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CHAPTER 8

CHAPTER 8. Asset Pricing Models. What are we going to learn in this chaper ?. Why are we interested in these models ?. Capital Market Theory. Determination of the returns for risky assets Assumption s: All investors are efficient investors (p oints on the efficient frontier )

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CHAPTER 8

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  1. CHAPTER 8 AssetPricingModels

  2. Whatarewegoingtolearn in thischaper?

  3. Whyareweinterested in thesemodels?

  4. Capital Market Theory • Determination of thereturnsforriskyassets • Assumptions: • All investors are efficient investors (points on the efficientfrontier) (importance of utilityfunction) • Investors can borrow or lend any amount of money at the risk-free rate of return (RFR) (ease of lending, difficulty in borrowing) • All investors have homogeneous expectations (identical probabilitydistributions for future returns)

  5. Capital Market Theory • All investors have the same one-period time horizon • All investments are infinitely divisible, which means that it is possible to buy or sell fractionalshares of any asset or portfolio (investmentalternatives as continuous curves) • There are no taxes or transaction costs involved in buying or selling assets • There is no inflation or any change in interest rates, or inflation is fully anticipated • Capital markets are in equilibrium (all investments properlypriced in line with their risk levels)

  6. Risk FreeAsset • Development of Capital Market Theory • Whatwould be a risk freeasset? • Whywould it be considered risk free?

  7. Risk FreeAsset • What is theformula of covariance? • Ifthereturnforthe risk freeassetsarecertain, whatdoesthismean in terms of standarddeviation? • Howdoesthisaffectcovariance of the risk freeassetwith a riskyasset? • What is theformula of correlation? Theeffects on correlation?

  8. Risk FreeAsset • What happens to the averagerate of return when you combine a risk-free asset with aportfolio of risky assets such as those that exist on the Markowitz efficient frontier? • What happens to the standard deviation of returns when you combine a risk-free asset with aportfolio of risky assets such as those that exist on the Markowitz efficient frontier?

  9. Utilizing Risk FreeAsset • RFR-A • RFR-B • Tangentlinetotheefficient frontier • Point M

  10. Utilizing Risk FreeAsset

  11. IncorporatingLeverage • Howcould an investor attain a higher expectedreturn than is available at Point M? • What effect would addingleverage have on the return and risk for your portfolio if you borrow an amount equal to 50 percent of your original wealth at the risk-free rate? Assume that E(RFR) = 0.06 and E(RM) = 0.12 The return on your leveraged portfolioandits risk would be:

  12. IncorporatingLeverage

  13. IncorporatingLeverage • New efficient frontier: the straight line from the RFR tangent to Point M. • Capital market line (CML) • You either invest part of your portfolio in the risk-free assetand the rest in the risky asset Portfolio M, or you borrow at the riskfreerate and invest these funds in the risky asset portfolio. • In either case, all the variability comesfrom the risky asset M portfolio.

  14. Market Portfolio • What is specialaboutportfolio M? • Whatshould be theweight of eachasset in thisportfolio? • Market portfolio • Whatwould be someassetsincluded in thisportfolio? • Completely diversified portfolio

  15. Market Portfolio • Completely diversified portfolio: all the risk unique toindividual assets in the portfolio is diversified away. • Unsystematic risk • Systematic risk

  16. Diversification • What is diversification? • What is thepurpose of diversification? • How many securities mustbe included to arrive at a completely diversified portfolio? • Can reduce the overall standard deviation of the portfoliobut you cannot eliminate variabilityby adding stocks to the portfolio?

  17. Diversification

  18. CAPM • Capital assetpricing model (CAPM) • What is CAPM usedfor? • Security market line (SML)

  19. SML • The relevant risk measure for an individual risky asset is its covariance with themarket portfolio (Covi,M) • Slope of SML • Restatementusing Beta

  20. SML

  21. Beta • Whatdoes Beta measure? • Standardized measure of risk • What is the beta of the market portfolio? • Whatdoes a beta higher/lowerthan 1 mean?

  22. Beta

  23. Beta & ExpectedReturns

  24. Beta • In equilibrium, all assets and all portfolios of assets should plot on the SML. • Whatiftheestimated rate of returnliesabovethe SML? • Whatiftheestimated rate of returnliesbelowthe SML? • In an efficient market in equilibrium, you would not expect any assets to plot off the SMLbecause. Iftherearedeviations, whatwould be thesource?

  25. Identifying Undervalued and Overvalued Assets • How do weidentifywhether a stock is underorovervalued? • Whattoolstouseforestimations of returns? • Whichactiontotakewhen a stock is under/overvalued?

  26. Identifying Undervalued and Overvalued Assets

  27. Identifying Undervalued and Overvalued Assets

  28. CalculatingSystematic Risk • How do wecalculatethesystematic risk? • What is thecharacteristicline?

  29. CalculatingSystematic Risk

  30. END OF CHAPTER

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