The risks in the Securities Market - Free Essay Example

Sample details Pages: 5 Words: 1444 Downloads: 1 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Did you like this example? In the securities markets, both casual observation and formal research has suggested that investment risk is as important to investors as expected return. Formal research such as Capital Asset Pricing Model (CAPM) has demonstrated a strong correlation between risk and return in the securities markets. This paper will focus on the analysis of the theory: first to demonstrate how risk is priced by using such theory and its relations to expected return in the financial markets. Then a brief recap of the historical tests on CAPM and other alternative suggestions to the CAPM. CAPM- risk and return The model is based on mean-variance analysis, it assumes investors are risk averse and when deciding among group of assets they tend to choose mean-variance efficient optimal portfolios. This means that they face a tradeoff between risk and expected return: the portfolio is constructed in a way that either to minimize the variance for a given expected return or VICE VERSA to maximize expected return for a given variance. (Fama and French, 2004) It also suggests that the only relevant measure of a portfolio risk is the Beta, see more in later section. When investors can borrow and lend at the risk-free rate and also have homogenous expectations that is to say, all investors share the same view of the economic world and they analyze securities in the same way (p280, Bodie etc.2009), in terms of expected returns, standard deviation and correlations among asset returns(Sharpe 1964), thus, nobody thinks differently than another. The portfolios of risky assets held by each investor wi ll therefore the same and each obtain optimal portfolio, thus everybody holds the market portfolio as their optimal risky portfolio at M (Figure 1). Figure 1, all efficient portfolios should plot along the Capital Market Line (CML) and this new efficient frontier may change as risk-free rate or risk preference changes. (Somerville and OConnell, 2002). Here, we consider a standard position where portfolio B (Sharpe 1964) indicates a MORE RISK AVERSE INVESTOR and lends some of his funds at Rf and invest the rest in the market portfolio (M) which consists many risky assets, while portfolios C and D invested all the funds plus additional borrowed funds to M. All investors hold M; the capital market must in equilibrium. This is known as the Tobins Separation Theorem (Somerville and OConnell, 2002). Figure.1. The efficient frontier when risk-free borrowing and lending allowed. New efficient frontier-CML Risk here has two components: systematic or unsystematic and its measured by standard deviation ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢. The efficient portfolios along CML contain zero unsystematic risk and only carry the systematic risk. Thus, only efficient portfolio plot on CML and inefficient portfolio do not. i.e., portfolio C is efficient, D is inefficient. Consider portfolio C with risk as follow (p248 Bodie etc.2009): ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢C = ÃÆ'Ã… ½Ãƒâ€šÃ‚ ²CÃÆ' Ãƒâ€ Ã¢â‚¬â„¢M + ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢eC Total risk = Systematic risk + Unsystematic risk Since portfolio C is efficient, thus unsystematic risk becomes zero: ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢eC =0 and it contains only systematic risk which cannot be eliminated through diversification: ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢C = ÃÆ'Ã… ½Ãƒâ€šÃ‚ ²CÃÆ' Ãƒâ€ Ã¢â‚¬â„¢M. Whereas portfolio D is inefficient, thus unsystematic risk is not equal to zero: ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢eD ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‚ °Ãƒâ€šÃ‚   0, which means firm`s specific risk cannot be fully diversified. However, both portfolios offer the same expected return: this implies unsystematic risk is not priced in CAPM, which means there is no additional return for bearing unsystematic risk because it can be eliminated through diversification. Thus, in a fully diversified portfolio only systematic risk remains. The earlier measure of risk by using standard deviation ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢, it is an absolute measure of risk but we need a measure just for the systematic component in this case, thus, ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢ becomes invalid. The appropriate measure is beta ÃÆ'Ã… ½Ãƒâ€šÃ‚ ², where ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢ in figure1 will also replaced by ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² and CML too, will be replaced by the Security Market Line (SML) Figure 2 below. (Copeland and Weston, 1993). Don’t waste time! Our writers will create an original "The risks in the Securities Market" essay for you Create order Figure.2. New efficient frontier SML and risk measure ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² when only systematic risk is priced in CAPM. Portfolio C D (Figure 2) will have the same beta and offering the same expected return, but will not have the same standard deviation as C contains only systematic risk, whereas D contains both systematic and unsystematic risks. The market portfolio M (consists many risky assets) corresponds of beta of one, since beta measures the extent to which returns on the risky assets and market move together (p281 Bodie ect.2009) Portfolio C D lie above M, they must have beta greater than one, which means they are riskier than market index. Portfolio B is just the vice versa of C D. Rf has a beta of zero because its a guaranteed return. Since investors all hold the market portfolio, and its expected return is determined by only one factor of risk (ÃÆ'Ã… ½Ãƒâ€šÃ‚ ²). Then, expected return on any assets i becomes a function of beta, risk free return and market return: Wher e , is the market beta premium and this beta premium is positive meaning the expected return on the market portfolio exceeds the expected return on assets whose returns are uncorrelated with the market return. (Fama, French, 2004) So far, the CAPM tells us size of risk/return tradeoff and prices of risk, it bears only systematic risk ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² give a return, since unsystematic risk is not priced. The higher the beta the higher must be equilibrium expected return, thus relationship between expected return and beta is linear as shown in figure 1. It also suggests that if beta is zero, the expected return is the risk-free rate. CAPM- shortcomings CAPM fails empirical tests in definite, first, many of the CAPM assumptions were considered to be too simple and unrealistic (Fama French (2004). It says all investors hold the same market portfolio of risky assets, Perold (2004) has pointed out in fact they do not, since taxes alone will cause investors to behavior differently. Number of earlier tests such as Black, Jensen and Scholes (1972), Miller and Scholes (1972), and more recent Fama and MacBeth (1973), Fama and French (1992) has rejected the notion of a positive relation between beta and average return. Their results show CAPM tends to be over/under predicts the actual returns: The returns on the low beta portfolios are too high, and the returns on the high beta portfolios are too lowÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ (Fama, French, 2004). The one factor ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² determines the market return was also rejected later, such as earning price ratio (Basus, 1977), firm size effect (Banz 1981), ratio of book value to market value ( Statman 1980, etc), all these factors are associated with returns too. (Fama and French, 2004). The CAPM has been extended in many different versions because its imperfectness including those mentioned above. E.g.: Perolds (2004): risk-free rate borrowing and lending disallowed (Black, 1972); extensions to international investing (Solnik, 1974) along with these, the well known one is the Arbitrage Pricing Theory -APT. (Ross, 1976). Similar model to CAPM but APT returns are determined by not one beta, instead a multi-beta expression and its not based on notion of mean-variance, or market portfolios. (p176 Copeland and Weston, 2004.) Rather its based on the law of one price: two items that are the same cannot sell at different prices (p325, Bodie etc.2009). Otherwise an arbitrage opportunity will rise. The E(R) of APT is a function of several factors and each with its own beta (p176 Copeland and Weston, 2004.). The APT model is more general in a sense 1) many factors used to measure risk 2) unspecified factors: it can be inflation, dividend yield, firm size, etc. CAPM is a special case of the APT 1) one factor market risk premium 2) known risk/return tradeoff- how to measure /price risk. (p188 Copeland and Weston, 2004.). This multi-factor model is significant and empirical tests such as Roll and Ross (1986), suggested that CAPM can be rejected in favor of APT. Conclusion The traditional financial theories like CAPM/APT enable us to price risky assets in the securities markets. CAPM defined risk as ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² and it remains a valid measure of risk in the financial filed today. Its linearly relating to expected return and trade-off between return and risk is positive, these important concepts are also considered to be useful as it allows further research and improvement in the financial theory developments such as the APT. Also Sharpe (1964) used the underlying factors of the traditional CAPM to examine capital assets individually and was able to show results that are consistent with the traditional concept. The traditional financial theories therefore, offer a foundation of understanding and educational insights to the financial markets. Neither CAPM/APT are perfect or free of testing problems, more importantly both have shown value in asset pricing and provided a logic framework for the portfolio management: for that risk and return are s uch fundamental concepts in the financial markets (Varian 1993). Both models are still a useful tool for portfolio selection and evaluation, risk management and capital budgeting. (Copeland Weston, 2004).