Bodie, Kane, and Marcus Essentials of Investments 2024 Chapter 7 PDF

Chapter 7 CAPM and APT Bodie, Kane, and Marcus Essentials of Investments 2024 Release © McGraw Hill LLC. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distrib...

Chapter 7 CAPM and APT Bodie, Kane, and Marcus Essentials of Investments 2024 Release © McGraw Hill LLC. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC.  7.1 The Capital Asset Pricing Model Capital Asset Pricing Model (CAPM) Security’s required rate of return relates to systematic risk measured by beta E (rM )  rf  A M2 Market Portfolio (M) Each security held in proportion to market value © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 2  Table 7.1 The Capital Asset Pricing Model: Assumptions © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 3  7.1 The Capital Asset Pricing Model Hypothetical Equilibrium All investors choose to hold market portfolio Market portfolio is on efficient frontier, optimal risky portfolio © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 4  7.1 The Capital Asset Pricing Model Hypothetical Equilibrium Risk premium on market portfolio is proportional to variance of market portfolio and investor’s risk aversion Risk premium on individual assets Proportional to risk premium on market portfolio Proportional to beta coefficient of security on market portfolio © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 5  Figure 7.1 Efficient Frontier and Capital Market Line © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 6  7.1 The Capital Asset Pricing Model Passive Strategy is Efficient Mutual fund theorem: All investors desire same portfolio of risky assets, can be satisfied by single mutual fund composed of that portfolio If passive strategy is costless and efficient, why follow active strategy? If no one does security analysis, what brings about efficiency of market portfolio? © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 7  7.1 The Capital Asset Pricing Model Risk Premium of Market Portfolio Demand drives prices, lowers expected rate of return/risk premiums When premiums fall, investors move funds into risk-free asset Equilibrium risk premium of market portfolio proportional to Risk of market Risk aversion of average investor © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 8  7.1 The Capital Asset Pricing Model Expected Returns on Individual Securities Expected return-beta relationship Implication of CAPM that security risk premiums (expected excess returns) will be proportional to beta E (rD ) rf   D [ E (rM )  rf ] © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 9  7.1 The Capital Asset Pricing Model The Security Market Line (SML) Represents expected return-beta relationship of CAPM Graphs individual asset risk premiums as function of asset risk Alpha Abnormal rate of return on security in excess of that predicted by equilibrium model (CAPM) © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 10  Figure 7.2 The SML and a Positive-Alpha Stock © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 11  7.1 The Capital Asset Pricing Model Applications of CAPM Use SML as benchmark for fair return on risky asset SML provides “hurdle rate” for internal projects © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 12  7.2 CAPM and Index Models Index Model, Realized Returns, Mean-Beta Equation : HPR i: Asset t: Period : Intercept of security characteristic line : Slope of security characteristic line : Index return : Firm-specific effects © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 13  7.2 CAPM and Index Models Estimating Index Model , excess return Residual = Actual return Predicted return for Google © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 14  7.2 CAPM and Index Models: SCL Security Characteristic Line (SCL) Plot of security’s expected excess return over risk-free rate as function of excess return on market Required rate = Risk-free rate + β x Expected excess return of index © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 15  7.2 CAPM and Index Models Predicting Betas Mean reversion Betas move towards mean over time To predict future betas, adjust estimates from historical data to account for regression towards 1.0 © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 16  7.3 CAPM and the Real World CAPM is false based on validity of its assumptions Useful predictor of expected returns Untestable as a theory Principles still valid Investors should diversify Systematic risk is the risk that matters Well-diversified risky portfolio can be suitable for wide range of investors © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 17  7.4 Multifactor Models and CAPM Multifactor models Models of security returns that respond to several systematic factors Two-index portfolio in realized returns Two-factor SML © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 18  7.4 Multifactor Models and CAPM Fama-French Three-Factor Model Estimation results Three aspects of successful specification Higher adjusted R-square Lower residual SD Smaller value of alpha © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 19  Table 7.2 Single & Multifactor Models © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 20  7.5 Arbitrage Pricing Theory Arbitrage Relative mispricing creates riskless profit Arbitrage Pricing Theory (APT) Risk-return relationships from no-arbitrage considerations in large capital markets Well-diversified portfolio Nonsystematic risk is negligible Arbitrage portfolio Positive return, zero-net-investment, risk-free portfolio © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 21  7.5 Arbitrage Pricing Theory Calculating APT rP rf   P (rM  rf )  eP Returns on well-diversified portfolio E (rP ) rf   P [ E (rM )  rf ] © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 22  Figure 7.3 Scatter diagram for Intel © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 23  Figure 7.4 Security Characteristic Lines © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 24  7.5 Arbitrage Pricing Theory Multifactor Generalization of APT and CAPM Factor portfolio Well-diversified portfolio constructed to have beta of 1.0 on one factor and beta of zero on any other factor Two-Factor Model for APT Ri  i   i1 RM 1   i 2 RM 2  ei © McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 25