Chapter 7: Capital Asset Pricing Model
Capital asset pricing model
• Formula used to calculate the expected return of a given security given its level of
systematic risk
• Calculate our expectation with regards to return given a certain asset
• Compensate for systematic risk
• 𝑟𝑖 = 𝑟𝑓 +𝛽𝑖 (𝑟𝑚 − 𝑟𝑓 )
• 𝑟(𝑖)𝑖𝑠 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑖
• (r(m)-r(f)) is the market risk premium
• Cost of equity capital
• Return that investors expect to receive given the level risk that they are bearing
(beta)
• Higher systematic risk= higher expected return of investors
• If beta increase, then the expected return will increase
7.1 THE CAPM
Beta
• Sensitivity of a stock’s return on the market portfolio
• Value of market risk exposure that a security has
• Measure systematic (market) risk
• SD is the volatility (unsystematic; firm specific and systematic; market wide
conditions or market risk)
• Unsystematic risk is diversified away
• Beta is the percentage change is the asset’s return given a 1% change in the market
portfolio (all firms)
• Measures the sensitivity of the stocks return to the overall market portfolio
• Example: economy conditions affect the return (how volatile compared to the market)
add the returns in the conditions for the asset and divide that with the sum of the
market returns of all the scenarios. If it is possible then there is more risk than the
average asset of firms (very sensitive)
Market Portfolio
• Portfolio of all assets in the economy
• All the assets in the economy
• Furthest diversification
• Reference point (always =1)
BETA (β)
• The higher Beta, the higher systematic risk
• Β=1 – Average security (Market portfolio)
• Β>1 – Aggressive: a security with an above-average market risk (sensitivity to market
risk is high)
• Β<1 – Defensive: a security with a below-average market risk
,Method 2: used when it’s based on historical data
• SCENARIO ANALYSIS= looking forward
PORTFOLIO BETA
• The beta of a portfolio will be the weighted average of the betas of the shares in the
portfolio.
,• Alpha – good securities to buy
• Alpha= difference between required rate of return and the actual expected return
, CHAPTER 8: The Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH)
• CENTRAL IDEA: asset prices reflect the available information
• Correctly prices
• Establishes investors’ confidence
• Contributes to allocational efficiency (capital allocation)
• Important for investors, important for companies and important for Industrial Policy
Competition and the EMH
• Competition among investors eliminate unexploited profit opportunities
• Once information becomes available, market participants quickly analyze it and trade
on it
• Frequent, low-cost trading assures prices reflect information
Random Price changes
• Prices react to new information: changing prices becomes random
• Flow of new information is random, and therefore price changes are random
• Stock prices follow a “random walk”
• Expected price changes are positive, random change are superimposed on the
positive trend
• Expect share prices to go up in the long term
• Random changes are superimposed on the positive trend
• E(price(j,t))> E(price (j,t-1))
• T= time periode
Forms of the EMH
Weak form of efficiency
• The relevant information is historical prices and other trading data (such as trading
volumes)
• If the markets are weak form efficient, use of such information provides no benefit
(after taking into account the cost of obtaining and using the information)
Semi-strong form efficiency
• The relevant information is “all publicly available information, including past prices
and volume data.”
• If the markets are semi-strong form efficient, then studying past price and volume
data and studying earnings and growth forecast provides no net benefit (after costs)
Strong form efficiency
• The relevant information is “all information” both public and private or “inside”
information
• If the markets are strong form efficient, use of any information (public or private)
provides no benefit (after costs)
• NB: inside trading is illegal and in violation of Standard II(A) of the CFA Institute
Standards of Professional conduct
Capital asset pricing model
• Formula used to calculate the expected return of a given security given its level of
systematic risk
• Calculate our expectation with regards to return given a certain asset
• Compensate for systematic risk
• 𝑟𝑖 = 𝑟𝑓 +𝛽𝑖 (𝑟𝑚 − 𝑟𝑓 )
• 𝑟(𝑖)𝑖𝑠 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑖
• (r(m)-r(f)) is the market risk premium
• Cost of equity capital
• Return that investors expect to receive given the level risk that they are bearing
(beta)
• Higher systematic risk= higher expected return of investors
• If beta increase, then the expected return will increase
7.1 THE CAPM
Beta
• Sensitivity of a stock’s return on the market portfolio
• Value of market risk exposure that a security has
• Measure systematic (market) risk
• SD is the volatility (unsystematic; firm specific and systematic; market wide
conditions or market risk)
• Unsystematic risk is diversified away
• Beta is the percentage change is the asset’s return given a 1% change in the market
portfolio (all firms)
• Measures the sensitivity of the stocks return to the overall market portfolio
• Example: economy conditions affect the return (how volatile compared to the market)
add the returns in the conditions for the asset and divide that with the sum of the
market returns of all the scenarios. If it is possible then there is more risk than the
average asset of firms (very sensitive)
Market Portfolio
• Portfolio of all assets in the economy
• All the assets in the economy
• Furthest diversification
• Reference point (always =1)
BETA (β)
• The higher Beta, the higher systematic risk
• Β=1 – Average security (Market portfolio)
• Β>1 – Aggressive: a security with an above-average market risk (sensitivity to market
risk is high)
• Β<1 – Defensive: a security with a below-average market risk
,Method 2: used when it’s based on historical data
• SCENARIO ANALYSIS= looking forward
PORTFOLIO BETA
• The beta of a portfolio will be the weighted average of the betas of the shares in the
portfolio.
,• Alpha – good securities to buy
• Alpha= difference between required rate of return and the actual expected return
, CHAPTER 8: The Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH)
• CENTRAL IDEA: asset prices reflect the available information
• Correctly prices
• Establishes investors’ confidence
• Contributes to allocational efficiency (capital allocation)
• Important for investors, important for companies and important for Industrial Policy
Competition and the EMH
• Competition among investors eliminate unexploited profit opportunities
• Once information becomes available, market participants quickly analyze it and trade
on it
• Frequent, low-cost trading assures prices reflect information
Random Price changes
• Prices react to new information: changing prices becomes random
• Flow of new information is random, and therefore price changes are random
• Stock prices follow a “random walk”
• Expected price changes are positive, random change are superimposed on the
positive trend
• Expect share prices to go up in the long term
• Random changes are superimposed on the positive trend
• E(price(j,t))> E(price (j,t-1))
• T= time periode
Forms of the EMH
Weak form of efficiency
• The relevant information is historical prices and other trading data (such as trading
volumes)
• If the markets are weak form efficient, use of such information provides no benefit
(after taking into account the cost of obtaining and using the information)
Semi-strong form efficiency
• The relevant information is “all publicly available information, including past prices
and volume data.”
• If the markets are semi-strong form efficient, then studying past price and volume
data and studying earnings and growth forecast provides no net benefit (after costs)
Strong form efficiency
• The relevant information is “all information” both public and private or “inside”
information
• If the markets are strong form efficient, use of any information (public or private)
provides no benefit (after costs)
• NB: inside trading is illegal and in violation of Standard II(A) of the CFA Institute
Standards of Professional conduct
