MODELS FOR THE PRICING OF ASSETS

CHAPTER 9

9-2

CAPM Assumptions
All investors: Use the same information to generate an efficient frontier Have the same one-period time horizon Can borrow or lend money at the risk-free rate of return No transaction costs, no

personal income taxes, no inflation No single investor can affect the price of a stock Capital markets are in equilibrium

Risk-Free Lending
Riskless assets can be

E(R) Z RF A X

combined with any portfolio in the efficient set B AB Set of portfolios on line RF to T dominates all portfolios below it

Risk
9-3

9-4

Borrowing Possibilities
Investor no longer restricted to own wealth

Interest paid on borrowed money Higher returns sought to cover expense Assume borrowing at RF
Risk will increase as the amount of borrowing increases Financial leverage

9-5

The New Efficient Set

Risk-free investing and borrowing creates a new set of

expected return-risk possibilities Addition of risk-free asset results in

A change in the efficient set from an arc to a straight line tangent to the

feasible set without the riskless asset Chosen portfolio depends on investors risk-return preferences

9-6

Portfolio Choice
The more conservative the investor the more is placed in risk-free

lending and the less borrowing The more aggressive the investor the less is placed in risk-free lending and the more borrowing
Most aggressive investors would use leverage to invest more in portfolio T

9-7

Market Portfolio
Most important implication of the CAPM All investors hold the same optimal portfolio of risky assets The optimal portfolio is at the highest point of tangency between RF and the efficient frontier The portfolio of all risky assets is the optimal risky portfolio
Called the market portfolio

CML & SML

CML : equilibrium relationship between expected return and

risk for efficient portfolio SML : equilibrium relationship between expected return and systematic risk

Capital Market Line

L
E(RM) M
Line from RF to L is

y
RF x M Risk

capital market line (CML) y = risk premium = E(RM) - RF x = risk = M Slope = y/x = [E(RM) - RF]/M y-intercept = RF

9-9

9-10

The Separation Theorem

The investment decision (which risky portfolio to hold) is separate

from the financing decision (how to allocate investable funds between risk-free & risky assets) Pg. 238

Important points about CML

Consist of RF and M portfolio

Always upward sloping (ex ante)

Can be downward sloping (ex post) if return on RF assets >

return on market portofolio

9-12

Capital Market Line

Slope of the CML is the market price of risk for efficient

portfolios, or the equilibrium price of risk in the market Relationship between risk and expected return for portfolio P (Equation for CML):

E(RM ) RF E(R p ) RF p M

9-13

Security Market Line

Equation for expected return for an individual stock

E(Ri ) RF i E(RM ) RF
Beta measures systematic risk Measures relative risk compared to the market portfolio of all stocks Volatility different than market

Security Market Line

SML E(R) kM A B C
Beta = 1.0 implies as risky

as market Securities A and B are more risky than the market

Beta >1.0

kRF

Security C is less risky than

the market
0 0.5 1.0 1.5 BetaM 2.0
Beta <1.0

9-14

9-15

CAPMs Expected Return-Beta Relationship

Required rate of return on an asset (ki) is composed of risk-free rate (RF) risk premium (i [ E(RM) - RF ])
Market risk premium adjusted for specific security

ki = RF +i [ E(RM) - RF ]
The greater the systematic risk, the greater the required return

9-16

Arbitrage Pricing Theory

APT is not critically dependent on underlying market portfolio

as is the CAPM, which predicts than only market risks influences E(R) Based on the Law of One Price
Two otherwise identical assets cannot sell at different prices Equilibrium prices adjust to eliminate all arbitrage opportunities

Assumptions
CAPM Single period investment horizon Absence of taxes Borrowing and lending at rate of RF Investor selects portfolios on the basis of expected return and variance Investor have homogenous beliefs Investor are risk averse utility maximizers Markets are perfect Return are generated by a factor model APT 4 terakhir

9-18

Factor Models
Major factors in economy that affect large number of securities

APT assumes returns generated by a factor model

Factor Characteristics Each risk must have a pervasive influence on stock returns Risk factors must influence expected return and have nonzero prices Risk factors must be unpredictable to the market

9-19

APT Model
The expected return-risk relationship for the APT can be

described as: E(Ri) =RF +bi1 (risk premium for factor 1) +bi2 (risk premium for factor 2) + +bin (risk premium for factor n)

Soal UTS 2007/2008 (20 poin)

Berdasarkan teori portofolio Markowitz, jelaskan bagaimana proses penentuan portofolio investasi yang terdiri dari aset bebas risiko dan sejumlah aset berisiko. Bagaimana peran tingkat risk aversion investor dalam menentukan portofolio investasinya? Gunakan grafik. b. Berikut adalah informasi mengenai saham A dan B: Saham A Saham B Harga sekarang Rp 5.000 Rp 1.500 Estimasi harga tahun depan Rp 5.500 Rp 1.725 Estimasi pembayaran div. Rp 300 Rp 0 Beta 2 0,5 Tingkat bunga bebas risiko 7%, E(Rm) = 13%. Tentukan saham mana yang sebaiknya dibeli dan dijual.
a.