University of Macau Faculty of Business Administration MFIN604 – Theory of Finance MSc in Finance (Fall 2012/13) Instructor: Prof. Keith Lam (Associate Professor of Finance) Office: L217 (Ext. 4167) Email: keithlam@umac.mo Webpage (intranet): http://personalweb.umac.mo/keithlam Course Objectives The course aims to provide students with solid theoretical frameworks in asset pricing and other fields of finance. For asset pricing, the concepts of risk and return, and state prices will be introduced as a stepping stone towards the discussions of more advanced topics including the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory (APT), and other more recent asset pricing models. Other topics in finance such as options and behavior finance may also be covered on an optional basis. Besides the theoretical frameworks, recent developments in empirical asset pricing and empirical finance will also be covered with an extensive use of academic research papers. (Pre-requisite: Principles of Accounting) Textbook 1. Elton, Edwin, Martin Gruber, Stephen J. Brown , and William Goetzmann, Modern Portfolio Theory and Investment Analysis, 8th Edition, John Wiley, 2011. Reference books: 1. Copeland, T.E., Weston, J.F., and Shastri, K. (CWS), Financial Theory and Corporate Policy, 4th edition, Pearson. 2. Bodie, Z., Kane, A., and Marcus A.J., Investment, 5th edition, McGraw Hill. Study Guidelines Assigned materials, papers and paper questions should be read and done prior to the class meeting in which they will be discussed. Students are encouraged to interact with me and/or fellow students in these discussions. Problems (academic and real world) do not always fit into a formula. Likewise, cramming right before an exam usually results in confusion, anxiety, and a lack of understanding the topics. Grading Scheme Participation Assignments Midterm Exam Final Exam

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University of Macau Faculty of Business Administration MFIN604 – Theory of Finance...

...1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
Undiversifiable (market )risk:
Market risk is the variability in all risky assets caused by macroeconomic variables. This risk cannot be avoided, regardless of the amount of diversification. Systematic risk (Market risk) factors are those macroeconomic variables that affect the valuation of all risky assets such as variability in the growth of the money supply, interest rate volatility, variability in aggregate industrial production, and natural shocks like drought, earth quake, hurricane, etc.
Diversifiable (unique )risk:
Many of the risks faced by an individual company are peculiar to its activity, its management, etc. These are the unique risks and can be diversified away. Examples of unique risks are a company winning a large contract, wildcat strikes hitting a company, litigation hitting a company or the company facing a governmental investigation.
a. A large fire severely damages three major U.S. cities.
Diversifiable risk
The entire economy will not be affected by a large fire in three major US cities. In fact some companies in cities not affected by fire will benefit as they will meet the demand not being met by companies in the three cities that are...

...CAPITALASSETPRICINGMODEL (CAPM) The capitalassetpricingmodel (CAPM) is an important model in finance theory. CAPM is a theory or model use to calculate the risk and expected return rate of an investment portfolio (normally refer to stocks or shares). All stocks have 2 risks: Systematic Risk (also called Market Risk which affect every stocks) and Unsystematic Risk (also called Specific or Unique Risk that only affects individual stocks). To diversify unsystematic risk, we selected and combined different stocks, which are negatively correlated with one another into one portfolio. In this way risk are eliminated greatly. See diagram below.
CAPM Equation The general formula used for CapitalAssetPricingModel is: re = rf + [ ß (rm - rf) ] where the components are as follows: re = Expected return rate of the investment portfolio rf = Risk free rate of return ß = Beta (correlation between the shares and the market) rm = Expected market return which also means: rm - rf = Market risk (systematic risk) ß (rm - rf) = Risk premium *Beta is overall risk value for investing in the stock market. The higher the beta, the more the risk.
CAPM Example Assume there is two Investment portfolio (stocks) or project - A & B. With the information given below, we can use CAPM to help us...

...CapitalAssetPricingModel (CAPM): Pros and Cons.
CAPM defines the relationship between risk and return. The premise of the model is that the expected investment return varies in direct proportion to its risk, i.e., the riskier the investment - the higher the return you should expect.
Shows:
• how much risk you are taking when investing in an instrument?
• whether the instrument is rightly priced
• whether you are getting sufficient return for the risk you are taking
CAPM calculates the risk-adjusted discount rate with the risk-free rate, the market risk premium, and beta (mathematical formula):
Return (R) = Rf + beta x (Rm - Rf)
Rf is the rate of risk-free investments
Beta - the risk of loss associated with your investments.
Rm is the expected market return.
(Rm-Rf) – market risk premium
beta x (Rm - Rf) – risk premium of specific company
Investments are good if the expected return from the investment equals/exceeds required return.
Market Risk Premium [Rm-Rf]
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk
Its size depends on the perceived risk of the overall stock market and investors’ degree of risk aversion
Varies across time. Usually ranged between 4-8%
BETA in CAPM measures a stock’s degree of systematic or market risk. It can also be thought of as the stock’s contribution to the risk of a...

...CapitalAssetPricingModel: The Indian Context
R Vaidyanathan
T
he CapitalAssetPricingmodel is based on two parameter portfolio analysis
model developed by Markowitz (1952). This model was simultaneously and
independently developed by John Lintner (1965), Jan Mossin (1966) and
William Sharpe (1964). In equation form the model can be expressed as follows:
E (Ri) = Rf + (i [E(rm) – Rf] = Rf +(im / (m (E(Rm) – Rf / (m)
Where E(Ri) is expected return on asset i, Rf is the risk-free rate of return, E(Rm) is expected return on market proxy and (i; is a measure of risk specific to asset i. This relationship between expected return on asset i and expected return on market portfolio is also called the security market line. If CAPM is valid, all securities will lie in a straight line called the security market line in the E(R), (i frontier. The security market line implies that return is a linearly increasing function of risk. Moreover, only the market risk affects the return and the investor receive no extra return for bearing diversifiable (residual) risk.
The set of assumptions employed in the development of the CAPM can be summarized as follows [Sears and Trennepohl (1993)]:
1. Investors are risk-averse and...

...Introduction
Capitalassetpricingmodel (CAPM) is regarded as a superior model of security price behavior to others based on wealth maximization criteria. CAPM explicitly identifies the risk associated with an ordinary share as well as the future returns it is expected to generate. Until recent the empirical tests supported CAPM, but a test by Fama and French in 1992 did not, stating that it is useless for the precisely what it was developed for. Following the criticism of the model questions such as whether to abandon the model and develop a new one arose.
In this essay I will describe the model and describe the researchers test, which justify the usefulness of the model.
Main concepts behind the problem and discussion
The CAPM was developed by Sharpe (1963) as a logical extension to the basic portfolio theory, followed by numerous academics, notably Lintner (1965). The model was developed to explain the difference in risk premium across assets. According to the model this differences are due to the differences in the riskiness of the expected returns. The model affirmers that the correct measure of risk is beta and that the risk premium of riskiness is same across all assets. Given the beta and the risk free rate, the model predicts the expected...

...A Chartered Financial Analyst, Jeffrey Bruner, uses the CapitalAssetPricingModel (CAPM) to help identify mispriced securities. However, a consultant suggests Bruner to use Arbitrage Pricing Theory (APT) instead. As the following, it will mention the role of CAPM in the modern portfolio management; to clarify the APT faction and explain the reasons why should Bruner use APT to help identify mispriced securities.
In modern portfolio management, the role of CapitalAssetPricingModel (CAPM) is a model that attempts to describe the relationship between the risk and the expected return on an investment and that is used in the pricing of risky securities. The assumption behind the CAPM is that there is only one risk-free rate in the model, investors can borrow and lend unlimited amounts under the risk rate of interest; the perfect information is freely available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and desire to maximise their own utility; and the capital market is characterised by perfect competition, there are broadly diversified across a range of investments and the investors will only require a return for the systematic risk of their portfolio, since unsystematic risk has been removed and can ignored. It also assumes...

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FINA3080Investment Analysis and Portfolio Analysis
Midterm Examination
Date: March 12, 2013
1. If all investors become more risk averse the SML will _______________ and stock prices will _______________. A. shift upward; riseB. shift downward; fallC. have the same intercept with a steeper slope; fallD. have the same intercept with a flatter slope; rise
2. According to the capitalassetpricingmodel, a security with a _________. A. negative alpha is considered a good buyB. positive alpha is considered overpricedC. positive alpha is considered underpricedD. zero alpha is considered a good buy
3. The beta of a security is equal to _________. A. the covariance between the security and market returns divided by the variance of the market's returnsB. the covariance between the security and market returns divided by the standard deviation of the market's returnsC. the variance of the security's returns divided by the covariance between the security and market returnsD. the variance of the security's returns divided by the variance of the market's returns
4. Consider the following two stocks, A and B. Stock A has an expected return of 10% and a beta of 1.20. Stock B has an expected return of 14% and a beta of 1.80. The expected market rate of return is 9% and the risk-free rate is 5%. Security __________ would be considered a good buy because _________. A. A, it offers an expected excess return of 0.2%B. A, it...

...CAPM: THEORY, ADVANTAGES, AND DISADVANTAGES
THE CAPITALASSETPRICINGMODEL RELEVANT TO ACCA QUALIFICATION PAPER F9
Section F of the Study Guide for Paper F9 contains several references to the capitalassetpricingmodel (CAPM). This article is the last in a series of three, and looks at the theory, advantages, and disadvantages of the CAPM. The first article, published in the January 2008 issue of student accountant introduced the CAPM and its components, showed how the model can be used to estimate the cost of equity, and introduced the asset beta formula. The second article, published in the April 2008 issue, looked at applying the CAPM to calculate a project-specific discount rate to use in investment appraisal.
CAPM FORMULA The linear relationship between the return required on an investment (whether in stock market securities or in business operations) and its systematic risk is represented by the CAPM formula, which is given in the Paper F9 Formulae Sheet: E(ri) = Rf + βi(E(rm) - Rf) E(ri) = return required on financial asset i Rf = risk-free rate of return βi = beta value for financial asset i E(rm) = average return on the capital market The CAPM is an important area of financial management. In fact, it has even been suggested that finance only became ‘a fully-fledged, scientific...