A collection of all of the risky assets in the marketplace.
Capital Market Theory Assumptions
- All investors are Markowitz-efficient in that they seek to invest in tangent points on the
- efficient frontier.
Investors can borrow or lend any amount of money at the risk-free rate of return (RFR).
All investors have homogeneous expectations (they estimate identical probability distributions for future rates of return.)
All investors have the same one-period time horizon, such as one month or one year.
All investments are infinitely divisible, so it is possible to buy or sell fractional shares of any asset or portfolio.
There are no taxes or transaction costs involved in buying or selling assets. This is a reasonable assumption in many instances.
- There is no inflation or any change in interest rates, or inflation is fully anticipated. This
- is a reasonable initial assumption, and it can be modified.
Capital markets are in equilibrium. This means that we begin with all investments properly priced in line with their risk levels.
Completely Diversified Portfolio
All risk unique to individual assets is diversified away.
Market Risk Premium
Risk market - risk free rate
Security Market Line (SML)
Trade-off between risk and expected return as a straight line intersecting the vertical axis at the risk-free rate.
Considers only the systematic component of an investment’s volatility.
Applied to any individual asset or collection of assets.
Capital Market Line (CML)
Trade-off between risk and expected return as a straight line intersecting the vertical axis (i.e., zero-risk point) at the risk-free rate.
Measures risk by the standard deviation (i.e., total risk) of the investment.
Applied only to portfolio holdings that are already fully diversified.
= Estimated return - Required return
- = overvalued (below SML)
+ = undervalued (above SML)
Impact of the Time Interval
- Major cause of the differences in beta was the
- use of monthly versus weekly return intervals.
Also, the shorter weekly interval caused a larger beta for large firms and a smaller beta for small firms.
The Effect of the Market Proxy
The market portfolio of all risky assets should include U.S. stocks and bonds, non-U.S. stocks and bonds, real estate, coins, stamps, art, antiques, and any other marketable risky asset from around the world.
Differential Borrowing and Lending Rates (Relaxing CAPM)
It is reasonable to assume that investors can lend unlimited amounts at the risk-free rate by buying government securities (e.g., T-bills).
In contrast, it is quite unlikely that investors can borrow unlimited amounts at the T-bill rate.
Zero-Beta Model (Relaxing CAPM)
If the market portfolio (M) is mean-variance efficient, an alternative model, derived by Black (1972), does not require a risk-free asset.
- Among the several zero-beta portfolios, you
- would select the one with minimum variance.
May have some unsystematic risk.
- The availability of this zero-beta portfolio
- will not affect the CML, but it will allow construction of a linear SML.
Transaction Costs (Relaxing CAPM)
The CAPM assumes that there are no transaction costs, so investors will buy or sell mispriced securities until they plot on the SML.
If there are transaction costs, investors will not correct all mispricing because in some instances the cost of buying and selling the mispriced security will exceed any potential excess return.
Therefore, securities will plot very close to the SML, but not exactly on it.
- Thus, the SML will be a band rather than a
- single line.
The width of the band is a function of the amount of the transaction costs
Heterogeneous Expectations and Planning Periods (Relaxing CAPM)
If all investors had different expectations about risk and return, each would have a unique CML or SML, and the composite graph would be a group of lines with a breadth determined by the divergence of expectations.
If all investors had similar information and background, the width of the group would be reasonably narrow.
If you are using a one-year planning period, your CML and SML could differ from someone with a one-month planning period.
Generally Accepted Accounting Principles (GAAP)
Formulated by the Financial Accounting Standards Board (FASB)
Shows the assets the firm controls and how it has financed these assets.
Indicates current and fixed assets 'at a point in time'.
Contains information on the operating performance of the firm during 'some period of time' (a quarter or a year).
Flow of sales, expenses and earnings.
Statement of Cash Flows
- Integrates the effects on the firm’s cash flow
- of income flows (based on the most recent year’s income statement) and changes on the balance sheet (based on the two most recent annual balance sheets).
- - Cash flows from operating activities
- - Cash flows from investing activities
- - Cash flows from financing activities
Traditional Cash Flow
Measure of cash flow equals net income plus depreciation expense and the change in deferred taxes.
Earnings before interest, taxes, depreciation, and amortisation
Importance of Relative Financial Ratios
The aggregate economy
Its industry or industries
Its major competitors within the industry
Its past performance (time-series analysis)
Operating Efficiency Ratios
Total Asset Turnover (the effectiveness of the firm’s use of its total asset base)
Net Fixed Asset Turnover (reflects the firm’s utilisation of fixed assets)
Operating Probability Ratios
Gross Profit Margin (the basic cost structure of the firm)
Operating Profit Margin (indicates the business risk of the firm)
Net Profit Margin (seeks to derive insights about future expectations)
Common Size Income Statement (lists all expenses and income items as a % of sales)
Return on Total Invested Capital (relates the firm’s earnings to all the invested capital involved in the enterprise (debt, preferred stock, and common stock))
Return on Owner's Equity (indicates the rate of return that management has earned on the capital provided by stockholders after accounting for payments to all other capital suppliers)
DuPont System (ROE)
ROE = (Net Income / Common Equity) = (Net Income / Net Sales ) x (Net Sales / Common Equity)
Uncertainty of operating income caused by the firm’s industry.
Volatility of Operating Earnings
Volatility of the firm’s sales over time.
How the firm produces its products in terms of its mix of fixed and variable costs (operating leverage)
Business Risk = SD of Operating Earnings / Mean Operating Earnings
Employment of fixed production costs.
Greater operating leverage (caused by a higher proportion of fixed production costs) makes the operating earnings series more volatile relative to the sales series.
- Uncertainty of returns to equity holders due to
- a firm’s use of fixed financial obligation securities.
Determinants of Growth
The amount of resources retained and reinvested in the entity
The rate of return earned on the reinvested funds
Use of Financial Ratios
Assigning credit ratings on bonds
Predicting insolvency (bankruptcy)