DBA4110: Finance Theory

Week 3: Asset Pricing Theories Click to edit Master subtitle style

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Contents

Elementary asset pricing theory History and theoretic development of the portfolio theory Separation theorem Capital Asset Pricing Model Arbitrage pricing theory

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Elementary Pricing Theory

Based on fundamental valuation of securities, the theory asserts that the value of an asset is determined as the present value of the cash flows expected from it; ascertained using a specific discount rate. The discount rate is expected to reflect the risk inherent in the generation of 5/13/12 cash flows by the asset.

Portfolio Analysis and Selection

The best combination of expected value of return and standard deviation depends on the investors utility function. Risk averse investors associate risk with divergence from the expected value of return in an indifference curve situation (upward).
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Portfolio choice
Investors want to hold the portfolio of securities that place them on the highest indifference curve, and will therefore choose it from the opportunity set of available portfolios. Markowitz mean-variance rule: Investors should choose a portfolio of securities that lie on the efficient 5/13/12 frontier.

Investment Opportunity Set

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Risk taking
Risk can be quantified as the sum of the variance of the returns over time. It is possible to assign a utility score (utility value, utility function) to any portfolio by subtracting its variance from its expected return to yield a number that would be commensurate with an investors 5/13/12 tolerance for risk, or a measure of their

Utility Score and risk taking

Utility Score = Expected Return 0.0052 x Risk Aversion Coefficient Risk aversion coefficient - a number proportionate to the amount of risk aversion of the investor and is usually set to integer values less than 6,
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Illustration
The t-bill rate is 8%, expected return on a portfolio is 16%, volatility is 25%. Determine if its viable for the investor to invest in the portfolio. Assume risk aversion coefficient of 2. Note: U = E(r) 0.05A2

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Risk Aversion

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Presence of a Risk Free Asset

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Separation Theorem
Individuals utility preferences independent or separate from optimal portfolio of risky assets. are the

The determination of an optimal portfolio of risky assets is independent of the individuals risk preferences. Two phases of investment;
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Optimal Combination with the Risk Free Asset

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Capital Asset Pricing Model

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Implies an equilibrium relationship between risks and returns for each security. In a market equilibrium, a security will be expected to provide a return commensurate with the unavoidable risk (cannot be avoided with diversification)
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CAPM Assumptions
1. 2. 3. 4.

Capital markets are efficient Absence of transaction costs Absence of taxes No investor is large enough to affect prices in the market Information symmetry

5.

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The Characteristic Line Security Market Line

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SML
Compares the expected return for an individual stock with the market portfolio. The greater the expected return for the market, the greater the expected excess return for the stock. Three measures;
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Alpha
The intercept of the characteristic line on the vertical axis. If the excess return of the market portfolio was zero, the alpha would be the expected excess return for the stock. The alpha for the individual stock = 0; in theory
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Beta

A measure of the systematic risk The slope of the SML Depicts the sensitivity of the securitys excess return to that of the market portfolio Historical betas should be adjusted most popular method of adjustment being the bayesian approach
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The adjustment considers the debt

Adjusted beta
The additional information is subjected to regression analysis or other statistical techniques to produce a weighting of the importance of the factor involved.

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CAPM
R = Rf + (Rm Rf)B B = (rjmjm)/2m (rjmjm) = The covariance of the security with the market

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Distortions of the CAPM

1. Heterogeneous expectations of the investors 2. Transaction and information costs 3. Faulty use of the market index 4. Allowance for a tax effect 5. The presence of inflation

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