Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 8
 Chapter 8 - An Introduction to
Asset Pricing Models
Questions to be answered:
• What are the assumptions of the capital asset
pricing model?
• What is a risk-free asset and what are its risk-return
characteristics?
• What is the covariance and correlation between the
risk-free asset and a risky asset or portfolio of risky
assets?
 Chapter 8 - An Introduction to
Asset Pricing Models
• What is the expected return when you combine the
risk-free asset and a portfolio of risky assets?
• What is the standard deviation when you combine
the risk-free asset and a portfolio of risky assets?
• When you combine the risk-free asset and a
portfolio of risky assets on the Markowitz efficient
frontier, what does the set of possible portfolios
look like?
 Chapter 8 - An Introduction to
Asset Pricing Models
• Given the initial set of portfolio possibilities with a
risk-free asset, what happens when you add
financial leverage (that is, borrow)?
• What is the market portfolio, what assets are
included in this portfolio, and what are the relative
weights for the alternative assets included?
• What is the capital market line (CML)?
• What do we mean by complete diversification?
 Chapter 8 - An Introduction to
Asset Pricing Models
• How do we measure diversification for an
individual portfolio?
• What are systematic and unsystematic risk?
• Given the capital market line (CML), what is the
separation theorem?
• Given the CML, what is the relevant risk measure
for an individual risky asset?
• What is the security market line (SML) and how
does it differ from the CML?
 Chapter 8 - An Introduction to
Asset Pricing Models
• What is beta and why is it referred to as a
standardized measure of systematic risk?
• How can you use the SML to determine the
expected (required) rate of return for a risky asset?
• Using the SML, what do we mean by an
undervalued and overvalued security, and how do
we determine whether an asset is undervalued or
overvalued?
 Chapter 8 - An Introduction to
Asset Pricing Models
• What is an asset’s characteristic line and how do
you compute the characteristic line for an asset?
• What is the impact on the characteristic line when
you compute it using different return intervals (e.g.,
weekly versus monthly) and when you employ
different proxies (i.e., benchmarks) for the market
portfolio (e.g., the S&P 500 versus a global stock
index)?
 Capital Market Theory:
An Overview
• The major factor that allowed portfolio
theory to develop into capital market theory
is the concept of a risk-free asset.

• Capital asset pricing model (CAPM) will

allow you to determine the required rate of
return for any risky asset.it is a
mathematical model of capital market
theory.
 Risk-Free Asset
• an asset with zero variance
• An asset with zero standard deviation
(σRF = 0).
• 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
• expected return on a risk-free asset is
entirely certain,
 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

Consequently, the covariance of the risk-free asset with any

risky asset or portfolio will always equal zero. Similarly the
correlation between any risky asset and the risk-free asset
would be zero.
 Combining a Risk-Free Asset
with a Risky Portfolio
Expected return
the weighted average of the two returns

wRF = the proportion of the portfolio invested in the risk-free asset

E(Ri) = the expected rate of return on risky Portfolio i
 Combining a Risk-Free Asset
with a Risky Portfolio
Standard deviation
The expected variance for a two-asset portfolio is

Substituting the risk-free asset for Security 1, and the risky

asset for Security 2, this formula would become

Since we know that the variance of the risk-free asset is

zero and the correlation between the risk-free asset and any
risky asset i is zero we can adjust the formula
 Combining a Risk-Free Asset
with a Risky Portfolio
Given the variance formula
the standard deviation is

Therefore, the standard deviation of a portfolio that

combines the risk-free asset with risky assets is the
linear proportion of the standard deviation of the risky
asset portfolio.
 The Capital Market Line
1. The Capital Market Line is a graphical
representation of all the portfolios that
optimally combine risk and return.
2. CML is a theoretical concept that gives
optimal combinations of a risk-free asset
and the market portfolio.
3. The CML is superior to Efficient Frontier
because it combines risky assets with risk-
free assets.
• The CML is a tangent line drawn from the
risk-free rate to the efficient frontier.
• It helps investors determine the optimal
combination of risky and risk-free assets to
achieve the best risk-adjusted return
Portfolio Possibilities Combining the Risk-Free Asset
and Risky Portfolios on the Efficient Frontier

Exhibit 8.1

D
M
C B
RFR A
Difference between CML &SML
1. CML 1. SML
2. Risk=Beta
2. Risk =sigma 3. Graphical
3. Depends on representation of risk
& return
required return 4. Shows both efficient
and risk free and inefficient
return portfolios
5. Derived from CML
4. Shows efficient 6. Shows return of
portfolios individual securities
as well as portfolio
5. Show return of a
specific portfolio
Risk-Return Possibilities with Leverage
To attain a higher expected return than is
available at point M (in exchange for
accepting higher risk)
• Either invest along the efficient frontier
beyond point M, such as point D
• Or, add leverage to the portfolio by
borrowing money at the risk-free rate and
investing in the risky portfolio at point M
 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
• Therefore this portfolio must include ALL
RISKY ASSETS
 The Market Portfolio
Because the market is in equilibrium, all
assets are included in this portfolio in
proportion to their market value
 The Market Portfolio
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
 Systematic Risk
• Only systematic risk remains in the market
portfolio
• Systematic risk is the variability in all risky
assets caused by macroeconomic variables
• Systematic risk can be measured by the
standard deviation of returns of the market
portfolio and can change over time
 Examples of Macroeconomic
Factors Affecting Systematic Risk
• Variability in growth of money supply
• Interest rate volatility
• Variability in
– industrial production
– corporate earnings
– cash flow
 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
The Capital Asset Pricing Model:
Expected Return and Risk
• 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
• You can compare an estimated rate of return
to the required rate of return implied by
CAPM - over/under valued ?
The Security Market Line (SML)
• The relevant risk measure for an individual
risky asset is its covariance with the market
portfolio (Covi,m)
• This is shown as the risk measure
• The return for the market portfolio should
be consistent with its own risk, which is the
covariance of the market with itself - or its
variance:
 Exhibit 8.5
Graph of Security Market Line
(SML)
SML

RFR
The Security Market Line (SML)
The equation for the risk-return line is

We then define as beta

 Exhibit 8.6
Graph of SML with
Normalized Systematic Risk
SML

Negative
Beta
RFR
 Determining the Expected
Rate of Return for a Risky Asset

• 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 (R M-RFR)
 Determining the Expected
Rate of Return for a Risky Asset
Assume: RFR = 6% (0.06)
RM = 12% (0.12)
Implied market risk premium = 6% (0.06)

E(RA) = 0.06 + 0.70 (0.12-0.06) = 0.102 = 10.2%

E(RB) = 0.06 + 1.00 (0.12-0.06) = 0.120 = 12.0%
E(RC) = 0.06 + 1.15 (0.12-0.06) = 0.129 = 12.9%
E(RD) = 0.06 + 1.40 (0.12-0.06) = 0.144 = 14.4%
E(RE) = 0.06 + -0.30 (0.12-0.06) = 0.042 = 4.2%
 Determining the Expected
Rate of Return for a Risky Asset
• 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
• A superior investor must derive value estimates for
assets that are consistently superior to the consensus
market evaluation to earn better risk-adjusted rates
of return than the average investor
 Identifying Undervalued and
Overvalued Assets
• Compare the required rate of return to the
expected rate of return for a specific risky
asset using the SML over a specific
investment horizon to determine if it is an
appropriate investment
• Independent estimates of return for the
securities provide price and dividend
outlooks
 Price, Dividend, and
Rate of Return Estimates
Exhibit 8.7
 Comparison of Required Rate of
Return to Estimated Rate of Return
Exhibit 8.8
 Plot of Estimated Returns
on SML Graph Exhibit 8.9
.22 .
C
20 .1 SML
8 .16
.14 .
12
Rm .
10 .0
8 .06 A
E .04 .
02
B
D

-.40 -.20 .20 .40 .60 .80 1.20 1.40 1.60 1.80
 Calculating Systematic Risk:
The Characteristic Line
The systematic risk input of an individual asset is derived
from a regression model, referred to as the asset’s
characteristic line with the model portfolio:

where:
Ri,t = the rate of return for asset i during period t
RM,t = the rate of return for the market portfolio M during t
Scatter Plot of Rates of Return
The characteristic Ri Exhibit 8.10
line is the regression
line of the best fit
through a scatter plot
of rates of return

RM
The Impact of the Time Interval
• Number of observations and time interval used in
regression vary
• Value Line Investment Services (VL) uses weekly
rates of return over five years
• Merrill Lynch, Pierce, Fenner & Smith (ML) uses
monthly return over five years
• There is no “correct” interval for analysis
• Weak relationship between VL & ML betas due to
difference in intervals used
• The return time interval makes a difference, and
its impact increases as the firm’s size declines
The Effect of the Market Proxy
• The market portfolio of all risky assets must
be represented in computing an asset’s
characteristic line
• Standard & Poor’s 500 Composite Index is
most often used
– Large proportion of the total market value of
U.S. stocks
– Value weighted series
Weaknesses of Using S&P 500
as the Market Proxy
– Includes only U.S. stocks
– The theoretical market portfolio should include
U.S. and non-U.S. stocks and bonds, real estate,
coins, stamps, art, antiques, and any other
marketable risky asset from around the world
 Relaxing the Assumptions
• Differential Borrowing and Lending Rates
– Heterogeneous Expectations and Planning
Periods
• Zero Beta Model
– does not require a risk-free asset
• Transaction Costs
– with transactions costs, the SML will be a band
of securities, rather than a straight line
 Relaxing the Assumptions
• Heterogeneous Expectations and Planning
Periods
– will have an impact on the CML and SML
• Taxes
– could cause major differences in the CML and
SML among investors
 Empirical Tests of the CAPM
• Stability of Beta
– betas for individual stocks are not stable, but
portfolio betas are reasonably stable. Further,
the larger the portfolio of stocks and longer
the period, the more stable the beta of the
portfolio
• Comparability of Published Estimates of
Beta
– differences exist. Hence, consider the return
interval used and the firm’s relative size
Relationship Between Systematic
Risk and Return
• Effect of Skewness on Relationship
– investors prefer stocks with high positive
skewness that provide an opportunity for very
large returns
• Effect of Size, P/E, and Leverage
– size, and P/E have an inverse impact on returns
after considering the CAPM. Financial
Leverage also helps explain cross-section of
returns
Relationship Between Systematic
Risk and Return
• Effect of Book-to-Market Value
– Fama and French questioned the relationship
between returns and beta in their seminal 1992
study. They found the BV/MV ratio to be a key
determinant of returns
• Summary of CAPM Risk-Return Empirical
Results
– the relationship between beta and rates of return
is a moot point
 The Market Portfolio: Theory
versus Practice
• There is a controversy over the market portfolio.
Hence, proxies are used
• There is no unanimity about which proxy to use
• An incorrect market proxy will affect both the beta
risk measures and the position and slope of the
SML that is used to evaluate portfolio
performance
 What is Next?
• Alternative asset pricing models
 Summary

• The dominant line is tangent to the efficient

frontier
– Referred to as the capital market line (CML)
– All investors should target points along this line
depending on their risk preferences
 Summary
• All investors want to invest in the risky
portfolio, so this market portfolio must
contain all risky assets
– The investment decision and financing decision
can be separated
– Everyone wants to invest in the market
portfolio
– Investors finance based on risk preferences
 Summary
• The relevant risk measure for an individual
risky asset is its systematic risk or
covariance with the market portfolio
– Once you have determined this Beta measure
and a security market line, you can determine
the required return on a security based on its
systematic risk
 Summary

• Assuming security markets are not always

completely efficient, you can identify
undervalued and overvalued securities by
comparing your estimate of the rate of
return on an investment to its required rate
of return
 Summary
• When we relax several of the major
assumptions of the CAPM, the required
modifications are relatively minor and do
not change the overall concept of the
model.
 Summary
• Betas of individual stocks are not stable
while portfolio betas are stable
• There is a controversy about the
relationship between beta and rate of return
on stocks
• Changing the proxy for the market portfolio
results in significant differences in betas,
SMLs, and expected returns
 The Internet
Investments Online
www.valueline.com
www.barra.com
www.stanford.edu/~wfsharpe.com
 Future topics
Chapter 9
• Deficiencies of the Capital Asset Pricing Model
• Arbitrage Pricing Theory
• Multi-factor Models