The CAPM and Security Market Line The CML equation allows us to predict the expected rate of return

for all portfolios along the capital market line, but cannot be used to predict the return for securities which lie in the interior of the portfolio opportunity set (Figure 11.1)

Capital assets pricing model (CAPM) may be used to explain the required rate of return on all securities whether or not they are efficient The CAPM equation is E(Rj) = RF + [E(RM RF) j Where, E(Rj) = the expected return on jth risky assets RF = the rate of return on riskless asset E(RM) = the expected return on the market portfolio Bj = COV(Rj,RM)/VAR(RM) The CAPM is graphed in Figure 11.2 (b) (12)

The relationship between CML and SML The CML equation is

E(Rp) = Rf + [{E(RM)-Rf}/M] (Rp) (11)

The CAPM equation is E(Rj) = RF + [E(RM RF)] j Where, j = Cov(Rj,RM)/ 2M Rewriting the SML by using the definition of j, we have SML = E(Rj) = RF + [E(RM RF)] [Cov(Rj,RM)/ 2M] It can be rewritten as SML = E(Rj) = RF + [{E(RM RF)}/M] [Cov(Rj,RM)/ M] (12b) Equation 12b shows that the market price of risk per unit of risk is the same for the SML and CML Recalling Cov(Rj,RM) = jM jm, the SML equation can be written as SML = E(Rj) = RF + [{E(RM RF)}/m] [jM jm/ m] Which can be further reduced to SML = E(Rj) = RF + [{E(RM RF)}/m] [jM j] (12a) (13) (12)

Factors affecting beta Nature of business Financial leverage Other factors (dividend payout, liquidity, firm size, rate of growth, etc)

Derivation of CAPM Application of CAPM

Extension of CAPM Empirical Evidences on the CAPM Is CAPM theory empirically valid? The evidence is mixed The empirical analog of the CAPM is Rjt = RFt + (RMt RFt) j + jt (14)

The three differences between the above equation and theoretical equation (eq. 12) are The time subscripts have been added The expectation operator E has been dropped An error term, jt, has been added The model is tested in the following form Rjt - RF = a + b j + jt (15)

This equation is same as equation 13 except that the risk-free rate has been subtracted from both sides and an intercept term, a, has been added. It the CAPM is true, then The intercept term should not be significantly different from zero

Beta should be the only factor which explains the rate of return on a risky assets (ie other factors such dividend payout, firm size, p/e ratio should have no explanatory power). The relationship should be linear in beta. The coefficient of beta should be equal to RMt RFt

When the equation is estimated over long period of time intervals, the rate of return on the market portfolio should be greater than the riskfree rate (because market portfolio is riskier).

Major empirical studies Friend and Blume (1970), Black, Jensen and Scholes (197), Miller and Scholes (1972), Blume and Friend (1973), Fama and Macbeth (1973), Basu (1977), Banz (1981), Fama and French (1992, 1996), etc. Most of the studies:

Take monthly total return of listed common stock

Estimate betas of every security during a five year holding period Compute covariance between security and equally weighted index of all listed stocks Securities are ranked by beta and placed in N portfolios

Regression is run between portfolio beta and return is run

The empirical studies agree on the following conclusions. The intercept term, a, is significantly different from zero, and the slope, b, is less than the difference between the return on the market portfolio and the risk-free rate. Versions of the model which include unsystematic risk find that at best these explanatory factors are useful only in a small number of time periods sampled. Beta dominates them as a major of risk. The simple linear model fits the data best. Returns are linear in beta. Factors other than beta are successful in explaining the portion of security returns not captured by beta Fama and French (1992) Study

ARBITRAGE PRICING THEORY

One of the problems with using the CAPM is that only a single factor, the market portfolio, is used to explain the security returns The arbitrage pricing theory (APT) allows us to use many factors Like the CAPM, the APT is an equilibrium model as to how security prices are determined This theory is based on the idea that in competitive financial markets arbitrage will ensure that riskless assets provide the same expected return Arbitrage simply means finding two things that are essentially the same and buying the cheaper and selling the more expensive The model is based on the simple notion that security prices adjust as investors form portfolios in search of arbitrage profits When such profits opportunities are exhausted, security prices are said to be in equilibrium The APT suggests that the market equilibrium process is driven by individuals eliminating arbitrage profits The model does not tell us what the factors are or why they are relevant It merely states that there is a relationship between security returns and a limited number of factors. Accordingly, the basic model is:
Ri = E(Ri) + bi11 + bi22 + .. + bikk + i for i = 1 to n Where: Ri = the actual return on asset i during a specified time period, 1 = 1, 2, 3, n E(Ri) = the expected return for asset i if all the risk factors have zero changes bij = the reaction on asset is return to movements in a common risk factor j k = a set of common factors or indexes with a zero mean that influences the returns on all assets

i = a random error term n = number of assets

Explanation of j and bij terms are the multiple risk factors expected to have an impact on the returns of all assets. Examples inflation, growth in GDP, changes in interest rates, etc bij terms determine how each asset reacts to the jth common factor. For example, all assets may be affected by growth in GDP, the impact to a factor will differ. Stocks of cyclical firms will have larger bij for growth in GDP than for noncylical firms. The APT requires that in equilibrium the return on zero-investment, zero-systematic-risk portfolio is zero. E(Ri) = 0 + 1bi1 + 2bi2 + .. + kbik Where: 0 = the expected return on an asset with zero systematic risk 1 = the risk premium related to the jth common risk factor bij = the pricing relationship between the risk premium and the asset (the responsiveness of asset i to the jth common factor Comparing the CAPM and the APT
CAPM Form of equation Number of risk factor Factor risk premium Factor risk sensitivity Zero-beta return Linear 1 [E(Rm) Rf] i Rf APT Linear Greater than or equal to 1 j bij 0

Consider the following example of two stocks and two-factor model with following risk factor definitions and sensitivities
1 = unanticipated changes in inflation and the risk premium related to this factor is 2 percent (1 =0.02) 2 = unanticipated changes in growth rate of real GDP and the risk premium related to this factor is 3 percent (2 =0.03) 0 = the rate of return of zero-systematic risk asset is 4 percent (0 = 0.04)

Assume further that there are two assets (X and Y) that have the following response coefficients to the common risk factors: bx1 = the response of assets X to changes in the inflation factor is 0.50 (bx1 = .5) bx2 = the response of assets X to changes in the GDP factor is 1.5 (bx2 = 1.5) by1 = the response of assets Y to changes in the inflation factor is 2 (by1 = 2) by2 = the response of assets Y to changes in the GDP factor is 1.75 (by2 = 1.75) The expected return equation is E(Ri) = 0 + 1bi1 + 2bi2 = 0.04 + (0.02) bi1 + (0.03)bi2 Therefore, for asset x and y: E(Rx)= 0.04 + (0.02) (0.05) + (0.03)(1.5) = 9.5% E(Ry)= 0.04 + (0.02) (2.0) + (0.03)(1.75) = 13.25% If the prices of the two assets do not reflect these expected returns, we would expect investors to enter into arbitrage arrangements whereby they would sell overpriced assets short and use the proceeds to purchase the under priced assets until the relevant prices are corrected.

Security Valuation with the APT Suppose that three stocks (A, B and C) and two common systematic factors (1 and 2) have the following relationship: E(RA) = (0.8) 1 + (0.9)2 E(RB) = (-0.2) 1 + (1.3)2 E(RC) = (1.8) 1 + (0.5)2 (note for simplicity, it is assumed that zero-beta return (0) equals zero) If 1 = 4% and 2 = 5%, then the returns expected by the market over the next year can be expressed as: E(RA) = (0.8) (4%) + (0.9)(5%) = 7.7% E(RB) = (-0.2) (4%) + (1.3)(5%) = 5.7% E(RC) = (1.8) (4%) + (0.5) )(5%) = 9.7% If we further assume that all three stocks are currently priced at $35 and will not pay a dividend over the next year, the expected price of the stocks will be: E(RA) = $35(1.077) = $37.70 E(RB) = $35(1.057) = $37.00 E(RC) = $35(1.097) = $38.40 Now suppose you know that in one year the actual price of stocks A, B and C will be $37.2, $37.80 and $38.50. What will you do? Since the stocks are mispriced (A is overvalued, B and C are undervalued), an investment strategy to take advantage of mispricing need to consider purchasing stocks B and C and while selling short stock A. The idea of riskless arbitrage is to assemble a portfolio that: Requires no net wealth, Will bear no risk, but

Still earns a profit. To illustrate the process, consider the following investment proportion WA = -1.0 WB = 0.5 WC = 0.5 These investment weights imply the creation of a portfolio that is short two shares of stock A for each one share of stock B and C. Net initial investment: Short 2 shares of A Purchase 1 share of B Purchase 1 share of C Net investment +70 -35 -35 0

Net exposure to risk factors

Factor 1 Weighted exposure from stock A Weighted exposure from stock B Weighted exposure from stock C Net risk exposure (-1.0)(0.8) 0.5)(-0.2) (0.5)(1.8) 0 Factor 2 (-1.0)(0.9) (0.5)(1.3) (0.5)(0.5) 0

The net profit will be: [2(35)-2(37.20)] + [37.80-35] + [38.50-35] = $1.90 Thus, from a portfolio in which you invested no net wealth and assumed no net risk, you have realized a positive profit.

Roll and Ross and Their Five Factors The five factors are Change in expected inflation Unanticipated changes in inflation Unanticipated changes industrial production Unanticipated changes in yield differential between low- and highyield bonds (the difficult risk premium) Unanticipated changes in the yield differential between long-term and short-term bonds (the term structure of interest rates)

***