Chapter 7 Risk, Return, and the Capital Asset Pricing Model

Efficiency

- Allocative - Operational - Informational

Three Forms of Market Efficiency

- Weak Form - Semi-Strong Form - Strong Form

Semi-Strong Form Efficiency and Fundamental Analysis

- uses ALL PUBLIC INFORMATION as its definition of "information" (Earning announcements, SEC filings, annual reports, new reports) - Prices move so fast in response to public information that trading on it profitability is nearly impossible

Limitations of historical approach for individual stocks

-may reflect GE's past more than its future -Many stocks do not have a long history to forecast expected returns

Weak - Form Efficiency

-prices will be unpredictable and will change only in response to new information - this mean prices follow a random walk - pure random walk, or a "random walk with drift" E(Pt) = P0 + et or E(change in Pt) = E(R) + et

Informational

Asset prices incorporate all relevant information full and instantaneously When company A receives a takeover bid from Company B that seems certain to succeed, the stock price of A increases immediately to reflect the per share bid premium

The Historical Approach

Assume General Electric's long-run average return is 15.0%. T-Bills' average return over same period is 4% GE's historical risk premium: 15% - 4% = 11% GE's expected return = current T-bill rate + GE's historic risk premium = 2% + 11% = 13%

The Historical Approach

Assume that distribution of expected returns will be similar to historical distribution of returns Using annual returns over last 111 year, average risk premium for US stocks relative to Treasury bills is 7.5%. If T-bill currently offer a 2% yield to maturity. Expected return on US Stocks: 7.5% =

Low Beta

Because ConAgra's beta equals 0.6, we can say that the return on The ConAgra's shares moves, on average, 0.6 times as much as does the market return A stock that can gain or lose 12 percent in a week is a volatile, but ConAgra's volatility is only WEAKLY RELATED to fluctuations in the overall market Most of ConAgra's risk is SYSTEMATIC and can be eliminated through DIVERSIFICATION

High Beta

By definition, beta of average stock EQUALS 1.0 the return on a high-beta stock like Saks Incorporated experiences dramatic up-and-down swings WHEN THE MARKET RETURN MOVES Since Saks has a beta of 2.3, when the market's return one week moves 1%, then the return on Saks moves in the same direction by 2.3%

Security Market Line

Consider a portfolio composed of the following two assets: -an asset that pays a risk-free return Rf, and -a market portfolio that contains some of every risky asset in the market Risk-free asset: E(R): Rf Beta: 0 Market Portfolio: E(R): E(Rm) Beta: 1 Security market line: the line connecting the risk-free asset and the market portfolio -shows how an investor can construct a portfolio of T-bills and the market portfolio to achieve the desired level or risk and return

Expected Returns

Decisions must be based on expected returns - expect positive returns Methods used to estimate expected return: -Historical approach -Probabilistic approach -Risk-based approach *look at what has been returned in the past

Expected return of a portfolio with N securities

E(Rp) = w1E(R1)+w2E(R2)+....wnE(Rn) w1, w2, ...... wn: portfolio weights E(R1), E(R2),.... E(Rn): expected returns of securities Ex: E(Rp) = (0.125)(10%) + (0.25)(12%) + (0.125)(8%) + (0.5)(14%) = 12.25%

Weak Form

Financial asset (stock) prices incorporate ALL HISTORICAL INFORMATION into current prices Past stock price changes cannot help you predict future price changes

Allocative

Financial system allocated capital to its highest and best (most productive) use Ex. Stock market investors shun security offers from firms in declining industries but welcome offerings from firms in more promising industries

Operational

Financial system produces a given output at lowest possible input cost-or maximizes output for any given level of inputs Ex: average daily trading volume on NYSEnow over 10x its level of 20 yrs ago in same Wall Street location. NASDAQ markets trading volume increased even more

Probabilistic Approach

Identify all possible outcomes of returns and assign a probability to each possible outcome. Ex. assign probabilities for possible states of economy: boom, expansion, and recession, and project the returns of GE stock for the three states GE Expected Return = 0.20(-30%) + 0.70(15%)

2. Translate that risk measure into an expected return estimate

Plot beta against expected return for two assets: - a risk-free asset that pays 4% with certainty, with zero systematic risk AND - An "average stock", with beta equal to 1, with an expected return of 10% Draw a straight line connecting the two points investors holding a stock wit beta of 0.5 or 1.5 (example) can find the expected return on the line BETA MEASURES SYSTEMATIC RISK AND LINKS THE RISK AND EXPECTED RETURN OF AN ASSET An investor willing to accept an average level of systematic risk, by holding a stock with a beta of 1.0, expects a return of 10%. By holding only the risk-free asset, an investor can earn 4%, without having to accept any systematic risk at all.

Portfolio Expected Return with Short Selling

Portfolio weights have to ADD UP TO ONE However, these weights need NOT necessarily fall BETWEEN ZERO AND ONE

1. Measure the risk of the asset

Recall that: -systematic risks simultaneously affect many different securities -the market pays investors for bearing systematic risk(the risk that cannot be eliminated through diversification) -standard deviation measures an asset's total risk(which is equal to the sum of its systematic and unsystematic components)

Strong Form

Stock prices incorporate ALL INFORMATION, PRIVATE AS WELL AS PUBLIC Prices react as soon as new information is generated

Semi-Strong Form

Stock prices incorporate ALL PUBLICLY AVAILABLE information (Historical and current) Information in an SEC filing is incorporated into a stock price as soon as it is made public

Portfolio Expected Return

The portfolio expected return EQUALS the weighted average of the portfolio assets' expected returns

The Risk-Based Approach

This approach is more theoretically sound and used in practice

Negative Portfolio Weight

means that rather than investing in the given asset, an individual is borrowing that asset, selling it, and using the proceeds to invest in

Efficient Market

prices rapidly incorporate all relevant information

Strong Form of Market Efficiency

stock prices can affect their decision to use cash or stock in mergers - you can pay cash or you can use your own stock

Financial "BUBBLE"

unsustainable rising prices not supported by fundamentals? bubbles burst wanna be last person to sell before bubble bursts

Portfolio Risk

weighted average of systematic risk (beta) of the portfolio constituent securities Bp = (0.125)(1.00) + (0.25)(1.33) + (0.125)(0.67) + (0.50)(1.76) B: Beta (0.125) weights 1.00 Beta But portfolio volatility is not the same as the weighted average of all portfolio security volatilities