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Introduction
Asset Pricing how assets are priced? Equilibrium concept Portfolio Theory ANY individual investors optimal selection of portfolio (partial equilibrium) CAPM equilibrium of ALL individual investors (and asset suppliers) (general equilibrium)
Our expectation
Risky asset i: Its price is such that:
E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i)
CAPM tells us 1) what is the price of risk? 2) what is the risk of asset i?
An example to motivate
Expected Return Standard Deviation
Asset i
Asset j
10.9%
5.4%
4.45%
7.25%
E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i) Question: According to the above equation, given that asset j has higher risk relative to asset i, why wouldnt asset j has higher expected return as well? Possible Answers: (1) the equation, as intuitive as it is, is completely wrong. (2) the equation is right. But market price of risk is different for different assets. (3) the equation is right. But quantity of risk of any risky asset is not equal to the standard deviation of its return.
CAPMs Answers
E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i)
The intuitive equation is right. The equilibrium price of risk is the same across all marketable assets In the equation, the quantity of risk of any asset, however, is only PART of the total risk (s.d) of the asset.
CAPMs Answers
Specifically: Total risk = systematic risk + unsystematic risk CAPM says: (1)Unsystematic risk can be diversified away. Since there is no free lunch, if there is something you bear but can be avoided by diversifying at NO cost, the market will not reward the holder of unsystematic risk at all. (2)Systematic risk cannot be diversified away without cost. In other words, investors need to be compensated by a certain risk premium for bearing systematic risk.
CAPM results
E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i)
Precisely: [1] Expected Return on asset i = E(Ri) [2] Equilibrium Risk-free rate of return = Rf [3] Quantity of risk of asset i = COV(Ri, RM)/Var(RM) [4] Market Price of risk = [E(RM)-Rf]
Thus, the equation known as the Capital Asset Pricing Model: E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)] Where [COV(Ri, RM)/Var(RM)] is also known as BETA of asset I Or E(Ri) = Rf + [E(RM)-Rf] x i
Rf
bM= 1.0
b=
[COV(Ri, RM)/Var(RM)]
E(Rp)
B Q
E(RM)
A
Rf
Market Portfolio
E(Rp)
B Q
E(RM)
A
Rf
Market Portfolio
Efficient set
P Endowment Point
Efficient set
P M Endowment Point Rf
p
CAPM
2 sets of Assumptions: [1] Perfect market:
Frictionless, and perfect information No imperfections like tax, regulations, restrictions to short selling All assets are publicly traded and perfectly divisible Perfect competition everyone is a price-taker
[2] Investors:
Same one-period horizon Rational, and maximize expected utility over a meanvariance space Homogenous beliefs
Derivation of CAPM
Using equilibrium condition 3
wi = Vi / iVi for all i
wi =
market value of individual assets (asset i) -----------------------------------------------market value of all assets (market portfolio)
Consider the following portfolio: hold a% in asset i and (1-a%) in the market portfolio
Derivation of CAPM
The expected return and standard deviation of such a portfolio can be written as: E(Rp) = aE(Ri) + (1-a)E(Rm) (Rp) = [ a2i2 + (1-a)2m2 + 2a (1-a) im ] 1/2 Since the market portfolio already contains asset i and, most importantly, the equilibrium value weight is wi therefore, the percent a in the above equations represent excess demands for a risky asset We know from equilibrium condition 2 that in equilibrium, Demand = Supply for all asset. Therefore, a = 0 has to be true in equilibrium.
Derivation of CAPM
E(Rp) = aE(Ri) + (1-a)E(Rm) (Rp) = [ a2i2 + (1-a)2m2 + 2a (1-a) im ] 1/2
Consider the change in the mean and standard deviation with respect to the percentage change in the portfolio invested in asset i
E( R p ) = E( Ri ) - E( Rm ) a
( Rp ) 1 2 2 2 = [ a 2 i2 + (1 - a )2 m + 2a(1 - a) im ] -1/2 * [ 2a i2 - 2 m + 2a m + 2 im - 4a im ] a 2
(evaluated at a = 0) (evaluated at a = 0)
Derivation of CAPM
the slope of the risk return trade-off evaluated at point M in market equilibrium is E( R )/a E( R ) - E( R ) = (evaluated at a = 0) ( R )/a -
p i m p im 2 m
but we know that the slope of the opportunity set at point M must also equal the slope of the capital market line. The slope of the capital market line is
E( R m ) - R f
Therefore, setting the slope of the opportunity set equal to the slope of the capital market line
E( Rm ) - R f E( Ri ) - E( Rm ) = 2 ( im - m ) / m m
rearranging,
E( Ri ) = R f + im [E( Rm ) - R f ] 2
Derivation of CAPM
From previous page Rearranging
E( Ri ) = R f + im [E( Rm ) - R f ] 2
E( Ri ) = R f + [E( Rm ) - R f ] b i
CAPM Equation
Where
Ri R m = b i = im 2 VAR( Rm ) m COV( , )
Rf
bM= 1.0
b=
[COV(Ri, RM)/Var(RM)]
Properties of CAPM
In equilibrium, every asset must be priced so that its riskadjusted required rate of return falls exactly on the security market line. Total Risk = Systematic Risk + Unsystematic Risk Systematic Risk a measure of how the asset co-varies with the entire economy (cannot be diversified away) e.g., interest rate, business cycle Unsystematic Risk idiosyncratic shocks specific to asset i, (can be diversified away) e.g., loss of key contract, death of CEO CAPM quantifies the systematic risk of any asset as its Expected return of any risky asset depends linearly on its exposure to the market (systematic) risk, measured by . Assets with a higher require a higher risk-adjusted rate of return. In other words, in market equilibrium, investors are only rewarded for bearing the market risk.
Use of CAPM
For valuation of risky assets