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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
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Continued7-4
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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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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
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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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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.
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E(RM ) RFR
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Beta
0.70
1.00
1.15
1.40
-0.30
Applying
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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.
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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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factor
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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
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E ( Ri ) 0 1bi1 2bi 2
E ( Ri ) .04 .02bi1 .03bi 2
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Asset Y
E(Ry) = .04 + (.02)(2.00) + (.03)(1.75)
E(Ry)= .1325 = 13.25%
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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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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.
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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
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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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