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DiscussionIssuesandDerivations
1. ADerivationoftheCapitalAssetPricingModel
I.EstablishtheObjectsofChoice:MeanversusVariance
Theme:Investorsareriskaverse.Theymeasurerewardusingexpectedreturnandriskusing
variance.
Underlyingassumptions:Themeanvarianceassumptioncanholdonlyif(a)allinvestorshave
quadraticutilityfunctionor(b)returnsarenormallydistributed.
Implication:PortfolioAwithhigherexpectedreturnandthesamevarianceasportfolioBwill
bepreferredtoB
II.BenefitsofDiversification
Foranydesiredlevelofrisk(s)thereexistsaportfolioofseveralassetswhichyieldsahigher
expectedreturnthananyindividualsecurity
E(Rp)=wiE(Ri)
2p=wiwjCovij
Efficientportfolios:maximizereturnsforanylevelofrisk.
Implications:(a)Everybodyshoulddiversify(b)Investorsshouldtrytoidentifyandhold
efficientportfolios(c)Thismethodhasveryheavycomputationalrequirements.
III.TheSingleIndexModel:TheLogicalLimitofDiversification
Assumptions:(a)Riskfreelendingandborrowing(b)Marketswhicharefrictionlessthereare
notransactionscosts(c)Homogeneousexpectations
Implications:(1)Theriskyportfoliothanwhencombinedwiththerisklessassetmaximizes
returnsisthemarketportfolio.(2)Everybodyholdssomecombinationofthemarketportfolio
andtheriskyasset.Howmuchofeachisheldwillbeafunctionoftheinvestor'sriskaversion.
(3)Sinceallinvestorsholdthesamemarketportfolioitmustcontainallassetsintheeconomy
inproportiontotheirvalue.
IV.TheRiskofanIndividualAsset
Step1:Individualsdiversifyandholdportfolios
Step2:Theriskofasecurityistheriskitaddstotheportfolio
Step3:Everybodyholdsthemarketportfolio
Step4:Theriskofasecurityistheriskthatitaddstothemarketportfolio.
Step5:Thecovariancebetweenanasset"i"andthemarketportfolio(Covim)isameasureof
thisaddedrisk.Thehigherthecovariancethehighertherisk.
Step6:Thismeasurecanbestandardizedbydividingbythemarketvariance.b=Covim/2m.
VariantsoftheCapitalAssetPricingModel
I.NoRisklessAsset
Basis:Ifnorisklessassetexistsinvestorscanuseaportfolioofriskyassetswhichisuncorrelatedwith
themarketportfolioinsteadastherisklessasset.Thisportfolioiscalledthezerobetaportfolio.
PropertiesoftheZerobetaportfolio
(1)Ofallthethezerobetaportfoliosthishastheminimumvariance
(2)Theseparationprincipleappliesherewiththetwoportfolios,themarketportfolioandthezero
betaportfolio,i.e.allinvestorsholdcombinationsofthetwo.
(3)Theexpectedreturnonanysecuritycanbeexpressedasalinearfunctionofitsbeta.
E(Ri)=E(Rz)+(E(Rm)E(Rz))
whereE(Rz)istheexpectedreturnonazerobetaportfolio
II.RisklessLendingbutnoRisklessBorrowing
Basis:
(a)Thereisapiecewiselinearrelationshipbetweenexpectedreturnandbetaforefficientportfolios.
(b)EfficientportfolioswiththeriskfreeassetliealongthesegmentRfTandthosecontainingonly
riskyassetsliesalongthesegmentTMC.
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III.ExistenceofNonMarketableAssets(suchasHumanCapital)
Theseparationprinciplestillholdsbut,
(a)Investorsholddifferentportfoliosofriskyassetsdependingupontheportfoliosofnonmarketable
assetsthattheypossess.
(b)Themarketpriceofriskincludesthevarianceofthemarketandthecovariancebetweenthe
marketportfolioandtheportfolioofnonmarketableassets
IV.ExistenceofTaxes
Model:Themodelconsidersdifferentialtaxesondividendsandcapitalgainsinaoneperiodcontext
whereinvestorsmaximizetheironeperiodreturns.Thefinalmodelforexpectedreturnhasadividend
component
E(Ri)=a+i(E(Rm)Rf)+c(diRf)
wheredi=Dividendyieldonasseti
Rf=Aftertaxriskfreerate
V.ExistenceofHeterogeneousExpectationsandInformation
Model:Togetstrongconclusionswehavetoassumethatallinvestorshaveacertainclassofutility
functions(ConstantAbsoluteriskaversion)andcompletemarkets(Atleastasmanyindependent
securitiesasstates).
TestingtheCAPM:IssuesandDiscussion
Issue1:TheCAPMcanneverbetestedbecausethemarketportfoliocanneverbeobserved
CentraltotheCAPMistheconceptofamarketportfoliowhichincludeseveryassetintheeconomy.
TotesttheCAPMthereforeonehastoobserveandbeabletomeasurethisefficientmarketportfolio.
IfonecannotdosoonecannottesttheCAPM.OnecannotuseofaninefficientportfolioliketheS&P
500ortheNYSE2000oreveneverystockintheeconomytoestimatebetasandtestforlinearity(like
allthestudieshavedone)because
(a)Thebetasmeasuredagainstaninefficientportfolioaremeaninglessmeasuresandcannotbeused
toacceptorrejecttheCAPMwhichisreallyatheoryaboutbetasmeasuredagainsttheefficient
marketportfolio
(b)Foreveryinefficientportfoliothereexistsasetofbetaswhichwillsatisfythelinearitycondition.
Issue2:TheCAPMisdifficulttotestonindividualassets
ThenoisinessinbetaestimatesandthefactthattheCAPMyieldsexpectedreturnsforindividual
assetsoverthelongtermmakesitdifficulttotesttheCAPMbytryingtorelateexpectedreturnson
individualassets(suchasstocks)totheirbetas.WhatmosttestsoftheCAPMdoinsteadistolookat
portfoliosofstocks,baseduponbetas,andthencomparethesebetastoexpectedreturnsinthenext
timeperiod.
MoreonFactorAnalysisandtheArbitragePricingModel
Centraltoapplyingthearbitragepricingmodelistheuseofafactoranalysis.Inatypicalfactor
analysis,webeginwithpricingdataonalargenumberofassetsoververylongtimeperiods.Inthe
factoranalysis,welookforfactorsthatseemtomovepricesonlargenumbersofassetsinunison.To
preventfactorsfrombeingdoublecounted,weensurethatthefactorsthatemergeareindependentof
eachother.Whileallofthisoccursbehindthescreenofthefactoranalysis,whatemergesasoutput
fromtheanalysisincludes:
(a)thenumberofcommonfactorsthatappearedtoaffectassetpricesovertheperiodforwhichthe
dataisavailable
(b)thebetasofeachassetrelativetoeachfactor,againusingthesamedata
(c)the"riskpremiums"associatedwitheachfactor
Thesefactorbetasandfactorpremiumsarethenused,inconjunctionwithariskfreeratetogetan
expectedreturnforanasset.
EstimatingtheMacroEconomicFactorsinaMultiFactorModel
Oncethenumberoffactorshavebeenidentifiedinanarbitragepricingmodel,thetimeseries
behaviorofeachfactorcanbederivedfromthefactoranalysis.Thesearchthenbeginsformacro
economicfactorsthatexhibitthesametimeseriesbehavior.Oncemacroeconomicfactorshavebeen
matchedupwiththeunnamedfactorsinthefactoranalysis,thebetasofeachassetarereestimated
againsttheidentifiedmacroeconomicfactors.Thebetaestimationmaybedonebyrunningamultiple
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regressionofstockreturns(foreachstock)againstchangesinmacroeconomicvariables(suchas
interestrates,inflationratesandGNPgrowth)overtime.Thecoefficientsontheseregressionsyield
thebetas,andriskpremiumscanbeestimatedalsofromthehistoricaldata.
BuildingaRegressionModel
Generally,regressionmodelsbeginwiththecrosssectionaldifferencesinreturnsacrossstocksatany
pointintime,andtrytoexplainthesedifferencesusingdifferencesonmeasurablefinancial
characteristicsofthefirmsissuingtheseassets.Asanexample,FamaandFrench,intheirmuch
quotedstudy,useddifferencesinmarketcapitalizationandpricetobookratiostoexplaindifferences
inreturnsacrossstocks.
Themoredifficultquestionisdecidingwhichfinancialvariablestouseinexplainingreturns.Thebest
placetostartistolookattheempiricalevidencethathasbeenaccumulatedovertimeonmarket
efficiencyandtheCAPM.Thisevidencesuggeststhat
Lowmarketcapitalizationstocksseemtoearnhigherreturns,onaverage,thanhighmarket
capitalizationstocks
LowPE,PBVandPSratiostocksseemtoearnhigherreturns,onaverage,thanhighPE,PBVand
PSratiostocks
Highdividendyieldstocksseemtoearnhigherreturns,onaverage,thanlowdividendyieldstocks
Whiletheinitialregressionmayincludeallofthesevariables,manyofthesevariablestendtobe
correlatedwitheachother.Thus,lowPEstockstendtoalsobelowPBVratiostockswhichpayhigh
dividends.Intheinterestsofefficiency(andtopreventproblemsintheregressionfromindependent
variablesbeingcorrelatedwitheachother),itmakessensetousethemeasurethatismosthighly
correlatedwithreturnsanddroptheothers.Thus,theuseofpricetobookvalueratiosbyFamaand
French.
Whynotusebondbetastoarriveatthecostofdebt?
Giventhatweusestockbetastoarriveatexpectedreturnsforstocks,thequestionmayariseastowhy
wedonotusebondbetastogetexpectedreturnsforbonds.Thereasonliesintheabsenceorpresence
ofsymmetryinreturnsforeachoftheseassetclasses.Stocks,whichhavepotentiallyunlimitedupside
potentialaswellassignificantdownsidepotential,havemuchmoresymmetricreturnsthanbonds.
Thus,theytendtofitinmuchmorecleanlyintothemeanvarianceframeworkthandobonds.
Corporatebondshavesomeupsidepotential,butitislimitedbythefactthatbondscanatbestbecome
defaultfree.Thus,theupsidepotentialforaAAratedbondisfairlylimited.Consequently,therisk
measurethatwehavetousehastobeadownsideriskmeasure,whichiswhatdefaultriskandratings
measure.Clearly,thelowertheratingofabond,thegreatertheupsidepotential,andthus,thegreater
thelikelihoodthatwecanestimatebondbetasandexpectedreturnsonthem.Forajunkbond,for
instance,itmaybepossibletoestimateabetalikeastockbetaandgetanexpectedreturnfromit.
CreditScoresasAlternativestoBondRatings
Bondratingsareatoolthatweusetomeasuredefaultriskandarriveatacostofdebt.Lenders(such
asbanks)havehistoricallyusedcreditscoresasameasureofdefaultrisk,especiallywhenlendingto
individualsandprivatebusinessess.Acreditscoreisderivedbymeasuringhowaborrowerscoreson
avarietyofmeasures,whichovertimehavebeencorrelatedwithdefaultrisk.

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