Asset Pricing Model Lec2-Investment Managment And Portfolio-Lecture Notes, Study notes of Investment Management and Portfolio Theory

Download Asset Pricing Model Lec2-Investment Managment And Portfolio-Lecture Notes and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 37 ASSET PRICING MODEL Contd… Introduction of the Risk-Free Asset: The first assumption of CMT listed above is that investors can borrow and lend at the risk- free rate. Although the introduction of a risk-free asset appears to be a simple step to take in the evolution of portfolio and CMT, it is a very significant step. In-fact, it is the introduction of a risk-free asset that allows us to develop CMT from portfolio theory. With the introduction of risk-free asset, investors can now invest part of their wealth; in this asset and the remainder in any of the risky portfolios in the Markowitz efficient set. Lt allows Markowitz portfolio theory to be extended in such a way that the efficient frontier is completely changed, which in turn leads to a general theory for pricing assets under uncertainty. A risk-free asset can be defined as one, with a certain-to-be-earned expected return and a variance of return of zero. Since variance = 0, the nominal risk-free rate in each period will be equal to its expected value. Furthermore, the covariance between the risk-free asset and any risky asset i will be zero. The true risk-free asset is best thought of as a Treasury Security, which has no risk of default, with a maturity matching /the holding period of the investor. In this case, the amount of money to be received at the end of, the holding period is known with certainty at the beginning of the period. The Treasury bill typically is taken to be the risk-free asset, and its rate of return is referred to here as RF. Risk-Free Borrowing and Lending: Assume; that the efficient frontier, has been derived by an investor. The arc AB delineates the efficient set of portfolios of risky assets. We now introduce a risk-free asset with return RF and  = 0. What if we extend this analysis to allow investors to borrow money? The investors no longer restricted to his or, her wealth when investing in risky assets. Technically, we are show selling the riskless asset. One way to accomplish this borrowing is to buy stocks on margin, which has a current initial margin requirement of 50 percent. We will assume that investors can also borrow at the risk-free rate RF. This assumption can be removed without changing the basic arguments. Borrowing additional investable funds and investing them together with the investor's own wealth allows investors to seek higher, expected returns while assuming greater risk. These borrowed funds can be used to lever the portfolio position beyond point M, the point of tangency between the straight line emanating from RF and the efficient frontier AB. Estimating the SML: To implement the SML approach described here an investor needs estimates of the return on the risk-free asset (RF), the expected return on the market index, and the beta for an individual security. How difficult are these to obtain? The RF should, be the easiest of the three variables, to obtain. In estimating RF, the investor docsity.com y g ( ) can use as a proxy the return on Treasury bills for the coining period (e.g., a year). Estimating the market return is more difficult, because the expected return for the market index is not observable. Furthermore, several different market indexes could be used. Estimates of the market return could be derived from a study of previous market returns. Alternatively, probability estimates of market returns could be made, and the expected value calculated. This would provide an estimate of both the expected return and the standard deviation for the market. Finally, it is necessary to estimate the betas for individual securities. This is a crucial part of the CAPM estimation process. The estimates of RF and the expected return on the market are the same for each security being evaluated. Only beta is unique, bringing together the investor's expectations of returns for the stock with those for the market. Beta is the only company-specific factor in the CAPM; therefore, risk is the only asset-specific forecast that must be made in the CAPM. Estimating Beta: A less restrictive form of the single-index model is known as the market model. This model is identical to the Single-index model except that the assumption of the error terms for different securities being uncorrelated is not made. The market model equation is the same as for the single-index model: Ri = i + iRM + i Where; Ri = the return (TR) on security i RM = the return (TR) on the market index: i = the intercept term i = the slope term i = the random residual error; The market model produces an estimate of return for any stock. To estimate the market model, the TRs for stock i can be regressed on the corresponding TRs, for the market index. Estimates will be obtained of i (the constant return on security i that is earned regardless of the level of market returns) and i, (the slope coefficient that indicates the expected increase in a security's return for a 1 -percent, increase in market return). This is how the estimate of a stock's beta is often derived. Arbitrage Pricing Theory: An equilibrium theory of expected returns for securities involving few assumptions about investor preferences The CAPM is not the only model of security pricing. Another model that has received attention is based on arbitrage pricing theory (APT) as developed by Ross and enhanced by others. In recent years, APT has emerged as an alternative theory-of asset pricing to the CAPM. Its appeal is that it is more general than the1 CAPM, with less restrictive assumptions. However, like the CAPM, it has limitations, and like the CAPM, it is not the final word in asset pricing. docsity.com y g ( ) execute the necessary decisions for an investor. The process provides a framework and a control over the diverse activities involved, and allows every investor, an individual or institution, to be accommodated in a systematic, orderly manner. As outlined by Maginn and Tuttle, portfolio management is an ongoing process by which: 1. Objectives, constraints, and preferences are identified for each investor. This leads to the development of an explicit investment policy statement which is used to guide the money management process. 2. Capital market expectations for the economy, industries and sectors, and individual securities are considered arid quantified. 3. Strategies are developed arid implemented. This involves asset allocation, portfolio optimization, and selection of securities. 4. Portfolio factors are monitored and responses are; made as investor objectives and constraints and/or market expectations change. 5. The portfolio is rebalanced as necessary by repeating the asset allocation, portfolio strategy, and security selection steps. 6. Portfolio performance is measured and evaluated to ensure attainment of the investor objectives. Individual Investors Vs Institutional Investors: Significant differences exist among investors as to objectives, constraints, and preferences. We are primarily interested here in the viewpoint of the individual investor, but the basic investment management process applies to all investors, individuals, and institutions. Furthermore, individuals are often the beneficiaries of the activities of institutional investors, and an understanding of how institutional investors fit into the investment management process is desirable. A major difference between the two occurs with regard to time horizon, because institutional investors are often thought of on a perpetual basis, but this concept has no meaning when applied to individual investors. For individual investors, it is often useful to think of a life-cycle approach, as people go from the beginning of their careers to retirement. This approach is less useful for institutional investors, because they typically maintain a relatively constant profile across time. Kaiser has summarized the differences between individual investors and institutional investors as follows: 1. Individuals define risk as ''losing money”, whereas institutions use approach, typically defining risk in terms of standard deviation. 2. Individuals can be characterized by their personalities, whereas for institutions, we consider the investment characteristics of those with a beneficial interest in the portfolios managed by the institutions. 3. Goals are a key part of what individual investing is all about, along with their assets, whereas for institutions, we can be more precise as to their total package of assets and liabilities. 4. Individuals have great freedom in what they can do with regard to investing whereas institutions are subject to numerous legal and regulatory constraints. 5. Taxes often are a very important consideration for individual investors, whereas many institutions, such as pension funds, are free of such considerations. docsity.com y g ( ) The implications of all of this for the investment management process are as follows:  For individual investors: Because each individual's financial profile is different, an investment policy for an individual investor must incorporate that investor's unique factors. In effect, preferences are self-imposed constraints.  For institutional investors: Given the increased complexity in managing institu- tional portfolios, it is critical to establish a well defined and effective policy. Such a policy must clearly delineate the objectives being sought, the institutional investor's risk tolerance, and the investment Constraints and preferences under which it must operate. The primary reason for establishing a long term investment policy for institutional investors is two fold: 1. It prevents arbitrary revisions of a soundly designed investment policy. 2. It helps the portfolio manager to plan and execute on a long term basis and resist short term pressures that could derail the plan. docsity.com