Unit 3 Lecture Capital Asset Pricing Model (In the context of a well…
Unit 3 Lecture
Capital Asset Pricing Model
Opprtunity set: This is the possibilities from the combination of investments into option A, Option B etc
When plotting the combined return, the correlation, deviation etc cannot be changed but the return can be changed by adjusting the weights
Minimum Variance is where 100% of investment would be in one company and therefore the risk is lowest.
The Efficient Frontier is the point where the risk begins to change with the investment in company B. This is essentially the point where there would be minimum risk from the investment in a second company. As a rational investor you should try to remain with weights that keep you on the efficient frontier
Sharpe Ratio: Expected return (of your investments) / Standard Deviation
Separation Principle: a 2 stage process of diversification.
1) Estimate the risk return parameters and covariances between the two assets. This identifies the optimal portfolio on that frontier.
Determine how to combine the riskless asset with that optimal portfolio
The efficient frontier is the Capital Market Line and the location of the investment on that line is located due to the level of risk aversion from the investor
Holding market portfolio eliminates asset specific risk.
Market portfolio allows us to estmate risk which then helps to calculate the required rate of return.
The degree of an asset's responsiveness to changes in the market portfolio
Coeefficient of responsiveness:
This indicates the responsiveness of an asset in comparison to the market portfolio. In the example given, ABC plc has a coefficient of 1.67, so if the market rises by 10%, ABC will be expected to rise by 16.7%.
We can chart the rate of return on agraph along with the market portfolio - this line is called 'Beta' and also known as the characteristic line
In the context of a well diversified portfolio, the risk of an asset is no longer the deviation but the Beta.
Standard deviation still matters but more for the market or for one specific investment. The individual risk measure in a diversified folio is the Beta
Market Risk Premium - the return you get compensating for the risk of the portfolio
CAPM enables a decision maker to ascertain the required rate of return from the perspective of an equity investor
The reward for risk is determined by the Beta
CAPM estimates the cost of equity which can then be used in discounting cash flows.
By management - to use in NPV
Investors - Assess whether the share of a company is worth investing in
Analysts - to assess the performance of fund managers
It is not practical to use a market portfolio representing ALL the assets in the world.
A proxy is then used - for example the FTSE 100 or the FTSE AllShare. This uses the aggregate of all the assets included and it therefore acts as a proxy for market portfolio
CAPM will calculate the fair price of a share. You cna then use this as the current price of the share to estimate if you should buy it as the market will correct the price of the share if they are efficient.
Limitations of CAPM:
1) is there indeed a positive relationship between the estimated return of an asset and its risk?
2) Whether the market risk premium is the only factor that explains the unexpected return of assets
A big issue with CAPM is the Market Portfolio because it only exists in theory.
Rolls Critique states that testing CAPM is impossible due to the use of proxies rather than the true Market Portfolio. The proxy may or may not be the corrrect one.
Another problem is the concept of the Risk Free asset. History shows that governments can and do default at times.
Another limitation is the time and
Parts 1 and 2