UNIVERSITY OF GHANA BUSINESS SCHOOL

GROUP ASSIGNMENT- GROUP

PROGRAMME: MSC ACCOUNTING & FINANCE

MODULE TITLE:

INVESTMENT AND PORTFOLIO MANAGMENT

COURSE CODE: MSAF602

GROUP
NAMES OF GROUP MEMBERS STUDENT ID

MODULE LECTURERS:
PROF WILLIAM COFFIE, & DR. MICHAEL EFFAH ASAMOAH

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A)
This section assesses the impact of market risk premium on the excess return of an asset.
Thus, in line with the classical capital asset pricing model (CAPM) which suggests that a
single factor predicts the excess return on an asset or portfolio, monthly data is gathered to
test the validity of the model.
The Test of the CAPM is based on three implications of the relationship between the market
beta and the expected return which is implied by the model.
The expected return on the asset portfolios is linearly related to their betas. The beta premium
on the other hand if positive, means that the expected return on the market portfolios
exceed the expected return on the assets whose return are not correlated with the return on
the market and vice versa and finally, the Sharpe Lintner model which states that the asset
uncorrelated with the market have expected return equal to the risk free rate and the beta is
the market expected return less the risk free rate.
Time-series regression is used to test the validity of the classical CAPM using data for twelve
different portfolios.
The objective of the test is to establish CAPM which states that the only risk investors care
about or compensated for is systematic risk.

A testable model is expressed as

(𝑹𝒕 −𝑹𝒇𝒕)=𝒂𝒊 +𝜷𝒊(𝑹𝒎𝒕 −𝑹𝒇𝒕)+𝜺𝒕

Where.

Rft = is the month treasury bill rate, observed at the beginning of month ai
= Alpha or intercept,

Rmt = RMt is the value-weighted monthly per cent return on the market portfolio at time t
(Rmt – Rft) = Risk Premium

(Rt – Rft) = is the excess return on asset i at time t.

Ԑt = represents error correction mechanism. It represents the residual on return with a mean
value of zero, and it is assumed to be independent of all other variables

𝛽𝑖= must be significantly different from zero to capture all systematic risk

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Table a1: The result of the regression is as below.
Portfolio Beta Alpha R^2
Lo 30 VW 0.9811 0.00608 0.96051
(-0.0210) (0.03308)
Med 40VW 1.0256 0.00911 0.92217
(0.0478) (0.04954)
Hi 30VW 1.2172 0.01698 0.82785
(0.1779) (0.09229)
Lo 30 EW 1.1570 0.01585 0.83285
(-0.1404) (0.08618)
Med 40 EW 1.1904 0.01577 0.84197
(0.2519) (0.08575)
Hi 30EW 1.3460 0.02747 0.69187
(0.5730) (0.14935)
Small 30VW 1.3502 0.02374 0.75154
(0.1097) (0.12908)
Med 40 VW 1.1921 0.01158 0.90838
(0.0972) (0.06295)
Big 30 VW 0.9658 0.00261 0.99224
(0.0015) (0.01420)
Small 30 EW 1.3860 0.03091 0.65290
(0.3606) (0.16803)
Med 40 EW 1.2476 0.01386 0.88351
(0.0820) (0.07533)
Big 30EW 1.0780 0.00554 0.97254
(0.0119) (0.03012)

Source* Authors own computation using regression

Where expected CAPM return is

Expected return= E[Ri ]=Rf +i (E[RMkt]−Rf )

The average risk-free rate was computed as well as the average market risk premium. i.e.
(0.28 and 0.64) respectively
A result for Lo 30 VW is presented in the equation below for demonstrative purposes.
Results for the remaining Portfolio are presented in the table below
EXPECTED RETURN= 28%+ (0.98*0.64) 28%+
(0.63)
0.91
Table a2: Comparing CAPM return to Historical mean return
Market RETURN RETURN (HISTORICAL
Portfolio Beta RF premium (CAPM) MEAN)

Lo 30 VW 0.98 0.28 0.64 0.91 0.89

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 Med 40VW 1.03 0.28 0.64 0.94 0.99

Hi 30VW 1.22 0.28 0.64 1.06 1.24

Lo 30 EW 1.16 0.28 0.64 1.02 0.88

0.64
Med 40 EW 1.19 0.28 1.04 1.30

Hi 30EW 1.35 0.28 0.64 1.14 1.72

Small 30VW 1.35 0.28 0.64 1.14 1.26

Med 40 VW 1.19 0.28 0.64 1.04 1.14

Big 30 VW 0.97 0.28 0.64 0.90 0.90

Small 30 EW 1.39 0.28 0.64 1.17 1.53

Med 40 EW 1.25 0.28 0.64 1.08 1.16

Big 30EW 1.08 0.28 0.64 0.97 0.99

Source * Authors own computation.

The regression results for testing the validity of the classical CAPM is presented in table a1.
From the table, it can be observed that, there exist a positive relation between the market risk
premium and the excess return of all portfolios. Thus, the portfolios all recorded a positive
beta. This is significant at 5 percent level of significance. This therefore confirms the validity
of the classical CAPM and conclude that, the single factor that predicts excess return on an
asset is the market risk premium.
To determine the extent to market risk premium explains the variation in the excess return,
the R-squared is used to measure that. It can also be observed that, market risk premium has a
high explanation power due to R-square ranging between 65% and 98%.

Table a2 presents the historical mean return and the expected return as predicted by CAPM.
it can be observed that, CAPM predicted a higher return for LO 30VW which has 0.91 as
compared to 0.89 and LO 30EW which has 1.02 as compared to 0.88, however, CAPM
predicted the same return as the historical returns for BIG 30VW with 0.90 , for rest of the
returns, CAPM predicted a low return. Thus, most of the portfolios under consideration,
provided higher returns to the investors with the level of risk they bear. Thus, most of the
portfolios were under valued and investors over-compensated.

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B)
To repeat the test, we must include the error variance from the first pass regression in (a)
above for all the portfolio to test the null hypothesis that unsystematic risk is not priced.

With this, we considered all the beta from the regression for all the individual portfolios and
then average of all the excess returns for the 12 portfolios

We introduced the error variance which is the mean error for all the portfolios. And compute
the average returns of the portfolio which is (Ri-Rf)
A result for Lo 30 VW is presented in the equation below for demonstrative purposes. Results
for the remaining Portfolio are presented in the table below

Ri-Rt= (0.8899-0.2801)
0.6098

Note* Values were commutated by Authors own computation of average of (Ri-Rt)

Portfolio Ave. Ri-Rf BETA σ2

Lo 30 VW 0.60979 0.9811 1.15537

Med 40VW 0.7072 1.0256 2.59145

Hi 30VW 0.9605 1.2172 8.9949

Lo 30 EW 0.6035 1.157 7.84302

Med 40 EW 1.0173 1.1904 7.76457

Hi 30EW 1.0173 1.346 23.55504

Small 30VW 0.9779 1.3502 17.59612

Med 40 VW 0.8636 1.1921 4.18462

Big 30 VW 0.6225 0.9658 0.21295

Small 30 EW 1.2518 1.386 29.81515

Med 40 EW 0.8842 1.2476 5.99187

Big 30EW 0.705 1.078 0.95802

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To test whether systematic risk is priced, we use regression results from equation below

𝑹̅𝒕 − 𝑹̅𝒇𝒕 = 𝜸𝟎 + 𝜸𝟏𝜷̂𝒊 + 𝜺𝒕 … …𝒆𝒒𝒏 𝟏

The co-efficient of the systematic Beta 𝛾1 in equation above must be significant from the
computation of the linear regression computation

𝑹̅𝒕 − 𝑹̅𝒇𝒕
𝜸 -0.61053

-0.26416
𝜸𝟏 1.2412

(0.2227)

̂𝝈𝟐𝜺

It can be seen in the table above that the systematic risk is priced and the systematic risk
coefficient is significant at 1% (1.2) which boost the level of confidence of the portfolio
manager.

To test whether unsystematic risk is priced or not, we use regression results below in the table

We run the regression to test if co-efficient of the unsystematic risk is significant or not.

To determine if the unsystematic risk is priced or not depends on its significance. If it is

significant, then it means the unsystematic risk is priced, if it is not significant, it means it is
not priced.

𝑹̅𝒕 −𝑹̅𝒇𝒕

𝜸𝟎 -0.24003
(0.50052)

𝜸𝟏 0.87811

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 (0.47200)

̂𝝈 𝟐𝜺 0.00620
(0.00709)

It can be seen in the table above that the unsystematic risk is not priced and the unsystematic
risk co-efficient is insignificant which will not boost the level of confidence of the portfolio
manager.

C)
The Fama and French Three-Factor Model is an asset pricing model developed in 1992 that
expands on the capital asset pricing model (CAPM) by adding size risk premium and value
risk premium factors to the market risk factor in CAPM.
The Fama and French model has three factors: size of firms, book-to-market values, and
excess return on the market. In other words, the three factors used are SMB (small minus
big), HML (high minus low) and the portfolio's return less the risk free rate of return. SMB
accounts for publicly traded companies with small market caps that generate higher returns,
while HML accounts for value stocks with high book-to-market ratios that generate higher
returns in comparison to the market.
We use the formula below to test if the size premium and value premium has influence which
is significant on the return of the portfolios in market.

𝑹𝒕 −𝑹𝒇𝒕 =𝒂𝒊 +𝜷𝒊(𝑹𝒎𝒕 −𝑹𝒇𝒕)+𝒔𝒊(𝑺𝒎𝑩)𝒕 +𝒉𝒊(𝑯𝒎𝑳)𝒕+𝜺𝒕

where:

Rit=total return of a stock or portfolio i at time t

Rft=risk free rate of return at time t
RMt=total market portfolio returns at time t
Rit−Rft=expected excess return
RMt−Rft=excess return on the market portfolio (index)
SMBt=size premium (small minus big)
HMLt=value premium (high minus low)
coefficients
β1,2,3=factor

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Below is the computation as per the liner. regression using the Fama French three factors
model of asset pricing

Portfolio Mkt-RF SMB HML alpha R Square

Lo 30 VW 1.02233 -0.05046 -0.23401 0.33362 0.98205

(0.00442) (0.00725) (0.00644) (0.02236)
Med 40VW 0.98712 -0.06077 0.32050 0.24238 0.98205
(0.00735) (0.01205) (0.01069) (0.03715)
Hi 30VW 1.05847 0.19615 0.79864 0.20980 0.97993
(0.00626) (0.01026) (0.00910) (0.03163)
Lo 30 EW 1.06001 0.66709 -0.24129 0.14989 0.93309
(0.01081) (0.01773) (0.01573) (0.05466)
Med 40 EW 1.00186 0.70695 0.32771 0.37330 0.96586
(0.00791) (0.01297) (0.01151) (0.03998)
Hi 30EW 1.00832 1.06161 0.87296 0.50319 0.95789
(0.01096) (0.01797) (0.01594) (0.05539)
Small 30VW 1.04952 1.18768 0.45594 0.14937 0.97890
(0.00746) (0.01224) (0.01086) (0.03773)
Med 40 VW 1.05342 0.55675 0.18706 0.27332 0.98180
(0.00557) (0.00913) (0.00810) (0.02814)
Big 30 VW 0.98893 -0.13435 -0.00040 0.29608 0.99571
(0.00210) (0.00344) (0.00305) (0.01060)
Small 30 EW 1.02027 1.02027 0.65314 0.32586 0.92640
(0.00746) (0.01224) (0.01086) (0.03773)
Med 40 EW 1.08589 0.64453 0.22804 0.23816 0.97275
(0.00723) (0.01185) (0.01052) (0.03654)
Big 30EW 1.05488 0.03131 0.09497 0.26343 0.97382
(0.00583) (0.00957) (0.00849) (0.02950)

From the regression table above, we observed that the size premium and value premium using
the Fama French model are significant for all the portfolios in the market with the exception
of BIG 30-VW which is insignificant with value less than 1 %.

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D) Portfolio Performance Evaluation

In the section we are requested to evaluate the performances for each portfolio using the
CAPM, Fama-French, 3 factor model, Sharpe Ratio and Treynor ratio,

The CAPM and the Fama French three factor model have already been computed so we need
to compute for Sharpe Ratio and the Trenor Ratio by introducing the standard deviation.
𝑡 𝑓𝑡
(𝑅̅ −𝑅̅ )
Sharpe Ratio 𝑆𝑅 =
𝜎𝑖

A result for Lo 30 VW is presented in the equation below for demonstrative purposes. Results
for the remaining Portfolio are presented in the table below

SR= (0.60979/5.40)

=0.11

Note that 5.40 is the standard deviation for the portfolio (Lo 30VW)
𝑡 𝑓𝑡
(𝑅̅ −𝑅̅ )
Treynor Ratio 𝑇𝑅 =
𝛽𝑖

A result for Lo 30 VW is presented in the equation below for demonstrative purposes. Results
for the remaining Portfolio are presented in the table below

SR=(0.60979/0.99 )
=0.62

Note that 0.99 is the beta for the portfolio ( Lo 30VW)

PORTFOLIO BETA EXCESS CAPM FAMA SHARP TRENO

RETURN STDEV. ALPHA FRENC R
H
ALPHA
LO 30 VW
0.98 0.60979 5.40 (0.02) 0.33 0.11 0.62
MED 40VW
1.03 0.7072 5.76 0.05 0.24 0.12 0.69
HI 30VW
1.22 0.9605 7.22 0.18 0.21 0.13 0.79
LO 30 EW
1.16 0.6035 6.83 (0.14) 0.15 0.09 0.52

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 MED 40 EW
1.19 1.0173 6.99 0.25 0.37 0.15 0.85
HI 30EW
1.35 1.0173 8.72 0.57 0.50 0.12 0.76
SMALL
30VW 1.35 0.9779 8.40 0.11 0.15 0.12 0.72
MED 40 VW
1.19 0.8636 6.74 0.10 0.27 0.13 0.72
BIG 30 VW
0.97 0.6225 5.23 0.00 0.30 0.12 0.64
SMALL 30
EW 1.39 1.2518 9.24 0.36 0.33 0.14 0.90
MED 40 EW
1.25 0.8842 7.15 0.08 0.24 0.12 0.71
BIG 30EW
1.08 0.705 5.89 0.01 0.26 0.12 0.65

From the above table, for all positive alpha it means that it can be said that the portfolio
manager can predict prices of securities and delivers higher returns to the investors. A
negative alpha will then mean that the portfolio manager is not doing well at forecasting
prices of securities therefore delivers low value to the investors.

It can be seen form the table that, For Fama-French F3 Factor Alpha, the best performing
portfolio is Hi 30 EW with 0.50 of returns followed by Med 40 EW and the worst portfolio is
Small 30 VW and Lo 30 EW

The highest performing portfolio with relation to CAPM Alpha is Hi 30 EW (0.57) followed
Small 30 EW (0.36), Med 40 EW (25) and the worst performing portfolio is Lo 30 EW. (-
0.14)

CAPM as a Special Case

The CAPM developed by Jack Treynor, William F Sharpe, John Linter and Jan Mossin was
to determine a rate which is theoretically appropriate that an asset should yield given a level
of risk there after alternatively, Stephen Rose developed the Arbitrage pricing theory (APT),
its framework explains that, the expected rate of return of an asset, portfolio as a linear
function of the risk of the asset or the portfolio with respect to other factors to mitigate the
systematic risk.

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The difference between the CAPM and APT is that the CAPM has one factor and one beta,
but the APT was developed on the basis that the price of securities are driven by multiple
factors including the market risk premium which is the sole factor in CAPM. Thus, if a test is
conducted for APT on all factors and its impact on asset return and it is found to be not
significantly different from zero with exception of the market risk premium, then, this model
reverses back to the classical CAPM.

The consumption capital asset pricing model known as CCAPM is also an extension of the
CAPM that uses the beta instead of the market beta to explain expected return over the risk-
free rate. The beta of both pricing model shows the risk that cannot be diversified.

The Fama and French model has three factors: size of firms, book-to-market values, and
excess return on the market. In other words, the three factors used are SMB (small minus
big), HML (high minus low) and the portfolio's return less the risk free rate of return. SMB
accounts for publicly traded companies with small market caps that generate higher returns,
while HML accounts for value stocks with high book-to-market ratios that generate higher
returns in comparison to the market.

Reference:

Blume, M. E. (1975). Betas and their regression tendencies. The Journal of Finance,

30(3), 785– 795.

Breeden, D. T. (1979). An intertemporal asset pricing model with stochastic

consumption and investment opportunities. Journal of Financial Economics, 7,

265-296.

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Carhart, M. M. (1997). On persistence in mutual fund performance. The Journal of

finance, 52(1), 57-82.

Coffie, W. & Chukwulobelu, O. (2012). The Application of Capital Asset Pricing

Model (CAPM) to Individual Securities on Ghana Stock Exchange", Kojo

Menyah, Joshua Abor, in (ed.) Finance and Development in Africa. Research in

Accounting in Emerging Economies,12, 121 – 147

Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and

bonds. Journal of Financial Economics, 33, 3–56.

Fama, E. F., & French, K. R. (1996). Multifactor explanations of asset pricing

anomalies. Journal of Finance, 51(1), 55–84.

Markowitz, H. (1959). Portfolio selection: Efficient diversification of investments. New

York, NY: Wiley.

Lyn, E., & Zychowicz, E. (2004). Predicting stock returns in the developing markets of

eastern Europe. The Journal of Investing, 13(2), 63–71.

Reddy, T. L., & Thomson, R. J. (2011). The capital asset pricing model: The case of

South Africa. South African Actuarial Journal, 11, 43–84.

Ross, S. A. (1976). The current status of the capital asset pricing model (CAPM). The

Journal of Finance, 33(3), 885-901.

Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under

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https://www.investopedia.com/terms/f/famaandfrenchthreefactormodel.asp

https://www.investopedia.com/terms/c/ccapm.asp

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