FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

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FINANCE IN A CANADIAN SETTING Sixth Canadian
Edition

• Lusztig, Cleary, Schwab

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• CHAPTER EIGHT
• CAPITAL MARKET THEORY

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Learning Objectives

• 1. Explain the role of risk-free assets in an
  efficient portfolio.
• 2. Define the capital market line (CML), and
  explain what its slope indicates.
• 3. Compare and contrast systematic and
  non-systematic risk, and discuss the role of each
  in establishing the security market line (SML).

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Learning Objectives

• 4. Define beta measure, and explain why it is
  more stable for large portfolios than for small
  ones than for individual stocks.
• 5. Identify some of the weaknesses in the capital
  asset pricing model (CAPM), and discuss
  alternative theories.

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Building Efficient Portfolios

• Use approach based on portfolio theory developed
  by Harry Markowitz
• Portfolio theory is a normative meaning that
  tells investors how they should act to diversify
  optimally, which is based on the following
  assumptions
• A single investment period
• Liquidity of positions
• Investors preference based only ona portfolios
  expected return and risk
• Homogenous expectations among investors regarding
  expected return and risk

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The Efficient Set of Portfolios

• According to Markowitzs approach, investors
  should evaluate portfolios based on their return
  and risk as measured by the standard deviation
• Efficient portfolio a portfolio that has the
  smallest portfolio risk for a given level of
  expected return or the largest expected return
  for a given level of risk

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The Efficient Set of Portfolios

• The construction of efficient portfolios of
  financial assets requires identification of
  optimal risk-expected return combinations
  attainable from the set of risky assets available
• Efficient portfolios can be identified by
  specifying an expected portfolio return and
  minimizing the portfolio risk at this level of
  return

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The Efficient Set of Portfolios

• The Attainable Set and the Efficient Set of
  Portfolios

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The Efficient Set of Portfolios

• Risk averse investors should only be interested
  in portfolios with the lowest possible risk for
  any given level of return
• Efficient set (frontier) is the segment of the
  minimum variance frontier above the global
  minimum variance portfolio that offers the best
  risk-expected return combinations available to
  investors
• Portfolios along the efficient frontier are
  equally good

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Borrowing and Lending Possibilities

• Investors have the option of buying risk-free
  assets
• Investors can invest part of their wealth in
  risk-free asset and the rest in risky assets
  resulting in a new efficient frontier

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Borrowing and Lending Possibilities

• The Markowitz Efficient Frontier and the
  Possibilities Resulting from Introducing a
  Risk-Free Asset

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Risk-Free Lending

• The expected return on a combined portfolio of
  risk-free and risky assets would be
• Since the?? of risk-free assets is equal to 0
  than the ? of the portfolio would be

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Risk-Free Lending

• Through a combination of risk-free investing and
  investing in a portfolio of risky assets,
  investors can improve the opportunity set
  available from the efficient frontier

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Borrowing Possibilities

• Investors are no longer restricted to their
  initial wealth when investing in risky assets.
• Investors can
• Buy stock on margin
• Borrow at the risk-free rate
• Borrowing additional funds for investment
  purposes allows investors to seek higher expected
  returns while assuming more risk

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Borrowing Possibilities

• The Efficient Frontier when Lending and Borrowing
  Possibilities Are Allowed

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Borrowing Possibilities

• The proportion to be invested in the alternatives
  are stated as a percentage of an investors total
  investable funds with the different combinations
  adding up to 1.0

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The Capital Asset Pricing Model (CAPM)

• Capital market theory is concerned with
  equilibrium security prices and returns and how
  they are related to the risk-expected return
  trade-off that investors face
• It measures the relative risk of an individual
  security and the relationship between risk and
  the returns expected from investing

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Capital Market Line (CML)

• Depicts the equilibrium conditions that prevail
  in the market for efficient portfolios consisting
  of the optimal portfolio of risk-free and risky
  assets
• All combinations of assets are bound by the CML
  and at equilibrium all investors end up with
  efficient portfolios

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Capital Market Line (CML)

• Slope of the CML is the market price of risk for
  efficient portfolios
• Slope of the CML
• The CML is always upward sloping because the
  price of risk is always positive

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Capital Market Line (CML)

• The CML and the Components of Its Slope

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The Security Market Line (SML)

• The SML is the key contribution of the CAPM to
  asset pricing theory
• The SML equation is
• The SML represents the trade-off between
  systematic (as measured by beta) and expected
  returns for all assets

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The Security Market Line (SML)

• It is depicted as the line from RF-Z in Figure
  8.6

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Beta

• Beta the measure of the systematic risk of a
  security that cannot be avoided through
  diversification
• Beta measures a securitys volatility in price
  relative to a benchmark
• Beta risk-free asset 0
• market portfolio 1.0
• Stocks - ? betas are higher risk securities
• ? betas are lower risk securities

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Portfolio Betas

• Are weighted averages of the betas for individual
  securities in the portfolio
• The equation is

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Over- and Undervalued Securities

• Securities plotted above the SML are undervalued
  because they offer more expected return given its
  beta
• Securities plotted below the SML are overvalued
  because they offer less expected return given its
  beta

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Summary

• 1. An efficient portfolio has the highest
  expected return for a given level of risk or the
  lowest level of risk for a given level of
  expected return.
• 2. Capital market theory, based on the concept of
  efficient diversification, describes the pricing
  of capital assets in the market place. The new
  efficient frontier is called the capital market
  line (CML), and its slope indicates the
  equilibrium price of risk in the market.

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Summary

• 3. Based on the separation of risk into its
  systematic and non-systematic components, the
  security market line (SML) can be constructed for
  individual securities (and portfolios).
• 4. Beta is a relative measure of risk, which
  indicates the volatility of a stock relative to a
  market index. While all betas change through
  time, betas for large portfolios are much more
  stable than those for individuals stocks