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FIN 402

Capital Budgeting and Corporate Objectives


Yunjeen Kim
6. The CAPM.

Agenda
The Nature of Risk
The Capital Asset Pricing Model
How to Get a Discount Rate Using the CAPM

The Nature of Risk


Is variance (or standard deviation) the relevant measure of risk to
you? Why or why not?
Total fluctuation is not what matters but how the fluctuation is
related to the fluctuation in our wealth.
What should be the relevant measure?

Review of Portfolio Theory


When you start to combine stocks into a portfolio, you start to
reduce the overall risk to your investment. This phenomenon is
called diversification.
What makes it possible & what are the limits of diversification?
Diversification cannot eliminate total risk:

Even More Efficient Portfolios


Introducing a risk free asset. Lend/borrow money in the market at
the risk free rate.

Even More Efficient Portfolios


You can create an even better set of efficient portfolios: improving
return without increasing risk or decreasing risk without diminishing
return.

Capital Market Line


CML is a linear combination of the market portfolio and the riskfree rate.
Exp. Ret.

Capital Market Line


(CML)
M

Std. Dev.

Capital Market Line


What if an asset or a portfolio is not on the CML?

Adding a Risk-Free Asset (Many Risky)

Many Risky Assets & 1 Risk-Free Asset


The line from the risk-free rate that is tangent to the efficient frontier
is sometimes called the capital allocation line.
The unique portfolio of risky assets that is also on this line is called
the tangency portfolio.
It is the best efficient portfolio as it offers the highest ratio of risk
premium to standard deviation (the Sharpe Ratio)
Sharpe ratio = Risk premium / SD = (rp-rf)/p

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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 slope is called the Sharpe-Ratio.


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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:

The Security Market Line:


relationship between risk and expected return for individual assets.

Return

Security Market Line

Security Market Line


(SML)

Market Return = E(RM)

Risk Free Return = Rf


1.0

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:

In the CAPM world, all efficient portfolios are combinations of the


market portfolio and the risk free asset
The market portfolio is the tangency portfolio
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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?

Lets Take a Step Back


The total risk of a stock can be measured by its variance, or standard
deviation.
By combining stocks into a portfolio, we can come up with better
risk/return combinations through diversification. Some of the risk
of each stock in a portfolio is diversified away.
This is a critical idea. We do not care about all the risk, but only
about systematic, undiversifiable risk!
=> How do we measure the common source of risk?

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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:

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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

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What is the Market?


What is a market return?
The return on the market portfolio of all assets in the economy.
In practice, a broad stock market index, such as the S&P 500
Composite, is used to represent the market.
Why use the market return?
It reflects the movement of the broader economy and we care
about broad economic risks, not the individual risk of any firm

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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!

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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

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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?
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Calculating Beta

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Again: Beta - Intuition


The relative risk of an asset in the portfolio is:
=cov(Ri,Rm)/2m
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.
Beta measures a stocks relative sensitivity to market movements.
>1 => above average risk
<1 => below average risk
Will be important in determining discount rates.

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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
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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.

Step 2. Excess return of market, E(RM)-Rf.


Use the historical data

Step 3. Beta of stock j, j.


Use the regression method or Beta books (e.g. Merrill Lynch)

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Alternatives to CAPM: the APT


Arbitrage Pricing Theory was pioneered by Steve Ross at MIT as an
alternative to CAPM
Does not ask which portfolios are efficient. Instead, assumes that
each stocks return depends in part on macro factors and in part on
idiosyncratic events unique to each firm.
Imposes the following structure on expected return / risk premium
E(Risk Premium) = r - rf
= f1(rfactor1 - rf) + f2(rf2 - rf) +
E(Return)

= a + bf1(rfactor1) + bf2(rf2) +

In the matter of APT vs. CAPM


Like in the CAPM, in APT expected return depends on market-wide
factors and is unaffected by unique risk.
If the expected risk premium on each of the portfolios is
proportional to the portfolios market beta, then the APT and CAPM
will give the same answer. Otherwise, will not.
APT: need not measure the market portfolio. Can test on small
datasets. BUT
APT does not tell us what the factors are!

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Does the CAPM hold up?


Return vs. Book-to-Market

Dollars
(log scale) 100

High-minus-low book-to-market

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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

CAPM: The Three Factor Model


Take the regular CAPM and add to the market factor on the right
hand side.
Work by Gene Fama & Ken French: historically, small firms and
high BTM (value firms) have provided above-average returns.
Pick up these additional risk factors.
Include these 2 factors on the RHS of the CAPM.
E(R) = rf+bmkt(rm-rf)+bsize(rsmall-rlrg)+bmtb(rhibtm-rlobtm)

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CAPM: The Three Factor Model


How to apply the Fama-French 3 factor CAPM?
1. Identify the factors. Market, Size, BTM
2. Estimate the risk premium for each using historical data. ~7%
market; ~3.7% size, ~5.2% BTM (26-06)
3. Estimate the betas for each stock as we have done with the regular
CAPM (slope coefficient).

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Applying the Three Factor CAPM


Same as we did with the CAPM
Mastercards market beta is 0.92. It also has a size beta of -0.17 and
the BTM beta of 0.13.
What is its expected return if the T-bill rate is 3.5%?
E(R) = Rf+mkt (Rm-Rf)+size(Rsm-Rlrg)+ btm (Rhi-Rlo) =
= 3.5% + 0.92*7%-0.17*3.7%+0.13*5.2%
= 9.99%

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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.

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