FINC3017 Investments and Portfolio Management Tutorial 5 Solutions Capital Asset Pricing Model

1.

How might different borrowing and lending rates affect the CAPM?

If differential borrowing and lending rates exist, the traditional capital market line fails. It is no longer a line including the risk-free asset and the market portfolio. Investors no longer consistently choose to invest in the one-market portfolio of risky assets. There are an infinite number of possible portfolios that investors would choose and their choice is now determined by their preference function. The CAPM no longer applies to pricing assets. This is apparent in the following diagram where borrowing rate is greater than the lending rate. In this case there are two lines, one for borrowing and one for lending. There is no longer a single CML given a particular efficient set and so there is no longer a unique market portfolio (tangency point), as illustrated in the figure below

` However, the zero-beta CAPM will still apply in this case, so the CAPM can survive, albeit in a slightly different form. E (ri ) E (rZB ) i E (rM ) E (rZB )

2.

Is the CAPM affected if returns are skewed?

Define skewness.

The assumption of normally distributed returns imposes the restriction of no skewness in returns but there is evidence of skewness in returns in countries around the world. The effect of skewness on investors has been modelled by Kraus and Litzenberger (1976) and requires an adjustment to the CAPM. As investors prefer positive returns to negative returns a positively skewed return distribution would be favoured over a symmetric distribution or a negatively skewed distribution. Where the distribution is positively skewed the investor has a greater probability of earning extreme positive returns than of earning extreme negative returns. This suggests the need to adjust the standard CAPM for skewness, reducing the expected return if the distribution is positively skewed and increasing the expected return if the distribution is negatively skewed. Same intuition as usual CAPM: what counts is the systematic (undiversifiable) part of skewness (called coskewness). Covariance is the contribution of the security to the variance of the well diversified portfolio. Coskewness is the contribution of the security to the skewness of the well diversified portfolio.

3.

What are the key predictions of the CAPM?

The CAPM: completely determines the expected return of the portfolio explains return variation to the exclusion of all other alternative explanatory variables predicts that there is a linear relationship in beta predicts that the beta coefficient is equal to the risk premium, (E(Rm)Rf) predicts that over long periods of time the market rate of return will be greater than the riskfree rate of return to compensate for the greater risk associated with the market portfolio. (i.e. E(Rm) > Rf). 4. What are the four main problems with testing the CAPM?

All of the tests of the CAPM run into four problems. The first problem is the requirement that an ex-ante model be tested using ex-post information. The CAPM is ex-ante in the sense that it assumes investors price assets according to their beliefs about expected returns. The tests are expost in the sense that they rely on historical data. The assumption generally made in testing is that past information will reflect expectations given a sufficiently long time period. The second problem is found in estimating expected returns for the market portfolio, individual risky assets or portfolios of risky assets and the risk-free asset. The third problem arises from observed breaches of CAPM assumptions such as the existence of transaction costs and taxes, which tend to complicate testing. The last problem arises due to the inclusion of surviving companies and the exclusion of failed companies in tests of the CAPM.

5.

Summarise the empirical evidence on the CAPM. Given your evidence, in your opinion is the CAPM a useful model?

Early tests of the CAPM generally found support for the model's predictions. For example, Blume and Friend (1973) found that a cross-sectional regression run with mean return regressed against beta estimates supported the predictions made by CAPM, but also suggested the possibility of other factors driving expected returns. However, Roll's critique cast doubt on whether any test of the CAPM was reliable. Roll argues that to test the CAPM researchers must identify the market portfolio, which is impossible as there is no observable portfolio of all risky assets. This criticism is perhaps a little extreme as econometric theory can cater for situations where a suitable proxy for the market portfolio is found but the basic problem still remains with identifying such a proxy. Later, the study of Fama and French (1992) provided perhaps the most damning evidence against the CAPM in which other factors were found to explanatory power over returns. However, doubts of where they are true sources of risk and concerns over the estimation of risk premia have slowed the death of beta. This again focuses the discussion to whether CAPM is a useful model as if we do not use CAPM to price risky assets then what is the alternative?