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- Risk & Return
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Expectations of (i) Return, (ii) Risk (iii) liquidity are central elements in the dd for assets. Expectations of inflation have a major impact on bond prices Expectations about the likelihood of default are the most important factor that determines the risk structure of interest rates. Expectations of future short term interest rates play a crucial role in determining the term of interest rates.

Efficient market Hypothesis helps to understand how expectations are formed so as to understand how securities prices mover over time. Q. Why changes in stock prices are unpredictable and why tips of stock brokers may not be a good idea?

An efficient capital market is a market that is efficient in processing information. We are talking about an informationally efficient market, as opposed to a transactionally efficient market. In other words, we mean that the market quickly and correctly adjusts to new information. In an informationally efficient market, the prices of securities observed at any time are based on correct evaluation of all information available at that time. Therefore, in an efficient market, prices immediately and fully reflect available information.

The Efficient Markets Hypothesis (EMH) is made up of three progressively stronger forms:

Weak Form (incorporate information about past prices) Semi-strong Form (incorporate all publicly available information) Strong Form (all information, including inside information)

In this diagram, the circles represent the amount of information that each form of the EMH includes. Note that the weak form covers the least amount of information, and the strong form covers all information. Also note that each successive form includes the previous ones.

All historical prices and returns

Strong Form Semi-Strong

Weak Form

The weak form of the EMH says that past prices, volume, and other market statistics provide no information that can be used to predict future prices. If stock price changes are random, then past prices cannot be used to forecast future prices. Price changes should be random because it is information that drives these changes, and information arrives randomly. Prices should change very quickly and to the correct level when new information arrives . Most research supports the notion that the markets are weak form efficient.

The semi-strong form says that prices fully reflect all publicly available information and expectations about the future. This suggests that prices adjust very rapidly to new information, and that old information cannot be used to earn superior returns. Most studies find that the markets are reasonably efficient in this sense, but the evidence is somewhat mixed.

The strong form says that prices fully reflect all information, whether publicly available or not. Most studies have found that the markets are not efficient in this sense.

Weak form is supported, so technical analysis cannot consistently outperform the market. (Serial corrrelations) Semi-strong form is mostly supported , so fundamental analysis cannot consistently outperform the market. Strong form is generally not supported. If you have secret (insider) information, you CAN use it to earn excess returns on a consistent basis. Ultimately, most believe that the market is very efficient, though not perfectly efficient. It is unlikely that any system of analysis could consistently and significantly beat the market (adjusted for costs and risk) over the long run.

EMH states that prices of securities in financial markets fully reflect all available information. What does it mean? We know that R = (Pt+1 Pt +C)/Pt (1) Here, R is the rate of return on security held between t and t+1, Pt+1 is the price of security at t+1, end of the holding period. Pt is the price of security at t, beginning of the holding period. C is the cash payments (coupon/ dividend) made during the period.

Here, Pt and C are known. Only uncertain variable is the Pt+1. Suppose, Pet+1 is the expectation of the security price at the end of the holding period. (2) Now, Re = (Pet+1 Pt +C)/Pt EMH expectations as equal to optimal forecasts using all available information . Optimal forecast Best guess of the future using all available information. It does not mean that forecast is perfect, but only the best possible.

EMH Pet+1 = Pot+1 Re = Ro (3) However, we cannot observe either Re or Pet+1, Above equations themselves cannot tell us much about how the market behaves. Calls for devising some way to measure the value of Re leads to important implications for how prices of securities change in financial markets.

Example of Bond Market: DD-SS analysis of the bond market shows that expected return on a security (interest rate in a case of a bond) equilibrium return equates dd (bond) = ss (bond) i.e Re (exp) = R* (eqm.) (4) We determine eqm. return and thus determine expected return with the eqm. condition.

Substitute Re with R* in eqn (3): R* = Ro (4) Behaviour of pricing in efficient markets follows (4).

(4) Current

prices in a financial market will be set so that the optimal forecast of a securitys return using all available information equals the securitys equilibrium return A securitys price fully reflects all available information in an efficient market.

Why efficient market hypothesis makes sense If Rof > R* Pt Rof If Rof < R* Pt Rof

Until Rof = R*

All unexploited profit opportunities eliminated Efficient market condition holds even if there are uninformed, irrational participants in market

When an unexploited profit opportunity arises on a security (so-called because, on average, people would be earning more than they should, given the characteristics of that security), investors will rush to buy until the price rises to the point that the returns are normal again. Investors do not leave $5 bills lying on the sidewalk.

Rational investors use diversification to optimize their portfolios Diversification reduces portfolio risk

are not perfectly correlated) Efficient Portfolio

(assets that

What is it?

An hypothesis by Professor William Sharpe (1964) How to measure risk and what is the relation between risk and expected return. Hypothesizes that investors require higher rates of return for greater levels of relevant risk. There are no prices on the model, instead it hypothesizes the relationship between risk and return for individual securities. It is often used, however, the price securities and investments.

What is it?

CAPM is built on the model of portfolio choice of Harry Markoitwz (1959): Investors select a portfolio at t-1 that produces a stochastic return at t. Investors are risk averse and only concerned with mean and variance of the one-period return. Investors choose mean-variance efficient portfolio mean-variance model.

The CAPM turns this algebraic statement into a testable prediction about the relation between risk and expected return by identifying a portfolio that must be efficient if asset prices are to clear the market of all assets.

Sharpe (1964) and Lintner (1965) add two key assumptions to the Markowitz model to identify a portfolio that must be meanvariance-efficient. The first assumption is complete agreement (All investors have homogenous beliefs ): given market clearing asset prices at t-1, investors agree on the joint distribution of asset returns from t-1 to t. (Suppose that X and Y are two random variables. The joint (cumulative) distribution function of X and Y : F(x; y) = P(X x; Y y); (x; y) R.) The second assumption that there is borrowing and lending at a riskfree rate, which is the same for all investors and does not depend on the amount borrowed or lent.

Given that

some risk can be diversified, diversification is easy and costless, rational investors diversify,

There should be no premium associated with diversifiable risk. The question becomes: What is the equilibrium relation between systematic risk and expected return in the capital markets? The CAPM is the best-known and most-widely used equilibrium model of the risk/return (systematic risk/return) relation.

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.

Systematic risk results from political factors, wars, interest rate, economic crashes, and recessions, changes in taxation, natural disasters, and foreigninvestment policy. These risks are widespread as they can affect any investment or any organization. They affect the complete market and are unavoidable through diversification. Unsystematic risk: Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through appropriate diversification. unsystematic risk affects quite a particular group of securities or even an individual security. Ex. For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares, is considered to be unsystematic risk.

Standard deviation includes systematic and unsystematic risk; not used because unsystematic risk diversified away. Beta: A standardized measure of the risk of an individual asset, one that captures only the systematic component of its volatility; measures how sensitive an individual security is to market movements; measure of market risk.

Assumptions

1. All investors have identical expectations about expected returns, standard deviations, and correlation coefficients for all securities. 2. All investors have the same one-period investment time horizon. 3. All investors can borrow or lend money at the risk-free rate of return (RF). 4. There are no transaction costs. 5. There are no personal income taxes so that investors are indifferent between capital gains an dividends. 6. There are many investors, and no single investor can affect the price of a stock through his or her buying and selling decisions. Therefore, investors are price-takers. 7. Capital markets are in equilibrium.

The assumptions have the following implications:

1. The optimal risky portfolio is the one that is tangent to the efficient frontier on a line that is drawn from RF. This portfolio will be the same for all investors. 2. This optimal risky portfolio will be the market portfolio (M) which contains all risky securities.

9 - 27

SML represents the relationship between expected return and market risk; shows expected return of an overall market as a function of systematic risk. The market risk premium is determined from the slope of the SML. All the correctly priced securities are plotted on the SML. The assets above the line are undervalued because for a given amount of risk (beta), they yield a higher expected return.

SML =

Individual securities are plotted on the SML graph. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for its risk. (a) If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk.

(b) If a securitys risk versus expected return is plotted below the SMLsecurity is overvalued because the investor would be accepting less return for the amount of risk assumed.

The Y-intercept of the SML is equal to the risk-free interest rate. The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time: Market price of any asset is such that its expected return is just enough to compensate its investors to rationally hold it. Market Price of risk = [E(RM)-Rf]

The expected return on a specific asset equals the risk-free rate plus a premium that depends on the assets beta and the expected risk premium on the market portfolio.

Expected return of specific asset: E(Ri) Risk-free rate: Rf Expected risk premium: E(Rm) - Rf

CAPM

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.

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]

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

E(Ri)

E(RM) Rf

slope = [E(RM) - Rf] = Eqm. Price of risk

bM

b = [COV(Ri, RM)/Var(RM)]

CONDITION 1: Individual investors equilibrium: Max U

Assume: [1] Market is frictionless => borrowing rate = lending rate => linear efficient set in the return-risk space [2] Anyone can borrow or lend unlimited amount at risk-free rate [3] All investors have homogenous beliefs => they perceive identical distribution of expected returns on ALL assets => thus, they all perceive the SAME linear efficient set (we called the line: SECURITY MARKET LINE => the tangency point between SML and investors efficient set of risky asset is the MARKET PORTFOLIO.

CONDITION 1: Individual investors equilibrium: Max U

E(Rp)

B

E(RM)

A Rf

Market Portfolio

A combination of assets, i.e. a portfolio, is referred to as "efficient" if it has the best possible expected level of return for its level of risk (usually proxied by the standard deviation of the portfolio's return). Here, every possible combination of risky assets, without including any holdings of the risk-free asset, can be plotted in risk-expected return space, and the collection of all such possible portfolios defines a region in this space. The upward-sloped (positively-sloped) part of the left boundary of this region, a hyperbola, is then called the "efficient frontier that offers the highest expected return for a given level of risk, and lies at the top of the opportunity set or the feasible set.

Every investor holds exactly the same optimal portfolio of risky assets E(r)

SML 3 CAL 2

CAL 1 E Intuition : the optimal solution is the SML with the maximum slope

37

CONDITION 2: Demand = Supply for ALL risky assets

Remember expected return is a function of price. Market price of any asset is such that its expected return is just enough to compensate its investors to rationally hold it.

CONDITION 3: Equilibrium weight of any risky assets The Market portfolio consists of all risky assets. Market value of any asset i (Vi) = PixQi Market portfolio has a value of iVi Market portfolio has N risky assets, each with a weight of wi Such that wi = Vi / iVi for all i

CONDITION 4: Aggregate borrowing = Aggregate lending Risk-free rate is not exogenously given, but is determined by equating aggregate borrowing and aggregate lending.

Two-Fund Separation:

Given the assumptions of frictionless market, unlimited lending and borrowing, homogenous beliefs, and if the above 4 equilibrium conditions are satisfied, we then have the 2-fund separation. TWO-FUND SEPARATION: Each investor will have a utility-maximizing portfolio that is a combination of the risk-free asset and a portfolio (or fund) of risky assets that is determined by the Capital market line tangent to the investors efficient set of risky assets (IC) An optimal portfolio displays the lowest possible level of risk for its level of return. Additionally, since each additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio must comprise every asset. All such optimal portfolios, i.e., one for each level of return, comprise the efficient frontier.

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