BM61002: Corporate Finance

Portfolio Theory and CAPM

Abhijeet Chandra, PhD

Vinod Gupta School of Management

Indian Institute of Technology Kharagpur

January 27, 2015

Ecient Frontier

Figure: Ecient Frontier

CAPM: Assumptions

Everyone in the market agrees about

Everybody does the same mean-variance optimization, holding

E (ri )'s, i 's,

and

same ecient frontier portfolio(s).

The market is ecient.

There exists only one risk-free asset.

No market frictions: no taxes, no transaction costs.

Unlimited shorting is allowed.

ij 's.

What does it mean?

Every investor puts their money into two types of assets:

The risk-free asset that pays an interest rate

rf ,

and

A single portfolio of risky assets, let's call it the tangent portfolio.

All investors hold the risky assets in same proportions.

That is, they hold the same risky portfolio and the same
tangent portfolio.

Thus the tangent portfolio, T, is the market portfolio, M.

CAPM

The (marginal) return-to-risk ratio of risky asset

portfolio p is:
Marginal _return
Marginal _risk

Since

T = M,

be the same:
f
(r A1 r
A1M /M )

in a

ri rf
(ip /p )

the return-to-risk ratio of all risky assets must

r A2 rf
(A2M /M )

= ... =

r Ai rf
(AiM /M )

If we re-write this as follows:

f
f
(r i r
= r Mr
iM /M )
M

leading to:

r i rf = iM (r M rf ) = iM (r M rf )
M
2

or:

r i = rf + iM (r M rf ) [CAPM]

r M rf
M

CAPM: Features

r i = rf + iM (r M rf ) [CAPM]
iM is the measure of the systematic
part of risk) of the asset

r M rf

risk (non-diversiable

i.

is the market risk premium, that is, the premium per

unit of systematic risk.

The risk premium on asset

equals the amount of its

systematic risk multiplied with the premium per unit of the

risk.

Security Market Line

The relation between an asset's premium and its market beta is
called the Security Market Line (SML).

Figure: Security Market Line

Investor's dream shattered: Given an asset's beta/expected return,

we can determine its expected return/beta.

Decomposing Sources of Variations in Returns

r i rf = i

iM (r M rf )

i

where

E (i ) =

Covar[r M , i ]

=0

Three components:

Alpha (i ): CAPM assumes alpha () to be zero for all assets.

Beta (iM ): connotes an asset's systematic risk; assets with

higher betas are more sensitive to the market.

Sigma (i ): measures its non-systematic risk; uncorrelated

with systematic risk.

CAPM: Issues

A number of unrealistic underlying assumptions;

Investors had identical preferences, had the same information,

and hold the same portfolio (the market)

Dicult to measure (universal) market return; the market

portfolio (comprising every single available asset) is
unobservable.

Eugene Fama is quoted as saying:

"...beta as the sole variable explaining returns on stocks is

The relation between average return and beta is completely

dead." Eric N. Berg, New York Times, 18 Feb., 1992.

at. Michael Peltz, Institutional Investor, June 1992

Asset returns can not be merely a function of single factor,

such as beta.

Flattening Beta-return Relationship1

The relation between beta and actual average return has been much weaker
since the mid-1960s.

Risk-return relationship has been appended in recent times. FT, 2014.

Source: Beta and return, F. Black, Journal of Portfolio Management, v20, 1993

Flat Beta in Indian Market2

Source: Betting against beta in the Indian market, Agarwalla et al., IIMA WP 2014-07-01

Other Factors Aecting Returns3

Stocks with small market cap have outperformed large-cap stocks.

Stocks with low ratios of market-to-book value have outperformed

stocks with high ratios.

Source: The cross section of expected stock returns, Fama and French, Jo Finance, v47, 1992

Companies possessing similar characteristics may, in a given

month, show returns that are dierent from the other companies.
The pattern of diering shows up as the factor relation."

Source: Extra market components of covariance in security markets, Rogenberg et al., JFQA, 1974

Alternative Pricing Models

Conditional CAPM:

Do away with static risk factor, and use all

available information .

t1
t
E [Rit |t1 ] E [rft |t1 ] = iM
(E [RM
|t1 ] E [rft |t1 ])
where
t

Cov [Ri ,RM |t1 ]

t1
iM
= Var [R
t |
t1 ]
M
t1 represents all available

BAPM:

information.

Uses SDF as pricing kernel (Shefrin, 2008).

Investors with hetergeneous beliefs

where one investor predicts (price) continuation and the other investor
(price) predicts reversal.

Models heterogeneity through the discounted probability.

The discounted probability is a relative wealth-weighted convex

combination of the individual investors' probabilities.

Family of CAPM: Intertemporal CAPM, Consumption-based CAPM, International

CAPM, Production-based CAPM, and so on...
5

The conditional CAPM and the cross-section..., Jagannathan and Wang, Jo Finance, 1996

Multiple Risk Factors: An example

Only two sources of risk for a company, Synfosis:

Technological risk: Upgradation

Macroeconomic risk: Change in
RM = R S + RE

in software used (RS ),

exchange rate (RE )

CAPM: r Syn rf = Syn (r M rf )

Based on CAPM, the beta of Synfosis
Syn =

Cov (RSyn ,RM )

Var (RM )

will be:
Cov (RSyn ,RS )+Cov (RSyn ,RE )
Var (RM )

Both covariances should be priced same (as per CAPM).

Possible??

What if there are

Fama-French 3-factor model:

unique/unrelated risk factors?

Beta ( ), Size (SMB ), Book-to-price ratio (HML)

r Syn = rf + Syn (r M rf ) + bs SMB + bv HML +

Arbitrage Pricing Theory (APT)

Multi-factor model of asset pricing.

Based on law of one price and no arbitrage.

Makes much more sense as we don't assume:

There is only one risk factor;

Everyone is optimizing same mean-variance frontier;
Statistical model (unlike an equilibrium CAPM)

Yet, we assume:

Finite expected return and risk associated with each asset.

No market frictions: taxes, costs, etc.
There exists no arbitrage opportunity.
Someone out there forms well-diversied portfolio(s) for
relative assessment.

APT...
The market-risk model can be extended to multiple risk factors:

r i rf = bi 1 1 + bi 2 2 + ... + bij j
where,

bij
j

is factor loadings for each of the risk factos.

is a set of risk premia.

The expected return of an asset

is a linear function of the

asset's sensitivities (measured in terms of factor loadings,

to the

bij )

risk factors.

Risk in APT =

(Risk factor, Factor loadings, Factor risk

premium, Arbitrage)

APT: Example6

Suppose that we know that IBM is going to pay a liquidating

dividend in exactly one year, and this is the only payment that
it will make.

However, that dividend that IBM pays is uncertain  its size

depends on how well the economy is doing.

If the economy is in an expansion, then IBM will pay a

dividend of

However, if the economy is in a recession, then its dividend will

If the two states are equally likely, the expected cash ow from

be only
IBM is

$140.

$100.

E (CF1IBM ) = $120

Note that, consistent with our denition of uncertainty, we

know exactly what will happen to IBM in each scenario, but
we don't know which scenario will occur.

D. Papanikolaou, Kellogg-NWU.

APT Exapmple ...

IBM
Boom Payo (Pr=0.5)

140

Bust Payo (Pr=0.5)

100

E (CF1 )

120

Price at

t0

Discount Rate

100
20%

Assuming that the price of IBM is $100, we see that investors in

this economy are applying a discount rate of 20% to IBM's
expected cash-ows.

The way they come up with the price of IBM is to take the expected
cash ow at time 1 from IBM,

E (CF1IBM ) = $120,

and discount this

cash-ow back to the present at the "appropriate" discount rate,

which is apparently 20%.

Equivalently, we can say that the expected return of IBM is 20%.

APT Example...

Now let's consider a second security, DELL which, like IBM, will pay
a liquidating dividend in one year, and which has only two possible
cash ows, depending on whether the economy booms or goes into
a recession over the next year.

Boom Payo (Pr=0.5)

IBM

DELL

140

160

Bust Payo (Pr=0.5)

100

80

E (CF1 )

120

120

100

20%

Price at

t0

Discount Rate

Now let's consider how investors will "price DELL.

Note the IBM and DELL have the same expected cash-ow, so one
might guess that a reasonable price for DELL might also be $100.

APT Example...

However, even though the expected cash-ows for DELL are the
same, we see that the pattern of cash ows across the two states
are probably worse for DELL:

DELL's payo is lower in the bust/recession state, which is when we

are more likely to need the money. It only does better when things
are good.

The recession is when the rest of our portfolio is more likely to do poorly,
and when we are more likely to lose our job, and our consulting income is
likely to be lower. We need the cash more in a recession.

In the boom/expansion, our portfolio will probably do better; we're more

likely to have a good job; we'll probably have more consulting income.

This means that if DELL were the same price as IBM, we would buy
IBM.

APT Example...

Therefore, to induce investors to buy all of the outstanding DELL

shares, it will have to be the case that DELL's price is lower than
$100.

Also, note that the three are statements are equivalent:

The price investors will pay for DELL will be less than $100, even though
DELL's expected cash ows are the same as IBM's.

The discount rate investors will apply to DELL's cash ows will be higher
than the 20% applied to IBM's cash ows.

The expected return investors will require from DELL will be higher than
the IBM's expected return of 20%.

Let's assume that investors are only willing to buy up all of DELL's
shares if the price of DELL is $90, or, equivalently, that the discount
rate that they will apply to DELL is 33.33%:

E (RDELL ) =

E (CF1DELL )PDELL
PDELL

12090
90

30
90

= 0.3333

APT Example...
IBM

DELL

Boom Payo (Pr=0.5)

140

160

Bust Payo (Pr=0.5)

100

80

120

120

E (CF1 )
Price at

t0

Discount Rate

$100

$90

20%

33.33%

The way to think about expected returns is that this is something

that investors determine.

After looking at the pattern of cash-ows from any investment, and

deciding whether they like or dislike this pattern, investors
determine what rate they will discount these cash ows at (to
determine the price.)

expected return".

This rate is what we then call the "

Since investors accurately calculate the expected cash-ows, the

average return they realize on the investment will be the discount
rate.

APT: Implications (1)

Now let's see how all of this relates to the APT equations:

Calculating the business cycle factor fBC in the two states:

First, assume that we use the NBER (National Bureau of

Economic Research) business cycle indicator to construct our
factor.

The indicator is one (at the end of the next year) if the economy is
in an expansion, and zero if the economy is in a recession.

However, remember that for the factor, we need the

Assuming there is a 50%/50% chance that we will be in an

unexpected component of the business cycle.

expansion/recession, the expected value of the indicator is 0.5.

This means that the business-cycle factor has a value of

0.5

= 1 0.5

if the economy booms, and

economy goes bust.

0.5 = 0 0.5

if the

APT: Implications (2)

Calculating the factor loadings for the two securities:

The way of doing this is to run a time-series regression of the

returns of IBM on the factor. Let's do this rst for IBM:

rIBM,t = E (rIBM ) + bIBM,BC fBC ,t + eIBM,t

where

E (rIBM )

is the intercept and

bIBM,BC

is the slope

coecient.

Here, we have only two points, so we can t a line exactly:

= E (rIBM ) + bIBM,BC 0.5 (Boom)

= E (rIBM ) + bIBM,BC 0.5 (Bust)
Solving these gives E (rIBM ) = 0.20 (which we already knew)
and bIBM,BC = 0.4.
Similar calculations for DELL gives E (rDELL ) = 0.3333 and
bDELL,BC = 0.8889

0.40
0.00

APT: Implications (3)

Interpreting the factor loadings:

The factor loadings

bIBM,BC

and

bDELL,BC

tell us how much

risk IBM and DELL have.

Risk means that the security moves up or down when the

factor (the business cycle) moves up and down.

Based on the way that we have characterized uncertainty, the

expected return and the factor loading

bi,BC

of each security

tell us everything that we need to know to calculate all of the

payo, per dollar, in every state of nature.

This will be true for every well-diversied portfolio, in

every factor model.

One way of thinking about this is that the expected

return tells us what the reward is, and the
the risk of the security is.

b 's

tell us what

APT Implications (4)

Calculating the factor risk premia ('s):

The Factor Model tells us nothing about why investors are

discounting the cash ows from the dierent securities at
dierent rates.

To determine how investors view the risks associated with each

of the risks in the economy, we have to evaluate the APT
Pricing Equation.

Now that we have the factor loadings, we can determine the

's),
bik .

factor risk-premia (or

on factor loadings

by regressing expected returns

Eri

Since there is only one factor and two stocks:

E (rIBM ) = 0 + BC bIBM,BC
E (rDELL ) = 0 + BC bDELL,BC
to which the solutions are

0 = 0.0909

and

BC = 0.2727.

APT Implications (5)

Interpreting the risk premia ('s):

DELL is considered to be a riskier security than IBM, in the

sense that investors discount DELL's cashows at a higher rate
than IBM.

This is reected in DELL's higher loading on the BC factor.

The

BC

is a measure of how much more investors discount a

stock as a result of having one extra unit of risk relating to the

BC factor.

tells you how high a return investors require if a security

has no risk.

APT: Summary

Using the set of securities that we used to calculated the

pricing equations, we can always construct a portfolio

's

for the

with any set

of factor loadings (bp,k ).

The pricing equation then tells us what the expected return (or
discount rate) for the portfolio of securities is.

Alternatively, this equation tells us, if we nd a (well-diversied)

portfolio with certain factor loadings, what discount-rate that
portfolio must have for there to be no arbitrage.

Finally, if we add a third security to the mix and calculate its factor
loadings, the APT will tell us what its expected return must be in
order to avoid arbitrage opportunities.

Essentially what we doing is pricing securities relative to other

securities, in much the same way we are pricing derivatives relative
to the underlying security.

APT Application: Finding Arbitrage

Arbitrage arises when the price of risk diers across securities.
1. If investors are pricing risk inconsistently across securities, than,
assuming these securities are well diversied, arbitrage will be
possible.
2. To see this, let's extend the example to include a risk-free asset
which we can buy or sell at a rate of 5%.

That is the rate for borrowing or lending is 5%.

3. Since

0 = 0.0909,

we know that we can combine DELL and IBM in

such a way that we can create a synthetic risk-free asset with a

return of 9.09%.
4. So we borrow money at 5% (by selling the risk-free asset) and lend
money at 9.09%

APT Application: Buidling the arbitrage portfolio

To determine how much of IBM and DELL we buy/sell, we

solve the equation for the weights on IBM and DELL in a
portfolio which is risk-free:

wIBM bIBM,BC + (1 wIBM ) bDELL,BC = bp,BC =

or

wIBM =

bDELL,BC
bDELL,BC bIBM,BC

= 1.8182

This means that, to create an arbitrage portfolio, we can

invest $1.8182 in IBM, short $0.8182 worth of DELL, and
short $1 worth of the risk-free asset.

This portfolio requires zero initial investment and has a

positive payo in all states.

Building Arbitrage Portfolio...

To verify that this works, lets look at the payo to the

IBM/DELL risk-free portfolio in the two states:

Payo (boom) =

wIBM (140/100) + (1 wIBM ) (160/90) = 1.0909

Payo (bust) =

wIBM (100/100) + (1 wIBM ) (80/90) = 1.0909

This means that the payo from the zero-investment portfolio
is $0.0409 = 1.0909 - 1.05 in both the boom and bust states.
So this portfolio (in this simple economy) is risk free.

Of course, we can scale this up as much as we like. For $1

million investment in the long and short portfolios, we would
get a risk-free payo of $40,900 (assuming prices did not move
with our trades).

APT Application: Interpreting the arbitrage

What is going on here is that investors are pricing risk inconsistently

across securities.

With any pair of securities, we can calculate

and

each pair of securities will give you a dierent set of

BC ,
's:

however,

This means that, to nd the arbitrage, we could have:

1. Calculated the

's

using any pair of securities, and then

2. Calculated the expected return (or discount rate) for the third security,
3. Bought the high return and sold the low return.

APT Application

Here, we have used a simple example to understand how

investors price risky securities.

The idea behind the APT is that investors require dierent

rates of return from dierent securities, depending on the
riskiness of the securities.

If, however, risk is priced inconsistently across securities, then

there will be arbitrage opportunities.

Arbitrageurs will take advantage of these arbitrage

opportunities until prices are pushed back into line, risk is
priced consistently across securities, and arbitrages disappear.

What we have learnt so far...

Risk, Return, and Portfolio Theory

Risk-return relationship
Ecient frontier
Introducing risk-free asset
Mean-variance set

SML and CML

Capital Asset Pricing Model (CAPM)

Alternative asset pricing models

Arbitrage Pricing Theory