INVESTMENT ANALYSIS AND

PORTFOLIO MANAGEMENT

CAPITAL ASSET PRICING MODEL

 OBJECTIVES OF OUR STUDY
 What are the assumptions of the capital asset
pricing model?
 What is a risk-free asset and what are its risk-
return characteristics?
 What is the covariance and correlation between
the risk-free asset and a risky asset or portfolio
of risky assets?
 What is the expected return when you combine
the risk-free asset and a portfolio of risky
assets?
 What is the standard deviation when you
combine the risk-free asset and a portfolio of
risky assets?
 OBJECTIVES OF OUR STUDY
 When you combine the risk-free asset and a
portfolio of risky assets on the Markowitz
efficient frontier, what does the set of possible
portfolios look like?
 Given the initial set of portfolio possibilities with
a risk-free asset, what happens when you add
financial leverage (that is, borrow)?
 What is the market portfolio, what assets are
included in this portfolio, and what are the
relative weights for the alternative assets
included?
 What is the capital market line (CML)?
 What do we mean by complete diversification?
 OBJECTIVES OF OUR STUDY
 How do we measure diversification for an
individual portfolio?
 What are systematic and unsystematic risk?
 Given the CML, what is the separation theorem?
 Given the CML, what is the relevant risk
measure for an individual risky asset?
 What is the security market line (SML), and how
does it differ from the CML?
 What is beta, and why is it referred to as a
standardized measure of systematic risk?
 How can you use the SML to determine the
expected (required) rate of return for a risky
asset?
 OBJECTIVES OF OUR STUDY

 Using the SML, what do we mean by an

undervalued and overvalued security, and how do
we determine whether an asset is undervalued or
overvalued?
 What is an asset’s characteristic line, and how do
you compute the characteristic line for an asset?
 What is the impact on the characteristic line when
you compute it using different return intervals
(such as weekly versus monthly) and when you
employ different proxies (that is, benchmarks) for
the market portfolio
 What happens to the capital market line (CML)
when you assume there are differences in the
risk-free borrowing and lending rates?
 OBJECTIVES OF OUR STUDY
 What is a zero-beta asset and how does its use
impact the CML?
 What happens to the security line (SML) when
you assume transactions costs, heterogeneous
expectations, different planning periods, and
taxes?
 What are the major questions considered when
empirically testing the CAPM?
 What are the empirical results from tests that
examine the stability of beta?
 How do alternative published estimates of beta
compare?
 OBJECTIVES OF OUR STUDY

What are the results of studies that

examine the relationship between
systematic risk and return?
What other variables besides beta have
had a significant impact on returns?
What is the theory regarding the “market
portfolio” and how does this differ from the
market proxy used for the market
portfolio?
Assuming there is a benchmark problem,
what variables are affected by it?
 RECALLING PORTFOLIO THEORY

• One basic assumption of portfolio theory is that as an

investor you want to maximize the returns from your
investments for a given level of risk.
• Investors are basically risk averse, meaning that, given
a choice between two assets with equal rates of return,
they will select the asset with the lower level of risk.
• This does not imply that everybody is risk averse or that
investors are completely risk aversive regarding all
financial commitments.
• Certain people buy lottery tickets and gamble at race
tracks or in casinos, where it is known that the expected
returns are negative, which means that participants are
willing to pay for the excitement of the risk involved.
 RECALLING PORTFOLIO THEORY

• Our basic assumption is that most

investors committing large sums of money
to developing an investment portfolio are
risk aversive.
• It gives a positive relationship between
expected return and expected risk.
• Historically we also find that there is
generally a positive relationship between
the rates of return on various assets and
their measures of risk.
 RECALLING PORTFOLIO THEORY
• Risk is the uncertainty of future outcomes
• An alternative definition might be the probability of an
adverse outcome.
• In the early 1960s, the investment community talked
about risk, but there was no specific measure for the
term.
• The basic portfolio model was developed by Harry
Markowitz, who derived the expected rate of return for a
portfolio of assets and an expected risk measure.
• Markowitz showed that the variance of the rate of return
was a meaningful measure of risk.
• This portfolio variance formula indicated the importance
of diversifying your investments to reduce the total risk of
a portfolio but also showed how to effectively diversify.
 RECALLING PORTFOLIO THEORY

• Although there are numerous potential

measures of risk, variance or standard
deviation of returns are used because:
this measure is somewhat intuitive;
it is a correct and widely recognized risk
measure; and
it has been used in most of the theoretical
asset pricing models.
 RECALLING PORTFOLIO THEORY

• Expected return of an individual stock

Computation of Expected Return for an
individual risky stock
Expected Return

E( R )=
 RECALLING PORTFOLIO THEORY

• Expected return on portfolio of risky assets

Computation of Expected Return for a portfolio
of risky assets:
 RECALLING PORTFOLIO THEORY

Measurement of Risk
• Variance or the standard deviation of expected
returns is used as the measure of risk.
• Measurement of risk for an individual
Investment:

• Pi is the probability of the possible rate of return, Ri

 RECALLING PORTFOLIO THEORY
• COMPUTATION OF THE VARIANCE OF THE EXPECTED RATE
OF RETURN FOR AN INDIVIDUAL RISKY ASSET
 RECALLING PORTFOLIO THEORY

Measurement of Risk (cont’d)

Measurement of Risk for a portfolio:
Two basic concepts in statistics
• covariance; and
• correlation,
must be understood before we discuss
the formula for the variance of the rate of
return for a portfolio.
 RECALLING PORTFOLIO THEORY
• Covariance is a measure of the degree to which two
variables “move together” relative to their individual
mean values over time.
– A positive covariance means that the rates of return for two
investments tend to move in the same direction relative to their
individual means during the same time period.
– a negative covariance indicates that the rates of return for two
investments tend to move in different directions relative to their
means during specified time intervals over time.
– The magnitude of the covariance depends on the variances of
the individual return series, as well as on the relationship
between the series.
– For two assets, i and j, the covariance of rates of return is
defined as:
RECALLING PORTFOLIO THEORY
 RECALLING PORTFOLIO THEORY

Standard Deviation of a Portfolio

RECALLING PORTFOLIO THEORY
RECALLING PORTFOLIO THEORY
RECALLING PORTFOLIO THEORY
RECALLING PORTFOLIO THEORY
RECALLING PORTFOLIO THEORY
 CAPITAL ASSET PRICING MODEL
• Following the development of portfolio theory by
Markowitz, two major theories have been put forth that
derive a model for the valuation of risky assets.
• In first session I will introduce one of these two models—
that is, the capital asset pricing model (CAPM).
• The background on the CAPM is important at this point
because the risk measure implied by this model is a
necessary input for our subsequent discussion on the
valuation of risky assets.
• The presentation concerns capital market theory and the
capital asset pricing model that was developed almost
concurrently by three individuals.
• Subsequently, an alternative multifactor asset valuation
model was proposed, the arbitrage pricing theory (APT).
• This has led to the development of numerous other
multifactor models that are the subject of 2nd session.
 CAPITAL ASSET PRICING MODEL
• Capital market theory extends portfolio theory
and develops a model for pricing all risky assets.
The final product, the capital asset pricing
model (CAPM), will allow you to determine the
required rate of return for any risky asset.
• We begin with the background of capital market
theory that includes the underlying assumptions
of the theory and a discussion of the factors that
led to its development. This includes an
analysis of the effect of assuming the
existence of a risk-free asset.
• Notably, assuming the existence of a risk-free
rate has significant implications for the potential
return and risk and alternative risk-return
combinations.
 CAPITAL ASSET PRICING MODEL
Assumptions of Capital Market Theory

1. All investors are Markowitz efficient investors who want to target

points on the efficient frontier. The exact location on the efficient
frontier and, therefore, the specific portfolio selected will depend on
the individual investor’s risk-return utility function.
2. Investors can borrow or lend any amount of money at the risk-free
rate of return (RFR).
3. All investors have homogeneous expectations; that is, they estimate
identical probability distributions for future rates of return.
4. All investors have the same one-period time horizon
5. All investments are infinitely divisible,
6. There are no taxes or transaction costs involved in buying or selling
assets.
7. There is no inflation or any change in interest rates, or inflation is fully
anticipated.
8. Capital markets are in equilibrium.
 CAPITAL ASSET PRICING MODEL

• The assumption of a risk-free asset in the economy is

critical to asset pricing theory. Therefore, first we will
understand the meaning of a risk-free asset and shows its
effect on the risk and return measures when this risk-free
asset is combined with a portfolio.
• As the expected return on a risk-free asset is entirely
certain, the standard deviation of its expected return is
zero . The rate of return earned on such an asset
should be the risk-free rate of return (RFR),
• When we introduce this risk-free asset into the risky world
of the Markowitz portfolio model we find the covariance
of the risk-free asset with any risky asset or portfolio of
assets will always equal zero.
 CAPITAL ASSET PRICING MODEL
Combining a Risk-Free Asset with a Risky
Portfolio
• What happens to the average rate of return and
the standard deviation of returns when you
combine a risk-free asset with a portfolio of risky
assets?
1. Expected Return Like the expected return for a
portfolio of two risky assets, the expected rate of
return for a portfolio that includes a risk-free asset
is the weighted average of the two returns:
 CAPITAL ASSET PRICING MODEL
Combining a Risk-Free Asset with a Risky Portfolio
2. Standard Deviation the expected variance for a two-asset portfolio
is:

Substituting for the values for risk free assets:

We know that the variance of the risk-free asset is zero, that is, σ2RF =
0. Because the correlation between the risk-free asset and any risky
asset is also zero, the factor rRF,i in the preceding equation also
equals zero. Therefore, any component of the variance formula that
has either of these terms will equal zero. When you make these
adjustments, the formula becomes:

The standard deviation is

Therefore, the standard deviation of a portfolio that combines the risk-

free asset with risky assets is the linear proportion of the standard
deviation of the risky asset portfolio.
 CAPITAL ASSET PRICING MODEL
Combining a Risk-Free Asset with a Risky Portfolio
 CAPITAL ASSET PRICING MODEL
Combining a Risk-Free Asset with a Risky Portfolio
• Therefore, both return and risk increase in a
linear fashion along the original Line RFR-M, and
this extension dominates everything below the
line on the original efficient frontier.
• Thus, you have a new efficient frontier: the
straight line from the RFR tangent to Point M.
This line is referred to as the capital market line
(CML)
 CAPITAL ASSET PRICING MODEL
The Market Portfolio

• Because Portfolio M lies at the point of tangency, it has

the highest portfolio possibility line, and everybody will
want to invest in Portfolio M and borrow or lend to be
somewhere on the CML. This portfolio must, therefore,
include all risky assets.
• This portfolio that includes all risky assets is referred to as
the market portfolio.
• Because the market portfolio contains all risky assets, it is
a completely diversified portfolio, which means that all
the risk unique to individual assets in the portfolio is
diversified away.
• Specifically, a completely diversified portfolio would have
a correlation with the market portfolio of +1.00. This is
logical because complete diversification means the
elimination of all the unsystematic or unique risk.
 CAPITAL ASSET PRICING MODEL

The Market Portfolio

 CAPITAL ASSET PRICING MODEL
• Now we can proceed to use it to determine an
appropriate expected rate of return on a risky
asset. This step takes us into the capital asset
pricing model (CAPM), which is a model that
indicates what should be the expected or required
rates of return on risky assets.
• To accomplish the foregoing, we demonstrate the
creation of a security market line (SML) that
visually represents the relationship between risk
and the expected or the required rate of return on
an asset.
• The equation of this SML, together with estimates
for the return on a risk-free asset and on the
market portfolio, can generate expected or
required rates of return for any asset based on its
systematic risk.
 CAPITAL ASSET PRICING MODEL
• We know that the relevant risk measure for an individual risky asset is
its covariance with the market portfolio (Covi,M).
• Therefore, we can draw the risk-return relationship as shown below
with the systematic covariance variable (Covi,M) as the risk measure.
 CAPITAL ASSET PRICING MODEL
• The return for the market portfolio (RM) should be
consistent with its own risk, which is the covariance of the
market with itself. If you recall the formula for covariance,
you will see that the covariance of any asset with itself is
its variance,
Covi,i = σi2.
• In turn, the covariance of the market with itself is the
variance of the market rate of return Cov = σM2.
M,M

• Therefore, the equation for the risk-return line in the

previous graph will be:

• Defining Covi M / σM2 as beta, (βi), this equation can be

stated:
E(Ri) = RFR + βi (RM – RFR)
 CAPITAL ASSET PRICING MODEL
• Beta can be viewed as a standardized measure of systematic
risk.
• Specifically, we already know that the covariance of any asset i
with the market portfolio (CoviM) is the relevant risk measure.
• Beta is a standardized measure of risk because it relates this
covariance to the variance of the market portfolio.
• As a result, the market portfolio has a beta of 1. Therefore, if the
βi for an asset is above 1.0, the asset has higher normalized
systematic risk than the market, which means that it is more
volatile than the overall market portfolio.
• Given this standardized measure of systematic risk, the SML
graph can be expressed as shown on next page. This is the
same graph as shown on previous page, except there is a
different measure of risk. Specifically, the graph (next page)
replaces the covariance of an asset’s returns with the market
portfolio as the risk measure with the standardized measure of
systematic risk (beta), which is the covariance of an asset with
the market portfolio divided by the variance of the market
portfolio.
CAPITAL ASSET PRICING MODEL
 CAPITAL ASSET PRICING MODEL
Determining the Expected Rate of Return for a Risky Asset
• To demonstrate how you would compute the expected or required
rates of return, consider the following example stocks assuming you
have already computed betas:

• Assume that we expect the economy’s RFR to be 6 percent (0.06) and

the return on the market portfolio (RM) to be 12 percent (0.12). This
implies a market risk premium of 6 percent (0.06). With these inputs,
the SML equation would yield the following expected (required) rates
of return for these five stocks:
CAPITAL ASSET PRICING MODEL
CAPITAL ASSET PRICING MODEL
 CAPITAL ASSET PRICING MODEL
• Stock A has lower risk than the aggregate market, so
you should not expect (require) its return to be as high
as the return on the market portfolio of risky assets. You
should expect (require) Stock A to return 10.2 percent.
• Stock B has systematic risk equal to the market’s (beta =
1.00), so its required rate of return should likewise be
equal to the expected market return (12 percent).
• Stocks C and D have systematic risk greater than the
market’s, so they should provide returns consistent with
their risk.
• Finally, Stock E has a negative beta (which is quite rare
in practice), so its required rate of return, if such a stock
could be found, would be below the RFR.
CAPITAL ASSET PRICING MODEL
CAPITAL ASSET PRICING MODEL
 CAPITAL ASSET PRICING MODEL
EMPIRICAL TESTS OF THE CAPM
• When testing the CAPM, there are two major questions.
• First, How stable is the measure of systematic risk
(beta)? Because beta is our principal risk measure, it is
important to know whether past betas can be used as
estimates of future betas.
Also, how do the alternative published estimates of beta compare?
• Second, Is there a positive linear relationship as
hypothesized between beta and the rate of return on
risky assets? More specifically, how well do returns
conform to the following SML equation, discussed earlier
 CAPITAL ASSET PRICING MODEL

EMPIRICAL TESTS OF THE CAPM

• Numerous studies have examined the stability of beta
and generally concluded that the risk measure was not
stable for individual stocks but the stability of the beta for
portfolios of stocks increased dramatically. The larger
the portfolio of stocks (e.g., over 50 stocks)
• The longer the period (over 26 weeks), the more stable
the beta of the portfolio.
• Also, the betas tended to regress toward the mean.
Specifically, high-beta portfolios tended to decline over
time toward unity (1.00), whereas low-beta portfolios
tended to increase over time toward unity.
 CAPITAL ASSET PRICING MODEL

• Another factor that affects the stability of beta is how

many months are used to estimate the original beta and
the test beta. Roenfeldt, Griepentrog, and Pflamm (RGP)
compared betas derived from 48 months of data to
subsequent betas for 12, 24, 36, and 48 months.
• The 48- month betas were not good for estimating
subsequent 12-month betas but were quite good for
estimating 24-, 36-, and 48-month betas.
• To summarize, individual betas were generally volatile
over time whereas large portfolio betas were stable.
Also, it is important to use at least 36 months of data to
estimate beta and be conscious of the stock’s trading
volume and size.
 CAPITAL ASSET PRICING MODEL

ARBITRAGE PRICING THEORY

• What is the arbitrage pricing theory (APT)

and what are its similarities and
differences relative to the CAPM?
 CAPITAL ASSET PRICING MODEL

ARBITRAGE PRICING THEORY

• Arbitrage Pricing Theory (APT), was
developed by Ross in the mid-1970s with three
major assumptions:
1. Capital markets are perfectly competitive.
2. Investors always prefer more wealth to less wealth
with certainty.
3. The stochastic process generating asset returns can
be expressed as a linear function of a set of K risk
factors (or indexes).
 CAPITAL ASSET PRICING MODEL

ARBITRAGE PRICING THEORY