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1. EXTENSIONS TO THE CAPM Extensions to the CAPM

Asset Pricing V: Other Models

During the first half of the 1970s in particular, extensive progress was made in relaxing the strong assumptions of the CAPM → new separation theorems and new models were derived Many assumptions of the CAPM are clearly unrealistic. The key consideration is whether recognition of their existence is likely to have a first or second order impact on the conclusions of the standard model. Extensions include: • non-marketable assets - Mayers (1972) • heterogeneous expectations - Lintner (1969) • multi-period investment horizon - Merton (1973) • transaction costs and in particular liquidity – Amihud and Mendelson (1986) • International considerations – Solnick (1974) • Corporate Taxes and Differential Personal Taxes – Brennan (1970)

Topic Outline • • • • • Extensions to the CAPM Single Factor Models Multi Factor Models APT – Equilibrium Asset Pricing The Fama-French Model

References • BKM (2005), Chapters 9.2, 10.1-10.2, 11.1, 11.5

Technical Note: Elton and Gruber (1984), Journal of Finance present an interesting comparison of many of these extensions

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The Zero-Beta Model Assume (i) there is no risk free asset and (ii) short sales of risky assets are allowed Then it can be shown that there is no change in the functional form of the CAPM provided rf is replaced by E rZ( M )

What is a Zero-Beta Portfolio ? For any portfolio p in the efficient set (of risky assets) - except for the MVP - there exists a unique portfolio on the lower half of the minimum variance opportunity set, denoted Z ( p ) which has a zero covariance with p. Graphically, to identify Z ( p ) we: (i) draw a tangent to the ES at portfolio p (ii) the intersection of the tangent with the vertical axis gives E rZ( p )

(

)

E ( ri ) = E rZ( M ) + βi E ( rM ) − E rZ( M )

(

)

(

(

))

where E rZ( M ) is the expected return on the zero beta portfolio with respect to the market portfolio M

(

)

( )

(iii) the intersection of the horizontal with the MVOS gives Z ( p )

Note: BKM (p.293) call a zero beta portfolio a “companion portfolio”

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Why is the Zero-Beta Model Important ? The CAPM is conditional on the existence of a risk free asset In some cases it may be difficult to find a reasonable proxy for the risk free asset

2. SINGLE FACTOR MODELS The Motivation For a Single Factor Model There are two practical limitations with the mean variance portfolio theory developed by Markowitz: First, as the number of assets increases, the number of asset parameters that need to be estimated in order to calculate the Efficient Set becomes unfeasible. For n risky assets we need estimate n expected 1 returns, n variances and n (n − 1) covariances → 2 the ability to derive "good" parameter estimates is critical !! For example how many parameter estimates are required to determine the efficient set based on a portfolio of: (i) 3 assets (ii) 20 assets (iii) 250 assets

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**→ a practical need for a simple model to predict the covariance/correlation structure between assets
**

Second, most investment firms organize their analysts along traditional industry lines eg one analyst may cover Bank stocks only, another may cover Media stocks only but who will estimate the required covariances/correlations between the Bank and Media stocks ?

The Single Factor Model A single factor model assumes the return on an asset consists of two components: one part due to an underlying (economic) factor which impacts on all assets and one part which is asset specific and is independent of the first part For all assets i = 1, 2,..., n the return on the asset (over a single period) is:

ri = α i + γ i F + ε i

→ Single Factor Models were developed to overcome this problem where

ri = actual return on asset i α i = constant part of the return on asset i F = actual value of the underlying factor γ i = the "sensitivity" of ri to the factor (called the factor sensitivity, factor loading or factor beta) ε i = “residual” part of the return on asset i

and it is assumed that

E ( εi ) = 0 ρ εiε j = 0 for all assets i ≠ j

ρ εiF = 0 for all assets i

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Notes (1) F is a random variable with mean E ( F ) ≠ 0 and (constant) variance σ 2 . ε i is also a random F variable with zero mean and (constant) 2 “residual variance” of σ εi (2) ε i allows for random asset specific effects (unique to asset i).

**(6) BKM use an alternative specification of a single factor model:
**

ri = E ( ri ) + γ i F∗ + ε∗ i

where

ri = actual return on asset i E ( ri ) = expected return on asset i (at the start of the period) F∗ = unexpected/unanticipated part of the underlying factor F γ i = the "sensitivity" of ri to the factor ε∗ = unexpected/unanticipated part of the i “residual” part of the return on asset i

(3) The key assumption of the single factor model is that ε i is independent of ε j for all assets i ≠ j and therefore ρ εiε j = 0 for all assets i ≠ j → the only reason assets vary together (systematically) is because of the common impact of F

2 (4) α i , γ i , σ εi are typically estimated using linear regression techniques

(5) α i is the expected return on asset i in the absence of any sensitivity to F

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The Single Index Model The single index model assumes the common underlying factor F is the actual return on the market portfolio rM

→

ri = α i + γ i rM + ε i

Key Advantage of the Single Factor/Index Model The single factor/index model leads to simple expressions for the expected return and risk of any asset i and in particular, for the risk of a portfolio (i) Expected return of a single asset i

E(ri ) = α i + γ i E(rM )

**(ii) Variance of a single asset i
**

2 σ i2 = γ i2 σ 2 + σ εi M

Technical Note: A version of the single index model, known as the "market model" is commonly used in empirical tests of the CAPM. The market model is identical to the single index model except that it does not assume ρεiε j = 0 for all assets i ≠ j

**→ we can partition an asset's risk into systematic and unsystematic components
**

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**(iii) Covariance between two assets i and j
**

σ ij = γ i γ jσ 2 M

For large portfolios, this substantially reduces the number of input parameters required to calculate the efficient set (compared to the Markowitz based approach) and there is no need for direct estimates of covariances/correlations

→ the only reason two assets move together is due to a common response to movements in the market The Single Index Model and Diversification (iv) Expected return and variance of a portfolio Consider a portfolio of n assets with w i representing the weight of asset i. Then Assume for simplicity an equally weighted portfolio. Then: n 1 2 σ 2 = γ 2 σ 2 + ∑ w i2 σεi = γ 2 σ 2 + ARV p p M p M n i =1

1 n 2 ∑ σε is the average residual n i =1 i variance of the assets in the portfolio

E(rp ) = α p + γ p E(rM )

where

where ARV =

α p = ∑ w iαi

i =1

n

and

γp = ∑ wiγi

i =1

n

**and more importantly:
**

2 σ 2 = γ 2 σ 2 + ∑ w i2 σεi p p M i =1 n

Technical Note: If the single factor model is assumed to hold, then the method of calculating the efficient set is also substantially simplified.

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3. MULTIFACTOR MODELS The concept of a single factor (index) model can be generalised to a multifactor (index) model if one assumes the return on an asset depends on several mutually independent factors (indices). For all assets i = 1, 2,..., n the return on the asset (over a single period) is:

ri = α i + γ i1F1 + γ i2 F2 + .. + γ iK FK + ε i

Notes (1) Each FK is a random variable with mean E ( FK ) ≠ 0 and (constant) variance σ2K . ε i is F also a random variable with zero mean and 2 (constant) “residual variance” of σ εi (2) ε i allows for random asset specific effects (unique to asset i). (3) The key assumption of the multifactor model is that ε i is independent of ε j for all assets i ≠ j and therefore ρ εiε j = 0 for all assets i ≠ j → the only reason assets vary together (systematically) is because of the common impact of the K factors

2 (4) α i , γ iK , σ εi are typically estimated (multiple) linear regression techniques

where

ri = actual return on asset i α i = constant part of the return on asset i FK = actual value of factor K γ iK = the "sensitivity" of ri to factor K (called the factor sensitivities, factor loadings or factor betas) ε i = residual part of the return on asset i

**and it is assumed that
**

E(ε i ) = 0 ρ εiε j = 0 for all assets i ≠ j

using

**(5) α i is the expected return on asset i in the absence of any sensitivity to all of the factors
**

Technical Note: As with the single factor model, relatively simple expressions for the expected return and risk of any asset and for any portfolio of assets may be derived → the method of calculating the efficient set is substantially simplified.

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ρ εi FK = 0 for all assets i and factors K ρ FK FL = 0 for all factors L and K

4. APT – EQUILIBRIUM ASSET PRICING It is important to distinguish between portfolio construction and equilibrium asset pricing. An optimal portfolio can be formed using a single or multi factor model for any set of asset parameters E ( ri ) , σij i.e. it is not necessary to assume the market is in equilibrium APT or Arbitrage Pricing Theory is the mechanism which links factor models and expected returns when the market is in equilibrium Assumptions We make the same assumptions as per the CAPM except the assumption that investors use Markowitz mean-variance analysis (to form portfolios) is replaced by two new assumptions: (i) asset returns are determined by a multifactor model:

ri = α i + γ i1F1 + γ i2 F2 + .. + γ iK FK + ε i

Equilibrium Asset Pricing Equation It can be shown that the relationship between the expected return and risk of any asset is given by:

E ( ri ) = rf + γ i1λ1 + γ i2 λ 2 + .. + γ iK λ K

where

E(ri ) = expected return on asset i = riskfree rate of return rf γ iK = the "sensitivity" of ri to factor K (called the factor sensitivities, factor loadings or factor betas) λK = the “risk premium” or “factor premium” associated with factor K

Notes (1) For each factor K there exists a portfolio p ( K ) which is subject only to the risk of factor K and has unit sensitivity to that factor i.e. γ p( K )K = 1.

(ii)

a version of the “law of one price” holds → two assets/portfolios with the same risk must have the same expected return

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**(2) For each factor K, the factor premium is the expected excess return (i.e. risk premium) on portfolio p ( K ) i.e.
**

λ K = E rp( K ) − rf

5. THE FAMA-FRENCH MODEL One of the most recent developments in research in asset pricing stems from the work of Fama and French (1992) (1993) and (1996). They propose a three factor model of security prices which they claim is superior to the CAPM. The model assumes the expected return on an asset is related not only to market risk (as predicted by CAPM) but also to company size (measured by the market value of the company’s equity) and to the ratio of its book value of equity to its market value of equity. Specifically, the expected return on any asset i, (over a single period) is:

(

)

For example assume a two factor model:

E ( ri ) = rf + γ i1λ1 + γ i2 λ 2

(3) The big issue with the CAPM is the need to identify the market portfolio M. The big issues with APT is the need to identify the factors and to determine how many factors there are !! (4) The concepts of systematic and unsystematic risks can readily be extended to a multifactor/ APT framework whereby the total risk of an asset can be partitioned into K systematic components (corresponding to each of the K factors) and one unsystematic component

**E ( ri ) = rf + γ i1E ( MRP ) + γ i2 E ( SMB ) + γ i3E ( HML )
**

where

rf γ iK E ( MRP ) E(SMB ) E(HML )

the risk free rate of interest the "sensitivity" of ri to factor K is the expected Market Risk Premium is the expected Size Premium is the expected Book-to-Market Premium

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Notes (1) The equilibrium asset pricing equation follows from the following three factor model for asset returns:

ri = α i + γ i1R M + γ i2 R SMB + γ i3R HML + ε i

(5) Limitations include:

• The model is still new and is not universally accepted and is subject to challenge. • Fama and French actually derived the model empirically, rather than starting from a theoretical base, relying on previous research which documented empirical contradictions of the CAPM to identify the two new factors. • Practical problems associated with estimating the size and book-to-market premiums.

where R M is the return on the market portfolio, R SMB is the return on a portfolio of “small” stocks less the return on a portfolio of “big” stocks and R HML is the return on a portfolio of “high” book-to-market stocks less the return on a portfolio of “low” book-to-market stocks (2) Ex-ante all factor premiums are positive

(6) It is uncertain whether the size and book-tomarket factors are themselves just proxies for some other as yet unidentified underlying risk factors which may effect expected returns. For example Fama and French suggest that HML may proxy for relative distress as weak (strong) firms tend to have high (low) book-tomarket ratios and therefore are penalised (rewarded) by investors requiring a higher (lower) return

Technical Notes Ferguson, M.F. and R.L. Shockley, 2003, "Equilibrium Anomalies", Journal of Finance, present an alternative three factor model, incorporating relative leverage and relative distress factors, which they claim not only provides a theoretical rationale for the Fama-French three factor model but which "more important, provides the foundation for a better empirical model". For a discussion of CAPM vs FF see for example, Jagannathan and McGrattan (1995) and Malkiel and Xu (2002).

(3) What happens if γ i2 = γ i3 = 0 ?

(4) The model suggests that the expected return is higher for smaller companies and for those companies with higher book-to-market ratios.

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