INVESTMENT BANKING &

SECURITIES ANALYSIS
ASSET PRICING MODELS
•MODERN PORTFOLIO THEORY
•CAPM
•ALTERNATE PRICING (APT)

Ch. # 8: Reilly & Brown

Ch. # 7: Charles P. Jones

Syed Ghazanfar Ali

Expected Rate of Return

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 Determinants of Rate of Return
 Required Rate of Return (RRR)
 Selection for investment involves finding securities that provide a rate of return
that compensates you for: (1) the time value of money during the period of
investment, (2) the expected rate of inflation during the period, and (3) the risk
Involved.
 The summation of these three components is called the required rate of return.
This is the minimum rate of return that you should accept from an investment
to compensate you for deferring consumption.
 To arrive at RRR, we have to begin with Risk Free Rate (RFR). It is the basic
interest rate, that assumes no inflation and no uncertainty about future flows.
 Govt. T Bills are generally considered as Baseline Rate for RFR because of
certainty. However, they still does not take into account the effect of inflation.
Therefore, this RFR is also called Nominal RFR.
 Once the RFR is adjusted for expected inflation, it is called Real RFR.

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 Fundamental Risk Vs. Systematic Risk:
Fundamental Risk is, as we discussed, Business Risk, Financial Risk, Liquidity Risk,
Exchange Rate Risk, Country Risk
Systematic Risk is the risk associated with Entire Market (not just a sector or
stock) and, hence, also called ‘Market Risk’ or ‘Volatility’ or ‘Undiversifiable Risk’
It is measured in Beta (β) which represents volatility of a stock or portfolio
compared to market as whole (KSE 100 or S&P 500).
Beta of 1 means as volatile as the market
More than 1 is more volatile than the market
Less than 1 is less volatile than the market.
o Studies show that there exists a significant relationship between the market
measure of risk and the fundamental measures of risk. Therefore, the two
measures of risk can be complementary

Risk Premium = f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)
OR
Risk Premium = f (Systematic Market Risk)

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 Relationship between Risk & Return
o We have discussed how to measure risks and rates of return
o Now, risk – return combinations that may be available to investors. And
factors that causes changes in these combinations
o The graph that exhibits these combinations is called Security Market Line
(SML) which is a representation of CAPM theory.
o The higher the risk, the greater the required rate of return.

Where;
E(Ri) is expected return of a security
E(Rm) is Exp. Market return of a portfolio
Rf is Risk free rate
Beta is Systematic risk

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 Theory
Modern Portfolio Theory:
o The modern portfolio theory (MPT) is a practical method for selecting investments in
order to maximize their overall returns within an acceptable level of risk.
o American economist Harry Markowitz pioneered this theory in his paper.
o Most investments are either high risk and high return or low risk and low return.
o This theory suggests that investors could achieve their best results by choosing an
optimal mix of the two based on an assessment of their individual tolerance to risk.
o A key component of the MPT theory is diversification.
o The MPT assumes that investors are risk-averse, meaning they prefer a less risky
portfolio to a riskier one for a given level of return.
o As a practical matter, risk aversion implies that most people should invest in multiple
asset classes. ……… Meaning ????
o Diversification is a portfolio allocation strategy that aims to minimize non-systematic
risk ??????? by holding assets that are not perfectly positively correlated…… ??????
o Correlation is simply the relationship that two variables share, and it is measured using
the correlation coefficient, which lies between -1≤ρ≤1.
o So Diversification (in different assets classes…with different fundamental risk) reduces
the risk of a portfolio.

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 PORTFOLIO THEORIES | Modern Portfolio
Theory
Modern Portfolio Theory (MPT):
◦ Risk and return of a portfolio to be considered and not of individual security
◦ Portfolio diversifies the risk. i.e. multiple assets (classes) for reduced risk and high return.
◦ Therefore, based on a desired (required) rate of return, a portfolio can be constructed with
a reduced risk.
◦ Based on statistical measures such as variance and correlation, a single investment's
performance is less important than how it impacts the entire portfolio.
◦ The expected return of the portfolio is calculated as a weighted sum of the returns of the
individual assets.
◦ If a portfolio contained four equally weighted assets (A,B,C,D) with respective expected
returns (i.e. Probability x possible return) of 4%, 6%, 10%, and 14%, the portfolio's expected
return would be:
◦ (4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%
◦ To calculate the risk of a four-asset portfolio, an investor needs each of the four assets'
variances and six correlation values, since there are six possible ‘two-asset combinations’
with four assets (i.e. AB, AC, AD, BC, BD, CD).
◦ Because of the asset correlations, the total portfolio risk, or standard deviation, is lower
than what would be calculated by a weighted sum. ?????
B/c simple weighted sum would not consider how assets are moving in
relation (co-relation) to each other

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 PORTFOLIO THEORIES | Modern Portfolio
Theory
RISK REDUCTION—THE INSURANCE PRINCIPLE:
o To begin our analysis of how a portfolio of assets can reduce risk, assume that all risk sources
in a portfolio of securities are independent. (no positive correlation)
o As we add securities to this portfolio, effect of a particular source of risk becomes small.
o We are assuming that rates of return on individual securities are statistically independent such
that any one security’s rate of return is unaffected by another’s rate of return.
o In this situation, and only in this situation, the
standard deviation of the portfolio is given by
The variance of portfolio = (Wt. of Asset A)2 * (Var. A) +
(Wt. of B)2 * (Var. B) + 2(Wt. A)(Wt. B)(Covar. of As. A & B)

Std. deviation of portfolio = sqrt(variance of portfolio)

In simple words, the more securities, the less impact

By risk of each security in the overall portfolio (as in
Case of Insurance….. Larger number of policyholders
Mean better cashflows to settle claims)

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 PORTFOLIO THEORIES | CAPM
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship
between the expected return and risk of investing in a security.
It shows that the expected return on a security is equal to the risk-free return plus
a risk premium, which is based on the beta of that security.
It is widely used throughout finance for pricing risky securities and generating
expected returns for assets, given the risk of those assets and cost of capital.

The CAPM is often criticized as unrealistic because of the assumptions on which the
model is based, so it is important to be aware of these assumptions and the reasons
why they are criticized

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 PORTFOLIO THEORIES | CAPM
CAPM – Assumptions:
1.Investors hold diversified portfolios - Means that investors will only require a return for
the systematic risk of portfolios.
2.A standardized holding period is assumed – A return over six months, for example,
cannot be compared to a return over 12 months.
3.Investors can borrow and lend at the risk-free rate of return
4.Perfect capital market
◦ This assumption means that all securities are valued correctly and that their returns will
plot on to the SML.
◦ A perfect capital market requires that:
◦ there are no taxes
◦ No transaction costs;
◦ that perfect information is freely available to all investors
◦ who, as a result, have the same expectations;
◦ that all investors are risk averse, rational and desire to maximize their own utility;
◦ and that there are a large number of buyers and sellers in the market (Price Takers).

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 PORTFOLIO THEORIES | CAPM
Application of CAPM :
Cost of Equity in Capital Budgeting

Since Cost of Equity is the required

Rate of return on equity investment
Therefore, the CAPM formula can
Be written as

Ke = Ri = Rf + (Rm – Rf)

Where
Ke = cost of equity

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 PORTFOLIO THEORIES | Arbitrage
Pricing Theory
The arbitrage pricing theory is a model used to estimate the fair market value of a
financial asset on the assumption that an assets expected returns can be
forecasted based on its linear pattern or relationship to several macroeconomic
factors that determine the risk of the specific asset.
Arbitrage generally refers to the act of exploiting the price differences in a financial
asset in different markets
In APT, it may involve trading in two different assets where an investor sells one
asset that is overvalued as per the theory to buy another that is viewed
undervalued.
ASSUMPTIONS OF APT
ASSUMPTIONS
Unlike the CAPM,OF APT
APT does not assume APT, like the CAPM, does assume that

1. A single-period investment horizon 1. Investors have similar beliefs

2. The absence of taxes 2. Investors are risk-averse utility
3. Borrowing and lending at the rate RF maximizers
4. Investors select portfolios on the basis of 3. Markets are perfect
expected return and variance 4. Returns are generated by a factor model

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 PORTFOLIO THEORIES | Arbitrage
Pricing Theory
For instance, the theoretical fair market value of stock A can be determined using
the Arbitrage pricing model to be $20.However, the stock may be currently trading
at a market price of $11, (i.e.) Therefore, an arbitrageur would buy the stock, based
on the belief that further market price action will quickly correct the market price
back to the $20 per share price.
Alternatively, it may involve trading in two assets. For example, the theoretical fair
market value of stock B can be determined using the Arbitrage pricing model to be
$50.However, the stock may be currently trading at a market price of $65.
Therefore, an arbitrageur would sell the stock, based on the belief that it is
theoretically overpriced and if the market action corrects it, the price will drop.
The proceeds may be used to purchase Stock A which offers better short term
profitability (i.e. Arbitrage).
The arbitrage pricing theory is a multifactor model for financial asset valuation.
Factors, commonly, could be; inflation, GNP / GDP, bond spreads rates, commodity
prices, interest rates, market indices, Exchange rates etc.
The level of volatility in asset prices due to changes by these factors (beta) and
related risk premium determines the APT driven required rate of return.

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 PORTFOLIO THEORIES | Arbitrage
Pricing Theory
Formula: E(ri) = rf + 1*RP1 + 2*RP2 + .. + n*RPn
E(ri) - Expected return (r) on the financial asset i
rf - Risk-free rate of return
n (or Beta)- price volatility in relation to macroeconomic factor
RPn Risk premium of macroeconomic factor n
EXAMPLE:
•The following four macroeconomic factors have been identified.
•The stock’s sensitivity to each factor and the risk premium associated with each
factor have been given as below:
Gross domestic product (GDP) growth: = 0.6, RP = 4%
Inflation rate: = 0.8, RP = 2%
Gold prices: = -0.7, RP = 5%
Standard and Poor's 500 index return: = 1.3, RP = 9%
The risk-free rate is 3%
To calculate the expected return using the Arbitrage pricing theory
Solution; E(ri) = rf + 1 * RP1 + 2 * RP2 + ... + n * RPn
Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%

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QUIZ # 2

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 COMMON STOCK VALUATION |
Techniques
Common Stock Valuation Techniques / Approaches.
Major approaches to valuing common stocks using fundamental security analysis
include
1. Discounted cash flow (DCF) techniques
◦ Present value of estimated future cash flows discounted for time value of money (RRR)

2. Earnings multiplier approach.

◦ Based on estimated earning and a multiplier (EPS, P/E)

3. Relative valuation metrics

◦ Comparative analysis (peer / overall / Past) on few ratios (P/E, P/BV etc.) to pick a stock

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SESSION 5
Thank You

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