MONASH Agenda

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1. From Portfolio Theory to the CAPM

BFC3241
Equities and Investment Analysis 2. Implementation of the CAPM using historical data

3. Evaluating the CAPM

Lecture 3: Asset Pricing Models 4. Contemporary Asset Pricing Models

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1. From Portfolio Theory to the CAPM 1. From Portfolio Theory to the CAPM
• Recall from Topic 2 – Portfolio Theory: • Recall from Topic 2 – Portfolio Theory (cont.)

 In the world of many risky assets and no risk-free asset: A mean-variance optimizer  Investors with very
chooses to invest along the Efficient Frontier low coefficient of risk
aversion (A) are even
 In the world of many risky assets and a risk-free asset: A mean-variance optimizer willing to hold a portfolio
chooses to invest along the Capital Market Line (CML) with a negative weight
in the risk-free asset and
 The CML has the same intercept F(0, rf) with all the CALs and the highest slope among all over 100% weight in
the CALs and take the following functional form: portfolio M.

Having a negative weight

in the risk-free asset
= Borrowing at the rf.
 All investors hold the market portfolio M @ the tangency point between the CML and the
Efficient Frontier. They will choose a point on the CML (i.e., combining rf and rM)
depending on their risk aversion. • The separation theorem:
 Same investment (port.M)
 Less (more) risk averse investors hold less (more) risk-free asset and more (less) portfolio  Different financing of the
M  They are located further from (closer to) point F(0,rf) on the CML Investment in port. M, depending on individual investor’s risk preference.
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 1. From Portfolio Theory to the CAPM 1. From Portfolio Theory to the CAPM
• To reach this point, we have assumed: • Portfolio M and the Capital Market Line:

 Individual investors are price takers  Portfolio M is called the Market Portfolio

 Single period investment horizon  It is a value weighted portfolio of ALL risky assets

 Investments are limited to traded financial assets  the proportion of each security is its market value as a percentage of total market value

 No taxes and no transaction costs  In equilibrium, ALL investors invest in portfolio M (the separation theorem!!)

 Information is costless and available to all investors  The average risk aversion of ALL market participants determines the return per unit of risk

 Investors are rational mean-variance optimizers  The return per unit of risk is called the market price of risk

 Investors have homogeneous expectations  Given a level of risk, investors expect some level of return, which we refer to as either the
required rate of return

(In week 4, we will learn that this required rate of return is used as the discount rate!)
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1. From Portfolio Theory to the CAPM 1. From Portfolio Theory to the CAPM
• The Pricing of Individual Securities: • The Pricing of Individual Securities:

 Individual Securities are part of Portfolio M  Focusing on what matters to : its co-movement with portfolio M
, , ,
 Individual Securities are not mean-variance efficient on their own: ,

 Recall that when we combine securities into a portfolio, for , ,

where
lim ,
→
 In equilibrium, reward to a unit of risk of M = reward to a unit of risk of security
When there are enough securities in a portfolio, the variances of individual securities’ returns
are irrelevant to the variance of the portfolio. Only their co-variances matter!

 In the context of security as part of Portfolio M: The expected return on security is a

function of its contribution to the variance of Portfolio M via the covariance , Multiply both sides by we have the CAPM!!:

 We decompose the standard deviation of security as follows: With a bit of rearrangement, we can see its popular form:
, 1 ,
What What does
matters to not matter MONASH MONASH
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1. From Portfolio Theory to the CAPM 1. From Portfolio Theory to the CAPM
• The CAPM in words: • The CAPM in a graph: The Securities Market Line (SML)

 The CAPM describes the relation between the risk premium on security as a E(ri)
linear function of the risk premium on the Market Portfolio and the
contribution of security to the overall risk of the Market Portfolio. SML

 The total risk of security (i.e., its variance ) can be decomposed into the systematic
risk component (i.e., which depends on its beta) and the remaining component. 0.08
Rx=13%
 The remaining component has several names: unsystematic risk, idiosyncratic risk. RM=11%
If the CAPM is correct and the market is
Ry=7.8% in equilibrium, only β matters in
 The CAPM says that investors should not expect to have any reward for their exposure to
this element of risk. determining the risk premium of a
security or a portfolio of securities.
3%
 A security with high (and positive) is expected to generate a high expected return
in up market when is high. What happens to in down market when is
low? ßi
0.6 1.0 1.25
 Stocks with low beta are called defensive stocks. They are like investors’ insurance! βy βM βx
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1. From Portfolio Theory to the CAPM 1. From Portfolio Theory to the CAPM
• The CAPM in a graph: • The CAPM in a graph – The SML vs. CML:
Disequilibrium Examples
In equilibrium, assets can lie off the
Suppose a security with a of 1.25 is offering Disequilibrium Example CML but always lie on the SML.
an expected return of 15%
E(r)
E(r) Efficient portfolio B
lies on the CML
According to the SML, the E(r) should be 13% SML
E(r) = 0.03 + 1.25(.08) = 13% 15%
Rm=11%
The difference between the return required
for the risk level (13%)
rf=3% Portfolio is the weighted
as measured by the CAPM in this case ß average of the of all assets
1.0 1.25 that make up the portfolio.
and the actual return (15%)
Positive is good, negative is bad
is called the share’s alpha denoted by for investors seeking to BUY a security.
Security 1’s Security 1’s
unique risk
market risk
For any asset , in equilibrium, the reward to
What is the in this case? + gives the buyer a + abnormal return risk ratio ⁄ should be the same.
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Agenda 2. Implementation of the CAPM using historical data
• In practice, to bring the CAPM to the data, we make several compromises:

1. From Portfolio Theory to the CAPM  Proxy the Market Portfolio with a market index such as S&P500, ASX200

 Use actual realized returns instead of expected return E(r)

2. Implementation of the CAPM using historical data
 The CAPM is implemented as the Index Model:
3. Evaluating the CAPM , , , , ,

 Regression outputs: and

4. Contemporary Asset Pricing Models
 Predicted excess return of security at time : , ,
 Predicted return of security at time : , , ,

 Regression residual at at time = , = Actual excess return – Predicted excess return

with , 0. The std. dev. of the residual is called the standard error and is the
measure of unsystematic risk of security .
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2. Implementation of the CAPM using historical data 2. Implementation of the CAPM using historical data
Excess Returns (i) • Empirical steps to implement the CAPM:
Dispersion of the points Securities Characteristic Line (SCL)
 Collect share price (adjusted for stock split and dividends) of stock over a period (e.g. 5
around the line
. .. . Slope = 
years), compute its monthly HPR , .

.
measures
unsystematic risk
______________. .
. . .  Collect monthly stock market index, calculate monthly market return

. .
,

. . .
The statistic is
called e

. . .. . . ..  Collect monthly returns of one-month T-bill over the same period. This is , .

. .
 Calculate monthly excess stock return ( , , ) and excess mkt return ( , , )

. .. . . . Excess returns  Run the regression of excess stock return on excess market return, with intercept

. . . .. . .. . .
on market index
= 

. . .. .
 Using Excel: Data / Data Analysis / Regression
What should

. . . . .  equal?  Or any statistical software that you are familiar with!

R =  + ßR + e
i i i M i
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2. Implementation of the CAPM using historical data 2. Implementation of the CAPM using historical data
• Empirical steps to implement the CAPM – An example • Empirical steps to implement the CAPM – An example
Jan 2001‐ Dec 2005
 General Motor, Jan 2001-Dec 2005, US T-bill rate, S&P500 Index

 Beta of GM = 0.8554 and statistically significant  GM is a cyclical stock, returns varying

with the overall market

 If the period Jan 2001 – Dec 2005 is representative of the nature of GM going forward:

 Use beta of 0.8554 to compute expected future GM stock return

 GM current and future shareholders should use the following cost of equity capital to
value GM stock (need future expected rf and excess rm):

Required rate of return by equity-holders = rf + beta x expected excess S&P index return

 GM management should use this cost of equity capital in combination with after-tax cost
of debt to calculate weighted average cost of capital (WACC) in order to evaluate GM’s
investment projects
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2. Implementation of the CAPM using historical data Agenda

• Empirical steps to implement the CAPM: one more consideration…

 A firm with a beta >1 will tend to have a lower beta (closer to 1) in the future. A firm with a 1. From Portfolio Theory to the CAPM
beta <1 will tend to have a higher beta (closer to 1) in the future.

 Calculated betas are adjusted to account for the empirical finding that betas different from
1 tend to move toward 1 over time.
2. Implementation of the CAPM using historical data

 Collect share price (adjusted for stock split and dividends) of stock over a period (e.g. 5
years), compute its monthly HPR , . 3. Evaluating the CAPM

 A simple adjustment method:

4. Contemporary Asset Pricing Models
Adjusted β = 2/3 (calculated β) + 1/3 (1)
= 2/3 (0.8554) + 1/3 (1)
= 0.9036

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 3. Evaluating the CAPM 3. Evaluating the CAPM
• Roll’s (1977) critique • Revisiting the CAPM assumptions

 The CAPM is an ex-ante model, but testing it (and implementing it!) uses ex-post data  Short selling: either expensive or impossible or both!

 The proxy used for the market portfolio is not truly market portfolio. The true market
portfolio is unobservable
 The CAPM is 'false' based on the validity of its assumptions (How?)
 The CAPM could still be a useful predictor of expected returns? That is an
empirical question!
 Borrowing: impossible or at a higher rate than lending.
 Composition of the Market Portfolio: not ALL risky assets are tradable
 The existence of a risk-free asset: sometimes there is none
 Absence of transaction costs: in reality, trans. costs and liquidity are always a concern to
any investor!

 Conclusion: As a theory, the CAPM is untestable.  Mean-variance investors with homogeneous belief: How realistic are these assumptions?

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3. Evaluating the CAPM Agenda

• Does the CAPM “work” in the data?

 That is, is the required rate of return solely determined by an asset’s exposure to the 1. From Portfolio Theory to the CAPM
Market Portfolio through its market beta?

 No! Betas are not as useful at predicting returns as other measurable factors may be. 2. Implementation of the CAPM using historical data
 Qualitatively, exposure to the Market Portfolio increases an asset’s expected return
3. Evaluating the CAPM
 Quantitatively, that’s not the entire story! And up until today, we are still learning what
factors should be in an asset pricing model.
4. Contemporary Asset Pricing Models
 However, one should not discard the CAPM just because of its empirical failure.

 The key principles we learn from the CAPM are still valid: diversification, systematic risk,
etc.

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4. Contemporary Asset Pricing Models 4. Contemporary Asset Pricing Models
• Fama and French (1993, 1996) Three factor model (FF3): • Fama and French (1993, 1996) Three factor model (FF3):

 rf is the one-month T-bill rate   i , si , hi are the “loadings”

 Market factor (Similar to the CAPM): The expected excess return on the Market Portfolio  Excess Market return, SMB, HML are the risk premia

 The Size factor (SMB)  The positive relation between risk and return implies positive risk premia

 The Book-to-Market factor (HML)  Does this fundamental principle hold with the new factors SMB and HML?

E ri   rf   i [ E ( rM )  rf ]  si E ( SMB )  hi E ( HML)

rM--rf SMB HML
Average 1927-2020 (% p.a.) 8.71 3.09 3.97
 In the entire market, identify Small stocks and Big stocks.
 SMB = Returns on Small stocks – Big stocks Source: My own estimation using data from K. French’s website

 In the entire market, identify Value stocks (i.e., those with high Book Value of Equity /  What could possibly make Value stocks have higher systematic risk and higher return than
Market Value of Equity) and Growth stocks (those with low BM) Growth stocks?
 HML = Returns on High BM stocks – Low BM stocks in the
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4. Contemporary Asset Pricing Models 4. Contemporary Asset Pricing Models

• Carhart (1997) Four factor model (CH4): • Fama and French (2015) Five factor model (FF5):

 Medium term winners outperform medium term losers  Firms with Robust profitability outperform firms with Weak profitability

 FF3 factors do not capture this pattern of returns  Firms with Conservative investment outperform firms with Aggressive investment

 Hence Carhart suggests we should add the Momentum Factor to the FF3 model  FF3 factors do not capture these patterns of returns

ℎ  Hence they suggest we should add two factors to the FF3 model

ℎ +
 In the entire market, identify Winner stocks and Loser stocks. UMD = Ups – Downs =
Returns on Winner stocks – Loser stocks

 What could possibly cause Winner stocks to have higher systematic risk and higher return
than Loser stocks? rM--rf SMB HML RMW CMA
Average 1964-2020 (% p.a.) 7.33 3.25 3.29 3.10 3.29
 Fama and French never consider UMD as a risk factor! Source: My own estimation using data from K. French’s website

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4. Contemporary Asset Pricing Models
• Fama and French (2015) Five factor model (FF5):

ℎ +

 Fama and French (2015) motivate the addition of the two new factors with the Dividend
Discount Model (we will look at this model in week 4)

 Fama and French (2015) admit that with CMA and RMW, we don’t need the HML.

 But it’s still in their new model! Look how many funds advertise themselves as value
funds?

 Fama and French (2018) further suggest to include UMD into FF5 and make it FF6!

ℎ +

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