
Note: Risk Premium = Return Risk Free Rate
24
A Linear Relationship
Can you notice a relationship between IBMs return and the index
return? Draw a line through it! What does it tell you?
25
Calculating Beta
26
27
Key Takeaways
Use variance to measure the total risk.
BUT diversifiable risk doesnt matter because when you hold a
portfolio, it doesnt exist any more!
Use beta to figure out its systematic (or non-diversifiable) risk. This
is the risk that we will use to produce the discount rate (or
expected/required return).
Key ideas: risk-return tradeoff; what is an efficient portfolio; how
diversification works. Beta.
For risky cash flows: r = risk-free + risk premium. Risk premium
will be a function of beta. Estimate it.
Alphas and betas for investment funds / companies
28
Application of CAPM
Using the SML equation, we can estimate the expected rate of return
on equity.
Step 1. Risk-free rate, Rf.
Use the current yield on one-year T-bills.
29
= a + bf1(rfactor1) + bf2(rf2) +
31
Dollars
(log scale) 100
High-minus-low book-to-market
10
0.1
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
2003
1996
1986
1976
1966
1956
1946
1936
1926
Small-minus-big
33
34
35
Takeaways
Intuition about risk and portfolios.
What do you need to make the most efficient portfolios with the
CAPM? How would you do it?
You only need the tangency portfolio (which is the market portfolio)
plus a risk free asset to create any efficient portfolio.
CAPM & the enhanced 3 factor CAPM model.
Determine expected return (or discount rate) of assets if based on the
market risk premium and the risk free rate.
=> Discount the cash flows.
Think about it
Draw the Security Market Line (SML) and plot asset C such that it
has less risk than the market but plots above the SML, and asset D
such that it has more risk than the market and plots below the SML.
(Be sure to indicate where the market portfolio is on your graph, and
label axes.)
Which of the stocks C or D is overpriced? Explain why you reached
this conclusion.
Explain why such pricing cannot persist in a market that is in
equilibrium.