Vous êtes sur la page 1sur 65


Lecture 5

Chapter 9

Asset Pricing Principles

Capital Market Theory

Focus on the equilibrium relationship

between the risk and expected return
on risky assets
Builds on Markowitz portfolio theory
Each investor is assumed to diversify
his or her portfolio according to the
Markowitz model

Capital Market Theory Assumptions

All investors:
Use the same information to generate an efficient
Have the same one-period time horizon
Can borrow or lend money at the risk-free rate of
No transaction costs, no personal income
taxes, no inflation
No single investor can affect the price of a
Capital markets are in equilibrium

Borrowing and Lending Possibilities

Risk free assets

Certain-to-be-earned expected return and a
variance of return of zero
No correlation with risky assets
Usually proxied by a Treasury security
Amount to be received at maturity is free of
default risk, known with certainty
Adding a risk-free asset extends and
changes the efficient frontier

Borrowing Possibilities

Investor no longer restricted to own

Interest paid on borrowed money
Higher returns sought to cover expense
Assume borrowing at RF
Risk will increase as the amount of
borrowing increases
Financial leverage

The New Efficient Set

Risk-free investing and borrowing

creates a new set of expected return-
risk possibilities
Addition of risk-free asset results in
A change in the efficient set from an arc to
a straight line tangent to the feasible set
without the riskless asset
Chosen portfolio depends on investors risk-
return preferences

Risk-Free Lending
Riskless assets can
L be combined with
any portfolio in the
efficient set AB
E(R) T Z implies lending
Z X Set of portfolios on
RF line RF to T
A dominates all
portfolios below it

Portfolio Choice

The more conservative the investor the

more is placed in risk-free lending and
the less borrowing
The more aggressive the investor the
less is placed in risk-free lending and
the more borrowing
Most aggressive investors would use
leverage to invest more in portfolio T

Market Portfolio

Market Portfolio
All investors hold the same optimal portfolio
of risky assets
The optimal portfolio is at the highest point
of tangency between RF and the efficient
The portfolio of all risky assets is the
optimal risky portfolio
Called the market portfolio

Characteristics of the Market
All risky assets must be in portfolio, so
it is completely diversified
Includes only systematic risk
All securities included in proportion to
their market value
Unobservable but proxied by S&P 500
Contains worldwide assets
Financial and real assets

Capital Market Line
Efficient portfolios consists of Risky Assets
and Risk Free Assets
All possible combination of Risky Assets
and Risk Free Assets are on the CML.
In equilibrium, all investors will end up
with a portfolio somewhere on the CML
based on their risk tolerance i.e. based on
how much they lend or borrow

Capital Market Line

If investors were to
L invest in risky assets,
they must be
M compensated with a
E(RM) risk premium which is
x x =E(RM) RF
Slope = x/y which
y means how much
additional return
required for every
M increment of RISK
Risk =[E(RM) - RF]/M

Capital Market Line (CML)

Slope of the CML is the market price of

risk for efficient portfolios, or the
equilibrium price of risk in the market
Relationship between risk and expected

return for portfolio P (Equation for

E(R p ) RF p

The Separation Theorem
Investors use their preferences (reflected
in an indifference curve) to determine
their optimal portfolio
Separation Theorem:
The investment decision, which risky portfolio
to hold, is separate from the financing decision
Allocation between risk-free asset and risky
portfolio separate from choice of risky portfolio

Separation Theorem

All investors
Invest in the same portfolio
Attain any point on the straight line RF-T-L
by by either borrowing or lending at the
rate RF, depending on their preferences
Risky portfolios are not tailored to each
individuals taste

Capital Asset Pricing Model

Security Market Line

CML Equation only applies to markets

in equilibrium and efficient portfolios
The Security Market Line depicts the
tradeoff between risk and expected
return for individual securities
Under CAPM, all investors hold the
market portfolio
How does an individual security contribute
to the risk of the market portfolio?

Security Market Line

A securitys contribution to the risk of

the market portfolio is based on beta
Equation for expected return for an
individual stock

E(Ri ) RF i E(RM ) RF

Security Market Line

SM Beta = 1.0 implies

E(R) L as risky as market
Securities A and B
kM B are more risky than
C the market
kRF Beta >1.0
Security C is less

risky than the

0 0.5 1.0 1.5 2.0 market
Beta <1.0

Security Market Line

Beta measures systematic risk

Measures relative risk compared to the
market portfolio of all stocks
Volatility different than market
All securities should lie on the SML
The expected return on the security should
be only that return needed to compensate
for systematic risk

CAPMs Expected
Return-Beta Relationship
Required rate of return on an asset (ki)
is composed of
risk-free rate (RF)
risk premium (i [ E(RM) - RF ])
Market risk premium adjusted for specific
ki = RF +i [ E(RM) - RF ]
The greater the systematic risk, the greater
the required return

Example on CAPM

Assuming that the beta for IBM is 1.15, RF is

0.05 and expected return on the market is

What is the required return on IBM ?

Example on CAPM

ki = RF +i [ E(RM) - RF ]

K for IBM
= 0.05 + 1.15 (0.12-0.05)
= 0.1305
= 13.05%

Estimating the SML

Treasury Bill rate used to estimate RF

Expected market return unobservable
Estimated using past market returns and
taking an expected value
Estimating individual security betas
Only company-specific factor in CAPM
Requires asset-specific forecast

Estimating Beta
Market model
Relates the return on each stock to the return on the

market, assuming a linear relationship

Ri = i + i RM +ei
Characteristic line
Line fit to total returns for a security relative to total

returns for the market index


How Accurate Are Beta
Betas change with a companys
Not stationary over time
Estimating a future beta
May differ from the historical beta
RM represents the total of all
marketable assets in the economy
Approximated with a stock market index
Approximates return on all common stocks

How Accurate Are Beta
No one correct number of observations
and time periods for calculating beta
The regression calculations of the true
and from the characteristic line are
subject to estimation error
Portfolio betas more reliable than
individual security betas


Risk Measurement
CML uses standard deviation as the measure of risk

SML uses beta as the measure of risk

Efficient and Non-efficient

CML graph defines efficient portfolio

SML graph defines both efficient and non-efficient


Portfolio Vs Stock
CML determines risk or return for efficient portfolios

SML determines risk or return for individual stock

Arbitrage Pricing Theory

Arbitrage Pricing Theory
A general theory of asset pricing that
holds that the expected return of a
financial asset can be modeled as a linear
function of various macro-economic
factors where sensitivity to changes in
each factor is represented by a factor-
specific beta coefficient.
The model-derived rate of return will then
be used to price the asset correctly.

Arbitrage Pricing Theory
Based on the Law of One Price
Two otherwise identical assets cannot sell
at different prices
Equilibrium prices adjust to eliminate all
arbitrage opportunities
Unlike CAPM, APT does not assume
single-period investment horizon, normal
distribution of expected returns, riskless
borrowing or lending, mean-variance


APT assumes returns generated by a

factor model
Factor Characteristics
Each risk must have a pervasive influence
on stock returns
Risk factors must influence expected return
and have nonzero prices
Risk factors must be unpredictable to the

APT Model

The expected return-risk relationship

for the APT can be described as:
E(Ri) =RF +bi1 (risk premium for
factor 1) +bi2 (risk premium for
factor 2) + +bin (risk premium
for factor n)

Problems with APT

Factors are not well specified

To implement the APT model, need the
factors that account for the differences
among security returns
CAPM identifies market portfolio as single factor
but APT does not specify what are the factors nor
the number of factors
Neither CAPM or APT has been proven
Both rely on unobservable expectations

Chapter 12

What Happens if Markets

are Efficient Or Not?

Efficient Markets

How well do markets respond to new

Should it be possible to decide between
a profitable and unprofitable
investment given current information?
Efficient Markets
The prices of all securities quickly and fully
reflect all available information

Conditions for an Efficient Market

Large number of rational, profit-

maximizing investors
Actively participate in the market
Individuals cannot affect market prices
Information is costless, widely
available, generated in a random
Investors react quickly and fully to new
Consequences of Efficient Market

Quick price adjustment in response to

the arrival of random information
makes the reward for analysis low
Prices reflect all available information
Price changes are independent of one
another and move in a random fashion
New information is independent of past

Market Efficiency Forms

Efficient market hypothesis

To what extent do securities markets
quickly and fully reflect different available
Three levels of Market Efficiency
Weak form - market level data
Semistrong form - public information
Strong form - all (nonpublic) information

Weak Form

Prices reflect all past price and volume

Technical analysis, which relies on the
past history of prices, is of little or no
value in assessing future changes in
Market adjusts or incorporates this
information quickly and fully

Semistrong Form

Prices reflect all publicly available

Investors cannot act on new public
information after its announcement and
expect to earn above-average, risk-
adjusted returns
Encompasses weak form as a subset

Semistrong Form Evidence

Stock splits Initial public

Implications of split offerings
reflected in price Only issues
immediately following purchased at offer
the announcement price yield abnormal
Accounting returns
changes Announcements
Quick reaction to real and news
change in value Little impact on price
after release

Strong Form

Prices reflect all information, public and

No group of investors should be able to
earn abnormal rates of return by using
publicly and privately available
Encompasses weak and semistrong
forms as subsets

How to test for market

Evidence on Market Efficiency

Consistency of returns in excess of risk
Random short-lived inefficiency do not
constitute inefficient market. (maybe you
are just lucky!)
Economically efficient markets
Assets are priced so that investors cannot
exploit any discrepancies and earn unusual
Transaction costs is taken into consideration
when performing test on market efficiency.

Example of Economically Efficient Market

A test on technical analysis showed

that if you use a certain technical tool,
you can gain a return of 0.01%
However, you will always have to pay a
transaction cost of more than 0.01% when you
trade in the market.
Therefore you still cant outperform the market
when you apply the certain technical rule.
In conclusion, market is economically efficient.

Weak Form Evidence

Test for independence (randomness) of

stock price changes
If independent, trends in price changes do
not exist. The price change for today has
nothing to do with price change yesterday
or any other day.
Test results show small positive
relationships before transaction costs.
Test for profitability of trading rules
after brokerage costs
Simple buy-and-hold better
Semistrong Form Evidence

Event studies
Empirical analysis of stock price behavior
surrounding a particular event
Tests of the speed of price adjustments to
publicly available information.
Examine company unique returns
The residual error between the securitys actual
return and expected return (given by the index

Semistrong Form Evidence
Stock splits Initial public
Implications of split offerings
reflected in price Only issues purchased
immediately following at offer price yield
the announcement abnormal returns
Accounting changes Announcements and
Quick reaction to real news
change in value Little impact on price
after release

Strong Form Evidence

Test performance of groups which have

access to nonpublic information
Corporate insiders have valuable private
Evidence that many have consistently
earned abnormal returns on their stock
Insider transactions must be publicly

Implications of Efficient Market Hypothesis

What should investors do if markets

Technical analysis
Not valuable if weak form holds
Fundamental analysis of intrinsic value
Not valuable if semistrong form holds
Experience average results

Market Anomalies

Exceptionsthat appear to be contrary

to market efficiency

Market Anomalies Earnings
Earnings announcements affect stock prices.
Adjustment occurs before announcement but
significant amount after the announcement
Contrary to efficient market because the lag should
not exist
How much of the earning announcement has been
anticipated by the market?
How much of the announcement is surprise
How quickly is the surprise reflected in the price?
If there is a lag in the price, investor has a chance
to make extra return by acting quickly on those
Research results showed there is a lag in
adjustment in stock price on earning surprises.

Market Anomalies P/E
Low P/E ratio stocks tend to outperform
high P/E ratio stocks
Low P/E stocks generally have higher risk-
adjusted returns
But P/E ratio is public information

Market Anomalies Size Effect

Size effect
Tendency for small firms to have higher
risk-adjusted returns than large firms
What is definition of small?
Studies showed a significance of the size
effect occurred during the first 5 trading
days of January.

Market Anomalies January Effect
Strong performance in January by small
company stocks has become known as
the January effect.
January effect
Several studies have suggested that
seasonality exists in the stock market.
Tendency for small firm stock returns to be
higher in January
Why ?

Market Anomalies Value Line
Ranking System
Value Line is famous investment advisory
service in the USA.
Value Line Ranking System
Advisory service that ranks 1700 stocks in

5 groups from best (1) to worst (5)

Probable price performance in next 12
1980-1993, Group 1 stocks had annualized
return of 19.3%
Best investment letter performance overall

Behavioral Finance

Behavioral Finance
EMH assume that individual act
rationally and consider all information
when making decision.
However, we know that human being
tend to get emotional when making
BF says that investors often make
systematic mistakes when processing
market info due to emotion.

Behavioral Finance
Are there systematic deviations from
the norms of rationality?
How do human beings make decisions?
Distortion throughout the process of
In making predictions, perceiving the
Marriage of psychology and finance
BF studies market anomalies are
exceptions that appear to be contrary
to market efficiency
Conclusions About Market Efficiency

Market is efficient:
Proven by many researches using different
Even more efficient now with internet.
Market anomalies cannot be explained
satisfactorily and therefore not conclusive.
Markets very efficient but not totally
Most mutual funds cannot beat the market.
To outperform the market, fundamental
analysis beyond the norm must be done.

Conclusions About Market Efficiency

If markets operationally efficient, some

investors with the skill to detect a
divergence between price and
semistrong value earn profits
Excludes the majority of investors
Anomalies offer opportunities
Controversy about the degree of
market efficiency still remains.
If efficient, why would market drop 20% in
a single day?

The End

Tutorial Questions
Chapter 9
Questions: 1, 3, 4, 5, 8, 9, 10
Problems: 4

Chapter 12
Questions: 1, 2, 3, 4, 8