Capital asset pricing model ppt

risk return and the capital asset pricing model ppt and capital asset pricing model and modern portfolio theory ppt
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Published Date:26-07-2017
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0 Aswath  Damodaran   THE  INVESTMENT  PRINCIPLE:  RISK   AND  RETURN  MODELS       “You  cannot  swing  upon  a  rope  that  is  aCached  only   to  your  own  belt.”  First  Principles   1 Maximize the value of the business (firm) The Investment Decision The Dividend Decision The Financing Decision Invest in assets that earn a If you cannot find investments Find the right kind of debt return greater than the that make your minimum for your firm and the right minimum acceptable hurdle acceptable rate, return the cash mix of debt and equity to rate to owners of your business fund your operations The hurdle rate How much The return How you choose The optimal The right kind should reflect the should reflect the cash you can to return cash to mix of debt of debt riskiness of the return magnitude and the owners will and equity matches the investment and the timing of the depends upon depend on maximizes firm tenor of your the mix of debt cashflows as welll current & whether they value assets and equity used potential as all side effects. prefer dividends to fund it. investment or buybacks opportunities Aswath  Damodaran   1 The  noJon  of  a  benchmark     2 ¨  Since  financial  resources  are  finite,  there  is  a  hurdle  that   projects  have  to  cross  before  being  deemed  acceptable.   This  hurdle  should  be  higher  for  riskier  projects  than  for   safer  projects.   ¨  A  simple  representaJon  of  the  hurdle  rate  is  as  follows:   Hurdle  rate        =    Riskless  Rate  +  Risk  Premium   ¨  The  two  basic  quesJons  that  every  risk  and  return  model   in  finance  tries  to  answer  are:   ¤  How  do  you  measure  risk?   ¤  How  do  you  translate  this  risk  measure  into  a  risk  premium?   Aswath  Damodaran   2 What  is  Risk?   3 ¨  Risk,  in  tradiJonal  terms,  is  viewed  as  a  ‘negaJve’.   Webster’s  dicJonary,  for  instance,  defines  risk  as  “exposing   to  danger  or  hazard”.  The  Chinese  symbols  for  risk,   reproduced  below,  give  a  much  beCer  descripJon  of  risk   危机   ¨  The  first  symbol  is  the  symbol  for  “danger”,  while  the  second   is  the  symbol  for  “opportunity”,  making  risk  a  mix  of  danger   and  opportunity.  You  cannot  have  one,  without  the  other.   ¨  Risk  is  therefore  neither  good  nor  bad.  It  is  just  a  fact  of  life.   The  quesJon  that  businesses  have  to  address  is  therefore  not   whether  to  avoid  risk  but  how  best  to  incorporate  it  into  their   decision  making.   Aswath  Damodaran   3 A  good  risk  and  return  model  should…   4 1.  It  should  come  up  with  a  measure  of  risk  that  applies  to  all  assets   and  not  be  asset-­‐specific.   2.  It  should  clearly  delineate  what  types  of  risk  are  rewarded  and   what  are  not,  and  provide  a  raJonale  for  the  delineaJon.   3.  It  should  come  up  with  standardized  risk  measures,  i.e.,  an   investor  presented  with  a  risk  measure  for  an  individual  asset   should  be  able  to  draw  conclusions  about  whether  the  asset  is   above-­‐average  or  below-­‐average  risk.   4.  It  should  translate  the  measure  of  risk  into  a  rate  of  return  that   the  investor  should  demand  as  compensaJon  for  bearing  the   risk.   5.  It  should  work  well  not  only  at  explaining  past  returns,  but  also  in   predicJng  future  expected  returns.   Aswath  Damodaran   4 The  Capital  Asset  Pricing  Model   5 1.  Uses  variance  of  actual  returns  around  an  expected   return  as  a  measure  of  risk.   2.  Specifies  that  a  porJon  of  variance  can  be  diversified   away,  and  that  is  only  the  non-­‐diversifiable  porJon   that  is  rewarded.   3.  Measures  the  non-­‐diversifiable  risk  with  beta,  which  is   standardized  around  one.   4.  Translates  beta  into  expected  return  -­‐     Expected  Return  =    Riskfree  rate  +  Beta    Risk  Premium   5.  Works  as  well  as  the  next  best  alternaJve  in  most   cases.   Aswath  Damodaran   5 1.  The  Mean-­‐Variance  Framework   6 ¨  The  variance  on  any  investment  measures  the  disparity   between  actual  and  expected  returns.     Low Variance Investment High Variance Investment Expected Return Aswath  Damodaran   6 Aug-­‐13   Jun-­‐13   Apr-­‐13   Feb-­‐13   Dec-­‐12   Oct-­‐12   Aug-­‐12   Jun-­‐12   Apr-­‐12   Feb-­‐12   Dec-­‐11   Oct-­‐11   Aug-­‐11   Jun-­‐11   Apr-­‐11   Feb-­‐11   Dec-­‐10   Oct-­‐10   Aug-­‐10   Jun-­‐10   Apr-­‐10   Feb-­‐10   Dec-­‐09   Oct-­‐09   Aug-­‐09   Jun-­‐09   Apr-­‐09   Feb-­‐09   Dec-­‐08   Oct-­‐08   How  risky  is  Disney?  A  look  at  the  past…   7 Returns  on  Disney  -­‐  2008-­‐2013     25.00%   Average  monthly  return  =  1.65%   Average  monthly  standard  deviaJon  =  7.64%   20.00%   Average  annual  return  =  21.70%   Average  annual  standard  deviaJon  =  26.47%   15.00%   10.00%   5.00%   0.00%   -­‐5.00%   -­‐10.00%   -­‐15.00%   -­‐20.00%   -­‐25.00%   Aswath  Damodaran   7 Do  you  live  in  a  mean-­‐variance  world?   8 ¨  Assume  that  you  had  to  pick  between  two  investments.  They   have  the  same  expected  return  of  15%  and  the  same   standard  deviaJon  of  25%;  however,  investment  A  offers  a   very  small  possibility  that  you  could  quadruple  your  money,   while  investment  B’s  highest  possible  payoff  is  a  60%  return.   Would  you   a.  be  indifferent  between  the  two  investments,  since  they  have  the   same  expected  return  and  standard  deviaJon?   b.  prefer  investment  A,  because  of  the  possibility  of  a  high  payoff?   b.  prefer  investment  B,  because  it  is  safer?   ¨  Would  your  answer  change  if  you  were  not  told  that  there  is   a  small  possibility  that  you  could  lose  100%  of  your  money  on   investment  A  but  that  your  worst  case  scenario  with   investment  B  is  -­‐50%?   Aswath  Damodaran   8 The  Importance  of  DiversificaJon:  Risk  Types   9 Figure 3.5: A Break Down of Risk Competition may be stronger or weaker than Exchange rate anticipated and Political risk Projects may Interest rate, do better or Entire Sector Inflation & worse than may be affected news about expected by action economy Firm-specific Market Actions/Risk that Actions/Risk that Affects few Affects many affect only one affect all investments firms firms firm Firm can Investing in lots Acquiring Diversifying Diversifying Cannot affect reduce by of projects competitors across sectors across countries Investors Diversifying across domestic stocks Diversifying globally Diversifying across can asset classes mitigate by Aswath  Damodaran   9 Why  diversificaJon  reduces/eliminates   firm  specific  risk   10 ¨  Firm-­‐specific  risk  can  be  reduced,  if  not  eliminated,  by   increasing  the    number  of  investments  in  your  porlolio   (i.e.,  by  being  diversified).  Market-­‐wide  risk  cannot.  This   can  be  jusJfied  on  either  economic  or  staJsJcal   grounds.   ¨  On  economic  grounds,  diversifying  and  holding  a  larger   porlolio  eliminates  firm-­‐specific  risk  for  two  reasons-­‐   a.  Each  investment  is  a  much  smaller  percentage  of  the  porlolio,   muJng  the  effect  (posiJve  or  negaJve)  on  the  overall   porlolio.   b.  Firm-­‐specific  acJons  can  be  either  posiJve  or  negaJve.  In  a   large  porlolio,  it  is  argued,  these  effects  will  average  out  to   zero.  (For  every  firm,  where  something  bad  happens,  there   will  be  some  other  firm,  where  something  good  happens.)   Aswath  Damodaran   10 The  Role  of  the  Marginal  Investor   11 ¨  The  marginal  investor  in  a  firm  is  the  investor  who  is   most  likely  to  be  the  buyer  or  seller  on  the  next  trade   and  to  influence  the  stock  price.     ¨  Generally  speaking,  the  marginal  investor  in  a  stock  has   to  own  a  lot  of  stock  and  also  trade  that  stock  on  a   regular  basis.   ¨  Since  trading  is  required,  the  largest  investor  may  not  be   the  marginal  investor,  especially  if  he  or  she  is  a   founder/manager  of  the  firm  (Larry  Ellison  at  Oracle,   Mark  Zuckerberg  at  Facebook)   ¨  In  all  risk  and  return  models  in  finance,  we  assume  that   the  marginal  investor  is  well  diversified.   Aswath  Damodaran   11 IdenJfying  the  Marginal  Investor  in  your  firm…   12 Percent of Stock held Percent of Stock held by Marginal Investor by Institutions Insiders High Low Institutional Investor High High Institutional Investor, with insider influence Low High (held by Tough to tell; Could be insiders but only if they founder/manager of firm) trade. If not, it could be individual investors. Low High (held by wealthy Wealthy individual investor, fairly diversified individual investor) Low Low Small individual investor with restricted diversification Aswath  Damodaran   12 Gauging  the  marginal  investor:  Disney  in   2013   Aswath Damodaran 13 Extending  the  assessment  of  the  investor   base   ¨  In  all  five  of  the  publicly  traded  companies  that  we   are  looking  at,  insJtuJons  are  big  holders  of  the   company’s  stock.   Aswath Damodaran 14 The  LimiJng  Case:  The  Market  Porlolio   15 ¨  The  big  assumpJons  &  the  follow  up:  Assuming  diversificaJon   costs  nothing  (in  terms  of  transacJons  costs),  and  that  all  assets   can  be  traded,  the  limit  of  diversificaJon  is  to  hold  a  porlolio  of   every  single  asset  in  the  economy  (in  proporJon  to  market  value).   This  porlolio  is  called  the  market  porlolio.     ¨  The  consequence:    Individual  investors  will  adjust  for  risk,  by   adjusJng  their  allocaJons  to  this  market  porlolio  and  a  riskless   asset  (such  as  a  T-­‐Bill):   Preferred  risk  level    Alloca?on  decision   No  risk    100%  in  T-­‐Bills   Some  risk    50%  in  T-­‐Bills;  50%  in  Market  Porlolio;   A  liCle  more  risk  25%  in  T-­‐Bills;  75%  in  Market  Porlolio   Even  more  risk    100%  in  Market  Porlolio   A  risk  hog..    Borrow  money;  Invest  in  market  porlolio   Aswath  Damodaran   15 The  Risk  of  an  Individual  Asset   16 ¨  The  essence:  The  risk  of  any  asset  is  the  risk  that  it  adds  to   the  market  porlolio  StaJsJcally,  this  risk  can  be  measured  by   how  much  an  asset  moves  with  the  market  (called  the   covariance)   ¨  The  measure:  Beta  is  a  standardized  measure  of  this   covariance,  obtained  by  dividing  the  covariance  of  any  asset   with  the  market  by  the  variance  of  the  market.  It  is  a   measure  of  the  non-­‐diversifiable  risk  for  any  asset  can  be   measured  by  the  covariance  of  its  returns  with  returns  on  a   market  index,  which  is  defined  to  be  the  asset's  beta.   ¨  The  result:  The  required  return  on  an  investment  will  be  a   linear  funcJon  of  its  beta:   ¤  Expected  Return  =  Riskfree  Rate+  Beta    (Expected  Return  on  the   Market  Porlolio  -­‐   Riskfree  Rate)   Aswath  Damodaran   16 LimitaJons  of  the  CAPM   17 1.  The  model  makes  unrealisJc  assumpJons   2.  The  parameters  of  the  model  cannot  be  esJmated   precisely   ¤  The  market  index  used  can  be  wrong.   ¤  The  firm  may  have  changed  during  the  'esJmaJon'  period'   3.  The  model  does  not  work  well   ¤  -­‐  If  the  model  is  right,  there  should  be:       n   A  linear  relaJonship  between  returns  and  betas   n   The  only  variable  that  should  explain  returns  is  betas   ¤  -­‐  The  reality  is  that   n   The  relaJonship  between  betas  and  returns  is  weak     n   Other  variables  (size,  price/book  value)  seem  to  explain   differences  in  returns  beCer.   Aswath  Damodaran   17 AlternaJves  to  the  CAPM   18 Step 1: Defining Risk The risk in an investment can be measured by the variance in actual returns around an expected return Riskless Investment Low Risk Investment High Risk Investment E(R) E(R) E(R) Step 2: Differentiating between Rewarded and Unrewarded Risk Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk) Can be diversified away in a diversified portfolio Cannot be diversified away since most assets 1. each investment is a small proportion of portfolio are affected by it. 2. risk averages out across investments in portfolio The marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will be rewarded and priced. Step 3: Measuring Market Risk The CAPM The APM Multi-Factor Models Proxy Models If there are no If there is Since market risk affects In an efficient market, arbitrage opportunities 1. no private information most or all investments, differences in returns then the market risk of 2. no transactions cost it must come from across long periods must any asset must be the optimal diversified macro economic factors. be due to market risk captured by betas portfolio includes every Market Risk = Risk differences. Looking for relative to factors that traded asset. Everyone exposures of any variables correlated with affect all investments. will hold this market portfolio asset to macro returns should then give Market Risk = Risk Market Risk = Risk economic factors. us proxies for this risk. exposures of any added by any investment Market Risk = asset to market to the market portfolio: Captured by the factors Proxy Variable(s) Beta of asset relative to Betas of asset relative Betas of assets relative Equation relating Market portfolio (from to unspecified market to specified macro returns to proxy a regression) factors (from a factor economic factors (from variables (from a analysis) a regression) regression) Aswath  Damodaran   18 Why  the  CAPM  persists…   19 ¨  The  CAPM,  notwithstanding  its  many  criJcs  and  limitaJons,   has  survived  as  the  default  model  for  risk  in  equity  valuaJon   and  corporate  finance.  The  alternaJve  models  that  have   been  presented  as  beCer  models  (APM,  MulJfactor  model..)   have  made  inroads  in  performance  evaluaJon  but  not  in   prospecJve  analysis  because:   ¤  The  alternaJve  models  (which  are  richer)  do  a  much  beCer  job  than   the  CAPM  in  explaining  past  return,  but  their  effecJveness  drops  off   when  it  comes  to  esJmaJng  expected  future  returns  (because  the   models  tend  to  shiu  and  change).   ¤  The  alternaJve  models  are  more  complicated  and  require  more   informaJon  than  the  CAPM.   ¤  For  most  companies,  the  expected  returns  you  get  with  the  the   alternaJve  models  is  not  different  enough  to  be  worth  the  extra   trouble  of  esJmaJng  four  addiJonal  betas.   Aswath  Damodaran   19

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