PartB Factormodels

B.
The capital asset pricing model

1. Assumptions 7. The security market line
2. The market portfolio 8. CAPM in practice
3. The capital market line 9. The single-index model
4. The risk premium 10. Multifactor models
5. Individual securities 11. Efficient market hypothesis
6. Systematic risk
Investments, 2021-2022 Stephanie Heck, Ph.D. 88

Assumptions
All investors must arrive at the same composition of the optimal
risky portfolio…
• If all investors use mean-variance analysis.
Individual • If all investors plan for the same time horizon.
behaviour • If all investors use the same expected returns and covariance
matrix of security return (homogenous expectations).
• If all assets trade on public exchanges
Market • If all investors can borrow or lend at a common risk-free rate,
and can take short positions
structure
• If there are no taxes and no transaction costs.
The market portfolio
All investors hold the market portfolio
If all investors optimize their portfolios using the Markowitz model of efficient
diversification and they all use the same input:
• Each investor will draw the same efficient frontier and the same CAL.
• Hence each investor will choose an identical portfolio P of risky assets.
When we aggregate the portfolios of all individual investors:
• Lending and borrowing will cancel out
• The value of the aggregate risky portfolio will equal the entire wealth of
the economy
• This is the market portfolio

The aggregate risky portfolio is the market portfolio.
• This (efficient and completely diversified) portfolio includes all risky
assets, in proportion to their market value. If a market equilibrium is to
exist, the prices of all assets must adjust until all are held by investors.
• The proportion of each stock in this market portfolio equals the market
value of the stock divided by the sum of the market values of all stocks.
𝑉!
𝑤!,# = &
∑!$% 𝑉!
Where 𝑉! is the market value of stock i, hence price per share × number
of shares outstanding

The passive strategy is efficient
• The market portfolio must be efficient because all individual holdings are
efficient.
• This means that investors can skip the trouble of doing security analysis and
obtain an efficient portfolio simply by holding the market portfolio.
• The passive strategy of investing in a market index portfolio is efficient.
• Mutual fund theorem ≈ Separation property
• The Parable of the Money Managers (by Sharpe)
• The optimal CAL is constructed from the risk-free asset and the market
portfolio
• This is the capital market line (CML).

The capital market line
E(r )
Capital market line
𝐸 𝑟"
M
Market portfolio
𝑟! 𝐸 𝑟* − 𝑟)
𝐸 𝑟( = 𝑟) + 𝜎+
𝜎*
𝜎" σ
The capital market line
• The CML explains the relationship between the return on an efficient portfolio and
its total risk.
• All the (efficient) portfolios that lie on the CML are perfectly positively correlated
with each other and with the completely diversified market portfolio.
WHY?
• Because all the variability comes from the marketportfolio (market risk):
𝜎( = 𝑦𝜎* and 𝐸 𝑟( = 𝑟) + 𝑦[𝐸 𝑟* − 𝑟) ]
REMINDER:
• All combinations of perfectly positively correlated portfolios lie on a straight line.
• All efficient portfolios have the same Sharpe ratio, that of the market (which exhibits
the highest possible Sharpe ratio).

The risk premium
The risk premium on the market portfolio
By deciding how much to invest in portfolio M versus the risk-free asset
we can deduce the equilibrium risk premium of portfolio M.
Remember, the optimal fraction y* in the risky portfolio was: 𝑦 ∗ =
( )! *)"
+,!#
Hence we now have:
𝐸 𝑟# − 𝑟-
𝑦∗ = .
𝐴𝜎#
Where 𝐸 𝑟# − 𝑟- = 𝐸(𝑅# ) is the market risk premium.

The risk premium
When 𝑦. = 1, and 𝐴̅ is the representative investor’s risk aversion:
𝐸 𝑟# − 𝑟- = 𝐴𝜎 ̅ #
.
The market risk premium is proportional to

• The average degree of risk aversion of the investor population
• The risk of the market portfolio

Individual securities
Expected returns on individual securities
• Portfolio risk is what matters to investors and what governs the risk premiums they
demand.
• How do we measure the contribution of a stock to the risk of the overall portfolio?
• Let’s illustrate with the bordered covariance matrix and stock GE

• The contribution of GE’s stock to the variance of the market portfolio is:
𝑤$% [𝑤&𝑐𝑜𝑣 𝑅&, 𝑅$% + 𝑤'𝑐𝑜𝑣 𝑅', 𝑅$% + ⋯ + 𝑤$% 𝑐𝑜𝑣 𝑅$% , 𝑅$%
+ … + 𝑤( 𝑐𝑜𝑣 𝑅( , 𝑅$% ]
Every term in [ ] can be rearranged as: 𝑤) 𝑐𝑜𝑣 𝑅) , 𝑅$% = 𝑐𝑜𝑣 𝑤) 𝑅) , 𝑅$%
Moreover, because
(
covariance is additive,
(
the sum of the terms in [ (] is:
, 𝑤) 𝑐𝑜𝑣 𝑅) , 𝑅$% = , 𝑐𝑜𝑣(𝑤) 𝑅) , 𝑅$% ) = 𝑐𝑜𝑣(, 𝑤) 𝑅) , 𝑅$% )
)*& )*& )*&
(
∑)*& 𝑤) 𝑅) =
Since 𝑅+ we have:
(
, 𝑤) 𝑐𝑜𝑣 𝑅) , 𝑅$% = 𝑐𝑜𝑣(𝑅+ , 𝑅$% )
)*&
Hence the contribution of GE to the market portfolio’s variance is: 𝒘𝑮𝑬 𝒄𝒐𝒗(𝑹𝑴, 𝑹𝑮𝑬)
• The contribution of GE to the risk premium of the market portfolio is
𝑤!" 𝐸 𝑅!" .
• Therefore the reward-to-risk ratio for GE can be expressed as:
𝐺𝐸 ! 𝑠 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑡𝑜 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑤"# 𝐸(𝑅"# ) 𝐸(𝑅"# )

= =
𝐺𝐸 ! 𝑠 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑡𝑜 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑤"# 𝑐𝑜𝑣(𝑅"# , 𝑅$ ) 𝑐𝑜𝑣(𝑅"# , 𝑅$ )
• The market portfolio is the tangency (efficient mean-variance) portfolio. The

reward-to-risk ratio for investment in the market portfolio is:
𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝐸(𝑅$) Market price of risk

= &
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝜎$

• In equilibrium, all investments offer the same reward-to-risk ratio:
𝐸(𝑅,- ) 𝐸(𝑅. )
= /
𝑐𝑜𝑣(𝑅,- , 𝑅. ) 𝜎.
• Hence,
012 3/0 ,31
𝐸(𝑅/( )= # 𝐸 𝑅4
,1
Contribution of GE stock to the variance of the

market portfolio as a fraction of the total variance
𝛽/(
𝑬 𝒓𝑮𝑬 = 𝒓𝒇 + 𝜷𝑮𝑬[𝑬 𝒓𝑴 − 𝒓𝒇]

The expected return-beta relationship in general:
𝐸 𝑟0 = 𝑟) + 𝛽0 [𝐸 𝑟. − 𝑟) ]
• The risk premium of the individual stock does NOT depend on the total volatility of
the investment
• It only depends on the stock’s contribution to overall portfolio risk
• Only systematic risk is priced
The expected return-beta relationship holds for individual assets and for any
combination of assets
• It also holds for the market portfolio itself: 𝐸 𝑟. = 𝑟) + 𝛽. [𝐸 𝑟. − 𝑟) ]
(
(23(4' ,4' ) 7'
• We necessarily have: 𝜷𝑴 = 𝟏 (= ( = ()
7' 7'

• Beta is the risk of security j per unit of market portfolio risk.
• It measures the extent to which returns on the asset and the market
portfolio move together. If the market moves X, the portfolio moves
Beta*X. Thus, beta measures the market risk (or systematic risk), that
is nondiversifiable.
𝑐𝑜𝑣(𝑟9 , 𝑟4 )
𝛽9 = .
𝜎4
• It measures the contribution of j to the variance of the market portfolio
as a fraction of the total variance of the market portfolio.

Systematic risk
• In this setup, only systematic risk is rewarded.
• Do not confuse systematic risk and systemic risk:
Systematic risk arises from the co-movement of an individual asset or a

portfolio with the overall market. It can be quantified (beta) and hedged.
Systemic risk arises from spillovers of particularly severe distress events.

Such spillovers have a clear direction from market participants (e.g.,
financial institutions) to markets.

Systematic risk
The CAPM model gives us a prediction of the relationship between risk
and expected return of an asset.
This relationship serves two functions:
• It provides a benchmark rate of return for evaluating possible investments. We

can assess whether the expected return we forecast for a stock is more or less
than its ‘fair’ return (hence the equilibrium return of the model) given its risk
• The model helps to make a guess as to the expected return on assets that have
not yet been traded in the market

The security market line
• The expected return-beta relationship is a reward-risk equation
• β is the appropriate measure of risk; it measures the contribution of the
stock to the variance of the market portfolio.
• The risk premium of the individual stocks is therefore proportional to:
• the beta (β)
• the risk premium of the market portfolio (the market premium)
• We can illustrate the return-beta relationship graphically as the Security

Market Line (SML)

E(r) Market portfolio SML

M
𝐸 𝑟#
𝐸(𝑟. ) − 𝑟) = Slope of the SML
𝑟!
𝛽$ = 1 β

CML vs. SML
CML SML
• Risk premiums of efficient • Individual asset risk premiums as
portfolios as a function of a function of asset risk
portfolio standard deviation • The relevant risk measure for
• Standard deviation is a valid risk individual assets held as part of
measure for efficiently well-diversified portfolios the beta
diversified portfolios. (𝛽).

• The SML provides a benchmark for the evaluation of investment
performance.
• The SML provides the required rate of return necessary to compensate
investors for risk as well as the time value of money.
• We can use the SML, to assess whether an asset is:
• fairly priced
• undervalued
• overvalued

E(r) Market portfolio SML

M
𝐸 𝑟#
X 𝛼9
𝛼8 Y
𝑟!
𝛽$ = 1 β

• The investor makes an assessement of his ‘(actually) expected return’; the
latter can than be compared to the ‘required (fair) return’ provided by the
model.
• The difference between the two is called the security’s (ex-ante) alpha
(𝛼).
• expected return > required return ; positive alpha (𝛼 8 ) => underpriced security
• expected return < required return; negative alpha (𝛼 9 ) => overpriced security
• Each fairly priced asset plots exactly on the SML. We are in equilibrium.
(alphas = 0)

( )2 *)"
• The slope of the SML , is the Treynor ratio
:2
• The slope of the SML is a reward-to-market risk ratio; it gives the excess
return per unit of market risk (systematic risk), instead of total risk.
• Treynor measure is appealing because when an asset is part of a large
investment portfolio, one should weigh its excess return against its
systematic risk rather than against total risk to evaluate contribution to
performance.
• At equilibrium, the Treynor ratio is the same for all assets.

CAPM in practice
The CAPM is useful for:
• Security analysis: The starting point of portfolio management can be a

passive market-index portfolio. The manager will then uncover securities
with nonzero alphas and adjust the portfolio accordingly.
• Capital budgeting decisions: Any project can be assessed based on the

CAPM; the CAPM provides the required rate of return that the project
needs to yield, based on its beta, to be acceptable to investors. Managers
can thus obtain a cutoff internal rate of return, or ‘hurdle rate’.

CAPM in practice
How can we test the CAPM?
2 main elements:
• The market portfolio: is the market portfolio (or alternatively a portfolio
of huge size) mean-variance efficient?
• The CAPM implies expected returns; we can only observe realized
returns
• To make the leap from expected to realized returns and make the CAPM
implementable, we could use the single-index model. Additional
assumptions are however needed.

The single-index model
• Index models have initially been developped to address two main
drawbacks of the Markowitz procedure, namely:
• the huge number of covariance estimates required
• no guidelines on the forecasting of security risk premiums
• Index models explicitly decompose risk into systematic and firm-specific
components.
• An important assumption is that, at any time, security returns are driven
by one or more common variables.

• The single index model is expressed as:
𝑅!,; = 𝑎!,; + 𝛽! 𝑅4,;
where R denotes realized excess returns, hence 𝑟! − 𝑟- .
• We assume that the rate of return 𝑅4 on a broad index of securities is a
valid proxy for the common macroeconomic factor.
• 𝑎! represents the (firm specific) component of the return insensitive to
market returns.

• As the model is linear, the 𝛽! (the sensitivity of the security on the index)
can be estimated using a single-variable linear regression.
• The regression equation is given by:
𝑅!,; = 𝛼! + 𝛽! 𝑅4,; + 𝑒!,;
• Therefore, return variation comes from 2 sources:
• Component due to market movements: 𝛽0 𝑅.,:
• Component due to firm-specific events: 𝛼0 is the security’s expected excess
return when the market excess return is zero; 𝑒0,: (the residual) is the zero-
mean, firm-specific surprise in the security return in time t.

• The covariances between any two securities can be determined by their
betas:
𝜎!9 = 𝐸 𝑅! − 𝐸(𝑅! ) 𝑅9 − 𝐸(𝑅9 )
= 𝐸 𝛼0 + 𝛽0 𝑅. + 𝑒0 − (𝛼0 + 𝛽0 𝐸(𝑅. )) 𝛼; + 𝛽; 𝑅. + 𝑒; − (𝛼; + 𝛽; 𝐸(𝑅. ))

= 𝐸 𝛽0 (𝑅. − 𝐸(𝑅. )) + 𝑒0 𝛽; (𝑅. − 𝐸(𝑅. )) + 𝑒;
/
=𝛽0 𝛽; 𝜎. + 𝛽; 𝐸 𝑒0 𝑅. − 𝐸 𝑅. + 𝛽0 𝐸 𝑒; 𝑅. − 𝐸 𝑅. + E(𝑒0 𝑒; )
=𝜷𝒊 𝜷𝒋 𝝈𝟐
𝑴

• The variance (total risk) of the excess return of the stock can be derived
as follows:
𝜎!. = 𝐸 𝑅! − 𝐸(𝑅! ) .
/
= 𝐸 𝛼0 + 𝛽0 𝑅. + 𝑒0 − (𝛼0 + 𝛽0 𝐸(𝑅. ))
= 𝐸 𝛽0 (𝑅. − 𝐸(𝑅. )) + 𝑒0 /
=𝛽0/ 𝐸 𝛽0 (𝑅. − 𝐸(𝑅. )) + 𝑒0 /
= 𝛽0/ 𝐸 𝑅. −𝐸(𝑅. ) / + E 𝑒0/ + 2𝛽0 𝐸[𝑒0 𝑅. −𝐸(𝑅. )]

= 𝜷𝟐𝒊 𝝈𝟐𝑴 + 𝝈𝟐(𝒆𝒊 )

• The security’s total risk has two components:
𝜎!. = 𝛽!.𝜎4
.
+ 𝜎 .(𝑒! )
Market risk (systematic risk) Firm-specific risk (diversifiable or

attributable to its sensitivity to unique risk) reflected by residuals,
macroeconomic factors, common to the attributable to unexpected events
entire market (e.g. business cycles, monetary relevant only to the firm (e.g., litigation,
policy, inflation political unrest, etc.) management style, R&D, patents, etc. )
CAPM and single-index model
• The covariance of the excess return on security i with that of the
market index is:
𝑐𝑜𝑣 𝑅! , 𝑅4 = 𝑐𝑜𝑣(𝛽! 𝑅4 + 𝑒! , 𝑅4 )
=𝛽! 𝑐𝑜𝑣 𝑅4 , 𝑅4 + 𝑐𝑜𝑣 𝑒! , 𝑅4

= 𝜷𝒊 𝝈𝟐𝑴
012 33 ,31
• The sensitivity coefficient thus equals: 𝛽! = #
,1

• Why did we compute the covariance between two assets’ returns and the
variance of returns (total risk)?
• In the context of efficient frontier and portfolio optimization, the index
model considerably reduces the number of parameters to estimate
• Covariance between any pair of stocks is determined by their common exposure
to market risk
/
• We need much ‘less’ input: 𝛽0 , 𝛽; , 𝜎. , 𝜎 / (𝑒0 ),𝛼0
• Moreover, it turns out the the beta used in the single-index model is
exactly the same as the one in the CAPM (where the theoretical market
portfolio is replaced by a market index).

• Let’s illustrate how the single-index model estimation can be used for
tests of the CAPM.
• The CAPM relation is:
𝐸 𝑟! = 𝑟- + 𝛽! [𝐸 𝑟4 − 𝑟- ]
• The regression equation of the single-index model is:
𝑅!,; = 𝛼! + 𝛽! 𝑅4,; + 𝑒!,;
• And if we take expectations and total returns:
𝐸(𝑟! ) − 𝑟- = 𝜶𝒊 + 𝛽! 𝐸(𝑟4 − 𝑟- ]
• The CAPM predicts that 𝜶𝒊 = 0; the expected return = the fair return
• The CAPM predicts that expected alphas should be equal to zero for all
assets; the single-index model holds that realized alphas should average
out to zero:
𝜶𝒊 = 𝐸(𝑅! ) − 𝛽! 𝐸(𝑅4 ) = 0
• We can estimate these alphas from a regression of excess returns 𝑅! =
𝑟! − 𝑟- on the excess return of the index 𝑅4 .
• If the regression line uses total returns, the definition of alpha becomes:
𝛼!? = 𝐸 𝑟! − 𝛽! 𝐸 𝑟4 = 𝑟- + 𝛽! [𝐸 𝑟4 − 𝑟- ] −𝛽! 𝐸 𝑟4 = 1 − 𝛽! 𝑟-
The beta is unchanged, but alpha changes!

Tests of the CAPM
• Let’s illustrate this
with data on
Amazon’s stock
• We need excess
returns on the stock
and excess returns
on the market over
a certain period of
time
Excess monthly returns on Amazon and the market index; 5 years
ending June 2018;
BKM figure 8.3
Tests of the CAPM
• Alternatively, the same information is displayed in this scatter diagram
SCL
BKM figure 8.1

Tests of the CAPM
• The regression equation is: 𝑅+#@A,; = 𝛼+#@A + 𝛽+#@A 𝑅4,; + 𝑒+#@A,;
• 𝛼+#@A : The intercept, the security’s expected excess return when the
market excess return is zero.
• 𝛽+#@A : The slope of the regression line
• 𝑒+#@A,; : the residuals, the zero-mean, firm-specific surprise in the
security return in month t
• The line is called Amazon’s Security Characteristic Line (SCL)

Tests of the CAPM
Regression statistics for Amazon:

Tests of the CAPM
• 𝛽 is estimated at 1.5326
• Amazon’s share price tends to move 1.5326% for every 1% move in the market
index.
• The large t-stat and low p-value lead us to reject the hypothesis that the ‘true’ 𝛽 is zero.
• Let’s test the hypothesis that the 𝛽 is greater than 1.
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 − ℎ𝑦𝑝𝑜𝑡ℎ𝑒𝑠𝑖𝑧𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 1.5326 − 1

= = 1.69
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑒𝑟𝑟𝑜𝑟𝑠 0.3150
• In this case significance is lower, we cannot reject the hypothesis that the true 𝛽 is 1.

Tests of the CAPM
Estimations are sensitive to:
• The time interval:
o The number of observations and time interval used in regression vary, causing beta to vary
o There is no “correct” interval for analysis (daily, weekly, monthly, yearly returns…)
• The market portfolio:

o Theoretically, the market portfolio should include stocks and bonds, real estate coins, stamps,
art, antiques, and any other marketable risky asset worldwide
o In USA, most people use the S&P500 Composite Index as the proxy due to
§ It contains large proportion of the total market value of U.S. stocks
§ It is a value weighted index
o In Europe, the STOXX Europe 600 might be a good proxy
o Using a different proxy for the market portfolio will lead to a different beta estimate

Tests of the CAPM
The CAPM has many restrictive assumptions:
The identical input list

• In the absence of private information, we can reasonably admit that
investors agree on a firm’s prospects.
• There are however other elements which cast doubt on this assumption:
• Short sales are less common: more risky, limited supply of shares to be
borrowed, prohibited for many investors
• Taxes potentially affect returns to investors differently -> extension of CAPM
including personal taxes
Tests of the CAPM
Risk-free borrowing Portfolio when borrowing
E(r )
• Rates on borrowing are
typically higher than on
lending.
• Therefore borrowers and
lenders will arrive at different
tangency portfolios and thus 𝑟B
different optimal risky
portfolios. 𝑟-
• The market portfolio will no
longer be each investor’s
optimal risky portfolio σ
Extensions of the CAPM
A multiperiod model
• Investors use the mean-variance analysis and have a single period horizon. However,
consider the following question:
• Would you rather have wealth of €1.1 million and a price of oil of €400
per barrel or €1 million and oil priced at €40 per barrel?
• Would you rather have wealth of €1 million with a market standard
deviation of 10% or €1.1 million and a standard derivation of 50%?
• Investors should be more concerned by the stream of consumption
wealth can buy.
• Intertemporal CAPM of Merton (1992)

Liquidity and the CAPM
• There are no transaction costs. In reality, transaction costs exist and can be
important.
• The liquidity of an asset is the ease and speed with which it can be sold
at fair market value.
• Liquidity is a characteristic that affects asset values (Amihud and
Mendelson, 1986)
• Exposure to liquidity risk is also priced: liquidity beta (Pastor and
Stambaugh, 2003): high liquidity beta -> higher returns

Recap:
• CAPM: expected return-beta relationship; the expected risk THEORETICAL
premium is proportional to teh expected risk premium on the
market portfolio, with beta as the proportionality constant
• Single-factor model: F + firm-specific factors; one

(economic) factor (F) exerts the only common influence on PRACTICAL
security returns.
• Single-index model: the statistical/economic factor of the

factor model is replaced by an index of securities that can
proxy for the CAPM’s theoretical market portfolio. PRACTICAL

REGRESSIONS TO TEST THE CAPM
• Use the file ‘CAPM_dataforstudents.xls’
• Calculate returns and excess return series (frequency!)
• Calculate returns of the market index and the market premium
• Run regressions of excess returns on the market premium
• Discuss your findings of alpha’s and beta’s.

Multifactor models
• The CAPM is a special case of a one-factor model
• The decomposition of risk into market versus firm specific risk, that the
factor model offers is very appealing
• This can be extended to more economywide factors, such as business-
cycle risk, interest or inflation rate, energy price risk…
• In a multifactor model, risk premiums derive from exposure to multiple
risk sources, each with their own risk premium.
• The multifactor model is no more than a description of the factors that
affect security returns

Multifactor models
A single factor model is a bit restrictive to explain portfolio returns in a
satisfactory manner.
Let’s consider a two factor model with 2 sources of risk:
• the state of the business cycle
• interest rate changes
𝑅! = 𝐸 𝑅! + 𝑏!/CD 𝐺𝐷𝑃 + 𝑏!E3 𝐼𝑅 + 𝑒!
Factor loadings or factor betas

Multifactor models
• We need models with multiple factors. The specification for a K-factor
model is:
F
𝑅!,; = 𝛼! + I 𝛽!,9 𝐹9,; + 𝑒!,;
9$%
• There are essentially two main families of multi-factor models:
• Arbitrage Pricing Theory (APT) which tries to extract a number of
risk factors from the structure of asset returns and link it with
macro- or micro-economic factors
• Empirical Multifactor models that create factors from observed asset
return sensitivities to a number of specific and pre-determined
attributes, which are in turn associated to risk factors
Multifactor models
• An arbitrage opportunity arises when an investor can earn a riskless
profit without any net investment.
• Two equivalent assets should have the same price: law of one price.
• In the APT, a violation of this rule, will cause pressure to restore prices,
even if only a limited number of investors are aware of the
disequilibrium.
• Establishing an APT model relies on the concept of factor portfolios
-> it is a well-diversified portfolio that has a beta of 1 on one of the
factors and 0 on the others. Hence the returns on such a portfolio track
the evolution of particular sources of macroeconmic risk but are
uncorrelated with other sources of risk.
Multifactor models
The APT model
E(Ri)=λ0+ λ1bi1+ λ2bi2+…+ λKbiK

where:
λ0=the expected return on an asset with zero systematic risk
λj=the risk premium related to the j th common risk factor
bij=the pricing relationship between the risk premium and the asset; that
is, how responsive asset i is to the j th common factor
Central assumption: security prices satisfy a no arbitrage condition

Multifactor models
Illustration
• There are two factor portfolios 1 and 2: 𝜆< = 10% and 𝜆= = 12%; and
𝑟> =4%
• Portfolio A has b?< = 0.5 and b?= = 0.75
• The APT suggests: risk premium of portfolio A = sum of the risk premiums
required for each source of systematic risk; hence 13%.
• What if A has an expected return of 12%?
• Let’s construct Q as a combination of factor portfolios: 0.5 in portfolio 1, 0.75
in portfolio 2 and -0.25 in the risk-free asset.
• This portfolio Q has exactly the same exposure to risk as portfolio A.
• However an arbitrage opportunity exists: we would be long in Q and short in
A; this would yield an arbitrage profit of 1%.
Multifactor models
Empirical models: The Fama & French model
• E.Fama and K. French (FF) monitored 9,500 US stocks from 1963 to 1990 and
found that two classes of stock outperformed the market: Small caps and Stocks
with a high book-to-price ratio (“value stocks”), in contrast to “growth stocks”.
• Therefore, the market seems to allocate a premium to these characteristics.
• They suggest a three-factor specification:
𝑅$% = 𝛼$ + 𝛽$& 𝑅#% + 𝛽$' 𝑆𝑀𝐵% + 𝛽$( 𝐻𝑀𝐿% + 𝜀$%
“SMB” = “Small minus Big” account for the size effect;

“HML” = “High minus Low” accounts for the BTM effect.

Multifactor models
• To construct the empirical factors, FF propose to allocate all stocks into 6 portfolios
on the basis of the partitioning in small/big and high/medium/low (thus: BH=Big-
High, BM=Big-Medium etc.).
• Then the premiums are given by:
1 1
𝐻𝑀𝐿 = 𝑆𝐻 + 𝐵𝐻 − 𝑆𝐿 + 𝐵𝐿
2 2
1 1
𝑆𝑀𝐵 = 𝑆𝐻 + 𝑆𝑀 + 𝑆𝐿 − 𝐵𝐻 + 𝐵𝑀 + 𝐵𝐿
3 3
• The factor are constructed with NYSE, AMEX and NASDAQ data

Multifactor models
Estimates of single-index and three-factor Fama-French regressions for
Amazon, monthly data, 5 years ending June 2018.
BKM, Table 10.1.

Multifactor models
Smart betas
• Investors’ portfolios are subject to more than one systematic source of
risk.
• A smart-beta ETF will provide exposure to specific characteristics such
as value, growth, or volatility.
• These products allow investors to tailor portfolio exposure toward or
away from a range of extra-market risk factors.
• When assessing performance (the alpha) it is important to account for
these multidimensional sources of systematic risk.

Multifactor models
• The risk-return relationship is widely explored
• Momentum: past winners outperform past loosers; the momentum
factor is added by Carhart to the FF model (Carhart, 1997)
• Many other characteristics are explored: stock issues, accruals,
profitability, dividend yield, turnover…
• Liquidity: The effect of liquidity on an asset’s expected return is
composed of two factors:
• Transaction costs dominated by the bid–ask spread that dealers set to
compensate for losses incurred when trading with informed traders.
• Liquidity risk resulting from the sensitivity of asset returns to changes in market
liquidity (Pastor and Stambaugh 2003, Acharya and Pedersen 2005)

Efficient market hypothesis
Should stock prices be predictable?
• Imagine you have a stock selling today for EUR 100 and you would
predict its price in 3 days to be at EUR 110.
• This could not persist for long.
• A forecast about favorable future performance leads instead to
favorable current performance, as market participants all try to get in on
the action before the price jump.
• More generally, this implies that any information that could be used to
predict stock performance is already reflected in the price.

• Stock prices appear to follow a random walk: as likely to go up as down
• If all available information is already incorporated in the price, it must be
that stock prices only react to new information.
• New information, by definition, must be unpredictable: if it could be
predicted, then the prediction would be part of today’s information.
• Stock prices that change in response to new (previously unpredicted)
information must move unpredictably.
• Random price movements indicate a well-functioning or
efficient market, not an irrational one.
Cumulative abnormal
returns before takeover
attempts: target
companies
BKM, figure 11.1

The efficient market hypothesis: stock prices already reflect all
available information
1. Weak-Form EMH
• Current prices reflect all security-market historical information, including the
historical sequence of prices, rates of return, trading volume data, and other
market-generated information
• This implies that past rates of return and other market data should have no
relationship with future rates of return
3. Strong-Form EMH
• Stock prices fully reflect all information from public and private sources
• This implies that no group of investors should be able to consistently derive
above-average risk-adjusted rates of return
2. Semistrong-Form EMH
Current security prices reflect all public information, including market
and non-market information
This implies that decisions made on new information after it is public
should not lead to above-average risk-adjusted profits from those
transactions

So, Are Markets Efficient?
• There is a telling joke about two economists walking down the street.
They spot a $20 bill on the sidewalk. One stops to pick it up, but the
other one says, “Don’t bother; if the bill were real someone would have
picked it up already.”

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B.

The capital asset pricing model

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The market risk premium is proportional to

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𝐺𝐸 ! 𝑠 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑡𝑜 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑤"# 𝐸(𝑅"# ) 𝐸(𝑅"# )

• The market portfolio is the tangency (efficient mean-variance) portfolio. The

𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝐸(𝑅$) Market price of risk

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Contribution of GE stock to the variance of the

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Systematic risk arises from the co-movement of an individual asset or a

Systemic risk arises from spillovers of particularly severe distress events.

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This relationship serves two functions:

• It provides a benchmark rate of return for evaluating possible investments. We

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• We can illustrate the return-beta relationship graphically as the Security

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E(r) Market portfolio SML

𝐸(𝑟. ) − 𝑟) = Slope of the SML

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E(r) Market portfolio SML

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• Security analysis: The starting point of portfolio management can be a

• Capital budgeting decisions: Any project can be assessed based on the

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= 𝐸 𝛼0 + 𝛽0 𝑅. + 𝑒0 − (𝛼0 + 𝛽0 𝐸(𝑅. )) 𝛼; + 𝛽; 𝑅. + 𝑒; − (𝛼; + 𝛽; 𝐸(𝑅. ))

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=𝛽0/ 𝐸 𝛽0 (𝑅. − 𝐸(𝑅. )) + 𝑒0 /

= 𝛽0/ 𝐸 𝑅. −𝐸(𝑅. ) / + E 𝑒0/ + 2𝛽0 𝐸[𝑒0 𝑅. −𝐸(𝑅. )]

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Market risk (systematic risk) Firm-specific risk (diversifiable or

=𝛽! 𝑐𝑜𝑣 𝑅4 , 𝑅4 + 𝑐𝑜𝑣 𝑒! , 𝑅4

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BKM figure 8.1

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𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 − ℎ𝑦𝑝𝑜𝑡ℎ𝑒𝑠𝑖𝑧𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 1.5326 − 1

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• The market portfolio:

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The identical input list