RISK & CAPM

CORPORATE FINANCE
LECTURE 02

Copyright © 2010 by Nelson Education Ltd. 6-1

Risk and Return Fundamentals

• In most important business decisions there are two key

financial considerations: risk and return.
• Each financial decision presents certain risk and return
characteristics, and the combination of these
characteristics can increase or decrease a firm’s share
price.
• Analysts use different methods to quantify risk depending
on whether they are looking at a single asset or a
portfolio—a collection, or group, of assets.

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Risk and Return Fundamentals:
Risk Defined
• Risk is a measure of the uncertainty surrounding the
return that an investment will earn or, more formally, the
variability of returns associated with a given asset.
• Return is the total gain or loss experienced on an
investment over a given period of time; calculated by
dividing the asset’s cash distributions during the period,
plus change in value, by its beginning-of-period
investment value.

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– Systematic risk refers to the chance an entire market or economy will
experience a downturn or even fail. Economic crashes, recessions, wars,
interest rates and natural disasters are common sources of systematic risk.
– Unsystematic risk describes the chance a specific company or line of
business will experience a downturn or even fail. Unlike systematic risk,
unsystematic risk can vary greatly from business to business. Sources of
unsystematic risk include the strategic, management and investment
decisions a small business owner faces every day.
– Systematic risk is uncontrollable by an organization and macro in nature.
– Unsystematic risk is controllable by an organization and micro in nature.

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• Systematic Risk
Systematic risk is due to the influence of external factors on an organization. Such
factors are normally uncontrollable from an organization's point of view.
It is a macro in nature as it affects a large number of organizations operating under a
similar stream or same domain. It cannot be planned by the organization.
The types of systematic risk are depicted and listed below.

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1. Interest rate risk
Interest-rate risk arises due to variability in the interest rates from time to time. It particularly
affects debt securities as they carry the fixed rate of interest.
The types of interest-rate risk are depicted and listed below.

1. Price risk and

2. Reinvestment rate risk.
The meaning of price and reinvestment rate risk is as follows:
Price risk arises due to the possibility that the price of the shares, commodity, investment, etc.
may decline or fall in the future.
Reinvestment rate risk results from fact that the interest or dividend earned from an investment
can't be reinvested with the same rate of return as it was acquiring earlier.

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2. Market risk
• Market risk is associated with consistent fluctuations seen in the trading price of any
particular shares or securities. That is, it arises due to rise or fall in the trading price of listed
shares or securities in the stock market.
• The types of market risk are depicted and listed below.

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• The meaning of different types of market risk is as follows:
• Absolute risk is without any content. For e.g., if a coin is tossed, there is fifty percentage
chance of getting a head and vice-versa.
• Relative risk is the assessment or evaluation of risk at different levels of business functions.
For e.g. a relative-risk from a foreign exchange fluctuation may be higher if the maximum
sales accounted by an organization are of export sales.
• Directional risks are those risks where the loss arises from an exposure to the particular
assets of a market. For e.g. an investor holding some shares experience a loss when the
market price of those shares falls down.
• Non-Directional risk arises where the method of trading is not consistently followed by the
trader. For e.g. the dealer will buy and sell the share simultaneously to mitigate the risk
• Basis risk is due to the possibility of loss arising from imperfectly matched risks. For e.g. the
risks which are in offsetting positions in two related but non-identical markets.
• Volatility risk is of a change in the price of securities as a result of changes in the volatility of a
risk-factor. For e.g. it applies to the portfolios of derivative instruments, where the volatility of
its underlying is a major influence of prices.

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3. Purchasing power or inflationary risk
• Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates)
from the fact that it affects a purchasing power adversely. It is not desirable to invest in
securities during an inflationary period.
• The types of power or inflationary risk are depicted and listed below.

• Demand inflation risk arises due to increase in price, which result from an excess of
demand over supply. It occurs when supply fails to cope with the demand and hence cannot
expand anymore. In other words, demand inflation occurs when production factors are under
maximum utilization.
• Cost inflation risk arises due to sustained increase in the prices of goods and services. It is
actually caused by higher production cost. A high cost of production inflates the final price of
finished goods consumed by people.

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• B. Unsystematic Risk
• Unsystematic risk is due to the influence of internal factors prevailing within an organization.
Such factors are normally controllable from an organization's point of view.
• It is a micro in nature as it affects only a particular organization. It can be planned, so that
necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk.
• The types of unsystematic risk are depicted and listed below.

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• 1. Business or liquidity risk
• Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the
sale and purchase of securities affected by business cycles, technological changes, etc.
• The types of business or liquidity risk are depicted and listed below.

• Asset liquidity risk is due to losses arising from an inability to sell or pledge assets at, or
near, their carrying value when needed. For e.g. assets sold at a lesser value than their
book value.
• Funding liquidity risk exists for not having an access to the sufficient-funds to make a
payment on time. For e.g. when commitments made to customers are not fulfilled as
discussed in the SLA (service level agreements).

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2. Financial or credit risk
• Financial risk is also known as credit risk. It arises due to change in the capital structure of
the organization. The capital structure mainly comprises of three ways by which funds are
sourced for the projects. These are as follows:
• Owned funds. For e.g. share capital.
• Borrowed funds. For e.g. loan funds.
• Retained earnings. For e.g. reserve and surplus.
• The types of financial or credit risk are depicted and listed below.

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• The meaning of types of financial or credit risk is as follows:

• Exchange rate risk is also called as exposure rate risk. It is a form of financial risk that arises
from a potential change seen in the exchange rate of one country's currency in relation to
another country's currency and vice-versa. For e.g. investors or businesses face it either
when they have assets or operations across national borders, or if they have loans or
borrowings in a foreign currency.
• Recovery rate risk is an often neglected aspect of a credit-risk analysis. The recovery rate is
normally needed to be evaluated. For e.g. the expected recovery rate of the funds tendered
(given) as a loan to the customers by banks, non-banking financial companies (NBFC), etc.
• Sovereign risk is associated with the government. Here, a government is unable to meet its
loan obligations, reneging (to break a promise) on loans it guarantees, etc.
• Settlement risk exists when counterparty does not deliver a security or its value in cash as
per the agreement of trade or business.

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3. Operational risk
• Operational risks are the business process risks failing due to human errors. This risk will
change from industry to industry. It occurs due to breakdowns in the internal procedures,
people, policies and systems.The types of operational risk are depicted and listed below.

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• Model risk is involved in using various models to value financial securities. It is due to
probability of loss resulting from the weaknesses in the financial-model used in assessing
and managing a risk.
• People risk arises when people do not follow the organization’s procedures, practices and/or
rules. That is, they deviate from their expected behavior.
• Legal risk arises when parties are not lawfully competent to enter an agreement among
themselves. Furthermore, this relates to the regulatory-risk, where a transaction could
conflict with a government policy or particular legislation (law) might be amended in the
future with retrospective effect.
• Political risk occurs due to changes in government policies. Such changes may have an
unfavorable impact on an investor. It is especially prevalent in the third-world countries.

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BASIS FOR SYSTEMATIC RISK UNSYSTEMATIC RISK
COMPARISON
Meaning Systematic risk refers to the hazard Unsystematic risk refers to
which is associated with the market the risk associated with a
or market segment as a whole. particular security,
company or industry.
Nature Uncontrollable Controllable
Factors External factors Internal factors
Affects Large number of securities in the Only particular company.
market.
Types Interest risk, market risk and Business risk and financial
purchasing power risk. risk
Protection Asset allocation Portfolio diversification

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• Explain how expected return and return
variance are used to describe return
distrubition for a security or portfolio of
securities.

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Risk and Return Fundamentals:
Risk Defined (cont.)
The return on an investment in a single stock or a portfolio can be
expressed as the percentage increase in the total value of the
investment over a 1-year horizon.
The expression for calculating the total rate of return earned on any
asset over period t, rt, is commonly defined as

rt = actual, expected, or required rate of return during period t

Ct = cash (flow) received from the asset investment in the time
period t – 1 to t
Pt = price (value) of asset at time t
Pt –1 = price (value) of asset at time t – 1
Risk and Return Fundamentals:
Risk Defined (cont.)
At the beginning of the year, Apple stock traded for $90.75 per share,
and Wal-Mart was valued at $55.33. During the year, Apple paid no
dividends, but Wal-Mart shareholders received dividends of $1.09 per
share. At the end of the year, Apple stock was worth $210.73 and
Wal-Mart sold for $52.84.
We can calculate the annual rate of return, r, for each stock.
Apple: ($0 + $210.73 – $90.75) ÷ $90.75 = 132.2%

Wal-Mart: ($1.09 + $52.84 – $55.33) ÷ $55.33 = –2.5%

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The percentage returns we will refer to in this section are those that would be
realized in perfect markets. Perfect markets are those in which:
• There are no costs or trading or enforcing contracts.
• Investors have identical information.
• No taxes are levied.
• There are no restrictions on the buying or selling of securities.
• Purchases and sales of securities do not affect the market price of the
securities. This assumption allows us to focus solely on the relation
between risk characteristics of securities and their expected returns.

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Table 8.1 Historical Returns on
Selected Investments (1900–2009)

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Risk and Return Fundamentals:
Risk Preferences
Economists use three categories to describe how investors
respond to risk.
– Risk averse is the attitude toward risk in which investors would
require an increased return as compensation for an increase in
risk.
– Risk-neutral is the attitude toward risk in which investors
choose the investment with the higher return regardless of its
risk.
– Risk-seeking is the attitude toward risk in which investors
prefer investments with greater risk even if they have lower
expected returns.

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Risk of a Single Asset:
Risk Assessment
• Scenario analysis is an approach for assessing risk that
uses several possible alternative outcomes (scenarios) to
obtain a sense of the variability among returns.
– One common method involves considering pessimistic (worst),
most likely (expected), and optimistic (best) outcomes and the
returns associated with them for a given asset.
• Range is a measure of an asset’s risk, which is found by
subtracting the return associated with the pessimistic
(worst) outcome from the return associated with the
optimistic (best) outcome.

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Risk of a Single Asset:
Risk Assessment (cont.)
Norman Company wants to choose the better of two investments, A and B.
Each requires an initial outlay of $10,000 and each has a most likely annual
rate of return of 15%. Management has estimated the returns associated with
each investment. Asset A appears to be less risky than asset B. The risk
averse decision maker would prefer asset A over asset B, because A offers
the same most likely return with a lower range (risk).

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Risk of a Single Asset:
Risk Assessment
• Probability is the chance that a given outcome will occur.
• A probability distribution is a model that relates
probabilities to the associated outcomes. It provides a
more quantitative insight into an asset’s risk.
• A bar chart is the simplest type of probability
distribution; shows only a limited number of outcomes
and associated probabilities for a given event.
• A continuous probability distribution is a probability
distribution showing all the possible outcomes and
associated probabilities for a given event.

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• A discrete random variable is one for which the number of possible outcomes can be
counted, and for each possible outcome, there is a measurable and positive probability.
• An example of a discrete random variable is the number of days it rains in a given month
because there is a finite number of possible outcomes—the number of days it can rain in a
month is defined by the number of days in the month.

• A continuous random variable is one for which the number of possible outcomes is
infinite, even if lower and upper bounds exist. The actual amount of daily rainfall between
zero and 100 inches is an example of a continuous random variable because the actual
amount of rainfall can take on an infinite number of values. Daily rainfall can be measured in
inches, half inches, quarter inches, thousandths of inches, or even smaller increments.
Thus, the number of possible daily rainfall amounts between zero and 100 inches is
essentially infinite.

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Risk of a Single Asset:
Risk Assessment (cont.)
Norman Company’s past estimates indicate that the
probabilities of the pessimistic, most likely, and optimistic
outcomes are 25%, 50%, and 25%, respectively. Note that
the sum of these probabilities must equal 100%; that is, they
must be based on all the alternatives considered.

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Figure 8.1 Bar charts for asset
A’s and asset B’s returns

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Figure 8.2 Continuous
Probability Distributions

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Risk of a Single Asset:
Risk Measurement
• Standard deviation (σr) is the most common statistical indicator of
an asset’s risk; it measures the dispersion around the expected value.
• Expected value of a return (r) is the average return that an
investment is expected to produce over time.

where

rj = return for the jth outcome

Prt = probability of occurrence of the jth outcome
n = number of outcomes considered

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Table 8.3 Expected Values of
Returns for Assets A and B

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Risk of a Single Asset:
Standard Deviation
The expression for the standard deviation of returns,
σr, is

In general, the higher the standard deviation, the

greater the risk.

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Table 8.4a The Calculation of the Standard
Deviation of the Returns for Assets A and B

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Table 8.4b The Calculation of the Standard
Deviation of the Returns for Assets A and B

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Table 8.5 Historical Returns and Standard Deviations on
Selected Investments (1900–2009)

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NORMAL DISTRIBUTION

A probability distribution that plots all of its

values in a symmetrical fashion and most of the
results are situated around the probability's
mean. Values are equally likely to plot either
above or below the mean. Grouping takes place
at values that are close to the mean and then
tails off symmetrically away from the mean.
Also known as a "Gaussian distribution" or "bell
curve".
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Figure 8.3
Bell-Shaped Curve

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The Relation to Finance and Investments
Any investment has two aspects: risk and return. Investors look for the lowest
possible risk for highest possible return. The normal distribution quantifies these two
aspects by the mean for returns and standard deviation for risk.
Mean or Expected Value
A particular share’s price mean change could be 1.5% on a daily basis - meaning that
on an average, it goes up by 1.5%. This mean value or expected value signifying
return can be arrived at by calculating the average on a large enough dataset
containing historical daily price changes of that stock. The higher the mean, the
better.
Standard Deviation
Standard deviation indicates the amount by which values deviate on average from the
mean. The higher the standard deviation, the riskier the investment, as it leads to
more uncertainty.
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the graphical representation of normal distribution
through its mean and standard deviation, enables
representation of both returns and risk within a
clearly defined range.

It helps to know (and be assured with certainty) that if

some dataset follows the normal distribution pattern,
its mean will enable us to know what returns to
expect, and its standard deviation will enable us to
know that around 68% of the values will be within 1
standard deviation, 95% within 2 standard deviations
and 99% of values will fall within 3 standard
deviations. A dataset which has mean of 1.5 and
standard deviation of 1 is much riskier than another
dataset having mean of 1.5 and standard deviation of
0.1.

Knowing these values for each selected asset (i.e.

stocks, bonds and funds) will make an investor aware
of the expected returns and risks.

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Risk of a Single Asset:
Standard Deviation (cont.)
Using the data in Table 8.2 and assuming that the probability
distributions of returns for common stocks and bonds are
normal, we can surmise that:
– 68% of the possible outcomes would have a return ranging
between 11.1% and 29.7% for stocks and between –5.2% and
15.2% for bonds
– 95% of the possible return outcomes would range between
–31.5% and 50.1% for stocks and between –15.4% and 25.4%
for bonds
– The greater risk of stocks is clearly reflected in their much wider
range of possible returns for each level of confidence (68% or
95%).

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Risk of a Single Asset:
Coefficient of Variation
• The coefficient of variation, CV, is a measure of relative
dispersion that is useful in comparing the risks of assets
with differing expected returns.

• A higher coefficient of variation means that an investment

has more volatility relative to its expected return.

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Risk of a Single Asset:
Coefficient of Variation (cont.)
Using the standard deviations (from Table 8.4) and
the expected returns (from Table 8.3) for assets A
and B to calculate the coefficients of variation yields
the following:
CVA = 1.41% ÷ 15% = 0.094
CVB = 5.66% ÷ 15% = 0.377

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Personal Finance Example

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Personal Finance Example
(cont.)
Assuming that the returns are equally probable:

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 Risk of a Portfolio

• In real-world situations, the risk of any single

investment would not be viewed independently of
other assets.
• New investments must be considered in light of
their impact on the risk and return of an investor’s
portfolio of assets.
• The financial manager’s goal is to create an
efficient portfolio, a portfolio that maximum
return for a given level of risk.

© 2012 Pearson Prentice Hall. All rights reserved. 8-45

 Markowitz Portfolio Theory
• The basic portfolio model was developed by Harry
Markowitz (1952, 1959)
• Quantifies risk
• Derives the expected rate of return for a portfolio of
assets and an expected risk measure
• Shows that the variance of the rate of return is a
meaningful measure of portfolio risk
• Derives the formula for computing the variance of a
portfolio, showing not only the importance of
diversifying investments to reduce the total risk of a
portfolio but also how to effectively diversify a
portfolio Copyright © 2010 by Nelson Education Ltd. 6-46
 Markowitz Portfolio Theory

• Assumptions
• Consider investments as probability distributions of
expected returns over some holding period
• Maximize one-period expected utility, which
demonstrate diminishing marginal utility of wealth
• Estimate the risk of the portfolio on the basis of the
variability of expected returns
• Base decisions solely on expected return and risk
• Prefer higher returns for a given risk level. Similarly,
for a given level of expected returns, investors prefer
less risk to more risk

Copyright © 2010 by Nelson Education Ltd. 6-47

 Markowitz Portfolio Theory

• Using these five assumptions, a single asset

or portfolio of assets is considered to be
efficient if no other asset or portfolio of
assets offers higher expected return with the
same (or lower) risk, or lower risk with the
same (or higher) expected return

Copyright © 2010 by Nelson Education Ltd. 6-48

 Alternative Measures of Risk
• Variance or standard deviation of expected return(It
is a statistical measure of the dispersion of returns around the
expected value whereby a larger variance or standard
deviation indicates greater dispersion. The idea is that the
more dispersed the expected returns, the greater the
uncertainty of future returns).
• Range of returns(a larger range of expected returns, from
the lowest to the highest, means greater uncertainty regarding
future expected returns).
• Returns below expectations
• Semi-variance – a measure that only considers deviations
below the mean
• These measures of risk implicitly assume that investors
want to minimize the damage from returns less than some
target rate Copyright © 2010 by Nelson Education Ltd. 6-49
 Alternative Measures of Risk

• The Advantages of Using Standard

Deviation (σ)
• Somewhat intuitive
• Correct and widely recognized risk
measure
• Used in most of the theoretical asset
pricing models

Copyright © 2010 by Nelson Education Ltd. 6-50

 Expected Rate of Return
• For an Individual
Asset [E(Ri)]
• It is equal to the
sum of the potential
returns multiplied
with the
corresponding
probability of the
returns.

Copyright © 2010 by Nelson Education Ltd. 6-51

 Expected Rate of Return
Portfolio Investment Assets
If you want to construct a portfolio of n risky
assets, what will be the expected rate of return
on the portfolio if you know the expected rates
of return on each individual asset?

Copyright © 2010 by Nelson Education Ltd. 6-52

 Expected Rate of Return
Portfolio Investment Assets
• It is the weighted
average of the
expected rates of
return for the
individual
investments in
the portfolio. The
weights are the
proportion of total
value for the
individual
investment.
Copyright © 2010 by Nelson Education Ltd. 6-53
 Measuring Risk Using
Variance
• What is variance?
• Measure of the variation of possible rates of return Ri, from
the expected rate of return [E(Ri)]

Where: Pi is the probability of the possible rate

of return, Ri

Copyright © 2010 by Nelson Education Ltd. 6-54

 Measuring Risk Using
Standard Deviation

• What is standard deviation?

• Square root of the variance
• Standardized measure of risk

Copyright © 2010 by Nelson Education Ltd. 6-55

 Calculating Risk of an
Individual Investment Asset

Variance ( σ2) = 0.000451

Standard Deviation ( σ ) = 0.021237
To calculate σ take the square root of the variance

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 Monthly Return Rates
for Canadian Stocks & Bonds

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 Measuring Covariance of Assets
• A measurement of the degree to which two
variables “move together” relative to their individual
mean values over time
• A positive covariance
means that the rates of return for two investments tend to move
in the same direction relative to their individual means during the
same time period.
• A Negative covariance
that the rates of return for two investments tend to move in
different directions relative to their means during specified time
intervals over time.
The magnitude of the covariance depends on the variances of the
individual return series, as well as on the relationship between
the series.
Copyright © 2010 by Nelson Education Ltd. 6-58
Covij = E{[Ri - E(Ri)] [Rj - E(Rj)]}

Copyright © 2010 by Nelson Education Ltd. 6-59

Copyright © 2010 by Nelson Education Ltd. 6-60
Interpretation of a number such as −5.06 is difficult; is it high or low for covariance? We know the
relationship between the two assets is clearly negative, but it is not possible to be more specific.
It contains a scatterplot with paired values of Rit and Rjt plotted against each other. This plot
demonstrates the linear nature and strength of the relationship. It is not surprising that the relationship
during 2010 was a fairly strong negative value since during nine of the twelve months the two assets
moved counter to each other . As a result, the overall covariance was a definite negative value.
Copyright © 2010 by Nelson Education Ltd. 6-61
 Correlation Coefficient
• Coefficient can vary in the range +1 to -1.
• Value of +1 would indicate perfect positive
correlation. This means that returns for the two
assets move together in a positively and completely
linear manner.
• Value of –1 would indicate perfect negative
correlation. This means that the returns for two
assets move together in a completely linear manner,
but in opposite directions.

Copyright © 2010 by Nelson Education Ltd. 6-62

 PORTFOLIO RISK-RETURN ANALYSIS:
TWO-ASSET CASE

63
 Covariance and Correlation

• The correlation coefficient is obtained by

standardizing (dividing) the covariance by the
product of the individual standard deviations
• Computing correlation from covariance

Copyright © 2010 by Nelson Education Ltd. 6-64

correlation coefficient of
returns =
The value of rij = −0.746 means that the returns moved in completely opposite
directions. This significant negative correlation is not unusual for stocks versus
bonds during a short time period
Copyrightsuch
© 2010as one Education
by Nelson year. Ltd. 6-65
 Standard Deviation
of a Portfolio
• the standard deviation for a portfolio of
assets is a function of the weighted average
of the individual variances (where the
weights are squared), plus the weighted
covariances between all the assets in the
portfolio.
• the standard deviation for a portfolio of
assets encompasses not only the variances
of the individual assets but also includes the
covariances between all the pairs of
individual assets in theportfolio.
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 Standard Deviation
of a Portfolio
Markowitz (1959) derived the general formula for the
standard deviation of a portfolio as follows:

Copyright © 2010 by Nelson Education Ltd. 6-67

 Standard Deviation of a
Two Stock Portfolio
• Any asset of a portfolio may be described by two
characteristics:
• Expected rate of return
• Expected standard deviations of returns
• Correlation, measured by covariance, affects the
portfolio standard deviation
• Low correlation reduces portfolio risk while not
affecting the expected return

Copyright © 2010 by Nelson Education Ltd. 6-68

• When two assets have the same expected return, expected
standard deviation of return and equal weights in the portfolio.
Now consider the following five correlation coefficients (+1,
+.50, 0, -.5, -1) , Calculate the standard Deviation of the
portfolio.

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• Calculate the covariance

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• Use these formula to calculate SD

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 the returns for the two assets
are perfectly positively
correlated. we get no real
benefit from combining two
assets that are perfectly
correlated; they are like one
asset already because their
returns move together.
The only term that changed
from Case a is the last term,
Cov1,2, which changed from
0.01 to 0.005. As a result, the
standard deviation of the
portfolio declined by about 13
percent, from 0.10 to 0.0866.

the negative covariance term

exactly offsets the individual
variance terms, leaving an
overall standard deviation of the
portfolio of zero. This would be
Copyright © 2010 by Nelson Education Ltd. a risk-free portfolio. 6-72
 Standard Deviation of a
Two Stock Portfolio
• Assets may differ in
expected rates of return
and individual standard
deviations
• Negative correlation
reduces portfolio risk
• Combining two assets
with +1.0 correlation will
not reduces the portfolio
standard deviation
• Combining two assets
with -1.0 correlation may
reduces the portfolio
standard deviation to zero

Copyright © 2010 by Nelson Education Ltd. 6-73

 Combining Stocks with Different
Returns and Risk
• We now consider two assets (or portfolios) with different
expected rates of return and individual standard deviations

We will use the previous set of correlation coefficients, but we must

recalculate the covariances because this time the standard deviations
of the assets are different.

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• Calculate the Standard Deviation & Expected Return
of the portfolio

Expected Return
of the portfolio

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Copyright © 2010 by Nelson Education Ltd. 6-76
 Standard Deviation of a
Two Stock Portfolio
the results for the two
individual assets and the
portfolio of the two
assets assuming the
correlation coefficients
vary as set forth in Cases
a through e. As before,
the expected return does
not change because the
proportions are always
set at 0.50−0.50, so all the
portfolios lie along the
horizontal line at the
return, R = 0.15. Copyright © 2010 by Nelson Education Ltd. 6-77
 Standard Deviation of a
Two Stock Portfolio
Assuming the normal risk–return
relationship where assets with higher risk
(larger standard deviation of returns)
provide high rates of return, it is possible for
a conservative investor to experience both
lower risk and higher return by diversifying
into a higher risk-higher return asset,
assuming that the correlation between the
two assets is fairly low. Exhibit 7.13 shows
that, in the case where we used the
correlation of zero (0.00), the lowrisk
investor at Point L—who would receive a
return of 10 percent and risk of 7
percent—could, by investing in portfolio j,
increase his/her return to 14 percent and
experience a decline in risk to 5.8 percent by
investing (diversifying) 40 percent of the
portfolio in riskier Asset 2. As noted, the
benefits of diversification are critically
dependent on the correlation between
assets. The exhibit shows that there is even
some benefit when the correlation is 0.50
rather than zero.
Copyright © 2010 by Nelson Education Ltd. 6-78
 Constant Correlation with Changing
Weights
• If we changed the weights of the two assets while holding the correlation
coefficient constant, we would derive a set of combinations that trace an
ellipse starting at Asset 2, going through the 0.50−0.50 point, and ending at
Asset 1.

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• Calculate the Standard Deviation of the portfolio with different weight
of two assets:

Copyright © 2010 by Nelson Education Ltd. 6-80

Copyright © 2010 by Nelson Education Ltd. 6-81
 Standard Deviation of a
Two Stock Portfolio
• Assuming the normal risk–return relationship where assets
with higher risk (larger standard deviation of returns) provide
high rates of return, it is possible for a conservative investor to
experience both lower risk and higher return by diversifying
into a higher risk-higher return asset, assuming that the
correlation between the two assets is fairly low.
• in the case where we used the correlation
of zero (0.00), the lowrisk investor at
Point L—who would receive a return of 10
percent and risk of 7 percent—could, by
investing in portfolio j, increase his/her
return to 14 percent and experience a
decline in risk to 5.8 percent by investing
(diversifying) 40 percent of the portfolio in
riskier Asset 2. As noted, the benefits of
diversification are critically dependent on
the correlation between assets. The exhibit
shows that there is even some benefit
when the correlation is 0.50 rather than
zero.
Copyright © 2010 by Nelson Education Ltd. 6-82
Copyright © 2010 by Nelson Education Ltd. 6-83
8-83
Copyright © 2010 by Nelson Education Ltd. 6-84
8-84
 A Three-Asset Portfolio

• SD Formula:

Copyright © 2010 by Nelson Education Ltd. 6-85

• Three asset classes (stocks, bonds, and cash equivalents): ER,
SD, Weight and correlation are given here. Now calculate the
Expected return of the portfolio and standard Deviation of the
portfolio

Copyright © 2010 by Nelson Education Ltd. 6-86

• Expected return of the portfolio

• Standard Deviation of the portfolio

Copyright © 2010 by Nelson Education Ltd. 6-87

 Estimation Issues
• Results of portfolio allocation depend on accurate
statistical inputs
• Estimates of
• Expected returns
• Standard deviation
• Correlation coefficient
• Among entire set of assets
• With 100 assets, 4,950 correlation estimates
• Estimation risk refers to potential errors

Copyright © 2010 by Nelson Education Ltd. 6-88

 Estimation Issues
• With the assumption that stock returns can be
described by a single market model, the number of
correlations required reduces to the number of
assets

Copyright © 2010 by Nelson Education Ltd. 6-89

 Estimation Issues:
A Single Index Model

ai = is the stock's alpha, or abnormal return

bi = the slope coefficient that relates the returns for security i to the
returns for the aggregate market
Rm = the returns for the aggregate stock market
€i =are the residual (random) returns, which are assumed independent
normally distributed with mean zero and standard deviation

Copyright © 2010 by Nelson Education Ltd. 6-90

Estimation Issues

Copyright © 2010 by Nelson Education Ltd. 6-91

 Efficient Frontier

The efficient frontier represents that set of portfolios with the maximum rate of return
for every given level of risk, or the minimum risk for every level of return
Efficient frontier are portfolios of investments rather than individual securities except
the assets with the highest return and the asset with the lowest risk
https://www.youtube.com/watch?v=3ntwyjXZdS0
Copyright © 2010 by Nelson Education Ltd. 6-92
 Efficient Frontier & Investor Utility
• An individual investor’s utility curve specifies the
trade-offs he is willing to make between expected
return and risk
• The slope of the efficient frontier curve decreases
steadily as you move upward
• The interactions of these two curves will determine
the particular portfolio selected by an individual
investor
• The optimal portfolio has the highest utility for a
given investor

Copyright © 2010 by Nelson Education Ltd. 6-93

 Efficient Frontier & Investor Utility
• The optimal lies at the point of tangency between
the efficient frontier and the utility curve with the
highest possible utility
• As shown in Exhibit 6.16, Investor X with the set of
utility curves will achieve the highest utility by
investing the portfolio at X
• As shown in Exhibit 6.16, with a different set of
utility curves, Investor Y will achieve the highest
utility by investing the portfolio at Y
• Which investor is more risk averse?

Copyright © 2010 by Nelson Education Ltd. 6-94

Efficient Frontier

Copyright © 2010 by Nelson Education Ltd. 6-95

Efficient Frontier & Investor Utility

Copyright © 2010 by Nelson Education Ltd. 6-96

 https://www.youtube.com/watch?v=3ntwyjXZdS0

• The efficient frontier is the set of optimal portfolios that offer the
highest expected return for a defined level of risk or the lowest risk
for a given level of expected return. Portfolios that lie below the
efficient frontier are sub-optimal because they do not provide enough
return for the level of risk. Portfolios that cluster to the right of the
efficient frontier are sub-optimal because they have a higher level of
risk for the defined rate of return.
• Efficient frontier comprises investment portfolios that offer the highest
expected return for a specific level of risk.
• Returns are dependent on the investment combinations that make up the
portfolio.
• The standard deviation of a security is synonymous with risk. Lower
covariance between portfolio securities results in lower portfolio standard
deviation.
• Successful optimization of the return versus risk paradigm should place a
portfolio along the efficient frontier line.
• Optimal portfolios that comprise the efficient frontier tend to have a higher
degree of diversification.
Copyright © 2010 by Nelson Education Ltd. 6-97
Asset Pricing Models: CAPM & APT

• Capital Market Theory: An Overview

• The Capital Asset Pricing Model
• Relaxing the Assumptions
• Beta in Practice
• Arbitrage Pricing Theory (APT)
• Multifactor Models in Practice

Copyright © 2010 by Nelson Education Ltd. 6-98

 Capital Market Theory: An Overview
• Capital market theory extends portfolio theory
and develops a model for pricing all risky
assets, while capital asset pricing model
(CAPM) will allow you to determine the
required rate of return for any risky asset
• Four Areas
• Background for Capital Market Theory
• Developing the Capital Market Line
• Risk, Diversification, and the Market Portfolio
• Investing with the CML: An Example
Copyright © 2010 by Nelson Education Ltd. 6-99
Background to Capital Market Theory

• Assumptions:
• All investors are Markowitz efficient investors who
want to target points on the efficient frontier
• Investors can borrow or lend any amount of
money at the risk-free rate of return (RFR)
• All investors have homogeneous expectations;
that is, they estimate identical probability
distributions for future rates of return
• All investors have the same one-period time
horizon such as one-month, six months, or one
year
Continued…
Copyright © 2010 by Nelson Education Ltd. 6-100
Background to Capital Market Theory

• Assumptions:
• All investments are infinitely divisible, which
means that it is possible to buy or sell fractional
shares of any asset or portfolio
• There are no taxes or transaction costs involved
in buying or selling assets
• There is no inflation or any change in interest
rates, or inflation is fully anticipated
• Capital markets are in equilibrium, implying that
all investments are properly priced in line with
their risk levels
Copyright © 2010 by Nelson Education Ltd. 6-101
Copyright © 2010 by Nelson Education Ltd. 6-102
Background to Capital Market Theory

• Development of the Theory

• The major factor that allowed portfolio
theory to develop into capital market
theory is the concept of a risk-free asset
• An asset with zero standard deviation
• Zero correlation with all other risky assets
• Provides the risk-free rate of return (RFR)
• Will lie on the vertical axis of a portfolio graph

Copyright © 2010 by Nelson Education Ltd. 6-103

 Developing the Capital Market Line
• Covariance with a Risk-Free Asset
– Covariance between two sets of returns is

– Because the returns for the risk free asset are certain,
thus Ri = E(Ri), and Ri - E(Ri) = 0, which means that the
covariance between the risk-free asset and any risky
asset or portfolio will always be zero
– Similarly, the correlation between any risky asset and the
risk-free asset would be zero too since
rRF,i= CovRF, I / σRF σi
Copyright © 2010 by Nelson Education Ltd. 6-104
 Developing the Capital Market Line
• Combining a Risk-Free Asset with a
Risky Portfolio, M
• Expected return: It is the weighted
average of the two returns

• Standard deviation: Applying the

two-asset standard deviation formula, we
will have

Copyright © 2010 by Nelson Education Ltd. 6-105

Copyright © 2010 by Nelson Education Ltd. 6-106
 Developing the Capital Market Line
• The Capital Market Line
• With these results, we can develop the risk–return
relationship between E(Rport) and σport

• This relationship holds for every combination of

the risk-free asset with any collection of risky
assets
• However, when the risky portfolio, M, is the
market portfolio containing all risky assets held
anywhere in the marketplace, this linear
relationship is called the Capital Market Line
Copyright © 2010 by Nelson Education Ltd. 6-107
Copyright © 2010 by Nelson Education Ltd. 6-108
 Risk-Return Possibilities
• One can attain a higher expected return than is available at
point M
• One can invest along the efficient frontier beyond point M,
such as point D

Copyright © 2010 by Nelson Education Ltd. 6-109

 Risk-Return Possibilities
• With the risk-free asset, one can add leverage to the portfolio
by borrowing money at the risk-free rate and investing in the
risky portfolio at point M to achieve a point like E
• Point E dominates point D
• One can reduce the investment risk by lending money at the
risk-free asset to reach points like C

Copyright © 2010 by Nelson Education Ltd. 6-110

 Risk, Diversification & the Market
Portfolio: The Market Portfolio
• Because portfolio M lies at the point of tangency, it has the
highest portfolio possibility line
• Everybody will want to invest in Portfolio M and borrow or lend
to be somewhere on the CML
• It must include ALL RISKY ASSETS

Copyright © 2010 by Nelson Education Ltd. 6-111

 Risk, Diversification & the Market
Portfolio: The Market Portfolio
• Since the market is in equilibrium, all assets in this portfolio are
in proportion to their market values
• Because it contains all risky assets, it is a completely diversified
portfolio, which means that all the unique risk of individual
assets (unsystematic risk) is diversified away

Copyright © 2010 by Nelson Education Ltd. 6-112

Risk, Diversification & the Market Portfolio

• Systematic Risk
• Only systematic risk remains in the market
portfolio
• Variability in all risky assets caused by
macroeconomic variables
• Variability in growth of money supply
• Interest rate volatility
• Variability in factors like (1) industrial production (2) corporate
earnings (3) cash flow
• Can be measured by standard deviation of
returns and can change over time

Copyright © 2010 by Nelson Education Ltd. 6-113

Risk, Diversification & the Market Portfolio

• How to Measure Diversification

• All portfolios on the CML are perfectly positively
correlated with each other and with the
completely diversified market Portfolio M
• A completely diversified portfolio would have a
correlation with the market portfolio of +1.00
• Complete risk diversification means the
elimination of all the unsystematic or unique risk
and the systematic risk correlates perfectly with
the market portfolio

Copyright © 2010 by Nelson Education Ltd. 6-114

Risk, Diversification & the Market Portfolio:
Eliminating Unsystematic Risk
• The purpose of diversification is to reduce the standard
deviation of the total portfolio
• This assumes that imperfect correlations exist among
securities

Copyright © 2010 by Nelson Education Ltd. 6-115

Risk, Diversification & the Market Portfolio:
Eliminating Unsystematic Risk
• As you add securities, you expect the average covariance for
the portfolio to decline
• How many securities must you add to obtain a completely
diversified portfolio?

Copyright © 2010 by Nelson Education Ltd. 6-116

Risk, Diversification & the Market Portfolio

• The CML & the Separation Theorem

• The CML leads all investors to invest in the M
portfolio
• Individual investors should differ in position on
the CML depending on risk preferences
• How an investor gets to a point on the CML is
based on financing decisions

Copyright © 2010 by Nelson Education Ltd. 6-117

Risk, Diversification & the Market Portfolio

• The CML & the Separation Theorem

• Risk averse investors will lend at the risk-free rate
while investors preferring more risk might borrow
funds at the RFR and invest in the market
portfolio
• The investment decision of choosing the point on
CML is separate from the financing decision of
reaching there through either lending or
borrowing

Copyright © 2010 by Nelson Education Ltd. 6-118

Risk, Diversification & the Market Portfolio

• A Risk Measure for the CML

• The Markowitz portfolio model considers
the average covariance with all other
assets
• The only important consideration is the
asset’s covariance with the market
portfolio

Copyright © 2010 by Nelson Education Ltd. 6-119

Risk, Diversification & the Market Portfolio
• A Risk Measure for the CML
• Covariance with the market portfolio is the
systematic risk of an asset
• Variance of a risky asset i
Var (Rit)= Var (biRMt)+ Var(ε)
=Systematic Variance + Unsystematic Variance
where bi= slope coefficient for asset i
ε = random error term

Copyright © 2010 by Nelson Education Ltd. 6-120

 Using the CML to Invest: An Example

Suppose you have a riskless security at 4% and a market portfolio

with a return of 9% and a standard deviation of 10%. How should you
go about investing your money so that your investment will have a
risk level of 15%?

• Portfolio Return
E(Rport)=RFR+σport[(E(RM)-RFR)/σM)
E(Rport)=4%+15%[(9%-4%)/10%]
E(Rport)=11.5%
Continued…

Copyright © 2010 by Nelson Education Ltd. 6-121

 Using the CML to Invest: An Example
• How much to invest in the riskless security?

11.5%= wRF (4%) + (1-wRF )(9%)

wRF= -0.5
• The investment strategy is to borrow 50% and
invest 150% of equity in the market portfolio

Copyright © 2010 by Nelson Education Ltd. 6-122

 Conceptual Development of the CAPM
• The existence of a risk-free asset resulted in
deriving a capital market line (CML) that became the
relevant frontier
• However, CML cannot be used to measure the
expected return on an individual asset
• For individual asset (or any portfolio), the relevant
risk measure is the asset’s covariance with the
market portfolio
• That is, for an individual asset i, the relevant risk is
not σi, but rather σi riM, where riM is the correlation
coefficient between the asset and the market

Copyright © 2010 by Nelson Education Ltd. 6-123

 The Capital Asset Pricing Model

Applying the CML using this relevant risk

measure

Let βi=(σi riM) / σM be the asset beta measuring

the relative risk with the market, the systematic
risk

Copyright © 2010 by Nelson Education Ltd. 6-124

The Capital Asset Pricing Model

The CAPM indicates what should be the expected or

required rates of return on risky assets

This helps to value an asset by providing an appropriate

discount rate to use in dividend valuation models

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 The Security Market Line (SML)
• The SML is a graphical form of the CAPM
• Shows the relationship between the expected or required rate of
return and the systematic risk on a risky asset

Copyright © 2010 by Nelson Education Ltd. 6-126

 The Security Market Line (SML)
• The expected rate of return of a risk asset is determined by the
RFR plus a risk premium for the individual asset
• The risk premium is determined by the systematic risk of the
asset (beta) and the prevailing market risk premium
(RM-RFR)

Copyright © 2010 by Nelson Education Ltd. 6-127

 The Capital Asset Pricing Model
• Determining the Expected Rate of Return
– Assume risk-free rate is 5% and market return is 9%
Stock A B C D E
Beta 0.70 1.00 1.15 1.40 -0.30

– Applying
E(RA) = 0.05 + 0.70 (0.09-0.05) = 0.078 = 7.8%
E(RB) = 0.05 + 1.00 (0.09-0.05) = 0.090 = 09.0%
E(RC) = 0.05 + 1.15 (0.09-0.05) = 0.096 = 09.6%
E(RD) = 0.05 + 1.40 (0.09-0.05) = 0.106 = 10.6%
E(RE) = 0.05 + -0.30 (0.09-0.05) = 0.038 = 03.8%

Copyright © 2010 by Nelson Education Ltd. 6-128

 The Capital Asset Pricing Model

• Identifying Undervalued & Overvalued

Assets
• In equilibrium, all assets and all portfolios
of assets should plot on the SML
• Any security with an estimated return that
plots above the SML is underpriced
• Any security with an estimated return that
plots below the SML is overpriced

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The Capital Asset Pricing Model

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 The Capital Asset Pricing Model
• Calculating Systematic Risk
• The formula

σi Co ( Ri , RM )
βi = riM =
σM v σ2
M

Copyright © 2010 by Nelson Education Ltd. 6-131

The Characteristic Line
A regression line
between the returns
to the security (Rit)
over time and the
returns (RMt) to the
market portfolio.

The slope of the

regression line is
beta.

Copyright © 2010 by Nelson Education Ltd. 6-132

CAPM: The Impact of Time Interval
• The number of observations and time interval
used in regression vary, causing beta to vary
• There is no “correct” interval for analysis
• For example, Morningstar derives characteristic
lines using the most 60 months of return
observations
• Reuters uses daily returns for the most recent 24
months
• Bloomberg uses two years of weekly returns

Copyright © 2010 by Nelson Education Ltd. 6-133

CAPM: The Effect of Market Proxy
• Theoretically, the market portfolio should include all
Canadian stocks and bonds, real estate, coins, stamps, art,
antiques, and any other marketable risky asset from around
the world
• Most people use the S&P/TSX Composite Index as the proxy
due to
• It contains large proportion of the total market value of
Canadian stocks
• It is a value-weighted series
• Using a different proxy for the market portfolio will lead to a
different beta value

Copyright © 2010 by Nelson Education Ltd. 6-134

 Relaxing the Assumptions
• Differential Borrowing and Lending Rates
• When borrowing rate, R b, is higher than RFR, the SML will
be “broken” into two lines

Copyright © 2010 by Nelson Education Ltd. 6-135

 Relaxing the Assumptions

• Zero-Beta Model
• Instead of a risk-free rate, a zero-beta
portfolio (uncorrelated with the market
portfolio) can be used to draw the “SML”
line
• Since the zero-beta portfolio is likely to
have a higher return than the risk-free
rate, this “SML” will have a less steep
slope

Copyright © 2010 by Nelson Education Ltd. 6-136

 Relaxing the Assumptions

• Transaction Costs
• The SML will be a band of securities, rather than
a straight line
• Heterogeneous Expectations and Planning
Periods
• Heterogeneous expectations will create a set
(band) of lines with a breadth determined by the
divergence of expectations
• The impact of planning periods is similar

Copyright © 2010 by Nelson Education Ltd. 6-137

 Relaxing the Assumptions:
Impact of Taxes
• Taxes
• Differential tax rates could cause major differences in CML and
SML among investors
• Dividend tax credit on dividends received from Canadian
corporations would further return the total taxes owing on the
dividend income earned. In addition, capital gains exclusion rate
(50%) would also affect total taxes owing on capital gains

Copyright © 2010 by Nelson Education Ltd. 6-138

 Beta in Practice

• Stability of Beta
• Betas for individual stocks are not stable
• Portfolio betas are reasonably stable
• The larger the portfolio of stocks and longer the
period, the more stable the beta of the portfolio

E(Ri,t)=RFR + βiRM,t+ Et

Copyright © 2010 by Nelson Education Ltd. 6-139

 Beta in Practice

• Comparability of Published Estimates of Beta

• Differences exist
• Hence, consider the return interval used and the
firm’s relative size

E(Ri,t)=RFR + βiRM,t+ Et

Copyright © 2010 by Nelson Education Ltd. 6-140

Beta of Canadian Companies

Copyright © 2010 by Nelson Education Ltd. 6-141

 Arbitrage Pricing Theory
• CAPM is criticized because of
• Many unrealistic assumptions
• Difficulties in selecting a proxy for the market
portfolio as a benchmark
• Alternative pricing theory with fewer
assumptions was developed:
• Arbitrage Pricing Theory (APT)

Copyright © 2010 by Nelson Education Ltd. 6-142

 Arbitrage Pricing Theory
Three Major Assumptions:
1. Capital markets are perfectly competitive
2. Investors always prefer more wealth to
less wealth with certainty
3. The stochastic process generating asset
returns can be expressed as a linear
function of a set of K factors or indexes

Copyright © 2010 by Nelson Education Ltd. 6-143

 Arbitrage Pricing Theory

Does not assume:

• Normally distributed security returns
• Quadratic utility function
• A mean-variance efficient market
portfolio

Copyright © 2010 by Nelson Education Ltd. 6-144

 Arbitrage Pricing Theory
• The APT Model
E(Ri)=λ0+ λ1bi1+ λ2bi2+…+ λkbik
where:
λ0=the expected return on an asset with zero
systematic risk
λj=the risk premium related to the j th common
risk factor
bij=the pricing relationship between the risk
premium and the asset; that is, how
responsive asset i is to the j th common factor

Copyright © 2010 by Nelson Education Ltd. 6-145

Comparing the CAPM & APT Models

CAPM APT
Form of Equation Linear Linear
Number of Risk Factors 1 K (≥ 1)
Factor Risk Premium [E(RM) – RFR] {λj}
Factor Risk Sensitivity βi {bij}
“Zero-Beta” Return RFR λ0

Unlike CAPM that is a one-factor model,

APT is a multifactor pricing model

Copyright © 2010 by Nelson Education Ltd. 6-146

 Comparing the CAPM & APT Models

• However, unlike CAPM that identifies the

market portfolio return as the factor, APT
model does not specifically identify these
risk factors in application
• These multiple factors include
• Inflation
• Growth in GNP
• Major political upheavals
• Changes in interest rates

Copyright © 2010 by Nelson Education Ltd. 6-147

 Using the APT
• Primary challenge with using the APT in security
valuation is identifying the risk factors
• For this illustration, assume that there are two
common factors
• First risk factor: Unanticipated changes in the
rate of inflation
• Second risk factor: Unexpected changes in the
growth rate of real GDP

Copyright © 2010 by Nelson Education Ltd. 6-148

 Using the APT
• λ1: The risk premium related to the first risk
factor is 2 percent for every 1 percent change in
the rate (λ1=0.02)
• λ2: The average risk premium related to the
second risk factor is 3 percent for every 1 percent
change in the rate of growth (λ2=0.03)
• λ0: The rate of return on a zero-systematic risk
asset (i.e., zero beta) is 4 percent (λ0=0.04

Copyright © 2010 by Nelson Education Ltd. 6-149

 Determining Sensitivities for Assets

• bx1 = The response of asset x to changes in the

inflation factor is 0.50 (bx1 0.50)
• bx2 = The response of asset x to changes in the
GDP factor is 1.50 (bx2 1.50)
• by1 = The response of asset y to changes in the
inflation factor is 2.00 (by1 2.00)
• by2 = The response of asset y to changes in the
GDP factor is 1.75 (by2 1.75)

Copyright © 2010 by Nelson Education Ltd. 6-150

Using the APT to Estimate Expected Return

Copyright © 2010 by Nelson Education Ltd. 6-151

Using the APT to Estimate Expected Return

Asset X
E(Rx) = .04 + (.02)(0.50) + (.03)(1.50)

E(Rx) = .095 = 9.5%

Asset Y
E(Ry) = .04 + (.02)(2.00) + (.03)(1.75)

E(Ry)= .1325 = 13.25%

Copyright © 2010 by Nelson Education Ltd. 6-152

 Valuing a Security Using the APT:
An Example

• Three stocks (A, B, C) and two common systematic

risk factors have the following relationship (Assume
λ0=0 )

E(RA)=(0.8) λ1 + (0.9) λ2
E(RB)=(-0.2) λ1 + (1.3) λ2
E(RC)=(1.8) λ1 + (0.5) λ2

Copyright © 2010 by Nelson Education Ltd. 6-153

 Valuing a Security Using the APT:
An Example

• If λ1=4% and λ2=5%, then it is easy to compute the

expected returns for the stocks:
E(RA)=7.7%
E(RB)=5.7%
E(RC)=9.7%

Copyright © 2010 by Nelson Education Ltd. 6-154

 Valuing a Security Using the APT:
An Example

• Expected Prices One Year Later

• Assume that all three stocks are currently priced
at $35 and do not pay a dividend
• Estimate the price
E(PA)=$35(1+7.7%)=$37.70
E(PB)=$35(1+5.7%)=$37.00
E(PC)=$35(1+9.7%)=$38.40

Copyright © 2010 by Nelson Education Ltd. 6-155

 Valuing a Security Using the APT:
An Example

• If one “knows” actual future prices for these

stocks are different from those previously
estimated, then these stocks are either
undervalued or overvalued
• Arbitrage trading (by buying undervalued
stocks and short overvalued stocks) will
continue until arbitrage opportunity
disappears

Copyright © 2010 by Nelson Education Ltd. 6-156

 Valuing a Security Using the APT:
An Example
• Assume the actual prices of stocks A, B, and C
will be $37.20, $37.80, and $38.50 one year
later, then arbitrage trading will lead to new
current prices:
E(PA)=$37.20 / (1+7.7%)=$34.54
E(PB)=$37.80 / (1+5.7%)=$35.76
E(PC)=$38.50 / (1+9.7%)=$35.10

Copyright © 2010 by Nelson Education Ltd. 6-157

 Multi-Factor Models & Risk Estimation

• The Multifactor Model in Theory

• In a multifactor model, the investor
chooses the exact number and identity of
risk factors, while the APT model doesn’t
specify either of them

Copyright © 2010 by Nelson Education Ltd. 6-158

 Multi-Factor Models & Risk Estimation

Rit = ai + [bi1F1t + bi2 F2t + . . . + biK FKt] + eit

where:

Fit=Period t return to the jth designated risk factor

Rit =Security i’s return that can be measured as
either a nominal or excess return to

Copyright © 2010 by Nelson Education Ltd. 6-159

 Macroeconomic-Based
Risk Factor Models
• Security returns are governed by a set of
broad economic influences in the following
fashion by Chen, Roll, and Ross in 1986
modeled by the following equation:

Rit = ai + [bi1 Rmt + bi 2 M t + bi 3 DE t + bi 4U t + bi 5UP t

+ bi 6UT t ] + eit
P I I R S

Copyright © 2010 by Nelson Education Ltd. 6-160

Macroeconomic-Based
Risk Factor Models

Copyright © 2010 by Nelson Education Ltd. 6-161

 Macroeconomic-Based
Risk Factor Models

• Burmeister, Roll, and Ross (1994)

• Analyzed the predictive ability of a model based
on the following set of macroeconomic factors.
• Confidence risk
• Time horizon risk
• Inflation risk
• Business cycle risk
• Market timing risk

Copyright © 2010 by Nelson Education Ltd. 6-162

 Microeconomic-Based
Risk Factor Models

Fama and French (1993) developed a multifactor model

specifying the risk factors in microeconomic terms using the
characteristics of the underlying securities.

( Ri − RFR t ) = a i + bi1 ( R mt − RFR t ) + bi 2 SM t

+ b HML + e
i3 t i
t B t

Copyright © 2010 by Nelson Education Ltd. 6-163

 Microeconomic-Based
Risk Factor Models

Carhart (1997), based on the Fama-French three factor

model, developed a four-factor model by including a risk
factor
that accounts for the tendency for firms with positive past
return to produce positive future return

( Ri − RF t ) = ai + bi1 ( Rmt − RF t ) + bi 2 SM t
+ bi 3 HM t
+ bi 4 MOM t + eit
t R R B L

Copyright © 2010 by Nelson Education Ltd. 6-164

 Extensions of Characteristic-Based
Risk Models
• One type of security characteristic-based
method for defining systematic risk
exposures involves the use of index
portfolios (e.g. S&P 500, Wilshire 5000) as
common risk factors such as the one by
Elton, Gruber, and Blake (1996).

Copyright © 2010 by Nelson Education Ltd. 6-165

 Extensions of Characteristic-Based
Risk Models

• Elton, Gruber, and Blake (1996) rely on four

indexes:
• The S&P 500
• The Lehman Brothers aggregate bond index
• The Prudential Bache index of the difference
between large- and small-cap stocks
• The Prudential Bache index of the difference
between value and growth stocks

Copyright © 2010 by Nelson Education Ltd. 6-166