Asset Pricing Principles

Chapter 9
Charles P. Jones, Investments:
Principles and Concepts,
Eleventh Edition, John Wiley & Sons
 Overview
• In chapter (7) we introduced expected return and risk
calculations in terms of variance and standard
deviation in light of the MPT
• In Chapter (8) we introduced the Efficient set of
portfolios as well the optimal portfolio based on the
Markowitz’s approach to portfolio selection
• In chapter (9) we will be assessing the relationship
between the Required Rate of Return(RRR) and the
associated risk for a specific security in light of the
CAPM and the Capital Market Theory (CMT)
 Overview
• The CAPM, which was said to be so important in
finance, probably has a role to play in your investing
decisions.
• And in fact it does because it captures the concept of
a RRR for a stock, which is important to consider
when you are trying to decide which stocks to buy.
Capital Market Theory
 Capital Market theory
• Capital market theory is a positive theory in that it
hypothesizes how investors do behave rather than
how investors should behave, as in the case of
modern portfolio theory (MPT).
• It is reasonable to view capital market theory as an
extension of portfolio theory.
• The CMT begins where portfolio theory ends and
provides a model for pricing risky assets.
 Capital Market Theory
• The specific equilibrium model of interest to many
investors is known as the Capital Asset Pricing Model,
typically referred to as the CAPM.
• It allows us to assess the relevant risk of an
individual security as well as to assess the
relationship between risk and the returns expected
from investing.
 Capital Asset Pricing Model
• Focuses on the equilibrium relationship between the
risk and expected return on risky assets
• Builds on Markowitz portfolio theory
• Each investor is assumed to diversify his or her
portfolio according to the Markowitz model,
choosing a location on the efficient frontier that
matches his or her return-risk references.
Introduction of the Risk-Free Asset
• The first assumption of capital market theory listed
above is that investors can borrow and lend at the
risk-free rate.
• Although the introduction of a risk-free asset appears
to be a simple step to take in the evolution of
portfolio and capital market theory, it is a very
significant step.
• In fact, it is the introduction of a risk-free asset that
allows us to develop capital market theory from
portfolio theory.
Introduction of the Risk-Free Asset
• With the introduction of a risk-free asset, investors
can now invest part of their wealth in this asset and
the remainder in any of the risky portfolios in the
Markowitz efficient set.
• This allows Markowitz portfolio theory to be
extended in such a way that the efficient frontier is
completely changed, which in turn leads to a general
theory for pricing assets under uncertainty.
 Defining a Risk-Free Asset
• A risk-free asset can be defined as one with a certain-
to be-earned expected return and a variance of
return of zero
• Since variance is 0, the risk-free rate in each period
will be equal to its expected value
• Furthermore, the covariance between the risk-free
asset and any risky asset will be zero
 Defining a Risk-Free Asset
• The true risk-free asset is best thought of as a
Treasury security, which has little or no practical risk
of default, with a maturity matching the holding
period of the investor.
• In this case, the amount of money to be received at
the end of the holding period is known with certainty
at the beginning of the period.
• The Treasury bill (discussed in Chapter 2) typically is
taken to be the risk-free asset, and its rate of return
is referred to here as RF.
 Risk-Free Borrowing and Lending
• L • Riskless assets can be
combined with any
• B
portfolio in the efficient
set AB
• E(R) • T – Z implies lending
• Z • X • Set of portfolios on line
RF to T dominates all
• RF
portfolios below it
• A
 Risk-Free Borrowing and Lending
• AB is the efficient frontier showing the efficient set of
portfolios of risky assets such as common stocks.
• We need to introduce risk-free asset with return RF and σ = 0.
• As shown in Figure 9-1, the return on the risk-free asset (RF)
will plot on the vertical axis because the risk is zero.
• Investors can combine this riskless asset with the efficient set
of portfolios on the efficient frontier.
• By drawing a line between RF and various risky portfolios
on the efficient frontier, we can examine combinations of risk-
return possibilities that did not exist previously.
 Lending Possibilities
• In Figure 9-1 a new line could be drawn between RF and the
Markowitz efficient frontier above point X, for example,
connecting RF to point V.
• Each successively higher line will dominate the preceding set
of portfolios.
• This process ends when a line is drawn tangent to the efficient
set of risky portfolios, given a vertical intercept of RF.
• In Figure 9-1, we call this tangency point M.
• The set of portfolio opportunities on this line(RF to M)
dominates all portfolios below it
 Lending Possibilities
• The straight line from RF to the efficient frontier at point M, RF-M,
dominates all straight lines below it and contains the superior
lending portfolios given the Markowitz efficient set depicted in
Figure 9-1.
• Lending refers to the purchase of a riskless asset such as Treasury
bills, because by making such a purchase, the investor is lending
money to the issuer of the securities, the U.S. government.
• We can think of this risk-free lending simply as risk-free investing.
• Through a combination of investing in RF assets as well other risky
securities at point (T), many options will be available to investors .
• Accordingly; conservative investors will be closer to point RF, while
Aggressive investors will be closer to point (T)
The Equilibrium Return-Risk Tradeoff
 The Capital Market Line
• The tradeoff between expected return and risk for
efficient portfolios
• All combinations of the risk-free asset and the risky
portfolio M are on the CML, and, in equilibrium, all
investors will end up with a portfolio somewhere on the
CML based on their risk tolerance.
• Line from RF to L is capital market line (CML)
• x = risk premium =E(RM) - RF
• y =risk =M
• Slope =x/y =[E(RM) - RF]/M
• y-intercept = RF
 L

M
E(RM)

x
RF
y

M
Risk
 CML
• The slope of the CML is the market price of risk for
efficient portfolios.
• It is also called the equilibrium market price of risk.
• It indicates the additional return that the market
demands for each percentage increase in a portfolio’s
risk, that is, in its standard deviation of return.
 Risk Premium
• The risk premium should reflect all the uncertainty
involved in the asset.
• Thinking of risk in terms of its traditional sources,
such components as the business risk and the
financial risk of a corporation would certainly
contribute to the risk premium demanded by
investors for purchasing the common stock of the
corporation.
 Example
• Assume that the expected return on portfolio M is 13
percent, with a standard deviation of 20 percent, and
that RF is 5 percent.
• In our example a risk premium of 0.40 indicates that
the market demands this amount of return for each
percentage increase in a portfolio’s risk.
 Equation for CML

E(RM )  RF
E(R p )  RF  σp
σM
 Conclusion
• In words, the expected return for any portfolio on the
CML is equal to the risk-free rate plus a risk premium.
• The risk premium
. is the product of the market price
of risk and the amount of risk for the portfolio under
consideration.
Security Market Line
 SML
• The capital market line depicts the risk-return tradeoff
in the financial markets in equilibrium.
• However, it applies only to efficient portfolios and
cannot be used to assess the equilibrium expected
return for a single security.
• What about individual securities or inefficient portfolios
• Equation 9-2 states that the expected return for any
security is the sum of the risk-free rate and a risk
premium. This risk premium reflects the asset’s
covariance with the market portfolio
 SML

E(Ri )  RF  βi E(RM )  RF 
 Beta
• Beta We know that the relevant risk measure for any asset is
its covariance with the market portfolio.
• However, it is more convenient to use a standardized
measure of the systematic risk that cannot be avoided
through diversification.
• Beta relates the covariance of an asset with the market
portfolio to the variance of the market portfolio.
• Beta is a relative measure of risk—the risk of an individual
stock relative to the market portfolio of all stocks.
 Beta
• Reflects how risky the security is compared to the market risk
• Standardized measure of systematic risk
• Showing how much the stock price moves up/down compared to
the extent to which the stock market is moving up and down
• It is relating the risk of an individual security to the overall market
risk
• If the security’s returns move more than the market’s returns as
the latter changes, the security’s returns have more volatility
(fluctuations in price) than those of the market.
• For example, a security whose returns rise or fall on average 15
percent when the market return rises or falls 10 percent is said to
be an aggressive, or volatile, security.
 CAPM
• formally relates the expected rate of return for any
security or portfolio with the relevant risk measure.
• The CAPM’s expected return–beta relationship is the
most-often cited form of the relationship.
• Beta is the relevant measure of risk that cannot be
diversified away in a portfolio of securities and, as
such, is the measure that investors should consider in
their portfolio management decision process.
 CAPM
• The CAPM in its expected return–beta relationship form is a
simple but elegant statement.
• It says that the expected rate of return on an asset is a function
of the two components of the required rate of return—the risk-
free rate and the risk premium.
• It formalizes the basis of investments, which is that the greater
the risk assumed, the greater the expected (required)return
should be.
• This relationship states that an investor requires (expects) a
return on a risky asset equal to the return on a risk-free asset
plus a risk premium, and the greater the risk assumed, the
greater the risk premium.
 Example
• Assume that the beta for IBM is 1.15. Also assume
that RF is 0.05 and that the expected return on the
market is 0.12. Calculate The required return for
IBM.
 Problems
• 9-1 The market has an expected return of 12 percent, and the
risk-free rate is 5 percent. Pfizer has a beta of 0.73. What is
the required rate of return for Pfizer?
• 9-2 The market has an expected return of 14 percent, and the
risk-free rate is 4 percent. Activalue Corp. is 80 percent as
risky as the market as a whole. What is the required rate of
return for this company?
• 9-3 Electron Corporation is 30 percent more volatile than the
market as a whole. The market risk premium is 8 percent. The
risk-free rate is 5 percent. What is the required rate of return
for Electron?
 Problems
• 9.4 The expected return for the market is 12 percent,
and the risk-free rate is 4 percent. The following
information is available for each of five stocks.
• a. Calculate the required return for each stock.
• b. Assume that an investor, using fundamental
analysis, develops the estimates of expected return
labeled for these stocks. Determine which stocks are
undervalued and which are overvalued.
• c. What is the market’s risk premium?
• Text book
 Problems
• 9-5 Assume that Exxon is priced in equilibrium. Its
expected return next year is 14 percent, and its beta
is 0.41. The risk-free rate is 6 percent.
• a. Calculate the expected return on the market.
 Problems
• 9-6 Given the following information: Expected return
for the market, 12 percent; Standard deviation of
market return, 21 percent; Risk-free rate, 4 percent;
Correlation coefficient between Stock A and the
market, 0.8; Stock B and the market, 0.6; Standard
deviation for stock A, 25 percent; Standard deviation
for stock B, 30 percent.
• a. Calculate the beta for stock A and stock B.
• b. Calculate the required return for each stock.
 Problems
• 9-7 The expected return for the market is 12 percent,
with a standard deviation of 21 percent. The
expected risk-free rate is 4 percent. Information is
available for five mutual funds, all assumed to be
efficient:
• a. Calculate the slope of the CML.
• b. Calculate the expected return for each portfolio.
• c. Rank the portfolios in increasing order of expected
return.
• Page 251