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Lecture 4 CAPM

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Contemporary Issues in Corporate Finance Lecture 4 CAPM & Options – PowerPoint PPT presentation

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Title: Lecture 4 CAPM


1
Contemporary Issues in Corporate Finance

Lecture 4CAPM Options

2
Risk and Return
  • In previous lectures
  • we looked at the returns various investments
  • we considered various definitions of risk
  • The least risky investment was T-bills.
  • The market portfolio of common stocks was much
    riskier!
  • We used Standard Deviation and Beta to measure
    risk.
  • Standard deviation was a measure of total risk!
  • Beta was a measure of market risk.
  • We understood that in a competitive market
  • we can diversify away unique risk by forming
    portfolios
  • we can only be compensated for market risk!
  • Market risk is the relevant risk for the
    investor!
  • Beta is the measure of market risk

3
Risk and Return
  • We also understood that
  • most investors prefer lower risk to higher risk
    and higher return to lower return
  • most investors are risk averse, however the
    degree of risk aversion might change based on the
    individuals preference.
  • If you wanted to increase expected return and
    reduce risk, you would end up with one of the
    portfolios on the efficient frontier.
  • When we introduced borrowing and lending at the
    risk-free rate as an alternative,
  • you could get the highest expected return by
    investing in a mixture of the best efficient
    portfolio and borrowing/lending.
  • The efficient portfolio at the tangency point is
    better than all the others!

4
Risk and Return
  • The efficient portfolio at the tangency point is
    better than all the others
  • It offers the highest ratio of risk premium to
    standard deviation.
  • The difference between the investments expected
    return and the risk-free rate is called the risk
    premium.

Return
.
S
Efficient Portfolio
rf
Risk
5
Risk and Return
Return
  • Each investor should, then put money into two
    benchmark investments
  • the risk-free rate
  • the risky portfolio S!
  • What does portfolio S look like?
  • Market Portfolio!

.
S
Efficient Portfolio
rf
Risk
6
Security Market Line
Security Market Line
  • The relevant risk measure for a well diversified
    investor is Beta.
  • It measures market risk.
  • Return on T-bills is fixed.
  • T-bills have a beta of 0!
  • The market portfolio of common stocks has an
    average market risk
  • Beta of market portfolio1!
  • The difference between the return on the market
    and the risk free rate is termed the market risk
    premium.
  • market risk premium (rM - rf)

Return
.
S
rM
rf
Risk
(BETA)
1.0
7
Security Market Line
  • The market portfolio has a risk premium of (rM -
    rf),
  • T-bills have a market risk premium of zero.
  • WHAT IS THE RISK PREMIUM WHEN BETA IS NOT 0 OR 1?
  • Sharpe (1964) and Litner (1965) produced the
    answer.
  • Capital Asset Pricing Model

Return
rm
Security Market Line (SML)
rf
BETA
1.0
8
Security Market Line
Return
  • In a competitive market, the expected risk
    premium varies in direct proportion to Beta.
  • An investment with a beta of 0.5 has half the
    expected risk premium on the market.
  • An investment with a beta of 2 has twice the
    expected risk premium on the market.

SML
rf
BETA
1.0
SML Equation R rf B ( rm - rf )
9
Capital Asset Pricing Model
R rf B ( rm - rf )
CAPM
Expected risk premium on the stock Beta x
Expected risk premium on the market R -
rf B (rM - rf)
10
Capital Asset Pricing Model
  • A stocks sensitivity to changes in the value of
    the market portfolio is known as Beta.
  • We do not consider the risk of a stock in
    isolation but its contribution to the risk of a
    well diversified portfolio.
  • Beta measures the marginal contribution of a
    stock to the risk of the market portfolio.
  • The risk premium demanded by investors is
    proportional to Beta.

11
Capital Asset Pricing Model
Risk Premium
B
30 20 10 0
C
A
  • Would you buy stock A?
  • Would you buy stock B?
  • Would you buy stock C?

Market Portfolio
Beta
1.0
1.5
1.2
0.5
12
Testing the CAPM
  • Investors require extra return for taking on
    risk!
  • Investors are concerned with the risks they can
    not diversify away!
  • CAPM captures these ideas in a very simple way.
  • A very convenient tool for understanding the risk
    return relationship.
  • Easy to estimate, easy to understand
  • Popular among practitioners and academics!
  • Any economic model is a simplified statement of
    reality!
  • Assumptions of CAPM?
  • Are investments in T-bills risk free?
  • Can we lend and borrow at the same rate?
  • Will investors invest in a limited number of
    benchmark portfolios?
  • T-bills and Market portfolio?
  • Can we define market risk depending on other
    benchmark portfolios?
  • Are there better ways of modelling risk and
    return?

13
Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium 1931-65
SML
30 20 10 0
Investors
  • The SLM has actually been flat!

Market Portfolio
Portfolio Beta
1.0
14
Is Beta Dead?
Beta vs. Average Risk Premium
Avg Risk Premium 1966-2005
  • The SLM has actually been too flat!
  • Return has not risen with Beta!
  • Has return been related to other measures?
  • Size?
  • Book to Market?

30 20 10 0
SML
Investors
Market Portfolio
Portfolio Beta
1.0
15
Testing the CAPM
Company Size vs. Average Return
Average Return ()
Company size
Smallest
Largest
16
Testing the CAPM
Book-Market vs. Average Return
Average Return ()
  • Noise?
  • Data mining?
  • Other factors?

Book-Market Ratio
Highest
Lowest
17
Consumption Betas vs Market Betas
Stocks (and other risky assets)
  • People invest to provide future consumption!
  • Most important risks are those that might
    cut-back future consumption.
  • We can measure risk by measuring the sensitivity
    of a security to investors consumption!
  • Then a stocks expected return should move in
    line with its Consumption Beta!
  • How do you estimate aggregate consumption?

Market risk makes wealth uncertain.
Standard CAPM
Wealth market portfolio
18
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Stocks (and other risky assets)
Wealth is uncertain
Market risk makes wealth uncertain.
Consumption CAPM
Standard CAPM
Wealth
Consumption is uncertain
Wealth market portfolio
Consumption
19
Modelling Risk and Return
  • Investors require extra expected return for
    taking on risks!
  • Investors are concerned with the risks they can
    not eliminate by diversification!
  • Are there other ways of modelling risk and
    return?
  • Are there better ways of modelling risk and
    return?

20
Topics Covered
  • Hedging
  • Forwards and Futures
  • Calls, Puts
  • Financial Alchemy with Options
  • What Determines Option Value
  • Option Valuation
  • Binomial model
  • Black-Scholes formula

21
Hedging
  • Business has risk
  • They insure or hedge to reduce risks! Not to make
    money!
  • HOW? Kellogg produces cereal.
  • A major component and cost factor is sugar.
  • To fix your sugar costs, you would ideally like
    to purchase all your sugar today, since you like
    todays price, and made your forecasts based on
    it. But, you can not!
  • You can, however, sign a contract to purchase
    sugar at various points in the future for a price
    negotiated today.
  • This contract is called a Futures Contract.
  • This technique of managing your sugar costs is
    called Hedging.

22
Forward and Futures Contracts
  • 1- Spot Contract
  • A contract for immediate sale delivery of an
    asset.
  • 2- Forward Contract
  • A contract between two people for the delivery of
    an asset at a negotiated price on a set date in
    the future.
  • 3- Futures Contract
  • A contract similar to a forward contract, except
    there is an intermediary that creates a
    standardized contract.
  • Thus, the two parties do not have to negotiate
    the terms of the contract. The intermediary
    guarantees all trades provides a secondary
    market for the speculation of Futures.
  • Not an actual sale!
  • Always a winner a loser!

23
What is an Option?
  • Example Desert land that contains gold deposit!
  • What if the cost of extraction gt current price of
    gold?
  • Is it worthless?
  • No if there is uncertainty about gold prices!
  • The option to expand?
  • The option to abandon?
  • The option to default?
  • Traded options?
  • Common stocks
  • Stock indices
  • Bonds
  • Commodities
  • FX
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