CHAPTER 7
Asset Pricing
Models
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7.1 The Capital Asset Pricing Model
• The capital asset pricing model (CAPM) extends capital
market theory in a way that allows investors to evaluate
the risk–return trade-off for both diversified portfolios and
individual securities
• The CAPM:
• Redefines the relevant measure of risk from total volatility to just
the nondiversifiable portion of that total volatility (systematic risk)
• The CAPMs risk measure is called the beta coefficient and
calculates the level of a security’s systematic risk compared to
that of the market portfolio
• For individual asset (or any portfolio), the relevant risk measure
is the asset’s covariance with the market portfolio -> Beta.
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7.1.1 A Conceptual Development of the
CAPM (slide 2 of 2)
E Ri RFR i E RM RFR
• The CAPM indicates what should be the expected or required rates
of return on risky assets
• This helps to value an asset by providing an appropriate discount
rate to use in dividend valuation models
• Beta > 1 – Riskier than the market
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Derivation of Beta
• Beta is defined as the ratio of the covariance between the asset and the market to the
variance of the market:
• A beta coefficient for Security i can be calculated directly from the following formula:
Cov Ri , RM
i i riM
M M2
• The covariance between the returns of the asset and the returns of the market is
given by:
• Substituting the expressions for covariance and variance:
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FROM PREVIOUS CHAPTER 6
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Prove that the β of the Tangency Portfolio = 1
• Four Steps:
1. Calculate Tangency Portfolio’s Variance.
2. Find Covariance of each share with the
Tangency Portfolio.
3. Calculate the β for each share.
4. Use weighted averages of each share to
prove that Portfolio β is equal to 1.
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1. Calculate Tangency Portfolio’s Variance
Variance/Covariance table
Weighted variance/Covariance table
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2. Find Covariance of each share with the
Tangency Portfolio
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3. Calculate the β for each share.
Cov Ri , RM
i i riM
M M2
4. Use weighted averages of each share to prove
that Portfolio β is equal to 1.
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7.1.2 The Security Market Line
(slide 1 of 18)
• The SML
• Is a graphical form of the CAPM
• Shows the trade-off between risk and expected return as a straight
line intersecting the vertical axis at the risk-free rate
• Can be applied to any individual asset or collection of assets
Negative beta:
e.g. Gold
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7.1.2 The Security Market Line
(slide 3 of 18)
• Determining the Expected Rate of Return for a Risky Asset
Example:
• Risk-free rate is 5 percent, and the
market return is 9 percent
• This implies a market risk premium of 4
percent
Stock Beta
A 0.70
B 1.00
C 1.15
D 1.40
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7.1.2 The Security Market Line
(slide 5 of 18)
Identifying Undervalued and Overvalued Assets
• While the required rate of return represents the
minimum return investors demand to compensate for
risk, the estimated rate of return reflects investor’s
expectations regarding the investment's future
performance.
• In equilibrium, all assets and all portfolios of assets
should plot on the SML
• Any security with an estimated return that plots above
the SML is underpriced
• Any security with an estimated return that plots below
the SML is overpriced
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7.1.2 The Security Market Line
(slide 6 of 18)
• Example:
• Compare the required rate of return to the estimated rate of return for a
specific risky asset using the SML over a specific investment horizon to
determine if it is an appropriate investment
• Exhibits 7.2, 7.3, 7.4
E(ROR)= [(Expected price-Current Price) + Expected Dividend]/Current price
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7.1.2 The Security Market Line
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7.2 Empirical Tests of the CAPM
• When testing the CAPM, there are two
major questions
1. How stable is the measure of systematic risk
(beta)?
2. Is there a positive linear relationship as
hypothesized between beta and the rate of
return on risky assets?
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7.2.1 Stability of Beta
• Numerous studies have examined the
stability of beta and generally concluded that
the risk measure was not stable for individual
stocks but was stable for portfolios of stocks
• The larger the portfolio and the longer the period,
the more stable the beta estimate
• The betas tended to regress toward the mean
• High-beta portfolios tended to decline over time
toward 1.00, whereas low beta portfolios tended
to increase over time toward unity
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7.2.2 Relationship Between Systematic
Risk and Return (slide 4 of 5)
• The ultimate question regarding the CAPM is
whether it is useful in explaining the return on
risky assets
• Specifically, is there a positive linear relationship
between the systematic risk and the rates of
return on these risky assets?
• Black, Jensen, and Scholes (1972) examined
the risk and return for portfolios of stocks and
found a positive linear relationship between
monthly excess return and portfolio beta.
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7.2.2 Relationship Between Systematic
Risk and Return (slide 4 of 5)
• Effect of Size, P/E, and Leverage
• Size and P/E are additional risk factors that
need to be considered along with beta
• Expected returns are a positive function of
beta, but investors also require higher returns
from relatively small firms and for stocks with
relatively low P/E ratios
• Bhandari (1988) found that financial leverage
also helps explain the cross section of
average returns after both beta and size are
considered
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7.2.2 Relationship Between Systematic
Risk and Return (slide 5 of 5)
• Effect of Book-to-Market Value
• Fama and French (1992) concluded that size
and book-to-market equity capture the cross-
sectional variation in average stock returns.
• Size and BV/MV dominate other ratios such
as E/P ratio or leverage.
• Fama and French (1992) suggested the use
of a three-factor extension of the CAPM.
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7.3 The Market Portfolio: Theory versus
Practice (slide 1 of 4)
• The true market portfolio should
• Includes all the risky assets in the world
• Reasonable in theory, but difficult in practice
• Using U.S. Index as a market proxy
• Most studies use an U.S. index
• The U.S. stocks constitutes less than 15% of a truly global risky
asset portfolio
• Roll (1977a, 1978, 1980, 1981) concluded that the use of these
indexes as a proxy for the market portfolio had very serious
implications for tests of the CAPM and especially for using the
model when evaluating portfolio performance.
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7.3 The Market Portfolio: Theory versus
Practice (slide 2 of 4)
• Benchmark error
• A misspecified market portfolio can have two
effects:
• The beta computed for investor portfolios would be wrong
because the market portfolio used to compute the portfolio’s
systematic risk is inappropriate.
• The SML derived would be wrong because it goes through the
improperly specified M portfolio.
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7.3 The Market Portfolio: Theory versus
Practice (slide 3 of 4)
The beta intercept of the SML will differ if:
• There is an error in selecting the risk-free asset
• There is an error in selecting the market portfolio
Using the incorrect SML may lead to incorrect evaluation of a portfolio performance
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7.4 Arbitrage Pricing Theory (slide 1 of 5)
• CAPM is criticized because of
• The many unrealistic assumptions
• The difficulties in selecting a proxy for the market
portfolio as a benchmark
• Single-factor model
• An alternative pricing theory with fewer
assumptions was developed: Arbitrage Pricing
Theory (APT)
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7.4 Arbitrage Pricing Theory (slide 2 of 5)
• Three major assumptions:
1. Capital markets are perfectly competitive
2. Investors always prefer more wealth to less wealth
with certainty
3. The stochastic process generating asset returns can
be expressed as a linear function of a set of K
factors or indexes
• In contrast to CAPM, APT does not assume:
1. Normally distributed security returns
2. Quadratic utility function
3. A mean-variance efficient market portfolio
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7.4 Arbitrage Pricing Theory (slide 4 of 5)
• Similar to the CAPM model, the APT assumes that the
unsystematic will be diversified away in a large portfolio.
• This assumption implies that the expected return on any
Asset i can be expressed as:
E Ri 0 1bi1 2bi 2 k bik APT
where:
λ0 = expected return on an asset with zero systematic risk
λj = risk premium related to the jth common risk factor
bij = pricing relationship between the risk premium and the asset; that is, how
responsive Asset i is to the jth common factor. (These are called factor betas or
factor loadings.)
• Exhibit 7.12
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7.4 Arbitrage Pricing Theory (slide 5 of 5)
E Ri 0 1bi1 2bi 2 k bik APT
E Ri RFR i E RM RFR (CAPM)
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7.4.1 Using the APT (slide 1 of 3)
• Two-stock and a two-factor model example:
• Assume that there are two common risk factors: one related to
unexpected changes in the level of inflation and another related
to unanticipated changes in the real level of GDP
• Risk factor definitions and sensitivities:
δ1 = unanticipated changes in the rate of inflation. The risk premium related to this
factor is 2 percent for every 1 percent change in the rate (λ = 0.02).
δ2 = unexpected changes in the growth rate of real GDP. The average risk premium
related to this factor is 3 percent for every 1 percent change in the rate growth
(λ2 = 0.03).
λ0 = rate of return on a zero-systematic risk asset (zero-beta) is 4 percent (λ0 = 0.04).
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7.4.1 Using the APT (slide 2 of 3)
• Assume also that there are two assets (x and y) that have the following sensitivities to
these common risk factors (factor betas) :
bx1 = response of Asset x to changes in the inflation factor is 0.50
bx2 = response of Asset x to changes in the GDP factor is 1.50
by1 = response of Asset y to changes in the inflation factor is 2.00
by2 = response of Asset y to changes in the GDP factor is 1.75
• If the actual prices of the two assets do not reflect these expected returns, we would expect
investors to enter into arbitrage arrangements selling overpriced assets short and using the
proceeds to purchase the underpriced assets until the relevant prices are corrected.
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7.4.2 Security Valuation with the APT: An
Example (slide 1 of 3)
• Suppose that three stocks (A, B, and C) and two common
systematic risk factors (1 and 2) have the following relationship (for
simplicity, it is assumed that the zero-beta return [λ0] equals zero):
E(RA) = (0.80)λ1 + (0.90)λ2
E(RB) = (−0.20)λ1 + (1.30)λ2
E(RC) = (1.80)λ1 + (0.50)λ2
• If λ1 = 4 percent and λ2 = 5 percent, then the returns expected by the
market over the next year can be expressed as:
E(RA) = (0.80)(4%) + (0.90)(5%) = 7.7%
E(RB) = (−0.20)(4%) + (1.30)(5%) = 5.7%
E(RC) = (1.80)(4%) + (0.50)(5%) = 9.7%
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7.4.2 Security Valuation with the APT: An
Example (slide 2 of 3)
• Assuming that all three stocks are currently
priced at $35 and do not pay a dividend, the
following are the expected prices a year from
now:
• Expected Return = Price(1+Er)
E(PA) = $35(1.077) = $37.70
E(PB) = $35(1.057) = $37.00
E(PC) = $35(1.097) = $38.40
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Arbitrage Opportunity
• Expected prices of stocks A, B and C one year from now are 37.70, 37.00
and 38.40.
• Suppose your own fundamental analysis suggests that in one year the
actual prices of stocks A, B, and C will be $37.20, $37.80, and $38.50.
• You conclude that:
• Stock A is overvalued
• Stock B is undervalued
• Stock C is undervalued
• How can you take advantage of what you consider to be a market
mispricing? By purchasing undervalued stocks (stocks B and C) while
shorting overvalued stocks (Stock A).
• Create an arbitrage riskless portfolio
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7.4.2 Security Valuation with the APT: An
Example
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Arbitrage Opportunity
• Since Stock A is the only one that is overvalued, assume that it is the only
one that actually is short sold. The proceeds from the short sale of Stock A
can then be used to purchase the two undervalued securities, Stocks B and
C.
• To illustrate this process, consider the following investment proportions:
• Short sell stock A use proceeds to buy Stock B and C
WA = -1.0 negative weight for shares you are shorting
WB = 0.5 positive weight for shares you are buying
WC = 0.5 positive weight for shares you are buying
• These investment weights imply the creation of a portfolio that is short two
shares of Stock A for each one share of Stock B and one share of Stock C
held long.
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Arbitrage Opportunity
E(RA) = (0.80)λ1 + (0.90)λ2
E(RB) = (−0.20)λ1 + (1.30)λ2
E(RC) = (1.80)λ1 + (0.50)λ2
From a portfolio in which you invested no net wealth
and assumed no net risk, you have realized a positive
profit. This is the essence of arbitrage investing
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7.4.2 Security Valuation with the APT: An
Example (slide 3 of 3)
• If everyone else in the market today begins to believe
the future price levels of A, B, and C—but they do not
revise their forecasts about the expected factor returns
or factor betas for the individual stocks—then the current
prices for the three stocks will be adjusted by arbitrage
trading to:
PA = ($37.20) ÷ (1.077) = $34.54
PB = ($37.80) ÷ (1.057) = $35.76
PC = ($38.50) ÷ (1.097) = $35.10
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7.4.3 Empirical Tests of the APT
(slide 1 of 5)
• Roll-Ross Study (1980)
• Methodology followed a two-step procedure:
1. Estimate the expected returns and the factor
coefficients from time-series data on individual
asset returns
2. Use these estimates to test the basic cross-
sectional pricing conclusion implied by the APT
• The authors concluded that the evidence
generally supported the APT but
acknowledged that their tests were not
conclusive
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7.4.3 Empirical Tests of the APT
(slide 2 of 5)
• Extensions of the Roll–Ross Tests
• Dhrymes, Friend, and Gultekin (1984) found the
number of factors varies with the size of the
portfolio
• Roll and Ross (1984) pointed out that the number
of factors is a secondary issue compared to how
well the model can explain the expected return
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7.4.3 Empirical Tests of the APT
(slide 4 of 5)
• The APT and Stock Market Anomalies
• An alternative set of tests of the APT considers how
well the theory explains the January effect
• APT Tests of the January Effect
• Gultekin and Gultekin: APT not better than CAPM
• Gultekin and Gultekin (1987) tested the ability of the APT model to account for the
January effect, where returns in January are significantly larger than in any other
month. They concluded that the APT model could explain the risk–return relationship
only in January, meaning that the APT model does not explain this anomaly any better
than the CAPM.
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7.4.3 Empirical Tests of the APT
(slide 5 of 5)
• Is the APT Even Testable?
• Shanken (1982)
• APT has no advantage because the factors need not be
observable, so equivalent sets may conform to different
factor structures
• Empirical formulation of the APT may yield different
implications regarding the expected returns for a given set
of securities
• Thus, the theory cannot explain differential returns between
securities because it cannot identify the relevant factor
structure that explains the differential returns
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7.5 Multifactor Models and Risk
Estimation
• An advantage of the CAPM framework is that the identity
of the single risk factor is well specified.
• The challenge in implementing the CAPM is to specify
the market portfolio
• The primary practical problem associated with
implementing the APT is that neither the identity nor the
exact number of the underlying risk factors are
developed by theory
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7.5 Multifactor Models and Risk
Estimation
• The first attempt relied on factor analysis, which involved
analysing multiple periods of returns for several
securities to detect common patterns of behaviour.
• Most studies found there to be as many as three or four statistically
significant factors. However, researchers struggled to establish
consistency in the specific set of factors across different subsets of their
sample.
• A different approach to developing an empirical model
that captures the essence of the APT relies on the direct
specification of the form of the relationship to be
estimated.
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7.5 Multifactor Models and Risk
Estimation
• In a multifactor model, the investor
chooses the exact number and identity of
risk factors, while the APT model does not
specify either of them
Rit ai bi1F1t bi 2 F2t biK FKt eit
where:
Fit = Period t return to the jth designated risk factor
Rit = Security i’s return that can be measured as either a nominal
or excess return to Security i
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7.5.1 Multifactor Models in Practice
(slide 1 of 12)
• A wide variety of empirical factor
specifications have been employed in
practice
• Alternative models attempt to identify a set
of economic influences
• Two approaches:
• Risk factors can be viewed as
macroeconomic in nature
• Risk factors can also be viewed at a
microeconomic level
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7.5.1 Multifactor Models in Practice
(slide 2 of 12)
• Macroeconomic-Based Risk Factor Models
• Chen, Roll, and Ross (1986):
Rit ai bi1RMt bi 2 MPt bi 3 DEI t bi 4UI t bi 5UPRt bi 6UTSt eit
Where:
RM = return on a value-weighted index of NYSE-listed stocks
MP = monthly growth rate in U.S. industrial production
DEI = change in inflation; measured by the U.S. consumer price index
UI = difference between actual and expected levels of inflation
UPR = unanticipated change in the bond credit spread (Baa yield − RFR)
UTS = unanticipated term structure shift (long-term less short-term RFR)
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7.5.1 Multifactor Models in Practice
(slide 4 of 12)
• Burmeister, Roll, and Ross (1994) analyzed
the predictive ability of a model based on the
following set of macroeconomic factors:
1. Confidence risk
2. Time horizon risk
3. Inflation risk
4. Business cycle risk
5. Market timing risk
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7.5.1 Multifactor Models in Practice
(slide 5 of 12)
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7.5.1 Multifactor Models in Practice
(slide 6 of 12)
• Fama and French (1993) developed a multifactor
model specifying the risk factors in microeconomic
terms using the characteristics of the underlying
securities
Rit RFRt i bi1 RMt RFRt bi 2 SMBt bi3 HMLt eit
• SMB (i.e. small minus big) = return to a portfolio of small
capitalization stocks less the return to a portfolio of large
capitalization stocks
• HML (i.e. high minus low) = returns to a portfolio of value stocks
(with high book-to-market ratios) less the returns to a portfolio of
growth stocks (with low book-to-market value)
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7.5.1 Multifactor Models in Practice
(slide 7 of 12)
• Fama and French (1993)
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7.5.1 Multifactor Models in Practice
(slide 8 of 12)
• Carhart (1997), based on the Fama-French
three-factor model, developed a four-factor
model by including a risk factor that accounts for
the tendency for firms with positive past return to
produce positive future return
Rit RFRt i bi1 RMt RFRt bi 2 SMBt bi 3 HMLt bi 4 MOM t eit
Where:
MOMt = the momentum factor
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7.5.1 Multifactor Models in Practice
(slide 9 of 12)
• Fama and French (2015) developed their own extension
of the original three-factor model by adding two
additional terms to account for company quality: a
corporate profitability risk exposure and a corporate
investment risk exposure
Rit RFRt i bi1 RMt RFRt bi 2 SMBt bi3 HMLt bi 4 RMWt bi5CMAt eit
Where:
RMW (robust minus weak) = return to a portfolio of high profitability stocks less the
return to a portfolio of low profitability stocks
CMA (conservative minus aggressive) = return to a portfolio of stocks of low-
investment firms (low total asset growth) less the return to a portfolio of stocks in
companies with rapid growth in total assets
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