CAPM Risk Review

Risk - possibility that returns will be less than (greater than) those expected Measures of Risk o Total Risk Variability of returns on an investment in the firm A measure of risk stated in absolute terms (2 or ) A measure of risk state in relative (scaled) terms (CoV) where CoV = coefficient of variation (/expected value) If public firm - variability of stock returns If private return - variability of generated cash flows o Unsystematic Risk - Firm Specific Risk Diversifiable Risk A portion of Total risk that is considered unsystematic and is diversifiable through a Portfolio Effect that arises because returns across firms is less than perfectly positively correlated. With the assumption that investors are fully diversified, this risk disappears (is diversified away) and all that remains is non-diversifiable, or Systematic Risk. o Systematic risk Market Risk Non-diversifiable Risk A portion of Total Risk associated with the market where market risk is the economy wide risk that is inescapable. Conclusion: Systematic Risk represents the contribution to portfolio risk and, assuming that the typical investor is well diversified, is the only risk that is relevant to the investor. One systematic measure of risk is the CAPM Beta () Sometimes proxied by single index market model beta (b) Another could be a vector of betas in APT model
UNSYSTEMATIC RISK = FIRM-SPECIFIC RISK = DIVERSIFIABLE RISK SYSTEMATIC RISK = MARKET RISK = NON-DIVERSIFIABLE RISK

CAPITAL ASSET PRICING MODEL

Essentially a utility based valuation model that posits a linear relationship between the returns of an asset and the market risk premium. CAPM Beta Measure of systematic risk Standardized covariance between the individual security return and the market return Measures the sensitivity of a change in the return on a single security to the change in the market risk premium (and return of the market portfolio). Relates the required return on a stock to the risk free return and a market risk premium. Rj = Rf + Bj ( Rm - Rf ) Where: Rj Rf Bj Rm = required rate of return on stock j = risk free return = CAPM Beta coefficient for Stock j = Return on the market portfolio

Advantages: o Beta relates individual stock return to overall market return o Beta > 1 then individual return more volatile than market Stock has greater systematic risk o Beta = 1 then individual return volatility same as the market Systematic risk of stock same as overall market risk o Beta < 1 then individual return less volatile than the market Stock has lower systematic risk o Beta measures calculated and published by different financial companies S&P, Value Line o Beta of portfolio is weighted average of Betas of all stocks in portfolio

CAPITAL ASSET PRICING MODEL (cont.)

Assumes: o Particular investor utility function o Markets efficient and perfect o Rational investors o Single factor drives returns (market risk premium) o Linear relationship between stock return and market risk premium o Systematic Risk is only relevant risk Investors are well diversified o CAPM Beta is systematic risk measure Limitations: o Markets are really inefficient and imperfect o All investors are not well diversified o Disagreement over proper risk free return proxy o Disagreement over time period to estimate Beta o Disagreement over market portfolio proxy o Only focuses on single factor o Beta may shift over time o Beta calculation sensitive to historical time period used

ARBITRAGE PRICING MODEL

Essentially an arbitrage based valuation model that posits a multi-linear relationship between the returns of an asset and the returns of a set of multiple unknown economic factors. APM betas Measures of unknown economic factors driving asset returns Standardized covariances between the individual security return and the unknown factor values Measures the sensitivity of a change in the return on a single security to the changes in the set of factors included in the model. Relates the required return on a stock to an unspecified intercept term and a set of multiple unknown economic factors.
m

E(Rj) = 0 + ( Bij * Fi )
i=1

Where: E(Rj) 0 Bij Fi

= expected rate of asset j = a constant intercept term that is unspecified = APM sensitivity of asset j to factor i = Unknown Factor i of multiple (m) unknown factors

Advantages: o More general pricing model o Sensitivities relate individual asset return to multiple economic factors o Multiple economic factors, not just market risk premium Inflation Interest rates Economic growth Industry effects Market risk premium Exchange Rates ??? o Intercept term not specified o Does not require utility assumption o Relies on arbitrage for derivation o Does not require efficient and perfect markets as long as some arbitragers exist

ARBITRAGE PRICING MODEL (cont.)

Assumes: o Arbitrage activities force pricing relationship o Multiple unknown factors drives returns o Linear relationship between stock return factors Limitations: o Model does not specify what the factors are o Factors may differ for different assets o Disagreement over identification of factors o Disagreement over time period to estimate sensitivities o Sensitivities may shift over time o Sensitivity calculation may be affected by historical time period used

Comparison Chart Between CAPM and APM CAPM Capital Asset Pricing Model
utility based valuation model that posits a linear relationship between the returns of an asset and the market risk premium
Utility based derivation Single factor Single factor = market risk premium Intercept term = risk free rate Requires perfect markets for derivation Requires well diversified investors for derivation Theoretical model specifies CAPM Beta as single systematic risk measure

APM Arbitrage Pricing Model

arbitrage based valuation model that posits a multilinear relationship between the returns of an asset and the values of a set of multiple unknown economic factors Arbitrage based derivation Multi-factor Multiple factors = not defined Intercept term = not defined Requires only arbitrage for derivation Requires only arbitrage for derivation Theoretical model specifies unknown set of sensitivities to unknown economic factors