Capital Asset Pricing Model

1. Assume that the following assets are correctly priced according to the security market
line. Derive the security market line.
Ŕ1= 6% β1 = 0.5
Ŕ2 = 12% β2 = 1.5
What is the expected return on an asset with a Beta of 2?
Assume that an asset exists with Ŕ3 = 15% and β3 = 1.2. Design the arbitrage
opportunity.

Arbitrage Pricing Theory

1. Assume the following two index model describes the returns:
Ri=ai +bi 1 I 1 +bi 2 I 2 +e i

Multi factor model:

Consider the following three portfolios

Portfolio Expected Return (%) bi1 bi2

A 12.0 1.0 0.5
B 13.4 3.0 0.2
C 12.0 3.0 -0.5
Find the equation of the plane that must describe equilibrium returns.
Illustrate the arbitrage opportunities that would exist if a portfolio called D with the
following properties were observed:
Ŕ D= 10% bD1=2 bD2=0

2. Consider the following three portfolios:

Portfolio Expected Return (%) bi1 bi2
A 12.0 1.0 0.5
B 13.4 3.0 0.2
C 12.0 3.0 -0.5
If ( Rm −R F )=4
, λ0 = 10, λ1 = 1 and λ2 = 2, find the values for the following
variables that would make the given expected returns consistent with equilibrium
determined by the simple (Sharpe-Lintner-Mossin) CAPM
a. βλ1 and βλ2 b. βp for each of the three portfolios c. RF

Zero Beta CAPM (In the absence of risk free lending and borrowing)

Ŕi = Ŕ Z+ βi ( Ŕ M - Ŕ Z)

Ŕ Z = Return on zero beta portfolio

Arbitrage Pricing Model

Multi factor return generating process
Ri = ai + bi1I1+bi2I2+……bijIj+ei
ai = Expected level of return for stock I if all indices have a value of zero

1
Ij = Value of the jth index that impacts the return on stock i
bij = Sensitivity of stock i’s return to the jth index
ei = A random error with a mean of zero and variance equal to σei2
E(ei, ej) = 0 for all i and j where i is not equal to j

APT model that arises from this return generating process

Ŕi = λ0 + bi1λ1 + bi2λ2 + …….. bij λj

λ0 = RF
λj = Increase in expected return a one unit increase in bij (i.e. expected risk premium
associated with jth factor i.e. Ŕ j−¿RF

Factors considered by various models:

Chen, Roll and Ross (1986):
• Inflation
• Term structure of interest rates
• Risk premia (difference between return on safe bonds and risky bonds)
• Industrial production
Fama and French (1993):
• Difference in return on a portfolio of small stocks and a portfolio of large stocks
(small minus large), i.e. small firm effect (spread)
• Difference in return between a portfolio of high book to market stocks and a portfolio
of low book to market stocks (high minus low)
• Difference in return between the monthly long term government bond return and one
month Treasury bill return (spread for term structure)
• Difference in the monthly return on a portfolio of long-term corporate bonds and a
portfolio of long-term government bonds (credit spread)

Fama and French Three Factor Model (1993):

Ri = Rf + βmkt (Rmkt -Rf) + βSMB SMB + βHML HML + ε

Fama and French Five Factor Model (1993):

Ri = Rf + βmkt (Rmkt -Rf) + βSMB SMB + βHML HML + βTS TS+ βCR CR + ε

Carhart Four-Factor Model (1997):

Ri = Rf + βmkt (Rmkt -Rf) + βSMB SMB + βHML HML + βMOM MOM + ε