MODERN PORTFOLIO THEORY ASSET PRICING USING MPT - The above analysis describes optimal behavior of an individual investor. Asset pricing theory builds on this analysis in the following way. Since everyone holds the risky assets in identical proportions to each other—namely in the proportions given by the tang ency portfolio—in market equilibrium the risky assets prices, and therefore their expected returns, will adjust so that the ratios in the tang ency portfolio are the same as the ratios in which the risky assets are supplied to the market. Thus relative supplies will equal relative demands. MPT derives the required expected return for a correctly priced asset in this context.! SYSTEMATIC RISK & SPECIFIC RISK - Specific risk is the risk associated with individual assets - within a portfolio these risks can be reduced through diversification (specific risks cancel out). Specific risk is also called divers ifiable, unique, unsystematic, or idiosyncratic risk. Systematic risk (a.k.a. portfolio risk or market risk) refers to the risk common to all securities—except for selling short as noted below, systematic risk cannot be diversified away (within one market). Within the market portfolio, asset specific risk will be diversified away to the extent possible. Systematic risk is therefore equated with the risk (standard deviation) of the market portfolio.! Since a security will be purchased only if it improves the risk-expected return characteristics of the market portfolio, the relevant measure of the risk of a security is the risk it adds to the market portfolio, and not its risk in isolation. In this context, the volatility of the asset, and its correlation with the market portfolio, are historically observed and are therefore given. There are several approaches to asset pricing that attempt to price assets by modelling the stochastic properties of the moments of assets returns - these are broadly referred to as conditional asset pricing models.! Systematic risks within one market can be managed through a strategy of using both long and short positions within one portfolio, creating a market neutral portfolio. Market neutral portfolios, therefore will have a correlations of zero.! CAPITAL ASSET PRICING MODEL - The asset return depends on the amount paid for the asset today. The price paid must ensure that the market portfolios risk / return characteristics improve when the asset is added to it. The CAPM is a model that derives the theoretical required expected return (i.e., discount rate) for an asset in a market, given the risk-free rate available to investors and the risk of the market as a whole. The CAPM is usually expressed:! \operatorname{E}(R_i) = R_f + \beta_i (\operatorname{E}(R_m) - R_f) \beta , Beta, is the measure of asset sensitivity to a movement in the overall market; Beta is usually found via regression on historical data. Betas exceeding one signify more than average riskiness in the sense of the assets contribution to overall portfolio risk; betas below one indicate a lower than average risk contribution. (\operatorname{E}(R_m) - R_f) is the market premium, the expected excess return of the market portfolios expected return over the risk-free rate.! Once an assets expected return, E(R_i) , is calculated using CAPM, the future cash flows of the asset can be discounted to their present value using this rate to establish the correct price for the asset. A riskier stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. In theory, an asset is correctly priced when its observed price is the same as its value calculated using the CAPM derived discount rate. If the observed price is higher than the valuation, then the asset is overvalued; it is undervalued for a too low price.! HAVE A NICE DAY ,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,, FRIENDS !
Posted on: Sat, 27 Dec 2014 12:45:18 +0000
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