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Lecture 2: Mean Variance Analysis, Introduction to the CAPM

Overview

Mean-Variance Analysis in practice pitfalls for the unwary

Introduction to the CAPM

Reading BKM Chapter 9

Mean-Variance approach overly simplistic?

Mean-Variance analysis is a nice theory, but is difficult to implement in practice.

Assume Normality. Use returns and Co-variances based on historical data.

This approach is reasonable but dont trust the results too much.

A Cautionary Tale

During the 2007 credit crunch the CFO of Goldman Sachs, David Viniar, announced in August that Goldmans flagship Global Equity Opportunities hedge fund, had lost 27% of its value since the start of the year.
As Mr. Viniar explained, We were seeing things that were 25standard deviation moves, several days in a row.

What is a 25-sigma event?

-25

How likely is a 25-sigma event (assuming normality)?

For comparison 1.0e+6 years = how long since homo sapiens first appeared (<6 sigma event 6.0e+8 years = how long multi-cellular life has existed on this planet (<7 sigma event) 1.3e+10 years= time since the big bang (<8 sigma event)

So what went wrong?

Returns are not normally distributed: extreme events are more likely, especially negative ones. Variances and co-variances change: both tend to rise in bad times. So, not only are negative events more likely than the normal distribution implies, but diversifications fails when these extreme negative events occur.

Non-Normality of returns (1)

Difference in mean and median indicative of skew

Should be zero for normal

Should be 3 for normal

Non-Normality of returns (2)

Rising correlations in bad times (1)

Rising correlations in bad times (2)

Co-movement of asset returns (a)(b)

Sources: Bank of England FSR.

(a) Percentage of variability across daily asset returns explained by the first principal component over a six-month rolling window. (b) Commodities are grain, industrial and precious metals; equity indices are FTSE All-Share, S&P500 and Euro Stoxx50; bond indices are UScorporate BBB and euro corporate BBB.

Rising correlations in bad times (3)

Co-movement of asset returns (a)(b)

Source: Goetzmann, Li, and Rouwenhorst, 2005, Journal of Business 78, 1-38.

Is Mean Variance analysis any good?

Yes
It helps identify diversification benefits. Works OK in normal times.

But,
Not a risk management tool (bad at extreme times). Extreme care needed when estimating variance covariance matrices (Garbage in Garbage out GIGO).
This truly is the main drawback: Expected returns and covariance matrices are hard to estimate in general, and they are time-varying.

Is Mean Variance analysis any good? (contd)

To recap, practical use of mean-variance analysis is limited by:

The fact that returns are not normally distributed.
Higher moments therefore also play a role.

Covariances and correlations are time-varying.

Makes it extra difficult to estimate/predict the covariance matrix, and Diversification benefits are at their lowest when most needed.

Forming relevant estimates of the inputs (expected returns and covariances) is extremely difficult.

Overview Part II

1. Modern Portfolio Theory (Nobel Prize #1)

Only undiversifiable risk matters.

2. The CAPM (Nobel Prize #2)

High contribution to undiversifiable risk, high expected return. 3. CAPM as a Natural Performance Benchmark: example mutual fund performance

Introduction to the CAPM

CAPM: Capital Asset Pricing Model. Asset Pricing How assets are priced in the market? Portfolio Theory Optimal portfolio selection for a given individual investor. Equilibrium concept Aggregate implications of individual investor behaviour.
In equilibrium, everyone is happy (fully optimized) and markets clear (supply=demand).

Introduction to the CAPM (contd)

Asset pricing analyzes the equilibrium outcome of portfolio optimizing investors.

That is, in equilibrium all investors are happy, in the sense that they do not want to change their portfolio holdings given current prices. At the same time, markets must clear: The total demand for any asset must equal its supply. These two conditions will determine the equilibrium price, or equilibrium expected return on any asset. Asset pricing tries to derive these equilibrium prices or equilibrium expected returns.

Introduction to the CAPM (contd) Asset pricing is therefore a form of general equilibrium analysis:
Prices are determined by aggregate demand and aggregate supply, which are in turn determined by the optimal portfolio choice of investors, given market prices. Market prices and investor choices are determined simultaneously.

Portfolio Theory can be viewed as a form of partial equilibrium analysis:

Given a set of prices, we work out the individual investors optimal portfolio selection. Prices are taken as fixed. The investor does not affect prices.

Introduction to the CAPM (contd)

The CAPM derives the general equilibrium solution under the assumption that investors are meanvariance optimizers and that markets are perfect.

Our expectation

Consider a risky asset i Its price (or expected return) is such that:
E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i) = Rf + (Risk Loading)x(Risk Premium of asset i)

CAPM tells us 1) what is the price of risk? (a market-wide property) 2) what is the risk of asset i? (specific for each asset)

Aside: Decomposing expected returns

Note that writing

E(return) = Risk-free rate of return + Risk premium specific to asset i

is a tautology.
We can always decompose expected returns into the risk-free rate and a risk-premium. It is the structure, or functional form, of this riskpremium that tells us something interesting.

An example to motivate

Expected Return
Asset i Asset j 10.9% 5.4%

Standard Deviation
4.45% 7.25%

E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i)
Question: According to the above equation, given that asset j has higher risk relative to asset i, why wouldnt asset j has higher expected return as well? Possible Answers: (1) the equation is completely wrong. (2) the equation is right. But market price of risk is different for different assets. (3) the equation is right. But quantity of risk of any risky asset is not equal to the standard deviation of its return.

CAPMs Answers

E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i)

The intuitive equation is right. The equilibrium price of risk is the same across all marketable assets. But, in the equation above, the quantity of risk of any asset, is only PART of the total risk (standard deviation) of the asset.

CAPMs Answers

Specifically: Total risk = systematic risk + unsystematic risk CAPM says: (1) Unsystematic risk can be diversified away. Since there is no free lunch, if there is something you bear but can be avoided by diversifying at NO cost, the market will not reward the holder of unsystematic risk at all. (2) Systematic risk cannot be diversified away without cost. In other words, investors need to be compensated by a certain risk premium for bearing systematic risk.

CAPM results

E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i) Precisely: [1] Expected Return on asset i = E(Ri) [2] Equilibrium Risk-free rate of return = Rf [3] Quantity of risk of asset i = COV(Ri, RM)/Var(RM) [4] Market Price of risk = [E(RM)-Rf] This yields the equation known as the Capital Asset Pricing Model: E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)] Here [COV(Ri, RM)/Var(RM)] is also known as BETA of asset i We can then write: E(Ri) = Rf + [E(RM)-Rf] x i

Pictorial Result of CAPM: E(Ri) as a function of bi

E(Ri) Security Market Line

E(RM)
Rf
slope = [E(RM) - Rf] = Eqm. Price of risk

bM= 1.0

bi = COV(Ri, RM)/Var(RM)

Relationship between CAPM (SML) and MV (CML)

CAPM in Detail

Assume: [1] Market is frictionless => borrowing rate = lending rate [2] Anyone can borrow or lend unlimited amount at risk-free rate [3] All investors have homogenous beliefs => they perceive identical distribution of expected returns on ALL assets => thus, they all perceive the SAME linear efficient set (we called the line: CAPITAL MARKET LINE) => the tangency point is the MARKET PORTFOLIO

CAPM in Detail
CONDITION 1: Individual investors equilibrium: Max U

E(Rp)
B

Capital Market Line

E(RM)
A Rf

Market Portfolio

Investor Bs optimal portfolio

Investor As optimal portfolio

CAPM in Detail
CONDITION 2: Demand = Supply for ALL risky assets
Remember expected return is a function of price. Market price of any asset is such that its expected return is just enough to compensate its investors to rationally hold it. In equilibrium, the aggregate investor must hold the market portfolio (which consists of all risky assets). The market value of any asset i: Vi = PixQi Market portfolio has a value of iVi Market portfolio has N risky assets, each with a weight of wi Such that wi = Vi / iVi for all i The aggregate equilibrium weight on risky asset i is thus wi

CAPM in Detail

CONDITION 3: Aggregate borrowing = Aggregate lending (Demand = Supply for the risk-free asset) Risk-free rate is not exogenously given, but is determined by equating aggregate borrowing and aggregate lending.

CAPM in Detail
Two-Fund Separation and Mutual Fund Separation: Given the assumptions of frictionless market, unlimited lending and borrowing, homogenous beliefs, and if the above 3 equilibrium conditions are satisfied, we then have 2-fund separation. MUTUAL-FUND SEPARATION: Each investor will have a utility-maximizing portfolio that is a combination of a risk-free asset and a mutual fund that holds the market portfolio

Two-fund separation
Everyone holds a combination of the market portfolio and the risk-free asset

E(Rp)
B

Capital Market Line

E(RM)
A Rf

Market Portfolio

CAPM

To recap, we have two sets of assumptions: [1] Perfect market:

Frictionless, and perfect information No imperfections like tax, regulations, restrictions to short selling All assets are publicly traded and perfectly divisible Perfect competition everyone is a price-taker

[2] Investors:
Same one-period horizon Rational, and maximize expected utility over a mean-variance space Homogenous beliefs

Pictorial Result of CAPM

E(Ri) Security Market Line

E(RM)
Rf
slope = [E(RM) - Rf] = Eqm. Price of risk

bM= 1.0

bi =
[COV(Ri, RM)/Var(RM)]

Properties of CAPM

In equilibrium, every asset must be priced so that its risk-adjusted required rate of return falls exactly on the security market line.

Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk a measure of how the asset co-varies with the entire economy (cannot be diversified away) e.g., interest rate, business cycle

Unsystematic Risk idiosyncratic shocks specific to asset i, (can be diversified away) e.g., loss of key contract, death of CEO
CAPM quantifies the systematic risk of any asset as its Expected return of any risky asset depends linearly on its exposure to the market (systematic) risk, measured by . Assets with a higher require a higher risk-adjusted rate of return. In other words, in market equilibrium, investors are only rewarded for bearing the market risk.

Example of the SML (Security Market Line)

Example of the SML (Security Market Line)

The SML for this example is

What is the difference between this and the Capital Marke Line (CML)?

The Differences between the CML and SML

The differences are:

a. b. c. d. Every security will lie on the SML No security (other than the Mkt and the risk-free asset) will lie on the CML. The SML can be thought of as showing the systematic risk only The asset locations in the CML plot show the total risk (systematic and unsystematic)

Comparison Between the CAPM and Mean-Variance Analysis. 1. Mean-variance investors and perfect markets imply the CAPM. MV seems to imply similar things to the CAPM:
All MV investors hold the tangency portfolio and the risk-free asset. Tangency portfolio return must therefore be the only risk investors care about. This leads to two-fund separation. Note that tangency=market portfolio is an equilibrium argument.

2. Then why CAPM is more important?

Its a model about equilibrium return! Beta is easy to estimate. How many parameters? Very important applications:
1.
2.

Asset allocation: boosted the popularity of index funds

Asset return prediction: widely used in practice.

The CAPM Risk-Return Tradeoff for Portfolios (Nobel Prize #2)

Beta reflects the leverage of the only risk in the CAPM world. Hence, beta will be referred to as risk exposure or risk loading. Portfolio Return (r)

Leverage
B

Risk Free Rate

Dont forget: this a model. In reality there wont be a straight line ! Fact that investors seem to care about undiversifiable risk matters!

Use of CAPM

For valuation of risky assets For performance measurement For estimating required rate of return of risky projects

Empirical Tests on CAPM

In the next lecture, well go over some of the empirical tests of CAPM. Think about the following questions: [1] What are the predictions of the CAPM? [2] Are they testable? [3] What is the relationship between the CAPM and a regression? We will also discuss an empirical paper Betting Against Beta, by Andrea Frazzini and Lasse Pedersen.