CLASS 6 The Capital Asset Pricing Model

Bridge Program 2005 Finance module

Finance, Bridge Program 2005

Contents
1 2 Assignment 6 The CAPM 5 11

Finance, Bridge Program 2005

Recap
The optimal portfolio is given by a combination of the risk-free asset and a fund of the other (risky) assets. The optimal fund is obtained by maximizing the Sharpe ratio of the portfolio of risky assets.

Today
Thinking about risk in a portfolio context. How to determine discount rates as a function of the market risk of an asset.

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Some practical considerations

Recipe for optimal investment decisions: Estimate expected returns and variance-covariance matrix (using historical data). Maximize the Sharpe ratio of the portfolio using as inputs the estimates obtained from historical data. Likely output: very extreme weights (invest heavily in a few assets, short other assets, . . . ) - see example from lecture 5. Does this make sense? No! Our intuition tells us that an optimal portfolio should not have extreme weights. What is the problem? The standard errors on the estimated expected returns are large. Mean-variance optimization is used in most investment management rms, but with tons of adjustments. Finance, Bridge Program 2005 4

1 Assignment 6
Consider the following information on three dierent assets: Asset LNUX MSFT Market SD 0.6 0.3 0.2 Beta 0.15 1.2 1

What is the correlation between LNUX and the market? Between MSFT and the market? Using the denition of beta we have that 0.15 = 0.2 0.6 LNUX,M ; 2 0.2 LNUX,M = 0.05

Similarly one can nd that MSFT,M = 0.8 Finance, Bridge Program 2005 5

Risk of alternative investment strategies We currently have 99% of our wealth invested in the Market and 1% in the risk-free asset. Consider investing the 1% in either: (i) LNUX; (ii) MSFT; or (iii) the Market. What will be the standard deviation of the dierent portfolios returns? Apply our standard formula for the standard deviation of a portfolio to nd the answer: i = (0.22 0.992 + 0.62 0.012 + 2(0.99)(0.01)0.2(0.6)0.05)1/2 = 19.84% ii = (0.22 0.992 + 0.32 0.012 + 2(0.99)(0.01)0.2(0.3)0.80)1/2 = 20.04% iii = 20%

Finance, Bridge Program 2005

Risk in a portfolio context

Note that the overall risk of the portfolio was increased for all (i)-(iii) (since before we have the 1% in the risk-free asset). But it increased the least for the asset with the highest standard deviation, LNUX! What is the intuition? Diversication, i.e. low correlation and suciently low standard deviation for LNUX. Better explanation: the beta of LNUX is low when compared to that of the market and MSFT, thereby the lower risk.

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Summary statistics
Strategy with 1% in LNUX MSFT Market SD[rp] 19.84% 20.04% 20.00% Increase in SD 0.0391% 0.2408% 0.20%

Why is the portfolio with MSFT riskier than that with the market (ii vs. iii)? MSFTs beta is higher than that of the market!

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Equilibrium conditions
The suggestion in the question yields the following equilibrium condition: 0.01(E[rLNUX ] rf ) 0.01(E[rMSFT ] rf ) 0.01(E[rm ] rf ) = = 0.000391 0.002408 0.0020 which can be rearranged as: 0.0391 E[rLNUX ] = rf + (E[rm ] rf ) rf + 0.19(E[rm ] rf ) 0.2 0.2408 E[rMSFT ] = rf + (E[rm ] rf ) rf + 1.2(E[rm ] rf ) 0.2 Note that 0.19 and 1.2 are (almost) the betas for these two stocks! (see spreadsheet for what happens when w = 0.999 and w = 0.9999).
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The punchline
In a portfolio context: Standard deviation does not measure risk correctly. Beta does tell us how much more risk our portfolio will have from adding a given stock. In order for investors to be indierent holding dierent stocks (i.e. the market to be in equilibrium), their expected returns must be linearly related to their beta. From now on risk will be measured by beta.

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2 The CAPM
The Capital Asset Pricing Model is an equilibrium theory (supply equals demand) that concludes that the expected return of asset i ought to be given by E [Ri ] = Rf + i E [Rm ] Rf . Simple: in order to get a discount rate for a risky asset (stock, project, . . . ) we can nd its beta, and then given E [Rm ] and Rf we will have a discount rate to discount cash ows!!

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The CAPM investment story

All agents have symmetric information. All go through the same optimization problem. What does market clearing (supply=demand) imply about the portfolio that each agent will hold in equilibrium? It will be the same for everyone, and equal to the market portfolio. Best investment strategy is to invest in the market (i.e. index funds) and the risk-free asset (relative amounts depending on investors risk-aversion). After some yoga you ought to sort of see that this ties in with notions of market eciency (not assigned chapters from the book that ought to be fun to read).
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Estimating beta
Consider estimating the beta of EK using the data from assignment 5. Any ideas where to start? Well, so you just run a regression. In Excel you need to go to Data Analysis. Typical regression output:
Coecients Intercept S&P500 0.038 0.494 Standard Error 0.043 0.201 t Stat 0.871 2.455 p-value 0.389 0.019

Beta is 0.49. How good is our estimated beta? Uncertainty with respect to beta is 0.201 (1 SD). With 95% probability [0.087, 0.901].
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Estimating beta
Super-geek aside: we are cheating, we ought to have computed excess returns instead of using raw returns. Excess returns of an asset are simply returns in excess of the risk-free asset (Ri Rf , where Rf is 1-month T-bill rate). Alternative estimation methods? Look betas up in nancial information on the web. Publicly available betas are typically a weighted average of the beta estimated through regression and the number 1. Why the number 1? Because the average beta (that of the market) is 1.
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The risk-free rate

Where do we nd the risk-free rate? The WSJ ought to do it Should we use the long-term rate or the short-term rate? Good heuristic: match our investment horizon. But note that the CAPM has nothing to tell us about this (since it is essentially a one-period model). Lets say 5%, which is 7/2005s approximate 10-year spot rate.

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The equity premium E [Rm ] Rf

Short answer: pick a number between 1% and 8%. Some facts: US stocks average excess returns, sample analog of E [Rm ] Rf , are around 7-8%. Stock markets around the world performed worse. Implied discount rates nowadays around 3-5%. Consensus on E [Rm ] Rf (forward looking) around 5%. Personal take more like 3%. Lets say 5% for the purposes of this course.

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Standard errors in Finance Assignment 4 data example. S&P500 mean return was 0.0105 (monthly terms). Standard error of this estimate is 0.0016 ( 0.042/ 734). 95% condence interval is (0.0074, 0.0136). In annual terms 95% condence interval is (8.9%, 16.3%). Working with excess returns (NYSE/AMEX/NASDAQ value-weighted return versus 30-day T-bill return): average excess return is 7.8%, CI (3.1%, 11.8%). Very hard to estimate means in Finance.

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Recap classes 4-6

Estimating expected returns, volatility and correlations of assets. Framework for making investment decisions expected returns and standard deviations of portfolio returns. Risk in a portfolio context: the CAPM and its implications. Now you ought to be ready to: Measure risk and return of portfolio decisions. Come up with a discount rate for stocks.

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Next week
Class 7: Come up with a discount rate for a project (similar to discount rate for stocks). Critical concept: beta of assets versus beta of equity. Key hint: equation (22.22). Class 8: valuation exercise, what is a company worth? Achievement Test: take-home, open book, 2 hour test.

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