Capital Asset

Pricing and
Arbitrage
Pricing Theory

7
Bodie, Kane and Marcus
Essentials of Investments
9th Global Edition

7.1 THE CAPITAL ASSET PRICING MODEL

Assumptions

Markets are competitive, equally profitable

No investor is wealthy enough to individually affect prices
All information publicly available; all securities public
No taxes on returns, no transaction costs
Unlimited borrowing/lending at risk-free rate

Investors are alike except for initial wealth, risk aversion

Investors plan for single-period horizon; they are rational, meanvariance optimizers
Use same inputs, consider identical portfolio opportunity sets

7.1 THE CAPITAL ASSET PRICING MODEL

Hypothetical Equilibrium
All investors choose to hold market portfolio
Market portfolio is on efficient frontier, optimal risky portfolio
Risk premium on market portfolio is proportional to variance
of market portfolio and investors risk aversion
Risk premium on individual assets is proportional to risk
premium on market portfolio, and the beta coefficient of
security on market portfolio

FIGURE 7.1 EFFICIENT FRONTIER AND

CAPITAL MARKET LINE

7.1 THE CAPITAL ASSET PRICING MODEL

Passive Strategy is Efficient

Mutual fund theorem: All investors desire same portfolio of
risky assets, can be satisfied by single mutual fund
composed of that portfolio
If passive strategy is costless and efficient, why follow active
strategy?

If no one does security analysis, what

brings about efficiency of market portfolio?

7.1 THE CAPITAL ASSET PRICING MODEL

Risk Premium of Market Portfolio

Demand drives prices, lowers expected rate of return/risk
premiums
When premiums fall, investors move funds into risk-free
asset
Equilibrium risk premium of market portfolio proportional
to

Risk of market
Risk aversion of average investor
E(rm) - rf = A sM2

7.1 THE CAPITAL ASSET PRICING MODEL

EXPECTED RETURN AND RISK ON INDIVIDUAL SECURITIES

The risk premium on individual securities is a

function of the individual securitys
contribution to the risk of The market portfolio
__________________________________________
What type of individual security risk will matter,
systematic or unsystematic risk?
An individual securitys total risk (s2i) can be
partitioned into systematic and unsystematic risk:

s2i = bi2 sM2 + s2(ei)

M = market portfolio of all risky securities

7-7

7.1 THE CAPITAL ASSET PRICING MODEL

EXPECTED RETURN AND RISK ON INDIVIDUAL SECURITIES

Individual securitys contribution to the risk of the

market portfolio is a function of the covariance
__________ of the
stocks returns with the market portfolios returns and
is measured by BETA
With respect to an individual security, systematic
risk can be measured by bi = [COV(ri,rM)] / s2M

7-8

7.1 THE CAPITAL ASSET PRICING MODEL

7.1 THE CAPITAL ASSET PRICING MODEL

The Security Market Line (SML)

Represents expected return-beta relationship of CAPM
Graphs individual asset risk premiums as function of asset
risk

Alpha

Abnormal rate of return on security in excess of that

predicted by equilibrium model (CAPM)

FIGURE 7.2 THE SML AND A POSITIVEALPHA STOCK

Equation of the SML (CAPM)

E(ri) = rf + bi[E(rM) - rf]
Slope SML = (E(rM) rf )/ M
= price of risk for market

7.1 THE CAPITAL ASSET PRICING MODEL

SAMPLE CALCULATIONS FOR SML

Equation of the SML:

E(rm) - rf =.08

E(ri) = rf + bi[E(rM) - rf]

rf =.03

Return per unit of systematic risk = 8% & the return due to the TVM = 3%

bx = 1.25
E(rx) = 0.03 + 1.25(.08) = .13 or 13%
by = .6
E(ry) = 0.03 + 0.6(0.08) = 0.078 or 7.8%

If b = 1?
If b = 0?

7-12

7.1 THE CAPITAL ASSET PRICING MODEL

GRAPH OF SAMPLE CALCULATIONS

E(r)
SML
Rx=13%
RM=11%
Ry=7.8%
3%

.08
If the CAPM is correct, only
risk matters in determining
the risk premium for a given
slope of the SML.

.6 1.0 1.25
y M x

7-13

Disequilibrium Example
E(r)
SML
15%
Rm=11%

13%

rf=3%
1.0 1.25

Suppose a security with a b of

____
1.25 is offering an expected
15%
return of ____
According to the SML, the E(r)
13%
should be _____
E(r) = 0.03 + 1.25(.08) = 13%

Is the security under or overpriced?

Underpriced: It is offering too high of a rate of return for its level of risk
The difference between the return required for the risk level as measured
by the CAPM in this case and the actual return is called the stocks _____
alpha
denoted by
__
in this case? = +2% Positive is good, negative is bad
What is the __
+ gives the buyer a + abnormal return
7-14

PORTFOLIO BETAS
P = Wi i
1.5
If you put half your money in a stock with a beta of ___
30% of your money in a stock with a beta of 0.9
and ____
___and
the rest in T-bills, what is the portfolio beta?
P = 0.50(1.5) + 0.30(0.9) + 0.20(0) = 1.02

All portfolio beta expected return combinations

should also fall on the SML.
All (E(ri) rf) / i should be the same for all
stocks.
7-15

7.1 THE CAPITAL ASSET PRICING MODEL

Applications of CAPM
Use SML as benchmark for fair return on risky asset
SML provides hurdle rate for internal projects

7.2 CAPM AND INDEX MODELS

7.2 CAPM AND INDEX MODELS

TABLE 7.1 MONTHLY RETURN

STATISTICS 01/06 - 12/10
Statistic (%)

T-Bills

S&P 500

Google

Average rate of return

0.184

0.239

1.125

Average excess return

0.055

0.941

Standard deviation*

0.177

5.11

10.40

Geometric average

0.180

0.107

0.600

Cumulative total 5-year return

11.65

6.60

43.17

Gain Jan 2006-Oct 2007

9.04

27.45

70.42

Gain Nov 2007-May 2009

2.29

-38.87

-40.99

Gain June 2009-Dec 2010

0.10

36.83

42.36

* The rate on T-bills is known in advance, SD does not reflect risk.

FIGURE 7.4 SCATTER DIAGRAM/SCL: GOOGLE VS.

S&P 500, 01/06-12/10

TABLE 7.2 SCL FOR GOOGLE (S&P 500),

01/06-12/10
Linear Regression
Regression Statistics
R
R-square
Adjusted R-square
SE of regression
Total number of observations

0.5914
0.3497
0.3385
8.4585
60

Regression equation: Google (excess return) = 0.8751 + 1.2031 S&P 500 (excess return)
ANOVA
df
1
58
59

SS
2231.50
4149.65
6381.15

Coefficient
s
0.8751
1.2031

Standard
Error
1.0920
0.2154

Regression
Residual
Total

Intercept
S&P 500
t-Statistic (2%)

2.3924

LCL - Lower confidence interval (95%)

UCL - Upper confidence interval (95%)

MS
2231.50
71.55

F
31.19

p-level
0.0000

t-Statistic
0.8013
5.5848

p-value
0.4262
0.0000

LCL
-1.7375
0.6877

UCL
3.4877
1.7185

7.2 CAPM AND INDEX MODELS

Estimation results
Security Characteristic Line (SCL)

Plot of securitys expected excess return over

risk-free rate as function of excess return on
market
Required rate = Risk-free rate + x Expected excess return
of index

7.3 CAPM AND THE REAL WORLD

CAPM is false based on validity of its assumptions

Useful predictor of expected returns
Untestable as a theory
Principles still valid

Investors should diversify

Systematic risk is the risk that matters
Well-diversified risky portfolio can be
suitable for wide range of investors

7.4 MULTIFACTOR MODELS AND CAPM

FAMA-FRENCH (FF) 3 FACTOR

MODEL
smaller firmsand
Fama and French noted that stocks of ____________
book to markethave had
stocks of firms with a high
_________________
higher stock returns than predicted by single factor
models.
Problem: Empirical model without a theory
Will the variables continue to have predictive power?

7-25

FAMA-FRENCH (FF) 3 FACTOR MODEL

FF proposed a 3 factor model of stock returns as follows:
rM rf = Market index excess return
value of equity to market value of equity
of book
______________________________________
measured with a variable called HML
____:
HML:
High minus low or difference in returns between
firms with a high versus a low book to market
ratio.

Ratio

size variablemeasured
Firm
_______________

by the SMB
____ variable

SMB:
Small minus big or the difference in returns
between small and large firms.
7-26

7.4 MULTIFACTOR MODELS AND CAPM

FAMA-FRENCH (FF) 3 FACTOR MODEL

rGM rf =GM + M(rM rf ) + HMLrHML + SMBrSMB +

eGM

7-28

TABLE 7.3 MONTHLY RATES OF RETURN,

01/06-12/10
Security

T-bill

Monthly Excess Return % *

Standard
Average
Deviation

Total Return
Geometric
Cumulative
Average
Return

0.18

11.65

Market index **

0.26

5.44

0.30

19.51

SMB

0.34

2.46

0.31

20.70

HML

0.01

2.97

-0.03

-2.06

Google

0.94

10.40

0.60

43.17

*Total return for SMB and HML

** Includes all NYSE, NASDAQ, and AMEX
stocks.

7.5 ARBITRAGE PRICING THEORY

Arbitrage

Arbitrage Pricing Theory (APT)

Relative mispricing creates riskless profit

Risk-return relationships from no-arbitrage considerations in large

capital markets

Well-diversified portfolio
Nonsystematic risk is negligible
Arbitrage portfolio
Positive return, zero-net-investment, risk-free portfolio

FIGURE 7.5 SECURITY

CHARACTERISTIC LINES

7.5 ARBITRAGE PRICING THEORY

Multifactor Generalization of APT and CAPM

Factor portfolio

Well-diversified portfolio constructed to

have beta of 1.0 on one factor and beta of
zero on any other factor

Two-Factor Model for APT