Professional Documents
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McGraw-Hill/Irwin
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Chapter Outline
12.1 Introduction 12.2 Systematic Risk and Betas 12.3 Portfolios and Factor Models 12.4 Betas and Expected Returns 12.5 The Capital Asset Pricing Model and the Arbitrage Pricing Theory 12.6 Empirical Approaches to Asset Pricing
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Since no investment is required, an investor can create large positions to secure large levels of profit. In efficient markets, profitable arbitrage opportunities will quickly disappear.
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Total Risk
Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk. For well-diversified portfolios, unsystematic risk is very small. Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk.
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Fi !
Cov( Ri , RM ) W ( RM )
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FI
GNP
FGNP
FS
is the inflation beta is the GNP beta is the spot exchange rate beta
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GNP S
FI
GNP
FGNP
FS
Finally, the firm was able to attract a superstar CEO, and this unanticipated development contributes 1% to the return. ! 1%
R ! R 2.30 v FI 1.50 v FGNP 0.50 v FS 1%
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If it were the case that the inflation rate was expected to be 3%, but in fact was 8% during the time period, then: FI = Surprise in the inflation rate = actual expected = 8% 3% = 5%
R ! R 2.30 v 5% 1.50 v FGNP 0.50 v FS 1%
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If it were the case that the rate of GNP growth was expected to be 4%, but in fact was 1%, then: FGNP = Surprise in the rate of GNP growth = actual expected = 1% 4% = 3%
R ! R 2.30 v 5% 1.50 v (3%) 0.50 v FS 1%
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If it were the case that the dollar-euro spot exchange rate, S($,), was expected to increase by 10%, but in fact remained stable during the time period, then: FS = Surprise in the exchange rate = actual expected = 0% 10% = 10%
R ! R 2.30 v 5% 1.50 v ( 3%) 0.50 v ( 10 %) 1%
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Finally, if it were the case that the expected return on the stock was 8%, then:
R ! 8%
R ! 8% 2.30 v 5% 1.50 v (3%) 0.50 v (10%) 1% R ! 12%
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Relationship Between the Return on the Common Factor & Excess Return
Excess return
Ri R i !
F
Ii
If we assume that there is no unsystematic risk, then Ii = 0. The return on the factor F
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Relationship Between the Return on the Common Factor & Excess Return
Excess return
Ri R i !
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Relationship Between the Return on the Common Factor & Excess Return
Excess return
A
! 1.5
! 1.0
C
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F
RP ! X 1 ( R 1 . X N (R N
F 1) X 2 (R2
N
F 2)
F
)
2
RP ! X 1 R 1 X 1 1 F X 1 1 X 2 R 2 X 2 . X N RN X N
N
F X2
F XN
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RP ! X 1 R1 X 2 R 2 . X N R N
( X1 1 X 2 2 . X N N )F X1 1 X 2 2 . X N N
In a large portfolio, the third row of this equation disappears as the unsystematic risk is diversified away.
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The weighted average of expected returns. The weighted average of the betas times the factor F. RP ! X 1 R 1 X 2 R 2 . X N R N ( X1
1
X2
. X N
)F
In a large portfolio, the only source of uncertainty is the portfolios sensitivity to the factor.
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. X N
P
)F
and P ! X1
. X N
The return on a diversified portfolio is the sum of the expected return plus the sensitivity of the portfolio to the factor.
RP ! R P
P
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RF
R ! RF ( R P RF )
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12.5 The Capital Asset Pricing Model and the Arbitrage Pricing Theory
APT applies to well diversified portfolios and not necessarily to individual stocks. With APT it is possible for some individual stocks to be mispriced - not lie on the SML. APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio. APT can be extended to multifactor models.
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Quick Quiz
Differentiate systematic risk from unsystematic risk. Which type is essentially eliminated with well diversified portfolios? Define arbitrage. Explain how the CAPM be considered a special case of Arbitrage Pricing Theory?
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