essentials investment

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essentials investment

© All Rights Reserved

Als PDF, TXT **herunterladen** oder online auf Scribd lesen

- Multifactor Models Questions
- Capital Asset Pricing Model
- Ch11 End of Chapter Questions
- Capm Derivation
- Lesson 5
- Security Analysis
- The Capital Asset Pricing Model and the Arbitrage
- Notes Asset Pricing Cochrane Incomplete
- IPOM
- Peirson Business Finance10e PowerPoint 07
- F1 NOTES 2
- Michel Aglietta, Antoine Reberioux - Corporate Governance Adrift_ a Critique of Shareholder Value (Saint-Gobain Centre for Economic Studies) (2005)
- methodology to approve maximum prices for piped gas
- Development and Assessment of an Alternative Investment Product
- Equity bond valuation.pptx
- 101127_APT
- Pubblicazione Energy 2015_ENG-Def
- What is the right price for carbon.pdf
- Multiple_Choice_Questions_and_AnswersCap20160822-6407-y302nv.pdf
- Return and Risk Analysis Sagar Reddy Raju Rathipelli

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Models

Business Finance 722

Investment Management

Professor Karl B. Diether

The Ohio State University

Fisher College of Business

In the last few lectures we have considered how an investor

should allocate her wealth between different assets.

To solve the allocation problem we made some assumptions.

1. Utility maximization.

2. The investor likes expected return and dislikes variance.

3. Securities are infinitely divisible.

4. A frictionless financial market (borrow and sell at the

riskfree rate, and costless to short-sell).

5. The investor takes prices as given.

6. The investor knows the expected return vector and

covariance matrix of all the securities they can invest in.

The CAPM & Multifactor Models

u What do you think of these assumptions?

u Are they realistic?

u Are they too strong?

Given our assumptions what kind of portfolio does an investor

choose?

u The investor chooses a mean variance efficient portfolio.

u A portfolio that for a given level of standard deviation has

portfolios.

E(r)

riskfree rate

(r)

The CAPM & Multifactor Models

An investor allocates her money between the tangency

portfolio and the riskfree asset.

u The efficient frontier is the CAL line between the riskfree

How should we measure risk in this framework?

u For the portfolio you own?

u For a portfolio you dont own?

u For the security level?

The tangency portfolio has the highest Sharpe ratio for a

portfolio of just risky assets:

SR =

E(rT ) r f

(rT )

E(ri) r f

E(r j ) r f

=

for all i and j

cov(ri, rT ) cov(r j , rT )

Implications:

u We find the tangency portfolio by picking the weights so the

u The condition holds for all individual securities and for all

The CAPM & Multifactor Models

Since risk premium to covariance ratio equality holds for all

assets, it must also hold for itself.

E(rT ) r f

E(ri) r f

=

cov(ri, rT ) cov(rT , rT )

But remember that cov(rT , rT ) = 2(rT ). Therefore,

E(ri) r f

E(rT ) r f

=

cov(ri, rT )

2(rT )

We can use the above expression to derive a relation between

an assets expected return and risk.

E(ri) r f

E(rT ) r f

=

cov(ri, rT )

2(rT )

E(rT ) r f

E(ri) r f = cov(ri, rT ) 2

(rT )

cov(ri, rT )

E(ri) = r f +

[E(rT ) r f ]

2(rT )

How much an asset covaries with tangency portfolio

determines how risky the asset is.

cov(ri, rT )

2(rT )

Typically people call cov(ri, rT )/ 2(rT ), Beta ( ).

The CAPM & Multifactor Models

The relation between expected return and risk with the

tangency portfolio is typically written as,

cov(ri, rT )

2(rT )

iT .

The relation between expected return and iT is linear.

u The riskfree rate is the y-intercept.

u The risk premium of the tangency portfolio is the slope.

E(ri)

E(rT) - rf

rf

iT

The CAPM & Multifactor Models

10

Mean variance mathematics implies that,

cov(ri, rT )

2(rT )

u Why cant we use this practically to estimate expected

return or risk?

u What is missing or lacking?

11

How do we identify the tangency portfolio (i.e., find the

weights)?

u If we make one more assumption, then economic theory

u When I say identify, I mean economic theory will tell us

Identifying the weights of the tangency portfolio:

u So far we have discussed the relation between risk and

u However, inorder to identify the tangency portfolio, we need

The CAPM & Multifactor Models

12

Assumption: Investors all make the same forecasts of

expected returns, variances, and covariances.

u This is often called complete agreement.

u Very strong assumption that is almost certainly not true.

u Why make an assumption that we know doesnt hold? Isnt

that silly?

Implication: M = T:

u In equilibrium, prices must be set so that the market

13

The portfolio of all risky assets where the assets are held in

proportion to their market value. The return on such a portfolio

is,

n

rM = viri

i

where

vi =

total dollar value of all assets

14

Market Equilibrium

Complete agreement and M = T:

u Given the assumption what can we say about investors

portfolio choices?

u How are their allocations different from each other?

u What is the commonality across different investors

holdings?

u Why does this assumption imply that M=T?

15

Finally

Finally, we have identified the tangency portfolio (after we

made a few assumptions).

Prices must be set so that the market portfolio (M) is the

tangency portfolio.

u The market portfolio contains all assets we can invest in:

u The good thing is we know the weights of the market

portfolio:

l

today divided by the total value of all securities.

16

E(r)

CML

riskfree rate

(r)

The CAPM & Multifactor Models

17

The CAPM

Since the market portfolio (M) is the tangency portfolio, mean

variance mathematics implies the following:

cov(ri, rM )

2(rM )

The CAPM is a model where prices are set so that the market

portfolio is the tangency portfolio.

In the CAPM, iM is the measure of risk.

u There is a linear relation between expected return and

iM .

The CAPM & Multifactor Models

18

E(ri)

E(rM) - rf

rf

iM

The CAPM & Multifactor Models

19

Some Examples

Q: Suppose the risk free rate is 5%, and the expected return

on the market portfolio is 11%, the standard deviation 20%,

and the covariance of IBM with the market is 0.05. What is

IBMs beta and expected return?

cov(ribm, rM )

2(rM )

0.05

= 1.25

=

0.202

ibmM =

= 0.05 + 1.25(0.11 0.05)

= 12.5%

20

Some Examples

Q: Suppose the risk free rate is 4%, the expected return on the

market portfolio is 12%, and its standard deviation is 20%.

Stock Z has a standard deviation of 50%, but is uncorrelated

with the market. What is Zs beta and expected return?

cov(rz, rM )

2(rM )

0.00

=

=0

0.202

E(rz) = r f + zM [E(rM ) r f ]

= 0.04 + 0(0.12 0.04) = 4%

zM =

expected return is the riskfree rate.

21

Some Examples

Q: You invest 20% percent of your money in T-bills, and 80%

percent in the market portfolio. What is the beta of your

portfolio?

Statistical Fact: The beta of a portfolio is the weighted sum of

the component assets betas.

n

pM = wiiM

i=1

pM = 0.2 f M + 0.8MM

= 0.2 cov(r f , rM )/ 2(rM ) + 0.8 cov(rM , rM )/ 2(rM )

= 0 + 0.8 2(rM )/ 2(rM ) = 0.8

The CAPM & Multifactor Models

22

CAPM Intuition

High beta stocks are risky, and therefore investors will only buy

them if they offer higher returns on average.

Why are high beta stocks risky?

u High beta stocks tend to have good returns when when the

u High beta stocks tend to have poor returns when the

u If something is risky, then it is undesirable. You must be

beta stocks?

23

Other Models

The CAPM is a model.

u No model is perfect.

u We will find that the CAPM has some significant

weaknesses.

Other Models

u We need to consider other models if the CAPM is an

empirical failure.

u All our other models will build on the economic theory and

24

Factor: A variable that explains why a group of stocks have

returns that tend to move together.

u Put another way: a variable that helps explain common

A priced factor is a variable which helps explain the expected

returns of assets.

u Put another way: a variable that helps explain common

helps explain expected returns.

u We usually think of a priced factor in the context of a

The CAPM & Multifactor Models

25

Q: What is the only priced factor in the CAPM?

A: The excess return on the market is the only priced factor in

the CAPM.

E(rit ) r f t = iM [E(rMt ) r f t ]

u Stocks have high expected returns if they have high

u However, maybe one factor is not enough?

26

Q: Are there factors in security returns?

Everyone believes there are factors in security returns.

Controversy: Can we identify rational factors that explain the

cross-section of expected returns.

u Every one agrees that the excess return on the market

portfolio is a factor

u Debate: is that enough or are there other factors?

27

Types of Factors

Factors can be tradeable portfolios.

u They must be zero cost portfolios (weights add up to zero).

u For example, in the CAPM the portfolio is 100% in the

Factors can also be non-tradeable variables such as

macro-economic variables.

u Maybe GDP growth.

u Maybe unexpected inflation.

We will focus on the case where the factors are zero cost

portfolios.

The CAPM & Multifactor Models

28

A zero cost portfolio is a portfolio where the weights add up

to zero.

Usually we put zero cost portfolios in units such that the

positive weights add up to 100% and the negative weights add

up to -100%.

u Example: You go long IBM 100% and short T-bills 100%.

l

l

29

Zero cost portfolios are also called self financing portfolios.

u If the market is frictionless then a zero-cost portfolio is free.

u It requires no capital outlay.

or a differential return.

30

Multifactor Models

In general multifactor models will look like the following:

K

E(r p) r f =

p jE(Fj)

j=1

or portfolio is due entirely to factor loadings and factor risk

premia.

u Factor loadings:

p1, p2, . . ., pK

Pricing Theory (APT) models.

31

Suppose you believe that there are two priced risk factors:

u The excess return on the market portfolio.

u A crime factor.

How about the following?

No, the factors should be zero cost portfolios.

32

Solution: make the crime factor a zero cost portfolio.

We can just form a portfolio of securities that benefit from high

crime (gun companies, etc). Call the portfolio G.

Also form a portfolio of stocks that are hurt by high crime

(jewelry stores, etc). Call the portfolio J.

The crime factor as a zero cost portfolio is,

rg r j

and the multifactor model is,

33

A priced or risk factor is a variable which helps explain the

expected returns of assets.

u Risk factors are linked to investor happiness (marginal

u The excess return on the market will always be a risk factor

u If the market excess return is a risk factor, what does this

34

Investors dont like crime; it makes them less happy.

Suppose there is a crime factor in stock returns.

u If crime goes up, then companies that produce alarms,

guns, locks and security guards will see their returns go up.

u Returns go down for luxury car and jewelry companies.

u A stock that pays off more money when crime is high is

happy.

u A stock that has low returns during high crime is

unhappy.

u The crime factor will have low expected returns.

The CAPM & Multifactor Models

35

Factors reflect common movement in security returns.

u Priced factors should explain expected returns for

u Figuring out the correct priced factors is difficult, and there

is no general consensus.

u Risk and reward usually go together. If you want high

and poorly in bad times.

36

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