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CFA Institute

Samizdat: In Defense of the CAPM Author(s): Jack L. Treynor Reviewed work(s): Source: Financial Analysts Journal, Vol. 49, No. 3 (May - Jun., 1993), pp. 11-13 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4479643 . Accessed: 08/02/2013 07:22
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risk in securities refutes the CAPM. z D -J z -J z zL 11 This content downloaded on Fri. Both Vasicek and McQuown and the market model thus assume a single systematic in its various factor. the nature of correlations between surprises in different assets. there can be no conflict between the CAPM and factor structure. Arbitrage Pricing Theory (APT) provides investors with a result of great practical value that the CAPM does not provide. In particular. more complex factor structures. correlations in asset surprises can be due to a variety of pervasive. material will appear as an appendix to the second edition of the Guide to Portfolio Management by James L. actual return. and some discuss (usually without attribution) the Vasicek-McQuown pricing model. There is thus nothing about factor structure in the CAPM's assumptions. a CAPMthat abandons on either the assumptions of the the assumptions of homogeneous CAPM or its conclusions. Shortselling is permitted.but the CAPM forms (Sharpe. In demonstrating that the risk premium on an asset depends only on its systematic factor loadings. The market model takes the assumptions of the Diagonal Model and the result of the Vasicek and McQuown model and concludes that the actual. which they are all averse. 8 Feb 2013 07:22:28 AM All use subject to JSTOR Terms and Conditions . Black) makes no assumption about factor structure. It may not be coincidental that some of the same books that make the first complaint don't actually discuss the CAPM. This point is the key to the second complaint. which suggested (following up on a footnote in Harry Markowitz'sbook) that systematic risk could usefully be accounted for by a single factor. Evidence that it takes more than one factor to explain the shared. this offers him an infinite reward-to-riskratio. 2.where u1 are the systematic faccrease expected portfolio return tors in the market and ei is a or reduce portfolio variance. that investors agree on Xi= 2. Treynor. All it does as. to residual unique to the ith asset. In the Diagonal Model. Farrell Jr.* Vasicek and McQuown's argument proceeds as follows.Samizdat In Defense of the CAPM Jack L. Because expected return and surprise are mutually exclusive elements in ex post. Diagonal Model assumption that Vasicek and McQuown and the market model make. these risk measures. In order to demonstrate that APT'sprincipal conclusion-that an asset's risk premium depends only on its systematic factor loadings-also holds for the CAPM. 1 variances and covariances (with other assets). But there is also nothing about factor structure in the CAPM's conclusions. In richer. expectations (as Lintnerdid) and riskless borrowing and lending Consider a market in which abso(as Black did) doesn't make many lute surprise for the ith asset. he can drive the portfolio's residual risk to zero. Mossin. it does not make the one-factor. Both build on William Sharpe's Diagonal Model paper. Now. The conclusion of the CAPM-that an asset's expected return is proportional to its covariance with the market portfolio-makes no assertions about the surprise in that asset's return. or systematic. market-wide influences. Factor structure is about surprise-in particular.obeys: sume is that asset risk can be adequately expressed in terms of Eq. other assumptions.8ijuj + ei. the individual investor can hedge away all systematic risk. * This Thus he won't bear systematic risk unless it competes successfully with residual risk for inclusion in his portfolio. Some discuss the market model. Otherwise the investor will choose not to hold any systematic risk. xi. and that investors can trade costlessly to in. to be published by McGraw-HillBook Company. and the market won't clear. it must offer an infinite expected return. In order for market risk to compete successfully. ex post systematic return-surprise plus risk premium-of every asset will be proportional to the asset's market sensitivity. But if he includes enough positions (long or short) in his portfolio.we can assume a perfectly general factor structure without fear of tripping Actually. that these measures exist. Treynor Capital Management Many textbooks repeat two common complaints about the Capital Asset Pricing Model (CAPM): 1. such that residual risks can be uncorrelated both with this factor and with each other. By taking appropriately long positions in some securities and appropriately short positions in others. a single factor accounts for all correlation. Lintner. Treynor. Assume a single systematic risk factor exists.. if residual risk is priced.

What is outside the brackets is the factor loadings 3ij for the ith individual asset on the factors uj in the factor structure.e. Any corollaries that flow from this APT result also flow from the CAPM. then the expression within brackets in Equation (4) will in general have a different value for each of the systematic factors. 8 (8i11)(2I3h1lr1) O(jk = E[UjUk] + + (si)(s) To keep our exposition simple.. make all the 12 covariance terms in the system- Considerthe first term.Equathe respective tion (7). Figure A The CAPM asserts that any risk premiumof the ith assetdepends only on its covariancewith the market-i. z -J We can. is simplythe sum of absolutesurprisesfor the individualassets: x = Exi = 28ijuj + Eei.across several factors. to some constant of proportionality. ent systematic factors. A key issue is the relative size of these two terms. hence that price. 5 and z Eq. 7 several are correlated with the market portfolio. orders of magnitude bigger than the unique portion. z D We see that an asset's covariance 0 with the marketportfolio (absolute surprise with absolute surprise) has two terms-one for systematic factors and one for the asset's unique surprise. the market + .the latteris ordersof magnitudelarger (see FigureA).. This content downloaded on Fri. the price of risk. then. Bearingin mind thatthe u's and e's are surprise. 8 Feb 2013 07:22:28 AM All use subject to JSTOR Terms and Conditions . The value of the expression.Assignthe factorindex to the factorsso thatthe firstterm in the bracketed expressionis the + ei2].APTcan't specify the value of this expression. E[EZp ijphkUjUk termfor thatfactor. of course. One factor reflects the absolute factor weight of the asset. is generally going to be different for different factors. therefore it can't specify how factors will be priced in relation to each other. 2 ( f ijuj + ei)(E.+ Si. + (si)(si) WHOM 1)(13jlfl) portfolio could have been correlated with most or all of them. whereas the unique risk in the second term is that for a single asset. 2 3ij[2!3hkI'jk gives us: Eq. Unique Risk where Eq. But the value doesn't depend on i-the index that distinguishes between individual assets.x. we chose a special set of systemSame Order of Magnitude atic factors. 4 the covarianceexpression.Then than one factor. we can we have for this expectation: choose one in which only one factorcorrelateswith the market Eq.The formeris of the same order of magnitudeas the standarddeviationof the asset's uniquerisk. But this is the principal conclusion of APTthat an asset's risk premium should depend only on its factor loadings. Spreading it the covariance expression be. Then variance moment we can for the ignore or the other systematicterms and focus on the firstandlasttermsin Eq. What the APTdoes do is weaken the assumptions necessary to Systematicvs. This is because all the systematic risk in the marketportfolio'sabsolute gain or loss is reflectedin the market's factor weight.BhkUk + Ieh). t ~~~~~~t Orders of Magnitude Bigger rather than merely one.The absolute surprise for the market as a whole. Amongthe manypossiblechoices of orthogonal factors.But this meansthatthe systematicproductis ordersof magnitude larger than the unique product.. Whether one systematic factor or Eq. One of the differences between APTand the CAPM is the specifiof how systematic cation by CAPM factors should be priced in relation to each other.. Factoring terms into standard deviations 2] + Si2. won't diminish the magnitude of comes: the aggregate systematic portion. the systematic portion of an asset's cova+ A223n20f222 Pill&10hcr11 riance with the market will be 2 + . Then the systematic portion of an asset's covariance with the marketwould aticpartzero by choosinga set of have non-zero terms for more factorsthatare orthogonal. The expression in brackets in the first term of Equation (4) is. on the expectation of the followingproduct: Eq. and assuming that all covariancesbetween e's and between u's and e's are zero. however. 3 portfolio. 6 Si2= E[ei2]..the other the absolutefactorweightof the market portfolio. Had we chosen differr1. If we drop the unique term and relax the assumption that only one systematic factor correlates with the market.

as well as improvethe overall effectiveness of allyourasset allocation decisions.forthe firsttime.it has been Since derivativeportfolios impossible. APTjoins the idea of specifying security risk in terms of a factor structure (Farrar's 1960 doctoral thesis at Harvard.futures. with multiple risk factors substituted for their single risk factor. This writer has no desire to take a position in such controversies. Now. Post-Modern Portfolio Theoy e Comes Of Age An Infomercial from Sponsor-Software Systems. INC. APT appeals to the older.or other derivativecomponents. So. * Number Three in a Series In previous infomercialswe described how Post-ModernPortfolio the problemsassociated withstandard Theory(PM PT)has eliminated andthe normal deviation distribution whendoingportfolio optimization.today's most sophisticated. NY 10021 * 212/724-7535 * 212/580-9703 (Fax) This content downloaded on Fri. Software for the Serious Investor m 860 Fifth Avenue * New York.to accurately model these studies.we have developed TheAsset Allocation Expert. post-modern portfolio optimization system. Hester and Feeney's con- temporaneous work at Yale) with Modigliani and Miller's arbitrage argument. retire your old-fashioned optimizerand get The Asset AllocationExpert. 8 Feb 2013 07:22:28 AM All use subject to JSTOR Terms and Conditions . His only purpose is to clear up certain misunderstandings regarding the CAPM. One immediatebenefitof these advances appliesto portfolios having significant option. until the advent of PMPT.PMPT strategiesinformal optimization allows the real risksand rewardsof derivativesto be measured. Others may argue that the real provenance of APT is not Modigliani and Miller. in effect. To help you evaluate derivatives. better established tradition of arbitrage arguments exemplified by Modigliani and Miller's 1958 paper. Protective Put PMPT 2 M MPT \ / Retum For a demonstration program and additional information contact: SPONSOR-SOFTWARE SYSTEMS. Inc.but ratherVasicek and McQuown. PC-based. APT substitutes systematic risk factors for Modigliani and Miller's risk classes.reach this conclusion. are highlyskewed (see chart). ifyou're seriousaboutyourinvestment decisions.a full-featured. Some may argue that.most accurate asset allocationsoftware.