Week 2

Week 3
The CAL leads all investors to invest in the market portfolio. Individual investors should differ in position on the CAL depending on risk preferences. Risk averse investors will lend part of the portfolio at the rf rate and invest the remainder in the market portfolio Aggressive investors would borrow funds at the Rf and invest everything in the market portfolio Efficient Frontier- graph representing a set of portfolios that maximises expected return at each level of portfolio risk The slope of the Capital Allocation Line is the Sharp Ratio of the risky portfolio that is the ratio of excess return to sd:

Sp=

E(rp) rf op

This is the rate at which the investor can increase expected return by accepting higher portfolio sd. Optimal Risky Portfolio- the best combination of risky assets to be mixed with safe assets to form the complete portfolio Separation property- the property that implies portfolio choice can be separated into two independent tasks 1- Determination of the optimal risky portfolio which is a purely technical problem 2- The personal choice of the best mix of the risky portfolio and the risk-free asset Index model- model that relates stock returns to returns on both a broad market index and firmspecific factors

Ri(equity risk premium) = bi Rm + ei + ai - excess return which is the rate of return in excess of
the risk-free rate The securitys beta, Bi, is the typical response of that particular stocks excess return to changes in the market indexs excess return. The term ei represents the impact of firm-specific or residual risk. The E(ei) is 0 Firm-specific or residual risk is the component of return variance that is independent of the market factor Alpha- a stocks expected return beyond that induced by the market index; its expected excess return when the markets excess return is 0 Thus the total variance of the rate of return of each security Variance (Ri) = Bi2Rm + o2(ei)

= Systematic risk + Firm-specific risk A security with negative reduces the portfolio beta, thereby reducing exposure to market volatility. The unique risk of a portfolio approaches zero as the portfolio becomes more highly diversified. The Three Rules of 2 Risky Assets Portfolios Rule 1: The rate of return on a portfolio is the weighted avg of the expected returns on the component securities rp=wbrb + wsrs Rule 2: The expected rate of return on a portfolio is the weighted average of the expected returns on the component securities E(rp)=wbE(rb) + wsE(rs) Rule 1 and 2 say that a portfolios actual return and its mean return are linear fns of the component security returns and portfolio weights Rule 3: The variance of the rate of return on a two-risky-asset is: Op2 = (wbob)2 + 2(wbob)(wsos)pbs Equity risk premium- is the excess return that an individual stock or overall stock provides over a risk-free rate. Tutorial Questions 1a. The efficient portfolio is a graph representing a set of portfolios that maximises expected return at each level of portfolio risk 1b. Below the efficient frontier as it is highly risky 1c.Less risky as the Becks portfolio has low liquidity and high volatility 1d. In good economic times part ownership will reduce risk whilst also providing a high expected return however in poor economic times single asset portfolios become a lot cheaper and offer a high E(r) 1e. No they had no expertise and thus could be sold anything 1f. The GFC hit and as a result people moved their investments from stocks, which had been hit hard to safe government bonds. As more people were moving their money this resulted in a decrease in bond yields 1g. When gov bonds drop this usually as a result of more people buying bonds and thus means that investors do not trust the volatility of the current stock market as a result equity risk premium decreases as the risk free rate decreases. 1h. This is good if you like hamburgers however it is different for stocks. If you like BHP stock for example and the prices go down this might mean you can buy more stock but it means that your return will decrease. Its almost similar to eating lots of hamburgers and as you eat more you get fatter and fatter until you cant eat any more hamburgers. 1j. No buying a single asset portfolio is open to high volatility and low liquidity. It is hard to sell a house instantly whilst buying a well-diversified portfolio almost guarantees that you have very little risk.

1k. If his risk tolerance and view of the market did not change then he would move $15000 of his money from bonds to equity to retain his 50/50 ratio of bonds to equities. 2a. Yes as she the large majority of her portfolio is in the mining company her main concern is the risk involved in the company not guaranteeing revenue and thus any deal which would guarantee revenue and thus reduce her risk is positive on her behalf. Unless of course the revenue did not exceed the operating costs in which case this would not be a popular decision with the investor. 2b. No it will not be popular with large investment funds. They would look to this company to diversify the portfolio rather than to necessarily reduce risk and thus if the company decided to presell the gold this would reduce the risk involved in investing the company and thus would not be popular with investment banks. 3a. Increased correlation means that if one asset class is affected like airlines by say an increase in jet fuel prices then this will affect other industries. For a fully diversified portfolio stocks should be as uncorrelated as possible to reduce risk effectively. 3b. When a financial crisis hits the whole stock market is affected as a whole and thus as result the correlation will increases 3c. As a financial crisis hits and we recover from it not only is the stock market affected but the companies which are most affected are also companies that have junk bond status and thus this should be closely correlated. 3d. Gold is seen as a solid investment and thus people buy gold to ensure security whilst people invest in the stock market are more inclined to invest for returns. Thus they will be negatively correlated.

Week 4
MPT- Shows how an investor who aims to maximise return and minimise risk should select investments CAPM-provides the discount rate used to value the individual investments, assuming all investors follow MPT If the relevant risk of an asset is the extent to which it covaries with other assets in the investors portfolio then it follows that the covariance with the market portfolio is the relevant (systematic) risk of an asset Application of CAPM to pricing of a single security The risk of a security is a function of its covariance with the market portfolio Securities with higher covariance with the market portfolio are priced to yield a higher return Expected return above the risk-free rate is proportional to the covariance of the security with the market portfolio CAPITAL ASSET PRICING MODEL- For investors the relevant risk of a project is how correlated its returns are with their portfolios returns Well diversified investors hold the market portfolio. The relevant risk of a project is therefore the correlation of the projects returns with the market portfolios returns

CAPM yields counterintuitive propositions- investors require lower rates of returns for risk that is project specific Specific company risk premium- adjusts the cost of equity for company specific factors, including unsystematic risk factors, such as size, key customer/person/supplier and asymmetric cash flows The CAPM assumes, amongst other things, that rational investors seek to hold efficient portfolios, that is, portfolios that are fully diversified

Assets with > 1 have returns in same direction as market but proportionately more extreme Assets with 0 > < 1 have returns in same direction as market but proportionately less extreme Assets with = 0 do not covary with the market at all Assets with < 0 have returns in opposite direction to the market Stocks with higher betas should on average earn higher return. Actual returns do not line up very well with beta, however this is not true in practice Fama French Three Factor Model Size and book-to-market ratios predict returns on securities Smaller firms experience higher returns High book-to-market firms experience higher returns Size and book to market are factors that are proxies for sik associated with these attributes Results may indicate irrational preferences CAPM is useful in showing managers how to think about investors view the risk-return relationship about their company. Investors care about risk relative to their portfolio The CAPM provides a precise prediction of the relationship we should observe between the risk of an asset and its expected return. CAPM is a model that relates the required rate of return on a security to its systematic risk as measured by beta. Mutual fund theorem- states that all investors desire the same portfolio of risky assets and can be satisfied by a single mutual fund composed of that portfolio MPT- how do we put together a set of investments to maximise expected return and minimise return, CAPM answers this question and thus how would investors price individual assets if they followed MPT The discount rate is the expected return, E investors require to invest in an asset E(R)= Risk-free rate + risk premium Investors require higher expected return for riskier assets. Expected return for an equity or bond [(Expected payoff-Cost of Bond/Equity)]/Cost of Bond/Equity)]

Beta is a measure of the covariance of the returns of an asset with the returns to the market portfolio Week 5 Efficient Markets Stock prices should follow a random walk the notion that price changes are unpredictable Efficient market hypothesis- the hypothesis that prices of securities fully reflect available information about securities Eugene Famas three levels of market efficiency 1. Weak-form EMH asserts that stock prices already reflect all info contained in the history of past trading 2. Semi strong form EMH asserts that stock prices already reflect all publicly available info 3. Strong form EMH asserts that stock prices reflect all relevant info including inside info An Efficient capital market is a market that is efficient in processing info. The prices of securities observed at any time are based on correct evaluations of all info available at that time. In an efficient market, prices fully reflect available info Joint-Hypotheses Problem At least two hypotheses can explain a wrong price 1. Our model of what the price should be is right and the observed price is wrong 2. Our model of what the price should be is wrong and the observed price is right Joint-hypothesis is under-appreciated because the info that enters models of price is uncertain What about investment bubbles- a fundamentally unsound commercial undertaking accompanied by a high degree of speculation Markets are efficient in the sense that it is very difficult to persistently beat the markets capacity to analyse and evaluate information Predictable returns- a challenge to the EMH The CAPM states that E(R) is related to one factor only, beta. Fama argues small firms and firms with high book-to-market ratios are somehow riskier, therefore their higher returns are compensation for extra risk