# Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
VU
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 σ = 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?
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The RF should, be the easiest of the three variables, to obtain. In estimating RF, the investor
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 = αi + βiRM + еi
Where;
Ri
= the return (TR) on security i
= the return (TR) on the market index:
RM
αi
= the intercept term
βi
= the slope term
еi
= 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 αi (the constant return
on security i that is earned regardless of the level of market returns) and βi, (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
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
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final word in asset pricing.
Similar to the CAPM, or any other asset-pricing model, APT posits a relationship between
expected return and risk. It does so, however, using different assumptions and procedures.
Very importantly, APT is not critically dependent on an underlying market portfolio as is
the CAPM, which predicts that only market risk influences expected returns. Instead, APT
recognizes that several types of risk may affect security returns.
APT is based on the law of one price, which states that two otherwise identical assets cannot
sell at different prices. APT assumes that asset returns are linearly related to a set of
indexes, where each index represents a factor that influences the return on an asset. Market
participants develop expectations about the sensitivities of assets to the factor. They buy and
sell securities so that, given, the law of one price, securities affected equal by the same
factors will have equal expected returns. This buying and selling is the arbitrage process,
which determines the prices of securities.
APT states that equilibrium market prices will adjust to eliminate any arbitrage
opportunities, which refer to situations where a zero investment portfolio can be
constructing that, will yield a risk-free profit. If arbitrage opportunities arise, a relatively
few investors can act to restore equilibrium.
Unlike the CAPM, APT does not assume:
1.
A single-period investment horizon
2.
The absence of taxes
3.
Borrowing and lending at the rate RF
4.
Investors select portfolios on the basis of expected return and variance
APT, like the CAPM, does assume:
1.
Investors have homogeneous beliefs
2.
Investors are risk-averse utility maximizers
3.
Markets are perfect
4.
Returns are generated by a factor model
Factor Model used to depict the behavior of security prices by identifying major factors in
the economy that affect large numbers of securities
A factor model is based on the view that there are underlying risk factor's that affect
realized and expected security returns. These risk factors represent broad economic forces
and hot company-specific characteristics, and by definition they represent the element of
surprise in the risk factor--the difference between the actual value for the factor and its
expected value.
The factors must possess three characteristics:
1. Each risk factor must have a pervasive influence on stock returns. Firm-specific
events are not APT risk factors.
2. These risk factors must influence expected return, which means they must have
nonzero prices. This issue must be determined empirically, by statistically analyzing
stock returns to see which factors pervasively affect returns.
3. At the beginning of each period, the risk factors must be unpredictable to the market
as a whole, this raises an important point. In our example above, we used in flatten
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and the economy's output as the two factors affecting portfolio returns. The rate of
inflation is not an APT risk factor, because it is at least partially predictable. In an
economy with reasonable growth where the quarterly rate of inflation has averaged 3
percent on an annual basis, we can reasonably assume that next quarter inflation rate
is not going to be 10 percent. On the other hand, unexpected inflation--the
difference between actual inflation, and expected inflation--is an APT risk factor.
By definition, it cannot be predicted, since it is unexpected.
What really matters are the deviations of the factors from their expected values. For
example, if the expected value of inflation is 5 percent and the actual rate of inflation for a
period is only 4 percent, this, 1-percent deviation will affect the actual return for the period.
Portfolio Management:
Portfolio management involves a series of decisions and actions that must be made by every
investor whether an individual or institution. Portfolios must be managed whether investors
follow a passive approach or ail active approach to selecting and holding their financial
assets. As we saw when we examined portfolio theory, the relationships among the various
investment alternatives that are held as a portfolio must be considered if an investor is to
hold an optimal portfolio, and achieve his or her investment objectives.
Portfolio management can be thought of as a process. Having the process clearly in mind is
very important, allowing investors to proceed in an orderly manner.
In this chapter, we outline the portfolio management process, making it clear that a logical
and orderly flow does exist. This process can be applied to each investor and by any
investment manager. Details may vary from client to client, but the process remains the
same.
.
Portfolio Management as a Process:
The portfolio management process has been described by Maginn and Tuttle in a book that
forms the basis for portfolio management as envisioned by the Association for Investment
Management and Research (AIMR), and advocated in its curriculum for the Chartered
Financial Analyst (CFA) designation. This is an important development because of its
contrast with the past, where portfolio management was treated on an ad hoc basis,
matching investors with portfolios on an individual basis. Portfolio management should be
structured so that any investment organization can carry it out in an effective and timely
manner without serious omissions.
Maginn and Tuttle emphasize that portfolio management is a process, integrating a set of
activities in a logical and orderly manner. Given the feedback loops and monitoring that is
included; the process is both continuous and systematic. It is a dynamic and flexible
concept, and extends to all portfolio investments, including real estate, gold, and other real
assets.
The portfolio management process extends to all types of investment organizations and
investment styles. In fact, Maginn and Tuttle specifically avoid advocating how the process
should be organized by money management companies or others, who should make the
decisions, and so forth. Each investment management organization, should decide for itself
how best to carry out its activities consistent with viewing portfolio management as a
process.
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Having structured portfolio management as a process, any portfolio manager can
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.
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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.
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