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# Essentials of Investments

Fourth
Edition
Irwin / McGraw-Hill
Bodie Kane Marcus 1
Chapter 6
Risk and Return: Past
and Prologue
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 2
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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Fourth
Edition
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Bodie Kane Marcus 3
Rates of Return: Single Period
Example
Ending Price = 24
Beginning Price = 20
Dividend = 1

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

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Fourth
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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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Fourth
Edition
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Bodie Kane Marcus 5
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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Fourth
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Bodie Kane Marcus 6
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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Fourth
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Bodie Kane Marcus 7
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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Fourth
Edition
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Bodie Kane Marcus 8
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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Fourth
Edition
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Bodie Kane Marcus 9
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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Fourth
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r
Symmetric distribution
Normal Distribution
s.d. s.d.
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Fourth
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r
Negative Positive
Skewed Distribution: Large Negative
Returns Possible
Median
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Fourth
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r Negative Positive
Skewed Distribution: Large Positive
Returns Possible
Median
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Fourth
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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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Fourth
Edition
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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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Fourth
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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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Fourth
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Bodie Kane Marcus 16
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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Fourth
Edition
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Bodie Kane Marcus 17
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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Fourth
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Bodie Kane Marcus 18
Annual Holding Period Risk
Risk Real
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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Fourth
Edition
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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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Fourth
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Allocating Capital Between Risky &
Risk-Free Assets (cont.)
Issues
Demonstrate how different degrees of risk
aversion will affect allocations between
risky and risk free assets
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Fourth
Edition
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Bodie Kane Marcus 21
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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Fourth
Edition
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Bodie Kane Marcus 22
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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Fourth
Edition
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Bodie Kane Marcus 23
E(r)
E(r
p
) = 15%
r
f
= 7%
22%
0
P
F
Possible Combinations
s
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Fourth
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Bodie Kane Marcus 24
p
c
=
Since
r
f
y
Variance on the Possible Combined
Portfolios
= 0, then
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Fourth
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Bodie Kane Marcus 25
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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Fourth
Edition
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Bodie Kane Marcus 26
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 27
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 28
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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Fourth
Edition
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Bodie Kane Marcus 29
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
The larger A is, the larger will be the
Essentials of Investments
Fourth
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Bodie Kane Marcus 30
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 31
Chapter 7
Efficient
Diversification
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Fourth
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Bodie Kane Marcus 32
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
Essentials of Investments
Fourth
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Bodie Kane Marcus 33
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 34
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 35
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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Fourth
Edition
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Bodie Kane Marcus 36
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 37
r
p
= Weighted average of the
n securities
s
p
2
= (Consider all pair-wise
covariance measures)
In General, For an n-Security
Portfolio:
Essentials of Investments
Fourth
Edition
Irwin / McGraw-Hill
Bodie Kane Marcus 38
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 39
r = 0
E(r)
r = 1
r = -1
r = -1
r = .3
13%
8%
12% 20%
St. Dev
TWO-SECURITY PORTFOLIOS WITH
DIFFERENT CORRELATIONS
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 40
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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Fourth
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Bodie Kane Marcus 41
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
Essentials of Investments
Fourth
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Bodie Kane Marcus 42
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 43
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 44
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 45
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
Essentials of Investments
Fourth
Edition
Irwin / McGraw-Hill
Bodie Kane Marcus 46
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
Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 47
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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Fourth
Edition
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Bodie Kane Marcus 48
Extending to Include Riskless Asset
The optimal combination becomes
linear
A single combination of risky and
riskless assets will dominate
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Fourth
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Bodie Kane Marcus 49
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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Fourth
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Bodie Kane Marcus 50
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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Fourth
Edition
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Bodie Kane Marcus 51
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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Fourth
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Bodie Kane Marcus 52
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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Fourth
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Bodie Kane Marcus 53
Let: R
i
= (r
i
- r
f
)
R
m
= (r
m
- r
f
)
format
R
i
= a
i
+
i
(R
m
)

+ e
i

Essentials of Investments
Fourth
Edition
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Bodie Kane Marcus 54
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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Fourth
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Bodie Kane Marcus 55
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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Fourth
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Bodie Kane Marcus 56
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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Bodie Kane Marcus 57
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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Fourth
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Bodie Kane Marcus 58
Advantages of the Single Index Model
Reduces the number of inputs for
diversification
Easier for security analysts to specialize
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Fourth
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Bodie Kane Marcus 59
Chapter 8
Capital Asset Pricing
and Arbitrage
Pricing Theory
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Fourth
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Bodie Kane Marcus 60
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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Fourth
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Bodie Kane Marcus 61
Assumptions
Individual investors are price takers
Single-period investment horizon
financial assets
No taxes, and transaction costs
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Fourth
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Bodie Kane Marcus 62
Assumptions (cont.)
Information is costless and available to
all investors
Investors are rational mean-variance
optimizers
Homogeneous expectations
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Fourth
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Bodie Kane Marcus 63
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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Fourth
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Bodie Kane Marcus 64
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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Fourth
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Bodie Kane Marcus 65
E(r)
E(r
M
)
r
f
M
CML
s
m
Capital Market Line
s
Essentials of Investments
Fourth
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Bodie Kane Marcus 66

M = Market portfolio
r
f
= Risk free rate
E(r
M
) - r
f

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

= Slope of the CAPM
M
s
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Fourth
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Bodie Kane Marcus 67
Expected Return and Risk on
Individual Securities
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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Bodie Kane Marcus 68
E(r)
E(r
M
)
r
f
SML
M

= 1.0
Security Market Line
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Fourth
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Bodie Kane Marcus 69
SML Relationships
= [COV(r
i
,r
m
)] / s
m
2
Slope SML = E(r
m
) - r
f

SML = r
f
+ [E(r
m
) - r
f
]
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Fourth
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Bodie Kane Marcus 70
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%
Essentials of Investments
Fourth
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Bodie Kane Marcus 71
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
Essentials of Investments
Fourth
Edition
Irwin / McGraw-Hill
Bodie Kane Marcus 72
E(r)
15%
SML

1.0
R
m
=11%
r
f
=3%
1.25
Disequilibrium Example
Essentials of Investments
Fourth
Edition
Irwin / McGraw-Hill
Bodie Kane Marcus 73
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
Essentials of Investments
Fourth
Edition
Irwin / McGraw-Hill
Bodie Kane Marcus 74
Security Characteristic Line
Excess Returns (i)
SCL
.
.
.
.
.
.
.
.
. .
.
. .
.
. .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
. .
.
. .
.
. .
.
. .
. .
. .
Excess returns
on market index
R
i
= a
i
+
i
R
m
+ e
i
Essentials of Investments
Fourth
Edition
Irwin / McGraw-Hill
Bodie Kane Marcus 75
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.
Essentials of Investments
Fourth
Edition
Irwin / McGraw-Hill
Bodie Kane Marcus 76
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:
Essentials of Investments
Fourth
Edition
Irwin / McGraw-Hill
Bodie Kane Marcus 77
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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Fourth
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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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Bodie Kane Marcus 79
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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Bodie Kane Marcus 80
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
Essentials of Investments