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Chapter 13

Chapter 13. RISK/RETURN AND ASSET PRICING MODELS. Investment Return.

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Chapter 13

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  1. Chapter 13 RISK/RETURN AND ASSET PRICING MODELS

  2. Investment Return • Change in market value of the portfolio plus cash distributions received.Where: V1 = portfolio market value at end of interval V0 = portfolio market value at beginning of interval D1 = cash distributions during interval

  3. Portfolio Risk • Expected Portfolio Return • Variability of Expected Return

  4. Diversification • A portfolio of securities whose returns are not perfectly positively correlated. • Total Risk • Systematic or market-related risk, which is non-diversifiable. • Unsystematic or company-specific risk, which is diversifiable.

  5. The Risk of an Individual Security • Security Return • Systematic return • Unsystematic return • Systematic Risk • Security’s beta times the standard deviation of the market return • Unsystematic Risk • Standard deviation of security residual returns

  6. The Risk of a Portfolio of Securities • Portfolio Return • Systematic return • Unsystematic return • Systematic Risk • Portfolio beta times the standard deviation of the market return. • Portfolio beta is the market value-weighted average of the individual security betas. • Unsystematic Risk • Market value-weighted average of the individual security standard deviation of residual returns.

  7. Beta • Beta for a portfolio consisting of all stocks in the market is 1.0; it has average risk. • If a stock’s beta > 1.0, it has above average risk. • If a stock’s beta < 1.0, it has below average risk.

  8. Estimating Beta • Use regression analysis on historical data to estimate the market model. • The estimated slope of the market model is the beta estimate.

  9. The Capital Asset Pricing Model • The expected return on a portfolio should exceed the risk-free rate of return by an amount that is proportional to the portfolio beta.

  10. The Capital Asset Pricing Model • The expected risk premium of a portfolio should equal its beta times the expected market risk premium.

  11. Assumptions Underlying the CAPM • Investors are assumed to be risk-averse. • All investors have a common time horizon for investment decision-making. • All investors have the same expectations about future security returns and risks. • Capital markets are perfect.

  12. Empirical Evidence of CAPM • There is a significant positive relationship between realized returns and systematic risk. • The relationship between risk and return appears to be linear. • Effects of systematic and unsystematic risk on security returns are not fully understood.

  13. Arbitrage Pricing Theory (APT) • Several factors determine the rate of return on a security, not just one as in the CAPM. • Business cycle • Interest rates • Investor confidence • Short-term inflation • Inflationary expectations

  14. The Multifactor CAPM • External factors influence the expected returns on securities and portfolios. • Expected future labor income • Expected future relative prices of consumer goods • Expected future investment opportunities

  15. Empirical Evidence • Testability of APT is questionable. • APT gives no direction as to how to choose factors or how many factors should be considered.

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