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1. 2. 3. 4. Problems with CAPM and Multifactor Models Motivation: The 2 Factor Case Asset Pricing: The Simplest Case Overview of Uses Outline 09: Multifactor Models and Valuation 5. Optimal Portfolios 6. Tailoring Risk Exposures 7. Examples of Factor Models
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Problem 2: CAPM-based portfolios are not economically intuitive CAPM-based optimal portfolios are useless in the context of incomplete markets (individual risk). Optimal portfolio of, say, a worker vs. a pension fund, should only differ on the exposure to the S&P? In practice market portfolio does not exist, when using proxies we find that there are many other sources of risk which are relevant for investors. This means we need to set both the portfolio selection and the pricing problems in the context of MULTIFACTOR MODELS.
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(1)
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The factors capture the common variation in the N assets, so cov (it, jt) = 0 for i
j.
(2)
The general form of the corresponding two-factor pricing model, used to represent the sources of risk premia in expected returns is Ei = Rf + bi11 + bi22, where denotes the premium associated with factor k. Let us check the similarities between the one factor CAPM model (market model) and the bi-factorial model we have just introduced:
Return Generating Process One Factor Model (CAPM) 2-Factor Model Asset Pricing Formula Ei = Rf + i ( Rf)
(3)
% % % Rit = ai + bi RMt + it
Ei = Rf + bi11 + bi22
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Arbitrage Pricing (I) The Simplest Case To illustrate how (3) obtains just using arbitrage arguments, lets consider the simplest possible case. Assume o each assets return is generated through time by a single random factor, F1t, and o there are no idiosyncratic returns (its) Rit = Ei + bi1F1t bi1 of the form Ei = Rf + 1 bi1, for some slope 1. (5) (4) If there are no arbitrage opportunities, then there must be a cross-sectional linear relation between Ei and
Ei
1
Rf
bi1
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bi1
Example: Suppose that there are three assets with the following expected returns and sensitivities to the factor: bi1 Asset (i) Ei 1 .07 0.5 2 .11 1.5 3 .10 1.0 If we pick any two of these assets and determine the line relating their Eis and bi1s, the other asset does not lie on that line. For example, the line determined by assets 1 and 2 is Ei = 0.05 + 0.04 bi1,
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but the point for asset 3 lies above that line. There are a variety of ways to arbitrage in this case. For example, an equally weighted combination of assets 1 and 2, call it portfolio p, has its expected return and b given by Ep = 0.5E1 + 0.5E2 = 0.5(.07 + .11) = .09 bp1 = 0.5b11 + 0.5b21 = 0.5(0.5 +1.5) = 1.0. Going long $1 of asset 3 and short $1 of portfolio p provides the payoff R3t Rpt = (E3 + b31F1t) (Ep + bp1F1t) = (.10 + 1 F1t) (.09 + 1 F1t) = .01 which is a riskless arbitrage profit the random component of the return, F1t, has been hedged away. If a riskless asset exists, it too must lie on the line relating Ei to bi1. Since its bi1 is zero, its expected return, Rf, will be the intercept of the line, as we have written in (5). More formally: o Consider the following return generating process for three assets:
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(6) (7)
(8)
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Rit = Ei + bi1F1t i=1,2,3 o As we know, the economy exhibits arbitrage opportunities if it possible to find a portfolio with zero cost and non-negative profits in the future and strictly positive in some states of the world. o Let x=(x1, x2, x3) 0 be a zero cost portfolio (xi denotes the amount of $ invested in asset i), i.e.: x1+ x2+ x3 = 0 o The return of this portfolio is: Rpt = (E1x1 + E2x2+ E3x3) + (b11 x1 + b21 x2+ b31 x3)F1t o Now, set x so that: b11 x1 + b21 x2+ b31 x3 = 0 (b) (a)
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(c)
o Now, basic knowledge of matrix algebra is enough to conclude that (a), (b) and (c), and x 0 imply that there exists constants 0 and 1 such that: Ei = 0 + 1 bi1 i= 1, 2, 3. o Finally, if one of the assets is the risk free asset, it must be true that 0 = Rf. Hence, Ei = Rf + 1 bi1 o This completes the proof of the equation (5).
So, for a general factor model:
t = 1,...,T,
(9)
(10)
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Overview of Uses
Applications of multifactor model include o risk measurement and estimation o risk management and hedging o factor-neutral strategies o trading and arbitrage o portfolio optimization o tailoring risk exposures o style analysis o performance evaluation In fixed-income applications, it is often the case that o the number of factors is small, typically one or two (sometimes three) o the its are assumed to be zero o the Fkts (factors) are prespecified as functions of observable variables o the biks (sensitivities) change over time as functions of the factors In equity applications, it is often the case that o the number of factors is greater, typically three or more o the its are not assumed to be zero
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o the Fkts may or may not be prespecified o the biks are often assumed to be constant, at least in the short run, or change as functions of the firms characteristics
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(11)
The pricing relation can be written as Ei = Rf +ci1(E(1) Rf) + ci2(E(2) Rf), which implies ai = 0 in (11). If all assets are correctly priced, then each investors portfolio should be some combination of cash and the mimicking portfolios. Other portfolios have the same level of expected return and sensitivities to the factor but greater variance.
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(12)
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Example: Suppose an investor instead holds a portfolio or security A, which is correctly priced. The regression of portfolio As return on the mimicking-portfolio returns gives
~ ~ ~ ~ R At R f = 0 + 0.5 ( R(1),t R f ) + 0.4 ( R( 2 ),t R f ) + u At
(13)
An alternative portfolio P composed of 50% in mimicking portfolio 1 40% in mimicking portfolio 2 10% (100% - 50% - 40%) in cash has the same expected return and factor sensitivities but lower variance.
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The market portfolio is some, possibly different, combination of the mimicking portfolios. In other words, the CAPM need not hold. The relative demands by investors to tilt toward or away from a given source of risk determines E(k) Rf, the premium for that factor. If most investors prefer to tilt away from a given factor, then investors willing to tilt toward that factor will receive a large premium.
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One can then think of factors affecting price changes, or asset returns, as factor related either to changes in expected cash flows or to changes in discount rates. This reasoning led the authors ultimately to five factors: 1 monthly growth rate of industrial production 2 change in expected inflation 3 unexpected inflation 4 change in the risk premium 5 change in the term structure of interest rates
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The change in the risk premium is measured as the difference in returns between junk bonds (rated below BAA) and long-term U.S. Government bonds. The change in the term structure is measured as the difference in returns between long-term U.S. Government bonds and U.S. Treasury Bills. The return on the equally weighted portfolio of NYSE stocks is also included as a sixth factor.
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For each asset i, the sensitivities are the slopes (bi, si, hi) in the time-series regression, Ri,t Rf,t = ai + bi(RM,t Rf,t) + si S M Bt + hi H M Lt + i,t. The pricing relation is then Ei Rf = bi[EM Rf] + si E {S M B} + hi E {H M L}
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(15)
for all i
(16)
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When returns or return spreads on portfolios are used instead of non-traded factors, then an equivalent representation of the pricing relation is ai = 0 for all i
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Descriptor Formulas
Descriptor
Risk Indices
Asset Returns
Factor Loadings
GLS Weighting
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Factor Returns
Specific Returns
Covariance Matrix
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3. Thin Stocks: All stocks that are traded over the counter or are outside the HICAP universe, except those with listed options. Optioned stocks are distinct for several reasons. First, the option price provides an implicit forecast of the total standard deviation of the stock itself. Second, optioned stocks tend to be those with greatest investor interest and those with greatest effective trading volume. Stock trading volume descriptors understate the effective volume because they omit option volume. The thin stocks, about ten percent of the basic sample, are broken out because they tend to trade differently from other stocks. Over-thecounter stocks and other thinly traded securities show price behavior inconsistent with efficient and timely prices. This stocks also show less perfect synchrony with market movements, frequent periods in which no meaningful price changes can occur, and occasional outlying price changes that are promptly reversed. These influences cause some measures of stock prices variability to be biased. In defining the Variability in Markets index, we standardize the formulas for the three categories relative to one another to provide one index for the total population. Variability in Markets Descriptors A. Optioned Stocks 1. Cumulative Range (+) 2. Beta * Sigma (+) 3. Option Standard Deviation (+) 4. Daily Standard Deviation (+) B. Listed Stocks 1. Beta *Sigma (+) 2. Cumulative Range (+) 3. Daily Standard Deviation (+) 4. Volume to Variance (+) 5. Log of Price (-) 6. Serial Dependence (+) 7. Annual Share Turnover (-)
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Multifactor Models and Valuation C. Thin Stocks 1. Beta *Sigma (+) 2. Cumulative Range (+) 3. Annual Share Turnover (+) 4. Log of Price (-) 5. Serial Dependence (-) 2. Success (SCS)
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The Success index identifies stocks that have been recently successful mainly in terms of stock price but also in terms of earnings. The relative strength of a stock, shown by the stock price, is the chief indicator of how well the stock has gone. The Success index measures the success of the company over both the last year and the last five years. It does this in two ways: first, as measured by earnings growth (fiveyear growth in earnings, growth in earnings in the latest year, and present growth in earnings implied by the IBES data); and second, as measured by price behavior in the market over the last five years and the last year (historical alpha and relative strength). In addition, we use frequency of dividend cuts as a negative indication. Success Descriptors 1. Relative Strength (+) 2. Historical Alpha (+) 3. Recent Earnings Change (+) 4. IBES Earnings Growth (+) 5. Dividend Cuts, 5-Year (-) 6. Growth in EPS (+)
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