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1

Chapter 4

CAPM & APT

Asst. Prof. Dr. Mete Feridun
2
Capital Market Theory:
An Overview
Capital market theory extends portfolio
theory and develops a model for pricing all
risky assets
Capital asset pricing model (CAPM) will
allow you to determine the required rate of
return for any risky asset
3
Capital Asset Pricing Model (CAPM)
The asset pricing models aim to use the concepts of
portfolio valuation and market equilibrium in order
to determine the market price for risk and
appropriate measure of risk for a single asset.
Capital Asset Pricing Model (CAPM) has an
observation that the returns on a financial asset
increase with the risk. CAPM concerns two types of
risk namely unsystematic and systematic risks. The
central principle of the CAPM is that, systematic
risk, as measured by beta, is the only factor affecting
the level of return.

4
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) was
developed independently by Sharpe (1964),
Lintner (1965) and Mossin (1966) as a financial
model of the relation of risk to expected return for
the practical world of finance.
CAPM originally depends on the mean variance
theory which was demonstrated by Markowitzs
portfolio selection model (1952) aiming higher
average returns with lower risk.
5
Capital Asset Pricing Model (CAPM)
Equilibrium model that underlies all modern financial
theory
Derived using principles of diversification with
simplified assumptions
Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development5
6

7
Capital Asset Pricing Model
Introduction
Systematic and unsystematic risk
Fundamental risk/return relationship
revisited
8
Introduction
The Capital Asset Pricing Model (CAPM)
is a theoretical description of the way in
which the market prices investment assets
The CAPM is a positive theory
9
Systematic and
Unsystematic Risk
Unsystematic risk can be diversified and is
irrelevant

Systematic risk cannot be diversified and is
relevant
Measured by beta
Beta determines the level of expected return on a
security or portfolio (SML)
10
Fundamental Risk/Return
Relationship Revisited
CAPM
SML and CAPM
Market model versus CAPM
Note on the CAPM assumptions
Stationarity of beta
11
CAPM
The more risk you carry, the greater the
expected return:


( ) ( )
where ( ) expected return on security
risk-free rate of interest
beta of Security
( ) expected return on the market
i f i m f
i
f
i
m
E R R E R R
E R i
R
i
E R
|
|
(
= +

=
=
=
=
12
CAPM (contd)
The CAPM deals with expectations about
the future

Excess returns on a particular stock are
directly related to:
The beta of the stock
The expected excess return on the market


13
CAPM (contd)
CAPM assumptions:
Variance of return and mean return are all
investors care about
Investors are price takers
They cannot influence the market individually
All investors have equal and costless access to
information
There are no taxes or commission costs


14
CAPM (contd)
CAPM assumptions (contd):
Investors look only one period ahead

Everyone is equally adept at analyzing
securities and interpreting the news


15
SML and CAPM
If you show the security market line with
excess returns on the vertical axis, the
equation of the SML is the CAPM
The intercept is zero

The slope of the line is beta
16
Market Model Versus CAPM
The market model is an ex post model
It describes past price behavior

The CAPM is an ex ante model
It predicts what a value should be
17
Market Model
Versus CAPM (contd)
The market model is:

( )
where return on Security in period
intercept
beta for Security
return on the market in period
error term on Security in period
it i i mt it
it
i
i
mt
it
R R e
R i t
i
R t
e i t
o |
o
|
= + +
=
=
=
=
=
18
Note on the
CAPM Assumptions
Several assumptions are unrealistic:
People pay taxes and commissions
Many people look ahead more than one period
Not all investors forecast the same distribution

Theory is useful to the extent that it helps us learn
more about the way the world acts
Empirical testing shows that the CAPM works
reasonably well
19
Stationarity of Beta
Beta is not stationary
Evidence that weekly betas are less than
monthly betas, especially for high-beta stocks
Evidence that the stationarity of beta increases
as the estimation period increases

The informed investment manager knows
that betas change
20
Equity Risk Premium
Equity risk premium refers to the
difference in the average return between
stocks and some measure of the risk-free
rate
The equity risk premium in the CAPM is the
excess expected return on the market

Some researchers are proposing that the size of
the equity risk premium is shrinking
21
Using A Scatter Diagram to
Measure Beta
Correlation of returns
Linear regression and beta
Importance of logarithms
Statistical significance
22
Correlation of Returns
Much of the daily news is of a general
economic nature and affects all securities
Stock prices often move as a group

Some stock routinely move more than the
others regardless of whether the market
advances or declines
Some stocks are more sensitive to changes in
economic conditions
23
Linear Regression and Beta
To obtain beta with a linear regression:
Plot a stocks return against the market return

Use Excel to run a linear regression and obtain
the coefficients
The coefficient for the market return is the beta
statistic
The intercept is the trend in the security price
returns that is inexplicable by finance theory

24
Importance of Logarithms
Taking the logarithm of returns reduces the
impact of outliers
Outliers distort the general relationship

Using logarithms will have more effect the
more outliers there are
25
Statistical Significance
Published betas are not always useful
numbers
Individual securities have substantial
unsystematic risk and will behave differently
than beta predicts

Portfolio betas are more useful since some
unsystematic risk is diversified away
26
CAPM Assumptions
Individual investors are price takers
Single-period investment horizon
Investments are limited to traded financial assets
No taxes, and transaction costs
Information is costless and available to all
investors
Investors are rational mean-variance optimizers
Homogeneous expectations
27
Assumptions
Asset markets are frictionless and information
liquidity is high.
All investors are price takers; so that, they are not able
to influence the market price by their actions.
All investors have homogenous expectations about
asset returns and what the uncertain future holds for
them.
All investors are risk averse and they operate in the
market rationally and perceive utility in terms of
expected return.
28
Assumptions (cont.)
All investors are operating in perfect markets which
enables them to operate without tax payments on
returns and without cost of transactions entailed in
trading securities.
All securities are highly divisible for instance they
can be traded in small parcels (Elton and Gruber,
1995, p.294).
All investors can lend and borrow unlimited
amount of funds at the risk-free rate of return.
All investors have single period investment time
horizon in means of different expectations from
their investments leads them to operate for short or
long term returns from their investments.

29
Assumptions of
Capital Market Theory
1. All investors are Markowitz efficient
investors who want to target points on the
efficient frontier.
The exact location on the efficient frontier and,
therefore, the specific portfolio selected, will
depend on the individual investors risk-return
utility function.
30
Assumptions of
Capital Market Theory
2. Investors can borrow or lend any amount of
money at the risk-free rate of return (RFR).
Clearly it is always possible to lend money at
the nominal risk-free rate by buying risk-free
securities such as government T-bills. It is not
always possible to borrow at this risk-free rate,
but we will see that assuming a higher
borrowing rate does not change the general
results.
31
Assumptions of
Capital Market Theory
3. All investors have homogeneous
expectations; that is, they estimate identical
probability distributions for future rates of
return.
Again, this assumption can be relaxed. As long
as the differences in expectations are not vast,
their effects are minor.
32
Assumptions of
Capital Market Theory
4. All investors have the same one-period
time horizon such as one-month, six
months, or one year.
The model will be developed for a single
hypothetical period, and its results could be
affected by a different assumption. A
difference in the time horizon would require
investors to derive risk measures and risk-free
assets that are consistent with their time
horizons.
33
Assumptions of
Capital Market Theory
5. All investments are infinitely divisible,
which means that it is possible to buy or sell
fractional shares of any asset or portfolio.
This assumption allows us to discuss
investment alternatives as continuous curves.
Changing it would have little impact on the
theory.
34
Assumptions of
Capital Market Theory
6. There are no taxes or transaction costs
involved in buying or selling assets.
This is a reasonable assumption in many
instances. Neither pension funds nor religious
groups have to pay taxes, and the transaction
costs for most financial institutions are less than
1 percent on most financial instruments. Again,
relaxing this assumption modifies the results,
but does not change the basic thrust.
35
Assumptions of
Capital Market Theory
7. There is no inflation or any change in
interest rates, or inflation is fully
anticipated.
This is a reasonable initial assumption, and it
can be modified.
36
Assumptions of
Capital Market Theory
8. Capital markets are in equilibrium.
This means that we begin with all investments
properly priced in line with their risk levels.
37
Assumptions of
Capital Market Theory
Some of these assumptions are unrealistic
Relaxing many of these assumptions would
have only minor influence on the model and
would not change its main implications or
conclusions.
A theory should be judged on how well it
explains and helps predict behavior, not on
its assumptions.
38
Resulting Equilibrium Conditions
All investors will hold the same portfolio for risky
assets market portfolio
Market portfolio contains all securities and the
proportion of each security is its market value as a
percentage of total market value
Risk premium on the market depends on the
average risk aversion of all market participants
Risk premium on an individual security is a
function of its covariance with the market
39
Capital Market Line
If a fully diversified investor is able to
invest in the market portfolio and lend or
borrow at the risk free rate of return, the
alternative risk and return relationships can
be generally placed around a market line
which is called the Capital Market Line
(CML).
40
Security Market Line
The SML shows the relationship between
risk measured by beta and expected return.
The model states that the stocks expected
return is equal to the risk-free rate plus a
risk premium obtained by the price of the
risk multiplied by the quantity of the risk.
41
E(r)
E(r
M
)
r
f
M
CML
o
m
Capital Market Line
o
42
E(r)
E(r
M
)
r
f
SML
M


= 1.0
Security Market Line
43
Capital Market Line
CML: E(r
p
)= r
F
+
p


E(r
p
): Expected return on portfolio
r
F
: Return on the risk free asset
: Market price risk

p
: Market portfolio risk

44

M = Market portfolio
r
f
= Risk free rate
E(r
M
) - r
f
= Market risk premium

E(r
M
) - r
f
= Market price of risk

= Slope of the CAPM
Slope and Market Risk Premium
M
o
45
SML Relationships
| = [COV(r
i
,r
m
)] / o
m
2
Slope SML = E(r
m
) - r
f
= market risk premium

SML = r
f
+ |[E(r
m
) - r
f
]
(
S
p
S,M
) is the market price of risk
SML: E(r
S
)=r
F
+
S
p
S,M

46
Expected Return and Risk on Individual
Securities
The risk premium on individual securities
is a function of the individual securitys
contribution to the risk of the market
portfolio
Individual securitys risk premium is a
function of the covariance of returns with
the assets that make up the market
portfolio
47
Exercise
If E(r
m
) - r
f
= .08 and r
f
= .03
Calculate exp. ret. based on betas given below:
|
x
= 1.25
E(r
x
) = .03 + 1.25(.08) = .13 or 13%

|
y
= .6
E(r
y
) = .03 + .6(.08) = .078 or 7.8%
48
E(r)
R
x
=13%
SML
m


1.0
R
m
=11%
R
y
=7.8%
3%
x

1.25
y

.6
.08
Graph of Sample Calculations
49
Disequilibrium Example
Suppose a security with a beta of 1.25 is
offering expected return of 15%
According to SML, it should be 13%
So the security is underpriced: offering too
high of a rate of return for its level of risk
50
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
51
Risk-Free Asset
Covariance between two sets of returns is

=
=
n
1 i
j j i i ij
)]/n E(R - )][R E(R - [R Cov
Because the returns for the risk free asset are certain,
0
RF
= o
Thus R
i
= E(R
i
), and Ri - E(Ri) = 0
Consequently, the covariance of the risk-free asset with any
risky asset or portfolio will always equal zero. Similarly the
correlation between any risky asset and the risk-free asset
would be zero.
52
Combining a Risk-Free Asset
with a Risky Portfolio
Expected return
the weighted average of the two returns
) )E(R W - (1 (RFR) W ) E(R
i RF RF port
+ =
This is a linear relationship
53
Combining a Risk-Free Asset
with a Risky Portfolio
Standard deviation
The expected variance for a two-asset portfolio is
2 1 1,2 2 1
2
2
2
2
2
1
2
1
2
port
r w w 2 w w ) E( o o o o o + + =
Substituting the risk-free asset for Security 1, and the risky
asset for Security 2, this formula would become
i RF i RF
o o o o o
i RF, RF RF
2 2
RF
2 2
RF
2
port
)r w - (1 w 2 ) w 1 ( w ) E( + + =
Since we know that the variance of the risk-free asset is
zero and the correlation between the risk-free asset and any
risky asset i is zero we can adjust the formula
2 2
RF
2
port
) w 1 ( ) E(
i
o o =
54
Combining a Risk-Free Asset
with a Risky Portfolio
Given the variance formula
2 2
RF
2
port
) w 1 ( ) E(
i
o o =
2 2
RF port
) w 1 ( ) E(
i
o o =
the standard deviation is

i
o ) w 1 (
RF
=
Therefore, the standard deviation of a portfolio that
combines the risk-free asset with risky assets is the
linear proportion of the standard deviation of the risky
asset portfolio.
55
Combining a Risk-Free Asset
with a Risky Portfolio
Since both the expected return and the
standard deviation of return for such a
portfolio are linear combinations, a graph of
possible portfolio returns and risks looks
like a straight line between the two assets.
56
Portfolio Possibilities Combining the Risk-Free Asset
and Risky Portfolios on the Efficient Frontier
) E(
port
o
) E(R
port
RFR
M
C
A
B
D
57
Risk-Return Possibilities with Leverage
To attain a higher expected return than is
available at point M (in exchange for
accepting higher risk)
Either invest along the efficient frontier
beyond point M, such as point D
Or, add leverage to the portfolio by
borrowing money at the risk-free rate and
investing in the risky portfolio at point M
58
Capital Market Line - CML
A line used in the capital asset pricing
model to illustrate the rates of return for
efficient portfolios depending on the risk-
free rate of return and the level of risk
(standard deviation) for a particular
portfolio.
59
Portfolio Possibilities Combining the Risk-Free Asset
and Risky Portfolios on the Efficient Frontier
) E(
port
o
) E(R
port
RFR
M
60
An Exercise to Produce the
Efficient Frontier Using Three
Assets
Risk, Return and Portfolio Theory
61
An Exercise using T-bills, Stocks
and Bonds
Base Data: Stocks T-bills Bonds
Expected Return(%) 12.73383 6.151702 7.0078723
Standard Deviation (%) 0.168 0.042 0.102
Correlation Coefficient Matrix:
Stocks 1 -0.216 0.048
T-bills -0.216 1 0.380
Bonds 0.048 0.380 1
Portfolio Combinations:
Combination Stocks T-bills Bonds
Expected
Return Variance
Standard
Deviation
1 100.0% 0.0% 0.0% 12.7 0.0283 16.8%
2 90.0% 10.0% 0.0% 12.1 0.0226 15.0%
3 80.0% 20.0% 0.0% 11.4 0.0177 13.3%
4 70.0% 30.0% 0.0% 10.8 0.0134 11.6%
5 60.0% 40.0% 0.0% 10.1 0.0097 9.9%
6 50.0% 50.0% 0.0% 9.4 0.0067 8.2%
7 40.0% 60.0% 0.0% 8.8 0.0044 6.6%
8 30.0% 70.0% 0.0% 8.1 0.0028 5.3%
9 20.0% 80.0% 0.0% 7.5 0.0018 4.2%
10 10.0% 90.0% 0.0% 6.8 0.0014 3.8%
Weights Portfolio
Historical
averages for
returns and risk for
three asset
classes
Historical
correlation
coefficients
between the asset
classes
Portfolio
characteristics for
each combination
of securities
Each achievable
portfolio
combination is
plotted on
expected return,
risk () space,
found on the
following slide.
62
Achievable Portfolios
Results Using only Three Asset Classes
Attainable Portfolio Combinations
and Efficient Set of Portfolio Combinations
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
0.0 5.0 10.0 15.0 20.0
Standard Deviation of the Portfolio (%)
P
o
r
t
f
o
l
i
o

E
x
p
e
c
t
e
d

R
e
t
u
r
n

(
%
)
Efficient Set
Minimum Variance
Portf olio
The plotted points are
attainable portfolio
combinations.
The efficient set is that set of
achievable portfolio
combinations that offer the
highest rate of return for a
given level of risk. The solid
blue line indicates the efficient
set.
63
Achievable Two-Security
Portfolios
Modern Portfolio Theory
8 - 9 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Standard Deviation (%)
13

12







11






10






9







8






7

6
0 10 20 30 40 50 60
This line
represents
the set of
portfolio
combinations
that are
achievable by
varying
relative
weights and
using two
non-
correlated
securities.
64
Efficient Frontier
The Two-Asset Portfolio Combinations
A is not attainable
B,E lie on the
efficient frontier and
are attainable
E is the minimum
variance portfolio
(lowest risk
combination)
C, D are
attainable but are
dominated by
superior portfolios
that line on the line
above E
8 - 10 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Standard Deviation (%)
A
E
B
C
D
65
Efficient Frontier
The Two-Asset Portfolio Combinations
8 - 10 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Standard Deviation (%)
A
E
B
C
D
Rational, risk
averse
investors will
only want to
hold
portfolios
such as B.

The actual
choice will
depend on
her/his risk
preferences.
66
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
Therefore this portfolio must include ALL
RISKY ASSETS
67
The Market Portfolio
Because the market is in equilibrium, all
assets are included in this portfolio in
proportion to their market value
68
The Market Portfolio
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
69
Systematic Risk
Only systematic risk remains in the market
portfolio
Systematic risk is the variability in all risky
assets caused by macroeconomic variables
Systematic risk can be measured by the
standard deviation of returns of the market
portfolio and can change over time
70
Examples of Macroeconomic
Factors Affecting Systematic Risk
Variability in growth of money supply
Interest rate volatility
Variability in
industrial production
corporate earnings
cash flow
71
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
72
Diversification and the
Elimination of Unsystematic Risk
The purpose of diversification is to reduce the
standard deviation of the total portfolio
This assumes that imperfect correlations exist
among securities
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?
73
Diversification and the
Elimination of Unsystematic Risk
Observe what happens as you increase the
sample size of the portfolio by adding
securities that have some positive
correlation
74
Number of Stocks in a Portfolio and the
Standard Deviation of Portfolio Return

Standard Deviation of Return
Number of Stocks in the Portfolio
Standard Deviation of
the Market Portfolio
(systematic risk)
Systematic Risk
Total
Risk
Unsystematic
(diversifiable)
Risk
75
The CML and 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
Risk averse investors will lend part of the
portfolio at the risk-free rate and invest the
remainder in the market portfolio
76
A Risk Measure for the CML
Covariance with the M portfolio is the
systematic risk of an asset
The Markowitz portfolio model considers
the average covariance with all other assets
in the portfolio
The only relevant portfolio is the M
portfolio
77
A Risk Measure for the CML
Together, this means the only important
consideration is the assets covariance with
the market portfolio
78
A Risk Measure for the CML
Because all individual risky assets are part of the M portfolio, an
assets rate of return in relation to the return for the M
portfolio may be described using the following linear model:
c + + =
Mi i i it
R b a R
where:
R
it
= return for asset i during period t
a
i
= constant term for asset i
b
i
= slope coefficient for asset i
R
Mt
= return for the M portfolio during period t
= random error term c
79
Variance of Returns for a Risky Asset
) R b a ( Var ) Var(R
Mi i i it
c + + =
) ( Var ) R b ( Var ) a ( Var
Mi i i
c + + =
) ( Var ) R b ( Var 0
Mi i
c + + =
risk ic unsystemat or portfolio market the
to related not return residual the is ) ( Var
risk systematic or return market to
related variance is ) R b ( Var that Note
Mi i
c
80
The Capital Asset Pricing Model:
Expected Return and Risk
The existence of a risk-free asset resulted in
deriving a capital market line (CML) that
became the relevant frontier
An assets covariance with the market
portfolio is the relevant risk measure
This can be used to determine an
appropriate expected rate of return on a
risky asset - the capital asset pricing model
(CAPM)
81
The Capital Asset Pricing Model:
Expected Return and Risk
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
You can compare an estimated rate of return
to the required rate of return implied by
CAPM - over/under valued ?
82
The Security Market Line (SML)
The relevant risk measure for an individual
risky asset is its covariance with the market
portfolio (Cov
i,m
)
This is shown as the risk measure
The return for the market portfolio should
be consistent with its own risk, which is the
covariance of the market with itself - or its
variance:
2
m
o
83
Graph of Security Market Line
(SML)
) E(R
i
Exhibit 8.5
RFR
im
Cov
2
m
o
m
R
SML
84
The Security Market Line (SML)
The equation for the risk-return line is
) Cov (
RFR - R
RFR ) E(R
M i,
2
M
M
i
o
+ =
RFR) - R (
Cov
RFR
M
2
M
M i,
o
+ =
2
M
M i,
Cov
o
We then define as beta
RFR) - (R RFR ) E(R
M i i
| + =
) (
i
|
85
Graph of SML with
Normalized Systematic Risk
) E(R
i
Exhibit 8.6
) Beta(Cov
2
M
im/o
0 . 1
m
R
SML
0
Negative
Beta
RFR
86
Determining the Expected
Rate of Return for a Risky Asset
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 (R
M
-RFR)
RFR) - (R RFR ) E(R
M i i
| + =
87
Determining the Expected
Rate of Return for a Risky Asset
Assume: RFR = 6% (0.06)
R
M
= 12% (0.12)
Implied market risk premium = 6% (0.06)
Stock Beta
A 0.70
B 1.00
C 1.15
D 1.40
E -0.30
RFR) - (R RFR ) E(R
M i i
| + =
E(R
A
) = 0.06 + 0.70 (0.12-0.06) = 0.102 = 10.2%
E(R
B
) = 0.06 + 1.00 (0.12-0.06) = 0.120 = 12.0%
E(R
C
) = 0.06 + 1.15 (0.12-0.06) = 0.129 = 12.9%
E(R
D
) = 0.06 + 1.40 (0.12-0.06) = 0.144 = 14.4%
E(R
E
) = 0.06 + -0.30 (0.12-0.06) = 0.042 = 4.2%
88
Determining the Expected
Rate of Return for a Risky Asset
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
A superior investor must derive value estimates for
assets that are consistently superior to the consensus
market evaluation to earn better risk-adjusted rates
of return than the average investor
89
Identifying Undervalued and
Overvalued Assets
Compare the required rate of return to the
expected rate of return for a specific risky
asset using the SML over a specific
investment horizon to determine if it is an
appropriate investment
Independent estimates of return for the
securities provide price and dividend
outlooks
90
Price, Dividend, and
Rate of Return Estimates
Stock (P
i
) Expected Price (P
t+1
) (D
t+1
) of Return (Percent)
A 25 27 0.50 10.0 %
B 40 42 0.50 6.2
C 33 39 1.00 21.2
D 64 65 1.10 3.3
E 50 54 0.00 8.0
Current Price Expected Dividend Expected Future Rate
Exhibit 8.7
91
Comparison of Required Rate of Return
to Estimated Rate of Return
Stock Beta E(R
i
) Estimated Return Minus E(R
i
) Evaluation
A 0.70 10.2% 10.0 -0.2 Properly Valued
B 1.00 12.0% 6.2 -5.8 Overvalued
C 1.15 12.9% 21.2 8.3 Undervalued
D 1.40 14.4% 3.3 -11.1 Overvalued
E -0.30 4.2% 8.0 3.8 Undervalued
Required Return Estimated Return
Exhibit 8.8
92
Plot of Estimated Returns
on SML Graph
Exhibit 8.9
) E(R
i
Beta
0 . 1
m
R
SML
0
.20 .40 .60 .80 1.20 1.40 1.60 1.80
-.40 -.20
.22
.20
.18
.16
.14
.12
R
m

.10
.08
.06
.04
.02
A
B
C
D
E
93
Calculating Systematic Risk:
The Characteristic Line
The systematic risk input of an individual asset is derived
from a regression model, referred to as the assets
characteristic line with the model portfolio:
c | o + + =
t M, i i t i,
R R
where:
R
i,t
= the rate of return for asset i during period t
R
M,t
= the rate of return for the market portfolio M during t
m i i i
R - R | o =
2
M
M i,
Cov
o
| = i
error term random the = c
94
Scatter Plot of Rates of Return
Exhibit 8.10
R
M

R
i

The characteristic
line is the regression
line of the best fit
through a scatter plot
of rates of return
95
The Impact of the Time Interval
Number of observations and time interval used in
regression vary
Value Line Investment Services (VL) uses weekly
rates of return over five years
Merrill Lynch, Pierce, Fenner & Smith (ML) uses
monthly return over five years
There is no correct interval for analysis
Weak relationship between VL & ML betas due to
difference in intervals used
The return time interval makes a difference, and
its impact increases as the firms size declines
96
The Effect of the Market Proxy
The market portfolio of all risky assets must
be represented in computing an assets
characteristic line
Standard & Poors 500 Composite Index is
most often used
Large proportion of the total market value of
U.S. stocks
Value weighted series
97
Weaknesses of Using S&P 500
as the Market Proxy
Includes only U.S. stocks
The theoretical market portfolio should include
U.S. and non-U.S. stocks and bonds, real estate,
coins, stamps, art, antiques, and any other
marketable risky asset from around the world
98
Relaxing the Assumptions
Differential Borrowing and Lending Rates
Heterogeneous Expectations and Planning
Periods
Zero Beta Model
does not require a risk-free asset
Transaction Costs
with transactions costs, the SML will be a band
of securities, rather than a straight line
99
Relaxing the Assumptions
Heterogeneous Expectations and Planning
Periods
will have an impact on the CML and SML
Taxes
could cause major differences in the CML and
SML among investors
100
Empirical Tests of the CAPM
Stability of Beta
betas for individual stocks are not stable, but
portfolio betas are reasonably stable. Further,
the larger the portfolio of stocks and longer
the period, the more stable the beta of the
portfolio
Comparability of Published Estimates of
Beta
differences exist. Hence, consider the return
interval used and the firms relative size


101
Relationship Between Systematic
Risk and Return
Effect of Skewness on Relationship
investors prefer stocks with high positive
skewness that provide an opportunity for very
large returns
Effect of Size, P/E, and Leverage
size, and P/E have an inverse impact on returns
after considering the CAPM. Financial
Leverage also helps explain cross-section of
returns
102
Relationship Between Systematic
Risk and Return
Effect of Book-to-Market Value
Fama and French questioned the relationship
between returns and beta in their seminal 1992
study. They found the BV/MV ratio to be a key
determinant of returns
Summary of CAPM Risk-Return Empirical
Results
the relationship between beta and rates of return
is a moot point
103
The Market Portfolio: Theory
versus Practice
There is a controversy over the market portfolio.
Hence, proxies are used
There is no unanimity about which proxy to use
An incorrect market proxy will affect both the beta
risk measures and the position and slope of the
SML that is used to evaluate portfolio
performance


104
What is Next?
Alternative asset pricing models
105
Summary
The dominant line is tangent to the efficient
frontier
Referred to as the capital market line (CML)
All investors should target points along this line
depending on their risk preferences
106
Summary
All investors want to invest in the risky
portfolio, so this market portfolio must
contain all risky assets
The investment decision and financing decision
can be separated
Everyone wants to invest in the market
portfolio
Investors finance based on risk preferences
107
Summary
The relevant risk measure for an individual
risky asset is its systematic risk or
covariance with the market portfolio
Once you have determined this Beta measure
and a security market line, you can determine
the required return on a security based on its
systematic risk
108
Summary
Assuming security markets are not always
completely efficient, you can identify
undervalued and overvalued securities by
comparing your estimate of the rate of
return on an investment to its required rate
of return
109
Summary
When we relax several of the major
assumptions of the CAPM, the required
modifications are relatively minor and do
not change the overall concept of the model.
110
Summary
Betas of individual stocks are not stable
while portfolio betas are stable
There is a controversy about the
relationship between beta and rate of return
on stocks
Changing the proxy for the market portfolio
results in significant differences in betas,
SMLs, and expected returns
111
Arbitrage Pricing Theory
APT background
The APT model
Comparison of the CAPM and the APT
112
Arbitrage Pricing Theory
Arbitrage Pricing Theory was developed by Stephen Ross
(1976). His theory begins with an analysis of how investors
construct efficient portfolios and offers a new approach for
explaining the asset prices and states that the return on any
risky asset is a linear combination of various
macroeconomic factors that are not explained by this theory
namely.
Similar to CAPM it assumes that investors are fully
diversified and the systematic risk is an influencing factor in
the long run. However, unlike CAPM model APT specifies
a simple linear relationship between asset returns and the
associated factors because each share or portfolio may have
a different set of risk factors and a different degree of
sensitivity to each of them.

113
APT Background
Arbitrage pricing theory (APT) states that a
number of distinct factors determine the
market return
Roll and Ross state that a securitys long-run
return is a function of changes in:
Inflation
Industrial production
Risk premiums
The slope of the term structure of interest rates
114
APT Background (contd)
Not all analysts are concerned with the
same set of economic information
A single market measure such as beta does not
capture all the information relevant to the price
of a stock
115
Arbitrage Pricing Theory (APT)
CAPM is criticized because of the
difficulties in selecting a proxy for the
market portfolio as a benchmark
An alternative pricing theory with fewer
assumptions was developed:
Arbitrage Pricing Theory
116
The Assumptions of APT
Capital asset returns properties are consistent
with a linear structure of the factors. The returns
can be described by a factor model.
Either there are no arbitrage opportunities in the
capital markets or the markets have perfect
competition.
The number of the economic securities are either
inestimable or so large that the law of large
number can be applied that makes it possible to
form portfolios that diversify the firm specific
risk of individual stocks.
Lastly, the number of the factors can be estimated
by the investor or known in advance (K. C. John
Wei, 1988)
117

118
Arbitrage Pricing Theory - APT
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
119
Assumptions of CAPM
That Were Not Required by APT
APT does not assume
A market portfolio that contains all risky
assets, and is mean-variance efficient
Normally distributed security returns
Quadratic utility function
120
Arbitrage Pricing Theory (APT)
For i = 1 to N where:
= return on asset i during a specified time period
i k ik i i i i t t
b b b E R c o o o + + + + + = ...
2 1
R
i


121
Arbitrage Pricing Theory (APT)
For i = 1 to N where:
= return on asset i during a specified time period
= expected return for asset i
i k ik i i i i t t
b b b E R c o o o + + + + + = ...
2 1
R
i

E
i
122
Arbitrage Pricing Theory (APT)
For i = 1 to N where:
= return on asset i during a specified time period
= expected return for asset i
= reaction in asset is returns to movements in a common
factor
i k ik i i i i t t
b b b E R c o o o + + + + + = ...
2 1
R
i

E
i
b
ik
123
Arbitrage Pricing Theory (APT)
For i = 1 to N where:
= return on asset i during a specified time period
= expected return for asset i
= reaction in asset is returns to movements in a common
factor
= a common factor with a zero mean that influences the
returns on all assets

i k ik i i i i t t
b b b E R c o o o + + + + + = ...
2 1
R
i

E
i
b
ik
k
o
124
Arbitrage Pricing Theory (APT)
For i = 1 to N where:
= return on asset i during a specified time period
= expected return for asset i
= reaction in asset is returns to movements in a common
factor
= a common factor with a zero mean that influences the
returns on all assets
= a unique effect on asset is return that, by assumption, is
completely diversifiable in large portfolios and has a
mean of zero
i k ik i i i i t t
b b b E R c o o o + + + + + = ...
2 1
R
i

E
i
b
ik
k
o
i
c
125
Arbitrage Pricing Theory (APT)
For i = 1 to N where:
= return on asset i during a specified time period
= expected return for asset i
= reaction in asset is returns to movements in a common
factor
= a common factor with a zero mean that influences the
returns on all assets
= a unique effect on asset is return that, by assumption, is
completely diversifiable in large portfolios and has a
mean of zero
= number of assets
i k ik i i i i t t
b b b E R c o o o + + + + + = ...
2 1
R
i

E
i
b
ik
k
o
i
c
N
126
Arbitrage Pricing Theory (APT)
Multiple factors expected to have an
impact on all assets:
k
o
127
Arbitrage Pricing Theory (APT)
Multiple factors expected to have an impact
on all assets:
Inflation
128
Arbitrage Pricing Theory (APT)
Multiple factors expected to have an impact
on all assets:
Inflation
Growth in GNP
129
Arbitrage Pricing Theory (APT)
Multiple factors expected to have an impact
on all assets:
Inflation
Growth in GNP
Major political upheavals
130
Arbitrage Pricing Theory (APT)
Multiple factors expected to have an impact
on all assets:
Inflation
Growth in GNP
Major political upheavals
Changes in interest rates
131
Arbitrage Pricing Theory (APT)
Multiple factors expected to have an impact
on all assets:
Inflation
Growth in GNP
Major political upheavals
Changes in interest rates
And many more.
132
Arbitrage Pricing Theory (APT)
Multiple factors expected to have an impact
on all assets:
Inflation
Growth in GNP
Major political upheavals
Changes in interest rates
And many more.
Contrast with CAPM insistence that only beta
is relevant
133
Arbitrage Pricing Theory (APT)
B
ik
determine how each asset reacts to this common
factor
Each asset may be affected by growth in GNP, but
the effects will differ
In application of the theory, the factors are not
identified
Similar to the CAPM, the unique effects are
independent and will be diversified away in a
large portfolio
134
Arbitrage Pricing Theory (APT)
APT assumes that, in equilibrium, the return
on a zero-investment, zero-systematic-risk
portfolio is zero when the unique effects are
diversified away
The expected return on any asset i (E
i
) can
be expressed as:
135
Arbitrage Pricing Theory (APT)
where:
= the expected return on an asset with zero systematic
risk where
ik k i i i
b b b E + + + + = ...
2 2 1 1 0
0

0 1
E E
i
= =
0 0
E =
1
= the risk premium related to each of the common
factors - for example the risk premium related to
interest rate risk
b
i
= the pricing relationship between the risk premium and
asset i - that is how responsive asset i is to this common
factor K
136
The Model of APT
k
R
i
= E( R
i
)+
j

ij
+
i

j=1
where,
R
i
: The single period expected rate on security i , i
=1,2.,n

j
: The zero mean j factor common to the all assets
under consideration

ij
: The sensitivity of security is returns to the
fluctuations in the j th common factor portfolio

i
: A random of i th security that constructed to
have a mean of zero.

137
Arbitrage Pricing Theory-briefly
Arbitrage - arises if an investor can
construct a zero investment portfolio with a
sure profit
Since no investment is required, an investor
can create large positions to secure large
levels of profit
In efficient markets, profitable arbitrage
opportunities will quickly disappear
138
Arbitrage Portfolio
Mean Stan. Correlation
Return Dev. Of Returns
Portfolio
A,B,C 25.83 6.40 0.94

D 22.25 8.58
139
Arbitrage Action and Returns
E. Ret.
St.Dev.
* P
* D
Short 3 shares of D and buy 1 of A, B & C to form
P
You earn a higher rate on the investment than
you pay on the short sale
140
The APT Model
General representation of the APT model:

1 1 2 2 3 3 4 4
( )
where actual return on Security
( ) expected return on Security
sensitivity of Security to factor
unanticipated change in factor
A A A A A A
A
A
iA
i
R E R b F b F b F b F
R A
E R A
b A i
F i
= + + + +
=
=
=
=
141
Comparison of the
CAPM and the APT
The CAPMs market portfolio is difficult to
construct:
Theoretically all assets should be included (real estate,
gold, etc.)
Practically, a proxy like the S&P 500 index is used

APT requires specification of the relevant
macroeconomic factors
142
Comparison of the
CAPM and the APT (contd)
The CAPM and APT complement each
other rather than compete
Both models predict that positive returns will
result from factor sensitivities that move with
the market and vice versa
143
Example of Two Stocks
and a Two-Factor Model
= changes in the rate of inflation. The risk premium
related to this factor is 1 percent for every 1 percent
change in the rate
1

) 01 . (
1
=
= percent growth in real GNP. The average risk premium
related to this factor is 2 percent for every 1 percent
change in the rate
= the rate of return on a zero-systematic-risk asset (zero
beta: b
oj
=0) is 3 percent
2

) 02 . (
2
=
) 03 . (
3
=
3

144
Example of Two Stocks
and a Two-Factor Model
= the response of asset X to changes in the rate of inflation
is 0.50
1 x
b
) 50 . (
1
=
x
b
= the response of asset Y to changes in the rate of inflation
is 2.00
) 50 . (
1
=
y
b
1 y
b
= the response of asset X to changes in the growth rate of
real GNP is 1.50
= the response of asset Y to changes in the growth rate of
real GNP is 1.75
2 x
b
2 y
b
) 50 . 1 (
2
=
x
b
) 75 . 1 (
2
=
y
b
145
Example of Two Stocks
and a Two-Factor Model
= .03 + (.01)b
i1
+ (.02)b
i2
E
x
= .03 + (.01)(0.50) + (.02)(1.50)
= .065 = 6.5%
E
y
= .03 + (.01)(2.00) + (.02)(1.75)
= .085 = 8.5%
2 2 1 1 0 i i i
b b E + + =
146
Roll-Ross Study
The methodology used in the study is as follows:
1. Estimate the expected returns and the factor
coefficients from time-series data on individual
asset returns
2. Use these estimates to test the basic cross-
sectional pricing conclusion implied by the APT
The authors concluded that the evidence
generally supported the APT, but acknowledged
that their tests were not conclusive
147
Extensions of the
Roll-Ross Study
Cho, Elton, and Gruber examined the
number of factors in the return-generating
process that were priced
Dhrymes, Friend, and Gultekin (DFG)
reexamined techniques and their limitations
and found the number of factors varies with
the size of the portfolio
148
The APT and Anomalies
Small-firm effect
Reinganum - results inconsistent with the APT
Chen - supported the APT model over CAPM
January anomaly
Gultekin - APT not better than CAPM
Burmeister and McElroy - effect not captured by model,
but still rejected CAPM in favor of APT

149
Shankens Challenge to
Testability of the APT
If returns are not explained by a model, it is not considered
rejection of a model; however if the factors do explain
returns, it is considered support
APT has no advantage because the factors need not be
observable, so equivalent sets may conform to different
factor structures
Empirical formulation of the APT may yield different
implications regarding the expected returns for a given set
of securities
Thus, the theory cannot explain differential returns between
securities because it cannot identify the relevant factor
structure that explains the differential returns
150
APT and CAPM Compared
APT applies to well diversified portfolios and not
necessarily to individual stocks
With APT it is possible for some individual stocks
to be mispriced - not lie on the SML
APT is more general in that it gets to an expected
return and beta relationship without the
assumption of the market portfolio
APT can be extended to multifactor models
151
Example-market risk
Suppose the risk free rate is 5%, the average investor
has a risk-aversion coefficient of A
*
is 2, and the st.
dev. Of the market portfolio is 20%.
A) Calculate the market risk premium.
B) Find the expected rate of return on the market.
C) Calculate the market risk premium as the risk-
aversion coefficient of A
*
increases from 2 to 3.
D) Find the expected rate of return on the market
referring to part c.
152
Answer-market risk
A) E(r
m
-r
f
)=A
*

2
m

Market Risk Premium =2(0.20)
2
=0.08
B) E(r
m
) = r
f
+Eq. Risk prem
=

0.05+0.08=0.13 or 13%
C) Market Risk Premium =3(0.20)
2
=0.12
D) E(r
m
) = r
f
+Eq. Risk prem
=

0.05+0.12=0.17 or 17%
153
Example-risk premium
Suppose an av. Excess return over Treasury
bill of 8% with a st. dev. Of 20%.

A) Calculate coefficient of risk-aversion of
the av. investor.

B) Calculate the market risk premium as the
risk-aversion coefficient is 3.5
154
Answer-risk premium
A) A
*
= E(r
m
-r
f
)/
2
m
=0.085/0.20
2
=2.1

B) E(r
m
)-r
f
=A
*

2
m
=3.5(0.20)
2
=0.14 or 14%

155
Example-Portfolio beta and risk premium
Consider the following
portfolio:
A) Calculate the risk
premium on each portfolio
B) Calculate the total
portfolio if Market risk
premium is 7.5%.

Asset

Beta

Risk
prem.

Portfolio
Weight

X

1.2

9%

0.5

Y

0.8

6

0.3

Z

0.0

0

0.2

Port.

0.84

?

1.0

156
Answer-Portfolio beta and risk premium
A) (9%) (0.5)=4.5
(6%) (0.3)=1.8
=6.3%
B) 0.84(7.5)=6.3%
157
Example-risk premium
Suppose the risk premium of the market portfolio
is 8%, with a st. dev. Of 22%.

A) Calculate portfolios beta.
B) Calculate the risk premium of the portfolio
referring to a portfolio invested 25% in x motor
company with beta 0f 1.15 and 75% in y motor
company with a beta of 1.25.
158
Answer-risk premium
A)
y
= 1.25,
x
= 1.15

p
=w
y

y
+ w
x


=0.75(1.25)+0.25(1.15)=1.225
B) E(r
p
)-r
f
=
p
[E(r
m
)-r
f
]
=1.225(8%)=9.8%

159
Example-SML
Suppose the return on the market is
expected to be 14%, a stock has a beta of
1.2, and the T-bill rate is 6%.
A) Calculate the expected return of the SML
B) If the return is 17%, calculate alpha of the
stock
160
Answer-SML
A) E(r
p
)=r
f
+[E(r
m
)-r
f
]
=6+1.2(14-6)=15.6%

E(r)
17%
SML

1.0
15.6%
14%
6%
1.2
M
Stock
=
17-15.6=1.4
161
Example-SML
Stock xyz has an expected return of 12% and risk of
beta is 1.5. Stock ABC is expected to return 13% with
a beta of 1.5. The market expected return is 11% and
r
f
=5%.
A) Based on CAPM, which stock is a better buy?
B) What is the alpha of each stock?
C) Plot the relevant SML of the two stocks
D) r
f
is 8% ER on the market portfolio is 16%, and
estimated beta is 1.3, what is the required ROR on the
project?
E) If the IRR of the project is 19%, what is the project
alpha?


162
Answer-SML
A and B) =E(r)-{r
f
+[E(r
m
)-r
f
]}

XYZ
= 12-{5+1.0[11-5]}=1
UNDERVALUED

ABC
= 13-{5+1.5[11-5]}= -1
OVERVALUED

163
Answer-SML-C


E(r)
14%
SML

1.0
13%
12%
5%
1.5
xyz
Stock
=
13-14=-1

ABC
=13-12=1
164
Answer-SML
D) E(r)={r
f
+[E(r
m
)-r
f
]}
= 8+1.3[16-8]=18.4%
E) If the IRR of the project is 19%, it is
desirable. However, any project with an
IRR by using similar beta is less than 18.4%
should be rejected.

165
Example-SML
Consider the following table:
Market
Return

Aggressive
stock

Defensive
stock

5%

2%

3.5%

20

32

14

166
Example-SML cont..
A) What are the betas of the two stock?
B) What is the E(ROR) on each stock if Market
return is equally likely to be 5% or 20%?
C) If T-bill rate is 8% and Market return is equally
likely to be 5% or 20%, draw SML for the
economy?
D) Plot the two securities on the SML graph and
show the alphas
167
Answer-SML
A)
A
=2-32/5-20=2
B
=3.5-14/5-20=0.7
B) E(r
A
)={r
f
+[E(r
m
)-r
f
]}
=0.5(2%+32%)=17%
=0.5(3.5%+14%)=8.75%