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Understanding Risk, Return, and Asset Pricing Models in Investment Strategies

This chapter explores key concepts in investment return and risk assessment, detailing how the market value of a portfolio changes and the significance of cash distributions. It differentiates between systematic and unsystematic risks, explains how to calculate portfolio beta, and introduces the Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT). It highlights the importance of diversification and empirically discusses the relationship between risk and returns while noting the assumptions underlying these models.

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Understanding Risk, Return, and Asset Pricing Models in Investment Strategies

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  1. Chapter 13 RISK/RETURN AND ASSET PRICING MODELS

  2. Investment Return • Change in market value of the portfolio plus cash distributions received.Where: V1 = portfolio market value at end of interval V0 = portfolio market value at beginning of interval D1 = cash distributions during interval

  3. Portfolio Risk • Expected Portfolio Return • Variability of Expected Return

  4. Diversification • A portfolio of securities whose returns are not perfectly positively correlated. • Total Risk • Systematic or market-related risk, which is non-diversifiable. • Unsystematic or company-specific risk, which is diversifiable.

  5. The Risk of an Individual Security • Security Return • Systematic return • Unsystematic return • Systematic Risk • Security’s beta times the standard deviation of the market return • Unsystematic Risk • Standard deviation of security residual returns

  6. The Risk of a Portfolio of Securities • Portfolio Return • Systematic return • Unsystematic return • Systematic Risk • Portfolio beta times the standard deviation of the market return. • Portfolio beta is the market value-weighted average of the individual security betas. • Unsystematic Risk • Market value-weighted average of the individual security standard deviation of residual returns.

  7. Beta • Beta for a portfolio consisting of all stocks in the market is 1.0; it has average risk. • If a stock’s beta > 1.0, it has above average risk. • If a stock’s beta < 1.0, it has below average risk.

  8. Estimating Beta • Use regression analysis on historical data to estimate the market model. • The estimated slope of the market model is the beta estimate.

  9. The Capital Asset Pricing Model • The expected return on a portfolio should exceed the risk-free rate of return by an amount that is proportional to the portfolio beta.

  10. The Capital Asset Pricing Model • The expected risk premium of a portfolio should equal its beta times the expected market risk premium.

  11. Assumptions Underlying the CAPM • Investors are assumed to be risk-averse. • All investors have a common time horizon for investment decision-making. • All investors have the same expectations about future security returns and risks. • Capital markets are perfect.

  12. Empirical Evidence of CAPM • There is a significant positive relationship between realized returns and systematic risk. • The relationship between risk and return appears to be linear. • Effects of systematic and unsystematic risk on security returns are not fully understood.

  13. Arbitrage Pricing Theory (APT) • Several factors determine the rate of return on a security, not just one as in the CAPM. • Business cycle • Interest rates • Investor confidence • Short-term inflation • Inflationary expectations

  14. The Multifactor CAPM • External factors influence the expected returns on securities and portfolios. • Expected future labor income • Expected future relative prices of consumer goods • Expected future investment opportunities

  15. Empirical Evidence • Testability of APT is questionable. • APT gives no direction as to how to choose factors or how many factors should be considered.

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