POST GRADUATE CERTIFICATE PROGRAMME MANAGEMENT
Financial Econometrics
PGP I : Term 2
Finance - I
Session # 12
CAPM – Beta – Cost of Equity
Any Questions ??
Portfolio Risk and Portfolio Return
Case of two assets
No diversification benefits when stocks have perfect positive
correlation.
Diversification benefits are maximum when stocks have perfect
negative correlation
Stocks A, B, and C are similar in some respects: Each has an expected return of 10%
and a standard deviation of 25%. Stocks A and B have returns that are independent of
one another; i.e., their correlation coefficient, r, equals zero. Stocks A and C have
returns that are negatively correlated with one another. Portfolio AB is a portfolio
with half of its money invested in Stock A and half in Stock B. Portfolio AC is a
portfolio with half of its money invested in Stock A and half invested in Stock C.
Which of the following statements is CORRECT?
Ans D
a. Portfolio AC has an expected return that is greater than 25%.
b. Portfolio AB has a standard deviation that is greater than 25%.
c. Portfolio AB has a standard deviation that is equal to 25%.
d. Portfolio AC has a standard deviation that is less than 25%.
e. Portfolio AC has an expected return that is less than 10%.
Portfolio Diversification
❑ One can reduce risk by combining stocks into portfolio
❑ Diversification benefits are available only when ρ<1
❑ Risk will not reduce for stocks that have ρ=1
❑ Risk will completely go away for stocks that have ρ=-1
❑ What type of stocks will have
❑ perfect negative correlation?
❑ Is it possible to find such stocks in real world?
❑ Perfect positive correlation?
❑ No correlation?
❑ In real world, most stocks have positive correlation !
❑ Which means….one can’t eliminate risk completely!!
Portfolio Diversification
❑ Suppose you plan to construct a portfolio of 10 stocks
❑ Start with stock 1
❑ How do you choose 2nd stock
❑ Other things equal, the one that is having least correlation with first
stock. Percentage reduction in risk from holding single stock to
portfolio of two stocks is high.
❑ How do you choose 3rd stock
❑ Other things equal, the one that is having least correlation with the
portfolio of first two stocks.
❑ This process continues
❑ When you choose 10th stock
❑ As long as the correlation between 10th stock and portfolio of 9 stocks
is less than perfect positive, portfolio (of 10 stocks) risk will reduce,
but the benefit of diversification (risk reduction) is not that high
compared to earlier.
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Implications of Diversification
Diversification reduces risk. If asset returns were uncorrelated on average, diversification
could eliminate all risk. They are actually positively correlated on average.
Diversification will reduce risk but will not remove all of the risk. So,
There are effectively two kinds of risk
Diversifiable / Unsystematic / Idiosyncratic risk.
Disappears in well diversified portfolios.
It disappears without cost, i.e. you need not sacrifice expected return to reduce this
type of risk.
Nondiversifiable / Systematic / Market risk.
Does not disappear in well diversified portfolios.
Must trade expected return for systematic risk.
Level of systematic risk in a portfolio is an important choice for an individual.
Stand-alone risk = Market risk + Diversifiable risk
Market risk is that part of a security’s stand-alone risk that
cannot be eliminated by diversification.
Firm-specific, or diversifiable, risk is that part of a security’s
stand-alone risk that can be eliminated by diversification.
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Diversification and Systematic Risk
❑ Figure illustrates that as the number of securities in a portfolio increases, the
contribution of the unsystematic or diversifiable risk to the standard deviation
of the portfolio declines.
❑ Systematic or non-diversifiable risk is not reduced even as we increase the
number of stocks in the portfolio.
❑ Systematic sources of risk (such as inflation, war, interest rates) are common
to most investments resulting in a perfect positive correlation and no
diversification benefit.
❑ Large portfolios will not be affected by unsystematic risk but will be
influenced by systematic risk factors.
400
Risk classification
❑ To understand how an asset contributes to the risk of the portfolio, we
categorize the risk of the individual asset (Stand alone risk ) into two
categories:
① Systematic risk / Non-diversifiable risk/Market risk
② Unsystematic risk / idiosyncratic risk / diversifiable risk / stock-
specific risk
401
Unsystematic/diversifiable risks
Examples
Firm discovers a gold mine beneath its property
Lawsuits
Technological innovations
Labor strikes
The key is that these events are random and unrelated across firms. For
the assets in a portfolio, some surprises are positive, some are negative.
On average, across assets, the surprises offset each other if your portfolio
is made up of a large number of assets.
Systematic/Nondiversifiable risk
We know that the returns on different assets are positively correlated with
each other on average. This suggests that economy-wide influences affect
all assets.
Examples:
Business Cycle
Inflation Shocks
Interest Rate Changes
Major Technological Change
These are economic events that affect all assets. The risk associated with
these events is systematic (system wide), and does not disappear in well
diversified portfolios.
Systematic risk
❑ An investment’s systematic risk is far more important than its
unsystematic risk.
❑ If the risk of an investment comes mainly from unsystematic risk,
the investment will tend to have a low correlation with the returns
of most of the other stocks in the portfolio and will make a minor
contribution to the portfolio’s overall risk.
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The Capital Asset Pricing Model (CAPM)
Given that
some risk can be diversified,
diversification is easy and costless,
rational investors diversify
There should be no premium associated with diversifiable risk.
The question becomes: What is the equilibrium relation between systematic risk and expected
return in the capital markets?
The CAPM is the best-known and most-widely used equilibrium model of the risk/return
(systematic risk/return) relation.
Proposed by Nobel prize winners: Markowitz and Sharpe
The Market Risk Premium
The market is defined as a portfolio of all wealth including real
estate, human capital, etc.
In practice, a broad based stock index, such as the S&P 500 or
Nifty or the portfolio of all NSE stocks, is generally used.
Market portfolio is a well-diversified portfolio
The Market Risk Premium Is Defined As:
[E[R M ] − R F ]
CAPM Intuition
E[Ri] = RF (risk free rate) + Risk Premium
= Appropriate Discount Rate
Risk free assets earn the risk-free rate
If the asset is risky, we need to add a risk premium.
The size of the risk premium depends on the amount of systematic risk for the asset
(stock, bond, or investment project) and the price per unit risk.
Risk premium depends on the amount of risk that the stock contributes
to the market portfolio
𝜎𝑖 𝜎 𝐶𝑜𝑣(𝑅𝑖,𝑅𝑀 )
This is: βi= *ρiM = 𝑖 *
𝜎𝑀 𝜎𝑀 𝜎𝑖 𝜎𝑀
The Security Market Line / CAPM:
Relating Risk and Required Return
The Security Market Line (SML) puts the pieces together,
showing how to determine the return required for bearing a
stock’s risk:
CAPM or SML: ri = rRF + (RPM)βi
All terms are synonymous:
Expected Return on equity
Required Return on equity
Cost of equity
CAPM is one way to estimate the return on equity
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The CAPM Intuition Formalized
Cov(R i , R M )
E[R i ] = R F + [E[R M ] − R F ]
Var(R M )
or, E[R i ] = R F + i [E[R M ] − R F ]
Number of units of
systematic risk () Market Risk Premium
or the price per unit risk
• The Beta Coefficient is the slope coefficient in an OLS
regression of stock returns on market returns
Beta is a measure of sensitivity: it describes how strongly the
stock return moves with the market return.
◼ Example: A Stock with = 2 will on average go up 20%
when the market goes up by 10%.
Summary
As we discussed, the “market” pays investors for two services they
provide: (1) surrendering their capital and foregoing current
consumption and (2) sharing in the total risk of the economy.
The first gets you the time value of money.
The second gets you a risk premium whose size depends on the share
of total risk you take on.
From this we found E(R) = Rf + θ
We refined this to E(R) = Rf + Units × Price
interpreting
if =
asset is market risk free
if =
asset return = market return
if
asset is riskier than market index
▪
asset is less risky than market index
Betas and Portfolios
The Beta of a portfolio is the weighted average of the component assets’ Betas.
Example: You have 30% of your money in Asset X, which has X = 1.4 and
70% of your money in Asset Y, which has Y = 0.8.
Your portfolio Beta is:
P = .30(1.4) + .70(0.8) = 0.98.
Why do we care about this feature of betas?
It shows directly that an asset’s beta measures the contribution
that asset makes to the systematic risk of a portfolio!
Also note that this is a linear relation.
Problems
The current risk free rate is 4% and the expected risk premium on the market
portfolio is 7%.
An asset has a beta of 1.2. What is the expected return on this asset? Interpret
the number 1.2.
An asset has a beta of 0.6. What is the expected return on this asset?
If we invest ½ of our money in the first asset and ½ of our money in the
second, what is our portfolio beta and what is its expected return?
The two stocks in your portfolio, X and Y, have independent returns, so the correlation between
them, rXY is zero. Your portfolio consists of Rs50,000 invested in Stock X and Rs50,000 invested in
Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%.
Which of the following statements best describes the characteristics of your 2-stock portfolio?
Ans B
Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6.
Your portfolio has a beta equal to 1.6, and its expected return is 15%.
Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%.
Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6.
Your portfolio has a standard deviation of 30%, and its expected return is 15%.
Assume that the risk-free rate is 5%. Which of the
following statements is CORRECT?
Ans E
a. If a stock's beta doubled, its required return under the CAPM would also double.
b. If a stock's beta doubled, its required return under the CAPM would more than double.
c. If a stock's beta were 1.0, its required return under the CAPM would be 5%.
d. If a stock's beta were less than 1.0, its required return under the CAPM would be less than
5%.
e. If a stock has a negative beta, its required return under the CAPM would be less than 5%.
Company A has a beta of 0.70, while Company B's beta is 1.20. The required return
on the stock market is 11.00%, and the risk-free rate is 4.25%. What is the
difference between A's and B's required rates of return?
Beta: A 0.70
Beta: B 1.20
Market return 11.00%
Risk-free rate 4.25%
Market risk premium 6.75%
Required return A = rRF + bA(RPM) = 8.98%
Required return B = rRF + bB(RPM) = 12.35%
Difference 3.38%
Suppose Shankar holds a portfolio consisting of a Rs10,000 investment in each of 8
different common stocks. The portfolio's beta is 1.25. Now suppose Shankar decided
to sell one of his stocks that has a beta of 1.00 and to use the proceeds to buy a
replacement stock with a beta of 1.35. What would the portfolio's new beta be?
Number of stocks 8
Percent in each stock = 1/number of stocks = 12.500%
Portfolio beta 1.25
Stock that's sold 1.00
Stock that's bought 1.35
Change in portfolio's beta = 0.125 ´ (b2 - b1) = 0.0438
New portfolio beta 1.29
S Varadarajan, a mutual fund manager, has a Rs40 million portfolio with a beta of
1.00. The risk-free rate is 4.25%, and the market risk premium is 6.00%.
Varadarajan expects to receive an additional Rs60 million, which she plans to
invest in additional stocks. After investing the additional funds, she wants the
fund's expected return to be 13.00%. What must be the average beta of the new
stocks be to achieve the target expected rate of return?
Old funds (millions) Rs 40.00 40.00%
New funds (millions) Rs 60.00 60.00%
Total new funds Rs100.00 100.00%
Beta on existing portfolio 1.00
Risk-free rate 4.25%
Market risk premium 6.00%
Desired expected return 13.00% 13% = rRF + b(RPM); b = (13% -rRF)/RPM
Required new bp 1.4583 beta = (Return - Risk-free)/RPM
Required beta, new stocks 1.76 Req. b = (Old$/Total$) ´ Old b +
(New$/Total$) ´ New b
Beta on new stocks = (Req. b - (Old$/Total$) ´ Old b)/(New$/Total$)
DHF Company has a beta of 1.5 and is currently in equilibrium. The required rate
of return on the stock is 12.00% versus a required return on an average stock
(market) of 10.00%. Now the required return on an average stock increases by
30.0% (not percentage points). Neither betas nor the risk-free rate change. What
would DHF's new required return be?
DHF's beta 1.50
DHF's initial required return 12.00%
Percentage increase in required market return 30.0%
Initial required return on the market 10.00%
New required return on the market 13.00%
Now for the algebra:
rStock = rRF + b(RPM) = rRF + 1.5(RPM)
rMarket = rRF + b(RPM) = rRF + 1.0(RPM)
Now insert known data and transpose:
12% = rRF + 1.5(RPM) >> 12% - rRF = 1.5(RPM)
10% = rRF + (RPM) >> 10% - rRF = 1.0(RPM)
Now solve for RPM: RPM = 2%/0.5 4.00%
Now find the risk-free rate: rRF = Initial rMarket - RPM = 10% - 6.00%
4% =
New RPM = New required return on the market - rRF 7.00%
Gaha Enterprises expects earnings and dividends to grow at a rate of 25% for the next 4
years, after that growth rate in earnings and dividends will fall to zero, i.e., g = 0. The
company paid a dividend, D0, of $1.25, its beta is 1.20, the market risk premium is
5.50%, and the risk-free rate is 3.00%. What is the current price of the stock?
First, estimate the cost of equity from CAPM and then use that in valuing stock
Last dividend (D0) $1.25
Short-run growth rate 25%
Long-run growth rate 0%
Beta 1.20
Market risk premium 5.50%
Risk-free rate 3.00%
Required return = rs = rRF + b(RPM) = 9.60%
Price = Sum of PVs = $29.05
The required rate of return on the market portfolio and the risk-free asset are
14% and 6% respectively. The standard deviation of the returns in market
portfolio is 20%. Afsan Raja is managing a Rs. 200 crore fund that consists of
four stocks with the following investments:
Investment in Rs.
Stock lakhs Beta
Arihant Ltd 40 1.5
Bellavista Ltd 60 2
Chellani Ltd 50 1.25
Dinkapur Ltd 50 0.75
Calculate
a. The fund’s beta estimate is ________________
1.4
b. The required return on the fund is ______________
17.2%
c. The required return on investment in Bellavista is ___________
22%
d. Suppose Arihant Ltd is replaced with Ervine Ltd that has beta of 0.50. Investment in both is same.
The revised required return and the beta of the fund would be _____; _____.
1.2;15.6%