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risk and return

Table of Contents

Learning outcomes .................................................................................................................... 2

Essential reading........................................................................................................................ 2

1. Introduction ........................................................................................................................... 3

2. Risk and return of a single financial security ........................................................................ 4

2a. Empirical evidence on risk, return and their relationship ................................................ 7

3. Risk and return of a portfolio: portfolio analysis ................................................................ 11

4. Benefits of diversification ................................................................................................... 14

5. Mean-standard deviation portfolio theory ........................................................................... 17

5a. Efficient frontier and optimal portfolio with no risk-free asset ..................................... 18

5b. Mean-standard deviation frontier with arbitrary correlation (ρ).................................... 25

5c. The introduction of a risk-free asset: the capital market line......................................... 26

6. Asset pricing models ........................................................................................................... 29

7. Capital Asset Pricing Model (CAPM) ................................................................................. 30

7a. Security market line ....................................................................................................... 36

7b. Diversifiable risk and market risk ................................................................................. 38

7c. Theoretical and practical limitations of the CAPM ....................................................... 40

8. Arbitrage Pricing Theory (APT) ......................................................................................... 43

8a. Factor models ................................................................................................................ 43

8b. Arbitrage Pricing Theory ............................................................................................... 46

8c. Theoretical and empirical validation of the APT........................................................... 49

Page 1 of 49

Chapter 8: Securities and portfolios - risk and return - Learning outcomes

Learning outcomes

By the end of this chapter, and having completed the essential readings and activities, you

should be able to:

explain how risk affects the return of a risky asset, and hence how risk affects the value of

the asset in equilibrium

calculate risk and return for individual securities and portfolios, and understand the basic

statistical tools of expected returns, standard deviations and covariances

explain the mean-standard deviation portfolio theory, and the meaning of its key concepts

(efficient frontier, feasible region, capital market line, and optimal portfolio)

illustrate the effects of diversification

explain the main assumptions and results of the CAPM

illustrate the key concepts of the CAPM (beta and security market line)

explain the main assumptions and results of the APT

compare the theoretical and empirical validation of the CAPM and APT.

Essential reading

Brealey, Myers and Allen 2010. Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate

Finance. (Boston, London: McGraw-Hill/Irwin, 2010) tenth edition Chapters 7 and 8.

Mishkin and Eakins 2009. Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston,

London: Addison Wesley, 2009) Chapter 4.

Page 2 of 49

Chapter 8: Securities and portfolios - risk and return - 1. Introduction

1. Introduction

Study Guide, pp. 160

In light of the main function performed by financial markets – to channel funds from saver-

lenders to spender-borrowers (as discussed in Chapter 2) – we now turn to the pay-off

required by saver-lenders when they invest in the financial assets (securities) issued on the

financial markets by the spender-borrowers (such as industrial firms) to finance their

investments in real assets (discussed earlier in Chapter 7).

Two main attributes characterise the pay-off of a security: return and risk.

But thus far we have said little about where the expected return used in the valuation methods

(as explained in Chapter 7) comes from, or about the relationship between the two attributes.

The objective of this chapter is to demonstrate how the risk of a security affects the return

required for it, and hence how risk affects the value assigned to the security in equilibrium.

Page 3 of 49

Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial

security

Study Guide, pp. 160 – 161

Mishkin and Eakins 2009, pp. 72 – 74

Brealey, Myers and Allen 2010, pp. 191 - 194

Risk and return are the two main attributes of a financial security.

The actual return of a security is the amount received divided by the amount invested.

Uncertain return

However, when securities are originally acquired, their returns are usually uncertain because

their prices are subject to changes.

For instance, say I bought shares in XYZ company in 2000 expecting a return of 10 per cent

per annum for 7 years.

Instead, my return was –20 per cent. Can you see that the actual return is –20 per cent, not

what I had hoped to get?

This implies that a variety of return outcomes are likely to exist, each occurring with a

specific probability.

Accordingly, the return measure of a risky asset is considered to be a random variable.

For analytical purposes the uncertainty of the return is measured by the expected (average)

return.

To provide a quantitative measure of the expected return we normally use the weighted average of all

possible returns, where the weights are the probabilities of occurrence of that return.

Formally, this is (Eqn 8.1):

E ( R) p1 R1 p2 R2 ... pn Rn (8.1)

where:

E(R) = expected return

Ri = return of the state of nature i

n = number of possible states of nature (outcomes)

pi = probability of occurrence of the return Ri.

Note that returns and their probabilities are not usually known.

Page 4 of 49

Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial

security

However, in practice, historical average returns and number of past observations are often used as

proxies.

Figure 8.1 shows a typical distribution for historical returns on stocks in major corporations. Each point

of the curve represents a stock.

Based on past performance in the overall market, we estimate that the expected return is 13 per cent.

We recognise that there can be significant deviations from the mean (13 per cent).

In fact it is quite possible that return could be –10 per cent in one year and +35 per cent in the next year.

(Note that the return can become arbitrarily large, but can never be less than –1, which represents the

complete loss of the original investment in the stock.)

The variation around the expected return is a measure of the risk of a security. This is a measure of

how far the actual return differs from the expected return.

To provide a quantitative measure of the degree of possible deviations from the expected return we

normally use a measure of dispersion of a distribution of historical returns: the variance.

We frequently use the square root of the variance, called standard deviation. The standard deviation

is a statistical measure of how variable the returns are around the average return.

Deviation = Ri - E(R)

More formally, to calculate the standard deviation of returns we need to calculate the expected return

E(R), then to subtract the expected return from each return to get a deviation.

Then we square each deviation and multiply it by the probability of occurrence of that outcome.

Finally we add up all these weighted squared deviations and take the square root, that is:

p1 ( R1 E ( R)) 2 p2 ( R2 E ( R)) 2 ... pn ( Rn E ( R)) 2 (8.2)

Page 5 of 49

Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial

security

The higher the standard deviation, the greater the variability, and hence the higher the risk.

Example: Consider First Class, a stock with a return of 24 per cent one-half of the time and 10 per cent

one-half of the time.

The expected return is 17 per cent (=0.5*0.24+0.5*0.10).

The standard deviation is 7 per cent:

Activity 8.1

Consider Second Class, a stock with a return of 16 per cent two-thirds of the time and 9 per cent one-

third of the time. Then answer the following questions:

Is the Second Class stock more or less risky than the First Class stock?

Page 6 of 49

Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial

security

relationship

Study guide, pp. 162 - 164

What are the levels of risk and return of financial securities around the world? The next activity enables

you to find out some empirical evidence on risk and average returns associated with different classes of

securities (stocks and bonds) for different countries.

Activity 8.2

Download the Credit Suisse Global Investment Returns Yearbook 2010, available at:

http://tinyurl.com/DMS2010

Carefully read the country profiles for the 19 countries focusing on figure 3 in each profile which shows

the returns and risks of major asset classes from 1900 to 2009.

The empirical evidence provided in the ‘Global Investment Returns Yearbook 2010’ shows both real and

nominal returns.

(Note that the difference between nominal and real performance rates arises because the purchasing

power of income is reduced by inflation.)

Among the 19 countries under investigation over 110 years, the best performer for stocks over the very

long term is Australia, with an annualised percentage real return of 7.5 per cent since 1900, compared

to a world average of 5.4 per cent.

The worst performer for stocks is Italy with an annualised percentage real return of about 2.1 per cent

since 1900.

The best performer for bonds is Denmark, with an annualised percentage real return of 3.0 per cent

since 1900, compared to a world average of 1.7 per cent.

The worst performer for bonds is Germany, with an annualised percentage real return of about –2.0 per

cent since 1900.

Let us now focus on the USA. To find out the risk and average returns associated with different classes

of securities in the US market, move to the next activity.

Page 7 of 49

Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial

security

Activity 8.3

Visit the Morningstar website at

http://corporate.morningstar.com/ib/documents/SampleContent/MktChartsImages.pdf and analyse the

figure ‘Stock, Bonds, Bills and Inflation’.

This Morningstar’s figure shows the amount available in 2006 by investing $1 at the start of 1926 in

each of the four security classes (small companies’ stocks, large companies’ stocks, government bonds

and Treasury bills). Values take into account inflation (i.e. real returns).

By 2006, the performances in real terms are (in increasing order):

long-term government bonds grew to $71,

large stocks grew to $5658, and

small stocks grew to $13796.

The performance of each security class coincides with the intuitive risk ranking.

Following on, we turn our attention to the relationship between risk and return.

Figure 8.2 shows the risk and return of US financial instruments over the period 1926–2000.

risk is measured as risk premium, i.e. the extra return versus Treasury bills

return is measured by the average nominal and real annual rate of return

Treasury bills were the least profitable (3.9 per cent nominal annual rate of return), but

were also virtually risk-free (0 per cent risk premium).

Common stocks obtained the highest average return (13 per cent nominal annual return),

but also experienced the highest risk (9.1 per cent risk premium).

Page 8 of 49

Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial

security

A first interesting fact about the relationship between risk and return emerges: this relationship is

positive. In other words, the performance of each security class increases with the risk ranking.

This occurs because investors require compensation for bearing risk.

The higher the risk associated with a financial instrument, the higher the return investors require to hold

a financial asset.

Page 9 of 49

Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial

security

Moreover the relationship between risk and return varies over time, as shown in the next activity.

Activity 8.4

Visit the Morningstar website at

http://corporate.morningstar.com/ib/documents/SampleContent/MktChartsImages.pdf and analyse the

figure on ‘Reduction of risk over time’.

This Morningstar’s figure provides evidence on how risk reduces over time.

In the US market (with reference to the years 1926–2006), the level of risk (measured in terms of

variability of returns) decreases by holding financial securities over longer periods of time.

When the holding period is one year only, the level of dispersion of returns is very high:

between –50 per cent and +135 per cent for small company stocks, and

between 0 per cent and +20 per cent for Treasury bills.

When the holding period is up to 20 years, the level of variability of returns is much more limited:

between +5 per cent and +20 per cent for small company stocks, and

between 0 per cent and +7 per cent for Treasury bills.

Note that when the holding period is up to 20 years, the average returns of different security class

converge towards the average nominal values analysed above. Specifically, they are:

12.6 per cent for small company stocks,

10.4 per cent for large company stocks,

5.5 per cent for government bonds and

3.7 per cent for Treasury bills.

A second interesting fact about the relationship between risk and return emerges: the relationship

changes over different holding periods. Specifically, the level of risk tends to reduce over longer

holding periods.

Page 10 of 49

Chapter 8: Securities and portfolios - risk and return - 3. Risk and return of a portfolio:

portfolio analysis

Study Guide, pp 164 – 165

Brealey, Myers and Allen 2010, pp. 198 - 202

Portfolio

A portfolio is a combination of different assets held by an investor.

Portfolio weight

The share of the value of each individual asset over the total value of the portfolio is referred to as the

weight of the asset in the portfolio.

Obviously the sum of the weights of all the assets of the portfolio must be one (unity).

Example: Consider an investor with a portfolio composed of two stocks: 75 The Coca Cola Company

stocks and 50 Microsoft stocks.

On 28 February 2008 the market prices of the two stocks were: The Coca Cola Company $41.16,

Microsoft $26.67.

The total value of the portfolio is $4,420. The portfolio weight for The Coca Cola Company is therefore

69.8 per cent.

Activity 8.5*

Calculate the portfolio weight for Microsoft.

The solution to this activity can be found at the end of the subject guide in Appendix 1.

The expected return of a portfolio – E(Rp) – is simply the weighted average of the expected returns of

the individual stocks of which the portfolio is composed, where the weights are the portfolio weights.

Formally, this is:

E ( R p ) w1 E ( R1 ) w2 E ( R2 ) ... wn E ( Rn ) (8.3)

where: wi = portfolio weight for stock i.

Example of E(Rp)

Going back to our example, assume that the expected return over the coming year will be 10 per cent

for The Coca Cola Company and 15 per cent for Microsoft.

The expected return of the portfolio of the investor is 11.5 per cent = (0.698 × 0.10 + 0.301 × 0.15).

Page 11 of 49

Chapter 8: Securities and portfolios - risk and return - 3. Risk and return of a portfolio:

portfolio analysis

The calculation of the risk of the portfolio is much more complex.

We need to understand the statistical concept of correlation, which measures the degree to which two

returns tend to move together.

A positive correlation means that the two returns tend to move together;

a negative correlation implies that the two returns tend to move in opposite directions;

a zero correlation indicates that the returns of the stocks are wholly unrelated.

Correlation coefficient

A statistical measure of correlation is known as the correlation coefficient.

It is simply the covariance divided by the product of the respective standard deviations.

Formally the correlation coefficient is defined as follows:

1, 2

1, 2 (8.4)

1 2

where: σ1,2 = covariance between stocks 1 and 2, which is a measure of the degree to which

the two stocks move together over time (covary).

Portfolio variance

The portfolio variance is the weighted average of several components:

a) the variance of the returns on each stock (σi2 with i = 1,2) multiplied by the square of its portfolio

weight (wi2);

b) the covariance between stocks 1 and 2. Formally, this is:

Portfolio SD

The portfolio standard deviation is of course the square root of the variance.

Note that the standard deviation of a portfolio is simply the weighted average of uncorrelated

(i.e. ρ1,2= 0).

Now, given the expected returns, return variances and correlation coefficient for any set of assets, we

should be able to calculate the expected return and variance of a portfolio composed of these assets.

Page 12 of 49

Chapter 8: Securities and portfolios - risk and return - 3. Risk and return of a portfolio:

portfolio analysis

Example: Recalling our portfolio composed of The Coca Cola Company and Microsoft, let us calculate

its variance.

In the past the standard deviations were 35 per cent for The Coca Cola Company and 50 per cent for

Microsoft.

Assume that the two stocks are positively – but not perfectly – correlated (i.e. ρ1,2= 0.5).

The variance of the portfolio is 11.9 per cent = [(0.698)2 × (0.35)2] + [(0.302)2 × (0.50)2] + 2 (0.698 ×

0.302 × 0.5 × 0.35 × 0.50).

Therefore the standard deviation is 34.5 per cent.

Activity 8.6

Using the same weights and standard deviations given above, calculate the portfolio return variance in

these three cases:

1. Negative correlation between returns, ρ1,2 = – 0.3.

The solution to this activity can be found at the end of the subject guide in Appendix 1

Page 13 of 49

Chapter 8: Securities and portfolios - risk and return - 4. Benefits of diversification

4. Benefits of diversification

Study Guide, pp. 165 – 166

Brealey, Myers and Allen 2010, pp. 196 - 198

From most of the above calculations, you can note that the variance of the portfolio return is lower than

that of any individual asset.

This suggests that by forming portfolios (or by including additional assets in the portfolio), risk-averse

investors are able to reduce risk.

This process is referred to as diversification.

The reason this works is that, in real stock return data, the correlations between returns are less than

perfect.

Note that diversification does not work in the extremely rare cases where returns move

perfectly together.

Conversely, if returns are uncorrelated, it is possible through diversification to reduce risk to zero.

Page 14 of 49

Chapter 8: Securities and portfolios - risk and return - 4. Benefits of diversification

As shown in Figure 8.3 diversification can significantly reduce risk. The portfolio variance falls as the

number of assets held increases.

This benefit can be achieved even with a relatively small number of stocks (around 20 stocks).

Activity 8.7

Read Mishkin and Eakins (2009), p.75 (footnote 2) and summarise their example of how diversification

works.

Page 15 of 49

Chapter 8: Securities and portfolios - risk and return - 4. Benefits of diversification

The effectiveness of diversification in reducing the risk of a portfolio varies from country to country as

shown in Figure 8.4.

In Switzerland, Germany and Italy stocks tend to move together (high covariance), and thus

diversification is less effective.

Instead, in Belgium and the Netherlands, much more of the risk of holding individual stocks can be

diversified away because of the low covariance.

Activity 8.8

Now think about what an investor in say, Germany, can do to achive greater risk reduction.

The investor could invest some of their wealth in stocks listed outside of Germany. In fact many

investors and investment funds diversify their portfolios internationally.

However, this brings an additional risk – exchange rate risk. That is, the value of the foreign investments

may decline due to changes in the exchange rate.

Page 16 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

Study Guide, pp. 166

Brealey, Myers and Allen 2010, pp. 213 - 220

The aim of this section is to identify the optimal holding of risky assets for a risk-averse agent, since

the investor seeks to minimise risk.

This is known as the mean-standard deviation portfolio theory, and was developed by Markowitz (1952).

The assumption is that agents have preferences that only involve expected portfolio returns and

return standard deviations.

Utility function

The utility function is increasing in expected portfolio returns, and decreasing in return standard

deviation.

Page 17 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

risk-free asset

Study Guide, pp. 166 - 169

Let us first consider two risky assets named X and Y. (We thus assume that there is no risk-free asset.)

The two assets can be combined, according to some weights, to form a portfolio (a new asset).

The diagram shown in Figure 8.5 describes the mean (Y-axis) and the standard deviation (X-axis) of

any risky asset, and each point in this diagram represents an asset.

As the portfolio weights for the two assets vary from 0 to 1,

to one that contains a mixture of assets X and Y, and then

to one that contains only asset Y.

As the portfolio weights vary, the new portfolios trace out a curve that includes assets X and Y.

This curve, which looks something like the curved shape in Figure 8.5, is named the mean-standard

deviation frontier.

It shows the expected return and risk that could be achieved by different combinations (portfolios)

of the two risky assets, and

Page 18 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

Trade-off between mean (return) and SD (risk) enables understanding of how investors view the trade-

offs between means and standard deviations when they choose the portfolio weights of the assets to

include in their portfolios.

Note that an implicit assumption is made that investors are prohibited from short selling the assets (and

thus borrowing the required money).

As the investor’s preferences are increasing in return and decreasing in standard deviation (the investor

wants to go up and to the right within the area of the diagram), the optimal portfolio will always lie on

the frontier and to the right of the point labelled V.

This point V represents the minimum-variance portfolio (i.e. a portfolio that offers the minimum risk).

The minimum variance portfolio is found by differentiating the equation for the portfolio variance

(equation 8.5) with respect to one of the weights, say, w1.

The derivative of this equation is then set to zero and solved for w1.

w1 ( 22 1 2 1, 2 ) /( 12 22 2 1 2 1, 2 )

Put w2 = 1 - w1, σp2 = w12 σ12 + (1 - w1)2 σ22 + 2 w1 (1- w1) ρ1,2 σ1 σ2

Differentiate σp with respect to w1,

2 σp (d/dw1(σp)) = 2 σ12 w1 -2 σ22 + 2 w1 σ22 + 2 ρ1,2 σ1 σ2 - 4 w1 ρ1,2 σ1 σ2

σp (d/dw1(σp)) = (σ12 + σ22 - 2 σ1σ2ρ1,2)w1 -σ22 + σ1σ2 ρ1,2

Set d/dw1(σp) = 0,

w1 = (σ22 - σ1σ2 ρ1,2) / (σ12 + σ22 - 2 σ1σ2ρ1,2)

The weight of the other asset (w2) in the minimum variance portfolio is found from: w2 = 1 – w1

Using the two calculated weights in equations 8.3 and 8.5 will give us the expected return and standard

deviation of the minimum variance portfolio.

Page 19 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

Only the upper part of the mean-standard deviation frontier will be of interest to risk-averse investors.

In fact only the portfolios on the frontier and to the right of V maximise the expected return for a given

standard deviation.

Efficient frontier

In the absence of a risk-free asset, this set of portfolios (on the frontier and to the right of V) is termed

the efficient frontier (as shown in Figure 8.6).

This is the group of portfolios that both minimise risk for a given level of expected return, and

maximise expected return for a given level of risk.

Page 20 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

Activity 8.9*

Risky asset A has an expected return of 15% and a standard deviation of 25%

Risky asset B has an expected return of 35% and a standard deviation of 40%. If the

correlation between the returns on assets A and B is 0.25 and the assets are combined in

the following proportions:

A B

1 1 0

2 .75 .25

3 .5 .5

4 .25 .75

5 0 1

Calculate

i. the expected return and standard deviation for the 5 portfolios

ii. the expected return and standard deviation for the minimum risk portfolio

iii. plot all the portfolios calculated in (i) and (ii) on a graph and identify the efficient frontier.

The solution to this activity can be found at the end of the subject guide in Appendix 1.

Page 21 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

Preference of investor

In order to identify the optimal portfolio (of two risky assets) for a given investor, we need to identify a

set of preferences for this investor.

Indifference curve

This set of preferences towards risk and return can be represented by an indifference curve. Figure

8.6 shows two indifference curves for investors A and B respectively.

The quite steep indifference curve on the left represents a relatively risk-averse investor (investor A),

while the flatter indifference curve on the right represents a less risk-averse investor (investor B).

The optimal portfolio is the portfolio where the investor’s indifference curve is tangent to the mean-

standard deviation frontier.

These two optimal portfolios (for the two different investors) are identified on Figure 8.6 at points A and

B.

Page 22 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

In Figure 8.7 we draw the mean-standard deviation frontier for N risky assets using every possible

weighting scheme.

Feasible region

The set of all points representing portfolios made from N assets is called the feasible set or feasible

region.

Same shape

The shape of the frontier is the same as in the case of two risky assets (as drawn in Figure 8.5).

The difference is that the shaded area represents feasible but inefficient portfolios, which do not

maximise the expected return for a given standard deviation.

Page 23 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

Activity 8.10*

Consider a rational investor who has to choose one portfolio. Which portfolio would always be preferred

for each of the following pairs of portfolios?

1. Portfolio A E(R) = 17% σ = 16%

Portfolio B E(R) = 17% σ = 6%

2. Portfolio C E(R) = 15% σ = 16%

Portfolio D E(R) = 12% σ = 16%

The solution to this activity can be found at the end of the subject guide in Appendix 1.

Page 24 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

correlation (ρ)

Study guide, pp. 169 - 170

In the last section, the mean-standard deviation frontier has been identified by assuming that the return

correlation coefficient was between plus and minus one.

Figure 8.8 shows the locus of the return-standard deviation frontier assuming different correlation

coefficients.

When there is perfect correlation (ρ = +1), the return–risk combinations are represented by a straight

line.

When the risky assets have less than perfect correlation (ρ <+1), the investor can reduce the portfolio

risk by diversification.

(As previously discussed, the standard deviation of this portfolio is less than the weighted average of the

two standard deviations.) This gives the curvature to the left. The correlation determines the degree of

curvature: the lower the correlation, the more distended the curvature.

Finally, when the investor can include in the portfolio a risk-free asset with a return perfectly negatively

correlated (ρ = –1), the return-risk combinations are represented by a pair of lines.

Page 25 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

market line

Study guide, pp. 170 - 171

Let us now introduce a risk-free asset, with expected return Rf and zero standard deviation.

(As discussed in Chapter 2, in the USA the least risky asset is a US Treasury bill.)

Fig 8.9 Mean-SD frontier with risk-free asset and N risky assets

In Figure 8.9 we have plotted the expected return and risk of a portfolio composed by the risk-free asset

and a combination of risky assets.

A range of combinations of the risk-free asset and a portfolio of risky assets exist and two possible

combinations (labelled CML1 and CML2) are shown in Figure 8.9.

Note that CML stands for capital market line.

We now need to identify the optimal portfolio for an investor who wants to hold a risk-free asset in

addition to N risky assets.

Page 26 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

What is the optimal portfolio of risky assets for the investor?

The optimal portfolio is represented by point K in Figure 8.8. The reason for this is that an investor will

prefer to be somewhere on CML1 rather than any other CML (joining the risk-free asset to the efficient

frontier (such as CML2).

As all points along CML1 are superior (in terms of return for a given risk) to points on

say, CML2.

In presence of a risk-free asset and N risky assets, the efficient set becomes the optimal capital market

line (CML1).

Two-fund separation

We have achieved a very important result known as two-fund separation. Any risk-averse investor

can form the optimal portfolio by combining two funds.

2. the second is the risky asset portfolio K.

Degree of risk-aversion

The degree of risk-aversion determines the portfolio weights placed on the two funds.

For example, in Figure 8.9, investor A is more risk-averse than investor B, and thus A puts more

weight on the risk-free asset.

This result allows us to identify the optimal portfolio of risky assets, K, that all investors who invest in

risky assets will choose to hold irrespective of their risk preference.

The two-fund separation theorem forms the starting point for the important Capital Asset Pricing Model,

discussed in the next section.

Optimal portfolios of the risk-free asset and the risky portfolio, K, lie along

CML1 such that

points to the left of K represent lending portfolios where the investor invests positive amounts in

the risk-free asset.

Points to the right of K represent borrowing portfolios where the investor borrows at the risk-free

rate to increase the amount of funds they can invest in the optimal risk assets portfolio K.

Page 27 of 49

Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio

theory

Example of lending

An example will help to illustrate this. Suppose an investor has $10,000 to invest. The expected return

on portfolio K is 15 per cent and the standard deviation of returns is 20 per cent. The risk-free rate of

interest is 5 per cent.

A risk-averse investor may wish to invest half of his/her wealth ($5,000) in the risk-free asset and half

($5,000) in portfolio K.

What is the expected return and risk for this efficient portfolio, say, A?

Answer:

E(RA) = 0.5 × 5% + 0.5 × 15% = 10%; σA = 0.5 × 0 + 0.5 × 20% = 10%

Note that the standard deviation of portfolio A is simply a linear weighted average of the individual risks

of the two funds.

Of course, the standard deviation of the risk-free asset is zero so the risk of this efficient lending portfolio

is simply the weight assigned to portfolio K multiplied by the

risk of portfolio K.

Example of borrowing

A more risk-seeking investor may choose to borrow, at the risk-free rate, an amount of $5,000 giving

him/her a total of $15,000 to invest in portfolio K.

The expected return and risk of this borrowing portfolio, say B, is given by:

Answer:

E(RB) = −0.5 × 5% + 1.5 × 15% = 20%; σB = −0.5 × 0 + 1.5 × 20% = 30%

Activity 8.11

How can investors identify the best set of efficient portfolios of common stocks?

What does ‘best’ mean?

Page 28 of 49

Chapter 8: Securities and portfolios - risk and return - 6. Asset pricing models

Goal: equilibrium asset price

The problem we want to solve in this section is to determine the correct, arbitrage-free, or fair price

of an asset in equilibrium. In order to do so, it is necessary to identify theories that enable us to deduce

this equilibrium price of a risky asset.

We analyse first the Capital Asset Pricing Model (CAPM), which identifies the equilibrium price within

the framework of the mean-standard deviation frontier.

We then move to the Arbitrage Pricing Theory (APT),

which does not require the assumption that investors choose their portfolios on the basis of

means and standard deviations,

but rather on the basis that two assets that are the same cannot sell at different prices.

The CAPM model has been developed primarily by Sharpe (1964) and Lintner (1965), and the APT by

Ross (1976).

Page 29 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Study Guide, pp. 172 – 174

Beta: Brealey, Myers and Allen 2010, pp. 202 – 205

CAPM: Brealey, Myers and Allen 2010, pp. 220 - 223

To implement the mean-standard deviation frontier requires observing the optimal portfolio, which is the

tangent portfolio (as discussed in the previous section).

However, it is impossible to derive the tangent portfolio simply from observed returns on large

numbers of risky assets.

We thus need a theory that identifies the tangent portfolio from sound theoretical assumptions. This

section develops one such theory, the Capital Asset Pricing Model (CAPM).

Assumptions of CAPM

To begin our discussion of the CAPM, let us first present the assumptions that underlie the theory:

1. Investors maximise their utility only on the basis of expected portfolio returns and return

standard deviations.

3. Markets are perfect and frictionless. (i.e. no taxes on sales or purchases, no transaction costs

and no short sales restrictions).

4. Investors have homogeneous beliefs regarding future returns, which means that all investors

have the same information and assessment about expected returns, standard deviations and

correlations of all feasible portfolios.

assumption 4 is an additional one needed to develop the CAPM

From these assumptions, the main conclusion of the CAPM is that in equilibrium the tangent portfolio

of risky assets must be the market portfolio.

From the two-fund separation theorem everybody will hold a risk-free asset and a combination of risky

assets.

Page 30 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Furthermore, as everybody shares the same beliefs, everybody will use the same efficient fund of risky

assets. This fund must be the market portfolio. Each investor will hold the same portfolio as everybody

else; in other words, everybody will hold the market portfolio.

The market portfolio is the portfolio comprising all assets, where the weight on each asset is the

market capitalisation (also called market value) of that asset divided by the total market capitalisation

of all risky assets. These weights are termed capitalisation weights.

The market portfolio should include all risky assets and therefore

Consequently, the implementation of the CAPM requires using proxies for the market portfolio. A

frequently used proxy is a broad-based equity index

such as the S&P500 (500 typically larger market capitalisation stocks traded on the NYSE and

Nasdaq).

Capital market equilibrium requires that the demand for risky assets be identical to their supply.

The demand for risky assets is represented by the optimal portfolio chosen by investors, whereas

Page 31 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Under the CAPM assumptions, the equilibrium between risk and return can be expressed as (Eqn 8.6):

E ( Ri* ) R f i [ E ( RM ) R f (8.6)

where:

βi = the covariance of the returns on asset i with the return on a market portfolio, divided by the

variance of the market return. Formally, this is: βi = σiM / σ2M

[E(RM) – Rf] = market risk premium, which is the amount by which the return of the market

portfolio is expected to exceed the risk-free rate.

Usage of Eqn 8.6: finding expected return = risk-free rate + market risk premium *

beta

The CAPM enables us to figure out what returns investors are looking for from particular security.

Specifically, under the CAPM framework, the expected return of a given risky asset (or portfolio of

assets) is equal to the risk-free rate plus a market risk premium multiplied by the asset or portfolio

beta.

To calculate this, we need three elements: risk-free rate, beta and market risk premium.

We showed estimates of the risk-free rate in the paragraph on ‘Empirical evidence on risk, return and

their relationship’; and we will do the same for beta and market risk premium in the next paragraphs.

Beta

βi = the covariance of the returns on asset i with the return on a market portfolio, divided

by the variance of the market return. Formally, this is: βi = σiM / σ2M

From SD to Beta

Under the CAPM framework, the standard deviation of an asset by itself is no longer an important

determinant of the expected return of that asset.

What is important is the beta of the risky asset (βi), which measures the sensitivity of an individual

security to the market movements.

The expected returns increase linearly with beta.

Page 32 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Stocks with betas greater than 1.0 tend to amplify the overall movement of the market: generally

speaking we expect aggressive companies or highly leveraged companies to have high betas.

Conversely, stocks with betas between 0 and 1 tend to move less than the market: and therefore are

typically conservative companies.

A stock with a beta equal to one will mimic the market.

Example of Beta

Example: Consider the beta of Microsoft stock, which is equal to 1.527 (this estimate is provided by

various data service organisations such as Bloomberg, and it is calculated by using a record of past

stock values).

This β value means that on average, when the market return increases by an extra 1 per cent,

Microsoft’s return will rise by an extra 1.527 per cent.

When the market decreases by an extra 2 per cent, Microsoft stock return will fall an extra 2

×1.572 = 3.144 per cent.

Activity 8.13

Decide whether each of the following statements is true or false.

The expected return of an asset with a beta of 0.5 is half the expected return of the market.

(True / False)

If the beta of an asset is lower than 0, the CAPM implies that its expected return will be lower

than the interest rate. (True / False)

Beta of a portfolio

The beta of a portfolio (βp) is simply the weighted average of the betas of the individual assets in the

portfolio (βi), where the weights are the portfolio weights (wi). Formally this is:

p wi i (8.7)

Page 33 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

What about the value of the market risk premium? The market risk premium cannot be measured with

precision, and practitioners and scholars are still debating about its magnitude and the method to be

used for the estimation.

Specifically, it can be estimated either by using an arithmetic average or a geometric average of

historical returns.

With regard to the magnitude, some recent empirical evidence, as summarised in Figure 8.10, shows

that the annualised arithmetic equity risk premium relative to bills was 7.05 per cent for the USA,

6.02 per cent for the UK and 5.09 per cent for the world index for the years from 1990–2001.

These values are somewhat lower than the historical average risk premium over the longer period

1926–2000: for example, for the USA the risk premium over 1926–2000 was equal to 9.1 per cent (=

0.13 – 0.039; see Figure 8.2).

The value of the market risk premium varies internationally: over the period 1990–2001, the risk

premium in Denmark was only 3.02 per cent (bottom end), whereas in Germany it was up to 10.0 per

cent and in Italy to 10.06 per cent.

Some of these variations may reflect differences in risk (i.e. Italian stocks may have been particularly

variable and investors may have required a higher return to compensate).

Page 34 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

As regard to the method to be used for the estimation, Figure 8.10 reveals that the risk premium

measured by geometric averages is much lower than the premium based on arithmetic averages.

For example, the annualised geometric equity risk premium relative to bills was 5.06 per cent for the

USA (instead of 7.05 per cent).

Accordingly, the Global Investment Returns Yearbook 2005 (LBS/ABN Amro) estimates that the

plausible forward-looking risk premium for the world’s major markets would be of the order of 3 per cent

relative to bills on a geometric mean basis, whereas the corresponding arithmetic mean risk premium

would be around 5 per cent.

Which method should be preferred? The arithmetic average is the norm for the estimation, but the

debate is still open. (for example Jacquier et al., (2003) show that the correct estimation requires

compounding at a weighted average of the arithmetic and geometric historical averages).

Page 35 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Study Guide, pp. 175

The CAPM equilibrium relationship between risk and return has a very simple graphical representation.

The CAPM formula can be seen as a linear relationship between the expected return and β, which is

known as the security market line (SML).

As shown in Figure 8.11, beta is on the horizontal axis, while the expected return is on the vertical

axis.

The expected return on a risk-free asset is Rf.

An asset with β of unity has an expected return equal to that of the market E(RM): this asset is the

market portfolio (M).

SML

Therefore the security market line is a straight line emanating from the risk-free point and passing

through the market portfolio.

Equilibrium on SML

In equilibrium every stock must lie on the security market line: no stock can lie below or above the

security market line.

This happens because any investor can always obtain a market risk premium of βi[E(RM) – Rf]

by holding a combination of the market portfolio and the risk-free asset.

Page 36 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Example: Consider Microsoft stock. Given a beta equal to 1.527, a market risk premium of 9 per cent,

and a risk-free rate of 3.5 per cent, the expected return for Microsoft must be

Activity 8.14*

Assume that the return on US Treasury bills is 3 per cent, the expected return on the market portfolio is

12 per cent. On the basis of the CAPM:

1. Draw a graph showing the relationship between the expected return and beta.

4. What is the beta of a stock if the market return is expected to be 12.5 per cent?

The solution to part of this activity can be found at the end of the subject guide in Appendix 1.

Page 37 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Study Guide, pp. 175 - 176

In equilibrium two assets with identical expected returns must have identical betas, although their

standard deviations can differ.

The reason for the difference in the standard deviation is that a portion of risk can be eliminated

through diversification (as discussed before).

Diversifiable risk

The risk that can be eliminated by diversification is known as diversifiable risk (or unique, specific,

non-systematic risk), which is the risk peculiar to a company or its immediate competitors.

Investors do not need any reward to bear such risk, and hence diversifiable risk does not affect

expected returns.

Market risk

However, there is some risk that cannot be avoided, regardless of how much investors diversify. This

risk is known as market risk (or systematic, undiversifiable risk), which can be thought of as the risk

of the market as a whole.

The exposure of an asset to such risk can be summarised by beta. For a reasonably well diversified

portfolio only market risk matters.

Page 38 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Recall Figure 8.3, which shows that the portfolio standard deviation depends on the number of securities

in the portfolio.

Following on, as shown in Figure 8.12, by adding securities, and therefore by diversification, portfolio

standard deviation decreases until all diversifiable risk is eliminated, and only market risk

remains.

If you have only one stock, diversifiable risk is very important; however,

The magnitude of market risk depends on the average betas of the securities included in the portfolio.

Page 39 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Study Guide, pp. 176 – 177

Brealey, Myers and Allen 2010, pp. 223 - 227. Validity and role of the CAPM

However, even before we examine these tests, it is useful to develop an asset pricing model based on

more realistic assumptions.

Standard CAPM

The CAPM developed in the previous section is termed the standard CAPM because it provides a

complete description of the behaviour of capital markets if each of the underlying assumptions are held.

A wide literature examines the effects of modifying these assumptions, with a special

emphasis on two of them:

1. the ability to lend and borrow infinite sums of money at the risk-free rate (in the real world,

generally the risk-free rate is not a real rate because of uncertainty about inflation, and

borrowing rates are higher than lending rates), and

2. the absence of personal taxes.

The removal of these assumptions leads to the development of the non-standard forms of the CAPM.

(Note that in practice none of these modified versions is as widely used as the standard CAPM.)

From a theoretical perspective, the implementation of the CAPM requires the use of proxies for the

market portfolio because the exact composition of the market portfolio is unobservable (as explained

earlier).

As argued by Roll (1977), the unobservability of the market portfolio makes the CAPM untestable.

Given that the quality of the proxies used for the market portfolio cannot be guaranteed, it is not

possible to test the CAPM.

There could be two alternative situations.

First, it might be the case that the market portfolio is efficient (and hence the CAPM is valid),

but the proxy chosen is inefficient (and hence the empirical tests incorrectly reject the CAPM).

Second, the proxy for the market portfolio might be efficient (and hence the empirical tests

validate the CAPM), but the market portfolio itself is not efficient (and hence the validation is

false).

Page 40 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

Academics have been debating whether the CAPM is testable for many years without arriving

at a consensus; nevertheless the model is widely applied by practitioners and largely tested by

researchers by using several proxies for the market portfolio.

These tests provide valuable – but not conclusive – insights on the appropriateness of the

CAPM.

Tests support for the CAPM, but less rapidly than predicted

Overall, these tests provide broad support for the CAPM by showing that the expected return

increased with beta over the period 1931–91, even if less rapidly than the CAPM has

predicted.

However, critics of the CAPM pointed out two problematic pieces of empirical evidence.

First, in recent years the slope of the security market line has been much flatter than one would expect

from the CAPM.

This means that high-beta stocks performed better than low-beta stocks,

but the difference in their actual returns was not as great as the CAPM would predict.

Counter argument: test only use actual return, but not E(R)

However, the supporters of the CAPM argue that the evidence could be due to the fact that the CAPM

itself is concerned with expected returns, whereas the tests only use actual returns.

Actual returns do reflect expectations, but they are also largely affected by noise.

Second, factors other than beta have all been found in empirical studies to explain ex-post realised

returns (after controlling for beta).

Factors such as firm size, book-to-market ratio, price-to-earnings ratio and dividend yield

This contrasts with the CAPM, which predicts that beta is the only factor that explains expected

returns.

For example, small capitalisation stocks (known as small-cap) did better than large capitalisation stocks

over the period 1932–97.

Although they have higher betas, the difference in betas is not enough to explain the difference in

returns.

It seems that investors saw risks in small-cap that were not captured in their beta.

Page 41 of 49

Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)

One explanation for this result could be ‘data-snooping’ or ‘data mining’.

(This refers to the fact that many researchers look at past sample returns, and they are bound to find

a strategy that, just by pure chance, has worked in the past.)

Actually, the supporters of the CAPM proved that the small–large cap results vanished once they

were discovered.

This empirical evidence can suggest either that the CAPM does not hold or that tests do not prove

anything about the CAPM because of Roll’s insights.

The controversial nature of the evidence and the difficulties in interpreting this evidence have led to

other asset pricing theories, such as the Arbitrage Pricing Theory (discussed in the next section).

Page 42 of 49

Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

Brealey, Myers and Allen 2010, pp. 227 - 231. Some Alternative Theories

The alternative asset pricing paradigm, known as Arbitrage Pricing Theory (APT) is, in some ways, less

complicated than the CAPM.

It simply requires that the returns on any stock be linearly related to one factor (or a set of factors), as

with factor models (discussed below).

Study guide, pp. 178

The basic idea of factor models is that all common variations in stock returns are generated by

movements in one factor (or a set of factors).

One-factor model

The simplest factor model is a one-factor model, which assumes that there is only one factor.

Formally, it can be written as (8.8):

Ri a i bi1 F1 i , E ( i ) 0 (8.8)

where:

ai = E(R) when Fi = 0

ai = expected level of return for stock i if all factors have a value of zero.

F1 = Value of Factor 1

F1 = value of the factor 1 that affects the returns on stock i. The factor is posited to affect all stock

returns, although different stocks can have different sensitivities.

The factor can be represented by macroeconomic conditions, financial conditions or political events.

Examples are:

yield spread (return on long-term government bonds less return on 30-day Treasury bills),

interest rate (change in Treasury bill return),

change in the forecast of real GNP (Gross National Product), and

change in forecast of inflation.

Page 43 of 49

Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

bi1 = sensitivity of the returns on stock i to factor 1. High values of bi1 imply that variations in F cause

very large movements in the return on stock i; whereas small values indicate that stock i reacts only

slightly to changes in F.

εi = random error term. This random stock return is termed the idiosyncratic return component for

stock i.

It has a mean equal to zero and variance equal to σ2ei.

Moreover, it is uncorrelated across stocks and with F; thus Cov (εi, εj)= 0, and Cov (εi, F)= 0.

The idiosyncratic return comes from events that are unique to the firm.

Examples of the idiosyncratic return can be a legal action against the company of stock i,

or the unexpected departure of a company’s CEO.

Multi-factor model

A generalisation of equation (8.8) represents a multi-factor model, where a set of j factors affects the

returns on stock i (8.9):

To determine the return on a portfolio, given the above factor structure, we need to calculate the

portfolio weighted averages of the individual factor sensitivities.

Page 44 of 49

Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

An example could clarify this simple calculation.

Example: Consider two stocks (X and Y), whose returns are determined by the following one-factor

model:

RY = 0.06 + 0.8F1 + εY

To determine the return of an equally weighted portfolio of the two assets (½ stock X and ½ stock Y), we

simply need to form a weighted average of the stock sensitivities of individual factors:

RP = 0.045 + 0.85F1 + εP

Activity 8.15*

Assume that the portfolio weights of the above stocks (X and Y) are 0.25 and 0.75. Using the data of the

previous example, compute the portfolio return representation.

The solution to this activity can be found at the end of the subject guide in Appendix 1.

Page 45 of 49

Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

Study Guide, pp. 178 - 179

The Arbitrage Pricing Theory (APT) is based on the primary – simple – assumption that when returns

are certain, investors prefer greater returns to lesser returns.

The mechanism for doing so involves the use of arbitrage portfolios, and thus the following four

assumptions:

1. No arbitrage opportunities

1. There are no arbitrage opportunities. Arbitrage opportunities represent the possibility of earning

riskless profits by taking advantage of differential pricing for the same asset.

There are two possible ways to define arbitrage strategies.

1. First, to invest in a set of assets that yield positive immediate cash inflow (obtained by the sale

of assets at a

relatively high price and the simultaneous purchase of the same assets at a relatively low price),

with no loss in the future.

2. Second, to invest today in costless investment strategy, and to obtain positive future cash

inflows (as described above). In both cases, when returns are certain, any investor who prefers

greater returns to lesser returns would invest as much as possible. Under the APT, these

investment strategies should not be permitted in properly functioning financial markets.

2. Returns of risky assets can be described by a factor model, as described in the previous subsection.

3. Financial markets are frictionless (i.e. there are no transaction costs or related market frictions).

4. There is a large number of securities and so investors hold well-diversified portfolios.

This implies that diversifiable risk does not exist.

(Note that the sources of risk for any individual stock are: risk arising from macroeconomic factors,

which cannot be eliminated by diversification; and diversifiable risk associated with events that are

unique to the firm, which can be totally eliminated by diversification.)

Under the APT, the absence of arbitrage opportunities places restrictions on the relationship between

the expected returns on individual assets (and hence on a well-diversified portfolio) given the factor

structure underlying returns.

Page 46 of 49

Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

Key of APT

The key to the APT is that a factor model with no arbitrage opportunities implies that assets with the

same factor sensitivities must offer the same expected returns in financial market equilibrium.

Expected risk premium {E(Rx)* - Rf} depends on sum of expected risk premiums

of each factor (λj) * factor sensitivity (bj)

Therefore the expected risk premium on an individual asset (equal to the expected return on

an individual asset minus the risk-free rate) depends on the sum of the expected risk

premiums associated with each factor multiplied by the asset sensitivity to each of these

factors.

Thus the expected return on an individual asset can be written as:

where:

λj = (RFj– Rf), which is the risk premium over the risk-free rate associated with factor j.

The risk premium is affected only by macroeconomic factors, and not by unique risk (note the

similarity with the CAPM).

For example, consider a risk premium equal to 5 per cent for the real GNP factor. It means that stocks

with a positive average sensitivity to changes in real GNP (i.e. with b = 1) give an additional return of 5

per cent a year compared with stocks completely unaffected by real GNP.

Conversely a risk premium equal to –1 per cent for the inflation factor means that stocks with average

exposure to inflation give a 1 per cent less return than stocks with no exposure to inflation.

(Note that an asset with zero sensitivity to each factor is essentially risk-free, and thus must be priced to

offer the risk-free rate.)

Page 47 of 49

Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

Activity 8.16*

Consider a two-factor APT model. The factors and associated risk premiums are:

Change in GNP 6%

Assuming a risk-free rate equal to 6 per cent, calculate the expected rates of return on the following

stocks:

a. A stock whose return is uncorrelated with all the two factors.

The solution to this activity can be found at the end of the subject guide in Appendix 1.

Page 48 of 49

Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)

Study guide, pp. 180

The APT provides an interesting alternative perspective to that of the CAPM on the nature of equilibrium.

From a theoretical point of view, however, the theory is far from easy to implement.

The advantage of the APT is that it does not require us to identify and measure the market portfolio

(solving most of the problems presented in the previous subsection on the theoretical limitations

of the CAPM).

The disadvantage is that it does not tell us what the underlying factors are

(unlike the CAPM, which collapses all the macroeconomic factors into the market portfolio).

Empirical research is still in the early stages as regards the APT, and is not as well developed as the

literature on the CAPM.

Many studies have been particularly interested in whether the APT explains the size effect discussed

about the CAPM.

Although the evidence is not conclusive, the majority of the studies (see among others: Chen, 1983;

Chan, Chen and Hsieh, 1985) find that the size effect becomes negligible in a multi-factor

framework.

Other studies focused on the identification of the factors with significant effects on risk premiums. Chen,

Roll and Ross (1986) emphasise the relevance of

interest spread and

changes in default spreads.

Page 49 of 49

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