Required Return Analysis

Capital Market Line (CML)

The CML is an indicator of the trade-off between expected return and risk as
measured by standard deviation for efficient portfolios.
Assumptions:
1. Homoeneous expectations
!. "o transaction costs
#. $ll securities are infinitely divisible
%. "o taxes
&. "o tradin price impacts' i.e.' no individual impacts the market.
(. )ne period time hori*on
+. ,tili*e the mean-variance criteria for decision makin
.. /orrowin-Lendin at the risk free rate
1
1
]
1

+
M
Free M
p Free P
R R E
R R R

0 1
0 1
2e3uire 2eturn 4 15rice of time0 6 1$mount of risk0 15rice of risk0
2eward for waitin 4 price of time 4 y-intercept 4 2
7ree
2eward per unit of 2isk 4 the price of risk 4 slope 4 the market price of risk for
all efficient portfolios 1i.e.' the extra return to ained by increasin the level of
risk as defined by the standard deviation of the efficient portfolio by one unit0.
8alid for efficient portfolios only.
/y definition
27
4 9.
"ote: 2
M
is the return on the market portfolio' usually proxied by some broad index of
securities such as the ;<5 &99. Technically' the market portfolio should consist of an
investment in all possible securities. =ach security invested should correspond to its
relative market value. The relative market value of a security is e3ual to the areate
market value of the security divided by the sum of the areate market values of all
securities.
"ote: 2
7ree
is the return on the risk-free security' usually proxied by some overnment
security such as the T-bill.
Security Market Line (SML)
The ;ML is a raphical depiction of the C$5M
Capital Asset Pricing Model (CAPM)
The C$5M is an e3uation relatin the re3uired rate of return for any security 1or
portfolio0 with the risk for that security as measured by beta.
> 0 1 ? 0 1
Free M i Free i
R R E R R R +
2e3uired rate of return
i
4 risk-free rate 6 risk premium
2eward for waitin 4 price of time 4 y-intercept 4 2
7ree
2eward per unit of 2isk 4 the price of risk 4 slope 4 the market risk premium
( )

,
_

,
_

+
M
Free M
M
M i
Free i
R R E
R R R

0 1
0 1
'
2e3uired rate of return
i
4 15rice of time0 6 1$mount of risk0 15rice of risk0
where the Beta of Security
I
equals
M
i M i
M
M i
i

!
Market portfolio beta e3uals 1.
2isk-free security beta e3uals 9.
Portfolio beta: the weihted averae of the betas on the securities that make up the
portfolio 1i.e.'
P i i
i
N
X

1
0.
Beta estimation: )ne method to estimate beta is to rely on historical returns. 2eress the
returns from the security aainst the returns on the market portfolio. This produces a
characteristic line. The slope of this line is an estimate for the historical beta. $nother
alternative' which is more fre3uently used' is to use excess returns 1i.e.' the return from
the security 1and market0 less the risk-free rate0 rather than @ust returns.
Equilibrium Expected Returns: $ccordin to C$5M' asset prices will ad@ust until
e3uilibrium occurs whereby each and every security plots on the ;ML.
=12
ei
0 4 212
i
0 4 2
7ree
6 ?=12
M
0 - 2
7ree
>
i
"ote: =12
ei
0 is the e3uilibrium expected return on security i.
Oer!alued "oer!priced# securities: Ahen the expected return from a security is lower
than the re3uired return enerated by the C$5M' then the security is said to be over-
valued 1over-priced0. ;ince the market is somewhat efficient' there will be excess sell-side
orders which will drive the price down to clear the market. This in turn will cause the
expected return to increase.
$nder!alued "under!priced# securities: Ahen the expected return from a security is
hiher than the re3uired return enerated by the C$5M' then the security is said to be
under-valued 1under-priced0. ;ince the market is somewhat efficient' there will be excess
buy-side orders which will drive the price up to clear the market. This in turn will cause
the expected return to decrease.
Separation %heorem: The idea that the decision of which portfolio of risky assets to hold
is separate from the decision of how to allocate investable funds between the risk-free
asset and the risky asset.
Arbitra&e Pricin& %heory "AP%#: $n e3uilibrium theory of expected returns for securities
involvin few assumptions about investor preferences.
%otal ris': Total risk of security i consists of market risk 1inherent in all investments0 and
firm specific risk as defined by
i
4 ?
i
!
B
!
M
6
!
e
>
9.&
where
i
!
B
!
M
is the market
risk 1also called systematic risk and nondiversible risk0 and
!
e
is the firm specific risk
1also called unsystematic risk and diversifiable risk0
(isprice (easure "Alpha#: The difference between a securityCs expected return and an
appropriate 1e3uilibrium0 expected return. 7or example with the C$5M' alpha is define as:

i
4 =12
i
0 - =12
ei
0 4 =12
i
0 - D2
7ree
6 ?=12
M
0 - 2
7ree
>
i
E.
"ote: Aith the C$5M' a securityCs alpha is e3ual to the vertical distance by which it lies
above or below the ;ML.
if
i
F 9 then security iCs expected return is above the ;ML and the security is
underpricedG
if
i
H 9 then security iCs expected return is below the ;ML and the security is
overpricedG
if
i
4 9 then security iCs expected return is on the ;ML and the security is
correctly priced.