IM3 Asset Pricing Models

Warwick Business School
Vikas Raman
Outline
Reviewing the CAPM
Using the CAPM
estimating beta and the market risk premium
Testing the CAPM
Rolls critique
Results
Factor models
the market factor model
APT
Fama and French Three-Factor Model

CAPM
If everyone should be holding the market (plus cash, or borrowing), then
no one holds or wants to hold idiosyncratic risk
it follows that you only get rewarded for holding market risk but not for
holding idiosyncratic risk:
you get r
f
interest for lending money without risk
you get E[r
M
] for holding the market
which means you get a premium of E[r
M
] - r
f
for taking the risk of the market
which means you should get a premium of b(E[r
M
] - r
f
) for taking the market risk
of a share with a beta of b
which means you should expect a return of
E[r
Y
] = r
f
+ b(E[r
M
] - r
f
)
for holding share Y

The CAPM
Suppose you were a CAPM-style investor holding the world wealth
portfolio, and someone offered you another stock to invest in.

What rate of return would you demand to hold this stock?

The answer before the CAPM might have depended upon the standard
deviation of a stock's returns. After the CAPM, it is clear that you care
about the effect of this stock on the TANGENCY portfolio.

The lower the average correlation a stock has with the rest of the assets
in the portfolio, the lower its expected return!
A Revision Question
Suppose that you are holding a portfolio M and somebody
offers you a share i, under what conditions would i help
improve your portfolio?
we are looking for a precise answer: ALPHA

Precise Answer: compute

i
= E[R
i
] {R
F
+
i
(E[R
M
] - R
F
)}
if
i
> 0, you can improve your portfolio by buying Y
if
i
< 0, you can improve your portfolio by short-selling Y
if
i
= 0, you should neither buy nor short Y

Jensens Alpha
On the SML:
i
E[R
i
]
R
F
M
0
E[R
M
]
1
E[R
M
]-R
F
E[R
B
]
E[R
A
]
B
A
B
C
A is below the SML. It
has a negative alpha.

Which one would you
buy and which one
would you short?
A
< 0
B
> 0
B is above the SML.
It has a positive alpha.
Jensens Alpha
Definition:
i
= E[R
i
] {R
F
+
i
(E[R
M
] - R
F
)}

According to CAPM, equilibrium asset prices should make
Jensens alpha equal to zero for any asset.

An asset with
i
> 0 offers expected return higher than the
equilibrium. This asset is an attractive investment and
therefore it must be underpriced.

An asset with
i
< 0 offers expected return lower than the
equilibrium. This asset is not an attractive investment and
therefore it must be overpriced.

Hence, Jensens alpha is an important performance measure.

Implications
If the portfolio M is mean-variance efficient, then by definition it cannot be improved by
adding or subtracting any share to it
so for any share Y, a
Y
= 0 , so:

Note 1: this is not some prediction or some theory that depends on efficient markets,
rational investors, absence of taxes etc. It is a simple mathematical consequence of M
being mean-variance efficient
Note 2: it holds whether the means, correlations and standard deviations are:
market consensus about the future,
my own subjective beliefs about the future based on my prejudices and private
information
the historic (realised) behaviour of prices
though of course the portfolio M will differ in each case as will the interpretation of m
Y

Usage of CAPM ( common sense)
Valuation
the value of a company is the value of the cash flow it generates
forecast the cash flows of the company
estimate the beta of the cash flows
use the CAPM to get the discount rate: ( Peter Corvi)

Portfolio Construction
identify securities which are mispriced off the SML
use portfolio optimiser to construct portfolio
Performance Measurement
see next week
Need to estimate beta and market risk premium

b Market Risk Premium
F
DR r
Market Risk Premium estimates from
fundamentals
Dividend growth models
value of share is present value of future dividends
if dividend share of GDP bounded, long run dividend growth limited by growth
in economy
MRP = return on equities interest rate
= dividend yield + dividend growth interest rate
dividend yield say 4%
dividend growth = GDP growth say 2%/year real
real interest rate say 2%
gives MRP of say 4%
Assumes that return to holders of shares comes solely and entirely from
dividends, but if return comes from capital repayments (eg cash takeovers,
share buybacks) or if substantial new share issues, argument does not
work

fundamentals
Implied MRP
Value of equity = Expected Earnings Next Period/Required Return on Equity
MRP = Required Return on Equity Interest Rate

Example:
If S&P 500 Index is at 900 and the expected earnings next period (value
weighted average of all companies that constitute the index) is 9000, then
required rate of return on the US market (proxied by S&P 500) is 10%.
If the risk-free rate is 4%, then MRP = 10% - 6% = 4%
fundamentals
From economics of risk aversion
The market risk premium exists to compensate people for the risk of the
market
so the more risk there is in the economy, and the more people dislike risk, the
higher the equity risk premium should be per unit of equity risk
risk aversion is measured by the risk aversion coefficient; 0 is indifference to risk,
and the higher the number the more risk averse people are
experiments suggest that typical risk aversion is about 3 implies that someone
with wealth of 100 would be indifferent if offered a gambel which could equally
well send them to 90 or 114 (see next slide)
looking at consumption per head suggests that people do not face much risk in
aggregate consumption growth varies by about 1% per annum
Mehra and Prescott (1985) show in a simple model that the equity risk premium
should equal market volatility (say 16%) x risk aversion coefficient (3) x volatility
of consumption (1%) = 0.5% per annum the Equity Premium Puzzle

Risk Aversion (NFE)
Economists assume people
maximise the expected utility of
wealth, where utility increases with
wealth, but at a decreasing rate
A standard utility function is power
utility, U(W) = W
1-g
/(1-g) where g is
the risk aversion coefficient
With g = 3, U(90) = -90
-2
/2= -6.2E-5;
U(100) = -5.0E-5; U(114) = -3.8E-5
so 50% 90 + 50% 114 has same
utility as 100
60 80 100 120 140
U
t
i
l
i
t
y
Wealth
Power Utility
Source: Barclays Equity Gilt Study 2004
(figures for UK).
Some Data
The Market Risk Premium - Empirical
Issues with historical premium.:
need very long run (standard error is
M
/T; with market volatility of
say 16%, need 250 years to be 95% confident of being 2%/yr);
quality of data, tax issues
time-varying? (development of much more sophisticated financial
markets, changing levels of risk);
survivorship bias
tend to focus on US
what about markets that disappeared?
what about disappeared asset classes?
is current state of world as good as might have been expected at the
outset?

Estimating Beta
Estimate historical beta using regression:
regress r
i,t
-r
F,t
on r
M,t
-r
F,t
(but in practice can do with returns rather than excess
returns, unless interest rates are very volatile)
use shorter return intervals to get more data, but problems with thin trading,
bid-ask bounce, stale prices if too frequent
use long data run to get more data, but problems with stability if too long
For individual share, may use monthly returns over 60 months, or weekly
returns over 1 year
but assumes reasonably liquid market
For portfolio, can use much more frequent data, shorter runs
because idiosyncratic risk of portfolio much smaller than of
individual share
Estimating Beta in Practice
Take BP shares, and
estimate beta regressing
returns against FTSE
estimates depend on whether
using daily or weekly returns
is it really varying?
estimate 5% confidence
intervals using 2 stand errors
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2004 2005 2006 2007 2008 2009 2010
B
e
t
a

(
+
/
-

2

s
d
e
v
s
)

BP's beta against the FTSE-100
based on daily returns over 250 days
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2004 2005 2006 2007 2008 2009 2010
B
e
t
a

(
+
/
-

2

s
d
e
v
s
)

BP's beta against the FTSE-100
based on weekly returns over 250 days
What the CAPM says
The only empirical prediction of the CAPM is that the market
portfolio is ex ante efficient
cannot construct a portfolio today that can be expected to have a higher
return, lower volatility in future than the market portfolio
Ex ante and ex post
Given returns on securities over a period, can compute actual means and
standard deviations
can identify portfolios that would have given maximum return for minimum risk
these are the ex post efficient portfolios (ex post because the portfolio can only
be identified afterwards)
heavily weighted towards stocks that happen to have done well
CAPM is about constructing portfolios that are expected to have maximum
return for given risk
CAPM asserts only that the market portfolio is efficient ex ante (that is, using
information you can use to construct a portfolio in advance)
market portfolio is unlikely to be efficient ex post
CAPM says that no method of constructing a portfolio that does not involve
foresight on average produces higher return for less risk than the market
portfolio
The Roll Critique (Roll 1977)
The only economic content to the CAPM is the assertion that the market
portfolio is ex ante efficient
But the market portfolio is unobservable in practice it consists of all
investor wealth
To test the CAPM need a proxy say some index
tests may support the CAPM because the proxy is efficient even if the market
portfolio is not
tests may reject the CAPM because the proxy is not efficient even if the market
portfolio is
The critique does not say the CAPM is wrong or meaningless
but to use and test the CAPM need to commit to some proxy for the market
generally use the market-weighted domestic equity index (though could
consider other possibilities)
Source: Fama and French, 2004

Early tests (Black, Jensen, Scholes, 1972, Fama and MacBeth, 1973) showed beta was
priced, that idiosyncratic risk was not priced, but that the expected return on a zero
beta portfolio is significantly greater that r
F
.

But recent evidence finds a very flat relationship between Beta and returns:
relationship is not as strong as the theory suggests.
How Does the CAPM Perform
Empirically?
Empirically?
Also, a great deal of anomalous evidence has
come out suggesting that things other than beta
are important in determining expected returns:
The Small Firm Effect (Keim, 1981)
The Book-to-Market Effect (Stattman, 1980; Rosenberg, et
al., 1985)
The Momentum Effect (Jegadeesh and Titman, 1993)
Empirically?

Source: Mertens (2002) (http://www.elmarmertens.com/lecturenotes/financenotes)

Empirically?
B/M Quintile
Monthly excess returns sorted by Size and B/M quintiles
Source: Fama and French (1993)
Why does the CAPM not work well?
Have actually made some very strong assumptions
Investors only care about mean and variance: but may worry about skew would you
rather:
200 (Pr 10%) 120 (Pr 90%)
100 or 100 ?
100 (Pr 90%) 20 (Pr 10%)
(Both the gambles have the same mean and standard deviation, but differ in skewness)
all investors care only about risk to wealth next period: but if I am a long term investor I
may prefer an investment that pays more if say interest rates are low next period and less
if they are high
all investors are indifferent to tax: but some investors may prefer to receive return as
capital gain rather than dividends for tax reasons
the stock market is the sum of wealth: but there is a lot of other wealth (real estate, bonds,
human capital) and theory says that beta should be estimated on entire wealth portfolio
no transaction costs and unlimited shortselling: but stock market participation is limited,
and it is not possible to short sell ones human capital
Other Issues
Investors have a common information set and interpret it
rationally: but not clear how rational agents should form
expectations about future events, and significant evidence
that investors have biases, bounded rationality
Tests tend to assume stability of parameters: evidence of time
varying market price of risk, beta
Many models that try to relax one or other assumption:
models tend to introduce other priced factors (such as dividend yield,
sensitivity to other economic variables apart from the market return)
no consensus on a better model
CAPM remains as a flawed standard
Equilibrium Models
So far looked at equilibrium models
characterise demands of investors and find prices for securities that
brings supply/demand equilibrium
but empirical results are disappointing
maybe we are being too ambitious given that demands are affected by
complex factors
beliefs, fears, superstitions
different endowments, horizons and objectives
existence of substitutes (housing, human capital)
institutional frictions (herding, league tables)
Try a more limited approach: start with a simple description and then
explore the impact of arbitrageurs (prices may not be right, but they
should not allow easy certain profits)

Arbitrage Pricing Theory
An arbitrage opportunity arises when an investor can earn
riskless profits without making a net investment.
The law of one price states that if two assets are equivalent in
all economically relevant respects, then they should have the
same market price.
During the arbitrage activity, investors will bid up the price
where it is low and force it down where it is expensive. As a
result they eliminate the arbitrage opportunities.

Security prices should satisfy a no-arbitrage condition.
APT (Ross, 1976) predicts a security market line as
CAPM and shows a linear relation with expected
return and risk.
According to APT:
Security returns are described by a factor model
There are sufficient securities to diversify away idiosyncratic
risk
Well-functioning security markets do not allow for the
persistence of arbitrage opportunities
There are no taxes.
There are no transaction costs.
Notice that there are considerably fewer than with the CAPM.

Single Factor Model
A first attempt at characterising behaviour of returns
use excess returns (ie actual risk free rate) for ease
In SFM, assume return is a linear function of some factor common to all stocks,
and idiosyncratic noise: so R
i,t
= a
i
+ b
i
F
t
+ e
i,t
b
i
is a constant, measures is sensitivity to the factor F (will assume +ve);
E[e
i,t
] = 0, so e is noise;
Cov[F
t
, e
i,t
] = 0, so e is idiosyncratic;
With F equal to the market return, this model is called the Market Model
Suppose we have enough history and the as and bs are stable enough that we
(and everyone else) can estimate them accurately: how would we make up a good
portfolio? (assuming we want maximum return for minimum risk)

Optimum Portfolio
Obvious strategy:
the attractive shares are those that have a high a per unit of
b buy them
sell the shares that have a low a per unit of b
ensure that you end up with zero beta net
end up with high alpha portfolio, no factor exposure, and
just idiosyncratic risk
if you avoid putting too much in one share, you will have
diversified away almost all the idiosyncratic risk
so you will have a staggeringly good deal!
Simple Example
1000 G shares with a = 6%, b = 1, and
idio
= 20%
1000 B shares with a = 5%, b = 1, and
idio
= 20%
I go short 1 of each of the B shares, and go long 1 each of
the G shares
the portfolios beta = 0
the expected return is 6% on 1000 5% on 1000 = 10
this looks a fantastic deal

APT: securities must be priced such that these
arbitrage strategies are not profitable.
The risk-premiums of well-
diversified portfolios with
different betas should be
proportional to their betas.
The expected return on all
well-diversified portfolios must
lie on the straight line from the
risk-free asset.
The equation of the line will
also show the expected return
on all well-diversified
portfolios.
Take M, market index portfolio
as a well-diversified portfolio.
Since M is well-diversified,
should be on the line and its
beta is 1.
Thus, the equation of the line
is:
E[r
Y
] = r
f
+ b(E[r
M
] - r
f
)

The CAPM is an example of a
one-factor APT model

Identification of factors
APT fails to offer any guidance on either the number of factors or their
identity they have to be estimated empirically
Can deduce the factors by doing a factor analysis on security returns
factor analysis finds the best groupings of securities that minimises the variance
of residual returns
Roll and Ross (1980) identified at least three significant factors (using 42
portfolios of 30 US stocks, daily returns, 1962-72)
Alternatively, can pre-specify factors likely to be important. Chen, Roll and
Ross (1986) suggest that four most important factors are the
unanticipated changes in
inflation
slope of term structure (difference between long and short rates of interest)
risk premium on corporate debt (difference in yield between low and high
grade debt)
industrial output.
Three factor empirical model
(Fama and French ,1993)
The factors:
Return on the broad market
index (M)
Return on the portfolio long in
small stocks, short in big stocks
(small minus big, or SMB)
Return on the portfolio long in
high BM-ratio stocks, short in low
BM-ratio stocks (high minus low,
or HML)

] [ ] [ ] [ ] [
HML HML SMB SMB M M I
R E R E R E R E b b b
What do these factors measures?
SMB: measure of size risk
small companies logically should be expected to be more
sensitive to many risk factors as a result of their relatively
undiversified nature and their reduced ability to absorb
negative financial events.
HML: measure of distress risk
high B/M is usually an indication that their public market
value has plummeted because of hard times.
would be exposed to greater risk of bankruptcy than their
more highly valued counterparts.
Other interpretations?
APT vs. CAPM
APT looks like a multi-beta CAPM, with the expected excess return being
the product of a beta showing the exposure to a risk source, and a k being
the price of risk
also assumes frictionless markets, with shorting, borrowing etc
But the assumptions are different:
APT places no restrictions on what the factors are nor on the price of factor risk
exposure
multi-beta CAPM requires that factors enter into utility functions and economics
may well suggest plausible ranges or signs for factor prices
CAPM is an equilibrium theory so uneconomic agents will change the result;
APT makes no assumptions about other players
However, tendency to give economic interpretations to factors blurs
distinction

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.
There is exactly one well-diversified portfolio in the
CAPM: the market.
There can be more than one in the APT.
APT vs. CAPM
Summary
Two approaches to risk-return:
equilibrium model of CAPM and derivatives
factor models such as Market model and APT

Equilibrium models identify the factors and justify why they should attract a
premium gives more confidence that premium will persist
Factor models unconstrained in choice of factors, so can fit data more readily, but
do not explain why they should attract risk premia
Both types of model imply a distinction between systematic and idiosyncratic risk,
with the latter not being rewarded
No consensus about the right model
Key issues in applying models (beta estimation, estimation of risk premia) common
to all
Reading: BKM Chs 9-11

IM3 Asset Pricing Models

Diunggah oleh

Informasi Dokumen

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

IM3 Asset Pricing Models

Diunggah oleh

Hak Cipta:

Format Tersedia

Warwick Business School

Anda mungkin juga menyukai