Asset Pricing Models

Dr Nalan Gulpinar Imperial College London

381 Computational Finance

20-21 February 2006
Computational Finance

Problem Types in Investment Science

Determining

correct, arbitrage free price of an asset:

price of a bond, a stock

the best action in an investment situation: how to find the best portfolio how to devise the optimal strategy for managing an investment

Single period Markowitz model

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Topics Covered

The Capital Asset Pricing Model (CAPM) Single and Multi Factor Models CAPM as a Factor Model The Arbitrage Pricing Theory (APT)

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M-V model investor chooses portfolios on the efficient frontier deciding if given portfolio is on efficient frontier or not

no guarantee that a portfolio that was efficient ex ante will be efficient ex post

statistical considerations regarding time period over which to estimate & which assets to include are non-trivial

not mention implications of m-v optimisation on asset pricing

CAPM describes MV portfolios and provides asset pricing

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CAPM: Capital Asset Pricing Model

developed by Sharpe, Lintner and Mossin single period asset pricing model determines correct price of a risky asset within

the mean-variance framework

highlights the difference between systematic &

specific risk

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Assumptions
All investors

are mean variance optimisers portfolios on efficient frontier plan their investments over a single period of time use the same probability distribution of asset returns: the same borrow and lend at the risk free rate are price-takers: investors purchases & sales do NOT influence There is no transaction costs and taxes

mean, variance, & covariance of asset returns

price of an asset

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Market Portfolio

Everyone purchases single fund of risky asset, borrows (lends) at risk-free rate. Form a portfolio that is a mix of risk free asset and single risky fund Mix of the risky asset with risk free asset will vary across individuals according to their individual tastes for risk
Seek to avoid risk have high percentage of the risk free asset in their portfolio More aggressive to risk have a high percentage of the risky asset

What

is the fund that everyone purchases?

This

fund is Market Portfolio and defined as summation of all assets total invested wealth on risky assets
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An asset weight in market portfolio is the proportion of that assets total capital value to total market capital value capitalization weights

The Capital Market Line (CML)

Consider single efficient fund of risky assets (market portfolio) and a risk free asset

(a bond matures at the end of investment horizon):

If a risk free asset does not exist, investor would take positions at various points on

the efficient frontier. Otherwise, efficient set consists of straight line called CML.
Pricing

Line: prices are adjusted so that efficient assets fall on this line

Investors take positions on CML by

buying risk free asset (between M and rf) or selling risk free asset (beyond point M) and holding the same portfolio of risky assets

CML

describes all possible mean-variance efficient portfolios that are a combination

of the risk free asset and market portfolio

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The Capital Market Line

Equation describes all portfolios on CML

E (r ) = r = rf +
Expected Value of market rate of return

rM r f

Standard Deviation of market rate of return

CML relates the expected rate of return of an efficient portfolio to its

standard deviation

The slope the CML is called the price of RISK!

How much expected rate of return of a portfolio must increase if the risk of the portfolio Computational Finance

increases by one unit?

The Pricing Model

How

does the expected rate of return of an individual asset relate to

its individual risk?

If

the market portfolio M is efficient, then the expected return of an

asset i satisfies

E[ri ] rf = i ( E[rM ] rf

ri = rf + i ( rM r f
iM i = 2 M

The

beta of an asset (risk premium):

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The Pricing Model expected excess rate of return of an asset is proportional to the expected excess rate of return of the market portfolio: proportional factor is the beta of asset.

ri r f = i ( rM r f

Amount

that rate of return is expected to exceed risk free rate is proportional the amount that market portfolio return is expected to exceed risk free rate describes relationship between risk and expected return of asset
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Beta of an Asset

beta of an asset measures the risk of the asset with

respect to the market portfolio M.

high beta assets earn higher average return in

equilibrium because of
beta

i ( rM rf

of market portfolio: average risk of all assets

Cov (rM , rM ) 2M = = 2 =1 Var (rM ) M

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The Beta of Portfolio

If the betas of the individual assets are known, then the beta of the portfolio is
p = wi i
i =1 n

This

can be shown by using of return of the portfolio

n

rate

rp = wi ri
i =1

covariance

cov(rp , rM ) = wi cov(ri , rM )
i =1
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Systematic and Specific Risk

CAPM divides total risk of holding risky assets into two parts: systematic (risk of holding the market portfolio) and specific risk

Consider the random rate of return of an asset i:

ri = rf + i (rM rf ) + ei

Take expected value and the correlation of the rate of return with rM

E (ei ) = 0 and cov(ei , rM ) = 0

The

total risk of holding risky asset i is

2 i2 = i2 M + e2 i total risk systematic risk

specific risk
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Summary: CAPM
The

capital market line: expected rate of return of an efficient

r =r f + rM r f

portfolio to its standard deviation

The
to its risk

pricing model: expected rate of return of an individual asset

ri = r f + i (rM r f

) where

iM i = 2 M

The

risk of holding an asset i is

total 2 i2 = i2 M risk systematic

risk

i
specific risk
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e2

Beta of the Market

Average risk of all assets is 1 (beta of the market portfolio) Beta of market portfolio is used as a reference point to measure risk of other assets.

Capital Market Line

r =f r rM f r +

r
M

r
M

Security Market Line

= iM i 2 M
ri =r f + (rM f r i

rf

rf

2 M

cov(r , rM )

Assets or portfolios with betas greater than 1 are above average risk: tend to move more

than market. Example:

If risk free rate is 5% per year and market rises by 10 %, then assets with a beta of 2 will

tend to increase by 15%.

If market falls by 10%, then assets with a beta of 2 will tend

to fall by 25% on average.

Assets or portfolios with betas less than 1 are of below average risk: tend to move less
Computational Finance

than market.

CAPM as a Pricing Formula

CAPM is a pricing model.

standard CAPM formula only holds expected rates of return suppose an asset is purchased at price P and later sold at price S. rate of return is substituted in CAPM formula

S P r= P S P = r f + ( rM r f ) P S P= 1+ r f + ( rM r f

Rate of return CAPM formula

Price of asset in CAPM

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Discounting Formula in CAPM

P= 1+ r f + ( rM rf S

Price of an asset in CAPM

In the determinis tic case, discount factor In the random case, discount factor

1 1+ rf

1 1+ rf + (rM rf )
risk - adjusted interest rate

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Single-Factor Model

Consider n assets with rates of return ri for i=1,2,,n and one factor f which is a random quantity such as inflation, interest rate

Assume that the rates of return and single factor are linearly related.

ri = ai + bi f + ei
Constant Constant Random

i = 12,, n ,

Intercept

Factor Loadings

Error E [ ei ] = 0 E [ fei ] = 0 E e j ei = 0 i j ,

Errors
1. 2. 3.

have zero mean are uncorrelated with the factor are uncorrelated with each other

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Multi-Factor Model Single factor model is extended to have more than one factor. For two factors f and f the model can be written as 1 2

ri = ai + b1i f1 + b2i f 2 + ei
Constant Constant Constant Random

i = 12,, n ,

For

k number factors
ri = ai + b ji f j + ei i = 12, n , ,
j =1
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How to Select Factors?

Factors are external to securities:

consumer

price index, unemployment rate

Factors are extracted from known information about security returns:

the

rate of return on the market portfolio

Firm characteristics:
price

earning ratio, dividend payout ratio

How to select factors: It is part science and part art! Statistical approach principal component analysis Economical approach its beta, inflation rate, interest rate, industrial production etc.
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The CAPM as a Factor Model

Special case of a single-factor model f = rM

ri = ai + bi f + ei ri = ai + bi rM + ei ri rf = ai (1 bi )rf + bi (rM r f ) + ei = i + bi (rM rf ) + ei E[ri ] = rf + i + bi ( E[rM ] rf ) cov[ ri , rM ] = bi var[ rM ] cov[ ri , rM ] bi = and i = 0 bi = i var[rM ]
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The CAPM as a Factor Model: Example

Single factor model equation defines a linear fit to data Imagine several independent observations of the rate of return and factor Straight line defined by single factor model equation is fitted through these points such that average value of errors is zero. Error is measured by the vertical distance from a point to the line

Single Index Model applied to Lloyds

0.1 5 0.1 0.0 5 slope = Beta = 1 77 . -0 04 . -0 03 . -0 02 . -0 01 . 0 -0 05 . -0 1 . 0 0.0 1 0.02 0.0 3 0.0 4 0.0 5

Returns on Llloyds

intercept = alpha = 0(approx)

Market Returns

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Arbitrage: The law of one price Arbitrage relies on a fundamental principle of finance : the law of one price
says security must have the same price regardless of the means of creating that security. implies if the payoff of a security can be synthetically created by a package of other securities, the price of the package and the price of the security whose payoff replicates must be equal.

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Arbitrage Example
How can you produce an arbitrage opportunity involving securities A, B,C? Security A B C

Price 70 60 80

Payoff in State 1 50 30 38

Payoff in State 2 100 120 112

Replicating Portfolio:
combine securities A and B in such a way that replicate the payoffs of security C in either state

Let wA and wB be proportions of security A and B in portfolio

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Example Continued
Payoff

of the portfolio in state 1: 5 w A + 3 wB 0 0

in state 2: 1 0wA + 1 0wB 0 2

Create

a portfolio consisting of A and B that will reproduce the payoff of C regardless of the state that occurs one year from now. 5 wA + 3 wB = 3 0 0 8 1 0wA + 1 0wB = 1 2 0 2 1

Solving

equation system, weights are found

wB = 0.6 and wA = 0.4

An arbitrage opportunity will exist if the cost of this portfolio is different than the cost of security C. Cost of the portfolio is 0.4 x 70 + 0.6 x 60 = 64 - price of security C is 80. The synthetic security is cheap relative to security C.
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Example Continued
Riskless arbitrage profit is obtained by buying A and B in these proportions and shorting security C. Suppose you have 1m capital to construct this arbitrage portfolio.

Investing Investing Shorting

400k in A 600k in B 1m in C

400k 70 = 5714 shares 600k 60 = 10,000 shares 1m 80 = 12,500 shares

The outcome of forming an arbitrage portfolio of 1m

Security Investment A B C Total -400000 -600000 1000000 0 State 1 5714 x 50 = 285700 10000 x 30 = 300000 State 2 5714 x 100 = 571400 10000 x 120 =1200000

12500 x 38 = -475000 12500 x 112 = -1400000 110,700 371,400

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The Arbitrage Pricing Theory

CAPM is criticised for two assumptions:

The investors are mean-variance optimizers The model is single-period

Stephen Ross developed an alternative model based purely on arbitrage arguments

Published Paper: The Arbitrage Pricing Theory of Capital Asset Pricing, Journal of Economic Theory, Dec 1976.

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APT versus CAPM

APT is a more general approach to asset pricing than CAPM.

CAPM considers variances and covariance's as possible measures of risk while APT allows for a number of risk factors. APT postulates that a securitys expected return is influenced by a variety of factors, as opposed to just the single market index of CAPM

APT in contrast states that return on a security is linearly related to factors.

APT does not specify what factors are, but assumes that the relationship between security returns and factors is linear.

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Simple Version of APT

Consider a single factor model. Assume that the model holds exactly; no error The uncertainty comes from the factor f

ri = ai + bi f for i = 12 , n , ,
APT says that ai and bi are related if there is no arbitrage
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Derivation of APT
Choose Form

another asset j such that

bi b j

a portfolio from asset i and j with weights of w and (1-w)

rp = wai + (1 w)a j + [ wbi + (1 w)b j ] f

Choose

w so that the coefficient of factor is zero; so

w= rp =

bj b j bi aib j b j bi

and wbi + (1 w)b j = 0 + a j bi bi b j

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Derivation of APT

0 =
a j 0 bj

ai b j b j bi

a j bi bi b j

ai 0 = bi

ai 0 =c bi ai =0 + bi c

ai and bi are not independent

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Arbitrage Pricing Formula Once constants are known, the expected rate of return of an asset i is determined by the factor loading.

The

expected rate of return of asset i

ri = ai + bi f E[ri ] = ai + bi E[ f ] = 0 + bi c + bi E[ f ] = 0 + bi E[ f + c] = 0 + bi1
CAPM?

Computational Finance

CAPM as a consequence of APT

The

factor is the rate of return on the market

f = rM

0 = rf

E[ri ] = 0 + bi1

1 = E[rM ] rf

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

is identical to the CAPM with

bi = i
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