Risk and Capital Asset Pricing Model

Module 8

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Risk and Capital Asset Pricing Model
Module Outline

§ What is Risk

§ Portfolio Diversification

§ The Capital Asset Pricing Model--- An Equilibrium Model of

returns

§ Estimating the CAPM parameters

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What is Risk?
§ Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary,
for instance, defines risk as “exposing to danger or hazard”.

§ The Chinese symbols below give a much better description of risk

危机

§ The first symbol is the symbol for “danger”, while the second is the
symbol for “opportunity”, making risk a mix of danger and opportunity.
You cannot have one, without the other.

§ Risk is therefore neither good nor bad. It is just a fact of life. The
question that businesses have to address is therefore not whether to
avoid risk but how best to incorporate it into their decision-making.

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Related Statistics
§ The return in the next period is modeled as random variable
State of nature 1 2 … s … S
Probabilities p1 p2 … ps … pS
Investment i Ri,1 Ri,2 … Ri,s … Ri,S

Note: ps ³ 0 åp s
=1
§ Population Statistics s

§ Mean or Expected return: 𝐸 𝑅! ! ≡ 𝜇! = ∑" 𝜋" 𝑅!,"

$ $
§ Variance: 𝑉 𝑅( ! ≡ 𝜎!$ = ∑" 𝜋" 𝑅!," − 𝜇! = 𝐸 𝑅( !$ − 𝐸 𝑅( !

§ Standard Deviation: 𝜎! = 𝜎!$

§ Covariance: 𝐶𝑜𝑣 𝑅( ! , 𝑅(% ≡ 𝐸 𝑅( ! − 𝜇! 𝑅(% − 𝜇%
= 1 𝜋" 𝑅!," − 𝜇! 𝑅%," − 𝜇%
"
= 𝐸(𝑅( ! 𝑅(% ) − 𝐸 𝑅( ! 𝐸 𝑅(%
'() +* ! ,+* "
§ Correlation: 𝐶𝑜𝑟𝑟 𝑅( ! , 𝑅(% = = 𝜌!%
,! ,"

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Related Statistics
Example

State of Nature Recession Normal Boom

Probability 0.25 0.55 0.2

Return of Stock A -0.5 0 1.5

Return of Stock B 0 0 0.1

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Properties of Moment Calculations
§ Let 𝑅- , 𝑅$ and 𝑅. be random variables and 𝑤 a constant.

§ Mean or expected return:

§ 𝐸(𝑅- + 𝑅$ ) = 𝐸(𝑅- ) + 𝐸(𝑅$ )

§ 𝐸(𝑤𝑅- ) = 𝑤𝐸(𝑅- )

§ Variance:

§ 𝑉𝑎𝑟(𝑅- + 𝑅$ ) = 𝑉𝑎𝑟(𝑅- ) + 𝑉𝑎𝑟(𝑅$ ) + 2𝐶𝑜𝑣(𝑅- , 𝑅$ )

§ 𝑉𝑎𝑟(𝑤𝑅- ) = 𝑤 $ 𝑉𝑎𝑟(𝑅- )

§ Covariance:

§ 𝐶𝑜𝑣 𝑅- + 𝑅$ , 𝑅. = 𝐶𝑜𝑣 𝑅- , 𝑅. + 𝐶𝑜𝑣(𝑅$ , 𝑅. )

§ 𝐶𝑜𝑣(𝑤𝑅- , 𝑅. ) = 𝑤𝐶𝑜𝑣(𝑅- , 𝑅. )

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Portfolio Diversification
§ Invest your wealth in different assets.
§ Denote w# the fraction of the saving invested in the i-th asset. According to the definition, ∑ w#$% .
§ This set of assets is called a portfolio.
§ Short-selling:
§ 𝑤& < 0 means selling the stock 𝑖 short, i.e., selling it without owning it.
§ This can be done in two steps:
§ At 𝑡 = 0 borrow the stock from your broker and sell it on the market for 𝑃' .
§ At 𝑡 = 1 buy the stock on the market for 𝑃% and return the stock to your broker.
(! )(" )((" )(!)
§ Your rate of return is (!
= (!
= −𝑅%

§ Return of a two-asset portfolio

§ 𝑅-( = 𝑤% 𝑅-% + 𝑤+ 𝑅-+ , 𝑤% +𝑤+ = 1
§ Expected return of a two-asset portfolio:
§ 𝜇( = 𝑤% 𝜇% + 𝑤+ 𝜇+
§ Variance of the portfolio:
§ 𝜎(+ = 𝑤%+ 𝜎%+ + 𝑤++ 𝜎++ + 2𝑤% 𝑤+ 𝜎% 𝜎+ 𝜌%+
= 𝑤%+ 𝜎%+ + 𝑤++ 𝜎++ + 2𝑤% 𝑤+ 𝜎%+

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Portfolio Diversification
Example

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Portfolio Diversification
§ With two assets, suppose the weights of both securities are positive. As

long as the correlation coefficient is less than 1, the standard deviation

of a portfolio of two securities is less than the weighted average of the

standard deviations of the individual securities. --- Diversification Effect

§ Investors can obtain the same level of expected return with lower

risk.

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Portfolio Diversification
Example – Why Buy Gold?
§ The following estimates are based on US stock returns and gold price

movements from 1948 to 1975. The correlation coefficient between the

returns on these assets is −0.4.

Asset Mean Return Standard Deviation

Gold 0.088 0.208

S&P 500 0.128 0.183

§ Why would you like to hold gold in spite of its relatively low return and high
variance?

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Portfolio Diversification
Example – Why Buy Gold? (cont.)
§ Let 𝑤- be the percentage of your wealth invested in gold. Then the mean and
standard deviation of the portfolio for different 𝑤- ′𝑠 is

𝑤! 0.0 0.2 0.4 0.6 0.8 1.0

𝜇" 0.128 0.120 0.112 0.104 0.096 0.088

𝜎" 0.183 0.135 0.108 0.117 0.155 0.208

§ Holding gold decreases portfolio standard deviation because of its negative

correlation with the stock index.
§ With many assets, suppose the weights of all securities are positive. As long as
the correlations between pairs of securities are less than 1, the standard
deviation of a portfolio of many assets is less than the weighted average of the
standard deviations of the individual securities. --- Diversification Effect

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A Breakdown of Risk
Figure 3.5: A Break Down of Risk

Competition
may be stronger
or weaker than Exchange rate
anticipated and Political
risk
Projects may
do better or Interest rate,
worse than Entire Sector Inflation &
may be affected news about
expected by action economy

Firm-specific Market

Actions/Risk that Actions/Risk that

affect only one Affects few Affects many affect all investments
firm firms firms
Firm can Investing in lots Acquiring Diversifying Diversifying Cannot affect
reduce by of projects competitors across sectors across countries

Investors Diversifying across domestic stocks Diversifying globally Diversifying across

can asset classes
mitigate by

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Differentiate Different Types of Risk
§ Risks that affect all investments is called market risk — it cannot be diversified
away. E.g., interest rate, inflation, and news about economy.

§ Firm specific events like manager’s performance, changes in factors of

production, unanticipated events etc., is called idiosyncratic risk, or firm-
specific risk — it can be diversified away.
§ Investors are risk averse.
§ Required rate of return = Hurdle rate
= Riskless Rate + Risk Premium

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Equilibrium Model of Returns
§ Capital Asset Pricing Model (CAPM):
§ Expected Return = Risk-free rate + Beta * Market RP
0() +! ,+,
§ 𝐸 𝑅! = 𝑟/ + [𝐸 𝑅1 − 𝑟/ ]
,- +,
cov (Ri ,Rm )
§ where R 2 is the return of Risky Asset i and is referred to as the
σ 2(Rm )
beta of Asset i.
§ CAPM Theorem: The expected return of an asset is a linear and positive
function of its beta.

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Beta
§ A measure of an asset’s systematic risk
§ Property of CAPM:
§ The only risk that will be compensated for is undiversifiable risk (or market
risk).
§ This is based on the assumption that investors hold a well-diversified
portfolio.
§ β2 < 0⇒E R 2 < r3 < 𝐸 R 4 , Negative Risk, valuable as a hedge
§ β2 = 0⇒E R 2 = r3 < 𝐸 R 4 , No Systematic Risk, regardless of σ$2
§ 0 < 𝛽2 < 1⇒r3 < 𝐸 R 2 < 𝐸 R 4 , Less risky than market portfolio
§ β2 = 1⇒r3 < 𝐸 R 2 = E R 4 , Same risky as market portfolio

§ β2 > 1⇒r3 < 𝐸 R 4 < 𝐸 R 2 , Riskier than the market portfolio

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Beta
Example

§ Suppose Rf = 5%, E(RM) = 15%, and sM = 20%. The following data is available for

two securities:

Firm si Cov(Ri,RM)

1 50% 0.06

2 40% 0.08

§ What is the beta and expected return of each securities?

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Determinants of Beta
Cyclicality of Revenue

§ Empirical evidence suggests that retailers and automotive firms fluctuate with

the business cycle.

§ Transportation firms and utilities are less dependent upon the business cycle.

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Determinants of Beta
Operating Leverage
§ Measures the percentage change in EBIT for a given percentage change in sales or revenues.
§ Example: A firm can choose either technology A or B

Technology A Technology B
Fixed Cost: $1000/year Fixed Cost: $2000/year
Variable Cost: $7/unit Variable Cost: $6/unit
Price: $10/unit Price: $10/unit
Contribution Margin: $3(=$10-7) Contribution Margin: $4(=$10-6)
§ Technology B has higher fixed cost and lower variable cost, so its contribution margin and operating
leverage is greater.

§ The cyclicality of a firm’s revenue is a

determinant of the firm’s beta.
Operating leverage magnifies the
effect of cyclicality on beta.
§ Operating leverage refers to the firm’s
fixed costs of production.

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Determinants of Beta
Financial Leverage
§ measures the extent to which a firm relies on debt.
§ It refers to the firm’s fixed costs of financing.
§ The beta of a levered firm’s stock is the firm’s equity beta.

§ The beta of a levered firm’s asset is the firm’s asset beta, which is different
from the beta of its equity.
Debt Equity
β Asset = ´ β Debt + ´ β Equity
§ When there is no tax, Debt + Equity Debt + Equity

§ In practice, β5$%& is very low. If we make the commonplace assumption that

Equity Debt
β5$%& = 0, then β Asset = ´ β Equity or β Equity = β Asset (1 + )
Debt + Equity Equity
§ It follows that β'(($& < β , if 𝐷𝑒𝑏𝑡 > 0.
)*+,&-

§ It also says that the beta of the unlevered firm must be less than the beta of of
equity in an otherwise identical levered firm.

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Beta
Important Caveat
§ This does not say that the beta of the firm’s assets is determined by β. , β) and

its debt-equity ratio. Instead, the beta of the firm’s assets is determined by the

risk of the revenues and costs accruing to the firm. The debt-equity ratio

affects β) and eventually β. (when bankruptcy comes into play); β' is

constant throughout. The higher the debt-equity ratio, the higher β) .

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Beta
Example

§ Consider Grand Sport, Inc., which is currently all-equity and has a beta

of 0.90. The firm has decided to lever up to a capital structure of 1 part

debt to 1 part equity. What’s the asset beta and equity beta?

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Estimating the Risk-free Rate Rf

§ The risk free rate is the rate on government bond. The risk free rate that you

use in an analysis should be in the same currency that your cash flows are

estimated in.

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Estimation of the Market Risk Premium (E(RM)–Rf )

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Beta
§ In practice, the beta can change over time due to change of industry, or
changes in product line, changes in technology, deregulation and changes in
financial leverage etc.
§ The error in beta estimation on a single stock can be much higher than the
error for a portfolio of securities. Thus an alternative method is to estimate
industry betas.
§ A simple guideline:
§ If the operations of the firm are similar to the operations of the rest of the
industry, you should use the industry betas.
§ If the operations of the firm are fundamentally different from the
operations of the rest of the industry, use the firm’s betas.
§ Don’t forget about adjustments for financial leverage if the debt level in the
industry is different from that of the firm.
§ Several vendors of financial data provide betas for specific companies or for
industries

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