CAPM, BETA AND APT

CAPITAL MARKET THEORY: AN OVERVIEW

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) allows for the calculation of the required rate of 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

ASSUMPTIONS OF CAPITAL MARKET THEORY

All investors are Markowitz efficient investors (rational) who invest on the efficient frontier. Investors can borrow or lend any amount of money at the risk-free rate of return (RFR). Investors have homogeneous expectations All investors are risk averse and efficiently diversified. Only the systematic risk is of concern in determining estimated return.

ASSUMPTIONS OF CAPITAL MARKET THEORY

All investments are infinitely divisible, which means that it is possible to buy or sell fractional shares of any asset or portfolio. There are no taxes or transaction costs involved in buying or selling assets. Capital markets are efficient and no single investor can influence price (Perfect competition).

MAKING ASSUMPTIONS

Some of these assumptions are clearly unrealistic Relaxing many of these assumptions would have only minor influence on the model and would not change its main implications or conclusions. The primary way to judge a theory is on how well it explains and helps predict behavior, not on its assumptions.

THE CAPITAL ASSET PRICING MODEL

An assets covariance with the market portfolio is the relevant risk measure (helps in beta calculation) This can be used to determine an appropriate required rate of return on a risky asset CAPM indicates what should be the expected or required rates of return on risky assets This helps to value an asset by providing an appropriate discount rate to use in dividend valuation models

DETERMINING THE EXPECTED RETURN

E(R i ) ! RFR  F i (R M - RFR)

The expected 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)

WHAT IS THE MARKET RISK PREMIUM [RM - RRF]

The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.

CAPM AND BETA

R M - RFR E(R i ) ! RFR  (Cov i,M ) 2 WM Cov i,M (R M - RFR) ! RFR  2 WM Cov i,M (F i ) We then define as beta 2 WM

E(R i ) ! RFR  F i (R M - RFR)

CAPM AND REQUIRED RETURN FOR IBMS COMMON STOCK

Let rRF=6%, rM=12%, and the Beta of IBM common stock is IBM=1.3 rIBM = rRF + IBM[rM - rRF] rIBM = 0.06 + 1.3[0.12 0.06] rIBM = 0.06 + 1.3[0.06] rIBM = 0.06 + 0.078 =0.138 or 13.8% Note the following items:

The market risk premium is [12% - 6%] = 6% IBMs risk premium is 1.3[12% 6%] = 7.8%.

THE SECURITY MARKET LINE (SML)

The CAPM model is linear and when plotted on a graph paper gives a straight line called SML. The graphical version of CAPM is Security Market Line.

GRAPH OF SML
E(R i )
SML

Rm
Negative Beta

RFR

1 .0

Beta(Cov im/W 2 )
M

OVER AND UNDER PRICED

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

WHAT IF THE SML CHANGES?

Two possible SML changes can definitely occur. Each has important effects.

(1) Risk-free rates rRF can change. This can be due to the Inflation Premium (IP) or the real rate of interest changing. Note that in this case, the RM must also increase by the same amount so that the market risk premium [rM-rRF] is unchanged. (2) The market risk premium [rM-rRF] can change. This would typically be due to changing attitudes toward risk aversion by investors.

WHAT IF THE SML CHANGES?

Following slides allow for two separate SML changes:

In the first case, we let the risk-free rate rRF increase by 2% (from 5% to 7%). The market required return rM must increase by the same amount (from 10% to 12%), so that the market risk premium [rM-rRF] remains at 5%. In the second case, we allow for a 2% increase in the market risk premium (from 5% to 7%). The risk-free rate remains the same at 5%, however, rM must increase by 2% (from 10% to 12%) so that the market risk premium can now be [rM-rRF] = 7%.

THE SECURITY MARKET LINE

Risk-free rate increases from 5% to 7%. The new SML is ri = 0.07 + 0.05 i
ri (%)

12 10 7 5

SML, new SML, old

Mkt. risk prem. = 5%

rRF=7%
Risk,
i

0.5

1.0

1.5

THE SECURITY MARKET LINE

The market risk premium increases from 5 to 7%. The new SML is ri = 0.05 + 0.07 i
ri (%)

SML, new SML, old

Mkt. risk prem. = 7%

12 10 5

rRF=5% 0 0.5 1.0 1.5

Risk,

HOW TO INTERPRET BETA ( )

Beta measures a stocks degree of systematic or market risk. It can also be thought of as the stocks contribution to the risk of a well-diversified portfolio.

= 1: the stock has average market risk. The stock generally tends to go up (down) by the same percentage amount as the market. = 1.5: The stock generally tends to go up (down) by 50% (1.5x) more than the market. = 0.5: The stock generally tends to go up (down) by half as much as the market.

HOW TO INTERPRET BETAS ( ), CONTINUED

= 0: the stock has no correlation with movements in the overall stock market. All of this firms risk would actually be firm-specific risk. < 0: The stock generally tends move in a direction opposite that of the market (very rare).

Firms that supply basic consumer goods (Proctor & Gamble) and utilities (phone, cable, gas, or electric) tend to have low Betas (lower than 1.0, often around 0.4 to 0.6). Firms that are in economically cyclical industries would have higher Betas (greater then 1.0).

EXPECTED RETURN AND BETA OF A PORTFOLIO OF STOCKS

Both portfolio expected returns and portfolio Betas are always a weighted average of the stocks that comprise the portfolio. You invest $10,000: $6000 in Apple Computer and $4000 in Proctor & Gamble (PG).

Let rRF=5% and rM=10%. Let APPLE=1.3 and PG=0.6 The investment weights are (6000/10000)=0.6 for Apple and (4000/10000)=0.4 for PG. The weights must always sum up to 1.

EXPECTED RETURN AND BETA OF A PORTFOLIO OF STOCKS, CONTINUED

The portfolio Beta is always the weighted average of each of the stocks betas. P = wapple apple + wpg pg P = 0.6(1.30) + 0.4(0.6) P = 1.02 Now find the portfolio required return.
rP

= 0.05 + 1.02[0.10 0.05] = 0.101 or 10.1%

THE CONCEPT OF BETA

Beta(b) measures how the return of an individual asset (or even a portfolio) varies with the market. b = 1.0 : same risk as the market b < 1.0 : less risky than the market b > 1.0 : more risky than the market Beta is the slope of the regression line (y = a + bx) between a stocks return(y) and the market return(x) over time, b from simple linear regression.

CALCULATING BETA: THE CHARACTERISTIC LINE

The systematic risk input of an individual asset is derived from a regression model, referred to as the assets characteristic line with the model portfolio:

where: Ri,t = the rate of return for asset i during period t RM,t = the rate of return for the market portfolio M during t

R i,t ! E i  F i R M, t  I

Ei ! R i - FiR m Fi ! Cov i,M

2 WM

I ! the random error term

ESTIMATING THE BETA COEFFICIENT

If we know the securitys correlation with the market, its standard deviation, and the standard deviation of the market, we can use the definition of beta:

Fj !

V j ,M W j WM

Generally, these quantities are not known. We usually rely on their historical values to provide us with an estimate of beta.

INTERPRETING THE BETA COEFFICIENT

The beta of the market portfolio is always equal to 1.0: V M ,M W M FM ! !1 WM Since

V M ,M ! 1

The beta of the risk-free asset is always equal to 0:

F rf !
Since

V rf ,M W rf WM

!0

W rf ! 0

PROJECT, UN-GEARED & GEARED BETA

Beta Geared: The Beta attaching to the ordinary shares of a geared firm. These bear a risk higher than the firms basic activity. Beta Un-geared: The geared Beta stripped of the effect of gearing. Corresponds to the activity Beta in an equivalent un-geared firm. An indication of the systematic riskiness attaching to the returns on ordinary shares. It equates to the asset Beta for an un-geared firm, or is adjusted upwards to reflect the extra riskiness of shares in a geared firm., i.e. the Geared Beta

ARBITRAGE PRICING THEORY (APT)

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

ASSUMPTIONS OF ARBITRAGE PRICING THEORY

Capital markets are perfectly competitive Investors always prefer more wealth to less wealth with certainty The stochastic process generating asset returns can be presented as a k-factor model

ARBITRAGE PRICING THEORY

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

ARBITRAGE PRICING THEORY (APT)

Ei ! P0  P1bi1  P2bi 2  ...  Pk bik

P
where: 0= the expected return on an asset with zero systematic risk where
premium related to each the common factors P1= the riskthe risk premium related toofinterest rate risk - for example

bik = the pricing relationship between the risk premium and asset i - that is how responsive asset i is to this common factor K

EXAMPLE OF TWO STOCKS AND A TWO-FACTOR MODEL

P1= changes in the rate of inflation. The risk premium

1
real GNP. The average risk P2= percent2growth infor every 1 percent change inpremium related to this factor is percent the rate

related to this factor is 1 percent for every 1 percent change in the rate (P ! .01)

(P2 ! .02)

P3= the rate of return on a zero-systematic-risk asset (zero beta: b =0) is 3 percent
oj

(P3 ! .03)

EXAMPLE OF TWO STOCKS AND A TWO-FACTOR MODEL

bx1= the response of asset X to changes in the rate of

inflation is 0.50

(bx1 ! .50 )

by1= the response of asset Y to changes in the rate of inflation is 2.00

bx 2 = the response of asset X to changes in the growth rate of real GNP is 1.50
(bx 2 ! 1.50 )

by 2= the response of asset Y to changes in the growth rate of real GNP is 1.75
(by 2 ! 1.75 )

EXAMPLE OF TWO STOCKS AND A TWO-FACTOR MODEL

Ei ! P0  P1bi1  P2bi 2
= .03 + (.01)bi1 + (.02)bi2 Ex = .03 + (.01)(0.50) + (.02)(1.50) = .065 = 6.5% Ey = .03 + (.01)(2.00) + (.02)(1.75) = .085 = 8.5%

EMPIRICAL TESTS OF THE APT

Studies by Roll and Ross and by Chen support APT by explaining different rates of return with some better results than CAPM Dhrymes and Shanken question the usefulness of APT because it was not possible to identify the factors and therefore may not be testable