Lecture2A Asset Pricing

Stochastic Discount Factor
Single Factor Pricing Model

Multi-Factor Model
Lecture 2a: Asset Pricing-Beta Pricing Model
Y. Zhang1
1 Hanqing Advanced Research Institute of Economics and Finance

Renmin University of China
Master of Finance Program
Y.Z. Introduction
Multi-Factor Model
Outline
1 Stochastic Discount Factor

Overview
2 Single Factor Pricing Model

CAPM
Single Index Model
Empirical Test of CAPM
3 Multi-Factor Model
beta pricing model
Arbitrage Pricing Theory
Y.Z. Introduction
Single Factor Pricing Model Overview
Multi-Factor Model
Concavity and Risk Aversion
The coefficient
00 (w )
of absolute risk aversion at a wealth level w:
α(w ) = − uu0 (w )
The coefficient of relative risk aversion: w α(w )
Constant Relative Risk Aversion: the relative risk aversion is
the same at all wealth levels
A constant x is said to be the certainty equivalent of a
random variable w if
u(x) = E (u[w ])
If absolute risk aversion is the same at every wealth level, then
the investor has CARA (Constant Absolute Risk Aversion)
utility.
Y.Z. Introduction
Multi-Factor Model
Representative Agent
Pareto Optimal
N investors labeled by i=1,...N with utility function
ui (·) = −x −1
An allocation that it is impossible to improve the welfare of
any investor without harming theother investor’s welfare.
0 0
we can not find some allocation w̃ 1 , . . . , w̃ N satisfies
E [ui (w̃i0 )] ≥ E [ui (w̃i )] ∀i and E [ui (w̃i0 )] > E [ui (w̃i )] ∃i
Example
Suppose the total wealth is 10 and there are 2 agents
( (
4 recession, p = 0.5 6 recession, p = 0.5
w̃1 = , w̃2 =
6 boom 4 boom
Y.Z. Introduction
Multi-Factor Model
Pareto Optimal
N investors labeled by i=1,...N with utility function
ui (·) = −x −1
An allocation that it is impossible to improve the welfare of
any investor without harming theother investor’s welfare.
0 0
we can not find some allocation w̃ 1 , . . . , w̃ N satisfies
E [ui (w̃i0 )] ≥ E [ui (w̃i )] ∀i and E [ui (w̃i0 )] > E [ui (w̃i )] ∃i
Example
Suppose the total wealth is 10 and there are 2 agents
( (
4 recession, p = 0.5 6 recession, p = 0.5
w̃1 = , w̃2 =
6 boom 4 boom
Y.Z. Introduction
Multi-Factor Model
Solution
it not Pareto Optimal

A new allocation (5,5) for both investor can improve the utility
E [u1 (4, 6)] = 0.5 × −4−1 + 0.5 × −6−1 = −0.21.

E [u1 (5, 5)] = 0.5 × −5−1 + 0.5 × −5−1 = −0.2.

Problem Set: Write a R code to find the Pareto Optimal

Allocation
Y.Z. Introduction
Multi-Factor Model
Competitive Equilibrium
markets clear
each agent optimizes, taking prices as given.
At a Pareto-optimal competitive equilibrium, an investor
endowed with all of the assets and endowments of the
economy and possessing the utility functions of social planner
is a representative investor.
Reading: Ch1-3, 7 in <<Asset Pricing and Portfolio Choice
Theory>> by Kerry E. Back
Y.Z. Introduction
Multi-Factor Model
Et [m̃t,t+1 Rt+1 ] = 1
We can think of a return as a payoff with price one. If you pay
one dollar today, the return is how many dollars or units of
consumption you get tomorrow.
h i
Ct+1 1
Pt = 1+WACC = Et 1+WACC Ct+1 =⇒
 

1 Ct+1 
1 = Et  1+WACC
 
Pt 


| {z }
Rt+1
Et [m̃t,t+1 (Ri,t+1 − Rj,t+1 )] = 0
The expected present value of a zero-cost portfolio must be 0.
Y.Z. Introduction
Multi-Factor Model
Consumption Based Asset Pricing Model
(
Cov (m, x) = E [mx] − E (m)E (x)
p = E [mx]
p = E (m)E (x) + Cov (m, x)
1
Rf = E [m]
E (x)
p= + Cov (m, x)
R
| {zf }
| {z }
risk−adjustment
risk−neutral PV
cov [βu 0 (ct+1 ),xt+1 ]
Cov (m, x) = u 0 (ct )
E (x) cov [βu 0 (ct+1 ),xt+1 ]
p= Rf + u 0 (ct )
Y.Z. Introduction
Multi-Factor Model
Some Interesting Insights
Under the power utility, m = β × ( ct+1 −γ

ct ) . ct ↑=⇒ m ↓
Marginal utility u 0 (c) declines as c rises. Thus, an asset0 s price
is lowered if its payoff covaries positively with consumption.
Conversely, an asset0 s price is raised if it covaries negatively
with consumption.
Investors do not like uncertainty about consumption.
If an asset pays off well when you are already feeling wealthy,
and pays off badly when you are already feeling poor, this asset
will make your consumption stream more volatile.
If an asset0 s payoff covaries negatively with consumption, it
helps to smooth consumption and so is more valuable than its
expected payoff.
Insurance is an extreme example. The price of insurance is
greater than its expected present value.
Y.Z. Introduction
Stochastic Discount Factor CAPM
Single Factor Pricing Model Single Index Model
Multi-Factor Model Empirical Test of CAPM
CAPM

E [Ri ] = Rf + cov (m,Ri )
Var (m) − Var (m)
E (m)
E [Ri ] = Rf + βi,m λm
βi,m is asset specific. It is the projection of Ri on SDF
λm is price of risk - the same across assets
If the factor is market return, then replacing Ri with RM in
beta pricing model.
E [RM ] = Rf + covVar
(RM ,RM )
(RM ) λM
λM = E [RM ] − Rf
CAPM: E [Ri ] = Rf + βi,M (E [RM ] − Rf )
Y.Z. Introduction
CAPM derived from CML

Market portfolio contains all securities and the proportion of
each security is its market value as a percentage of total
market value.
Y.Z. Introduction
Construct A Portfolio
wGE on GE and (1 − wGE ) on Market Portfolio

This Portfolio must pass the point M. (Why?)
This portfolio is inferior to the market portfolio efficient
frontier. (Why?)
E (Rp ) = wGE E (RGE ) + (1 − wGE ) E (RM )
Var (Rp ) =
2 Var (R 2
wGE GE ) + (1 − wGE ) Var (RM ) +
2 (1 − wGE ) wGE Cov (RGE , RM )
It is tangent to CML at the point (E [RM ] , σM )
Tangency

∂E (Rp )
∂σp = slope of CML at the point (E [RM ] , σM )
wGE =0
Y.Z. Introduction
Construct A Portfolio
wGE on GE and (1 − wGE ) on Market Portfolio

This Portfolio must pass the point M. (Why?)
This portfolio is inferior to the market portfolio efficient
frontier. (Why?)
E (Rp ) = wGE E (RGE ) + (1 − wGE ) E (RM )
Var (Rp ) =
2 Var (R 2
wGE GE ) + (1 − wGE ) Var (RM ) +
2 (1 − wGE ) wGE Cov (RGE , RM )
It is tangent to CML at the point (E [RM ] , σM )
Tangency

∂E (Rp )
∂σp = slope of CML at the point (E [RM ] , σM )
wGE =0
Y.Z. Introduction
Derivation

∂E (Rp ) E (RM )−Rf
∂σp w = σM
GE =0
∂E (Rp ) ∂E (Rp ) ∂σp
∂σp = ∂wGE / ∂wGE
∂E (Rp )
∂wGE = E (RGE ) − E (RM )
∂σp2 p ∂σ
∂wGE = 2σp ∂wGE =
2 2 + 2 (1 − 2w
2wGE σGE − 2 (1 − wGE ) σM GE ) Cov (RGE , RM )
σp =σM
∂E (Rp ) ∂σp
∂wGE / ∂wGE ⇐⇒ [ECov (RGE )−E (RM )]σM
(R ,R )−σ 2
= E (RσMM)−Rf
wGE =0 given wGE =0 GE M M
2
Cov (RGE ,RM )−σM
E (RGE ) = E (RM ) + σM2 [E (RM ) − Rf ]
Cov (RGE ,RM )
E (RGE ) = Rf + 2
σM
[E (RM ) − Rf ]
Y.Z. Introduction
Security Market Line
Y.Z. Introduction
SML describes the expected return-beta relationship

The security market line provides a benchmark for the
evaluation of investment performance.
Given the risk of an investment, the SML provides the required
rate of return necessary to compensate investors for risk.
Y.Z. Introduction
Assumption of CAPM
Individuals
Investors are rational, mean-variance optimizers
Homogeneous expectations: all investors will have the same
expectations and make the same choices given a particular set
of circumstances. if investors are shown plans that have
different risks but the same returns, investors will choose the
plan that has the lowest risk.
Their planning horizon is a single period
Markets
All information is publicly available.
All assets are publicly held and trade on public exchanges,
short positions are allowed, and investors can borrow or lend at
a common risk-free rate
No taxes and Transaction Cost
Y.Z. Introduction
Challenges to the CAPM
The most worrisome assumption: short positions are not as

easy to take as long ones
The liability of investors who hold a short position in an asset
is potentially unlimited, since the price may rise without limit.
Hence a large short position requires large collateral, and
proceeds cannot be used to invest in other risky assets
There is a limited supply of shares of any stock to be borrowed
by would-be short sellers. It often happens that investors
simply cannot find shares to borrow in order to short.
Many investment companies are prohibited from short sales.
The short sales are restricted by the government.
Y.Z. Introduction
Why are short sales important?

When investors exhibit ?irrational exuberance? (excessive
optimism) about an asset and, as a result, prices rise above
intrinsic values
Rational investors will take short positions, thus holding down
the price.
If short sale is restricted, the prices can rise to an
unsustainable level. This really defines a ?bubble.?
Y.Z. Introduction

When investors exhibit ?irrational exuberance? (excessive
optimism) about an asset and, as a result, prices rise above
intrinsic values
Rational investors will take short positions, thus holding down
the price.
If short sale is restricted, the prices can rise to an
unsustainable level. This really defines a ?bubble.?
Y.Z. Introduction
Zero-Beta Model
Any portfolio that is a combination of two frontier portfolios

is itself on the efficient frontier.
Every portfolio on the efficient frontier, except for the global
minimum-variance portfolio, has a ”companion” portfolio on
the bottom (inefficient) half of the frontier with which it is
uncorrelated.
it is uncorrelated, the companion portfolio is referred to as the
zero-beta portfolio of the efficient portfolio.
If we choose the market portfolio M and its zero-beta
companion portfolio ZC(M), then we obtain a CAPM-like
equation
E (Ri ) = E RZC (M) + βM,j E (RM ) − E RZC (M)
Y.Z. Introduction
zero-beta portfolio
Y.Z. Introduction
The CAPM and the Single-Index Market
The market portfolio is efficient.

The risk premium on a risky asset is proportional to its beta
These two statements are substitutes because one can be derived
from the other (one is true if and only if the other is as well).
Single Index Model
Ri − Rf = αi + βi,M (RM − Rf ) + ei
The β in SIM is the same as the one in CAPM.
Y.Z. Introduction
Y.Z. Introduction
RHP (t) − Rf (t) = αi + βHP (RSP500 (t) − Rf (t)) + eHP (t)

The regression estimates describe a straight line with
intercept(αHP ) and slope(βHP ), which we call the security
characteristic line (SCL) for HP.
Y.Z. Introduction
Example
R 2 is coefficient of determination or percentage of variance

SSres SSreg
explained: R 2 = 1 − Total SS = Toal SS
2 2
SSres = Σ RHP (t) − R̂HP (t) , total SS = Σ RHP (t) − R̄HP (t) ,
t t
2
SSreg = Σ R̂HP (t) − R̄HP (t)
t √ n−1
Multiple R = R 2 , Adjust RA2 = 1 − 1 − R 2 n−p−1
Y.Z. Introduction
The Index Portfolio as an Investment Asset
The mutual fund firm allow only a relatively small subset of

listed shares in the exchange.
If these analyzed firms are the only ones allowed in the fund,
the fund manager may well be worried about limited
diversification.
A simple way to avoid inadequate diversification is to include
the SP 500 portfolio as one of the assets of the portfolio.
an active portfolio, denoted by A, comprised of the n analyzed
securities
the market index portfolio, the (n+1)th asset we include to aid
in diversification, which we call the passive portfolio and
denote by M.
Y.Z. Introduction
Optimization Procedure
Figure:
Y.Z. Introduction
Example
See Spreadsheet 8.1
Y.Z. Introduction
Is the Index Model Inferior to the Full-Covariance Model?
Full Markowitz model may be better in principle, but

Using the full-covariance matrix invokes estimation risk of
thousands of terms
Cumulative errors may result in a portfolio that is actually
inferior to that derived from the single-index model
The single-index model is practical and decentralizes macro
and security analysis
Y.Z. Introduction
Adjusted Beta
Adjust beta because

The average beta over all securities is 1; thus, the best forecast
of the beta would be that it is 1
Firms may become more ?typical? as they age, causing their
betas to approach 1
Adjusted β = 23 sampleβ + 31 (1)
Y.Z. Introduction
Empirical Test of CAPM
Essence of CAPM
expected return on any asset is a positive linear function of its
beta and that beta is the only measure of risk needed to
explain the cross-section of expected returns.
Why does CAPM fail?
investors do not have identical expectations (the same
forecasts of µ, σ, ρ for all risky assets under consideration).
The market portfolio does not contain every risky asset. Wage
income, residential real estate and risky corporate bond are not
included.
lending rate does not equal to borrowing rate
How to test CAPM?
Y.Z. Introduction
Fama and MacBeth 1973
First Step Regression: CAPM

Assume data ranges from 1966Q1 to 2000Q4
Select a Proxy of market, for example SP500 and N securities
Run the following linear regression over t=1,...T:
R1,t−1 − Rf ,t−1 = α̂1,t−1 + β̂1,t−1 (RM,t−1 − Rf ,t−1 ) + ε1,t−1
R2,t−1 − Rf ,t−1 = α̂2,t−1 + β̂2,t−1 (RM,t−1 − Rf ,t−1 ) + ε2,t−1
···
RN,t−1 − Rf ,t−1 = α̂N,t−1 + β̂N,t−1 (RM,t−1 − Rf ,t−1 ) + εN,t−1
Since the individual securities0 betas often contain
measurement error, you can use portfolio to do this step.
Y.Z. Introduction
CAPM Regression
Fama-Macbeth(1973) sorts the securities into 20 portfolios

based on the β̂i,t−1 by ranking them from lowest to highest.
Np
P = Σ w β̂ , where N is the
Calculate Portfolio Beta :β̂j,t k k,t p
k=1
1
number of securities in the jth portfolio, wk = Np , and β̂k,t is
recomputed using data in period t
Np
¯ p,t−1 (ε̂k ) = Σ wk sd (ε̂k,t−1 )
Calculate the sd
k=1
Y.Z. Introduction
Cross-Sectional Regression
Second Step Regression: SML

Compute the following means in period t+1: R̄p,t+1
Now,
we have 20 portfolio data points:
¯ p,t−1 (ε̂k )
R̄p,t+1 , β̂p,t−1 , sd
Run the cross-sectional regression:
R̄i = γ̂ˆ0 + γ̂ˆ1 β̂p,t−1 + γ̂ˆ2 β̂p,t−1
2
+ γ̂ˆ3 sd
¯ p,t−1 (ε̂k ) + ξi
The presence of the square term in the regression is a simple
test for nonlinearities in the return-systematic risk relationship
across the securities.
The fourth term tests an unsystematic risk-return relationship.
Y.Z. Introduction
Cross-Sectional Regression
Third Step: Repeating the Steps above

Repeating this procedure for sequential time periods for K
times, we have obtained a time series of γ̂î
î,k
Σk γ̂
γ̄i = K −1
the length of data window is not uniquely determined. We
recommend 4-5-4 years to do the test.
Do the t-test on γ̂î
Y.Z. Introduction
Empirical SML
Y.Z. Introduction
Implications
γ̄2 and γ̄3 are not statistically different from zero which is
consistent with the basic form of the SML.
γ̄1 is positive. It is, however, too small relative to the average
risk premium on the market.
The average return/systematic risk relationship across the 20
portfolios is ”too flat”: the returns to low beta portfolios are
too high relative to what the CAPM would predict while high
beta portfolios0 average returns are too low.
γ̄0 is positive but substantially in excess of the Rf .
Y.Z. Introduction
beta pricing model
Multi-Factor Model
Beta Pricing Model

E (R) = Rz + λ cov (f ,R) cov (f ,R)
Var (f ) , where Var (f ) is called beta
Rz is the expected value of an asset return satisfying
cov (f , Rz ) = 0  
f1
 f2 
A multifactor beta pricing model with factors F= .
 
 ..


fk
E (R) = Rz + λ0 Σ−1
F Cov (F , R), where λ is the factor risk
premium.
ΣF is the covariancew matrix of the vector
 F 
cov (f1 , R)
 cov (f2 , R) 
Cov (F , R) denotes the column vector, 
 
.. 
 . 
cov (fk , R)
Y.Z. Introduction
beta pricing model
Multi-Factor Model
The number of factor in a beta pricing model is not uniquely

determined.
Given a k factor model, we can always use λ0 Σ−1
F F as a single
factor.
If a factor is a return, then its factor risk premium is its
ordinary risk premium, treating Rz as a proxy of risk-free
return.
If a factor is an excess return, then the factor risk premium is
simply the expected value of the factor.
All factors can be replaced by returns or excess returns. These
returns should be the ones which have the maximum
correlations with factors.
These returns can be obtained by orthogonal projection of the
factor on the space of returns and a constant. These are
called factor-mimicking return.
Y.Z. Introduction
beta pricing model
Multi-Factor Model
Returns as Factors
Consider a k-factor model and factor is return.

E (fi ) = Rz + λ0 Σ−1
F Cov (F , fi )
The vector Cov (F, fi ) is the ith column of matrix ΣF .
0
 .. 
 . 
 
 0 
−1
 
 1 , where the ith element is 1 and 0
ΣF Cov (F , fi ) is  
 0 
 
 .. 
 . 
0
elesewhere.
λ0 Σ−1
F Cov (F , fi ) = λi = E (fi ) − Rz
Y.Z. Introduction
beta pricing model
Multi-Factor Model
Excess Returns as Factors
E (mRi ) = 1 and E (mRj ) = 1. So, E [m (Ri − Rj )] = 0

(Rf ) satisfies the formula above
Ri − Rj is called excess return.
If factor is excess return. Any R and R + fi is also a return.
E (R) = Rz + λ0 Σ−1
F Cov (F , R)
E (R + fi ) = Rz + λ0 Σ−1 0 −1
F Cov (F , R) + λ ΣF Cov (F , fi )
Subtracting the 1st from 2nd equation, we have
E (fi ) = λ0 Σ−1
F Cov (F , fi ) = λi
Y.Z. Introduction
beta pricing model
Multi-Factor Model
Intuition
The idea behind a factor model is that common exposure to

some systematic risk sources is what causes asset returns to
be correlated.
The risk of each asset return is assumed to consist of a
systematic component and an idiosyncratic component.
The idiosyncratic component is uncorrelated across assets.
In a diversified portfolio, the idiosyncratic risk can be omitted
by Law of Large Number.
The risk premium of each asset should depend only on the
asset0 s exposure to the common risk sources and not on its
idiosyncratic risk
An assumption about the correlations of assets implies APT.
Y.Z. Introduction

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Stochastic Discount Factor

Single Factor Pricing Model

Lecture 2a: Asset Pricing-Beta Pricing Model

1 Hanqing Advanced Research Institute of Economics and Finance

Master of Finance Program

1 Stochastic Discount Factor

2 Single Factor Pricing Model

Concavity and Risk Aversion

it not Pareto Optimal

E [u1 (5, 5)] = 0.5 × −5−1 + 0.5 × −5−1 = −0.2.

Problem Set: Write a R code to find the Pareto Optimal

Stochastic Discount Factor

Consumption Based Asset Pricing Model

Some Interesting Insights

Under the power utility, m = β × ( ct+1 −γ

CAPM derived from CML

wGE on GE and (1 − wGE ) on Market Portfolio

wGE on GE and (1 − wGE ) on Market Portfolio

Security Market Line

SML describes the expected return-beta relationship

Challenges to the CAPM

The most worrisome assumption: short positions are not as

Why are short sales important?

Why are short sales important?

Why are short sales important?

Why are short sales important?

Any portfolio that is a combination of two frontier portfolios

The CAPM and the Single-Index Market

The market portfolio is efficient.

RHP (t) − Rf (t) = αi + βHP (RSP500 (t) − Rf (t)) + eHP (t)

R 2 is coefficient of determination or percentage of variance

The Index Portfolio as an Investment Asset

The mutual fund firm allow only a relatively small subset of

See Spreadsheet 8.1

Is the Index Model Inferior to the Full-Covariance Model?

Full Markowitz model may be better in principle, but

Adjust beta because

Empirical Test of CAPM

Fama and MacBeth 1973

First Step Regression: CAPM

Fama-Macbeth(1973) sorts the securities into 20 portfolios

Second Step Regression: SML

Third Step: Repeating the Steps above

Beta Pricing Model

The number of factor in a beta pricing model is not uniquely

Consider a k-factor model and factor is return.

Excess Returns as Factors

E (mRi ) = 1 and E (mRj ) = 1. So, E [m (Ri − Rj )] = 0

The idea behind a factor model is that common exposure to

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