Required Rate of Return
Risk-Free rate of Return + Risk Premium
Required rate of return (expanded based on Fischer’s Model)
= Real-risk free rate of return + Expected rate of inflation + Risk premium
Capital Asset Pricing Model (CAPM)
can calculates Required Rate of Return for:
- Stock
- Industry
-Sector
-Domestic Capital Market
-International Capital Markets
CAPM Limitation
Main limitations:
It is a single-factor model
-only systematic risk is included
-It ignores non-systematic risk
-which is fine in theory for diversified portfolios
but weaker for individual stock analysis
It is a single-period model
-not great for multi-period real-world investing
Beta estimation is imperfect
depends on historical data
depends on benchmark used
beta can change over time
It uses unrealistic assumptions
-no taxes, no transaction costs, rational investors, same expectations
It is not very strong for predicting individual stock returns
better for diversified portfolios than single stocks
CAPM assumption
Investors are risk averse
Investors are utility maximizing
Investors are rational
There are no transaction costs
There are no taxes
There are no short-selling restrictions/costs
Borrowing and lending happen at the risk-free rate
All investors have the same time horizon
All investors analyze securities the same way
All investors arrive at the same valuations
Investments are infinitely divisible
There are many investors, and none can influence prices
A lot of these are unrealistic. That leads directly to the limitations.
Beta Limitations
Problems with beta
This is important because professors love asking for limitations.
- Beta is based on historical data
It uses the past to estimate future risk.
That is a problem because the future may not look like the past.
- Beta can change over time
A company’s business, industry, and growth stage can change.
So beta is not fixed forever.
- Choice of market index matters
In Canada, common indexes include:
S&P/TSX Composite
S&P/TSX 60
In the U.S.:
S&P 500
Different benchmark choices can affect beta estimates.
- Thinly traded or private firms are harder to analyze
private firms do not have public stock return data
infrequent trading can distort beta
- Beta assumes return patterns behave nicely
Real markets do not always behave normally.
There are shocks, surprises, crashes, and abnormal moves.
- Beta is more useful for short-term volatility analysis than long-term prediction
It becomes less useful for long-term investing because a stock’s volatility can shift a lot over time.
Beta
Beta measures the systematic risk (volatility) of a security relative to the market.
Types of Efficient markets
Efficient market
An efficient market is one in which prices quickly reflect available information.
Weak-form efficiency
Current prices reflect past trading data.
Semi-strong form efficiency
Current prices reflect all publicly available information.
Strong-form efficiency
Current prices reflect all public and private information.
