Jmr Book/Chaper 7

AN INTRODUCTION TO STOCK EXCHANGE

INVESTMENT
JANETTE RUTTERFORD

CHAPTER 7
Jmr Book/Chaper 7
THE SINGLE FACTOR MODEL
ALL SHARE RETURNS MOVE MORE OR LESS TOGETHER


ONLY COMMON FACTOR IS WHOLE MARKET


CAN DERIVE SINGLE INDEX MODEL CALLED MARKET MODEL
Jmr Book/Chaper 7
MARKET RISK AND THE CAPITAL ASSET PRICING MODEL
EXCESS SHARE RETURN = + X EXCESS MARKET RETURN (+ERROR)

EXCESS RETURN = RETURN - RISK FREE RATE = MARKET RISK PREMIUM
X
X
X
X
X
X
X
X
X
X
X
X
X
X
ALPHA ( ) EXCESS

RETURN ON MARKET
SLOPE RISK INDEX
= (BETA)
= SENSITIVITY OF
SHARE RETURNS
TO CHANGES IN
MARKET
EXCESS
RETURN
ON SHARE
SHARES RISK RISK RELATIVE TO
INDEX (BETA) MARKET
0 RISK FREE RATE
< 1 LESS THAN MARKET RETURN
= 1 MARKET RETURN
> 1 OVER MARKET RETURN

Jmr Book/Chaper 7

THE BETA OF A STOCK IS A MEASURE OF HOW IT IS EXPECTED TO MOVE
RELATIVE TO THE MARKET AS A WHOLE


= 2.0












HIGH BETA STOCKS ARE AGGRESSIVE

LOW BETA STOCKS ARE DEFENSIVE
BETA AND CYCLICALITY
= 0.5
TIME
MARKET
Jmr Book/Chaper 7
EXAMPLES OF UK BETAS

RESIDUAL
COMPANY BETA VARIABILITY R
2

STANDARD
% %
DEVIATION %

McCARTHY & STONE 1.87 52 26
45

TRAFALGAR HOUSE 1.52 54 16
50

LADBROKE 1.30 30 38
23

TR TECHNOLOGY 2.12 43 48
31
(SPLIT INV TRUST)

ALLIANCE TRUST (INV TRUST) 0.99 15 87
6

BRISTOL WATER 0.34 14 12
13

ROBERT WISEMAN DAIRIES 0.46 21 6
21

SAINSBURY 0.63 22 16
21

Source: LBSRMS
Jmr Book/Chaper 7
RISK



TOTAL MARKET RISK NON-MARKET RISK

RISK SYSTEMATIC RISK NON-SYSTEMATIC RISK

NON-SPECIFIC RISK SPECIFIC RISK

BETA RISK RESIDUAL RISK


NON-DIVERSIFIABLE DIVERSIFIABLE

CANNOT BE AVOIDED CAN BE AVOIDED

AN INDIVIDUAL STOCK'S RISK IS ALSO MEASURED BY BETA
SINCE INVESTORS HOLD DIVERSIFIED PORTFOLIOS
2
e
2
m
2 2
o + o | = o
Jmr Book/Chaper 7
EXAMPLES OF TYPES OF RISK
SPECIFIC RISK
TAKEOVERS
LOSS / GAIN MAJOR CUSTOMERS
LOSS / GAIN KEY PERSONNEL
INTRODUCTION / DEMISE OF MAJOR PRODUCTS

MARKET RISK
ECONOMIC FACTORS-
INTEREST RATE CHANGES
GROWTH IN ECONOMY
UNANTICIPATED INFLATION
GOVERNMENT POLICY

SOME SHARES / INVESTMENTS ARE MORE AFFECTED BY MARKET RISK
THAN OTHERS (THIS IS WHAT BETA MEASURES)

Jmr Book/Chaper 7
MEASUREMENT OF PORTFOLIO RISK AND RETURN
FUND ABNORMAL SPECIFIC
STOCK HOLDING BETA RETURN RISK
$000 (ALPHA)

A 210.0 1.24 1.39 6.87

B 150.4 2.38 5.23 26.83

C 25.9 0.78 3.18 13.68
R
F
= 5% R
M
= 11%
M
= 20%

PORTFOLIO = (210 x 1.39) + (150.4 x 5.23) + (25.09 x 3.18)
ALPHA 210 + 150.4 + 25.9

= 3.01

PORTFOLIO = (210 X 1.24) + (150.4 X 2.38) + (25.9 X 0.78)
BETA 210 + 150.4 + 25.9

= 1.65

o
Jmr Book/Chaper 7
PORTFOLIO MARKET RISK

= (1.65) (20) = 33.0%

PORTFOLIO SPECIFIC RISK








PORTFOLIO TOTAL RISK

= (MARKET RISK)
2
+ (SPECIFIC RISK)
2


= (33)
2
+ (11.12)
2
= 1212.68


= 34.82%
MP
o
( ) ( ) ( )
2
2
2
2
2
2
2
S
68 . 13
3 . 386
9 . 25
83 . 26
3 . 386
4 . 150
87 . 6
3 . 386
210
|
.
|

\
|
+
|
.
|

\
|
+
|
.
|

\
|
= o
% 12 . 11
S
= o
68 . 123 =
2
P
o
P
o
Jmr Book/Chaper 7
WHAT DOES THIS MEAN





= 5% + 3.01% + 1.65 [11% - 5%]

= 17.91% (QUARTERLY = 4.48%)



TOTAL RISK OF = 34.82% (QUARTERLY = 17.41%)
PORTFOLIO

OVER THE NEXT THREE MONTHS YOU CAN EXPECT TO
EARN 4.48% WITH A 95% CONFIDENCE THAT THE
PORTFOLIO VALUE WILL NOT DECLINE BY MORE THAN
24.25%
(

+ + =
MARKET ON
RETURN EXCESS
x BETA ALPHA
RATE
RISKLESS
PORTFOLIO ON
RETURN EXPECTED
Jmr Book/Chaper 7
MULTI-FACTOR MODELS (I)
ATTRIBUTION OF COVARIANCES TO TWO OR MORE FACTORS,
USUALLY INCLUDING THE MARKET.

EXAMPLE

ASSUME STOCKS RESPOND TO TWO FACTORS

RETURN ON MARKET PORTFOLIO

UNEXPECTED CHANGES IN INDUSTRIAL PRODUCTION

jt j m mt I t jt
R A R l = + | + | A + c
Jmr Book/Chaper 7
MULTI-FACTOR MODELS (II)
PORTFOLIO HAS MARKET BETA (WEIGHTED AVERAGE) AND
INDUSTRIAL PRODUCTION BETA (WEIGHTED AVERAGE).







HOW MANY FACTORS DO WE NEED TO ELIMINATE COVARIANCE
BETWEEN RESIDUALS.
TOTAL SYSTEMATIC SYSTEMATIC
RESIDUAL
PORTFOLIO MARKET INDUSTRIAL
VARIANCE
VARIANCE RISK PRODUCTION RISK
= + +
Jmr Book/Chaper 7
POSSIBLE FACTOR CATEGORIES
RISK FACTORS : MARKET BETA, INDUSTRIAL PRODUCTION BETA,
VOLATILITY OF RETURN, LEVERAGE LEVEL, VARIABILITY
OF EARNINGS, ETC

LIQUIDITY FACTORS : PRICE PER SHARE, VOLUME/MKT CAPITALISATION, BID-
ASK SPREAD, OWNERSHIP, ETC

PRICE FACTORS : PRICE/EARNINGS RATIO, PRICE/CASH FLOW, PRICE/BOOK
VALUE, ETC

GROWTH POTENTIAL: EARNINGS/EQUITY, OPERATING INCOME/TOTAL ASSETS,
EARNINGS GROWTH, ETC

TECHNICAL FACTORS: