Investment Analysis Investment Analysis: 8 - CAPM (Chp. 9)

HKUST- FINA 3104
INVESTMENT ANALYSIS
8 CAPM (Chp. 9)
Entela Benz
The Issue
2
Issues;
How to compare possible investment against each other, in a
portfolio context?
What is the fair return given its risk?
How much should we ask for return from a stock that has never
been traded?
Solution: Use Capital Asset Pricing Model (CAPM)
HKUST-Investment Analysis
10/19/2012
CAPM
CAPM Assumptions
CAPM Implications
The Security Market Line (SML)
CAPM & the Index Model
Chasing the alpha
10/19/2012
Learning Outcomes
4
Be able to explain the theory of the capital asset

pricing model (CAPM),
Be able to construct and use the security market
line.
Understand what fair pricing means.
Recommend the appropriate strategy for a
mispriced security.
10/19/2012
CAPM-Assumptions
5
1.
2.
3.
4.
5.
6.
7.
Individual investors are price takers

Single-period investment horizon
Investments are limited to traded financial assets
No taxes and no transaction costs
Information is costless and available to all investors
Investors are rational mean-variance optimizers
There are homogeneous expectations, same input list to
derive expected returns and covariance matrix.
10/19/2012
CAPM-Implication 1
6
1. All investors will hold the same portfolio of risky assets

market portfolio M.
o
Use same input, same securities, time horizon etc,

therefore get same optimal risky portfolio.
The borrowing and lending cancel out, so the market

portfolio equals the entire wealth of economy.
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CAPM-Implication 2
7
2. The market
portfolio, M, contains
all securities in the
economy in proportion
to its market value
versus total market
value.
The M portfolio lies in

the efficient frontier
and t he highest CAL
Remember: The CML

(the CAL of the risky
portfolio P where P is the
Market portfolio) plots the
risk premium versus the
risk of efficient portfolios.
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CAPM-Implication 3
8
3. Market Risk Premium depends on the market variance

adjusted by the average degree of risk aversion.
rm
rf
2
m
Because lending
cancels out with
borrowing, the
average position is
y=100%
Example: If expected excess return on index is 6% and

standard deviation 20%, the average risk aversion equals ?
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CAPM-Implication 4
9
4. An individual securitys risk premium is proportional to

the risk premium of the market portfolio.
E ri
Cov ri , rm
rf
E rm
2
m
The b coefficient measure

the contribution of the
asset risk to the market
portfolio risk as a fraction
of the total market
portfolio risk.
Cov ri , rm
i
2
m
CAPM formulation
E ri
rf
E rm
rf
rf
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CAPM-Implication 5
10
5. CAPM is an equilibrium model, therefore all the

assets included in the market portfolio should have
same risk reward ratio.
E ri
Cov
rf
i,
E ri
rf
i
E rj
Cov
rf
j,
E rj
j
rf
j
E rm
rf
2
m
E rm
rf
m
10/19/2012
The Security Market Line (SML)

11
The SML plots the risk premium as a function of the contribution

of asset risk to the portfolio variance captured by b.
In equilibrium all risky asset are

found along the SML, because they
have the same slope.
E ri
rf
i
E rj
rf
E rm
rf
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CAPM Problems
12
Problems:
o
The market portfolio M is unobservable, therefore it is
difficult to test is mean-variance efficiency.
o
Impossible to get the expected return for all risky assets in
the portfolio.
Solution:
Index Model replaces the unobservable market portfolio
with an observable index. Use past returns to create an
expected returns.
10/19/2012

13
CAPM
E ri
E ri
rf
rf
E rm
rf
E rm
Index
Model
rf
Implications
a. Same beta if market index is the market portfolio.
b. CAPM inherently assumes a zero expected alpha.
c. Alpha is therefore the expected return in excess/below the
CAPM return.
10/19/2012

14
= expected return required return (CAPM)
Example: The stock A of b=1.5 has a required expected

return of (CAPM rate):
E(rA ) - .06 = 1.5 (.15 .06) therefore E(rA ) =19.5%
If the analysts forecast of expected return is 22%, then
A = 22% 19.5% = 2.5%.... BUY the stock!!!
If the analysts forecast of expected return is 15%, then
A = 15% 19.5% = 4.5%.....SELL the stock!!!
10/19/2012

15
If alpha is positive, the

stock is undervalued.
Buy the stock!

If alpha is negative,
the stock is overvalued.
Sell the stock!
10/19/2012
Chasing Alpha
16
In average the
mutual fund
managers fail
outperform the
market.
The averaged
of realized
alphas is
insignificant.
10/19/2012
Takeaways
17
CAPM is an equilibrium model derived using principles

of diversification with simplified assumptions.
CAPM is useful in;
i.
ii.
iii.
deriving the Fair Expected Rate of Return given the risk,

calculating the Required Rate of Return, ie. the discount rate
of the future cash flows,
identifying Mispriced Securities, that is positive or negative
alpha investment opportunities.
10/19/2012
Quiz
18
20. According to the Capital Asset Pricing Model (CAPM),

A. a security with a positive alpha is considered overpriced.
B. a security with a zero alpha is considered to be a good buy.
C. a security with a negative alpha is considered to be a good
buy.
D. a security with a positive alpha is considered to be
underpriced.
E. a security with a positive beta is considered to be
underpriced.
10/19/2012
Quiz
19
24. Your personal opinion is that a security has an expected rate

of return of 0.11. It has a beta of 1.5. The risk-free rate is
0.05 and the market expected rate of return is 0.09.
According to the Capital Asset Pricing Model, this security is
A. underpriced.
B. overpriced.
C. fairly priced.
D. cannot be determined from data provided.
E. can either be overpriced or underpriced but not fairly
priced.
10/19/2012

Investment Analysis Investment Analysis: 8 - CAPM (Chp. 9)

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HKUST- FINA 3104

Solution: Use Capital Asset Pricing Model (CAPM)

Be able to explain the theory of the capital asset

Individual investors are price takers

1. All investors will hold the same portfolio of risky assets

Use same input, same securities, time horizon etc,

The borrowing and lending cancel out, so the market

The M portfolio lies in

Remember: The CML

3. Market Risk Premium depends on the market variance

Example: If expected excess return on index is 6% and

4. An individual securitys risk premium is proportional to

The b coefficient measure

5. CAPM is an equilibrium model, therefore all the

The Security Market Line (SML)

The SML plots the risk premium as a function of the contribution

In equilibrium all risky asset are

CAPM & the Index Model

CAPM & the Index Model

= expected return required return (CAPM)

Example: The stock A of b=1.5 has a required expected

CAPM & the Index Model

If alpha is positive, the

Buy the stock!

Sell the stock!

CAPM is an equilibrium model derived using principles

deriving the Fair Expected Rate of Return given the risk,

20. According to the Capital Asset Pricing Model (CAPM),

24. Your personal opinion is that a security has an expected rate

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