Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

ECO562-Financial Economics
Semester: Spring 2017

Dr. Zulfiqar Hyder

Institute of Business Administration, Karachi

April 01, 2017

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

The Capital Asset Pricing Model (CAPM) and the Security

Market Line-I

Although the capital market line holds for efficient portfolios,

it does not describe the relationship between expected return
and risk for individual assets.
In equilibrium, the expected return on a risky asset (i)
[CAPM equation] can be shown to be:

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

The Capital Asset Pricing Model (CAPM) and the SML-II

The significance of the security market line is that in
equilibrium each risky asset should be priced so that it plots
exactly on the line.

The betas of individual assets will

Dr. Zulfiqar Hyder be distributed
ECO562-Financial around
Economics Semester: the
Spring 2017
Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Implementation of the CAPM

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Risk, Return and CAPM-I

Why the CAPM should represent the risk-return relationship

for assets such as shares?
For this, the distinction between systematic and unsystematic
risk is important.
The returns on a firms shares can vary for many reasons: for
example, interest rates may change, or the firm may develop a
new product, attract important new customers or change its
chief executive.
These factors can be divided into two categories:
Firm-specific factors and Market-wide factors
Firm-specific factors and Diversification.
Even with diversification, the effects of the market-wide
factors will remain, no matter how many different shares are
included in the portfolio.
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017
Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Risk, Return and CAPM-II

Because unsystematic risk can be eliminated by diversification,

the capital market will not reward investors for bearing this
type of risk.
The capital market will only reward investors for bearing risk
that cannot be eliminated by diversificationthat is, the risk
inherent in the market portfolio.
The reward for bearing systematic risk is a higher expected
return and, according to the CAPM.
Which suggests a simple linear relationship between expected
return and systematic risk as measured by beta.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

The Arbitrage Pricing Theory-APT

What if there are Multiple Sources of Systematic Risk?

Voluminous empirical research has shown that there are other
factors that also explain returns.
APT model assumes that returns follow a multi-factor linear
model:

Then the APT implies the following relation:

Cost of capital depends on K sources of systematic risk

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

The Arbitrage Pricing Theory-II

Strengths of the APT

Derivation does not require market equilibrium.
Allows for multiple sources of systematic risk, which makes
sense.
Weaknesses of the APT
No theory for what the factors should be.
Assumption of linearity is quite restrictive.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

The Three-factor Model of Expected Returns FAMA and

French (1993)
Other factors that also explain returns include:
1 a companys dividend yield
2 its priceearnings (PE) ratio
3 its size (as measured by the market value of its shares)
4 the ratio of the book value of its equity to the market value of
its equity.
Fama and French (1992) show that the size and
book-to-market ratio were dominant and that dividend yield
and the priceearnings ratio were not useful in explaining
returns after allowing for these more dominant factors.
Fama and French (1993) tested the following three-factor
model of expected returns:

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

The Three-factor Model II

In above equation, the first factor is the market risk premium

[CAPM].
The next factor, SMB, refers to the difference between the
returns of a diversified portfolio of small and large firms.
The third factor, HML reflects the differences between the
returns of a diversified portfolio of firms with high versus low
book-to-market values.
All three factors were found to have strong explanatory
power.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

The Three-factor Model III

Fama and French (1996) argue that smaller companies are

more likely to default than larger companies.
In addition, they argue that this risk is likely to be systematic
in that small companies as a group are more exposed to
default during economic downturns.
Zhang (2005) argues that companies with high
book-to-market ratios will on average have higher levels of
physical capacity. Excess capacity during economic downturns
exposes such companies to increased risk.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Momentum Effect

Carhart (1997) added a fourth factor, Momentum Effect, to

the three-factor model to explain returns earned by mutual
funds.
In an earlier paper Jegadeesh and Titman (1993), using US
data from 1963 to 1989, identified better-performing shares
[the winners] and poorer-performing shares [the losers] over a
period of 6 months.
They then tracked the performance of the shares over the
following 6 months and conclude that on average, the biggest
winners outperformed the biggest losers by 10 per cent per
annum [Momentum Effect].
When Carhart (1997) added this momentum effect to the
three-factor model, he found that it too explained returns.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Portfolio Performance Appraisal

Assume that an investor observes that during the past 12 months,

his or her portfolio has generated a return of 15 per cent.

Is this a good, bad or indifferent result?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Portfolio Performance Appraisal II

The answer to that question depends on the expected return
of the portfolio given the portfolios risk.
For this, we need to compare the performance of investor
portfolio with the performance of a benchmark portfolio of
similar risk.
The performance may differ due to four reasons:
1 Asset allocation: Investors must decide how much of their
wealth should be allocated between alternative assets.
2 Market timing: Investors need to make decisions about when
to buy and sell the assets held in a portfolio.
3 Security selection: Investors need to choose between many
different individual assets within each class. Beliefs about
under-priced and over-priced securities.
4 Random influences: Ultimately, investing is an uncertain
activity and in any given period the performance of a portfolio
may not reflect the skills of the investor who makes the
investment decisions. [bad luck or good luck].
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017
Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Portfolio Performance Appraisal III

Lets consider four commonly used ways of measuring the

performance of a portfolio.
1 Simple benchmark index: involves a simple comparison
between the portfolios return and the return on a benchmark
index that has similar risk to the portfolio being measured. For
example, a well-diversified portfolio of domestic shares might
be bench marked against the KSE 100 Index.
2 The Sharpe ratio: is a measure of the excess return of the
portfolio per unit of total risk and is calculated using the
following formula:

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Portfolio Performance Appraisal IV

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Portfolio Performance Appraisal V

The Treynor ratio: measures excess returns per unit of risk, but
differs from the Sharp ratio as it defines risk as non-diversifiable
(or systematic) risk instead of total risk. It can be calculated using
the following formula:

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Portfolio Performance Appraisal VI: Example

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Portfolio Performance Appraisal VII: Example (conti. . . )

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Risk, Return and CAPM The Arbitrage Pricing Theory The Three-factor Model Portfolio Performance Appraisal

Portfolio Performance Appraisal VIII

Jensens alpha: is a measure that relies on a multi-period analysis

of the performance of an investment portfolio relative to some
proxy for the market generally.
Recall, the CAPM is an ex-ante single-period model, in the
sense that it is concerned with the returns that might be
expected over the next time period.
The regression equation for Jensens alpha is as follows:

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017