Risk-

Return and
CAPM

CAPM Development Finance

Home bias

Multifactor
CAPM
Dr. Jianying Qiu

Institute of Emerging Markets, Beijing Normal University

j.qiu@fm.ru.nl
 The Evaluation of a Risky Security

Risk-
Return and
CAPM A risky security:
CAPM

Home bias Outcome Possible Payoff Subjective Probability

Multifactor 1 50% 0.1
CAPM
2 30% 0.2
3 10% 0.4
4 -10% 0.2
5 -30% 0.1

How should investor evaluate such a risky security?

What kind of return should investors expect?
How does the above evaluation process change if it is a significant part of your
wealth?
 The Evaluation of a Facebook share

initial evaluation: from $28 to $35 per share,

On May 14, it raised the targets to $34 to $38 per share,
Risk-
Return and final IPO price of $38 per share.
CAPM

CAPM

Home bias

Multifactor
CAPM
 Expected Return and Variability

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM
 Expected Return and Variance

Expected return and variance of a financial asset:

Risk-
Return and Outcome Possible Return Subjective Probability
CAPM 1 50% 0.1
CAPM 2 30% 0.2
Home bias 3 10% 0.4
Multifactor
4 -10% 0.2
CAPM 5 -30% 0.1

E (R) = p1 R1 + p2R2 + p3 R3 + p4 R4 + p5 R5
= 0.1 × 50 + 0.2 × 30 + 0.4 × 10 + 0.2 × (−10) + 0.1 × (−30)
= 10(%)

Var (R) = σR2 = p1 [R1 − E (R)]2 + p2[R2 − E (R)]2 + p3 [R3 − E (R)]2 (1)
2 2
+p4 [R4 − E (R)] + p5 [R5 − E (R)]
= 0.1 × (50 − 10)2 + 0.2 × (30 − 10)2 + 0.4 × (10 − 10)2 (2)
+0.2 × (−10 − 10)2 + 0.1 × (−30 − 10)2 = 480(%)
 Expected Return and Variability

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM
 Expected Return and variance: more than one financial assets

Risk- Table: Asset 1

Return and
CAPM
Outcome Possible Return Subjective Probability
CAPM
Greek defaults 60 Euro 0.5
Home bias
Greek does not default -40 Euro 0.5
Multifactor
CAPM

Table: Asset 2

Outcome Possible Return Subjective Probability

Greek defaults -40 Euro 0.5
Greek does not default 60 Euro 0.5

Table: Asset 3

Outcome Possible Return Subjective Probability

Good weather 30 Euro 0.5
Bad weather -10 Euro 0.5
 Expected Return and variance of a Portfolio

Example
An investment of 1 in two risky assets, asset 1 and asset 2. Random returns for asset
Risk- 1 is r1 and for asset 2 is r2 . w1 is the percentage invested in asset 1 and w2 is the
Return and
CAPM percentage invested in asset 2.
CAPM We have a portfolio: w1 of asset 1 and w2 = 1 − w1 of asset 2:
Home bias If we know the value of r1 and r2 , then we can compute the mean return of the
Multifactor
portfolio:
CAPM rp = w1 × r1 + w2 × r2

Typically we don’t know r1 and r2

E (rp ) = w1 × E (r1 ) + w2 × E (r2 )
E (r1 ) = 5% and E (r2 ) = 10%, estimated from historical data
E (rp ) = w1 × E (r1 ) + w2 × E (r2 ) = 0.05 × w1 + 0.10 × w2
E (rp ) = 1? What is w1 and w2 ?
Risk (Variance):
var (rp ) = w12 var (r1 ) + w22 var (r2 ) + 2w1 w2 cov (r1 , r2 )

let σ 2 denote variance

correlation between r1 and r2
cov (r1 , r2 ) cov (r1 , r2 )
ρ12 = p =
var (r1 )var (r2 ) σ1 σ2
σp2 = w12 σ12 + w22 σ22 + 2w1 w2 ρ12 σ1 σ2
 The Mean-Variance Model

Assumptions in the the Mean-Variance Model:

Risk- Investors care only about expected return (mean) and variance (variance)
Return and
CAPM Investors prefer a higher expected return to lower returns
CAPM
Investors dislike risk (variance)
Home bias

Multifactor
CAPM Minimum variance of the portfolio:
Note w1 + w2 = 1 or w2 = 1 − w1 , and thus:

var (rp ) = w12 σ12 + (1 − w1 )2 σ22 + 2w1 (1 − w1 )ρσ1 σ2 (3)

To minimize the portfolio variance, differentiating with respect to w1 :

∂σp2
= 2w1 σ12 − 2(1 − w1 )σ22 + 2(1 − 2w1 )ρσ1 σB = 0 (4)
∂w1
Solving the equation:

σ22 − ρσ1 σ2
w1 = (5)
σ12 + σ22 − 2ρσ1 σ2
 Portfolio diversification

Example
Risk- Stock 1 Stock 2
Return and
CAPM Mean 8.75% 21.25%
CAPM SD 10.83% 19.80%
Home bias Correlation - 0.9549
Multifactor
Covariance - 204.763
CAPM
 Portfolio diversification

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM

Figure: Example: Efficient Frontier

 Portfolio diversification: Exercise

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM
 Portfolio diversification

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM

Figure: Efficient and Inefficient Portfolios

How to calculate efficient frontier:

Choose an arbitrary “’target” return on the portfolio µp (e.g. µp = 10%)
minimize σp2 by choosing wi , given the constraint of µp .
such a minimization gives µp as a function of wi (µp = f (w1 , w2 , . . . , wn ))
The function µp = f (w1 , w2 , . . . , wn ) is then the efficient frontier.
 The power of diversification: Wagner and Lau (1971)

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM
 The power of diversification: Wagner and Lau (1971)

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM
 The power of diversification: Wagner and Lau (1971)

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM
 How to measure riskiness of a portfolio: Betas

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM

Estimating Betas:
Use regression analysis on historical data.
The estimated slope of the market model is the beta estimate.
Ri = α + βi Rm + i
 How to measure riskiness of a portfolio: Betas

Risk-
Return and
CAPM

CAPM
Betas represent an asset’s systematic (market or non-diversifiable) risk
Home bias

Multifactor
The βi of a stock measures the incremental effect of stock i on the risk of the
CAPM market portfolio
2
σm = w1 cov (R1 , Rm ) + w2 cov (R2 , Rm ) + . . . + wi cov (R, Rm ) + wn cov (Rn , Rm )
1 = w1 β 1 + w2 β 2 + . . . + wn β n

Beta of the market portfolio: βm = 1

Beta of the risk free asset: βf = 0
P
Beta of a portfolio: βp = wi β i
 Betas

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM

Figure: US Companies: β and σ (7th December 1979)

Industry cost of capital and Betas

 Portfolio diversification

Introducing Borrowing and Lending of Risk Free Asset:

Risk-
Return and
You are now allowed to borrow and lend at the risk free rate r while still investing
CAPM in any SINGLE “risky bundle” on the efficient frontier.
CAPM For each SINGLE risky bundle, this gives a new set of risk return combination
Home bias known as the “transformation line”
Multifactor Rather remarkably the risk-return combination you are faced with is a straight
CAPM
line (for each single risky bundle) – transformation line.
You can be anywhere you like on this line.

Expected return
E (RN ) = (1 − x)rf + xE (Rp )
Riskiness
2
σN = x 2 σp2
where
x = proportion invested in the portfolio of risky assets (what if x > 1?)
E (Rp ) = expected return on the portfolio containing only risky assets
σp = standard deviation of the portfolio of risky assets
E (RN ) = expected return of new portfolio (including the risk free asset)
σN = standard deviation of new portfolio
 Risky Assets + Risk Free asset

Example

Risk-
Two assets: a stock and a risk-free asset (Treasury bill)
Return and
CAPM
Return: the stock (22.5%); Treasury Bill (10%)
CAPM Standard deviation: Stock (24.87%), Treasury Bill (0%)
Home bias

Multifactor
CAPM

Figure: New Portfolio With Risk Free Asset

 Risky Assets + Risk Free asset

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM

Figure: Transformation Line

 Risky Assets + Risk Free asset

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM

Figure: Best Transformation Line

 The Capital Market Line (CML)

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM

Figure: The Capital Market Line (CML)

 Capital Asset Pricing Model: A first observation

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM

To derive capital asset pricing model, note that:

Any portfolio’s return is determined by its systematic risk.
βi = βm implies Ri = Rm .
βi = 0 implies Ri = Rf .
 Capital Asset Pricing Model: Derivation

Risk-
Return and
CAPM What should be the return of the portfolio Rp with w of market portfolio and
CAPM 1 − w of risk free asset?
Home bias

Multifactor
CAPM
βp = (1 − w ) × 0 + w × 1 = w
E (Rp ) = (1 − w ) × Rf + w × E (Rm )
E (Rp ) = (1 − βp ) × Rf + βp × E (Rm )

Capital Asset Pricing Model:

E (Rp ) = Rf + βp × (E (Rm ) − Rf )
 Capital Asset Pricing Model

Risk-
Return and Applications of Beta:
CAPM
Market timing
CAPM
if you expect the market to go up you want to move into higher beta stocks to get
Home bias
more exposure to the bull market
Multifactor if market goes down you want less exposure to the stock market and hence should buy
CAPM stocks with lower betas
P
To construct a customized portfolio. (Rem: βp = wi β i )
Performance measures
Risk Management
Calculating the WACC
to use for the DPV for assessing the viability of a project or the value of a
company.
 Performance Measures

E (Ri )−rf
Sharpe Ratio: SRi = σi
Risk-
Return and Sharpe Ratio is a reward-to-variability ratio
CAPM
It is a good performance measure when the new asset has zero correlation with the
CAPM existing portfolio
Home bias
It is biased if the above assumption is violated: systematic risk vs non-systematic risk
E (Ri )−rf
Multifactor Treynor Ratio: TRi = β
CAPM
it is the excess return per unit of incremental portfolio risk of the stock i.
It may give results different from Sharpe ratio.
If TRA > TRB , then
RA − rf RB − rf
> (6)
βA βB
SRA SRB
> , (7)
ρA,M ρB,M
Ri −rf
where SRi = σi , i = A or B. The inequality may not hold.

Jensen’s alpha: E (Ri ) − rf = αi + βi [E (Rm ) − rf ] + t

Performance measure (over-perform or under-perform) relative to beta risk of the
portfolio
Objective: To maximize Sharpe ratio (or Treynor ratio, or Jensen’s alpha)
 Performance Measures

CAPM can be used to evaluate the performance of an investment portfolio (i.e.

mutual fund):
Risk- Step 1: Calculate the summary stats of the investment portfolio (e.g. average
Return and
CAPM rate of return, variance)
CAPM Step 2: Calculate the covariance between the investment portfolio and the
Home bias market portfolio and the variance of the market portfolio
Multifactor
CAPM Cov (Ri , Rm )
β=
Var (Rm )

Step 3: Calculate Jensen’s alpha performance measure

(Ri − rf ) = α + β(Rm − rf )

Obtaining β:
Time series regression:

Ri,t − rf ,t = αi + βi (Rm,t − rf ,t ) + i,t

Alternative models are also available: different β specification.

Decision:
How much historical data to use (i.e. 1 years, 2 years, 5 years, 10 years or what)?
What data frequency to use (i.e. daily data, weekly data, monthly data or what)?
Should I use the model above or an alternative model?
 CAPM and Investment Appraisal (All Equity Firm)

Risk-
Return and
CAPM B/(B + S) B/S βl Leverage effect
CAPM 0% 0% 1.28 (= βU ) 0
Home bias 50% 100% 2.1 0.82
Multifactor
CAPM
70% 233% 3.2 1.92
90% 900% 8.7 7.4
B
 
Table: Above uses βL = βU × 1 + (1 − t) × S with t = 0.36

The leverage-beta increases with leverage (B/S) and hence so does

the required return on equity E (Ri ) given by the CAPM
and hence the discount rate for cash flow
E (Ri ) can then be used with the bond yield to calculate WACC, if
debt and equity finance is being used for the new project
 Portfolio Choice: individual risk attitudes

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor
CAPM

Figure: Portfolio Choice

 Separation Principle

Separation Principal: Investors make two separate decisions:

Risk-
Return and The determination of market portfolio
CAPM He uses his knowledge of expected return, variance and covariances to calculate the set
CAPM of stocks represented by the efficient frontier.
He then determines point M as the point of tangency of the straight line from r to the
Home bias
efficient frontier.
Multifactor During this process, individual risk attitudes play no role.
CAPM
An implication: each investor must hold assets in the proportions in which they are in
FirmValue
the market ( MarketValue ).
If AT&T is 10% of total stock market value, then each investor should hold 10%
AT&T in his own portfolio
The investor now determines how he will combine the market portfolio with the
risk-less asset.
This decision depends on his subjective risk attitudes.
He is risk averse if he holds some positive amount of risk-less asset,
He is less risk averse if he holds negative amount of risk-less asset, i.e. borrowing
money to invest in the market portfolio.
2 ) on the capital market
For any portfolio (N, with mean return µN and variance σN
line, we have  
µ−r
µN = r + σN
σm
 Home bias

Risk-
Return and
CAPM

CAPM

Home bias

Multifactor Home bias

CAPM Investors concentrate their investments in the equities of their home country.

There are benefits with international diversification.

Do people hold optimal portfolio?
Two methods to test this implication: model-based method and data-based
method.
 Home bias: The model based method

The model based method:

Assumes investors behave according to CAPM.
Everyone holds the market portfolio.
Risk-
Return and One should do so internationally.
CAPM

CAPM

Home bias

Multifactor
CAPM

Figure: Cooper and Kaplanis (1994): Table 1

 Home bias: Data based method

Data based method:

Given the returns and covariance
One can construct efficient frontier
Risk-
Return and Do our actual holdings belong the efficient frontier?
CAPM
Lewis: Trying To Explain Home Bias in Equities and Consumption 573
CAPM
12.4 -
Home bias

Multifactor
12.2 _ Uo
CAPM
100%
Foreign

12.0

E 11.8

11.6
B

11.4

11.2

U.S.

11.0- ,
13 13.6 14.1 14.7 15.3 15.9 16.5 17.0

StandardDeviation of Wealth
Figure 1. Risk ReturnTrade-OffPortfoliosof U.S. and Foreign MutualFunds
 Home bias: Explanations

Risk-
Return and Institutional factors:
CAPM
Restrictions on international capital flows,
CAPM

Home bias
Withholding taxes, and
Multifactor Transaction costs.
CAPM
These explanations do not work.

Investor behavior explanations:

Investors may simply be relatively more optimistic about their domestic markets
(French and Poterba, 1991): higher returns and lower standard deviations.
Home bias works even within U.S. and information asymmetries may be driving
this effect (Coval and Moskowitz, 1999).
They work somewhat.
 Multifactor Capital Asset Pricing Model

Risk-
Return and
CAPM Multifactor Capital Asset Pricing Model:
CAPM (single factor) CAPM assumes only one risk: uncertainty about the future price
Home bias of a security
Multifactor Investors could be concerned with more factors: income, inflation, investment
CAPM
opportunities, etc.
Robert Merton: Multifactor CAPM

E (rp ) = βpm E (rm ) + βpF 1 E (rF 1 ) + βpF 2 E (rF 2 ) + . . . + βpFk E (rFk )

where
k: number of factors (extra-market sources of risk),
βpFk: the sensitivity of the portfolio to the kth factor,
E (rFk ): the expected return of factor k minus the risk-free rate
investors want to be compensated for the risk associated with each source of
extra-market risk (in addition to market risk)
 Fama-French three factors model

Risk-
Return and
CAPM

CAPM
Fama-French three factors model
Home bias

Multifactor E (rp ) = βpm E (rm ) + βv E (rHML ) + βs E (rSMB ))

CAPM

where
rm : the returns of the market portfolio
rH ML: the returns of a portfolio consists of the difference of firms with high
book-to-market ratios and firms of low book-to-market ratios.
rS MB: the returns of a portfolio consists of the difference of firms with large
capitalization and firms of low capitalization.
 Fama-French three factors model: A concrete example

Risk-
Return and Company book-to-market ratio market value returns
CAPM Alphabet Inc 0.24 497B 44.70%
CAPM Deutsche bank 2.44 31.26 B -21%
Home bias Apple 0.22 546.30 B -10.61%
Multifactor Microsoft 0.19 417.77B 12.81%
CAPM
IBM 0.10 129.25B -15.04%
Citi Group 1.49 139.57B -6.31%
Facebook 0.15 275.76B 27.55%
Royal Dutch Shell 1.27 127.09B -21%
Amazon 0.04 289.57B 109.59%

Recall:
rm : the returns of the market portfolio
rHML : the returns of a portfolio consists of the difference of firms with high
book-to-market ratios and firms of low book-to-market ratios.
rSMB : the returns of a portfolio consists of the difference of firms with large
capitalization and firms of low capitalization.
 Fama-French three factors model: A concrete example

Risk-
Return and
CAPM

CAPM

Home bias
Small Neutral Big
Multifactor Value DB: -21% Citi:-6.31% Apple: -10.61%
CAPM
Neutral Shell: -21% Amazon: 109.59% Alphabet: 44.70%
Growth IBM: -15% FB: 27.55% MS: 12.81%

Calculations:
SMB = 1/3(SmallValue + SmallNeutral + SmallGrowth) − 1/3(BigValue +
BigNeutral + BigGrowth).
HML = 1/2(SmallValue + BigValue) − 1/2(SmallGrowth + BigGrowth).
 Arbitrage Pricing Theory Model

APT model:
Risk- a security’s expected return is influenced by many factors – Multifactor CAPM
Return and
CAPM
Ri = E (Ri ) + βiF 1 F 1 + βiF 2 F 2 + . . . + βiFh Fh . . . + βiFH FH + i
CAPM

Home bias where

Multifactor Ri : the random rate of return on security i,
CAPM E (Ri ): the expected return on security i,
Fh : the hth common factor that influences the returns of securities,
βih : the sensitivity of the ith security to hth factor,
i : the unsystematic return of security i
No arbitrage opportunity in equilibrium

E (Ri ) = βiF 1 E (RF 1 ) + βiF 2 E (RF 2 ) + . . . + βiFh E (RFh ) . . . + βiFH E (RFH )

This is the APT model.

The APT states that investors want to be compensated for all the factors that
systematically affect the return of a security.
βiFh the quantity of systematic risk accepted for factor Fh,
E (RFh ) = RFh − rf : market price of the factor Fh risk.
Empirical evidence of APT is inconclusive: It is difficult to identify underlying
factors.
 Key points

Key points:
Risk-
Return and Portfolio diversification
CAPM

CAPM

Home bias
Systematic risk and beta
Multifactor
CAPM

Unsystematic risk

CAPM and multifactor CAPM.

APT and its empirical testing.

Home bias and empirical tests.