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AF5353: Security Analysis &

Portfolio Management
Lecture 5
Instructor: Yong (Jimmy) JIN (jimmy.jin@polyu.edu.hk)
Office: M507D, Li Ka Shing Tower
Office Hour: Tuesday 17:20 to 18:20, 21:30 to 22:30; Friday 13:00 to 15:00
Agenda
• Capital Asset Pricing Model (CAPM)
• Security market line
• Arbitrage Pricing Theory (APT)
– Multifactor models
• Examples
What is CAPM?
• CAPM is capital asset pricing model, one of the most
fundamental concepts in investment theory.

• It is an equilibrium model that predicts return on a


stock

• To get the prediction, we need to know the expected


return on the market, the stock’s beta coefficient,
and the risk-free rate
CAPM assumptions
• Frictionless markets
– No trading costs

• Unlimited borrowing and lending


– No restrictions on short sales

• Lending and borrowing rates are the same


• Investors care only about means and variances
CAPM assumptions
• Since everyone holds the same risky tangency portfolio and
since the supply of risky assets must equal the demand, this
implies

THE TANGENCY PORTFOLIO IS


THE MARKET PORTFOLIO
• All investors will hold the same portfolio for risky assets –
market portfolio
• Market portfolio contains all securities and the proportion of
each security is its market value as a percentage of total
market value
The formula of CAPM

E[r ]  r f 
Cov(r , rM )
E[rM ]  r f 
Var (rM )
E[r ]  r f   E[rM ]  r f 
Beta
𝑐𝑜𝑣 𝑟 ,𝑟𝑀
• We refer to as beta, 
𝑣𝑎𝑟 𝑟𝑀

E[r ]  rf   E[rM ]  rf 

• Beta of a portfolio is portfolio-weighted average of


individual assets
– For example, beta of an equal-weighted average
of the individual betas
 p  0.5 X  0.5Y
Beta and expected return
• Assume risk-free rate of 3% and equity premium of
6%
• Expected return on GM assuming CAPM is true is
3%+1.269*6%= 10.61%
• In valuation applications, 10.61% would be the
discount rate in the present value formula
– Eg. If you expect GM’s price to be $50 in one year and
expect it to pay a dividend of $2, then the current fair price
is $(50+2)/(1+.1061)=$47.0
Beta and expected return
• A project has the following net after-tax cash flows ( in millions of dollars)
Year from now After-tax Cash Flow
0 -20
1 15
2 25

• The project’s beta is 1.7, rf=9%, E(Rm)=19%


• What’s the NPV of the project?
Security Market Line
E(r)

SML

E(rM)

rf


M= 1.0
Capital Market Line

E(r)

CML
M
E(rM)
rf


m
CML vs. SML
• The CML plots the relation between expected
returns and standard deviation, while the SML is a
relationship between expected returns and 

• All portfolios, whether efficient or not, must lie on


the SML. This is not true for the CML
– Investments with the same mean return can have different
standard deviations, but must have the same . In other
words, the only relevant measure of risk for pricing
securities is  (a measure of covariance)
Sample calculations using CAPM
• E(rm) - rf = .08 rf = .03
• Two securities
– x = 1.25
• E(rx) = .03 + 1.25(.08) = .13 or 13%
– y = .6
• E(ry) = .03 + .6(.08) = .078 or 7.8%
Graph of sample calculations
E(r)

SML

Rx=13%
.08
Rm=11%

Ry=7.8%

3%


.6 1.0 1.25
y x
Disequilibrium example graph
E(r)

SML

15%

Rm=11%

rf=3%


1.0 1.25
Disequilibrium example calculations
• Suppose a security with a  of 1.25 is offering
expected return of 15%
• According to SML, it should be 13%
• Since 15%>13%, this security is underpriced:
offering a high rate of return for its level of risk
Disequilibrium example calculations
• Suppose E(Rm)=12%, risk-free rate=5%
• Security A: beta=-0.5, offers an expected return of 3%
• Security B: beta=1.2, offer an expected return of 12%
• Which security is underpriced and which one is overpriced? Why?
Bottom-line
• Assumption of CAPM are restrictive
• But gives a simple and elegant relation for
expected returns
• Research shows that it is not very accurate
– Still widely used

Other factors affecting returns?


Arbitrage Pricing Theory
• Given 𝑛 factors to determine the asset returns, as follows,

𝑟𝑗 = 𝑎𝑗1 + 𝛽𝑗1 𝐹1 + 𝛽𝑗2 𝐹2 + ⋯ + 𝛽𝑗𝑛 𝐹𝑛 + 𝜖

• where 𝐹𝑘 is some systematic factor, 𝛽𝑗𝑘 is the beta, or


sensitivity to factor 𝑘, or the risk.

𝐸 𝑟𝑗 = 𝑟𝑓 + 𝛽𝑗1 𝑅𝑃1 + 𝛽𝑗2 𝑅𝑃2 + ⋯ + 𝛽𝑗𝑛 𝑅𝑃𝑛

under the no-arbitrage and prefect competition assumption.

Which one is more important?


Factors
• What are the factors?
• For example, firm size?
– Choice 1: firm size, or other characteristics
• The relationship may be nonlinear
– Choice 2: constructed long-short portfolios
• Sort all the firms according to their size, using bottom 50% average return
minus top 50% average return

• Why choice 2 is better?


– Can capture the nonlinear relationship, especially the outliers
– Risk Premium is straightforward, simply average return of the
long short portfolios
Factors
• How does the factor affect the returns?
– Depends on the (risk) exposure to different factors
• Factors can capture the variation of the returns

– The exposure is not necessarily positive


• For example, the negative coefficient of size factor means the
firm is more likely to be a large firm

– Factor model works better for explanation


• Not prediction for the future return
• Mainly discover the alpha
Fama-French Three Factor Model
• Fama-French found that size and B/M do a better job of
explaining returns, so they said the model should be:
ri  rf  i  i (rM  rf )  si ( SMB)  hi ( HML)  ei

SMB = small minus big = rsmall  rbig


HML = high B/M minus low B/M = rvalue  rgrowth

• F&F does a better job  alpha very close to zero


• Main criticism: No theory justifying why size and B/M
should be risk factors.
Fama-French Three Factor Model

ri  rf  i  i (rM  rf )  si ( SMB)  hi ( HML)  ei

SMB = small minus big = rsmall  rbig


HML = high B/M minus low B/M = rvalue  rgrowth
Important Factors
• Market Excess Return: MRP
• Size Factor: SMB
• Value Factor: HML
• Momentum Factor: MOM

• Others:
• Share Issuance: McLean, Pontiff and Watanabe (2009)
• Profitability and Investment: Fama French (2016)
• Volatility: Ang, Hodrick, Xing and Zhang (2006)
• …
0
50
100
150
200
250
300
350
400
450
196306
196603
196812
197109
197406
197703
197912
198209
198506
198803

RMW
199012
199309
199606
199903
200112
200409
200706
• Size Factor: SMB

201003
201212
• Value Factor: HML

201509

0
100
300
400
600
700

200
500
800
196306
196603
196812
197109 • Investment Factor: CMA
• Profitability Factor: RMW

197406
197703
197912
198209
198506
198803
CMA

199012
199309
199606
199903
200112
200409
0
100
300
400
500

200

200706
0
200
400
600
800
1000
1200

201003 196306
201212 196306 196604
201509 196608 196902
196910 197112
197212 197410
197602 197708
197904 198006
198206 198304
198508 198602
Fama French 5 Factors

198810 198812
SMB

HML

199112 199110
199502 199408
199804 199706
200106 200004
200408 200302
200710 200512
201012 200810
201402 201108
201406
Factors
• How many factors do we have?
– In academic papers, there are more than 200….
– For example, “… and the Cross-Section of Expected
Returns”
– “Predicting Anomaly Performance with Politics, the
Weather, Global Warming, Sunspots and the Stars”

• Why not many factors needed?


– One factor can be the noise version of the other factor
– One factor can be the linear combination of the other factors
0
5
10
15
20
25
1926
1930
1934
1938
1942
1946
1950
1954
1958

Mkt
1962
1966
1970
1974
1978
Ln(Total Wealth)

1982
1986

Selected Portfolio
1990
1994
1998
2002
2006
2010
2014
0
50
100
150
200
250
300

-100
-50

1926
1930
1934
1938
1942
1946
1950
1954
Mkt

1958
1962
1966
1970
1974
• Just based on SMB and HML two factors

1978
Annual Return (%)

1982
Stock Selection Example

1986
Selected Portfolio

1990
1994
1998
2002
2006
2010
2014
CAPM Example #1
• Given information: Assume CAPM holds

𝐸 𝑟𝐴 = 12%, 𝜎𝐴 = 25%

𝐸 𝑟𝐵 = 16%, 𝜎𝐵 = 45%

𝐸 𝑟𝐶 = 10%, 𝜎𝐶 = 30%

• The risk-free rate 𝑟𝑓 = 4%


• Also given that stock C has a β of 0.6
• Find the β of stock B
CAPM Example #1
• Our objective: find the β of stock B
• 𝐸 𝑟𝑏 = 𝑟𝑓 + 𝛽𝑏 [𝐸 𝑟𝑚 − 𝑟𝑓 ]
• _____ = ____ + 𝛽𝑏 [𝐸 𝑟𝑚 − 𝑟𝑓 ]
• _____ = 𝛽𝑏 [𝐸 𝑟𝑚 − 𝑟𝑓 ]

• We need to find the market risk premium so we use stock C


• 𝐸 𝑟𝑐 = 𝑟𝑓 + 𝛽𝑐 [𝐸 𝑟𝑚 − 𝑟𝑓 ]
• ___ = ____ + ____ [𝐸 𝑟𝑚 − 𝑟𝑓 ]
• [𝐸 𝑟𝑚 − 𝑟𝑓 ]=____

• Plug in to find the β of stock B


• ____=𝛽𝑏 ∗ _______ 𝛽𝑏 =_____
CAPM Example #2
Assume CAPM holds and use the following information:
• Portfolio A has E(r) of 15% and β of 2
• Portfolio B has E(r) of 10% and β of 1

Find the expected return on a portfolio with a β of 0.5


CAPM Example #2
• What information do we need?
– Risk-free rate and market risk premium
• What information do we have?
– Two CAPM equations for portfolio A and portfolio B

• Two equations with two unknowns, we can solve these


unknowns
CAPM Example #2
• Two equations:
𝐸 𝑟𝐴 = 𝑟𝑓 + 𝛽𝐴 𝐸 𝑟𝑚 − 𝑟𝑓
____= 𝑟𝑓 + _____ ∗ 𝐸 𝑟𝑚 − 𝑟𝑓 (1)
𝐸 𝑟𝐵 = 𝑟𝑓 + 𝛽𝐵 𝐸 𝑟𝑚 − 𝑟𝑓
____= 𝑟𝑓 + _____ ∗ 𝐸 𝑟𝑚 − 𝑟𝑓 (2)

• Subtract (2) from (1)

____= 𝐸 𝑟𝑚 − 𝑟𝑓
CAPM Example #2
• Plug this into either of the equations

____= 𝑟𝑓 + ______ so 𝑟𝑓 = _____


• Plug this into CAPM to find the return on a portfolio with a
β of 0.5
𝐸 𝑟𝑝 = ________________________
CAPM Example—Question
Assume CAPM holds and use the following information:
• Portfolio A has E(r) of 18% and β of 2.5
• Portfolio B has E(r) of 12% and β of 1.2

Find the expected return on a portfolio with a β of 1.5


CAPM Example #3
• Given the following:
– Assume CAPM holds
– The expected return on the market is 14% with a SD of 20%
– The risk free rate of return is 4%
– The expected return on stock XYZ is 17% with a SD of 40%
– The covariance of XYZ with the market is 6%
– Question asks: Is XYZ fairly priced?
CAPM Example #3
• What do we need?
– Calculate expected return of stock XYZ, and then compare with the offered return
– Beta of XYZ

• What do we have?
– Covariance of the market with XYZ
– Formula to calculate beta using covariance and variance of the market
CAPM Example #3
𝐸 𝑟𝑋𝑌𝑍 = 𝑟𝑓 + 𝛽𝑋𝑌𝑍 𝐸 𝑟𝑚 − 𝑟𝑓

• Calculate 𝛽𝑋𝑌𝑍
𝜎𝑚,𝑋𝑌𝑍
𝛽𝑋𝑌𝑍 = =
𝑉𝑎𝑟(𝑚)

• Calculate expected return of stock XYZ if CAPM holds


0.04+1.5*(0.14-0.04)=0.19 or 19% (remember this is the fair return)

• Compare with the offered return: 17%


17%<19%, future cash flows will be discounted at a lower discount
rate, therefore, the stock is overpriced.
CAPM Example --Question
• Given the following:
– Assume CAPM holds
– The expected return on the market is 14% with a variance of 8%
– The risk free rate of return is 4%
– The expected return on stock XYZ is 17% with a variance of 15%
– The covariance of XYZ with the market is 4%
– Question asks: Is XYZ fairly priced?