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Ch 03 Mini Case

3/8/2001

Chapter 3. Mini Case

Situation
To begin, briefly review the Chapter 2 Mini Case. Then, extend your knowledge of risk and return by
answering the following questions.

CAPM
The Capital Asset Pricing Model is an equilibrium model that specifies the relationship between risk and
required rate of return for assets held in well diversified portfolios.
Assumptions
Investors all think in terms of a single holding period.
All investors have identical expectations.
Investors can borrow or lend unlimited amounts at the risk free rate.
All assets are perfectly divisible.
There are not taxes and transaction costs.
All investors are price takers, that is, investors buying and selling will not influence stock prices.
Quantities of all assets are given and fixed.

FEASIBLE AND EFFICIENT PORTFOLIOS

The feasible set of portfolios represent all portfolios that can be constructed from a given set of stocks.
An efficient portfolio is one that offers: the most return for a given amount of risk or the least risk for a
given amount of return.

Expected
Portfolio
Return, kp

Efficient Set

Feasible Set

Feasible and Efficient Portfolios

Risk, p

OPTIMAL PORTFOLIOS
An investor's optimal portfolio is defined by the tangency point between the efficient set and the investor's
indifference curve. The inderference curve reflect an investor's attitude toward risk as reflected in his or
her risk/return trade off function.

Expected
Michael C.Return,
Ehrhardt kp

IB2 I
B1

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Expected
Return, kp

IB2 I
B1

Optimal Portfolio
Investor B

IA2
IA1

Optimal Portfolio
Investor A

Risk p

Optimal Portfolios
.

EFFICIENT SET WITH A RISK-FREE ASSET

When a risk free asset is added to the feasible set, investors can create portfolios that combine this asset
with a portfolio of risky asset. The straight line connecting krf with M, the tangency point between the line
and the old efficiency set, becomes the new efficient frontier.

Efficient Set with a Risk-Free Asset

Expected
Return, kp

^
kM

kRF

The Capital Market

Line (CML):
New Efficient Set

.
M

Risk, p

OPTIMAL PORTFOLIO WITH A RISK-FREE ASSET

The optimal portfolio for any investor is the point of tangency between the CML and the investors indifference
curve.

Expected
Return, kp

CML
I2

Michael C. Ehrhardt

^
kM
^
k

I1

. .
M

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Return, kp

CML

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I2

Model

I1

.
.
M

^
kM
^
k

R = Optimal
Portfolio

kRF

Risk, p

Capital Market Line

The capital market line is all linear combinations of the risk free asset and portfolio M.

khat=

krf

(km-krf)/ m

Intercept

Slope

Risk Measure

The CML gives the risk and return relationship for efficient portfolios
The SML , also part of CAPM, gives the risk and return relationship for individual stocks.
ki

SML =

(RPm)

Beta Calculation
Run a regression line of past returns on Stock I versus returns on the market

Year
1
2
3

km

ki

15%
-5%
12%

18%
-10%
16%

Stock Return

Beta Calculation
20%
f(x) = 1.4441260745x - 0.0259025788
15%
R
= 0.9943163136
10%
beta calculation

5%

Linear (beta
calculation)

0%
-10%

-5%

-5%

0%

5%

10%

15%

20%

-10%
-15% Market Return

Michael C. Ehrhardt

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-15% Market Return
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R2 measures the percent of a stock's variance as explained by the market.

Relationship between stand alone, market, and diversifiable risk

2j =

b2j * 2m

2j =

2ej

stand alone risk of stock J

b j * m =
2

market risk of stock J

2ej =

diversifiable risk of stock J

Test to verify CAPM

Beta stability test and tests based on the slope of the SML.
Test of the SML indicate a more-or-less linear relationship between realized return and market risk.
Slope is less than predicted
Irrelevance of diversifiable risk specified in the CAPM model can be questioned.
Betas of individual securities are not good estimators of future risk.
Betas of ten or more randomly selected stocks are reasonably stable.
Past betas are good estimates of future portfolio volitility.
Conclusions regarding CAPM
It is impossible to verify.
Recent studies have questioned its validity.
Investors seemed to be concerned with both market and stand alone risk. Therefore, the SML may not produce the correct estimate of kj.
CAPM/SML concepts are based on expectations, yeta betas are calculated using historical data.
CAPM and the Arbitrage Pricing Theory
The CAPM is a single factor model. The APT proposes that the relationship between risk and return is more complex and may be due
to multiple factos such as GDP, growth, expected inflation, tax rate changes, and dividend yield.
Required Return for stock I under the Fama-French-3-Factor Model
Fama and French propose three factors:
The excess market return, km-krf.
The return on, S, a portfolio of small firms minus the return on B, a portfolio of big firms. This return is called
ksmb, for S minus B.
The return on, H, a portfolio of firms with high book-to-market ratios minus the return on L, a portfolio of firms
with low book-to-market ratios. This return is called k hml, for H minus L.
Required return for Stock I
ki =

krf

(km-krf) b

(ksmb) c

b= Sensitivity of stock I to the market

c= Sensitivity of stock I to the size factor
c= Sensitivity of stock I to the book-to-market factor
b=
krf =
RPm =
c=
value for size factor =
d=
book-to-market factor=

Michael C. Ehrhardt

0.9
6.8%
6.3%
-0.5
4.0%
-0.3
5.0%

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ki =

8.97%

CAPM =

12.47%

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f(x) =
R = 0

Excess Ret urns

on Wal-Mart, kS-kRF

Excess Returns
on the Market, kM-kRF

-0.2
-0.3

Michael C. Ehrhardt

5.55111512312578E-017
-0.1
0.1

0.2
0.3

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