Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Capital Asset Pricing Model (CAPM) The CAPM has –A macro component explains risk and return in a portfolio context –A micro component explains individual stock returns –The micro component is also used to value stocks
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Capital Market Line The capital market line –adds a risk-free return –redefines the efficient frontier
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Capital Market Line
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Risk and Return The investor continues to select the portfolio that –offers the highest return for a given level of risk –maximizes satisfaction Different investors may select different combinations of risk and return
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Risk and Return Different asset classes lie on the capital market line
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Beta Coefficients An index of risk Measures the volatility of a stock (or portfolio) relative to the market
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Beta Coefficients Combine The variability of the asset’s return The variability of the market return The correlation between –the stock's return and –the market return
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Beta Coefficients Beta coefficients are the slope of the regression line relating –the return on the market (the independent variable) to –the return on the stock (the dependent variable)
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Beta Coefficients
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Interpretation of the Numerical Value of Beta Beta = 1.0 Stock's return has same volatility as the market return Beta > 1.0 Stock's return is more volatile than the market return
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Interpretation of the Numerical Value of Beta
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Interpretation of the Numerical Value of Beta Beta < 1.0 Stock's return is less volatile than the market return
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Interpretation of the Numerical Value of Beta
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. High Beta Stocks More systematic market risk May be appropriate for high-risk tolerant (aggressive) investors
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Low Beta Stocks Less systematic market risk May be appropriate for low-risk tolerant (defensive) investors
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Individual Stock Betas May change over time Tendency to move toward 1.0, the market beta
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Portfolio Betas Weighted average of the individual asset's betas May be more stable than individual stock betas
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Beta Coefficients and The Security Market Line The return on a stock depends on –the risk free rate (r f ) –the return on the market (r m ) –the stock's beta –the return on a stock: k= r f + (r m - r f )beta
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Beta Coefficients and The Security Market Line The figure relating systematic risk (beta) and the return on a stock
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Beta Coefficients and The Security Market Line
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Arbitrage Pricing Theory (APT) In the CAPM –a stock's return depends only on the market return the volatility of the stock (the beta) APT is an alternative to the Capital Asset Pricing Model
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Arbitrage Buying in one market and simultaneously selling in another market to take advantage of price differentials Assures there can be only one price Assures that portfolios with the same risk will have the same returns
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. APT explains security returns in terms of The expected return A series of factors that may affect security prices How the individual stock responds to unanticipated changes in those factors
Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Common Factors Unexpected inflation Unexpected changes in industrial production Unanticipated shifts in risk premiums Unanticipated changes in the structure of yields