Question

CAPM potpourri

• Can you re- define the CAPM mode as:

                               E(Ri) – Rf = [E(Rm) - Rf]

                a. Yes or not? Why?

• Studies have found that Beta is not the only factor that matters for determining the expected return on a stock

a. Mention 3 other factors that impact the expected return of the stock and how they could affect

     it. Explain thoroughly

• Why Beta was declared “dead” after the market crash of 1987?

a. Explain what was the reasoning for this statement?

Answer 1

Ans ) Capital asset pricing model : displays the relationship between risk and expected return for a company’s assets. This model is used throughout financing for calculating expected returns for assets while including risk and cost of capital.

Calculating Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) states that the expected return on an asset is related to its risk as measured by beta:

E(Ri) = Rf + ßi * (E(Rm) – Rf)

Or = Rf + ßi * (risk premium )

E(Ri) = the expected return on asset given its beta

Rf = the risk-free rate of return

E(Rm) = the expected return on the market portfolio

ßi = the asset’s sensitivity to returns on the market portfolio

E(Rm) – Rf = market risk premium, the expected return on the market minus the risk free rate.

Beta :

The beta of an asset, such as a stock, measures the market risk of that particular asset as compared to the rest of the market — hence, it also measures volatility of the asset compared to the general market. The beta is calculated by comparing the historical return of an asset compared to the market return using statistical techniques to calculate their covariance:

Formula for the Beta Coefficient of a Stock

Beta Coefficient of Stock	=	Cov(rs, rm)σ2m
rs = Stock Return rm = Market Return σ2m = Market Variance

Betas are mostly used to compare return/risk ratios for stocks and mutual funds, because the stock market, or funds composed of stocks, have a greater diversity of volatility than other asset classes. However, stock betas don't have to be calculated, since most are published in detailed stock quotations offered by major online financial services.

Factors determining stock return

The Ideal Asset Mix

The asset mix of an investment portfolio determines its overall return. There is a risk-return tradeoff with every asset – the higher the risk, the higher the volatility and return potential. For example, stocks are generally riskier and more volatile than bonds, but the rates of return on stocks have exceeded those of bonds over the long term.

An investment portfolio fully invested in stocks is likely to suffer in a down economy and during periods of high market volatility. On the other hand, a conservative portfolio invested mainly in high-quality bonds is likely to have lower, although more predictable and stable returns.

Government and Political Factors

Fiscal policy, regulations and political stability also affect investment rates of return. Large fiscal deficits reduce government flexibility and may result in higher borrowing costs for businesses. An arduous regulatory approval process can hamper business investments in the resource and energy sectors. Political stability creates investor and business confidence because there is more visibility into possible investment returns. Investors tend to avoid countries that change governments frequently or have civil strife.

The General Economy

Macroeconomic conditions affect investment rates of return. A growing economy means that more people have jobs, which means they spend more. For businesses, this leads to increases in sales, profits and investments in new employees and equipment. However, rapid economic growth can lead to higher interest rates. This makes credit more expensive, thus dampening consumer spending and business investments.

Economic slowdowns lead to low employment, which usually means lower profits and stock prices. The resulting weakness in the stock markets could improve bond prices as investors move funds to the relative safety of bonds.

1987 market crash :.

The crash of 1987 was a big one-day correction to a stock market that had spent the first half of the year gaining momentum, Shilling said.

As many of the managers interviewed noted, one of the big causes of the crash was a strategy called “portfolio insurance,” which was designed to limit losses by buying stock index futures in a rising market and selling them in a declining market.