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**Investment Analysis and Portfolio Management
**

Sixth Edition by

Frank K. Reilly & Keith C. Brown

Chapter 10

Saif Ullah Economist_of_Pakistan@Yahoogroups.com Saifullah271@yahoo.com +923216633271

**Chapter 10 - Extensions and Testing of Asset Pricing Theories
**

Questions to be answered: • What happens to the capital market line (CML) when you assume there are differences in the risk-free borrowing and lending rates? • What is a zero-beta asset and how does its use impact the CML? • What happens to the security market line (SML) when you assume transaction costs, heterogeneous expectations, different planning periods, and taxes?

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Chapter 10 - Extensions and Testing of Asset Pricing Theories
**

• What are the major questions considered when empirically testing the CAPM? • What are the empirical results from tests that examine the stability of beta? • How do alternative published estimates of beta compare? • What are the empirical test results of studies that examine the relationship between systematic risk and return?

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Chapter 10 - Extensions and Testing of Asset Pricing Theories
**

• What other variables besides beta have had a significant impact on returns? • What is the theory and practice regarding the “market portfolio”? How does this difference between theory and the market proxy relate to the benchmark problem? • Assuming there is a benchmark problem, what variables are affected by it? • What are the major assumptions not required by the APT model compared to the CAPM?

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Chapter 10 - Extensions and Testing of Asset Pricing Theories
**

• How do you test the APT by examining anomalies found with the CAPM? • What are the empirical test results related to the APT? • Why do some authors contend that the APT model is untestable? • What are the concerns related to the multiple factors of the APT model?

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Relaxing the Assumptions of the CAPM
**

• CAPM assumption: all investors can borrow or lend at the risk-free rate - unrealistic

– Differential borrowing and lending rates – Unlimited lending at risk-free rate – Borrowing at higher rate

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Investment Alternatives When The Cost of Borrowing is Higher Than The Cost of Lending
**

Figure 10.1

E(R) G

**K F Rb RFR Risk (standard deviation σ)
**

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Relaxing the Assumptions of the CAPM
**

• Zero-beta portfolio: create a portfolio that is uncorrelated to the market (beta 0)

– The return of the zero-beta portfolio may differ from the risk-free rate

• Any combination of portfolios on the efficient frontier will be on the frontier • Any efficient portfolio will have associated with it a zero-beta portfolio

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Implications of Black’s Zero-beta model
**

• The expected return of any security can be expressed as a linear relationship of any two efficient portfolios E(Ri) = E(Rz) + βi[E(Rm) - E(Rz)] • If CAPM defines the relationship between risk and return, then the return on the zero-beta portfolio should equal RF • To test this - identify a market portfolio and solve for the return of a zero-beta portfolio

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Security Market Line With A Zero-Beta Portfolio
**

Figure 10.2

E(R) M E(Rm) - E(Rz) E(Rz) 0.0 1.0

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SML

E(Rm)

βi

**Relaxing the Assumptions of the CAPM
**

• Transaction costs

– affect mispricing corrections – affect diversification

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Security Market Line With Transaction Costs
**

Figure 10.3

E(R) SML

E(Rm)

E(RFR) or E(Rz) 0.0 1.0

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

βi

**Relaxing the Assumptions of the CAPM
**

• Heterogenous expectations

– If all investors have different expectations about risk and return, each would have a unique CML and/or SML, and the composite graph would be a band of lines with a breadth determined by the divergence of expectations

• Planning periods

– CAPM is a one period model, and the period employed should be the planning period for the individual investor, which will vary by individual, affecting both the CML and the SML

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Relaxing the Assumptions of the CAPM
**

• Taxes

– Tax rates affect returns – Tax rates differ between individuals and institutions

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Empirical Testing of CAPM
**

• How stable is the measure of systematic risk (beta)? • Is there a positive linear relationship as hypothesized between beta and the rate of return on risky assets? • How well do returns conform to the SML equation?

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Empirical Testing of CAPM
**

• Beta is not stable for individual stocks over short periods of time (52 weeks) • Stability for portfolios increase significantly • The larger the portfolio and the longer the period, the more stable the beta of the portfolio • Betas tend to regress toward the mean

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Empirical Testing of CAPM
**

• Different estimates of beta for a stock vary typically in data used • Value Line estimates use 260 weekly observations • Merrill Lynch estimates using 60 monthly observations • Securities market value affects the size and direction of the interval affect

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Relationship Between Systematic Risk and Return
**

• Sharpe and Cooper: positive, but non-linear • Douglas: intercept higher than the risk-free rate • Miller and Scholes: possible error in Douglas findings • Black, Jensen, and Scholes: positive linear relationship between monthly excess return and portfolio beta • Fama and McBeth: supported the CAPM with the intercept equal to the RFR

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Relationship Between Systematic Risk and Return
**

• Effect of skewness on the relationship

– preference for high risk and returns

**• Effect of size, P/E and leverage • Effect of book-to-market value
**

– The Fama-French Study

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**The Market Portfolio: Theory Versus Practice
**

• Difficult to test full market • Portfolio used as market proxy may be correlated to true market portfolio • Benchmark error

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Criticism of CAPM by Richard Roll
**

• Limits on tests: only testable implication from CAPM is whether the market portfolio lies on the efficient frontier • Range of SML’s - infinite number of possible SML’s, each of which produces a unique estimate of beta

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Criticism of CAPM by Richard Roll
**

• Market efficiency effects - substituting a proxy, such as the S&P 500 creates two problems

– Proxy does not represent the true market portfolio – Even if the proxy is not efficient, the market portfolio might be

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Criticism of CAPM by Richard Roll
**

• Conflicts between proxies - different substitutes may be highly correlated even though some may be efficient and others are not, which can lead to different conclusions regarding beta risk/return relationships • So, CAPM is not testable - but it still has value and must be used carefully • Stephen Ross devised an alternative way to look at asset pricing - APT

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Arbitrage Pricing Theory - APT
**

• Arbitrage is a process of buying a lower priced asset and selling a higher priced asset, both of similar risk, and capturing the difference in arbitrage profits • The general arbitrage principle states that two identical securities will sell at identical prices • Price differences will immediately disappear as arbitrage takes place

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Arbitrage Pricing Theory - APT
**

Three major assumptions: 1. Capital markets are perfectly competitive 2. Investors always prefer more wealth to less wealth with certainty 3. The stochastic process generating asset returns can be expressed as a linear function of a set of K factors or indexes

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Arbitrage Pricing Theory - APT
**

Ri = Ei + bi1δ 1 + bi 2δ 2 + + bik δ k + ∈i for i = 1 to N Ri = return on asset i during a specified time period Ei = expected return for asset i if all the factors or indexes have zero changes bik = reaction in asset i ' s returns to movements in a comon factor K or index K δ k = a set of common factors or indexes with a zero mean that influences the returns of all assets ∈i = a unique effect on asset i ' s return (random error) N = number of assets

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Roll-Ross Study
**

1. Estimate the expected returns and the factor coefficients from time-series data on individual asset returns 2. Use these estimates to test the basic crosssectional pricing conclusion implied by the APT

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Extensions of the Roll-Ross Study
**

• Cho, Elton, and Gruber examined the number of factors in the return-generating process that were priced • Dhrymes, Friend, and Gultekin (DFG) reexamined techniques and their limitations and found the number of factors varies with the size of the portfolio

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**The APT and Anomalies
**

• Small-firm effect

Reinganum - results inconsistent with the APT Chen - supported the APT model over CAPM

• January anomaly

Gultekin - APT not better than CAPM Burmeister and McElroy - effect not captured by model, but still rejected CAPM in favor of APT

**• APT and inflation
**

Elton, Gruber, and Rentzler - analyzed real returns

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

• If returns are not explained by a model, it is not considered rejection of a model; however if the factors do explain returns, it is considered support • APT has no advantage because the factors need not be observable, so equivalent sets may conform to different factor structures • Empirical formulation of the APT may yield different implications regarding the expected returns for a given set of securities • Thus, the theory cannot explain differential returns between securities because it cannot identify the relevant factor structure that explains the differential returns

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

The Shanken Challenge to Testability of the APT

**Alternative Testing Techniques
**

• Jobson proposes APT testing with a multivariate linear regression model • Brown and Weinstein propose using a bilinear paradigm • Others propose new methodologies

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**The Internet Investments Online
**

www.barra.com www.wsharpe.com www.cob.ohio-state.edu/~fin/journal.jof.htm www3.oup.co.uk/revfin/scope

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

End of Chapter 10

–Extensions and Testing of Asset Pricing Theories

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

**Future topics Chapter 11
**

• • • • Derivative Markets Forwards Futures Options

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

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