chapter 7
DESCRIPTION
Chapter 7. Capital Asset Pricing. Outline. Beta: the market risk Relationship between risk and return: CAPM Security Market Line: graphic representation of CAPM. 1. Beta. Breaking down sources of risk. Stand-alone risk = Market risk + Firm-specific risk - PowerPoint PPT PresentationTRANSCRIPT
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Outline
1. Beta: the market risk
2. Relationship between risk and return: CAPM
3. Security Market Line: graphic representation of CAPM
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Breaking down sources of risk
Stand-alone risk = Market risk + Firm-specific risk
• Market risk – portion of a security’s stand-alone risk that cannot be eliminated through diversification. Measured by beta.
• Firm-specific risk – portion of a security’s stand-alone risk that can be eliminated through proper diversification.
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Beta
• Measures a stock’s market risk, and shows a stock’s volatility relative to the market.
• Indicates how risky a stock is if the stock is held in a well-diversified portfolio.
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Calculating betas
= [COV(ri,rm)] / m2
• Run a regression of past returns of a security against past returns on the market.
• The slope of the regression line is defined as the beta coefficient for the security.
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Comments on beta
• If beta = 1.0, the security is just as risky as the average stock.
• If beta > 1.0, the security is riskier than average.
• If beta < 1.0, the security is less risky than average.
• Most stocks have betas in the range of 0.5 to 1.5.
• Check beta in real world
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Creating a portfolio:Beginning with one stock and adding randomly selected stocks to portfolio
• σp decreases as stocks added, because they would not be perfectly correlated with the existing portfolio.
• Expected return of the portfolio would remain relatively constant.
• Eventually the diversification benefits of adding more stocks dissipates (after about 10 stocks), and for large stock portfolios, σp tends to converge to 20%.
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Illustrating diversification effects of a stock portfolio
# Stocks in Portfolio10 20 30 40 2,000+
Company-Specific Risk
Market Risk
20
0
Stand-Alone Risk, p
p (%)35
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Portfolio beta
• Since beta cannot be diversified away, Portfolio beta is the weighted average of individual stock beta. The weight is the proportion of individual stock to whole portfolio.
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Capital Asset Pricing Model (CAPM)
• Model based upon concept that a stock’s required rate of return is equal to the risk-free rate of return plus a risk premium that reflects the riskiness of the stock after diversification.
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Capital Asset Pricing Model (CAPM)
• Model linking risk and required returns. CAPM suggests that a stock’s required return equals the risk-free return plus a risk premium that reflects the stock’s risk after diversification.
ri = rRF + (rM – rRF) bi • Ri: required return of stock i
• rM : Expected return of the market
• Risk premium RP: additional return to take additional risk
• The market (or equity) risk premium is (rM – rRF)
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Calculating required rates of return
• Risk free rate:5.5%, market return:10.5%Investment BetaHigh Tech 1.32Market 1US Rubber 0.88T bill 0Collection -0.87
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Calculating required rates of return
• rHT = 5.5% + (5.0%)(1.32)
= 5.5% + 6.6% = 12.10%
• rM = 5.5% + (5.0%)(1.00) = 10.50%
• rUSR = 5.5% + (5.0%)(0.88) = 9.90%
• rT-bill = 5.5% + (5.0%)(0.00) = 5.50%
• rColl = 5.5% + (5.0%)(-0.87) = 1.15%
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Applying CAPM
• Computing other variables: risk free rate, market return, market risk premium
• Computing the difference of return between two stocks.
• Computing price in the future when current price is given
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SML Relationships
= [COV(ri,rm)] / m
2
Slope SML = E(rm) - rf
= market risk premium
SML = rf + [E(rm) - rf]
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Sample Calculations for SML
E(rm) - rf = .08 rf = .03
x = 1.25
E(rx) = .03 + 1.25(.08) = .13 or 13%
y = .6
e(ry) = .03 + .6(.08) = .078 or 7.8%