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Management

By Reilly, Brown, Hedges, Chang

Chapter 7

Asset Pricing Models: CAPM & APT

Capital Market Theory: An Overview

The Capital Asset Pricing Model

Relaxing the Assumptions

Beta in Practice

Arbitrage Pricing Theory (APT)

Multifactor Models in Practice

7-2

Capital market theory extends portfolio theory

and develops a model for pricing all risky

assets, while capital asset pricing model

(CAPM) will allow you to determine the

required rate of return for any risky asset

Four Areas

Background for Capital Market Theory

Developing the Capital Market Line

Risk, Diversification, and the Market Portfolio

Investing with the CML: An Example

Copyright 2010 by Nelson Education Ltd.

7-3

Assumptions:

All investors are Markowitz efficient investors who

want to target points on the efficient frontier

Investors can borrow or lend any amount of

money at the risk-free rate of return (RFR)

All investors have homogeneous expectations;

that is, they estimate identical probability

distributions for future rates of return

All investors have the same one-period time

horizon such as one-month, six months, or one

year

Copyright 2010 by Nelson Education Ltd.

Continued7-4

Assumptions:

All investments are infinitely divisible, which

means that it is possible to buy or sell fractional

shares of any asset or portfolio

There are no taxes or transaction costs involved

in buying or selling assets

There is no inflation or any change in interest

rates, or inflation is fully anticipated

Capital markets are in equilibrium, implying that

all investments are properly priced in line with

their risk levels

Copyright 2010 by Nelson Education Ltd.

7-5

Development of the Theory

The major factor that allowed portfolio

theory to develop into capital market

theory is the concept of a risk-free asset

An asset with zero standard deviation

Zero correlation with all other risky assets

Provides the risk-free rate of return (RFR)

Will lie on the vertical axis of a portfolio graph

7-6

Covariance with a Risk-Free Asset

Covariance between two sets of returns is

n

i 1

Because the returns for the risk free asset are certain,

thus Ri = E(Ri), and Ri - E(Ri) = 0, which means that the

covariance between the risk-free asset and any risky

asset or portfolio will always be zero

Similarly, the correlation between any risky asset and the

risk-free asset would be zero too since

rRF,i= CovRF, I / RF i

7-7

Combining a Risk-Free Asset with a

Risky Portfolio, M

Expected return: It is the weighted

average of the two returns

E(Rport ) WRF (RFR) (1- WRF )E(RM )

have

2

2

2

port

w RF

RF

(1 w RF ) 2 M2 2 w RF (1- w RF )rRF, M RF M

7-8

The Capital Market Line

With these results, we can develop the riskreturn

relationship between E(Rport) and port

E(RM ) RFR

E(Rport ) RFR port [

]

M

This relationship holds for every combination of

the risk-free asset with any collection of risky

assets

However, when the risky portfolio, M, is the

market portfolio containing all risky assets held

anywhere in the marketplace, this linear

relationship is

called the Capital Market Line

Copyright 2010 by Nelson Education Ltd.

7-9

Risk-Return Possibilities

One can attain a higher expected return than is available at point

M

One can invest along the efficient frontier beyond point M, such as

point D

7-10

Risk-Return Possibilities

With the risk-free asset, one can add leverage to the portfolio by borrowing money at

the risk-free rate and investing in the risky portfolio at point M to achieve a point like E

Point E dominates point D

One can reduce the investment risk by lending money at the risk-free asset to reach

points like C

7-11

Portfolio: The Market Portfolio

Because portfolio M lies at the point of tangency, it has the

highest portfolio possibility line

Everybody will want to invest in Portfolio M and borrow or lend

to be somewhere on the CML

It must include ALL RISKY ASSETS

7-12

Portfolio: The Market Portfolio

Since the market is in equilibrium, all assets in this portfolio

are in proportion to their market values

Because it contains all risky assets, it is a completely

diversified portfolio, which means that all the unique risk of

individual assets (unsystematic risk) is diversified away

7-13

Systematic Risk

Only systematic risk remains in the market

portfolio

Variability in all risky assets caused by

macroeconomic variables

Variability in growth of money supply

Interest rate volatility

Variability in factors like (1) industrial production (2) corporate

earnings (3) cash flow

returns and can change over time

Copyright 2010 by Nelson Education Ltd.

7-14

How to Measure Diversification

All portfolios on the CML are perfectly positively

correlated with each other and with the

completely diversified market Portfolio M

A completely diversified portfolio would have a

correlation with the market portfolio of +1.00

Complete risk diversification means the

elimination of all the unsystematic or unique risk

and the systematic risk correlates perfectly with

the market portfolio

Copyright 2010 by Nelson Education Ltd.

7-15

Eliminating Unsystematic Risk

The purpose of diversification is to reduce the standard

deviation of the total portfolio

This assumes that imperfect correlations exist among

securities

7-16

Eliminating Unsystematic Risk

As you add securities, you expect the average covariance for the

portfolio to decline

How many securities must you add to obtain a completely

diversified portfolio?

7-17

The CML & the Separation Theorem

The CML leads all investors to invest in the M

portfolio

Individual investors should differ in position on

the CML depending on risk preferences

How an investor gets to a point on the CML is

based on financing decisions

7-18

The CML & the Separation Theorem

Risk averse investors will lend at the risk-free rate

while investors preferring more risk might borrow

funds at the RFR and invest in the market portfolio

The investment decision of choosing the point on CML

is separate from the financing decision of reaching

there through either lending or borrowing

7-19

A Risk Measure for the CML

The Markowitz portfolio model considers

the average covariance with all other

assets

The only important consideration is the

assets covariance with the market

portfolio

7-20

A Risk Measure for the CML

Covariance with the market portfolio is the

systematic risk of an asset

Variance of a risky asset i

Var (Rit)= Var (biRMt)+ Var()

=Systematic Variance + Unsystematic Variance

where bi= slope coefficient for asset i

= random error term

7-21

Suppose you have a riskless security at 4% and a market portfolio

with a return of 9% and a standard deviation of 10%. How should you

go about investing your money so that your investment will have a

risk level of 15%?

Portfolio Return

E(Rport)=RFR+port[(E(RM)-RFR)/M)

E(Rport)=4%+15%[(9%-4%)/10%]

E(Rport)=11.5%

Continued

Copyright 2010 by Nelson Education Ltd.

7-22

How much to invest in the riskless security?

11.5%= wRF (4%) + (1-wRF )(9%)

wRF= -0.5

invest 150% of equity in the market portfolio

7-23

The existence of a risk-free asset resulted in deriving a

capital market line (CML) that became the relevant frontier

However, CML cannot be used to measure the expected

return on an individual asset

For individual asset (or any portfolio), the relevant risk

measure is the assets covariance with the market portfolio

That is, for an individual asset i, the relevant risk is not i,

but rather i riM, where riM is the correlation coefficient

between the asset and the market

7-24

Applying the CML using this relevant risk

measure

E(RM ) RFR

the relative risk with the market, the systematic

risk

7-25

The CAPM indicates what should be the expected or

required rates of return on risky assets

This helps to value an asset by providing an appropriate

discount rate to use in dividend valuation models

7-26

The SML is a graphical form of the CAPM

Shows the relationship between the expected or required rate

of return and the systematic risk on a risky asset

7-27

The expected rate of return of a risk asset is determined by the

RFR plus a risk premium for the individual asset

The risk premium is determined by the systematic risk of the

asset (beta) and the prevailing market risk premium

(RM-RFR)

7-28

Determining the Expected Rate of Return

Assume risk-free rate is 5% and market return is 9%

Stock

Beta

0.70

1.00

1.15

1.40

-0.30

Applying

E(RB) = 0.05 + 1.00 (0.09-0.05) = 0.090 = 09.0%

E(RC) = 0.05 + 1.15 (0.09-0.05) = 0.096 = 09.6%

E(RD) = 0.05 + 1.40 (0.09-0.05) = 0.106 = 10.6%

E(RE) = 0.05 + -0.30 (0.09-0.05) = 0.038 = 03.8%

Copyright 2010 by Nelson Education Ltd.

7-29

Identifying Undervalued & Overvalued

Assets

In equilibrium, all assets and all portfolios

of assets should plot on the SML

Any security with an estimated return that

plots above the SML is underpriced

Any security with an estimated return that

plots below the SML is overpriced

Copyright 2010 by Nelson Education Ltd.

7-30

7-31

Calculating Systematic Risk

The formula

7-32

R i, t i i R M, t

A regression line

between the returns

to the security (Rit)

over time and the

returns (RMt) to the

market portfolio.

regression line is

beta.

7-33

The number of observations and time interval

used in regression vary, causing beta to vary

There is no correct interval for analysis

For example, Morningstar derives characteristic

lines using the most 60 months of return

observations

Reuters uses daily returns for the most recent 24

months

Bloomberg uses two years of weekly returns

7-34

Theoretically, the market portfolio should include all

Canadian stocks and bonds, real estate, coins, stamps, art,

antiques, and any other marketable risky asset from

around the world

Most people use the S&P/TSX Composite Index as the

proxy due to

It contains large proportion of the total market value of

Canadian stocks

It is a value-weighted series

Using a different proxy for the market portfolio will lead to

a different beta value

7-35

Differential Borrowing and Lending Rates

When borrowing rate, R b, is higher than RFR, the SML will

be broken into two lines

7-36

Zero-Beta Model

Instead of a risk-free rate, a zero-beta

portfolio (uncorrelated with the market

portfolio) can be used to draw the SML

line

Since the zero-beta portfolio is likely to

have a higher return than the risk-free

rate, this SML will have a less steep

slope

Copyright 2010 by Nelson Education Ltd.

7-37

Transaction Costs

The SML will be a band of securities, rather than

a straight line

Periods

Heterogeneous expectations will create a set

(band) of lines with a breadth determined by the

divergence of expectations

The impact of planning periods is similar

7-38

Impact of Taxes

Taxes

Differential tax rates could cause major differences in CML and

SML among investors

Dividend tax credit on dividends received from Canadian

corporations would further return the total taxes owing on the

dividend income earned. In addition, capital gains exclusion rate

(50%) would also affect total taxes owing on capital gains

7-39

Beta in Practice

Stability of Beta

Betas for individual stocks are not stable

Portfolio betas are reasonably stable

The larger the portfolio of stocks and longer the

period, the more stable the beta of the portfolio

E(Ri,t)=RFR + iRM,t+ Et

7-40

Beta in Practice

Comparability of Published Estimates of Beta

Differences exist

Hence, consider the return interval used and the

firms relative size

E(Ri,t)=RFR + iRM,t+ Et

7-41

7-42

CAPM is criticized because of

Many unrealistic assumptions

Difficulties in selecting a proxy for the market

portfolio as a benchmark

assumptions was developed:

Arbitrage Pricing Theory (APT)

7-43

Three Major Assumptions:

1. Capital markets are perfectly competitive

2. Investors always prefer more wealth to

less wealth with certainty

3. The stochastic process generating asset

returns can be expressed as a linear

function of a set of K factors or indexes

7-44

Does not assume:

Normally distributed security returns

Quadratic utility function

A mean-variance efficient market

portfolio

7-45

The APT Model

E(Ri)=0+ 1bi1+ 2bi2++ kbik

where:

0=the expected return on an asset with zero

systematic risk

j=the risk premium related to the j th common

risk factor

bij=the pricing relationship between the risk

premium and the asset; that is, how

responsive asset i is to the j th common

Copyright 2010 by Nelson Education Ltd.

factor

7-46

CAPM

APT

Form of Equation

Linear

Number of Risk Factors 1

Factor Risk Premium

[E(RM) RFR]

Linear

K ( 1)

{j}

{bij}

Zero-Beta Return

RFR

APT is a multifactor pricing model

Copyright 2010 by Nelson Education Ltd.

7-47

However, unlike CAPM that identifies the

market portfolio return as the factor, APT

model does not specifically identify these risk

factors in application

These multiple factors include

Inflation

Growth in GNP

Major political upheavals

Changes in interest rates

Copyright 2010 by Nelson Education Ltd.

7-48

Primary challenge with using the APT in security

valuation is identifying the risk factors

For this illustration, assume that there are two

common factors

First risk factor: Unanticipated changes in the

rate of inflation

Second risk factor: Unexpected changes in the

growth rate of real GDP

7-49

1: The risk premium related to the first risk

factor is 2 percent for every 1 percent change in

the rate (1=0.02)

2: The average risk premium related to the

second risk factor is 3 percent for every 1 percent

change in the rate of growth (2=0.03)

0: The rate of return on a zero-systematic risk

asset (i.e., zero beta) is 4 percent (0=0.04

7-50

bx1 = The response of asset x to changes in the

inflation factor is 0.50 (bx1 0.50)

bx2 = The response of asset x to changes in the

GDP factor is 1.50 (bx2 1.50)

by1 = The response of asset y to changes in the

inflation factor is 2.00 (by1 2.00)

by2 =

GDP factor is 1.75 (by2 1.75)

7-51

E ( Ri ) 0 1bi1 2bi 2

E ( Ri ) .04 .02bi1 .03bi 2

7-52

Asset X

E(Rx)

Asset Y

E(Ry) = .04 + (.02)(2.00) + (.03)(1.75)

E(Ry)= .1325 = 13.25%

7-53

An Example

Three stocks (A, B, C) and two common systematic

risk factors have the following relationship (Assume

0=0 )

E(RA)=(0.8) 1 + (0.9) 2

E(RB)=(-0.2) 1 + (1.3) 2

E(RC)=(1.8) 1 + (0.5) 2

7-54

An Example

If 1=4% and 2=5%, then it is easy to compute the

expected returns for the stocks:

E(RA)=7.7%

E(RB)=5.7%

E(RC)=9.7%

7-55

An Example

Expected Prices One Year Later

Assume that all three stocks are currently priced

at $35 and do not pay a dividend

Estimate the price

E(PA)=$35(1+7.7%)=$37.70

E(PB)=$35(1+5.7%)=$37.00

E(PC)=$35(1+9.7%)=$38.40

7-56

An Example

If one knows actual future prices for these stocks

are different from those previously estimated, then

these stocks are either undervalued or overvalued

Arbitrage trading (by buying undervalued stocks

and short overvalued stocks) will continue until

arbitrage opportunity disappears

7-57

An Example

Assume the actual prices of stocks A, B, and C

will be $37.20, $37.80, and $38.50 one year

later, then arbitrage trading will lead to new

current prices:

E(PA)=$37.20 / (1+7.7%)=$34.54

E(PB)=$37.80 / (1+5.7%)=$35.76

E(PC)=$38.50 / (1+9.7%)=$35.10

7-58

The Multifactor Model in Theory

In a multifactor model, the investor

chooses the exact number and identity of

risk factors, while the APT model doesnt

specify either of them

7-59

Rit = ai + [bi1F1t + bi2 F2t + . . . + biK FKt] + eit

where:

Fit=Period t return to the jth designated risk factor

Rit =Security is return that can be measured as

either a nominal or excess return to

7-60

Macroeconomic-Based

Risk Factor Models

Security returns are governed by a set of

broad economic influences in the following

fashion by Chen, Roll, and Ross in 1986

modeled by the following equation:

Rit ai [bi1 Rmt bi 2 MPt bi 3 DEIt bi 4UI t bi 5UPRt bi 6UTSt ] eit

7-61

Macroeconomic-Based

Risk Factor Models

7-62

Macroeconomic-Based

Risk Factor Models

Burmeister, Roll, and Ross (1994)

Analyzed the predictive ability of a model based

on the following set of macroeconomic factors.

Confidence risk

Time horizon risk

Inflation risk

Business cycle risk

Market timing risk

7-63

Microeconomic-Based

Risk Factor Models

Fama and French (1993) developed a multifactor model

specifying the risk factors in microeconomic terms using the

characteristics of the underlying securities.

7-64

Microeconomic-Based

Risk Factor Models

Carhart (1997), based on the Fama-French three factor

model, developed a four-factor model by including a risk factor

that accounts for the tendency for firms with positive past

return to produce positive future return

7-65

Extensions of Characteristic-Based

Risk Models

One type of security characteristic-based

method for defining systematic risk

exposures involves the use of index

portfolios (e.g. S&P 500, Wilshire 5000) as

common risk factors such as the one by

Elton, Gruber, and Blake (1996).

7-66

Extensions of Characteristic-Based

Risk Models

Elton, Gruber, and Blake (1996) rely on four

indexes:

The S&P 500

The Lehman Brothers aggregate bond index

The Prudential Bache index of the difference

between large- and small-cap stocks

The Prudential Bache index of the difference

between value and growth stocks

7-67

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