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Problem in portfolio selection

What if the investment universe is large? If 100 assets on the input list, how many estimates does one need to prepare? 100 E(ri), 100 si, and r how many? Answer: (100 x 99)/2 = 4950 unique r

Advantage of the Single Index Model stems from its simplifying assumptions

Single index model

All assets derive only from the common factor RM ei is firm-specific, and hence uncorrelated across assets Hence, if there are 100 assets in the investment universe, only need 100 beta estimates and the variance of RM to calculate all the covariance's

Advantages: Reduces the number of inputs for diversification A simplified model for portfolio analysis by Sharpe (1963) Easier for security analysts to specialize, e.g., communications, resources. Everything is related only to the aggregate market Drawback: rules out other important risk sources (e.g., industry factors) Is the market index appropriate/representative?

Computational Advantages

The single-index model compares securities to a single benchmark all

An alternative to comparing a security to each of the others By observing how two independent securities behave relative to a third value, we learn something about how the securities are likely to behave relative to each other

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Ri i i RM ei

RP P PRM eP

Beta

A securitys beta is

COV ( Ri , Rm )

2 sm

2 s m variance of the market returns

Ri return on Security i

Beta of a portfolio:

p xi i

i 1

p p m ep

s

2 p

2 m

As the number of assets in portfolio increases, the second term becomes less and less 8 important

Multi-Index Model

A multi-index model considers independent variables other than the performance of an overall market index

Of particular interest are industry effects

Factors associated with a particular line of business

Multi-Index Model

The general form of a multi-index model:

Ri ai im I m i1 I1 i 2 I 2 ... in I n where ai constant I m return on the market index I j return on an industry index

ij Security i's beta for industry index j im Security i's market beta

Ri return on Security i

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Capital market theory extends portfolio theory and seeks to develops a model for pricing all risky assets based on their relevant risks Asset Pricing Models

Capital asset pricing model (CAPM) is a single factor model allows for the calculation of the required rate of return (also Known as Model Return) for any risky asset based on the securitys beta Arbitrage Pricing Theory (APT) is a multi-factor model for determining the required rate of return

There are rather large implications for capital market theory when a risk-free asset exists. What is a risk-free asset?

An asset with zero variance Provides the risk-free rate of return (RFR) It will be an intercept value on a portfolio graph between expected return and standard deviation.

Since it has zero variance, it will also have zero correlation with all other risky assets

Expected return is the weighted average of the two returns

This is a linear relationship

Standard deviation: The expected variance for a two-asset

portfolio is

E(s

2 port

) w s w s 2w 1 w 2 r1,2s 1s 2

2 1 2 1 2 2 2 2

Substituting the risk-free asset for Security 1, and the risky asset for Security 2, this formula would become

2 2 E(s port ) w 2 s RF (1 w RF ) 2 s i2 2w RF (1 - w RF )rRF,is RFs i RF

Since we know that the variance of the risk-free asset is zero and the correlation between the risk-free asset and any risky asset i is zero we can adjust the formula

E(s

2 port

) (1 w RF ) s

2

2 i

2 E(s port ) (1 w RF ) 2 s i2 Given the variance formula

E(s port ) (1 w RF ) 2 s i2

(1 w RF ) s i

Therefore, the standard deviation of a portfolio that combines the risk-free asset with risky assets is the linear proportion of the standard deviation of the risky asset portfolio.

12%

8%

4%

Risk-free rate

0% 0% 10% 20% 30% 40%

A risktaker

12%

8%

4%

Risk-free rate

0% 0% 10% 20% 30% 40%

12%

8%

4%

Risk-free rate

0% 0% 10% 20% 30% 40%

Assumption of unlimited lending and borrowing at risk-free rate. Lending if portion of portfolio held in risk-free assets. Borrowing (leverage) if more than 100% of portfolio is invested in risky assets. Superior returns made possible with lending and borrowing; creates spectrum of risk preference for different investors.

Portfolio Possibilities Combining the Risk-Free Asset and Risky Portfolios on the Efficient Frontier

E(R port )

RFR

E(s port )

Portfolio M lies at the point of tangency, so it has the highest portfolio possibility line This line of tangency is called the Capital Market Line (CML) Everybody will want to invest in Portfolio M and borrow or lend to be somewhere on the CML (the CML is a new efficient frontier)

Therefore this portfolio must include all risky assets (or else some assets would have no demand)

Because the market is in equilibrium, all assets are included in this portfolio in proportion to their market value. Because it contains all risky assets, it is a completely diversified portfolio, which means that all the unique risk of individual assets (unsystematic risk) is diversified away

The CML leads all investors to invest in the M portfolio (The Investment Decision) Individual investors should differ in position on the CML depending on risk preferences (which leads to the Financing Decision)

Risk averse investors will lend part of the portfolio at the risk-free rate and invest the remainder in the market portfolio (points left of M) Aggressive investors would borrow funds at the RFR and invest everything in the market portfolio (points to the right of M)

Fund Separation

Everyones U-maximizing portfolio consists of a combination of 2 assets only: Risk-free asset and the market portfolio. This is true irrespective of the difference of their risk-preferences

E(Rp)

B E(RM)

CML

A

Rf M

(Rp)

CAPM indicates what should be the required rates of return on risky portfolios This helps to value an asset by providing an appropriate discount rate to use in dividend valuation models You can compare an expected rate of return to the required rate of return implied by CAPM over/ under valued? If required Return (Model Return is less than expected, Security is under valued)

R(R i ) RFR i (R M - RFR)

The required rate of return of a risk asset is determined by the RFR plus a risk premium for the individual asset The risk premium is determined by the systematic risk of the asset (beta) and the prevailing market risk premium (RM-RFR)

In equilibrium, all assets and all portfolios of assets should plot on the SML

The SML gives the market going rate of return or what you should earn as a return for a security Any security with an expected return that plots above the SML is underpriced Any security with an expected return that plots below the SML is overpriced

If the market portfolio is not efficient, then stocks will not all lie on the security market line. The distance of a stock above or below the security market line is the stocks alpha (). We can improve upon the market portfolio by buying stocks with positive alphas and selling stocks with negative alphas.

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Graph of SML

R(R i )

SML

Rm

Negative Beta

RFR

1.0

Beta(Cov im/ s 2 )

M

Please notice that the CML is used to illustrate all of the efficient portfolio combinations available to investors. It differs significantly from the SML that is used to predict the required return that investors should demand given the riskiness (beta) of the investment.

After its discovery, the CAPM was immediately applied in the real world. To measure the correct excess expected return for any security all one has to know is: (1) the market risk premium (E(RM) r) (2) security beta (j)

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The Impact of the Time Interval

Number of observations and time interval used in regression vary weekly rates of return Vs. monthly return There is no correct interval for analysis

The Effect of the Market Proxy

A measure of the market portfolio is needed Nifty/Sensex Composite Index is most often used

Includes a large proportion of the total market value of Indian stocks

Includes only Indian stocks The theoretical market portfolio should include all types of assets from all around the world

Nonstationary Beta Problems

Nonstationary Beta Problem: Difficulty tied to the fact that betas are inherently unstable

, the slope of the regression of a securitys return on the market return, is the only risk factor needed to explain expected return. captures a positive expected return premium for risk. Other risk factors emerge:

firm size

low P/E, price/cash flow, P/B, and sales growth

Other Problems:

(1926-2004) US Market

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Small Stocks

Looking at that plot, small stocks appear to have higher returns. Do these stocks correctly plot on the SML?

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It is difficult to say decisively, whether the Single-factor model or the standard CAPM are good or bad.

There is much empirical support for both

Even so, there are very cogent arguments questioning this evidence

Return and risk appear to be linearly related over long periods of time (when risk is defined as systematic risk; that is, the risk measured by beta) is important The fact that return is not related to residual risk is also important

While these facts certainly do not constitute tests, per se, they have important implications for behavior

Within the CAPM investors are not rewarded for taking nonmarket risk

They are, however, rewarded for bearing added market risk

Regardless of the model being explored, these facts seem to hold in the CAPM

CAPM is criticized because of the difficulties in selecting a proxy for the market portfolio as a benchmark An alternative pricing theory with fewer assumptions was developed:

Arbitrage Pricing Theory

Developed by Stephen Ross (1976) Basic idea: Calculate relations among expected returns that will rule out arbitrage by investors Arbitrage: Creation of riskless profits made possible by relative mispricing among securities.

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Multiple factors expected to have an impact on all assets: Inflation Growth in GNP Major political upheavals Changes in interest rates And many more. Contrast with CAPM assumption that only beta is relevant

The expected return on any asset i (Ei) can be expressed as:

in the rate The risk 1 = changes to this factor of 1inflation. for every 1premium related is percent percent

change in the rate

(1 .01) (2 .02)

= percent growth in real GNP. The average risk premium 2 related to this factor is 2 percent for every 1 percent change in the rate

oj

(3 .03)

Multifactor Models in Practice Macroeconomic-Based Risk Factor Models Microeconomic-Based Risk Factor Models Extensions of Characteristic-Based Risk Factor Models

Fama-French found that size and B/M do a better job of explaining returns, so they said the model should be:

ri rf i i (rM rf ) si ( SMB) hi ( HML) ei

SMB = small minus big = rsmall rbig HML = high B/M minus low B/M = rvalue rgrowth

F&F does a better job alpha very close to zero Main criticism: No theory justifying why size and B/M should be risk factors.

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