Asset pricing Models

Unit III
Borrowing and Lending Possibilities

 Risk-free assets
 Certain-to-be-earned expected return, zero variance
 No correlation with risky assets
 Usually proxied by a Treasury Bill
 Amount to be received at maturity is free of default risk, known with
certainty
 Adding a risk-free asset extends and changes the efficient
frontier
 Combining a Risk-Free Asset
with a Risky Portfolio
Expected return
the weighted average of the two returns

E(R port )  WRF (RFR)  (1 - WRF )E(R i )

This is a linear relationship

3
 Combining a Risk-Free Asset
with a Risky Portfolio
Standard deviation
The expected variance for a two-asset portfolio is

E( 2
port )  w   w   2 w 1 w 2 r1,2 1 2
2
1
2
1
2
2
2
2
Substituting the risk-free asset for Security 1, and the risky asset for Security 2,
this formula would become

E( port
2
)  w 2RF RF
2
 (1  w RF ) 2  i2  2 w RF (1 - w RF )rRF,i RF  i
Since we know that the variance of the risk-free asset is zero and the correlation
between the risk-free asset and any risky asset i is zero we can adjust the
formula

E( port
2
)  (1  w RF ) 2  i2
4
Impact of Risk-Free Lending

 If wRF placed in a risk-free asset

 Expected portfolio return

E(R p )  w RFRF  (1 - w RF )E(R X )

– Risk of the portfolio
 p  (1 - w RF ) X

 Expected return and risk of the portfolio

with lending is a weighted average
Expected return and risk

An investor can combine a risky investment with a riskless security such as an

investment in treasury bill. Assume that the an investor has Rs. 1000.He
chooses to invest 35% in common stock and 65% in risk-free asset.

Common Risk-free
stock(Merville)
Expected Return (ER) 14% 10%
Standard Deviation .20 0
Expected return and risk
 E(R)=(.35x.14+(.65x.10)=0.114 0r 11.4%
 Variance of the portfolio=(.35)2 x(.20) 2 =.0049
Standard deviation of portfolio composed
of the riskless asset and one risky asset= .35 × .20= .07
Relationship between expected return
and risk
Relationship between expected return
and risk
Borrowing Possibilities

 Investor no longer restricted to own wealth

 Interest paid on borrowed money
 Higher returns sought to cover expense
 Assume borrowing at RF
 Risk will increase as the amount of borrowing increases
 Financial leverage
Borrowing (leverage)
 Suppose that, alternatively, one borrows RS.200 at the risk-free
rate. Combining this with her original sum of Rs.1,000, one
invests a total of Rs.1,200 in Merville. The expected return would
be:
 Expected return on portfolio formed by borrowing = 14.8% =
1.20 × .14 + (−.2 × .10) to invest in risky asset
 Here, one invests 120 percent of original investment of Rs.1,000
by borrowing 20 percent of original investment. Note that the
return of 14.8 percent is greater than the 14 percent expected
return on Merville Enterprises. This occurs because one is
borrowing at 10 percent to invest in a security with an expected
return greater than 10 percent.
 The standard deviation is: Standard deviation of portfolio formed
by borrowing to invest in risky asset = .24 = 1.20 × .2
Borrowing (leverage)
 The standard deviation of .24 is greater than .20, the
standard deviation of the Merville investment, because
borrowing increases the variability of the investment. This
investment also appears in Figure 11.8.
 So far, we have assumed that Ms. Bagwell is able to borrow at
the same rate at which she can lend.
 Now let us consider the case where the borrowing rate is
above the lending rate. The dotted line in Figure 11.8
illustrates the opportunity set for borrowing opportunities in
this case. The dotted line is below the solid line because a
higher borrowing rate lowers the expected return on the
investment
The New Efficient Set
 Risk-free investing and borrowing creates a new set of
expected return-risk possibilities
 Addition of risk-free asset results in
 A change in the efficient set from an arc to a straight line
tangent to the feasible set without the riskless asset
 Chosen portfolio depends on investor’s risk-return preferences
Portfolio Choice
 The more conservative the investor, the more that is placed
in risk-free lending and the less in borrowing
 The more aggressive the investor, the less that is placed in
risk-free lending and the more in borrowing
 Most aggressive investors would use leverage to invest more in
portfolio T
Portfolio Possibilities Combining the Risk-Free Asset
and Risky Portfolios on the Efficient Frontier

E(R port )

RFR

15
E( port )
Capital Asset Pricing Model

The capital asset pricing model is a set of

predictions concerning equilibrium expected
returns on risky assets. Harry Markowitz laid
down the foundation of modern portfolio
management in 1952. The CAPM was developed
12 years later in articles by William Sharpe, John
Lintner, and Jan Mossin.
 Capital Market Theory:
An Overview
 Capital market theory extends portfolio theory and develops
a model for pricing all risky assets.
 Capital asset pricing model (CAPM) is widely used for
portfolio selection, performance evaluation and capital
budgeting

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The Capital Asset Pricing Model (CAPM)
 Capital market theory is concerned with equilibrium security
prices and returns and how they are related to the risk-
expected return trade-off that investors face
 It measures the relative risk of an individual security and the
relationship between risk and the returns expected from
investing
 Capital Market Line - CML
A line used in the capital asset pricing model to illustrate the
rates of return for efficient portfolios depending on the risk-
free rate of return and the level of risk (standard deviation)
for a particular portfolio.

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Assumptions Behind the CAPM
1. The capital market is characterized by perfect competition.
2. All investors choose their portfolio according to the mean-
variance criterion.
3. All investors have homogeneous expectations regarding the
future in terms of means, variances and covariances. (This
implies investors have the same investment horizon.)
4. Investors can borrow and lend at the risk-free rate.
Capital Market Line (CML)
 Depicts the equilibrium conditions that prevail in the market
for efficient portfolios consisting of the optimal portfolio of
risk-free and risky assets.

 It traces out the risk-return trade off for efficient portfolio.

Portfolio is M is tangent to straight line drawn from RF
Capital Market Line (CML)
The CML and the Components of Its Slope
CML
 Equilibrium in the security line is characterized by two key
numbers:
 The first is the vertical intercept of CML ( risk-free rate)
 The second is the slope of the CML( reward per unit of risk
born)
 Security market is place where time and risk can be traded.
Capital Market Line (CML)
 Slope of the CML is the market price of risk for efficient
portfolios

 Slope of the CML =

E ( RM )  RF
M
 The CML is always upward sloping because the price of
risk is always positive
Market portfolio
 Market portfolio:
This portfolio that includes all risky assets is referred to as the market
portfolio. It includes not only common stocks but all risky assets, but
bonds, options, real estate, coins, stamps, art, or antiques. 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. This unique (diversifiable) risk is also referred to as
unsystematic risk. This implies that only systematic risk, which is
defined as the variability in all risky assets caused by
macroeconomic variables, remains in the market portfolio.

•Proxied by some broad-based market index.

•It plays central role in CML.

The security market Line
 Capital Market Line depicts the risk-return tradeoff in
financial market in equilibrium.
 It applies only to efficient portfolios and can not be based be
used to assess individual securities or inefficient portfolios.
 An investor should hold diversified portfolio to reduce
portfolio risk.
 The risk that matters in the world of CAPM is non-
diversifiable, market risk or systematic risk.
 The Security Market Line (SML)
The equation for the risk-return line is

R M - RFR
E(R i )  RFR  (Cov i,M )
 2
M
Cov i,M
 RFR  (R M - RFR)
 2
M
We then define as beta
Cov i, M ( i )
 M2
E(R i )  RFR   i (R M - RFR)
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Beta of market portfolio
Beta
 Beta – the measure of the systematic risk of a security
that cannot be avoided through diversification
 Beta measures a security’s volatility in price relative to a
benchmark( Market portfolio).
• Beta – risk-free asset = 0
– market portfolio = 1.0
• Stocks -  betas are higher risk securities
 betas are lower risk securities
The Security Market Line: I
Under the assumptions of the CAPM, only compensating investors
for bearing systemic risk, the following linear risk-return relation
should hold:

E(Ri)  r  [E(Rm) – r] × i
  
Expected Rate of Return  Risk-Free Rate  Risk Premium
Security market line
 Aggressive, Neutral and Defensive
Assets

 Aggressive Asset
 i > 1, asset i has more (systematic) risk than the
market.
 Neutral Asset
 i  1, asset i has the same (systematic) risk as the
market.
 Defensive Asset
 i < 1, asset i has less (systematic) risk than the market.
Estimating an Asset’s Beta:
The Security Market Line:
III – Illustration
 Determining the Expected
Rate of Return for a Risky Asset
E(R i )  RFR   i (R M - RFR)
 The expected rate of return of a risk asset is determined by
the RFR plus a risk premium for the individual asset
 The risk premium is determined by the systematic risk of the
asset (beta) and the prevailing market risk premium (R M-
RFR)

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A negative beta stock
 Calculating Systematic Risk:
The Characteristic Line
The systematic risk input of an individual asset is derived from a
regression model, referred to as the asset’s characteristic line with
the model portfolio:

where:
R i, t   i   i R M, t  
Ri,t = the rate of return for asset i during period t
RM,t = the rate of return for the market portfolio M during t

i  R i - iR m
i  Cov i,M
M
2

  the random error term

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Calculation of beta
Calculation of beta
COV(RA,RM)=221/15=15.79
Variance of market=624/15=44.57

Beta = Covariance(stock price, market index)

Variance(market index)

=15.79/44.57=0.354
Portfolio Betas
 Are weighted averages of the betas for individual securities in
the portfolio

 The equation is:

 p  w11  w2  2  ...wn  n
 Exercise
If E(r m) - rf = .08 and rf = .03
Calculate exp. ret. based on betas given below:
 x = 1.25
E(rx) = .03 + 1.25(.08) = .13 or 13%

 y = .6
E(ry) = .03 + .6(.08) = .078 or 7.8%

45
 Graph of Sample Calculations

E(r)
SML
Rx=13% .08
Rm=11%
Ry=7.8%
3%
ß
.6 1.0 1.25
46
ßy ßm ßx
 Disequilibrium Example
 Suppose a security with a beta of 1.25 is offering expected
return of 15%
 According to SML, it should be 13%
 So the security is underpriced: offering too high of a rate of
return for its level of risk

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Over- and Undervalued Securities
• Securities plotted above the SML are undervalued because
they offer more expected return given its beta
• Securities plotted below the SML are overvalued because
they offer less expected return given its beta
Over- and Undervalued Securities
(contd)
 Arbitrage Pricing Theory
 Arbitrage Pricing Theory was developed by Stephen Ross (1976).
His theory begins with an analysis of how investors construct
efficient portfolios and offers a new approach for explaining the
asset prices and states that the return on any risky asset is a linear
combination of various macroeconomic factors.
 Similar to CAPM it assumes that investors are fully diversified and
the systematic risk is an influencing factor in the long run. However,
unlike CAPM model APT specifies a simple linear relationship
between asset returns and the associated factors because each share
or portfolio may have a different set of risk factors and a different
degree of sensitivity to each of them.

51
Assumptions of APT
 The capital market is characterized by perfect competition.
 All investors have the same expectations regarding the future
in terms of mean, variance and covariance terms
(homogeneous expectations).
 Investors prefer more wealth to less wealth. Note that no
assumptions are made regarding risk attitude; investors may
be risk-average, risk-neutral or even risk-seeking.
 A very large number of capital assets exist in the economy.
The number of assets is sufficiently large to create portfolios
with no non-systematic risk and with any desired values for
the factor sensitivity coefficients (the betas)
 Arbitrage
• Arbitrage - arises if an investor can construct a zero
investment portfolio with a sure profit.
 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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Arbitrage (contd.)
Arbitrage:

 A strategy that makes a positive return without requiring an

initial investment.
 In other words: arbitrage opportunities exist when two items
that are the same sell at different prices.
 A simple case of arbitrage
 If one can borrow an unlimited amount of money at 5% and lend at
6%, then potential profit would be infinite. Such a case is called “
money machine”
Factor Risk Models
 Relate the common movements of asset prices to a series of
common risk factors.

 Examined here:

SIM (Single Index Model)

MIM (Multiple Index Model)
 The Single Index Model: II
Relationship:

Where:

Ri is the rate of return on asset i,

I is the percentage change in the common risk factor,
ei is asset-specific component,
βi measures the sensitivity of the ith asset’s return to changes in
the common risk factor.
 The Multiple Index Model

 Allows for several common factors to influence a given

asset’s rate of return.

 Relationship:
The Arbitrage Pricing Theory: II
 The APT investigates the market equilibrium prices when all
arbitrage opportunities are eliminated.

 The APT implies a linear equilibrium relationship between

expected return and the factor sensitivities (betas)
 The Arbitrage Pricing Theory:
 The expected return on a security under the APT with a
single factor is given by:

 The expected return on a security under the APT with

multiple factors is given by:
APT vs. CAPM
 Both models are based on completely different sets of
assumptions.
 APT employs fewer restrictive assumptions
 In APT, no particular role for the “Market Portfolio,” which can’t be measured
anyway
 None the less, both models can predict the same risk-return
relationship: when the asset returns obey the SIM the APT
relationship is identical to the SML.
Empirical evidence.
APT does NOT specify the systematic factors
Chen, Roll and Ross (1986) suggest:
 Industrial production
Yield curve
 Default spreads
 Inflation