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Asset Pricing V:

During the first half of the 1970s in particular,

Other Models extensive progress was made in relaxing the strong

assumptions of the CAPM → new separation

theorems and new models were derived

unrealistic. The key consideration is whether

• Extensions to the CAPM recognition of their existence is likely to have a first

• Single Factor Models or second order impact on the conclusions of the

• Multi Factor Models standard model.

• APT – Equilibrium Asset Pricing

• The Fama-French Model Extensions include:

• non-marketable assets - Mayers (1972)

• heterogeneous expectations - Lintner (1969)

• multi-period investment horizon - Merton (1973)

References • transaction costs and in particular liquidity –

Amihud and Mendelson (1986)

• BKM (2005), Chapters 9.2, 10.1-10.2, 11.1, • International considerations – Solnick (1974)

11.5 • Corporate Taxes and Differential Personal

Taxes – Brennan (1970)

interesting comparison of many of these extensions

1 2

Assume (i) there is no risk free asset and (ii) short For any portfolio p in the efficient set (of risky

sales of risky assets are allowed assets) - except for the MVP - there exists a unique

portfolio on the lower half of the minimum variance

Then it can be shown that there is no change in the opportunity set, denoted Z ( p ) which has a zero

functional form of the CAPM provided rf is replaced covariance with p.

(

by E rZ( M ) )

Graphically, to identify Z ( p ) we:

( ) ( (

E ( ri ) = E rZ( M ) + βi E ( rM ) − E rZ( M ) )) (i) draw a tangent to the ES at portfolio p

(ii) the intersection of the tangent with the vertical

( )

where E rZ( M ) is the expected return on the zero

( )

axis gives E rZ( p )

(iii) the intersection of the horizontal with the MVOS

beta portfolio with respect to the market portfolio M gives Z ( p )

3 4

Why is the Zero-Beta Model Important ? 2. SINGLE FACTOR MODELS

The CAPM is conditional on the existence of a risk The Motivation For a Single Factor Model

free asset

There are two practical limitations with the mean

In some cases it may be difficult to find a variance portfolio theory developed by Markowitz:

reasonable proxy for the risk free asset

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.

1

returns, n variances and n (n − 1) covariances →

2

the ability to derive "good" parameter estimates is

critical !!

required to determine the efficient set based on a

portfolio of:

(i) 3 assets

(ii) 20 assets

(iii) 250 assets

5 6

→ a practical need for a simple model to predict the The Single Factor Model

covariance/correlation structure between assets

A single factor model assumes the return on an

asset consists of two components: one part due to

Second, most investment firms organize their an underlying (economic) factor which impacts on

analysts along traditional industry lines eg one all assets and one part which is asset specific and

analyst may cover Bank stocks only, another may is independent of the first part

cover Media stocks only but who will estimate the

required covariances/correlations between the For all assets i = 1, 2,..., n the return on the asset

Bank and Media stocks ? (over a single period) is:

ri = α i + γ i F + ε i

overcome this problem

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

E ( εi ) = 0

ρ εiε j = 0 for all assets i ≠ j

7 8

Notes (6) BKM use an alternative specification of a single

factor model:

(1) F is a random variable with mean E ( F ) ≠ 0 and

(constant) variance σ 2F . ε i is also a random ri = E ( ri ) + γ i F∗ + ε∗i

variable with zero mean and (constant)

“residual variance” of σ ε2i where

(2) ε i allows for random asset specific effects

E ( ri ) = expected return on asset i (at the start of

(unique to asset i).

the period)

F∗ = unexpected/unanticipated part of the

underlying factor F

(3) The key assumption of the single factor model γ i = the "sensitivity" of ri to the factor

is that ε i is independent of ε j for all assets i ≠ j ε∗i = unexpected/unanticipated part of the

and therefore ρ εiε j = 0 for all assets i ≠ j → the “residual” part of the return on asset i

only reason assets vary together

(systematically) is because of the common

impact of F

regression techniques

absence of any sensitivity to F

9 10

The Single Index Model Key Advantage of the Single Factor/Index Model

The single index model assumes the common The single factor/index model leads to simple

underlying factor F is the actual return on the expressions for the expected return and risk of any

market portfolio rM asset i and in particular, for the risk of a portfolio

E(ri ) = α i + γ i E(rM )

σ i2 = γ i2 σ 2M + σ ε2i

"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 → we can partition an asset's risk into systematic

assume ρεiε j = 0 for all assets i ≠ j and unsystematic components

11 12

(iii) Covariance between two assets i and j For large portfolios, this substantially reduces the

number of input parameters required to calculate

σ ij = γ i γ jσ 2M the efficient set (compared to the Markowitz based

approach) and there is no need for direct estimates

of covariances/correlations

to a common response to movements in the market

The Single Index Model and Diversification

(iv) Expected return and variance of a portfolio

Assume for simplicity an equally weighted portfolio.

Consider a portfolio of n assets with w i Then:

n

1

representing the weight of asset i. Then σ 2p = γ 2p σ 2M + ∑ w i2 σε2i = γ 2p σ 2M + ARV

i =1 n

E(rp ) = α p + γ p E(rM )

1 n 2

where where ARV = ∑ σε is the average residual

n i =1 i

n n variance of the assets in the portfolio

α p = ∑ w iαi and γp = ∑ wiγi

i =1 i =1

n

σ 2p = γ 2p σ 2M + ∑ w i2 σε2i

i =1

Technical Note: If the single factor model is assumed to hold, then the

method of calculating the efficient set is also substantially simplified.

13 14

The concept of a single factor (index) model can be (1) Each FK is a random variable with mean

generalised to a multifactor (index) model if one E ( FK ) ≠ 0 and (constant) variance σ2FK . ε i is

assumes the return on an asset depends on

also a random variable with zero mean and

several mutually independent factors (indices).

(constant) “residual variance” of σ ε2i

For all assets i = 1, 2,..., n the return on the asset

(over a single period) is: (2) ε i allows for random asset specific effects

(unique to asset i).

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

where

(3) The key assumption of the multifactor model is

ri = actual return on asset i that ε i is independent of ε j for all assets i ≠ j

α i = constant part of the return on asset i and therefore ρ εiε j = 0 for all assets i ≠ j → the

FK = actual value of factor K only reason assets vary together

γ iK = the "sensitivity" of ri to factor K (called the (systematically) is because of the common

factor sensitivities, factor loadings or factor betas) impact of the K factors

ε i = residual part of the return on asset i

(multiple) linear regression techniques

E(ε i ) = 0

ρ εiε j = 0 for all assets i ≠ j (5) α i is the expected return on asset i in the

absence of any sensitivity to all of the factors

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

Technical Note: As with the single factor model, relatively simple

ρ FK FL = 0 for all factors L and K 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.

15 16

4. APT – EQUILIBRIUM ASSET PRICING Equilibrium Asset Pricing Equation

It is important to distinguish between portfolio It can be shown that the relationship between the

construction and equilibrium asset pricing. An expected return and risk of any asset is given by:

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

market is in equilibrium

where

APT or Arbitrage Pricing Theory is the mechanism

which links factor models and expected returns E(ri ) = expected return on asset i

when the market is in equilibrium rf = riskfree rate of return

γ iK = the "sensitivity" of ri to factor K (called the

Assumptions factor sensitivities, factor loadings or factor betas)

λK = the “risk premium” or “factor premium”

We make the same assumptions as per the CAPM associated with factor K

except the assumption that investors use Markowitz

mean-variance analysis (to form portfolios) is Notes

replaced by two new assumptions:

(1) For each factor K there exists a portfolio p ( K )

(i) asset returns are determined by a multifactor

model: which is subject only to the risk of factor K and

has unit sensitivity to that factor i.e. γ p( K )K = 1.

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

assets/portfolios with the same risk must have

the same expected return

17 18

(2) For each factor K, the factor premium is the 5. THE FAMA-FRENCH MODEL

expected excess return (i.e. risk premium) on

portfolio p ( K ) i.e. One of the most recent developments in research in

asset pricing stems from the work of Fama and

( )

λ K = E rp( K ) − rf French (1992) (1993) and (1996).

For example assume a two factor model: prices which they claim is superior to the CAPM.

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.

(3) The big issue with the CAPM is the need to (over a single period) is:

identify the market portfolio M. The big issues

with APT is the need to identify the factors and E ( ri ) = rf + γ i1E ( MRP ) + γ i2 E ( SMB ) + γ i3E ( HML )

to determine how many factors there are !!

where

(4) The concepts of systematic and unsystematic

risks can readily be extended to a multifactor/ rf the risk free rate of interest

APT framework whereby the total risk of an γ iK the "sensitivity" of ri to factor K

asset can be partitioned into K systematic

E ( MRP ) is the expected Market Risk Premium

components (corresponding to each of the K

factors) and one unsystematic component E(SMB ) is the expected Size Premium

E(HML ) is the expected Book-to-Market

Premium

19 20

Notes (5) Limitations include:

(1) The equilibrium asset pricing equation follows • The model is still new and is not universally

from the following three factor model for asset accepted and is subject to challenge.

returns:

• Fama and French actually derived the model

ri = α i + γ i1R M + γ i2 R SMB + γ i3R HML + ε i empirically, rather than starting from a

theoretical base, relying on previous research

where R M is the return on the market portfolio, which documented empirical contradictions of

R SMB is the return on a portfolio of “small” the CAPM to identify the two new factors.

stocks less the return on a portfolio of “big”

stocks and R HML is the return on a portfolio of • Practical problems associated with estimating

“high” book-to-market stocks less the return on the size and book-to-market premiums.

a portfolio of “low” book-to-market stocks

(6) It is uncertain whether the size and book-to-

(2) Ex-ante all factor premiums are positive market factors are themselves just proxies for

some other as yet unidentified underlying risk

factors which may effect expected returns.

(3) What happens if γ i2 = γ i3 = 0 ? For example Fama and French suggest that

HML may proxy for relative distress as weak

(strong) firms tend to have high (low) book-to-

market ratios and therefore are penalised

(rewarded) by investors requiring a higher

(4) The model suggests that the expected return is (lower) return

higher for smaller companies and for those

companies with higher book-to-market ratios. 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).

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