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CHAPTER OUTLINE

Introduction The market model Portfolio risk and return using the market model The capital asset pricing model Assumptions of the CAPM The theory behind the CAPM Expressing the CAPM in risk premium form The securities market line

8.9

8.10 Empirical testing of the CAPM 8.11 The empirical evidence on the CAPM 8.12 The multifactor CAPM 8.13 The arbitrage pricing theory critique of the CAPM 8.14 Conclusions

8.1

Introduction

One of the problems with implementing portfolio theory is that a huge number of covariances have to be calculated when assessing the risk to a portfolio. While the Markowitz model provides a relatively straightforward solution for the two-asset case, it becomes much more complicated to solve for the efficiency frontier when there are more than two assets. In the N securities case, it is necessary to calculate (N2 N)/2 covariances. This means with 100 securities one would need to calculate 4,950 covariances, and with 500 securities this increases to 124,750 covariances. The amount of calculation required for the Markowitz method was one of the factors stimulating other approaches to investment management. The foundations for the capital asset 188

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pricing model (CAPM) were laid by portfolio theory and the introduction of a risk-free asset. Underlying the CAPM is, however, the basic idea that agents will only accept increased risk for an increased expected rate of return. The CAPM attempts to place a price on the increased risk and show that the market will only place a price on market risk, that is risk that cannot be diversified away. In its turn, the expected return tells us how any security or any portfolio should be priced.

8.2

The first attempt to simplify portfolio theory was suggested by Sharpe (1963). The basic observation behind Sharpes market model was that shares tend to move in varying degrees in line with market itself. When the market rises, then most shares have some degree of positive correlation with the market and tend to rise as well. Sharpe postulated a linear link between a security and the market as a whole as given by: E(Ri) = ai + bi E(Rm) (8.1)

where E(Ri) is the expected rate of return on security i; E(Rm) is the expected rate of return on the market; ai is a constant factor which varies between securities; bi is the securitys beta which measures the sensitivity of the return on security i to the return in the market as a whole. The Sharpe model introduces the idea via the beta coefficient that the return on a security is sensitive to fluctuations in the market as a whole. If a share has a beta of unity it would rise or fall by a similar percentage as the market rises or falls. If, however, it has a beta of greater than unity it will tend to be more volatile than the market as a whole and therefore should have a higher expected return. If the share has a beta of less than unity it will fluctuate less than the market as a whole and should therefore command a return lower than the market as a whole assuming alpha is zero. According to Sharpes market model, the sole common factor affecting all securities is the market rate of return; influences such as dividend yield, priceearnings ratios, quality of management and industry-specific factors have no separate influence. For regression purposes the market model given by equation (8.1) becomes: Ri = ai + bi (Rm) + ei (8.2)

where Ri is the actual return of an individual security; Rm is the actual market return over the period; and ei is a random error.

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unsystematic component x

ei x

i =intercept positive

Figure 8.1

Equation (8.2) is often referred to as the characteristic line of a security as shown in Figure 8.1. The systematic component is ai + bi (Rm), and the unsystematic or specific component is picked up by the error term ei. The alpha term in equation (8.2) gives the constant of the regression; in this case alpha is positive suggesting that on average the security in question tends to earn a positive return even when there is no movement in the market as a whole. The beta coefficient is picked up by the slope of the regression line and it tells us how much on average the return on the security can be expected to rise for a 1 per cent rise in the market rate of return. If a security has a beta equal to 1.5, this means that if the market rises by 10 per cent, then one can expect the security to rise on average by 15 per cent because of this factor; whereas, if a security has a beta of 0.7 and if the market rises by 10 per cent, then the companys share would rise on average by 7 per cent. The regression line is a fitted equation giving the line of best fit for the data. The deviation of an observation from the line of best fit is known as the error of the regression and in this case picks up the unsystematic risk of the security. The greater the deviation of the square of these observations, the greater the unsystematic risk of the security, other things being equal. We use

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the square of the error terms because the ordinary least-squares estimation technique ensures that the sum of these errors is zero (the positive and negative deviations from the regression line cancelling each other out). Squaring the errors means that positive and negative deviations are both relevant to the unsystematic risk. The total risk factor on an individual security, since ai is a constant, is given by: si2 = bi2 sm2 + sei2 Total = Market + Specific risk risk risk (8.3)

If a security has a high proportion of its total risk made up of specific (diversifiable) risk, this can be easily reduced or eliminated by low-cost diversification.

8.3

Using the market model the expected return and variance of a portfolio are given by: E(Rp) = ap + bp E(Rm) with ap = (8.4)

i=1 N

wi ai

(8.5)

bp =

wi bi

i=1

(8.6)

where wi is the value weight of security i in the portfolio; ap is the alpha of a portfolio of securities; and bp is the beta of a portfolio of securities; N is the number of securities in the portfolio. Note that the sum of the weights in equations (8.5) and (8.6) must sum to unity. Equations (8.4) to (8.6) say that the expected rate of return on a portfolio is given by a weighted average of all the weighted alpha and beta coefficients, where the portfolio beta is multiplied by the market rate of return. Since the a coefficients are assumed to be constant and therefore have zero variance, then the total risk of the portfolio is given by:

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N

s2 = b2 s2 + p p m

i=1

w2 s2i i e

(8.7)

Total portfolio = Market + Specific portfolio risk risk risk where s2 is the variance of the portfolio; b2 is the square of the portfolio beta; p p s2 is the variance of the market; w2 is the square of the weight of security i; m i and s2 is the variance of the error of security i. ei The first expression on the right-hand side of equation (8.7) shows the market risk of the portfolio, while the summation expression involving the error terms shows the systematic risk of holding the portfolio. Hence, the market model looks at total risk, both systematic and unsystematic, when evaluating a portfolio. The effect of including a large number of securities into a portfolio is to make their random error components cancel each other out leaving only the systematic/market risk factor for investors to worry about. In the case where wealth is allocated in equal proportion over N securities, then wi = 1/N in equation (8.7) and it is clear that as N increases, specific risk can be eliminated entirely since w2 = 1/N 2 which becomes smaller and smaller as N increases. i A major advantage of the market model is that it dramatically reduces the number of variables required to evaluate a portfolio. All we need is 3N + 2 data items; that is, for each security we need to calculate ai, bi and s2 and the releei vant market risk and portfolio specific risk as in equation (8.7), rather than N(N 1)/2 covariances as required by the Markowtiz model. For 100 securities we need only 302 calculations rather than 4,950 under the Markowitz method! Against this, however, a major problem with Sharpes model is that it lacks a clear theoretical base. Such a base is provided by the capital asset pricing model (CAPM).

8.4

The CAPM was originally devised as an offshoot from the market model by Sharpe (1964) and Lintner (1965). It attempts to explain the relationship between the risk and return on a financial security, and this relationship can then be used to determine the appropriate price for the security. The basic idea of the CAPM is that if a share helps to stabilize a portfolio, that is make it more in line with the market, then that share will earn a similar rate of return to the market portfolio. Whereas, if a share makes a portfolio more risky as compared to the market portfolio it will be in less demand by risk-averse investors, its price will fall and its expected rate of return will

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be above the market rate of return. Conversely, if a share reduces the risk of a portfolio compared to the market portfolio it will be more in demand by riskaverse investors, its price will be bid up so that it earns a lower rate of return than the average market return. Another key idea of the CAPM is that in an efficient market all diversifiable risk will be eliminated (given that there are no transaction costs), so that the only risk that will be priced by the market on a portfolio is systematic or market risk. Hence, the CAPM model concentrates only on the pricing of undiversifiable market risk. As we shall see, the CAPM provides a simple measure of the systematic risk attached to a security given by the securitys beta.

8.5

The CAPM makes a number of key assumptions relating to the operation of capital markets and investors behaviour: 1 Capital markets are perfect, there is only a single borrowing and lending rate (no transaction costs), all capital assets are perfectly divisible (one can buy fractions of a security) and there are no taxes, investors can sell short (sell stock they do not own), and information is freely available to all market participants. Investors attempt to maximize their utility, which consists of maximizing returns for a given level of risk. Investors are risk-averse and measure risk in terms of standard deviations of returns. Investors use a common one-period-ahead time horizon for investment decisions. All investment decisions are made at the beginning of the period and no changes are made during the investment horizon. Investors have identical expectations about the risk and return on various securities. Hence, the only reason why investors hold different portfolios is because they have different risk preferences. There exists a single risk-free asset at which borrowing and lending can take place.

These assumptions set the CAPM apart from the Markowitz model. In particular, assumption 4 means that investors all have the same efficiency frontier, which is more restrictive than portfolio theory whereby investors with different perceptions can have different efficiency frontiers. The inclusion of the risk-free asset means that in the CAPM there is a linear trade-off between risk and return that is not present in the Markowitz model.

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l2

Risk (p)

Figure 8.2

8.6

Consider the efficiency frontier with N risky securities, given by the curve EF in Figure 8.2. Since we have assumed that all investors have identical expectations, then this efficiency frontier is the same for all investors in the economy. A straight line L1 is drawn in the figure from the risk-free rate of interest R* tangential to the efficiency frontier at point M. The question we need to consider is which out of portfolios M, A and B, or any other portfolio along the efficiency frontier, will investors choose? The striking result of the CAPM model is that in equilibrium all investors will choose to allocate their investment wealth between the same mix of securities as given by portfolio M and the risk-free asset. The only difference between investors will be the proportions in which they allocate their wealth between the portfolio of securities given by M, and the risk-free rate of interest. First consider portfolios A and B which lie on the efficiency frontier EF. We have placed two indifference curves representing two different investors, one at A and one at B. The investor at point A is more risk-averse than the investor at B; that is, the investor at A prefers less risk for a lower expected rate of return than the investor at B. Investor 1 at A is on indifference curve I1, and

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investor 2 at B is on indifference curve I2. These are their optimum positions in the absence of a risk-free security. With the possibility of lending and borrowing at the risk-free rate of interest, it is relatively straightforward to show that both investors should pick portfolio M regardless of their riskreturn preference, and then borrow or lend funds at the risk-free rate of interest R*. To understand this result and the significance of the portfolio given by M, consider what happens when the risk-free asset is introduced into the picture. There is now a linear trade-off between risk and return, and the line that will enable either investor to get on the highest indifference curve is L1 which is tangential to the efficiency frontier at portfolio M which is known as the market portfolio. Line L1 is known as the capital market line and shows that there is a linear trade-off between risk and return. Since the standard deviation of the risk-free asset is zero, sR* = 0, then the standard deviation of the combined portfolio is simply the standard deviation of the risky market portfolio M times the weight of the risky market portfolio. s p = w sm (8.8)

where w is the weight invested in the risky market portfolio. When all wealth is invested in the market portfolio (that is, w = 1), the investor will have a portfolio with the same standard deviation as the market portfolio. However, since investors can borrow or lend money at the risk-free rate of interest R*, they might wish to invest all their money in the portfolio M or a mixture of the two. The investor that was at A now has the option of investing a proportion of his money (w) in a risky market portfolio M, and the remainder (1 w) in the risk-free asset. By doing this the investor can move onto a higher indifference curve I1*. This means that investor 1 is lending funds. The proportion of his money invested in the risk-free asset is given by (1 w) or the distance R* A*/R* M. The closer A* is to M then the greater the proportion invested in the market portfolio. Since the portfolio includes a risk-free asset, then we have already determined from equation (8.8) that sp = w sm. The variance is the square of this as given by: sp2 = w2 sm2 (8.9)

where sp2 is the variance on the portfolio; and sm2 is the variance on the market portfolio. The investor that was at B could also reach a higher indifference curve I2*; to do this, however, the investor needs to borrow funds at the risk-free rate of interest since the investor has a w greater than 1 and therefore invests more

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that 100 per cent of his wealth in the risky asset. Where w is greater than 1, then (1 w) has a negative position in the risk-free asset indicating that the investor has borrowed money at the risk-free rate of interest. By doing this he can move onto a higher indifference curve I2*. The proportion of his money invested in the risk-free asset is given by (1 w) or the distance R* B*/R* M. The striking result is that either investor will be content to invest in the market portfolio regardless of their riskreturn preferences. The issue is not what portfolio of risky securities to invest in, but rather how much of ones wealth should be allocated to the risk-free asset and how much to the market portfolio. We have established that M is the optimum portfolio, but why is it called the market portfolio? The answer is that since M is the only portfolio that all investors will hold, then all the risky securities in the economy that make up portfolio M must be correctly priced and willingly held by all investors. In consequence, the market portfolio is a portfolio of all the risky assets in the economy weighted by their market value over the market value of all assets in the economy. Since the market portfolio is by definition a value-weighted portfolio of all the risky assets in the economy, it is also a portfolio with no diversifiable risk. The only risk in the market portfolio is market risk, all specific/diversifiable risk has been eliminated. The expected rate of return on a combined portfolio M is given by: E(Rp) = (1 w) R* + w E(Rm) (8.10)

where E(Rp) is the expected rate of return on a composite portfolio of the riskfree asset and the market portfolio; and E(Rm) is the expected rate of return on the market portfolio. Equation (8.10) can be rearranged to yield equation (8.11): E(Rp) = R* + w[E(Rm) R*] (8.11)

from which we can see that when w is greater than 1 (borrowing), the expected return on the combined portfolio is greater than the market rate of return; while if w is less then 1 the portfolio earns less than the market rate of return. By rearranging equation (8.8) we obtain: sp w= sm and substituting equation (8.12) into equation (8.11) yields: sp E(Rp) = R* + [E(Rm) R*] sm (8.12)

(8.13)

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Equation (8.13) represents the capital market line (CML) which expresses the expected return for a portfolio in terms of risk. Any portfolio on the CML is efficient since it must be perfectly positively related with the market portfolio. The expression [E(Rm) R*]/sm gives the slope of the CML and is often referred to as the unit market price of risk. If we define beta as sp/sm, then equation (8.13) becomes: E(Rp) = R* + bp [E(Rm) R*] (8.14)

Equations (8.13) and (8.14) represent the CAPM for portfolios of securities. Equation (8.14) says that the average expected return on a composite portfolio made up of a risk-free asset and a portfolio of risky assets will exceed the riskless rate of interest by an amount proportional to the portfolios beta. Furthermore, this relationship is linear.

NUMERICAL EXAMPLE The risk-free rate of interest is 7%, the market rate of return is 12% and the standard deviation of a portfolio is 0.5 while the standard deviation of the market is 0.7. The expected rate of return on the portfolio is: sp E(Rp) = R* + [E(Rm) R*] sm 0.5 = 7 + [12 7] 0.7 = 10.57% The average expected rate of return for different values of beta are: Composite portfolios beta 0 0.5 1.0 1.5 2.0 Average expected rate of return on composite portfolio 7 9.5 12 14.5 17

The predictions of the CAPM model are that a portfolio that has a weight of 0 (bp = 0) in the risky assets will earn only the risk-free rate of interest. As the beta of a portfolio rises, investors are undertaking an increasingly risky portfolio of

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investments and consequently require a higher expected rate of return to compensate. An investor with a portfolio of relatively safe assets compared to the market portfolio has a lower expected rate of return than the market portfolio. Conversely, an investor that holds a portfolio which is relatively risky compared to the market portfolio can expect a rate of return that is greater than the expected return on the market portfolio. Any combined portfolio along the capital market line is perfectly correlated with the market portfolio and therefore contains no unsystematic/specific risk. Movements along the capital market line therefore reflect changes only in systematic or market risk.

8.7

The CAPM is frequently defined in terms of a risk premium. If we define the expected risk premium on a portfolio E(RPp) as the difference between the expected return on the portfolio E(Rp) and the risk-free rate of interest, and E(RPm), the expected risk premium on the market portfolio, as the difference between the expected rate of return on the market portfolio and the risk-free rate of interest, then: E(RPp) = E(Rp) R* and E(RPm) = E(Rm) R* (8.16) (8.15)

Substituting equations (8.15) and (8.16) into equation (8.14) we obtain: E(RPp) = bp E(RPm) (8.17)

which tells us that the excess return above the risk-free assets on a portfolio is a function of the beta of the portfolio and the difference between the market rate of return and the risk-free rate of interest. When the beta of a portfolio is equal to unity, the excess return coincides with the market excess return. When beta is greater than unity, the portfolio can be expected to have a higher excess return than the market portfolio. Conversely, when beta is less than unity the portfolio can be expected to have a lower excess return than the market portfolio. We can conclude that the correct measure of risk for an efficient portfolio,

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as represented by the capital market line, is the standard deviation of the return, that is the total risk. This must be so because in an efficient portfolio all diversifiable/specific risk has been eliminated, leaving only undiversifiable market risk. By definition an efficient portfolio has no diversifiable/specific risk since it has all been diversified away.

8.8

The capital market line is a useful expression for the pricing of efficient portfolios, that is combinations of the market portfolio and the risk-free security, but does not give a clue to the pricing of inefficient portfolios, for example the pricing of individual securities or a poorly diversified portfolio containing only a few securities. Ideally, we would like to derive an expression for the riskreturn trade-off for any individual security or any portfolio, not just efficient portfolios which lie on the capital market line. It can be shown that the appropriate measure of the risk of an individual security is given by: sim E(Ri) = R* + [E(Rm) R*] sm2 (8.18)

where sim is the covariance of security i with the market portfolio M; and sm2 is the variance of the market portfolio. Or equivalently: si rim E(Ri) = R* + [E(Rm) R*] sm (8.19)

where si is the standard deviation of security i; and rim is the correlation coefficient of security i with the market portfolio. Equation (8.19) is the equation for the securities market line (SML) and relates the rate of return for a security to its systematic risk as given by its beta. It looks reasonably similar to the equation for the CML, but a crucial difference is the inclusion of the correlation coefficient of the security with the market. When a new security is added to the portfolio we are concerned not only about its variance relative to the market, but also its correlation with the market. If it has a low correlation with the market it will help to stabilize a portfolio and will thus tend to receive a lower return than a security that adds to the instability of a portfolio. Equation (8.19) can be rewritten as: E(Ri) = R* + bi [E(Rm) R*] where bi = si rim/sm (8.20)

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An individual stocks beta (bi) is a function not only of its variance compared to the market, but also its covariance with the market. If a stock is perfectly correlated with the market portfolio (that is rim = 1) then its standard deviation will also coincide with the market portfolio (si = sm) and therefore its beta is unity and its expected rate of return coincides with the market rate of return. Stocks with a beta of less than unity (that is, si rim < sm) help to stabilize portfolios and are referred to as defensive securities. While stocks with betas greater than unity (that is si rim > sm) increase the volatility of a portfolio and expected to earn the market rate of return and are known as aggressive securities. Typical defensive stocks are companies in relatively stable sectors of the economy such as food retailers, gas and electricity companies (so called utilities) while aggressive stocks include those that are more volatile than the market such as property stocks, luxury goods manufacturers, technology stocks, fashion industries and so on. When it comes to inefficient portfolios or single securities, total risk is no longer an appropriate measure because an inefficient portfolio is not welldiversified and so contains both diversifiable/specific and market risk. Since the specific risk could be easily diversified away, then only the systematic component of total risk as reflected in the beta of the security will be priced by the market. This undiversifiable component is correlated with the market return which represents the inherent risk of the economy in general. The return on an individual share should be based on the systematic risk rather than on total risk. All inefficient portfolios contain both systematic and unsystematic risk; no one will pay for that component of risk that can be easily diversified away at low cost, and the market will only pay for undiversifiable risk. The CAPM suggests that the required rate of return on a security consists of three components: 1 2 3 The price of time as measured by the risk-free rate of interest (that is, the reward to the investor for delaying consumption. The quantity of risk as measured by the beta of the security The market price of risk as measured by the difference between the expected return on the market and the risk-free rate of interest [E(Rm) R*].

Once we know the market price of risk, we can calculate the required rate of return on an individual security or portfolio by looking at the beta coefficient. When measuring risk to calculate the capital market, we looked only at systematic or market risk as measured by the total risk since all specific risk can be eliminated by low-cost diversification. When calculating the securities market line we again only need to look at the systematic risk and for this

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SML

0 z

=1

Beta (i)

Figure 8.3

reason we replace the standard deviation for the security with the securitys beta coefficient on the horizontal axis as depicted in Figure 8.3. If the CAPM holds, then the expected rate of return for any individual asset given its beta coefficient should lie on the SML. An asset that is not on the SML is deemed to be incorrectly priced. For example, if security Z has a return Rz above the SML, then it is underpriced since its rate of return is greater than its expected rate of return E(Rz) as indicated by its beta would merit. Conversely, if security Y has a return Ry which is below the SML, then it is overpriced since its return is below what its expected rate of return E(Ry) that its beta would merit. The key point about the CAPM as it relates to an individual security is that when adding a security to a portfolio an investor will only be rewarded for the covariance of the security with the market, not for its total risk as represented by the standard deviation of the security. The CAPM shows that the holder of a risky security can only expect to be rewarded for the systematic or market risk, and not for unsystematic or specific risk since the latter can be easily diversified away. Securities with betas above unity are classified as aggressive securities, while those with betas below unity are classified as defensive securities.

}

defensive securities

}

aggressive securities

202

8.9

It is possible to empirically estimate the value of a beta by using historical timeseries data. A study might also estimate the beta coefficient over different time periods to examine its stability over time. The data set can consist of daily, weekly, monthly or even quarterly data; the time period and frequency of the data will determine the number of observations used, and it is important that the time period and frequency used for estimation of the beta is the same for both the portfolio and the market. For the market index, the series of returns associated with a broad index such as the FTSE 100 or the Standard and Poor 500 are generally used. The estimated beta will be affected by a number of variables, such as the time period over which the return is calculated, the frequency of the data (daily, weekly, monthly or quarterly) and the market index used. Various agencies conduct regression analyses of equation (8.20) to find the relevant coefficients. The analyses are usually based on monthly observations of the last 5 years data. An essential prerequisite is that the estimated betas need to be stable over time (that is exhibit stationarity). Ri = R* + bi (Rm R*) + ei (8.21)

where ei is the random error (representing specific risk). Consider a regression analysis of five shares AE that are estimated using equation (8.21) and have the following results: Specific risk ei 0.25 0.35 0.55 0.30 0.40 Annual % return 20 15 7 18 10

Share A B C D E

Note specific risk ei is measured in this case by the standard deviation of the error term, that is, sei so we need to take the square to get the variance. The risk-free rate of interest R* = 6%, the market rate of return is Rm = 12% and the standard deviation of the market is sm = 0.20. The question we would like to answer is does a portfolio made up equally of the five shares A to E have a good riskreturn performance? We shall assume that an investor has equal amounts invested in the five shares so that wi becomes 1/N where N is the number of shares in the portfolio.

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We need to calculate three things: 1 2 3 the portfolios beta; the total risk of the portfolio, that is, both systematic and unsystematic risk; and the actual return of the portfolio against its systematic return as required by the CAPM.

i=1

wi bi

(8.22)

bp = 0.2 (0.6) + 0.2 (0.8) + 0.2 (0.7) + 0.2 (1.1) + 0.2 (0.9) bp = 0.82 The total risk of the portfolio is made up of systematic and unsystematic risk: s2 = b2 s2 + p p m

i=1

w2 s2i i e

(8.23)

The systematic risk is given by: b2 s2 = (0.82)2 (0.2)2 p m b2 s2 = 0.02690 p m The specific risk is simply the weighted average of the specific risk factors:

w2 s2i i e

i=1

(8.24)

Where s2 is the specific risk (as measured by the variance) of the portfolio. ei The weight for each share is 1/5 so we use 1/5 1/5 = 1/25:

N

i=1

25 25 25 25 = 0.0295

(0.4)2

25

Note that the portfolios specific risk is lower than the specific risk of any of the individual constituents; however, it is still present but diminishes rapidly as the number of assets in the portfolio increases. The total variance of the portfolio is:

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2 sp = 0.02690 + 0.0295 2 sp = 0.0564

In the above example, 0.02690/0.0564 = 47.7% of the total risk cannot be diversified away, while 0.0295/0.0564 = 52.3% of the total risk can be diversified away. The standard deviation of the portfolio is the square root of 0.0564%: sp = 0.2374 The standard deviation of the portfolio, 0.2375, is greater than the standard deviation of the market, 0.2. We are now in a position to evaluate the performance of the portfolio. The beta of the portfolio is 0.82 so, according to the CAPM, the appropriate rate of return is: Rp = R* + bp [(Rm) R*] Rp = 7 + 0.82 (12 7) Rp = 11.1% The return actually achieved was: Rp = 0.2 (20%) + 0.2 (15%) + 0.2 (7%) + 0.2 (18%) + 0.2 (10%) Rp = 14% So this particular portfolio of shares has outperformed a CAPM strategy. The diversifiable (specific) risk in this instance led to a performance which beat the benchmark of investing in the risk-free asset and the market index.

8.10

The CAPM model can be applied to both individual shares and to portfolios of shares. However, tests of the CAPM based on individual shares are not very powerful tests. This is because the estimated beta on an individual share will be vulnerable to a large number of error factors, that is the return on an individual security typically has a large random component. This problem is considerably reduced by grouping shares with similar risk characteristics (that is similar betas) into portfolios of shares since much of the measurement error in the individual securities will tend to cancel each other out (shares with positive errors being offset by shares with negative errors). This enables a

205

clearer picture of the relationship between systematic risk and return to emerge. A typical empirical estimation of the CAPM involves looking at portfolio betas. Repeating equation (8.17) below: E(RPp) = bp E(RPm) then empirically a regression would be run such that: RPp = a + b RPm + ep (8.25)

where RPp is the excess return on the portfolio above the risk-free rate of interest; RPm is the market risk premium (excess return on the market over risk-free return); and ep is the specific risk on the portfolio. The intercept term is captured by the parameter a, and the empirical estimate of beta by b. The CAPM makes the following five key predictions: 1 The intercept term in equation (8.25) should be equal to zero, that is a = 0; if it were non-zero then it would mean that the CAPM model is missing something as a complete explanation of a portfolios excess return. The beta coefficient should be the sole explanation of the rate of return on the risky portfolio, the estimated slope b should be positive and not differ significantly from the risk premium on the market portfolio RPm, that is Rm R*. There should be a linear relationship given by beta between the average portfolio risk premium and the average market risk premium. Over time, Rm should exceed R*, since a market portfolio is riskier than the risk-free asset. Other explanatory variables such as dividend yield, firm size, priceearnings ratios should not prove to be statistically significant in predicting the required rate of return.

3 4 5

8.11

There have been numerous empirical studies of the CAPM model. Among the most important are Friend and Blume (1970), Black, Jensen and Scholes (1972), Miller and Scholes (1972), Blume and Friend (1973), Fama and MacBeth (1973), Litzenberger and Ramaswamy (1979), Gibbons (1982) and Shanken (1985). Empirical results are, generally speaking, reasonably supportive of the basic tenet of the model, but this is not to say that they constitute

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a full endorsement. The results of the various studies can be summarized along the following lines: 1 2 The estimated intercept term, a, tends to be significantly different from zero contrary to prediction 1. The estimated slope, b, while positive tends to be less than the difference between the market rate of return and the risk-free rate of interest contrary to prediction 2. The estimated relationship tends to be linear with respect to beta, and over long periods of time the return on the market portfolio exceeds the risk-free rate of interest so that predictions 3 and 4 seem valid. Contrary to prediction 5, it is possible to find other factors that can explain a portfolios excess return; for example Basu (1977) found low price-earning ratio portfolios have higher rates of return than predicted by the CAPM. Banz (1981) found that firm size was important, with smaller firms having higher returns than predicted by the CAPM, while Litzenberger and Ramaswamy (1979) found that equities with high dividend yields required higher rates of return than predicted by the CAPM.

The overall conclusion of the studies is that the empirical securities market line differs somewhat from the theoretical line as depicted in Figure 8.4. The general implication is that securities (and portfolios) with low betas tend to

Theoretical SML

Empirical SML M

R*

= 1

Beta (i)

Figure 8.4

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earn a higher rate of return than the theoretical model would suggest, while securities (and portfolios) with high betas tend to earn less.

8.12

The CAPM model that we have looked at suggests that the only risk factor facing an investor is uncertainty concerning the future price of a security. Merton (1973) argues that investors over their lifetime also face other sources of risk that can affect their ability to consume goods and services in the future; these factors include uncertainty over future earnings, future prices of goods and future investment opportunities. Recognizing the existence of these other factors Merton extended the single-factor CAPM to describe the optimal lifetime consumption for consumers facing these extra market sources of risk. The Merton multifactor CAPM for an individual security is given by: E(RPi) = bim E(RPm) + biF1 E(RPF1) + biF2 E(RPF2) + . . . + biFk E(RPFk) [8.26]

where E(RPi) is the risk premium on security i, that is the expected return on the security less the risk free rate of interest; k is the number of factors F, that is extra market sources of risk; and biF1,2...k is the sensitivity of security i to the 1, 2 . . . kth factor; and E(RPF1,2...k) is the risk premium associated with the 1, 2 . . . kth factor; that is the expected rate of return required for factor k minus the risk-free rate of interest. Equation (8.26) says that in addition to the risk premium associated with market risk on a security, investors require compensation for all sources of extra market risk. The model is not specific on either how many extra market sources of risk there are, or indeed precisely what they are. However, just as investors will diversify away unsystematic risk associated with securities, they will also attempt to reduce extra market sources of risk. The Merton multifactor CAPM model for a portfolio of securities is given in risk-premium form by: E(RPp) = bm E(RPm) + bpF1 E(RPF1) + bpF2 E(RPF2) + . . . + bpFk E(RPFk) (8.27) where E(RPp) is the risk premium on the portfolio, that is the expected return on the portfolio less the risk-free rate of interest; k is the number factors F, that is extra market sources of risk; bpFk is the sensitivity of the portfolio to the kth factor; and E(RPFk) is the risk premium associated with the kth factor, that is the expected return of factor k minus the risk-free rate of interest.

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8.13

In two papers Ross (1976) and Roll and Ross (1980) argued that the CAPM model was empirically untestable. The basic criticism being that a true market portfolio needs to contain all assets both financial and non-financial in an economy, and many of these are not empirically observable such as human capital and so on. Furthermore, the CAPM is based upon microeconomic foundations which require the investors utility function to be measured in terms of expected return and risk as measured by the standard deviation of return. The basic postulate of the arbitrage pricing theory (APT) is that market risk is itself made up of a number (k) of separate systematic factors. In other words, the single beta reflecting market risk of the CAPM is insufficient. The arbitrage pricing model is derived from a number of arbitrage conditions. In a nutshell, the APT says that the return on a security is linearly related to k systematic factors without specifying exactly what these factors are: E(Ri) = r + biF1 E(RPF1) + biF2 E(RPF2) + . . . + biFk E(RPk) (8.28)

where E(Ri) is the expected return on security i; r is the risk-free rate of interest; biF1,2...k is the beta for security i with respect to factors 1, 2, 3 . . . k; RPF1,2,3...k is the risk premium required to compensate for the systematic risk on factors 1, 2, 3 . . . k, for example RPF1 = (R1 R*) where R1 is the required rate of return for factor 1 and R* is the risk-free rate of interest. If we move the risk-free factor to the left-hand side, equation (8.28) can be written in risk-premium form as: E(RPi) = biF1 E(RPF1) + biF2 E(RPF2) + . . . + biFk E(RPk) (8.29)

where E(RPi) is the risk premium of security i, that is the expected rate of return on security i less the risk-free rate of interest. Equations (8.28) and (8.29) say that the return on a security is affected separately by all the k factors that systematically affect the return on a security. These factors might include exchange rate and interest rate risk, for example, which can vary from one company to another. The required compensation is equal to the quantity of risk accepted for factor 1, 2, 3 . . . k, which is measured by the beta of the security with respect to factor 1, 2, 3 . . . k and the market price of factor 1, 2, 3 . . . k risk as measured by the risk premium for that systematic risk factor. Equation (8.29) contrasts with equation (8.25) of the CAPM in that it has

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several beta coefficients rather than just one. In addition, the CAPM deals with market-risk while the APT does not have a market risk coefficient, the whole point of the model being that market risk is unidentifiable. The proponents of the APT argue that it has two main advantages over the CAPM model: 1 The CAPM requires that the investors utility function is based upon expected returns and the standard deviation of systematic risk. The APT does not require standard deviations to be used as a measure of risk. The other main advantage is that the APT does not require an unobservable market index to be compiled.

Against this, however, the APT has its own defects. It does not say what are the relevant factors or even how many relevant factors there are! It can be argued that although the APT gets rid of the problem of an unobservable market index, it fails to provide a solution for choosing alternative factors. In an empirical study, Chen, Roll and Ross (1986) suggested that possible relevant factors for shares were unanticipated changes in industrial production, unanticipated changes in interest rates and the slope of the yield curve, unanticipated inflation, and unanticipated changes in the spread between high and low-grade bonds. Nonetheless, this list is far from definitive and modelling unanticipated variables is itself far from easy.

8.14

Conclusions

The risk attached to an individual security is made up of two components, the systematic/market and unsystematic/specific components. We have seen that the unsystematic component can be reduced or even eliminated by portfolio diversification. Since diversification is a relatively low-cost option this risk will not normally command any return. The systematic risk on the security that remains after appropriate diversification can be measured by the value of its beta times the standard deviation of the market portfolio. The value of a beta is reflected in the average expected return on the asset. Portfolio risk is also made up of two components, the systematic and unsystematic components. As the number of shares in a portfolio rises, the unsystematic/specific risk is reduced and eventually disappears. The systematic/market risk attached to a portfolio of shares is represented by the portfolio beta which is simply a weighted average of the individual betas in the portfolio. The introduction of beta as a measure of risk in the CAPM dramatically reduces the number of computations necessary to construct an optimal

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investment portfolio. There is no need to calculate the standard deviation or the covariance of each pair of securities to calculate the variance of the portfolio. The beta of a portfolio is simply the weighted average of all the individual betas that make up the portfolio. This means that a fund manager or investor can construct aggressive (beta greater than one) and defensive (beta less than one) portfolios by selecting shares with relatively high or low betas as appropriate. The great contribution of the market model and the capital asset pricing model is that they make it clear that the expected return on a security is not dependent upon the total risk embedded in the security, but only due to that part of total risk that cannot be diversified away, that is the systematic risk. Before the development of modern portfolio analysis, such as the CAPM, it was widely believed that the risk on a financial asset could be measured by the standard deviation of its return distribution. This meant that a securitys risk could be measured without reference to other securities. The crucial insight of modern portfolio theory such as the market model and CAPM is that some of the risk attached to a financial asset can be reduced by holding it in a portfolio with other assets, and the risk that cannot be eliminated by this process is the only risk that will be priced by financial markets. The CAPM assumes that the only risk that is relevant to the pricing of a security is uncertainty over the expected future return attached to that security. The CAPM was extended into a multi-factor CAPM by Robert Merton to include additional risks such as those facing investors concerning the inflation rate and so on. In the multifactor version of the CAPM the total risk on a security is measured by market risk and a number of non-market sources of risk. In theory, the market portfolio should include all marketable assets such as works of art, property, precious stones, rare coins and the like, as well as listed securities. This has led to some critics of the CAPM to argue that the true market index is unobservable and to propose alternative theories, and this is the motivation behind the arbitrage pricing theory. In practice, most investors do not hold market portfolios as predicted by the CAPM, indeed for an individual with very limited investment funds the transaction costs involved in constructing a market portfolio will be insurmountable. However, in recent years there has been a phenomenal rate of growth in the use of index-tracking funds which track general market indices such as the S&P 500 and the FTSE 100. This means that individual investors can now allocate a proportion of their wealth into index-tracking funds in a manner required by the CAPM without great difficulty.

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MULTIPLE CHOICE QUESTIONS 1 The risk-free rate of interest is 10%, the rate of return on the market portfolio is 25% and you hold a portfolio of stocks worth 1,000 that has a portfolio beta of 1.5 that is efficiently priced in line with the CAPM. If you borrow 600 and invest it fully in the portfolio that you currently own, the expected rate of return of the leveraged portfolio is: a 32.5% b 34.0% c 37.5% d none of the above The risk-free rate of interest is 4%, the return on the market portfolio is 10% and the standard deviation of the market return is 30%. If a combination of the risk-free asset and the market portfolio has a standard deviation of 15%, the beta of the combined portfolio and expected rate of return is: a beta 0, expected rate of return 6% b beta 0.5, expected rate of return 7% c beta 1, expected rate of return 8% d none of the above 3 In determining the required rate of return on a security, the appropriate value of risk is its: a standard deviation b covariance c correlation coefficient d beta Security A has a beta of 0.5, the risk-free rate of interest is 5% and the expected return on the market is 15%. If the security offers a prospective yield of 9% then according to the capital asset pricing model the security is: a correctly valued b undervalued and should be bought c overvalued and should be sold d on the securities market line Which of the following is not a characteristic of the securities market line? a The standard deviation is on the horizontal axis. b It is positively sloped. c It intersects the vertical axis at the risk free rate of interest. d The slope represents the market price of risk.

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SHORT ANSWER QUESTIONS 1 The returns on share ABC and the market portfolio are: Year 1996 1997 1998 1999 2000 2001 2002 (i) (ii) (iii) (iv) (v) Return ABC 2.0% 13.0% 10.0% 5.0% 8.0% 2.0% 6.0% Return on market portfolio 12.0% 18.0% 5.0% 15.0% 10.0% 12.0% 26.0%

Calculate the average rate of return for the ABC shares and the market portfolio. Calculate the sample (IR using N 1) standard deviation of returns on share ABC and the return on the market portfolio. Calculate the sample (i.e. using N 1) covariance between ABC shares and the market portfolio. Calculate the beta coefficient of the ABC shares. Assuming that the risk-free rate of interest is 4%, what is the expected return on ABC shares? Sketch the securities market line and ABCs risk (beta) and return. Are ABC shares undervalued or overvalued?

Assume that the following data represent all risky securities in the economy: Security A B C D (i) Value 20 20 30 30 100 Standard deviation 5.0% 10.0% 20.0% 30.0% Correlation coefficient matrix A B C D A 1.0 0.0 0.0 0.0 B 0.0 1.0 0.0 0.0 C 0.0 0.0 1.0 0.0 D 0.0 0.0 0.0 1.0

What is the market portfolio (i.e. what percentage of each security must be invested to achieve the market portfolio)? What is the standard deviation of the market portfolio? If the risk-free rate of return is 2% and the expected return on the market portfolio is 7%, what is the capital market line equation? If the risk-free rate of return is 2% and the expected return on the market portfolio is 7%, what is the security market line equation? A pension fund that you are advising wishes to have an expected rate of return of 5%. How should the fund invest to obtain this? What would be the standard deviation and the beta of the pension funds portfolio?

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(v) 3

You would like to have an expected return of 10%. How should you invest your money to obtain this?

You have the following investments in securities A, B and C: Security A B C Amount invested 10,000 8,000 7,000 Beta 1.15 1.90 1.72 Expected 1-year return 14% 20% 18%

The current risk-free rate of interest is 5% and you have heard that analysts are expecting a 15% return on the market portfolio over the next year. Based on your expectations for the 1-year returns of each of the securities, is your portfolio underpriced, overpriced or correctly priced? 4 Consider a regression analysis of five shares AE with the following results: Share A B C D E Beta 0.5 0.7 0.8 1.2 1.3 Specific risk ei 0.30 0.35 0.60 0.40 0.50 Annual % return 20 15 9 18 10

(Note that specific risk ei is measured in this case by the standard deviation of the error term, that is sei, so we need to take the square to get the variance.) The risk-free rate of interest R* = 5%, the market rate of return is Rm = 14% and the standard deviation of the market is sm = 0.25. (i) (ii) (iii) (iv) (v) 5 Calculate the portfolios beta. Calculate the systematic risk of the portfolio. Calculate the unsystematic risk of the portfolio. Calculate the total risk of the portfolio as measured by the variance of the portfolio. Calculate the actual return of the portfolio against its systematic return as required by the CAPM.

The risk-free rate of interest is 5%, the covariance of returns of share A with the market is sAM = 0.2, and the standard deviation of the market sM is 0.5. The expected rate of return on market is 12%. (i) (ii) Calculate the beta of share A. Calculate the expected return on share A.

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Further reading

Blake, D. (2000) Financial Market Analysis, 2nd edn, McGraw-Hill. Elton, E., Gruber, M., Brown, S. and Goetzmann, W.N. (2002) Modern Portfolio Theory and Investment Analysis, Wiley. Sharpe, W.F., Alexander, G.J. and Baley, J. (2002) Investments, 6th edn, Pearson.

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