Risk & Return in Asset Pricing Models

Portfolio Theory Managing Risk Asset Pricing Models

I. Portfolio Theory
how does investor decide among group of assets? assume: investors are risk averse
additional compensation for risk tradeoff between risk and expected return

goal
efficient or optimal portfolio
for a given risk, maximize exp. return OR for a given exp. return, minimize the risk

tools
measure risk, return quantify risk/return tradeoff

Measuring Return
return = R =

change in asset value + income

initial value

R is ex post
based on past data, and is known

R is typically annualized

example 1
T bill, 1 month holding period buy for Rs.9488, sell for Rs.9528 1 month R: 9528 - 9488 9488 = .0042 = .42%

 annualized R: (1.0042)12 - 1 = .052 = 5.2%

example 2
100 shares IBM, 9 months buy for Rs. 62, sell for Rs.101.50 Rs.80 dividends 9 month R: 101.50 - 62 + .80 62 = .65 =65%

 annualized R: (1.65)12/9 - 1 = .95 = 95%

Expected Return
measuring likely future return based on probability distribution random variable E(R) = SUM(Ri x Prob(Ri))

example 1
R 10% 5% -5% E(R) = Prob(R) .2 .4 .4

(.2)10% + (.4)5% + (.4)(-5%)

= 2%

example 2
R 1% 2% 3% E(R) = Prob(R) .3 .4 .3 (.3)1% + (.4)2% + (.3)(3%)

= 2%

examples 1 & 2
same expected return but not same return structure
returns in example 1 are more variable

Risk
measure likely fluctuation in return
how much will R vary from E(R) how likely is actual R to vary from E(R)

measured by
variance (s2) standard deviation (s)

s2 = SUM[(Ri - E(R))2 x Prob(Ri)]

s = SQRT(s2)

example 1
s2 =
(.2)(10%-2%)2 + (.4)(5%-2%)2

+ (.4)(-5%-2%)2
= .0039 s = 6.24%

example 2
s2 =
(.3)(1%-2%)2 + (.4)(2%-2%)2

+ (.3)(3%-2%)2
= .00006 s = .77%

 same expected return but example 2 has a lower risk

preferred by risk averse investors

variance works best with symmetric distributions

prob(R)

prob(R)

E(R)

E(R)

symmetric

asymmetric

II. Managing risk

Diversification
holding a group of assets lower risk w/out lowering E(R)

 Why?
individual assets do not have same return pattern combining assets reduces overall return variation

two types of risk

unsystematic risk
specific to a firm can be eliminated through diversification examples: -- Safeway and a strike -- Microsoft and antitrust cases

 systematic risk
market risk cannot be eliminated through diversification due to factors affecting all assets -- energy prices, interest rates, inflation, business cycles

example
choose stocks from NSE listings go from 1 stock to 20 stocks
reduce risk by 40-50%

s unsystematic risk total risk systematic risk # assets

measuring relative risk

if some risk is diversifiable,
then s is not the best measure of risk is an absolute measure of risk

need a measure just for the systematic component

Beta, b
variation in asset/portfolio return relative to return of market portfolio
mkt. portfolio = mkt. index -- NSE index

% change in asset return b= % change in market return

interpreting b
if b = 0 asset is risk free if b = 1 asset return = market return if b > 1 asset is riskier than market index b<1 asset is less risky than market index

Sample betas
Amazon Anheuser Busch Microsoft Ford General Electric Wal Mart
(monthly returns, 5 years back)

2.23 -.107 1.62 1.31 1.10 .80

measuring b
estimated by regression
data on returns of assets data on returns of market index estimate

R = bR m

problems
what length for return interval?
weekly? monthly? annually?

choice of market index?

NSE survivor bias

 # of observations (how far back?)

5 years? 50 years?

time period?
1970-1980? 1990-2000?

III. Asset Pricing Models

CAPM
Capital Asset Pricing Model 1964, Sharpe, Linter quantifies the risk/return tradeoff

assume
investors choose risky and risk-free asset no transactions costs, taxes same expectations, time horizon risk averse investors

implication
expected return is a function of
beta risk free return market return

E( R ) = R f b[ E( R m ) R f ]
or

E( R ) R f = b[ E( R m ) R f ]
where

E( R ) R f is the portfolio risk premium

E( R m ) R f

is the market risk premium

so if b >1,
E( R ) R f

>

E( R m ) R f

E( R )

> E( R m )

portfolio exp. return is larger than exp. market return riskier portfolio has larger exp. return

so if b <1,
E( R ) R f

<

E( R m ) R f

E( R )

< E( R m )

portfolio exp. return is smaller than exp. market return less risky portfolio has smaller exp. return

so if b =1,
E( R ) R f

E( R m ) R f

E( R )

= E( R m )

portfolio exp. return is same than exp. market return equal risk portfolio means equal exp. return

so if b = 0,
E( R ) R f

=0 =
Rf

E( R )

portfolio exp. return is equal to risk free return

example
Rm = 10%, Rf = 3%, b = 2.5

E( R ) = R f b[ E( R m ) R f ]

E( R ) = 3% 2.5[10% 3%] E( R ) = 3% 17.5% E( R ) = 20.5%

 CAPM tells us size of risk/return tradeoff CAPM tells use the price of risk

Testing the CAPM

CAPM overpredicts returns
return under CAPM > actual return

relationship between and return?

some studies it is positive some recent studies argue no relationship (1992 Fama & French)

 other factors important in determining returns

January effect firm size effect day-of-the-week effect ratio of book value to market value

problems w/ testing CAPM

Roll critique (1977)
CAPM not testable

do not observe E(R), only R do not observe true Rm do not observe true Rf results are sensitive to the sample period

APT
Arbitrage Pricing Theory 1976, Ross assume:
several factors affect E(R) does not specify factors

 implications
E(R) is a function of several factors, F each with its own b

E( R ) R f = b1F1 b2 F2 b3F3 .... b N FN

APT vs. CAPM

APT is more general
many factors unspecified factors

CAPM is a special case of the APT

1 factor factor is market risk premium

testing the APT

how many factors? what are the factors? 1980 Chen, Roll, and Ross
industrial production inflation yield curve slope other yield spreads

summary
known risk/return tradeoff
how to measure risk? how to price risk?

neither CAPM or APT are perfect or free of testing problems both have shown value in asset pricing