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CORPORATE FINANCE

Laurence Booth W. Sean Cleary Chapter 9 The Capital Asset Pricing Model

Lecture Agenda

Learning Objectives Important Terms The New Efficient Frontier The Capital Asset Pricing Model The CAPM and Market Risk Alternative Asset Pricing Models Summary and Conclusions

Concept Review Questions Appendix 1 Calculating the Ex Ante Beta Appendix 2 Calculating the Ex Post Beta

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9-3

Learning Objectives

1. 2. What happens if all investors are rational and risk averse. How modern portfolio theory is extended to develop the capital market line, which determines how expected returns on portfolios are determined. How to assess the performance of mutual fund managers How the Capital Asset Pricing Models (CAPM) security market line is developed from the capital market line. How the CAPM has been extended to include other riskbased pricing models.

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9-4

3. 4. 5.

Arbitrage pricing theory (APT) Capital Asset Pricing Model (CAPM) Capital market line (CML) Characteristic line Fama-French (FF) model Insurance premium Market portfolio Market price of risk Market risk premium New (or super) efficient frontier No-arbitrage principle Required rate of return Risk premium Security market line (SML) Separation theorum Sharpe ratio Short position Tangent portfolio

9-5

The Capital Asset Pricing Model (CAPM)

The Two-Asset Case

It is possible to construct a series of portfolios with different risk/return characteristics just by varying the weights of the two assets in the portfolio. Assets A and B are assumed to have a correlation coefficient of -0.379 and the following individual return/risk characteristics

Expected Return 8% 10% Standard Deviation 8.72% 22.69%

Asset A Asset B

The following table shows the portfolio characteristics for 100 different weighting schemes for just these two securities:

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9-7

You repeat this procedure down until you have determine the portfolio characteristics The first for all 100 The second combination portfolios. portfolio simply assumes 99% Next plot the in A and 1% in assumes you returns on a B. Notice the invest solely graph (see in the increase in Asset A next slide) return and the decrease in portfolio risk!

Asset A B Expected Return 8.0% 10.0% Standard Deviation 8.7% 22.7% Correlation Coefficient -0.379

Portfolio Components Weight of A Weight of B 100% 0% 99% 1% 98% 2% 97% 3% 96% 4% 95% 5% 94% 6% 93% 7% 92% 8% 91% 9% 90% 10% 89% 11%

Portfolio Characteristics Expected Standard Return Deviation 8.00% 8.7% 8.02% 8.5% 8.04% 8.4% 8.06% 8.2% 8.08% 8.1% 8.10% 7.9% 8.12% 7.8% 8.14% 7.7% 8.16% 7.5% 8.18% 7.4% 8.20% 7.3% 8.22% 7.2%

9-8

Attainable Portfolio Combinations for a and Example of Portfolio Combinations Two Asset Portfolio Correlation

12.00% Expected Return of the Portfolio 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

9-9

Figure 8 10 describes five different portfolios (A,B,C,D and E in reference to the attainable set of portfolio combinations of this two asset portfolio.

9 - 10

Efficient Frontier

The Two-Asset Portfolio Combinations

8 - 10 FIGURE

efficient frontier and are attainable

B C

E is the minimum

variance portfolio (lowest risk combination)

C, D are

%n ru t e R de t ce px E

D

Standard Deviation (%)

attainable but are dominated by superior portfolios that line on the line above E

9 - 11

Getting to the n Asset Case

In a real world investment universe with all of the investment alternatives (stocks, bonds, money market securities, hybrid instruments, gold real estate, etc.) it is possible to construct many different alternative portfolios out of risky securities. Each portfolio will have its own unique expected return and risk. Whenever you construct a portfolio, you can measure two fundamental characteristics of the portfolio:

Portfolio expected return (ERp) Portfolio risk (p)

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 12

You could start by randomly assembling ten risky portfolios. The results (in terms of ER p and p )might look like the graph on the following page:

9 - 13

The First Ten Combinations Created ERp

10 Achievable Risky Portfolio Combinations

9 - 14

You could continue randomly assembling more portfolios. Thirty risky portfolios might look like the graph on the following slide:

9 - 15

Thirty Combinations Naively Created ERp

9 - 16

All Securities Many Hundreds of Different Combinations

When you construct many hundreds of different portfolios naively varying the weight of the individual assets and the number of types of assets themselves, you get a set of achievable portfolio combinations as indicated on the following slide:

9 - 17

More Possible Combinations Created

The highlighted portfolios are efficient in that they offer the highest rate of return for a given level of risk. Rationale investors will choose only from this efficient set.

ERp

E is the minimum variance portfolio

9 - 18

The Capital Asset Pricing Model (CAPM)

Efficient Frontier (Set)

Efficient frontier is the set of achievable portfolio combinations that offer the highest rate of return for a given level of risk.

ERp

9 - 20

Efficient Portfolios

9 - 1 FIGURE

ER

Efficient Frontier

B A

MVP

Risk

Figure 9 1 illustrates three achievable portfolio combinations that are efficient (no other achievable portfolio that offers the same risk, offers a higher return.) 9 - 21

Underlying Assumption

Investors are Rational and Risk-Averse

We assume investors are risk-averse wealth maximizers. This means they will not willingly undertake fair gamble.

A risk-averse investor prefers the risk-free situation. The corollary of this is that the investor needs a risk premium to be induced into a risky situation. Evidence of this is the willingness of investors to pay insurance premiums to get out of risky situations.

The implication of this, is that investors will only choose portfolios that are members of the efficient set (frontier).

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 22

The Capital Asset Pricing Model (CAPM)

Risk-free Investing

When we introduce the presence of a risk-free investment, a whole new set of portfolio combinations becomes possible. We can estimate the return on a portfolio made up of RF asset and a risky asset A letting the weight w invested in the risky asset and the weight invested in RF as (1 w)

9 - 24

Risk-Free Investing

Expected return on a two asset portfolio made up of risky asset A and RF:

[9-1]

ER p = RF + w (ER A - RF)

The possible combinations of A and RF are found graphed on the following slide.

9 - 25

Attainable Portfolios Using RF and A

9 - 2 FIGURE

ER

[9-3]

RF

Risk

This means you can 9 2 Equation Rearranging 9 achieve any illustrates -2 where w= portfolio what you can p / A and combination seeportfolio substituting in along the blue risk increases Equation 1 we coloured line in direct get an simply by to proportion equation for a changing the the amount straight line relative weight invested with a in the of RFasset. and A in risky constant the two asset slope. portfolio.

9 - 26

Attainable Portfolios using the RF and A, and RF and T

9 - 3 FIGURE

ER T A

RF

Which risky portfolio would a rational riskaverse investor choose in the presence of a RF investment? Portfolio A?

Risk

Tangent Portfolio T? 9 - 27

Efficient Portfolios using the Tangent Portfolio T

9 - 3 FIGURE

ER T A

Clearly RF with T (the tangent portfolio) offers a series of portfolio combinations that dominate those produced by RF and A. Further, they dominate all but one portfolio on the efficient frontier!

RF

Risk

9 - 28

Lending Portfolios

9 - 3 FIGURE

ER

Lending Portfolios

T A

RF

Portfolios between RF and T are lending portfolios, because they are achieved by investing in the Tangent Portfolio and lending funds to the government (purchasing a T-bill, the RF).

Risk

9 - 29

Borrowing Portfolios

9 - 3 FIGURE

ER

T A

RF

The line can be extended to risk levels beyond T by borrowing at RF and investing it in T. This is a levered investment that increases both risk and expected return of the portfolio.

Risk

9 - 30

The New (Super) Efficient Frontier

9 - 4 FIGURE

ER T A2 A B2 B

RF

This is now called the Clearly RFnew with (or super) T (the market The optimal efficient frontier portfolio) offers risky portfolio of risky a series of (the market portfolios. portfolio portfolio M) combinations Investors can that dominate achieve any those produced one of these by RF and A. portfolio combinations Further, they by borrowing or but dominate all investing in RF one portfolio on in combination the efficient with the market frontier! portfolio. 9 - 31

All investors will only hold individually-determined combinations of: The separation theorem

The risk free asset (RF) and The model portfolio (market portfolio)

The investment decision (how to construct the portfolio of risky assets) is separate from the financing decision (how much should be invested or borrowed in the risk-free asset) The tangent portfolio T is optimal for every investor regardless of his/her degree of risk aversion. The market portfolio must be the tangent portfolio T if everyone holds the same portfolio Therefore the market portfolio (M) is the tangent portfolio (T)

9 - 32

The Capital Market Line

The CML is that set of superior The optimal portfolio risky portfolio combinations (the market that are M) portfolio achievable in the presence of the equilibrium condition.

CML

ER

RF

9 - 33

The Hypothesized Relationship between Risk and Return

What is it?

Hypothesizes that investors require higher rates of return for greater levels of relevant risk. There are no prices on the model, instead it hypothesizes the relationship between risk and return for individual securities. It is often used, however, the price securities and investments.

9 - 35

How is it Used?

Uses include:

Determining the cost of equity capital. The relevant risk in the dividend discount model to estimate a stocks intrinsic (inherent economic worth) value. (As illustrated below)

i =

COVi,M 2 M

ki = RF + ( ERM RF ) i

D1 P0 = kc g

9 - 36

Assumptions

1. All investors have identical expectations about expected returns, standard deviations, and correlation coefficients for all securities. 2. All investors have the same one-period investment time horizon. 3. All investors can borrow or lend money at the risk-free rate of return (RF). 4. There are no transaction costs. 5. There are no personal income taxes so that investors are indifferent between capital gains an dividends. 6. There are many investors, and no single investor can affect the price of a stock through his or her buying and selling decisions. Therefore, investors are price-takers. 7. Capital markets are in equilibrium. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 37

The assumptions have the following implications:

1. The optimal risky portfolio is the one that is tangent to the efficient frontier on a line that is drawn from RF. This portfolio will be the same for all investors. 2. This optimal risky portfolio will be the market portfolio (M) which contains all risky securities.

9 - 38

9 - 5 FIGURE

ER

CML

ERM

ERM RF k P = RF + P M

RF M

The CML is that setThe of achievable market portfolio The portfolio CML ishas the combinations optimal standard risky that deviation portfolio, are possible of it contains portfolio when investing all returns risky in as only the two securities and lies independent assets tangent (the (T) market on variable. the efficient portfolio and frontier. the risk-free asset (RF).

9 - 39

The Market Portfolio and the Capital Market Line (CML)

The slope of the CML is the incremental expected return divided by the incremental risk.

[9-4]

ER M - RF M

This is called the market price for risk. Or The equilibrium price of risk in the capital market.

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 40

The Market Portfolio and the Capital Market Line (CML) Solving for the expected return on a portfolio in the presence of a RF asset and given the market price for risk :

[9-5]

ERM - RF E ( RP ) = RF + P M

Where:

ERM = expected return on the market portfolio M M = the standard deviation of returns on the market portfolio P = the standard deviation of returns on the efficient portfolio being considered CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 41

Using the CML Expected versus Required Returns

In an efficient capital market investors will require a return on a portfolio that compensates them for the risk-free return as well as the market price for risk. This means that portfolios should offer returns along the CML.

9 - 42

Expected and Required Rates of Return

9 - 6 FIGURE

Required Return on C

ER

Expected return on A

CML

A C B

Expected Return on C

Required return on A

RF

C is an A B a portfolio overvalued that undervalued offers portfolio. andExpected expected portfolio. return equal is less Expected to than the return required the required is greater return. return. than the required Selling pressure return. will cause the price Demand to fall and for the yield Portfolio to rise until A will increase driving expected equalsup the required price, and return. therefore the expected return will fall until expected equals required (market equilibrium condition is achieved.)

9 - 43

Risk-Adjusted Performance and the Sharpe Ratios

William Sharpe identified a ratio that can be used to assess the riskadjusted performance of managed funds (such as mutual funds and pension plans). It is called the Sharpe ratio:

[9-6]

Sharpe ratio =

ER P - RF P

Sharpe ratio is a measure of portfolio performance that describes how well an assets returns compensate investors for the risk taken. Its value is the premium earned over the RF divided by portfolio risk so it is measuring valued added per unit of risk. Sharpe ratios are calculated ex post (after-the-fact) and are used to rank portfolios or assess the effectiveness of the portfolio manager in adding value to the portfolio over and above a benchmark. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 44

Sharpe Ratios and Income Trusts

Table 9 1 (on the following slide) illustrates return, standard deviation, Sharpe and beta coefficient for four very different portfolios from 2002 to 2004. Income Trusts did exceedingly well during this time, however, the recent announcement of Finance Minister Flaherty and the subsequent drop in Income Trust values has done much to eliminate this historical performance.

9 - 45

Table 9-1 Income Trusts Estimated Values

Return

Median income trusts Equally weighted trust portfolio S&P/TSX Composite Index Scotia Capital government bond index 25.83% 29.97% 8.97% 9.55%

P

18.66% 8.02% 13.31% 6.57%

Sharpe

1.37 3.44 0.49 1.08

Source: Adapted from L. Kryzanowski, S. Lazrak, and I. Ratika, " The True Cost of Income Trusts," Canadian Investment Review 19, no. 5 (Spring 2006), Table 3, p. 15.

9 - 46

The Capital Asset Pricing Model

CML applies to efficient portfolios Volatility (risk) of individual security returns are caused by two different factors:

Non-diversifiable risk (system wide changes in the economy and markets that affect all securities in varying degrees) Diversifiable risk (company-specific factors that affect the returns of only one security)

Figure 9 7 illustrates what happens to portfolio risk as the portfolio is first invested in only one investment, and then slowly invested, naively, in more and more securities.

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 48

Portfolio Risk and Diversification

9 - 7 FIGURE

Total Risk () Market or systematic risk is risk that cannot be eliminated from the portfolio by investing the portfolio into more and different securities.

Number of Securities

9 - 49

Relevant Risk

Drawing a Conclusion from Figure 9 - 7

Figure 9 7 demonstrates that an individual securities volatility of return comes from two factors:

Systematic factors Company-specific factors

When combined into portfolios, company-specific risk is diversified away. Since all investors are diversified then in an efficient market, no-one would be willing to pay a premium for company-specific risk. Relevant risk to diversified investors then is systematic risk. Systematic risk is measured using the Beta Coefficient.

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 50

The Capital Asset Pricing Model (CAPM)

What is the Beta Coefficient?

A measure of systematic (non-diversifiable) risk As a coefficient the beta is a pure number and has no units of measure.

9 - 52

How Can We Estimate the Value of the Beta Coefficient?

1. Using a formula (and subjective forecasts) 2. Use of regression (using past holding period returns)

(Figure 9 8 on the following slide illustrates the characteristic line used to estimate the beta coefficient)

9 - 53

The Characteristic Line for Security A

9 - 8 FIGURE

Security A Returns (%)

-6

-4

-2

0 0 -2

-4

-6

9 - 54

) % ( sn ru t e Rt ekr a M

The Theslope plotted of the points regression are the line coincident is beta. rates of return earned The line on of the investment best fit is and known the market in finance portfolio as over the characteristic past periods. line.

Beta is equal to the covariance of the returns of the stock with the returns of the market, divided by the variance of the returns of the market:

[9-7]

COVi,M i , M i i = = 2 M M

9 - 55

How is the Beta Coefficient Interpreted?

The beta of the market portfolio is ALWAYS = 1.0 The beta of a security compares the volatility of its returns to the volatility of the market returns:

s = 1.0 s > 1.0 s < 1.0 s < 0.0 the security has the same volatility as the market as a whole aggressive investment with volatility of returns greater than the market defensive investment with volatility of returns less than the market an investment with returns that are negatively correlated with the returns of the market

9 - 56

Canadian BETAS

Selected

Table 9-2 Canadian BETAS

Company

Abitibi Consolidated Inc. Algoma Steel Inc. Bank of Montreal Bank of Nova Scotia Barrick Gold Corp. BCE Inc. Bema Gold Corp. CIBC Cogeco Cable Inc. Gammon Lake Resources Inc. Imperial Oil Ltd.

Industry Classification

Materials - Paper & Forest Materials - Steel Financials - Banks Financials - Banks Materials - Precious Metals & Minerals Communications - Telecommunications Materials - Precious Metals & Minerals Financials - Banks Consumer Discretionary - Cable Materials - Precious Metals & Minerals Energy - Oil & Gas: Integrated Oils

Beta

1.37 1.92 0.50 0.54 0.74 0.39 0.26 0.66 0.67 2.52 0.80

9 - 57

The beta of a portfolio is simply the weighted average of the betas of the individual asset betas that make up the portfolio.

[9-8]

P = wA A + wB B + ... + wn n

Weights of individual assets are found by dividing the value of the investment by the value of the total portfolio.

9 - 58

The Capital Asset Pricing Model (CAPM)

The Security Market Line (SML) The SML is the hypothesized relationship between return (the dependent variable) and systematic risk (the beta coefficient). It is a straight line relationship defined by the following formula:

[9-9]

ki = RF + ( ERM RF ) i

Where:

ki = the required return on security i ERM RF = market premium for risk i = the beta coefficient for security i

(See Figure 9 - 9 on the following slide for the graphical representation)

9 - 60

The Security Market Line (SML)

9 - 9 FIGURE ER

ki = RF + ( ERM RF ) i

M

ERM

RF

The SML The SML is uses usedthe to beta predict coefficient requiredas the measure returns for of relevant individual risk. securities

M = 1

9 - 61

The SML and Security Valuation

9 - 10 FIGURE ER

ki = RF + ( ERM RF ) i

SML

A B

RF

Similarly, Required A is an returns B is an are forecast using undervalued overvalued this equation. security security. because its expected return You can see Investors willthat sell is greater than the the to lock required in gains, return required return. on any but the security selling is a functionwill Investors pressure will of its systematic flock cause to the A market and risk bid () and up price the market to price fall, factors the causing expected (RF and market return expected to fall return till itto premium equals rise until the it equals for risk) required the required return. return. 9 - 62

The SML and CML

The CAPM is well entrenched and widely used by investors, managers and financial institutions. It is a single factor model because it based on the hypothesis that required rate of return can be predicted using one factor systematic risk The SML is used to price individual investments and uses the beta coefficient as the measure of risk. The CML is used with diversified portfolios and uses the standard deviation as the measure of risk.

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 63

The Capital Asset Pricing Model (CAPM)

Challenges to CAPM

Empirical tests suggest:

CAPM does not hold well in practice:

Ex post SML is an upward sloping line Ex ante y (vertical) intercept is higher that RF Slope is less than what is predicted by theory

Beta possesses no explanatory power for predicting stock returns (Fama and French, 1992)

Advantages include relative simplicity and intuitive logic.

Because of the problems with CAPM, other models have been developed including:

Fama-French (FF) Model Abitrage Pricing Theory (APT)

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 65

The Fama French Model

A pricing model that uses three factors to relate expected returns to risk including:

1. 2. 3. A market factor related to firm size. The market value of a firms common equity (MVE) Ratio of a firms book equity value to its market value of equity. (BE/MVE)

This model has become popular, and many think it does a better job than the CAPM in explaining ex ante stock returns.

9 - 66

The Arbitrage Pricing Theory A pricing model that uses multiple factors to relate expected returns to risk by assuming that asset returns are linearly related to a set of indexes, which proxy risk factors that influence security returns.

[9-10]

It is based on the no-arbitrage principle which is the rule that two otherwise identical assets cannot sell at different prices. Underlying factors represent broad economic forces which are inherently unpredictable.

9 - 67

The Arbitrage Pricing Theory the Model

Underlying factors represent broad economic forces which are inherently unpredictable.

[9-10]

Where:

ERi = the expected return on security i a0 = the expected return on a security with zero systematic risk bi = the sensitivity of security i to a given risk factor Fi = the risk premium for a given risk factor

The model demonstrates that a securitys risk is based on its sensitivity to broad economic forces. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 68

The Arbitrage Pricing Theory Challenges

Underlying factors represent broad economic forces which are inherently unpredictable. Ross and Roll identify five systematic factors:

1. 2. 3. 4. 5. Changes in expected inflation Unanticipated changes in inflation Unanticipated changes in industrial production Unanticipated changes in the default-risk premium Unanticipated changes in the term structure of interest rates

Clearly, something that isnt forecast, cant be used to price securities todaythey can only be used to explain prices after the fact.

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 69

In this chapter you have learned:

How the efficient frontier can be expanded by introducing riskfree borrowing and lending leading to a super efficient frontier called the Capital Market Line (CML) The Security Market Line can be derived from the CML and provides a way to estimate a market-based, required return for any security or portfolio based on market risk as measured by the beta. That alternative asset pricing models exist including the FamaFrench Model and the Arbitrage Pricing Theory.

9 - 70

The Capital Asset Pricing Model

Risk Aversion

What is risk aversion and how do we know investors are risk averse?

9 - 72

APPENDIX 1

Ex Ante means forecast You would use ex ante return data if historical rates of return are somehow not indicative of the kinds of returns the company will produce in the future. A good example of this is Air Canada or American Airlines, before and after September 11, 2001. After the World Trade Centre terrorist attacks, a fundamental shift in demand for air travel occurred. The historical returns on airlines are not useful in estimating future returns.

9 - 74

Appendix 1 Agenda

The beta coefficient The formula approach to beta measurement using ex ante returns

Ex ante returns Finding the expected return Determining variance and standard deviation Finding covariance Calculating and interpreting the beta coefficient

9 - 75

Under the theory of the Capital Asset Pricing Model total risk is partitioned into two parts:

Systematic risk Unsystematic risk diversifiable risk

Systematic Risk

Unsystematic Risk

Systematic risk is non-diversifiable risk. Systematic risk is the only relevant risk to the diversified investor The beta coefficient measures systematic risk

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 76

The Formula

Beta =

Covariance of Returns between stock ' i' returns and the market Variance of the Market Returns

[9-7]

COVi,M i , M i i = = 2 M M

9 - 77

What does the term relevant risk mean in the context of the CAPM?

It is generally assumed that all investors are wealth maximizing risk averse people It is also assumed that the markets where these people trade are highly efficient In a highly efficient market, the prices of all the securities adjust instantly to cause the expected return of the investment to equal the required return When E(r) = R(r) then the market price of the stock equals its inherent worth (intrinsic value) In this perfect world, the R(r) then will justly and appropriately compensate the investor only for the risk that they perceive as relevant Hence investors are only rewarded for systematic risk.

NOTE: The amount of systematic risk varies by investment. High systematic risk occurs when R-square is high, and the beta coefficient is greater than 1.0

9 - 78

Every investment in the financial markets vary with respect to the percentage of total risk that is systematic. Some stocks have virtually no systematic risk.

Such stocks are not influenced by the health of the economy in generaltheir financial results are predominantly influenced by company-specific factors. An example is cigarette companiespeople consume cigarettes because they are addictedso it doesnt matter whether the economy is healthy or notthey just continue to smoke. Returns on these stocks are strongly influenced by the health of the economy. Durable goods manufacturers tend to have a high degree of systematic risk. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 79

Some stocks have a high proportion of their total risk that is systematic

You need to calculate the covariance of the returns between the stock and the marketas well as the variance of the market returns. To do this you must follow these steps: Calculate the expected returns for the stock and the market Using the expected returns for each, measure the variance and standard deviation of both return distributions Now calculate the covariance Use the results to calculate the beta CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 80

A Sample

A set of estimates of possible returns and their respective probabilities looks as follows:

9 - 81

Since the beta relates the stock By observation returns to the market returns, you can see the the greater range range is much of stock returns greater for the changing in the stock than theas same direction market and they the market indicates the beta move in the will be direction. greater same than 1 and will be positive. (Positively correlated to the market returns.)

This means that we have considered all of the possible outcomes in this discrete probability distribution

100.0%

9 - 82

The expected return is weighted average returns from the given ex ante data

(1) (2) (3) (4)

Boom 25.0% 28.0% Normal 50.0% 17.0% Recession 25.0% -14.0% Expected return on the Stock =

9 - 83

The expected return is weighted average returns from the given ex ante data

(1) (2) (3) (4)

Boom 25.0% 20.0% Normal 50.0% 11.0% Recession 25.0% -4.0% Expected return on the Market =

9 - 84

Using the expected return, calculate the deviations away from the mean, square those deviations and then weight the squared deviations by the probability of their occurrence. Add up the weighted and squared deviations from the mean and you have found the variance!

(1)

(2)

(3)

(4)

(5)

(6)

Squared Deviations

(7)

Weighted and Squared Deviations

Deviations

0.16 0.0256 0.05 0.0025 -0.26 0.0676 12.0% Variance (stock)= Standard Deviation (stock) =

0.07 0.085 -0.035

9 - 85

Now do this for the possible returns on the market

(1)

(2)

(3)

(4)

(5)

(6)

Squared Deviations

(7)

Weighted and Squared Deviations

Deviations

0.105 0.011025 0.015 0.000225 -0.135 0.018225 9.5% Variance (market) = Standard Deviation (market)=

0.05 0.055 -0.01

9 - 86

Covariance

From Chapter 8 you know the formula for the covariance between the returns on the stock and the returns on the market is:

[8-12]

i =1

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 87

Correlation Coefficient

Correlation is covariance normalized by the product of the standard deviations of both securities. It is a relative measure of co-movement of returns on a scale from -1 to +1. The formula for the correlation coefficient between the returns on the stock and the returns on the market is:

[8-13]

AB =

COV AB

AB

The correlation coefficient will always have a value in the range of +1 to -1.

+1 is perfect positive correlation (there is no diversification potential when combining these two securities together in a two-asset portfolio.) - 1 - is perfect negative correlation (there should be a relative weighting mix of these two securities in a two-asset portfolio that will eliminate all portfolio risk)

9 - 88

Measuring Covariance

from Ex Ante Return Data

Using the expected return (mean return) and given data measure the deviations for both the market and the stock and multiply them together with the probability of occurrencethen add the products up.

(1)

Possible Future State of the Economy

(2)

(3)

Possible Returns on the Stock

(4)

(5)

(6)

(7)

(8)

"(9)

Prob.

(4) = (2)*(3)

Deviations Possible from the Returns on mean for the Market (6)=(2)*(5) the stock

9 - 89

Using Ex Ante Covariance (stock, market) and Market Variance Now you can substitute the values for covariance and the variance of the returns on the market to find the beta of the stock:

Beta =

A beta that is greater than 1 means that the investment is aggressiveits returns are more volatile than the market as a whole. If the market returns were expected to go up by 10%, then the stock returns are expected to rise by 18%. If the market returns are expected to fall by 10%, then the stock returns are expected to fall by 18%. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 90

Let us assume we are comparing the possible market returns against itselfwhat will the beta be?

(1) (2) (3) (4) (5) (6) (6)

Deviations from the mean for the stock

(7)

(8)

Possible Possible Future Returns State of the on the Economy Prob. Market

0.05 0.055 -0.01

Cov

0.05 0.055 -0.01 9.5%

Since Sincethe thevariance varianceof ofthe thereturns returnson onthe themarket marketis is= =.007425 .007425the thebeta betafor for the market is indeed equal to 1.0 !!! the market is indeed equal to 1.0 !!!

9 - 91

If you now place the covariance of the market with itself value in the beta formula you get:

The beta coefficient of the market will always be 1.0 because you are measuring the market returns against market returns. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 92

Expected versus Required Return

Once you have estimated the expected and required rates of return, you can plot them on the SML and see if the stock is under or overpriced.

% Return

R(ks) = 4.76% E(kM)= 4.2%

E(Rs) = 5.0%

SML

Risk-free Rate = 3%

BM= 1.0

Bs = 1.464

9 - 94

The stock is fairly priced if the expected return = the required return. This is what we would expect to see normally or most of the time in an efficient market where securities are properly priced.

% Return

E(Rs) = R(Rs) 4.76%

SML

E(RM)= 4.2%

Risk-free Rate = 3%

B M= 1.0

BS = 1.464

9 - 95

We can use the forecast beta, together with an estimate of the risk-free rate and the market premium for risk to calculate the investors required return on the stock using the CAPM:

This is a market-determined return based on the current riskfree rate (RF) as measured by the 91-day, government of Canada T-bill yield, and a current estimate of the market premium for risk (kM RF) CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 96

Conclusions

Analysts can make estimates or forecasts for the returns on stock and returns on the market portfolio. Those forecasts can be analyzed to estimate the beta coefficient for the stock. The required return on a stock can then be calculated using the CAPM but you will need the stocks beta coefficient, the expected return on the market portfolio and the risk-free rate. The required return is then using in Dividend Discount Models to estimate the intrinsic value (inherent worth) of the stock.

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 97

APPENDIX 2

You need to gather historical data about the stock and the market You can use annual data, monthly data, weekly data or daily data. However, monthly holding period returns are most commonly used. Daily data is too noisy (short-term random volatility) Annual data will extend too far back in to time You need at least thirty (30) observations of historical data. Hopefully, the period over which you study the historical returns of the stock is representative of the normal condition of the firm and its relationship to the market. If the firm has changed fundamentally since these data were produced (for example, the firm may have merged with another firm or have divested itself of a major subsidiary) there is good reason to believe that future returns will not reflect the pastand this approach to beta estimation SHOULD NOT be used.rather, use the ex ante approach. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 99

The Approach Used to Create the Characteristic Line

In this example, we have regressed the quarterly returns on the stock against the quarterly returns of a surrogate for the market (TSE 300 total return composite index) and then using Excelused the charting feature to plot the historical points and add a regression trend line.

Charac teristic Line (Regression) 30.0% 25.0% Returns on Stock 20.0% 15.0% 10.0% 5.0% -40.0% 0.0% -20.0% -5.0% 0.0% -10.0% -15.0% Returns on TSE 300 20.0% 40.0%

The cloud of plotted points Period HPR(Stock) HPR(TSE 300) represents diversifiable or company 2006.4 1.2% specific risk-4.0% in the securities returns 2006.3 -16.0% that can be eliminated from-7.0% a portfolio 2006.2 32.0% 12.0% through diversification. Since 2006.1 16.0% 8.0% company-specific risk can be eliminated, investors dont require 2005.4 -22.0% -11.0% compensation for it according 2005.3 15.0% 16.0% to Portfolio Theory. 2005.2Markowitz 28.0% 13.0% 2005.1 19.0% 7.0% 2004.4 -16.0% -4.0% The regression line is a line of best 2004.3 8.0% 16.0% fit that describes the inherent 2004.2 -3.0% -11.0% relationship between the returns on 2004.1 34.0% 25.0% the stock and the returns on the market. The slope is the beta coefficient.

9 - 100

Characteristic Line

The characteristic line is a regression line that represents the relationship between the returns on the stock and the returns on the market over a past period of time. (It will be used to forecast the future, assuming the future will be similar to the past.) The slope of the Characteristic Line is the Beta Coefficient. The degree to which the characteristic line explains the variability in the dependent variable (returns on the stock) is measured by the coefficient of determination. (also known as the R2 (r-squared or coefficient of determination)). If the coefficient of determination equals 1.00, this would mean that all of the points of observation would lie on the line. This would mean that the characteristic line would explain 100% of the variability of the dependent variable. The alpha is the vertical intercept of the regression (characteristic line). Many stock analysts search out stocks with high alphas.

9 - 101

Low R2

An R2 that approaches 0.00 (or 0%) indicates that the characteristic (regression) line explains virtually none of the variability in the dependent variable. This means that virtually of the risk of the security is company-specific. This also means that the regression model has virtually no predictive ability. In this case, you should use other approaches to value the stockdo not use the estimated beta coefficient.

9 - 102

An Example of Volatility that is Primarily Company-Specific

Returns on Imperial Tobacco % Characteristic Line for Imperial Tobacco

High alpha High alpha R-square is very R-square is very low 0.02 low 0.02 Beta is largely Beta is largely irrelevant irrelevant

9 - 103

High R2

An R2 that approaches 1.00 (or 100%) indicates that the characteristic (regression) line explains virtually all of the variability in the dependent variable. This means that virtually of the risk of the security is systematic. This also means that the regression model has a strong predictive ability. if you can predict what the market will dothen you can predict the returns on the stock itself with a great deal of accuracy.

9 - 104

A Positive Beta with Predictive Power

Returns on General Motors % Characteristic Line for GM (high R2)

Positive Positivealpha alpha R-square R-squareis is very high very high 0.9 0.9 Beta Betais ispositive positive and close and closeto to1.0 1.0

9 - 105

A Negative Beta with Predictive Power

Returns on a Stock % Characteristic Line for a stock that will provide excellent portfolio diversification (high R2)

Positive Positivealpha alpha R-square R-squareis is very high very high Beta Betais isnegative negative <0.0 and <0.0 and>>-1.0 -1.0

9 - 106

Diversifiable Risk

(Non-systematic Risk)

Volatility in a securitys returns caused by companyspecific factors (both positive and negative) such as:

a single company strike a spectacular innovation discovered through the companys R&D program equipment failure for that one company management competence or management incompetence for that particular firm a jet carrying the senior management team of the firm crashes (this could be either a positive or negative event, depending on the competence of the management team) the patented formula for a new drug discovered by the firm.

Obviously, diversifiable risk is that unique factor that influences only the one firm.

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 107

OK lets go back and look at raw data gathering and data normalization

A common source for stock of information is Yahoo.com You will also need to go to the library a use the TSX Review (a monthly periodical) to obtain:

Number of shares outstanding for the firm each month Ending values for the total return composite index (surrogate for the market)

You want data for at least 30 months. For each month you will need:

Ending stock price Number of shares outstanding for the stock Dividend per share paid during the month for the stock Ending value of the market indicator series you plan to use (ie. TSE 300 total return composite index) CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 108

The following slides will be based on Alcan Aluminum (AL.TO)

9 - 110

Process:

Go to http://ca.finance.yahoo.com Use the symbol lookup function to search for the company you are interested in studying. Use the historical quotes buttonand get 30 months of historical data. Use the download in spreadsheet format feature to save the data to your hard drive.

9 - 111

Alcan Example

Date Open High Low Close Volume 01-May-02 57.46 62.39 56.61 59.22 753874 01-Apr-02 62.9 63.61 56.25 57.9 879210 01-Mar-02 64.9 66.81 61.68 63.03 974368 01-Feb-02 61.65 65.67 58.75 64.86 836373 02-Jan-02 57.15 62.37 54.93 61.85 989030 03-Dec-01 56.6 60.49 55.2 57.15 833280 01-Nov-01 49 58.02 47.08 56.69 779509

9 - 112

Alcan Example

Volume Volumeof of trading Opening tradingdone done Openingprice priceper pershare, share,the the The day, in highest The day, inthe thestock stockon on highestprice priceper pershare shareduring duringthe the month and the month, month and theTSE TSEin inthe the month,the thelowest lowestprice priceper pershare share year month achieved year monthin in achievedduring duringthe themonth monthand andthe the numbers closing numbersof of closingprice priceper pershare shareat atthe theend end of CHAPTER 9month The Capital Asset Pricing 9 - 113 board boardlots lots ofthe the month Model (CAPM)

Alcan Example

From Yahoo, the only information you can use is the closing price per share and the date. Just delete the other columns.

9 - 114

Alcan Example

In addition to the closing price of the stock on a per share basis, you will need to find out how many shares were outstanding at the end of the month and whether any dividends were paid during the month. You will also want to find the end-of-the-month value of the S&P/TSX Total Return Composite Index (look in the green pages of the TSX Review) You can find all of this in The TSX Review periodical.

9 - 115

Alcan Example

Closing Price Cash for Alcan Dividends AL.TO per Share $59.22 $0.00 $57.90 $0.15 $63.03 $0.00 $64.86 $0.00 $123.70 $0.30 $119.30 $0.00

Number of shares doubled and share price fell by half between January and February 2002 this is indicative of a 2 for 1 stock split. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 116

Alcan Example

Closing Price for Cash Alcan Dividends Adjustment AL.TO per Share Factor $59.22 $0.00 1.00 $57.90 $0.15 1.00 $63.03 $0.00 1.00 $64.86 $0.00 1.00 $123.70 $0.30 0.50 $111.40 $0.00 0.45

Normalized Normalized Stock Price Dividend $59.22 $0.00 $57.90 $0.15 $63.03 $0.00 $64.86 $0.00 $61.85 $0.15 $50.26 $0.00

The adjustment factor is just the value in the issued capital cell divided by 321,400,589.

9 - 117

(P 1P 0 ) + D1 P0

HPR = =

Use $59.22 as the ending price, $57.90 as the beginning price and during the month of May, no dividend was declared. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 118

Now Put the data from the S&P/TSX Total Return Composite Index in

Ending TSX Value 16911.33 16903.36 17308.41 16801.82 16908.11 16881.75

Normalized Normalized Stock Price Dividend $59.22 $0.00 $57.90 $0.15 $63.03 $0.00 $64.86 $0.00 $61.85 $0.15 $50.26 $0.00

You Youwill willfind findthe theTotal TotalReturn ReturnS&P/TSX S&P/TSXComposite Composite Index Indexvalues valuesin inTSX TSXReview Reviewfound foundin inthe thelibrary. library. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 119

HPR = (P 1P 0) P0

Normalized Normalized Stock Price Dividend $59.22 $0.00 $57.90 $0.15 $63.03 $0.00 $64.86 $0.00 $61.85 $0.15 $50.26 $0.00

Ending TSX HPR on Value the TSX 16911.33 0.05% 16903.36 -2.34% 17308.41 3.02% 16801.82 -0.63% 16908.11 0.16% 16881.75

Again, Again,you yousimply simplyuse usethe theHPR HPRformula formulausing usingthe the ending endingvalues valuesfor forthe thetotal totalreturn returncomposite compositeindex. index. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 120

Regression In Excel

If you havent alreadygo to the tools menudown to add-ins and check off the VBA Analysis Pac When you go back to the tools menu, you should now find the Data Analysis bar, under that find regression, define your dependent and independent variable ranges, your output range and run the regression.

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 121

Regression

Defining the Data Ranges

Ending TSX HPR on Value the TSX 16911.33 0.05% 16903.36 -2.34% 17308.41 3.02% 16801.82 -0.63% 16908.11 0.16% 16881.75

The independent variable variable is is the the returns returns on on the the Stock. Market. Thedependent independent dependent variable variable is is the the returns returns on on the the Stock. Market. CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 122

Now Use the Regression Function in Excel to regress the returns of the stock against the returns of the market

SUMMARY OUTPUT Regression Statistics Multiple R 0.05300947 R Square 0.00281 Adjusted R Square -0.2464875 Standard Error 5.79609628 Observations 6 ANOVA df Regression Residual Total SS MS 1 0.3786694 0.37866937 4 134.37893 33.5947321 5 134.7576 F Significance F 0.011271689 0.920560274

Intercept X Variable 1

Upper 95% Lower 95.0%Upper 95.0% 67.38836984 51.2957934 67.38837 96.46332302 -89.3577443 96.46332

9 - 123

Alcan Example

You can use the charting feature in Excel to create a scatter plot of the points and to put a line of best fit (the characteristic line) through the points. In Excel, you can edit the chart after it is created by placing the cursor over the chart and right-clicking your mouse. In this edit mode, you can ask it to add a trendline (regression line) Finally, you will want to interpret the Beta (Xcoefficient) the alpha (vertical intercept) and the coefficient of determination.

CHAPTER 9 The Capital Asset Pricing Model (CAPM) 9 - 124

The Beta

Alcan Example

Obviously the beta (X-coefficient) can simply be read from the regression output.

In this case it was 3.56 making Alcans returns more than 3 times as volatile as the market as a whole. Of course, in this simple example with only 5 observations, you wouldnt want to draw any serious conclusions from this estimate.

9 - 125

Copyright

Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

9 - 126

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