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Investment Analysis and Portfolio

Management

First Canadian Edition


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

Copyright 2010 by Nelson Education Ltd.

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Capital Market Theory: An Overview


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
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Background to Capital Market Theory


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
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Continued7-4

Background to Capital Market Theory


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
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Background to Capital Market Theory


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

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Developing the Capital Market Line


Covariance with a Risk-Free Asset
Covariance between two sets of returns is
n

Cov ij [R i - E(R i )][R j - E(R j )]/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

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Developing the Capital Market Line


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 )

Standard deviation: Applying the twoasset standard deviation formula, we will


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

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Developing the Capital Market Line


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
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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

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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

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Risk, Diversification & the Market


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

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Risk, Diversification & the Market


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

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Risk, Diversification & the Market Portfolio


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

Can be measured by standard deviation of


returns and can change over time
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Risk, Diversification & the Market Portfolio


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
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Risk, Diversification & the Market Portfolio:


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

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Risk, Diversification & the Market Portfolio:


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?

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Risk, Diversification & the Market Portfolio


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

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Risk, Diversification & the Market Portfolio


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

Copyright 2010 by Nelson Education Ltd.

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Risk, Diversification & the Market Portfolio


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

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Risk, Diversification & the Market Portfolio


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

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Using the CML to Invest: An Example


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
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Using the CML to Invest: An Example


How much to invest in the riskless security?
11.5%= wRF (4%) + (1-wRF )(9%)
wRF= -0.5

The investment strategy is to borrow 50% and


invest 150% of equity in the market portfolio

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Conceptual Development of the CAPM


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

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The Capital Asset Pricing Model


Applying the CML using this relevant risk
measure

E(Ri ) RFR i riM [

E(RM ) RFR

Let i=(i riM) / M be the asset beta measuring


the relative risk with the market, the systematic
risk

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The Capital Asset Pricing Model

E(Ri ) RFR i [E(RM ) RFR]


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

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The Security Market Line (SML)


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

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The Security Market Line (SML)


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)

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The Capital Asset Pricing Model


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(R i ) RFR i [E(R M ) RFR]

E(RA) = 0.05 + 0.70 (0.09-0.05) = 0.078 = 7.8%


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%
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The Capital Asset Pricing Model


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
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The Capital Asset Pricing Model

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The Capital Asset Pricing Model


Calculating Systematic Risk
The formula

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The Characteristic Line

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.

The slope of the


regression line is
beta.

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CAPM: The Impact of Time Interval


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

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CAPM: The Effect of Market Proxy


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

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Relaxing the Assumptions


Differential Borrowing and Lending Rates
When borrowing rate, R b, is higher than RFR, the SML will
be broken into two lines

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Relaxing the Assumptions


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
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Relaxing the Assumptions


Transaction Costs
The SML will be a band of securities, rather than
a straight line

Heterogeneous Expectations and Planning


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

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Relaxing the Assumptions:


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

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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

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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

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Beta of Canadian Companies

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Arbitrage Pricing Theory


CAPM is criticized because of
Many unrealistic assumptions
Difficulties in selecting a proxy for the market
portfolio as a benchmark

Alternative pricing theory with fewer


assumptions was developed:
Arbitrage Pricing Theory (APT)

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Arbitrage Pricing Theory


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

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Arbitrage Pricing Theory


Does not assume:
Normally distributed security returns
Quadratic utility function
A mean-variance efficient market
portfolio

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Arbitrage Pricing Theory


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
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factor
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Comparing the CAPM & APT Models


CAPM

APT

Form of Equation
Linear
Number of Risk Factors 1
Factor Risk Premium
[E(RM) RFR]

Linear
K ( 1)
{j}

Factor Risk Sensitivity

{bij}

Zero-Beta Return

RFR

Unlike CAPM that is a one-factor model,


APT is a multifactor pricing model
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Comparing the CAPM & APT Models


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
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Using the APT


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

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Using the APT


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

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Determining Sensitivities for Assets


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 =

The response of asset y to changes in the


GDP factor is 1.75 (by2 1.75)

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Using the APT to Estimate Expected Return

E ( Ri ) 0 1bi1 2bi 2
E ( Ri ) .04 .02bi1 .03bi 2

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Using the APT to Estimate Expected Return


Asset X
E(Rx)

= .04 + (.02)(0.50) + (.03)(1.50)

E(Rx) = .095 = 9.5%

Asset Y
E(Ry) = .04 + (.02)(2.00) + (.03)(1.75)
E(Ry)= .1325 = 13.25%

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Valuing a Security Using the APT:


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

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Valuing a Security Using the APT:


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%

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Valuing a Security Using the APT:


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

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Valuing a Security Using the APT:


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

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Valuing a Security Using the APT:


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

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Multi-Factor Models & Risk Estimation


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

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Multi-Factor Models & Risk Estimation


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

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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

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Macroeconomic-Based
Risk Factor Models

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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

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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.

( Rit RFR t ) a i bi1 ( R mt RFR t ) bi 2 SMB t bi 3 HML t eit

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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

( Rit RFR t ) ai bi1 ( Rmt RFR t ) bi 2 SMB t bi 3 HML t bi 4 MOM t eit

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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).

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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

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