Capital Asset Pricing Model(CAPM) : 4/24/2011 Capital Asset Pricing Model 1 Capital Asset Pricing Model(CAPM) E[Ri] = RF + βi (RM – RF)
Risk and Return : 4/24/2011 Capital Asset Pricing Model 2 Risk and Return Find the expected return for Company A and B.
Find the standard deviation for Company A and B.
Find Expected Return : 4/24/2011 Capital Asset Pricing Model 3 Find Expected Return
Slide 4 : 4/24/2011 Capital Asset Pricing Model 4 Find Standard Deviation =3.8%
Risk and Return : 4/24/2011 Capital Asset Pricing Model 5 Risk and Return Standard
Deviation | |
Portfolio Risk and the Phantom Egg Crusher : 4/24/2011 Capital Asset Pricing Model 6 Portfolio Risk and the Phantom Egg Crusher Your Portfolio Market
Lessons from P.E.C. : 4/24/2011 Capital Asset Pricing Model 7 Lessons from P.E.C. 1. Assets are not held in isolation; rather, they are held as parts of portfolios.
2. Assets are priced according to their value in a portfolio.
3. Investors are concerned about how the portfolio of stocks perform--not individual stocks.
Risk and Return : 4/24/2011 Capital Asset Pricing Model 8 Risk and Return Expected return for Sun Tan Company = 12%
Expected return for Umbrella Company = 12%
Standard deviation for Sun Tan Company = 17.15%
Standard deviation for Umbrella Company = 17.15% Find the expected return and standard deviation for a portfolio which invests half its money in the Sun Tan and half its money in Umbrella Company.
Portfolio Risk and Return : 4/24/2011 Capital Asset Pricing Model 9 Portfolio Risk and Return
Portfolio Risk and Return : 4/24/2011 Capital Asset Pricing Model 10 Portfolio Risk and Return
Lessons from Tahitian Island : 4/24/2011 Capital Asset Pricing Model 11 Lessons from Tahitian Island 1. Combining securities into portfolios reduces risk.
2. How? A portion of a stock’s variability in return is canceled by complementary variations in the return of other securities
3. However, since to some extent stock prices (and returns) tend to move in tandem, not all variability can be eliminated through diversification.
or
Even investors holding diversified portfolios are exposed to the risk inherent in the overall performance of the stock market.
4. Therefore,
Total Risk = unsystematic + systematic
diversifiable nondiversifiable
firm specific market
Portfolio Choice : 4/24/2011 Capital Asset Pricing Model 12 Portfolio Choice Standard
Deviation
Risk and Return : 4/24/2011 Capital Asset Pricing Model 13 Risk and Return Standard
Deviation ρ = - 1 1 2 ρ= 1
Variability of Returns Compared with Size of Portfolio : 4/24/2011 Capital Asset Pricing Model 14 Variability of Returns Compared with Size of Portfolio 1 10 20 25 49% -
24% -
19% - Systematic or nondiversifiable
risk (result of general market
influences) Unsystematic or diversifiable
risk (related to company-unique events) Total Risk Number of stocks
in portfolio Average annual
standard deviation (%)
Risk & Return : 4/24/2011 Capital Asset Pricing Model 15 Risk & Return X X X X X X X X X RF -- X
Risk & Return : 4/24/2011 Capital Asset Pricing Model 16 Risk & Return X X X X X X X X X RF -- Lending Borrowing X RM --
Security Market Line: Risk/ReturnTrade-Off with CAPM : 4/24/2011 Capital Asset Pricing Model 17 Security Market Line: Risk/ReturnTrade-Off with CAPM RF -- SML β
Security Market Line: E[Ri] = RF + βi (RM – RF) : 4/24/2011 Capital Asset Pricing Model 18 Security Market Line: E[Ri] = RF + βi (RM – RF) RF -- SML RM -- 1 2 | | β
CAPM : 4/24/2011 Capital Asset Pricing Model 19 CAPM Provides a convenient measure of systematic risk of the volatility of an asset relative to the markets volatility.
is this measure--gauges the tendency of a security’s return to move in tandem with the overall market’s return.
Average systematic risk
High systematic risk, more volatile than the market
Low systematic risk, less volatile than the market
Betas for a Five-year Period(1987-1992) : 4/24/2011 Capital Asset Pricing Model 20 Betas for a Five-year Period(1987-1992) 2006 Betas:
The SML and WACC : 4/24/2011 Capital Asset Pricing Model 21 The SML and WACC 16% --
14% --
7% -- 15% -- A B Incorrect
rejection = 8% SML WACC = 15% Beta Incorrect
acceptance If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency toward incorrectly accepting risky projects and incorrectly rejecting less risky projects.
The SML and the Subjective Approach : 4/24/2011 Capital Asset Pricing Model 22 The SML and the Subjective Approach 14% --
10% --
7% -- Low risk
(-4%) SML Beta WACC = Moderate risk
(+0%) High risk
(+6%) 20% -- With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm’s WACC.
Finding Beta for Three Companies: High, Average, and Low Risk & Market : 4/24/2011 Capital Asset Pricing Model 23 Finding Beta for Three Companies: High, Average, and Low Risk & Market
Slide 24 : 4/24/2011 Capital Asset Pricing Model 24 The Concept of Beta (cont.) 30 --
20 --
10 --
0 -10 --
-20 -- -20 -10 | | 10 20 30 | | | Stock L, Low Risk: β = 0.5 Stock A, Average Risk: β = 1.0 Stock H, High Risk: β = 1.5
Slide 25 : 4/24/2011 Capital Asset Pricing Model 25 Summary of Relationship Between Risk and Return