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333301 INVESTMENTS 1.

EXTENSIONS TO THE CAPM

Extensions to the CAPM


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

Topic Outline Many assumptions of the CAPM are clearly


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)

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 What is a Zero-Beta Portfolio ?

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 )

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

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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.

For n risky assets we need estimate n expected


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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 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

→ Single Factor Models were developed to where


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

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 (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

ri = actual return on asset i


(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

(4) α i , γ i , σ ε2i 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 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

→ ri = α i + γ i rM + ε i (i) Expected return of a single asset i

E(ri ) = α i + γ i E(rM )

(ii) Variance of a single asset i

σ i2 = γ i2 σ 2M + σ ε2i

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 → we can partition an asset's risk into systematic
assume ρεiε j = 0 for all assets i ≠ j and unsystematic components

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(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

→ 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
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

and more importantly:


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.

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3. MULTIFACTOR MODELS Notes

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

and it is assumed that (4) α i , γ iK , σ ε2i are typically estimated using


(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.

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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

(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 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).

They propose a three factor model of security


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

E ( ri ) = rf + γ i1λ1 + γ i2 λ 2 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,


(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

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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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