Part A.

2: Extending the CAPM

The conclusion of the first part of this assignment was that differences in exposures to the market
portfolio could not explain the cross-sectional return differences of the sorted portfolios. This could
have been the result of the market portfolio not capturing all the systematic risks to which a particular
asset or portfolio is exposed. Our test portfolios were formed on size and Book-to-Market value.
Returns of these portfolios could be different because the firm characteristics on which these portfolios
were sorted, proxy for exposures to latent risk factors. Therefore, in this second part of the assignment,
the two firm characteristics size and Book-to-Market value are first transformed into risk factors. We
then extend the CAPM by adding these two risk factors to the pricing equation. Subsequently, this
multiple factor model is tested whether it is able to explain the cross-sectional return differences of the
sorted portfolios.

1.
In this assignment we chose to use portfolios that were formed on two firm characteristics, namely
size and Book-to-Market value. In order to turn the effect of a firm characteristic into a risk factor, a
hedge portfolio is constructed. As the portfolio sorts were done with respect to two firm
characteristics, we will also need two hedge portfolios, one for each firm characteristic.

2.
We could have used a linear combination of the test portfolios to form the hedge portfolios, but we
have chosen to use other portfolios. In the literature, a linear combination of our six test portfolios is,
in general, used to construct the hedge portfolios associated with size and Book-to-market value. The
hedge portfolio associated with size is called the SMB (small-minus-big) factor and is constructed
from all six test portfolios. The hedge portfolio associated with Book-to-Market value is called the
HML (high-minus-low) factor and is constructed by combining four of our test portfolios. If we would
follow the same procedure in our assignment, the probable consequence is that we are not able to
improve the Sharpe ratio of the MV efficient portfolio of the risk factors (SMB, HML, and market
portfolio) after we add our test portfolios to the investment possibility set (question 5). This is because
we artificially constructed the SMB and HML factor as a linear combination of almost all our test
portfolios. After we add these test portfolios to the investment possibility set, we are, in essence,
adding nothing new to this set such that the Sharpe ratio of the MV efficient portfolio cannot be or is
hardly improved (insignificant GRS-test statistic)1. In order to circumvent this problem, the hedge
portfolios in this assignment are not constructed as a linear combination of our test portfolios. We
instead considered the 25 portfolios formed on size and Book-to-Market value from Kenneth French
Data Library and used these to construct the hedge portfolios. Individual assets are first sorted on size
and then put into groups of equal size (group containing 20% smallest assets to the group containing
20% biggest assets). Then the assets in each of these groups are sorted on Book-to-Market value and
put into portfolios of equal size (portfolio with 20% lowest Book-to-Market values to portfolio with
20% highest Book-to-Market values).This results in a total of 25 portfolios. The SMB factor is
calculated as the average return of the five portfolios belonging to the 20% smallest assets minus the
average return of the five portfolios belonging to the 20% biggest assets. Each size group contains five
BM (book-to-market) portfolios. Each size group thus has one portfolio with the 20% highest BM
values and one portfolio with the 20% lowest BM values. With five size groups, this means that there
are five portfolios that contain assets with an high BM value and five portfolios that contain assets

1 We constructed our risk factors as a linear combination of our test portfolios

and the value of the GRS-test statistic was indeed insignificantly different from
zero.

with a low BM value. The HML factor is calculated by subtracting the average return of the last five
portfolios from the average return of the first five portfolios.
The hedge portfolios are no longer a linear combination of all test portfolios such that there now is a
possibility to improve the Sharpe ratio of the MV efficient portfolio instead of artificially impossible
or unlikely.
Table 5. (Co)variances,
correlations, and average
returns
SMB
HML
Mkt-RF

SMB

HML

Mkt-RF

19.56
-0.363
0.250

-5.298
10.88
-0.044

4.915
-0.639
19.75

Average return

0.240

0.459

0.499

Table 5 shows the (co)variances, variances, correlations, and average returns of the three risk factors
considered in this assignment. If we discard the average return part of this table, then the lower left
corner contains the correlations, the diagonal the variances, and the upper right corner the covariances.
The correlation between the SMB and HML factors is negative and of moderate magnitude. It seems
that both factors move in opposite direction on average. Both SMB and HML have a low correlation
with the excess returns on the market portfolio, especially the HML factor.
The HML factor seems to have the best risk-return trade-off. Its average return is comparable to the
average return of the market portfolio, while its variance is almost twice as small. The SMB factor
seems to have the worst risk-return trade-off.

3.
^ i

P-value

^ mi

P-value

^ i

R2

SMB

0.116
(0.172)

0.499

0.249
(0.038)

0.000

4.285

0.063

HML

0.476
(0.132)

0.000

-0.032
(0.030)

0.275

3.298

0.002

Table 6. Regression results

SMB and HML

Table 6 contains the results of regressing each factor on the excess market returns and a constant,
where the standard errors are given in parentheses below the coefficient estimates. The results in this
table confirm the correlations we saw in table 5. Due to the low linear dependence between the risk
factors and the market portfolio, the regression model is not able to explain a lot of the variation in
both factors. This means that variations in both factors are not (closely) related to variations in returns
on the market portfolio such that both factors do not proxy for the risk related to the market portfolio
but possibly represent a different (latent) type of risk. We can therefore add these two risk factors to
the CAPM pricing equation and hopefully with help of these two additional risk factors, we are able to
explain the cross-sectional return differences of our test portfolios.

4.
Table 7. Regression results
test portfolios
Small Growth

^ i

^ mi

^ SMB
i

^ HML
i

^ i

P-value

-0.143
(0.053)

1.170
(0.012)

0.650
(0.013)

-0.209
(0.017)

1.294

0.007

Small Neutral

0.118
(0.050)

0.940
(0.011)

0.566
(0.012)

0.315
(0.016)

1.231

0.018

Small Value

0.103
(0.044)

0.909
(0.010)

0.659
(0.011)

0.603
(0.010)

1.085

0.020

Big Growth

0.094
(0.035)

1.035
(0.008)

-0.127
(0.009)

-0.213
(0.011)

0.871

0.008

Big Neutral

-0.032
(0.049)

0.936
(0.011)

-0.093
(0.012)

0.249
(0.016)

1.210

0.514

Big Value

-0.065
(0.057)

0.914
(0.013)

0.067
(0.014)

0.560
(0.018)

1.405

0.256

Table 7 contains the results of regressing the excess test portfolio returns on the excess market
portfolio returns, the SMB factor returns, the HML factor returns, and a constant. For each test
portfolio individually, the regression model does a great job in explaining the variations in the
portfolio returns. The residual volatility is low and the

R2 varies between .91 and .96 (not shown

in the table). Further, all SMB and HML factor sensitivities are significant. This indicates that
portfolio returns are related to these risk factors and that besides risk implied by the market portfolio,
there also are other risks to which these portfolios are exposed and in turn are rewarded for. The factor
sensitivities have in most cases the predicted sign, accept the SMB factor sensitivity of the portfolio
Big Value, where we would expect the sensitivity to be negative. SMB factor sensitivities are much
bigger for portfolios consisting of small assets than for portfolios that contain assets with an high
market value. This could indicate that this risk factor is more important for smaller assets than for
bigger assets. From an asset pricing perspective, the results in table 7 are mixed. The average pricing
error is in four out of six cases significant at the 5% significance level. In two cases, the 3-factor
model is able to price the portfolios correctly. Because of these mixed results, we are not able to
conclude whether this model can explain the cross-sectional return differences of our test portfolios.
We will therefore now perform a GRS-test.

5.
Table 8. GRS-test
Sharpe ratio MV portfolio of SMB, HML,
and market

0.202

Sharpe ratio MV portfolio of SMB, HML,

market, and six test portfolios

0.324

GRS-test statistic

6.384

Degrees of Freedom

6, 621

P-value

0.000

The results of the GRS-test are shown in table 8. It tests whether the estimated alphas in table 7 are
jointly significantly different from zero. The value of the GRS-test statistic differs significantly from
zero with a P-value close to zero. The null hypothesis is rejected and we conclude that the average
pricing errors are jointly significantly different from zero. This means that the asset pricing model is
not able to explain the cross-sectional return differences of our test portfolios. The hedge portfolios

together with the market portfolio thus do not capture the effect of the portfolio sorts. Lastly, table 8
also shows the Sharpe ratios of MV efficient portfolios. After we add our test portfolios to the three
risk factors, the Sharpe ratio of the MV efficient portfolio significantly increases as indicated by the
value of the GRS-test statistic which is significant.
The final conclusion is that extending the CAPM with the factors SMB and HML is worthwhile but
also that this 3-factor model is not the complete story yet. Maybe additional risk factors should be
added to this model in order for it to able to explain the cross-sectional return differences of the
portfolios.