ISM Notes - ISM Notes.oo3 03/04/2008 15:16:33 Lecture...

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03/04/2008 15:16:33 ISMNotes.oo3 1 Lecture Investments and Securities Markets Untitled #1 1 CAPM Background Assumptions All investors are risk averse, measure risk in terms of Standard Deviation of Portfolio Return Common Time Horizon Identical Subjective Estimates of future returns and risk for all assets there exists a risk-free asset all investors may borrow or lend unlimted amounts at the risk free rate all assets are completely divisible no transaction costs or differential taxes no restrictions on short selling information is freely and simultaneously available to all investors. Calculation Direct relationship between expected return and beta value expected return on share i= risk free rate+ beta{expected return on market - risk free rate} Equity Market: 6% more than risk free rate Equity Risk Premium Testing Typical Approach Measure each security beta relative to a index over a period of time Form portfolios each with many stocks having similar historic betas("risk return groups") Risk return groups = risk class Calculate average annual return for each risk return group over a number of years. Problems CAPM is stated in terms of investor expectations instead of historic returns One period model that must be tested using returns over a particular test period Beta True Betas required for calculations Beta is sensitive to calculations Frequency of Data points Market portfolio should include all risky assets Share Betas are unstable
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03/04/2008 15:16:33 ISMNotes.oo3 2 Portfolio betas are more stable Assumptions The following must be constant Risk free rate Market Risk Premium Asset's Beta coefficient Early Tests Black, Jensen and Scholes(1972) Fama and Macbeth(1973) Risk Return Equity Empirical Tests Positive Relationship between beta values and returns Supported Zero Beta version of CAPM Market Anomalies in 90's Inconsistencies with market efficiency and CAPM Small Firms Effect Higher Beta > 1 lower returns than expected Low Beta < 1 higher returns than expected Flatter line/gradient Implications if CAPM is rejected no relationship between risk and return beta is the wrong reason of risk average realised returns are useless as estimates of expected returns CAPM Summary Less convincing now than in 1970s. Fama and French - Three Factor Model Method 1 Calculate marcap for share, 2 Rank by size and form 10 portfolios, from largest to smallest 3 Estimate β of every share each year using data for previous 5 years 4 Within each size portfolio, form 10 portfolios ranked by β , from highest to lowest, then have 100 portfolios with 100 different shares every year. 5 Calculate monthly returns for each portfolio for 1963-1990 6 Calculate portfolio beta for each portfolio using date from the whole period
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03/04/2008 15:16:33 ISMNotes.oo3 3 Lecture Investments and Securities Markets Untitled #1 7 Relate average monthly returns to size and β (and other variables) Results Negative relation between size and return Smaller Size --> larger return No relation between β and return even if β is the only variable Small shares do have higher β s
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This note was uploaded on 04/03/2008 for the course MSE ISM taught by Professor Andrewadams during the Fall '07 term at University of Edinburgh.

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ISM Notes - ISM Notes.oo3 03/04/2008 15:16:33 Lecture...

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