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Essentials of Investments

2001 The McGraw-Hill Companies, Inc. All rights reserved.


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Bodie Kane Marcus 1
Chapter 6
Risk and Return: Past
and Prologue
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Rates of Return: Single Period

HPR
P P D
P


1 0 1
0
HPR = Holding Period Return
P
1
= Ending price
P
0
= Beginning price
D
1
= Dividend during period one
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Rates of Return: Single Period
Example
Ending Price = 24
Beginning Price = 20
Dividend = 1

HPR = ( 24 - 20 + 1 )/ ( 20) = 25%

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Data from Text Example p. 154
1 2 3 4
Assets(Beg.) 1.0 1.2 2.0 .8
HPR .10 .25 (.20) .25
TA (Before
Net Flows 1.1 1.5 1.6 1.0
Net Flows 0.1 0.5 (0.8) 0.0
End Assets 1.2 2.0 .8 1.0

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Returns Using Arithmetic and
Geometric Averaging
Arithmetic
r
a
= (r
1
+ r
2
+ r
3
+ ... r
n
) / n
r
a
= (.10 + .25 - .20 + .25) / 4
= .10 or 10%
Geometric
r
g
= {[(1+r
1
) (1+r
2
) .... (1+r
n
)]}
1/n
- 1
r
g
= {[(1.1) (1.25) (.8) (1.25)]}
1/4
- 1
= (1.5150)
1/4
-1 = .0829 = 8.29%
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Dollar Weighted Returns
Internal Rate of Return (IRR) - the
discount rate that results present value
of the future cash flows being equal to
the investment amount
Considers changes in investment
Initial Investment is an outflow
Ending value is considered as an inflow
Additional investment is a negative flow
Reduced investment is a positive flow
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Dollar Weighted Average Using Text
Example
Net CFs 1 2 3 4
$ (mil) - .1 - .5 .8 1.0

Solving for IRR
1.0 = -.1/(1+r)
1
+ -.5/(1+r)
2
+ .8/(1+r)
3
+
1.0/(1+r)
4
r = .0417 or 4.17%


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Quoting Conventions
APR = annual percentage rate
(periods in year) X (rate for period)
EAR = effective annual rate
( 1+ rate for period)
Periods per yr
- 1
Example: monthly return of 1%
APR = 1% X 12 = 12%
EAR = (1.01)
12
- 1 = 12.68%
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Characteristics of Probability
Distributions
1) Mean: most likely value
2) Variance or standard deviation
3) Skewness

* If a distribution is approximately normal,
the distribution is described by
characteristics 1 and 2
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r
Symmetric distribution
Normal Distribution
s.d. s.d.
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r
Negative Positive
Skewed Distribution: Large Negative
Returns Possible
Median
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r Negative Positive
Skewed Distribution: Large Positive
Returns Possible
Median
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Subjective returns
p(s) = probability of a state
r(s) = return if a state occurs
1 to s states
Measuring Mean: Scenario or
Subjective Returns
E ( r ) = p ( s ) r ( s )
S
s

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Numerical Example: Subjective or
Scenario Distributions
State Prob. of State r
in
State
1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35
E(r) = (.1)(-.05) + (.2)(.05)...+ (.1)(.35)
E(r) = .15
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Standard deviation = [variance]
1/2
Measuring Variance or Dispersion of
Returns
Subjective or Scenario
Variance =
S
s
p ( s ) [ r
s
- E ( r )]
2

Var =[(.1)(-.05-.15)
2
+(.2)(.05- .15)
2
...+ .1(.35-.15)
2
]
Var= .01199
S.D.= [ .01199]
1/2
= .1095
Using Our Example:
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Real vs. Nominal Rates
Fisher effect: Approximation
nominal rate = real rate + inflation premium
R = r + i or r = R - i
Example r = 3%, i = 6%
R = 9% = 3% + 6% or 3% = 9% - 6%
Fisher effect: Exact
r = (R - i) / (1 + i)
2.83% = (9%-6%) / (1.06)

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Annual Holding Period Returns
From Figure 6.1 of Text
Geom Arith Stan.
Series Mean% Mean% Dev.%
Lg Stk 11.01 13.00 20.33
Sm Stk 12.46 18.77 39.95
LT Gov 5.26 5.54 7.99
T-Bills 3.75 3.80 3.31
Inflation 3.08 3.18 4.49
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Annual Holding Period Risk
Premiums and Real Returns
Risk Real
Series Premiums% Returns%
Lg Stk 9.2 9.82
Sm Stk 14.97 15.59
LT Gov 1.74 2.36
T-Bills --- 0.62
Inflation --- ---
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Possible to split investment funds
between safe and risky assets
Risk free asset: proxy; T-bills
Risky asset: stock (or a portfolio)
Allocating Capital Between Risky &
Risk-Free Assets
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Allocating Capital Between Risky &
Risk-Free Assets (cont.)
Issues
Examine risk/ return tradeoff
Demonstrate how different degrees of risk
aversion will affect allocations between
risky and risk free assets
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r
f
= 7%
s
rf
= 0%
E(r
p
) = 15%
s
p
= 22%
y = % in p (1-y) = % in r
f
Example Using the Numbers in
Chapter 6 (pp 171-173)
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E(r
c
) = yE(r
p
) + (1 - y)r
f
r
c
= complete or combined portfolio
For example, y = .75
E(r
c
) = .75(.15) + .25(.07)
= .13 or 13%
Expected Returns for Combinations
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E(r)
E(r
p
) = 15%
r
f
= 7%
22%
0
P
F
Possible Combinations
s
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p
c
=
Since
r
f
y
Variance on the Possible Combined
Portfolios
= 0, then
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c
= .75(.22) = .165 or 16.5%
If y = .75, then
c
= 1(.22) = .22 or 22%
If y = 1
c
= 0(.22) = .00 or 0%
If y = 0
Combinations Without Leverage
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Using Leverage with Capital
Allocation Line
Borrow at the Risk-Free Rate and invest
in stock
Using 50% Leverage
r
c
= (-.5) (.07) + (1.5) (.15) = .19

s
c
= (1.5) (.22) = .33
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E(r)
E(r
p
) = 15%
r
f
= 7%
= 22%
0
P
F
P
) S = 8/22
E(r
p
) - r
f
= 8%
CAL
(Capital
Allocation
Line)
s
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Risk Aversion and Allocation
Greater levels of risk aversion lead to
larger proportions of the risk free rate
Lower levels of risk aversion lead to
larger proportions of the portfolio of
risky assets
Willingness to accept high levels of risk
for high levels of returns would result in
leveraged combinations
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Quantifying Risk Aversion
p f p A r r E s 005 .
E(r
p
) = Expected return on portfolio p
r
f
= the risk free rate
.005 = Scale factor
A x s
p
= Proportional risk premium
The larger A is, the larger will be the
added return required for risk
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Quantifying Risk Aversion

r r E
A
p
f p
2
.005
) (

Rearranging the equation and solving for A


Many studies have concluded that
investors average risk aversion is
between 2 and 4
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Chapter 7
Efficient
Diversification
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r
p
= W
1
r
1
+

W
2
r
2
W
1
= Proportion of funds in Security 1
W
2
= Proportion of funds in Security 2
r
1
= Expected return on Security 1
r
2
= Expected return on Security 2

Two-Security Portfolio: Return
W
i
S
i =1
n
= 1
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s
p
2

= w
1
2
s
1
2
+ w
2
2
s
2
2
+ 2W
1
W
2
Cov(r
1
r
2
)
s
1
2
= Variance of Security 1
s
2
2
= Variance of Security 2
Cov(r
1
r
2
) = Covariance of returns for
Security 1 and Security 2
Two-Security Portfolio: Risk
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Covariance
r
1,2
= Correlation coefficient of
returns


Cov(r
1
r
2
) = r
1,2
s
1
s
2
s
1
= Standard deviation of
returns for Security 1
s
2
= Standard deviation of
returns for Security 2
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Correlation Coefficients: Possible
Values
If r = 1.0, the securities would be
perfectly positively correlated
If r = - 1.0, the securities would be
perfectly negatively correlated
Range of values for r
1,2
-1.0 < r < 1.0
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s
2
p
= W
1
2
s
1
2
+ W
2
2
s
2
2
+ 2W
1
W
2
r
p
= W
1
r
1
+

W
2
r
2
+ W
3
r
3

Cov(r
1
r
2
)
+ W
3
2
s
3
2

Cov(r
1
r
3
) + 2W
1
W
3

Cov(r
2
r
3
) + 2W
2
W
3
Three-Security Portfolio
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r
p
= Weighted average of the
n securities
s
p
2
= (Consider all pair-wise
covariance measures)
In General, For an n-Security
Portfolio:
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E(r
p
) = W
1
r
1
+

W
2
r
2
Two-Security Portfolio
s
p
2

= w
1
2
s
1
2
+ w
2
2
s
2
2
+ 2W
1
W
2
Cov(r
1
r
2
)
s
p

= [w
1
2
s
1
2
+ w
2
2
s
2
2
+ 2W
1
W
2
Cov(r
1
r
2
)]
1/2
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r = 0
E(r)
r = 1
r = -1
r = -1
r = .3
13%
8%
12% 20%
St. Dev
TWO-SECURITY PORTFOLIOS WITH
DIFFERENT CORRELATIONS
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Portfolio Risk/Return Two Securities:
Correlation Effects
Relationship depends on correlation
coefficient
-1.0 < r < +1.0
The smaller the correlation, the greater
the risk reduction potential
If r = +1.0, no risk reduction is possible
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1
1
2

- Cov(r
1
r
2
)
W
1
=
+

- 2Cov(r
1
r
2
)
2
W
2
= (1 - W
1
)
Minimum Variance Combination
2
2
2
E(r
2
) = .14 = .20 Sec 2
12
= .2
E(r
1
) = .10 = .15 Sec 1
2
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W
1
=
(.2)
2
- (.2)(.15)(.2)
(.15)
2
+ (.2)
2
- 2(.2)(.15)(.2)
W
1
= .6733
W
2
= (1 - .6733) = .3267
Minimum Variance
Combination: r = .2
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r
p
= .6733(.10) + .3267(.14) = .1131
p
= [(.6733)
2
(.15)
2
+ (.3267)
2
(.2)
2
+
2(.6733)(.3267)(.2)(.15)(.2)]
1/2
p
= [.0171]
1/2
= .1308
Minimum Variance: Return and Risk
with r = .2
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W
1
=
(.2)
2
- (.2)(.15)(.2)
(.15)
2
+ (.2)
2
- 2(.2)(.15)(-.3)
W
1
= .6087
W
2
= (1 - .6087) = .3913
Minimum Variance
Combination: r = -.3
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r
p
= .6087(.10) + .3913(.14) = .1157
p
= [(.6087)
2
(.15)
2
+ (.3913)
2
(.2)
2
+
2(.6087)(.3913)(.2)(.15)(-.3)]
1/2
p
= [.0102]
1/2
= .1009
Minimum Variance: Return and Risk
with r = -.3
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Extending Concepts to All Securities
The optimal combinations result in
lowest level of risk for a given return
The optimal trade-off is described as the
efficient frontier
These portfolios are dominant
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E(r)
The minimum-variance frontier of
risky assets
Efficient
frontier
Global
minimum
variance
portfolio
Minimum
variance
frontier
Individual
assets
St. Dev.
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Extending to Include Riskless Asset
The optimal combination becomes
linear
A single combination of risky and
riskless assets will dominate
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E(r)
CAL (Global
minimum variance)
CAL (A)
CAL (P)
M
P
A
F
P P&F A&F
M
A
G
P
M
s
ALTERNATIVE CALS
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Dominant CAL with a Risk-Free
Investment (F)
CAL(P) dominates other lines -- it has the
best risk/return or the largest slope
Slope = (E(R) - Rf) / s
[ E(R
P
) - R
f
) / s
P
] > [E(R
A
) - R
f
) / s
A
]
Regardless of risk preferences
combinations of P & F dominate
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Single Factor Model
r
i
= E(R
i
) +
i
F + e

i
= index of a securities particular return
to the factor
F= some macro factor; in this case F is
unanticipated movement; F is commonly
related to security returns
Assumption: a broad market index like the
S&P500 is the common factor
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Single Index Model
Risk Prem
Market Risk Prem
or Index Risk Prem
i
= the stocks expected return if the
markets excess return is zero

i
(r
m
- r
f
)

= the component of return due to
movements in the market index
(r
m
- r
f
)

= 0
e
i
= firm specific component, not due to market
movements

a

e r r r r
i f m
i
i f i

a
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Let: R
i
= (r
i
- r
f
)
R
m
= (r
m
- r
f
)
Risk premium
format
R
i
= a
i
+
i
(R
m
)

+ e
i


Risk Premium Format
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Estimating the Index Model
Excess Returns (i)
Security
Characteristic
Line
.
.
.
.
.
.
.
.
. .
.
. .
.
. .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
. .
.
. .
.
. .
.
. .
. .
. .
Excess returns
on market index
R
i
= a
i
+
i
R
m
+ e
i
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Components of Risk
Market or systematic risk: risk related to the
macro economic factor or market index
Unsystematic or firm specific risk: risk not
related to the macro factor or market index
Total risk = Systematic + Unsystematic
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Measuring Components of Risk
s
i
2
=
i
2
s
m
2
+ s
2
(e
i
)
where;
s
i
2
= total variance

i
2
s
m
2
= systematic variance
s
2
(e
i
) = unsystematic variance

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Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk/Total Risk = r
2


i
2
s

m
2
/ s
2
= r
2

i
2
s
m
2
/
i
2
s
m
2
+ s
2
(e
i
) = r
2

Examining Percentage of Variance
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Advantages of the Single Index Model
Reduces the number of inputs for
diversification
Easier for security analysts to specialize
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Chapter 8
Capital Asset Pricing
and Arbitrage
Pricing Theory
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Capital Asset Pricing Model (CAPM)
Equilibrium model that underlies all modern
financial theory
Derived using principles of diversification
with simplified assumptions
Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Assumptions
Individual investors are price takers
Single-period investment horizon
Investments are limited to traded
financial assets
No taxes, and transaction costs
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Assumptions (cont.)
Information is costless and available to
all investors
Investors are rational mean-variance
optimizers
Homogeneous expectations
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Resulting Equilibrium Conditions
All investors will hold the same portfolio
for risky assets market portfolio
Market portfolio contains all securities
and the proportion of each security is its
market value as a percentage of total
market value
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Risk premium on the market depends
on the average risk aversion of all
market participants
Risk premium on an individual security
is a function of its covariance with the
market
Resulting Equilibrium Conditions
(cont.)
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E(r)
E(r
M
)
r
f
M
CML
s
m
Capital Market Line
s
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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M = Market portfolio
r
f
= Risk free rate
E(r
M
) - r
f
= Market risk premium

E(r
M
) - r
f
= Market price of risk

= Slope of the CAPM
Slope and Market Risk Premium
M
s
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Expected Return and Risk on
Individual Securities
The risk premium on individual
securities is a function of the individual
securitys contribution to the risk of the
market portfolio
Individual securitys risk premium is a
function of the covariance of returns
with the assets that make up the market
portfolio
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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E(r)
E(r
M
)
r
f
SML
M


= 1.0
Security Market Line
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
Fourth
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SML Relationships
= [COV(r
i
,r
m
)] / s
m
2
Slope SML = E(r
m
) - r
f
= market risk premium

SML = r
f
+ [E(r
m
) - r
f
]
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Sample Calculations for SML
E(r
m
) - r
f
= .08 r
f
= .03

x
= 1.25
E(r
x
) = .03 + 1.25(.08) = .13 or 13%

y
= .6
e(r
y
) = .03 + .6(.08) = .078 or 7.8%
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E(r)
R
x
=13%
SML
m


1.0
R
m
=11%
R
y
=7.8%
3%
x

1.25
y

.6
.08
Graph of Sample Calculations
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E(r)
15%
SML

1.0
R
m
=11%
r
f
=3%
1.25
Disequilibrium Example
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Disequilibrium Example
Suppose a security with a of 1.25 is
offering expected return of 15%
According to SML, it should be 13%
Underpriced: offering too high of a rate
of return for its level of risk
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Security Characteristic Line
Excess Returns (i)
SCL
.
.
.
.
.
.
.
.
. .
.
. .
.
. .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
. .
.
. .
.
. .
.
. .
. .
. .
Excess returns
on market index
R
i
= a
i
+
i
R
m
+ e
i
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Using the Text Example p. 245, Table
8.5:
Jan.
Feb.
.
.
Dec
Mean
Std Dev
5.41
-3.44
.
.
2.43
-.60
4.97
7.24
.93
.
.
3.90
1.75
3.32
Excess
Mkt. Ret.
Excess
GM Ret.
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Estimated coefficient
Std error of estimate
Variance of residuals = 12.601
Std dev of residuals = 3.550
R-SQR = 0.575

-2.590
(1.547)
1.1357
(0.309)
r
GM
- r
f
= + (r
m
- r
f
)
Regression Results:
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Arbitrage Pricing Theory
Arbitrage - arises if an investor can
construct a zero investment portfolio
with a sure profit
Since no investment is required, an
investor can create large positions to
secure large levels of profit
In efficient markets, profitable arbitrage
opportunities will quickly disappear
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Arbitrage Example from Text pp. 255-
257
Current Expected Standard
Stock Price$ Return% Dev.%
A 10 25.0 29.58
B 10 20.0 33.91
C 10 32.5 48.15
D 10 22.5 8.58
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Arbitrage Portfolio
Mean Stan. Correlation
Return Dev. Of Returns
Portfolio
A,B,C 25.83 6.40 0.94

D 22.25 8.58
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Arbitrage Action and Returns
E. Ret.
St.Dev.
* P
* D
Short 3 shares of D and buy 1 of A, B & C to form
P
You earn a higher rate on the investment than
you pay on the short sale
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2001 The McGraw-Hill Companies, Inc. All rights reserved.
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APT and CAPM Compared
APT applies to well diversified portfolios and
not necessarily to individual stocks
With APT it is possible for some individual
stocks to be mispriced - not lie on the SML
APT is more general in that it gets to an
expected return and beta relationship without
the assumption of the market portfolio
APT can be extended to multifactor models