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    CAPM and The Characteristic Line

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    agrawalrohit_228384
    The document discusses the characteristic line and how it relates to the Capital Asset Pricing Model (CAPM). [1] The characteristic line measures the systematic and diversifiable risk of individual assets and portfolios. [2] It shows the relationship between the expected return of an asset and its beta, which measures the volatility of the asset relative to the market. [3] CAPM holds that the expected return of an asset is determined by its systematic risk as measured by beta.

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    CAPM and The Characteristic Line

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    agrawalrohit_228384
    132 views25 pages
    The document discusses the characteristic line and how it relates to the Capital Asset Pricing Model (CAPM). [1] The characteristic line measures the systematic and diversifiable risk of individual assets and portfolios. [2] It shows the relationship between the expected return of an asset and its beta, which measures the volatility of the asset relative to the market. [3] CAPM holds that the expected return of an asset is determined by its systematic risk as measured by beta.

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    CAPM

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    The document discusses the characteristic line and how it relates to the Capital Asset Pricing Model (CAPM). [1] The characteristic line measures the systematic and diversifiable risk of individual assets and portfolios. [2] It shows the relationship between the expected return of an asset and its beta, which measures the volatility of the asset relative to the market. [3] CAPM holds that the expected return of an asset is determined by its systematic risk as measured by beta.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    132 views25 pages

    CAPM and The Characteristic Line

    Uploaded by

    agrawalrohit_228384
    The document discusses the characteristic line and how it relates to the Capital Asset Pricing Model (CAPM). [1] The characteristic line measures the systematic and diversifiable risk of individual assets and portfolios. [2] It shows the relationship between the expected return of an asset and its beta, which measures the volatility of the asset relative to the market. [3] CAPM holds that the expected return of an asset is determined by its systematic risk as measured by beta.

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    CAPM and the Characteristic

    Line
    The Characteristic Line

     Total risk of any asset can be assessed by


    measuring variability of its returns
     Total risk can be divided into two parts—
    diversifiable risk (unsystematic risk) and non-
    diversifiable risk (systematic risk)
     The characteristic line is used to measure
    statistically the undiversifiable risk and
    diversifiable risk of individual assets and
    portfolios
    Characteristic line for the ith asset is:
    ri,t = ai + birm,t + ei,t OR

    ri,t = birm,t + ai + ei,t

    Take Variance of both sides of Equation


     VAR (ri,t) = VAR(birm,t ) +VAR(ai) + VAR(ei,t)
     VAR(birm,t ) = VAR (ri,t) - VAR(ei,t) OR
     VAR(ei,t) = VAR(ri,t) - VAR(birm,t )
    Beta Coefficients

    An index of risk

    Measures the volatility of a stock (or


    portfolio) relative to the market
    Beta Coefficients Combine
    The variability of the asset’s return

    The variability of the market return

    The correlation between


    – the stock's return and
    – the market return
    Beta Coefficients

    Beta coefficients are the slope of


    the regression line relating
    – the return on the market (the
    independent variable) to
    – the return on the stock (the
    dependent variable)
    Beta Coefficients
    Interpretation of the
    Numerical Value of Beta

    Beta = 1.0 Stock's return has


    same volatility as the market return

    Beta > 1.0 Stock's return is more


    volatile than the market return
    Interpretation of the
    Numerical Value of Beta
    Interpretation of the Numerical
    Value of Beta
    Beta < 1.0 Stock's return is less
    volatile than the market return
    Interpretation of the Numerical
    Value of Beta
    High Beta Stocks

    More systematic market risk

    May be appropriate for high-risk


    tolerant (aggressive) investors
    Low Beta Stocks

    Less systematic market risk

    May be appropriate for low-risk


    tolerant (defensive) investors
    Individual Stock Betas

    May change over time

    Tendency to move toward 1.0, the


    market beta
    Portfolio Betas

    Weighted average of the individual


    asset's betas

    May be more stable than


    individual stock betas
    How Characteristic Line leads
    to CAPM?
    The characteristic regression line of an
    asset explains the asset’s systematic
    variability of returns in terms of market
    forces that affect all assets simultaneously
    The portion of total risk not explained by
    characteristic line is called unsystematic
    risk
    Assets with high degrees systematic
    risk must be priced to yield high
    returns in order to induce investors to
    accept high degrees of risk that are
    undivesifiable in the market
    CAPM illustrates positive relationship
    between systematic risk and return on
    an asset
    Capital Asset Pricing Model
    (CAPM)
    For a very well-diversified portfolio, beta
    is the correct measure of a security’s risk.
    All investments and portfolios of
    investments must lie along a straight-line
    in the return-beta space
    Required return on any asset is a linear
    function of the systematic risk of that asset
    E(ri) = rf + [E(rm) – rf]  i
    The Capital Asset Pricing
    Model (CAPM)

    The CAPM has


    – A macro component explains risk
    and return in a portfolio context
    – A micro component explains
    individual stock returns
    – The micro component is also used
    to value stocks
    Beta Coefficients and
    The Security Market Line

    The return on a stock depends on


    – the risk free rate (rf)
    – the return on the market (rm)
    – the stock's beta
    – the return on a stock:
    k= rf + (rm - rf)beta
    Beta Coefficients and
    The Security Market Line

    The figure relating systematic risk


    (beta) and the return on a stock
    Beta Coefficients and
    The Security Market Line
    CAPM can be used to price any asset provided
    we know the systematic risk of that asset
    In equilibrium, every asset must be priced so
    that its risk-adjusted required rate of return
    falls exactly on the straight line
    If an investment were to lie above or below
    that straight line, then an opportunity for
    riskless arbitrage would exist.
    Examples of CAPM

    Stocks Expected Return Beta


    A 16% 1.2
    B 19% 1.3
    C 13% 0.75
    E(rm) = 18% rf = 14%
    Which of these stocks is correctly priced?
    Example of CAPM

    Given the following security market line

    E(ri) = 0.07 + 0.09I

    What must be the returns for two stocks


    assuming their betas are 1.2 and 0.9?

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