FINM3093: Investments

Lecture 4

Dr Sherry Zhou
United International College, Zhuhai

1
Outline
• Index Models (Textbook Chapter 8)
• The Capital Asset Pricing Model (Textbook Chapter 9)

2
Why Index Models? (Textbook Chapter 8)
• Drawbacks to Markowitz procedure
• Requires a huge number of estimates to fill the covariance matrix
• Model does not provide any guidelines for finding useful estimates of these
covariances or the risk premiums
• Introduction of index models
• Simplifies estimation of the covariance matrix
• Enhances analysis of security risk premiums
• Optimal risky portfolios constructed using the index model
• While principles are the same as those employed previously, properties are
easier to derive and interpret

3
A Single-Factor Security Market
• Systematic versus firm-specific risk
• Number of estimates required is a small fraction of what would otherwise be
needed
• Specialization of effort in security analysis

ri = E (ri ) +  i m + ei
• βi = sensitivity coefficient for firm i
• m = market factor that measures unanticipated developments in the
macroeconomy
• ei = firm-specific random variable

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A Single-Factor Security Market
• Assume m and ei are uncorrelated
𝜎𝑖2 = 𝛽𝑖2 𝜎𝑚
2 + 𝜎 2 (𝑒 )
𝑖

• Assume firm-specific surprises are mutually uncorrelated

2
𝐶𝑜𝑣 𝑟𝑖 , 𝑟𝑗 = 𝐶𝑜𝑣 𝛽𝑖 𝑚 + 𝑒𝑖 , 𝛽𝑗 𝑚 + 𝑒𝑗 = 𝛽𝑖 𝛽𝑗 𝜎𝑚

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Single-Index Model
• Single-index model
• An equation similar to single-factor model with the market index used for the
common factor
• Regression equation

Ri (t ) =  i + i RM (t ) + ei (t )
• Expected return-beta relationship

E (Ri ) =  i +  i E (RM )

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Single-Index Model
• Total risk = Systematic risk + Firm-specific risk
 =   +  (ei )
i
2
i
2 2
M
2

• Covariance = Product of betas × Market-index risk

Cov ( ri , rj ) = i  j 2
M

• Correlation = Product of correlations with the market index

2 2 2
𝛽𝑖 𝛽𝑗 𝜎𝑀 𝛽𝑖 𝜎𝑀 𝛽𝑗 𝜎𝑀
Corr 𝑟𝑖 , 𝑟𝑗 = = × = Corr 𝑟𝑖 , 𝑟𝑀 × Corr 𝑟𝑗 , 𝑟𝑀
𝜎𝑖 𝜎𝑗 𝜎𝑖 𝜎𝑀 𝜎𝑗 𝜎𝑀

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Index Model and Diversification
• Variance of the equally-weighted portfolio of firm-specific
components:

• When n gets large, σ2(ep) becomes negligible

• As diversification increases, the total variance of a portfolio
approaches the systematic variance

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The Variance of an Equally Weighted Portfolio
with Risk Coefficient, βp

9
Excess Monthly Returns on Amazon and the
Market Index \beta

10
Scatter Diagram

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Security Characteristic Line (SCL)
Excess return of security i

Ri ( t ) =  i + i RS & P 500 ( t ) + ei ( t )
Zero-mean, firm-
Expected excess
specific surprise in
return when the
security i‘s return
market excess
in month t.
return is zero
(the residual)
Sensitivity of
security i‘s return Expected excess
to changes in the return of the
return of the market
market

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Excel Output: Regression Statistics

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 \alpha = 0
\alpha > 0

Output Analysis \beta = 1

\beta > 1
\beta < 1

R^2 \beta
R^2 \beta

• Multiple R – Correlation of the stock with the market index

• R-square – Percentage of return variance which is due to market factors
• Standard error – Standard deviation of the residual, measure of firm-
specific risk
• Intercept – Estimate of Alpha
• Can we conclude that alpha of the stock equal to zero? Why?
• Market Index – Estimate of Beta
• Can we conclude that beta of the stock equal to one? Why?
Multiple\ R = 1
Multiple\ R = -1
Multiple\ R = 0
Multiple R \beta \beta ( \sigma ) ( \sigma_M )
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15
The Industry Version of the Index Model
• Industry beta services most often use total returns, rather than excess
returns, in the regression, i.e.,
𝑟 = 𝑎 + 𝑏𝑟𝑀 + 𝑒 ∗
instead of
𝑟 − 𝑟𝑓 = 𝛼 + 𝛽 𝑟𝑀 − 𝑟𝑓 + 𝑒
• The motivation for adjusting beta estimates is that, as an empirical
matter, beta coefficients seem to move toward 1 over time.
• A simple way to adjust beta estimates is
2 1
Adjusted beta = estimated beta + (1.0)
3 3
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Capital Asset Pricing Model (CAPM) (Textbook
Chapter 9)
• CAPM is a set of predictions concerning equilibrium expected returns
on risky assets CAPM Capital Asset Pricing Model
• Based on two sets of assumptions
• Individual behavior
• Market structure
• Markowitz established modern portfolio management in 1952
• Sharpe, Lintner and Mossin published CAPM in 1964

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Assumptions
-
-

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The Market Portfolio
• All investors will hold the same portfolio for risky assets — market
portfolio

• Market portfolio contains all securities

• Proportion of each stock in this portfolio equals the market value of the stock
(price per share times number of shares outstanding) divided by the sum of
the market value of all stocks

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Capital Allocation Line

20
Capital Market Line

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Expected Returns on Individual Securities
• CAPM is build on the insight that the appropriate risk premium on an
asset will be determined by its contribution to the risk of investors’
overall portfolios
• All investors use the same input list (i.e., they all end up using the market as
their optimal risky portfolio)

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Individual Securities:
Example
• Covariance of GE return with the market portfolio:
𝐶𝑜𝑣(𝑅𝑀 , 𝑅𝐺𝐸 ) = 𝐶𝑜𝑣 σ𝑛𝑖=1 𝑤𝑖 𝑅𝑖 , 𝑅𝐺𝐸 = σ𝑛𝑖=1 𝑤𝑖 𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝐺𝐸 )

• The reward-to-risk ratio for GE would be:

GE's contribution to risk premium E ( RGE )

=
GE's contribution to variance Cov( RGE , RM )

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GE Example
(1 of 2)

• Reward-to-risk ratio for investment in market portfolio (i.e., market

price of risk):
Market risk premium E ( RM )
= 2
Market variance  ( RM )
• Equilibrium dictates all investments should offer the same reward-to-
risk ratio
E ( RGE ) E ( RM )
= 2
Cov( RGe , RM )  ( RM )

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GE Example
(2 of 2)

• Fair risk premium for GE stock:

𝐶𝑜𝑣(𝑅𝐺𝐸 , 𝑅𝑀 )
𝐸(𝑅𝐺𝐸 ) = 2
𝐸(𝑅𝑀 )
𝜎 (𝑅𝑀 )

• Restating, we obtain:


E(rGE ) = rf + GE E(rM ) − rf 

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Expected Return-Beta Relationship
• Expected return-beta relationship tells us the total expected rate of
return is the sum of the risk-free rate plus a risk premium
• Risk premium is the product of a “benchmark risk premium” and the relative
risk of the particular asset as measured by its beta

• The CAPM predicts that systematic risk should “be priced”, meaning
that it commands a risk premium, but firm-specific risk should not be
priced by the market.

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Expected Return-Beta Relationship
• Suppose that some portfolio P has weight wk for stock k, k = 1,…, n.
• Expected return on the portfolio is 𝐸 𝑟𝑃 = σ𝑘 𝑤𝑘 𝐸(𝑟𝑘 )
• Portfolio beta is 𝛽𝑃 = σ𝑘 𝑤𝑘 𝛽𝑘

• Beta of the market portfolio is 1 because

2
𝐶𝑜𝑣(𝑅𝑀 , 𝑅𝑀 ) 𝜎𝑀
𝛽𝑀 = 2 = 2 =1
𝜎𝑀 𝜎𝑀
• Betas greater than 1 are considered aggressive in that investment in high-beta stocks entails
above-average sensitivity to market swings.
• Betas below 1 can be described as defensive.

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The Security Market Line
𝐸 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝐸 𝑟𝑀 − 𝑟𝑓

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 SML CAPM α>0
SML α<0

The SML and a Positive-Alpha Stock

• The difference between the fair and
actually expected rates of return on a
stock is called the stock’s alpha, denoted
by .
• Underpriced stocks plot above the SML:
given their betas, their expected returns
are greater than dictated by the CAPM.
• Overpriced stocks plot below the SML.
• The portfolio manager will increase the
weights of securities with positive alphas
and decrease the weights of securities
with negative alphas.

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Self-Check Exercise
• Stock XYZ has an expected return of 12% and risk of β = 1. Stock ABC
has expected return of 13% and β = 1.5. The market’s expected return
is 11%, and rf = 5%. According to the CAPM, which stock is a better
buy?

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Summary
• Single-index model

• Total risk = Systematic risk + Firm-specific risk

 i2 =  i2 M2 +  2 (ei )
• Covariance = Product of betas × Market-index risk
Cov ( ri , rj ) = i  j M2
• Correlation = Product of correlations with the market index
2 2 2
𝛽𝑖 𝛽𝑗 𝜎𝑀 𝛽𝑖 𝜎𝑀 𝛽𝑗 𝜎𝑀
Corr 𝑟𝑖 , 𝑟𝑗 = = × = Corr 𝑟𝑖 , 𝑟𝑀 × Corr 𝑟𝑖 , 𝑟𝑀
𝜎𝑖 𝜎𝑗 𝜎𝑖 𝜎𝑀 𝜎𝑗 𝜎𝑀

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Summary
• Security characteristic line (SCL)
Ri ( t ) =  i + i RS & P 500 ( t ) + ei ( t )
• Output analysis: correlation, R-square, standard error, alpha, beta

• Industry version of the index model

• Use total returns, rather than excess returns, in the regression

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Summary
• The index model has been estimated for stocks A and B with the following results:
RA = 0.03 + 0.7RM + eA.
RB = 0.01 + 0.9RM + eB.
σM = 0.35; σ(eA) = 0.20; σ(eB) = 0.10.

The covariance between the returns on stocks A and B is

A) 0.0384.
B) 0.0406.
C) 0.1920.
D) 0.0772.
E) 0.4000.

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Summary
• Consider the following two
regression lines for stocks A
and B in the following figure.
a. Which stock has higher firm-
specific risk?
b. Which stock has greater
systematic risk?
c. Which stock has higher R2?
d. Which stock has higher alpha?
e. Which stock has higher
correlation with the market?

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Summary
• Assumptions of CAPM
• Individual behavior and Market structure
• All investors will hold the same portfolio for risky assets – market portfolio

• Which statement is not true regarding the market portfolio?

A) It includes all publicly-traded financial assets.
B) It lies on the efficient frontier.
C) All securities in the market portfolio are held in proportion to their market values.
D) It is the tangency point between the capital market line and the indifference curve.
E) All of the options are true.

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Summary
• CAPM model
• The CAPM predicts that systematic risk should be priced.
• Security market line
𝐸 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝐸 𝑟𝑀 − 𝑟𝑓
• Beta
𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑀 )
𝛽𝑖 =
𝜎 2 (𝑅𝑀 )
• 𝛽 = 1: Market portfolio; 𝛽 > 1: Aggressive stocks; 𝛽 < 1: Defensive stocks
• Alpha
αi = actually expected return – required return (obtained by CAPM)
• α = 0: fairly price stocks; α > 0: underpriced stocks; α < 0: overpriced stocks

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Summary
• Are the following true or false?
a. Stocks with a beta of zero offer an expected rate of return of zero.
b. The CAPM implies that investors require a higher return to hold highly
volatile securities.
c. You can construct a portfolio with beta of .75 by investing .75 of the
investment budget in T-bills and the remainder in the market portfolio
• If the simple CAPM is valid, is the following situation possible?
Portfolio Expected Return Beta
Risk-free 10% 0
Market 18% 1.0
A 16% 0.9
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