Bodie, Kane, and Marcus Essentials of Investments 12e Chapter 7 PDF

Chapter 7 CAPM and APT Bodie, Kane, and Marcus Essentials of Investments 12th Edition  7.1 The Capital Asset Pricing Model Capital Asset Pricing Model (CAPM) Security’s required rate of return relates to systematic risk measured by bet...

Chapter 7 CAPM and APT Bodie, Kane, and Marcus Essentials of Investments 12th Edition  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 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 2  Table 7.1 The Capital Asset Pricing Model: Assumptions Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 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 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 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 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 5  Figure 7.1 Efficient Frontier and Capital Market Line Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 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? Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 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 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 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 ] Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 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) Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 10  Figure 7.2 The SML and a Positive-Alpha Stock Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 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 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 12  7.2 CAPM and Index Models Index Model, Realized Returns, Mean-Beta Equation 𝑟𝑖𝑡 − 𝑟𝑓𝑡 = 𝛼𝑖 + 𝛽𝑖 𝑟𝑀𝑡 − 𝑟𝑓𝑡 + 𝑒𝑖𝑡 𝑟𝑖𝑡 : HPR i: Asset t: Period 𝛼𝑖 : Intercept of security characteristic line 𝛽𝑖 : Slope of security characteristic line 𝑟𝑀 : Index return 𝑒𝑖𝑡 : Firm-specific effects 𝐸 𝑟𝑖𝑡 − 𝑟𝑓𝑡 = 𝛼𝑖 + β𝑖 [𝐸 𝑟𝑀𝑡 − 𝑟𝑓𝑡 ] Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 13  7.2 CAPM and Index Models Estimating Index Model 𝑅𝐺𝑡 = α𝐺 + β𝐺 𝑅𝑀𝑡 + 𝑒𝐺𝑡 𝑅𝐺 = 𝑟𝐺 − 𝑟𝑓 , excess return Residual = Actual return − Predicted return for Google 𝑒𝐺𝑡 = 𝑅𝐺𝑡 − (α𝐺 + β𝐺 𝑅𝑀𝑡 ) Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 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 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 15  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 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 16  7.4 Multifactor Models and CAPM Multifactor models Models of security returns that respond to several systematic factors Two-index portfolio in realized returns 𝑅𝑖𝑡 = α𝑖 + β𝑖𝑀 𝑅𝑀𝑡 + β𝑖𝑇𝐵 𝑅𝑇𝐵𝑡 + 𝑒𝑖𝑡 Two-factor SML 𝐸 𝑟𝑖 = 𝑟𝑓 + β𝑖𝑀 𝐸 𝑟𝑀 − 𝑟𝑓 + β𝑖𝑇𝐵 [𝐸 𝑟𝑇𝐵 − 𝑟𝑓 ] Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 17  7.4 Multifactor Models and CAPM Fama-French Three-Factor Model 𝑟𝐺 − 𝑟𝑓 = α𝐺 + β𝑀 𝑟𝑀 − 𝑟𝑓 + β𝐻𝑀𝐿 𝑟𝐻𝑀𝐿 + β𝑆𝑀𝐵 𝑟𝑆𝑀𝐵 + 𝑒𝐺 Estimation results Three aspects of successful specification Higher adjusted R-square Lower residual SD Smaller value of alpha Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 18  Table 7.2 Single & Multifactor Models Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 19  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 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 20  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 ] Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 21  Figure 7.3 Scatter diagram for Intel Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 22  Figure 7.4 Security Characteristic Lines Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 23  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 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 24