Chapter 13.

Risk & Return in Asset Pricing Models

Portfolio Theory Managing Risk Asset Pricing Models

I. Portfolio Theory

how does investor decide among

group of assets? assume: investors are risk averse additional compensation for risk tradeoff between risk and expected return

goal

efficient or optimal portfolio

for a given risk, maximize exp. return OR for a given exp. return, minimize the risk

tools

measure risk, return quantify risk/return tradeoff

Measuring Return
change in asset value + income
return = R = initial value

R is ex post

based on past data, and is known R is typically annualized

example 1

Tbill, 1 month holding period buy for $9488, sell for $9528 1 month R:
9528 - 9488 9488 = .0042 = .42%

 annualized R:
(1.0042)12 - 1 = .052 = 5.2%

example 2

100 shares IBM, 9 months buy for $62, sell for $101.50 $.80 dividends 9 month R:
101.50 - 62 + .80 62 = .65 =65%

 annualized R:
(1.65)12/9 - 1 = .95 = 95%

Expected Return

measuring likely future return based on probability distribution random variable

E(R) = SUM(Ri x Prob(Ri))

example 1
R 10% 5% -5% Prob(R) .2 .4 .4

E(R) = (.2)10% + (.4)5% + (.4)(-5%)

= 2%

example 2
R 1% 2% 3% Prob(R) .3 .4 .3

E(R) = (.3)1% + (.4)2% + (.3)(3%)

= 2%

examples 1 & 2

same expected return but not same return structure

returns in example 1 are more variable

Risk

measure likely fluctuation in return

how much will R vary from E(R) how likely is actual R to vary from E(R) measured by variance (s2) standard deviation (s)

s2 = SUM[(Ri - E(R))2 x Prob(Ri)]

s = SQRT(s2)

example 1
s2 =
(.2)(10%-2%)2 + (.4)(5%-2%)2

+ (.4)(-5%-2%)2
= .0039 s = 6.24%

example 2
s2 =
(.3)(1%-2%)2 + (.4)(2%-2%)2

+ (.3)(3%-2%)2
= .00006 s = .77%

 same expected return but example 2 has a lower risk

preferred by risk averse investors variance works best with symmetric distributions

prob(R)

prob(R)

E(R)

E(R)

symmetric

asymmetric

II. Managing risk

Diversification
holding a group of assets lower risk w/out lowering E(R)

 Why?
individual assets do not have same return pattern combining assets reduces overall return variation

two types of risk

unsystematic risk
specific to a firm can be eliminated through diversification examples: -- Safeway and a strike -- Microsoft and antitrust cases

 systematic risk
market risk cannot be eliminated through diversification due to factors affecting all assets -- energy prices, interest rates, inflation, business cycles

example

choose stocks from NYSE listings go from 1 stock to 20 stocks

reduce risk by 40-50%

s unsystematic risk total risk systematic risk # assets

measuring relative risk

if some risk is diversifiable,

then s is not the best measure of risk is an absolute measure of risk need a measure just for the systematic component

Beta, b

variation in asset/portfolio return

relative to return of market portfolio mkt. portfolio = mkt. index -- S&P 500 or NYSE index
% change in asset return b= % change in market return

interpreting b if b = 0

asset is risk free if b = 1 asset return = market return if b > 1 asset is riskier than market index b<1 asset is less risky than market index

Sample betas
Amazon Anheuser Busch Microsoft Ford General Electric Wal Mart 2.23 -.107 1.62 1.31 1.10 .80

(monthly returns, 5 years back)

measuring b

estimated by regression
data on returns of assets data on returns of market index estimate

R = bR m

problems

what length for return interval?

weekly? monthly? annually? choice of market index? NYSE, S&P 500 survivor bias

 # of observations (how far back?)

5 years? 50 years? time period? 1970-1980? 1990-2000?

III. Asset Pricing Models

CAPM
Capital Asset Pricing Model 1964, Sharpe, Linter quantifies the risk/return tradeoff

assume

investors choose risky and risk-free

asset no transactions costs, taxes same expectations, time horizon risk averse investors

implication

expected return is a function of

beta risk free return market return

E( R ) = R f b[ E( R m ) R f ]
or

E( R ) R f = b[ E( R m ) R f ]
where

E( R ) R f is the portfolio risk premium

E( R m ) R f

is the market risk premium

so if b >1,
E( R ) R f

>

E( R m ) R f

E( R )

> E( R m )

portfolio exp. return is larger than

exp. market return riskier portfolio has larger exp. return

so if b <1,
E( R ) R f

<

E( R m ) R f

E( R )

< E( R m )

portfolio exp. return is smaller than

exp. market return less risky portfolio has smaller exp. return

so if b =1,
E( R ) R f

E( R m ) R f

E( R )

= E( R m )

portfolio exp. return is same than

exp. market return equal risk portfolio means equal exp. return

so if b = 0,
E( R ) R f

=0 =
Rf

E( R )
free return

portfolio exp. return is equal to risk

example

Rm = 10%, Rf = 3%, b = 2.5

E( R ) = R f b[ E( R m ) R f ]

E( R ) = 3% 2.5[10% 3%] E( R ) = 3% 17.5% E( R ) = 20.5%

 CAPM tells us size of risk/return

tradeoff CAPM tells use the price of risk

Testing the CAPM

CAPM overpredicts returns

return under CAPM > actual return relationship between and return? some studies it is positive some recent studies argue no relationship (1992 Fama & French)

 other factors important in

determining returns January effect firm size effect day-of-the-week effect ratio of book value to market value

problems w/ testing CAPM

Roll critique (1977)

CAPM not testable do not observe E(R), only R do not observe true Rm do not observe true Rf results are sensitive to the sample period

APT

Arbitrage Pricing Theory 1976, Ross assume:

several factors affect E(R) does not specify factors

 implications
E(R) is a function of several factors, F each with its own b

E( R ) R f = b1F1 b2 F2 b3F3 .... b N FN

APT vs. CAPM

APT is more general

many factors unspecified factors CAPM is a special case of the APT 1 factor factor is market risk premium

testing the APT

how many factors? what are the factors? 1980 Chen, Roll, and Ross
industrial production inflation yield curve slope other yield spreads

summary

known risk/return tradeoff

how to measure risk? how to price risk? neither CAPM or APT are perfect or free of testing problems both have shown value in asset pricing