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Week 5: Asset Pricing

The document discusses the Capital Asset Pricing Model (CAPM) and its assumptions for determining the expected return of securities based on their systematic risk as measured by beta. It also covers multifactor models, the Security Market Line, arbitrage pricing theory, and constructing arbitrage portfolios. Various graphs and equations are presented to illustrate CAPM, the efficient frontier, arbitrage pricing theory, and constructing portfolios.

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mike chan
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33 views26 pages

Week 5: Asset Pricing

The document discusses the Capital Asset Pricing Model (CAPM) and its assumptions for determining the expected return of securities based on their systematic risk as measured by beta. It also covers multifactor models, the Security Market Line, arbitrage pricing theory, and constructing arbitrage portfolios. Various graphs and equations are presented to illustrate CAPM, the efficient frontier, arbitrage pricing theory, and constructing portfolios.

Uploaded by

mike chan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Week 5

Asset pricing

Presented by
Dr James Cummings
Discipline of Finance

The University of Sydney Page 1


The Capital Asset Pricing Model
• Capital Asset Pricing Model (CAPM)
• Security’s required rate of return relates to
systematic risk measured by beta
2
𝐸𝐸 𝑟𝑟𝑀𝑀 − 𝑟𝑟𝑓𝑓 = 𝐴𝐴𝑜𝑜𝑀𝑀
• Market Portfolio (M)
• Each security held in proportion to market value
The Capital Asset Pricing Model: Assumptions

Market Assumptions Investor Assumptions


All investors are price takers Investors plan for the same (single-
period) horizon
All information relevant to security Investors are efficient users of
analysis is free and publicly analytical methods  investors have
available. homogeneous expectations.
All securities are publicly owned Investors are rational, mean-
and traded. variance optimisers.
No taxes on investment returns.
No transaction costs.
Lending and borrowing at the same
risk-free rate are unlimited.
The Capital Asset Pricing Model

• Hypothetical Equilibrium
• All investors choose to hold market portfolio
• Market portfolio is on efficient frontier, optimal
risky portfolio
The Capital Asset Pricing Model
• Hypothetical Equilibrium
• Risk premium on market portfolio is proportional to
variance of market portfolio and investor’s risk
aversion
• Risk premium on individual assets
• Proportional to risk premium on market portfolio
• Proportional to beta coefficient of security on
market portfolio
Efficient Frontier and Capital Market Line

Source: Bodie, Kane and Marcus (2019: 195)


The Capital Asset Pricing Model
• Passive Strategy is Efficient
• Mutual fund theorem: All investors desire same
portfolio of risky assets, can be satisfied by
single mutual fund composed of that portfolio
• If passive strategy is costless and efficient, why
follow active strategy?
• If no one does security analysis, what brings
about efficiency of market portfolio?
The Capital Asset Pricing Model
• Risk Premium of Market Portfolio
• Demand drives prices, lowers expected rate of
return/risk premiums
• When premiums fall, investors move funds into
risk-free asset
• Equilibrium risk premium of market portfolio
proportional to
• Risk of market
• Risk aversion of average investor
The Capital Asset Pricing Model
• Expected Returns on Individual Securities
• Expected return-beta relationship
• Implication of CAPM that security risk
premiums (expected excess returns) will be
proportional to beta
𝐸𝐸 𝑟𝑟𝐷𝐷 = 𝑟𝑟𝑓𝑓 + β𝐷𝐷 [𝐸𝐸 𝑟𝑟𝑀𝑀 − 𝑟𝑟𝑓𝑓 ]
The Capital Asset Pricing Model
• The Security Market Line (SML)
• Represents expected return-beta relationship of
CAPM
• Graphs individual asset risk premiums as
function of asset risk
• Alpha
• Abnormal rate of return on security in excess of
that predicted by equilibrium model (CAPM)
The SML and a Positive-Alpha Stock

Source: Bodie, Kane and Marcus (2019: 199)


The Capital Asset Pricing Model
• Applications of CAPM
• Use SML as benchmark for fair return on risky
asset
• SML provides “hurdle rate” for internal projects
CAPM and Index Models
• Index Model, Realised Returns, Mean-Beta
Equation
• 𝑟𝑟𝑖𝑖𝑖𝑖 − 𝑟𝑟𝑓𝑓𝑓𝑓 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑟𝑟𝑀𝑀𝑀𝑀 − 𝑟𝑟𝑓𝑓𝑓𝑓 + 𝑒𝑒𝑖𝑖𝑖𝑖
• 𝑟𝑟𝑖𝑖𝑖𝑖 : HPR
• i: Asset
• t: Period
• 𝛼𝛼𝑖𝑖 : Intercept of security characteristic line
• 𝛽𝛽𝑖𝑖 : Slope of security characteristic line
• 𝑟𝑟𝑀𝑀 : Index return
• 𝑒𝑒𝑖𝑖𝑖𝑖 : Firm-specific effects
• 𝐸𝐸 𝑟𝑟𝑖𝑖𝑖𝑖 − 𝑟𝑟𝑓𝑓𝑓𝑓 = 𝛼𝛼𝑖𝑖 + β𝑖𝑖 [𝐸𝐸 𝑟𝑟𝑀𝑀𝑀𝑀 − 𝑟𝑟𝑓𝑓𝑓𝑓 ]
CAPM and Index Models
• Estimating Index Model
• 𝑅𝑅𝐺𝐺𝐺𝐺 = α𝐺𝐺 + β𝐺𝐺 𝑅𝑅𝑀𝑀𝑀𝑀 + 𝑒𝑒𝐺𝐺𝐺𝐺
• 𝑅𝑅𝐺𝐺 = 𝑟𝑟𝐺𝐺 − 𝑟𝑟𝑓𝑓 , excess return
• Residual = Actual return − Predicted return for
Google
• 𝑒𝑒𝐺𝐺𝐺𝐺 = 𝑅𝑅𝐺𝐺𝐺𝐺 − (α𝐺𝐺 + β𝐺𝐺 𝑅𝑅𝑀𝑀𝑀𝑀 )
CAPM and Index Models: SCL

• Security Characteristic Line (SCL)


• Plot of security’s expected excess return over
risk-free rate as function of excess return on
market
• Required rate = Risk-free rate + β × Expected
excess return of index
CAPM and the Real World
• CAPM is false based on validity of its
assumptions
• Useful predictor of expected returns
• Untestable as a theory
• Principles still valid
• Investors should diversify
• Systematic risk is the risk that matters
• Well-diversified risky portfolio can be suitable
for wide range of investors
Multifactor Models and CAPM
• Multifactor models
• Models of security returns that respond to several
systematic factors
• Two-index portfolio in realised returns
• 𝑅𝑅𝑖𝑖𝑖𝑖 = α𝑖𝑖 + β𝑖𝑖𝑖𝑖 𝑅𝑅𝑀𝑀𝑀𝑀 + β𝑖𝑖𝑖𝑖𝑖𝑖 𝑅𝑅𝑇𝑇𝑇𝑇𝑇𝑇 + 𝑒𝑒𝑖𝑖𝑖𝑖
• Two-factor SML
• 𝐸𝐸 𝑟𝑟𝑖𝑖 = 𝑟𝑟𝑓𝑓 + β𝑖𝑖𝑖𝑖 𝐸𝐸 𝑟𝑟𝑀𝑀 − 𝑟𝑟𝑓𝑓 + β𝑖𝑖𝑖𝑖𝑖𝑖 [𝐸𝐸 𝑟𝑟𝑇𝑇𝑇𝑇 − 𝑟𝑟𝑓𝑓 ]
Multifactor Models and CAPM
• Fama-French Three-Factor Model
• 𝑟𝑟𝐺𝐺 − 𝑟𝑟𝑓𝑓 = α𝐺𝐺 + β𝑀𝑀 𝑟𝑟𝑀𝑀 − 𝑟𝑟𝑓𝑓 + β𝐻𝐻𝐻𝐻𝐻𝐻 𝑟𝑟𝐻𝐻𝐻𝐻𝐻𝐻 + β𝑆𝑆𝑆𝑆𝑆𝑆 𝑟𝑟𝑆𝑆𝑆𝑆𝑆𝑆 + 𝑒𝑒𝐺𝐺

• Estimation results
• Three aspects of successful specification
• Higher adjusted R-square
• Lower residual SD
• Smaller value of alpha
Multifactor Models and CAPM

Source: Bodie, Kane and Marcus (2019: 205)


Arbitrage Pricing Theory
• Arbitrage
• Relative mispricing creates riskless profit

• Arbitrage Pricing Theory (APT)


• Risk-return relationships from no-arbitrage
considerations in large capital markets
• Well-diversified portfolio
• Non-systematic risk is negligible
• Arbitrage portfolio
• Positive return, zero-net-investment, risk-free portfolio
Arbitrage Pricing Theory

• Calculating APT
•

• Returns on well-diversified portfolio


•
Portfolio Conversion

Steps to convert a well-diversified portfolio into an arbitrage portfolio:

*When alpha is negative, you would reverse the signs of each portfolio weight
to achieve a portfolio A with positive alpha and no net investment.

Source: Bodie, Kane and Marcus (2017: 215)


Security Characteristic Lines

Source: Bodie, Kane and Marcus (2017: 216)


Arbitrage Pricing Theory
• Multifactor Generalisation of APT and CAPM
• Factor portfolio
• Well-diversified portfolio constructed to have
beta of 1.0 on one factor and beta of zero on
any other factor
• Two-Factor Model for APT
•
Constructing an Arbitrage Portfolio

Constructing an arbitrage portfolio with two systemic factors

Source: Bodie, Kane and Marcus (2017: 220)


Homework problems
• BKM chapter 7
• Problems 1, 4, 5, 24, 26, 27, 30-33
• CFA problem 3

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