Week 5

Portfolio Theory III & Asset Pricing

Single index asset model

Capital asset pricing model (CAPM).
o Construct and explain the security market line.
o Construct the index model.
o Calculate the beta of a share.
o Evaluating CAPM
Multifactor model - Fama-French three-factor model.
Arbitrage pricing theory (APT).
o Compare the APT and the CAPM.

Investments FINA5632

Recap
Systematic and non-systematic risk
Construct a portfolio using two risky assets
Some useful formula...

How does covariance and correlation affect diversification?

Efficient frontier

T h e University of W estern Australia

Class activity (Chp 6 Q13)

Shares offer an expected rate of return of 10% with a
standard deviation of 20% and gold offers an expected
return of 5% with a standard deviation of 25%.
In light of the apparent inferiority of gold to shares with respect to
both mean return and volatility, would anyone hold gold? If so,
demonstrate graphically why one would do so.
How would you answer (a) if the correlation coefficient between
gold and shares were 1.0? Draw a graph illustrating why one would
or would not hold gold. Could these expected returns, standard
deviations and correlation represent an equilibrium for the security
market?
T h e University of W estern Australia

Class activity (Chp 6 Q13)

12.0%

Expected Return (%)

10.0%

8.0%
r=-1

r=-0.5

6.0%

r=-0
r=0.3625
4.0%

r=1

2.0%

0.0%
0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Standard Deviation (%)

T h e University of W estern Australia

Class activity (Chp 6 Q14)

Suppose that many shares are traded in the market and that
it is possible to borrow at the risk-free rate, rf. The
characteristics of two of the shares are as follows:
Share

Expected return

Standard deviation

8%

40%

13

60

Correlation = -1

Could the equilibrium rf be greater than 10%? (Hint: Can a

particular share portfolio be substituted for the risk-free
asset?)
T h e University of W estern Australia

Class activity (Chp 6 Q14)

s2 ()
0.62 1 (0.6)(0.4)
W A= 2 2
=
=0.6
s +s 2() 0.4 2+0.622 1 (0.6)(0.4)
WB= 0.4

T h e University of W estern Australia

Are stock returns less risky in the long run?

Consider the variance of a two-year investment with serially
independent returns r1 and r2:
Var (2-year total return) = Var (r1 r2 )
= Var (r1 ) Var (r2 ) 2Cov(r1 , r2 )
=s 2 s 2 0
= 2s 2
Standard deviation (2-year return) = s 2

The variance of the two-year return is double that of the oneyear return and is higher by a multiple of the square root of 2.
T h e University of W estern Australia

Are stock returns less risky in the long run?

Generalising to an investment horizon of n years and then
annualising:
Var (n year total return) = ns 2
Standard deviation (n year total return) = s n
1
s
s (annualised for an n-year investment)= s n =
n
n

Misconception.... n increases risk decreases

In fact, the variance grows linearly with the number of years
T h e University of W estern Australia

Are stock returns less risky in the long run?

100%
100%
Starting
investment
= $10

-50%
100%
-50%
-50%
t=0

t=1

t=2

To compare investments in two different time periods:

Examine risk of the total rate of return rather than average subperiod returns
Must account for both magnitudes of total returns and
probabilities of such returns occurring
T h e University of W estern Australia

A single index asset market

We have learned that investors should diversify.
Individual securities will be held in a portfolio. Consequently,
the relevant risk of an individual security is the risk that
remains when the security is placed in a portfolio.
Risk that cannot be diversified away, i.e., the risk that remains when
the stock is put into a portfolio
How do we measure a stocks systematic risk?

T h e University of W estern Australia

10

Systematic risk
Systematic risk arises from events that affect the entire
economy.
E.g., change in
interest rates or
GDP.

T h e University of W estern Australia

11

Systematic risk
If a well diversified portfolio has no unsystematic risk then
any risk that remains must be systematic.
Variation in returns of well diversified portfolio must be due to
changes in systematic factors.
Systematic factors

Returns
share A

Returns
well
diversified
portfolio

interest rates,
GDP,
consumer spending,
etc.

T h e University of W estern Australia

12

Single factor model

Ri = ai + iM + ei
Ri = Actual excess return = ri rf
ai = E(Ri) = Expected excess return
Two sources of Uncertainty
M = some systematic factor or proxy; in this case M is
unanticipated movement in a well diversified broad
market index like the S&P ASX 200
i = sensitivity of a securities particular return to the factor
ei = unanticipated firm specific events
T h e University of W estern Australia

13

Single index model parameter estimation

= + +
Risk premium

Market risk premium or index

risk premium

i = the stocks expected excess return if the markets excess

return is zero, i.e. (rm rf) = 0
i(rm rf) = the component of excess return due to
movements in the market index
ei = firm specific component of excess return that is not
due to market movements
T h e University of W estern Australia

14

Risk premium format

= + +
Let:

Ri = (ri rf)
Rm = (rm rf)

Risk premium
format

The model:

= + +

T h e University of W estern Australia

15

Estimating the index model

Excess returns (i)

Variation in Ri explained
by the line is the stocks
systematic risk.
Variation in Ri unrelated to
the market (the line) is
unsystematic risk.

. .. . . .. . .
. .
.
.
.
.
.
.
. .
.
.
.
.
.
.
.
.
.
. ..
.
.
.
.
.. . . .

Scatter
plot

.
. .
.
. .

Security
characteristic
line

.
. R. = a. + R

Excess returns
on market index

+ ei
Slope of SCL = beta
y-intercept = alpha
i

T h e University of W estern Australia

16

Components of risk
Market or systematic risk: risk related to the systematic or macro
economic factor in this case the market index

Unsystematic or firm specific risk: risk not related to the macro

factor or market index

Total risk = Systematic + Unsystematic

2 = Systematic risk + unsystematic risk

T h e University of W estern Australia

17

Class activity: Comparing security characteristic lines

Describe
a

se
for each.

T h e University of W estern Australia

18

Measuring components of risk

Total risk = Systematic + Unsystematic
si2 = i2 sm2 + s2(ei)
where

si2
= total variance
i2 sm2 = systematic variance
s2(ei) = unsystematic variance

Percentage of variance - Systematic risk / Total risk

i2 m2 / i2 = r2
i2 m2 / (i2 m2 + 2(ei)) = r2
T h e University of W estern Australia

19

Advantages of the single index model

Reduces the number of inputs needed to account for diversification
benefits.
If you want to know the risk of a n stock portfolio you would have
to calculate n variances and n(n-1)/2 covariance terms
With the index model you need only n betas.
Easy reference point for understanding stock risk.
M = 1, so if i > 1 what do we know?
If i < 1?

T h e University of W estern Australia

20

Capital asset pricing model (CAPM)

Equilibrium model that underlies all modern financial theory
Derived using principles of diversification, but with other
simplifying assumptions
Markowitz, Sharpe, Lintner and Mossin are researchers
credited with its development

T h e University of W estern Australia

21

Simplifying assumptions

Individual investors are price takers

Single-period investment horizon
Investments are limited to traded financial assets
No taxes and no transaction costs
Information is costless and available to all investors
Investors are rational mean-variance optimisers
Homogeneous expectations

T h e University of W estern Australia

22

Resulting equilibrium conditions

All investors will hold the same portfolio for risky assets; the
'market portfolio'
Market portfolio contains all securities and the proportion
of each security is its market value as a percentage of total
market value
Market price of risk or return per unit of risk depends on
the average risk aversion of all market participants

T h e University of W estern Australia

23

Capital market line

Equilibrium conditions: all investors will hold the same
portfolio for risky assets; the market portfolio
E(r)

CML
M

E(rM)

rf
sM

Efficient
frontier

Pricing of
individual
securities
is related to the
risk
that individual
securities
have when they
are included
in the market
portfolio.

T h e University of W estern Australia

24

Expected return and risk on individual securities

The risk premium on individual securities is a function of
the individual securitys contribution to the risk of the
market portfolio
What type of individual security risk will matter, systematic
or unsystematic risk?
An individual securitys total risk (s2i) can be partitioned into
systematic and unsystematic risk:

s2i = i2 sM2 + s2(ei)

T h e University of W estern Australia

25

Expected return and risk on individual securities (cont.)

An individual securitys contribution to the risk of the
market portfolio is...
Function of the covariance of the shares returns with the market
portfolios returns and is measured by BETA
Systematic risk can be measured by:
i = [COV(ri,rM)] / s2M

T h e University of W estern Australia

26

Individual shares: security market line

Slope SML = (E(rM) rf )/ M
= price of risk for market
E(r)

Equation of the SML (CAPM)

E(ri) = rf + i[E(rM) - rf]

E(rM)

SML

rf
M = 1.0

T h e University of W estern Australia

27

Class activity: Sample calculations for SML

E(rm) - rf = 0.08

rf = 0.03

x = 1.25 E(rx) = ?

y = .6 E(ry) = ?
If = 1?
If = 0?
T h e University of W estern Australia

28

Graph of sample calculations

E(r)

SML
0.08

Rx=13%
RM=11%

If the CAPM is correct, only risk

matters in determining the risk
premium for a given slope of the
SML.

Ry=7.8%

3%

0.6

1.0

1.25

x
T h e University of W estern Australia

29

Graph of sample calculations

Suppose a security with a of 1.25 is offering an expected
return of 15%. Is the security under or overpriced?
E(r)

SML
Rx=13%
RM=11%
Ry=7.8%
3%

0.6
y

1.0
M

1.25
x
T h e University of W estern Australia

30

One more example...

E(rM) = 14%
S = 1.5
rf = 5%
Required return = rf + S [E(rM) rf] =
If you believe the share will actually provide a return of
17%, what is the implied alpha?
a=
T h e University of W estern Australia

31

Portfolio betas
P

= Wi i

If you put half your money in a share with a beta of 1.5 and
30% of your money in a share with a beta of 0.9 and the
rest in T-bills, what is the portfolio beta?
P =
All portfolio beta expected return combinations should also
fall on the SML.
All (E(ri) rf) / i should be the same for all stocks.
T h e University of W estern Australia

32

Measuring beta
Concept
We need to estimate the relationship between the security and the
'market' portfolio.

Method
Can calculate the security characteristic line or SCL using historical
time series excess returns of the security a proxy for the market
portfolio.

T h e University of W estern Australia

33

Security characteristic line (SCL)

What does dispersion
of the points around
the line measure (se)?
What should a equal?

Excess Returns (i)

. . . .. . .
.
.
.
.
.
. . . ..
.
.
.
.
.
. . .. . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
. ..
.
.
.
.
.
R = a + R

SCL
Slope =

Excess returns
on market index

+ ei

T h e University of W estern Australia

34

Adjusted betas
Calculated betas are adjusted to account for the empirical finding
that betas different from 1 tend to move toward 1 over time.
A firm with a beta >1 will tend to have a lower beta (closer to 1)
in the future. A firm with a beta <1 will tend to have a higher
beta (closer to 1) in the future.
Adjusted = 2/3 (calculated ) + 1/3 (1)
= 2/3 (1.276) + 1/3 (1)
= 1.184
T h e University of W estern Australia

35

Evaluating the CAPM

The CAPM is 'false' based on the validity of its assumptions.
Huge measurability problems because the market portfolio is
unobservable.
Conclusion: As a theory the CAPM is untestable.
However... practicality of the CAPM is testable.
Betas are not as useful at predicting returns as other measurable factors
may be.
More advanced versions of the CAPM that do a better job at estimating
the market portfolio are useful at predicting stock returns.
Still widely used and well understood.
T h e University of W estern Australia

36

T h e University of W estern Australia

37

Evaluating the CAPM (cont.)

The principles we learn from the CAPM are still entirely
valid.
Investors should diversify.
Systematic risk is the risk that matters.
A well diversified risky portfolio can be suitable for a wide range of
investors.
Differences in risk tolerances can be handled by changing the
asset allocation decisions in the complete portfolio.

Even if the CAPM is 'false', the markets can still be

'efficient'.
T h e University of W estern Australia

38

Fama-French (FF) 3-factor model

Fama and French noted that shares of smaller firms and
shares of firms with a high book to market have had higher
share returns than predicted by single factor models.
Problem: empirical model without a theory
Will the variables continue to have predictive power?

T h e University of W estern Australia

39

Fama-French (FF) 3-factor model (cont.)

FF proposed a 3-factor model of share returns as follows:
rM rf = Market index excess return
Based on ratio of book value of equity to market value of equity
(HML) High minus low or difference in returns between firms
with a high versus a low book-to-market ratio.
Based on firm size variable
(SMB) Small minus big or the difference in returns between
small and large firms.

= + + + +
T h e University of W estern Australia

40

Arbitrage pricing theory (APT)

Arbitrage: Arises if an investor can construct a zero
investment portfolio with a sure profit
Zero investment: Since no net investment outlay is
required, an investor can create arbitrarily large positions to
secure large levels of profit
Efficient markets: With efficient markets, profitable arbitrage
opportunities will quickly disappear

T h e University of W estern Australia

41

Simple arbitrage example

If all of these stocks cost $8 today are there any arbitrage

opportunities?

T h e University of W estern Australia

42

Arbitrage example involving betas

Suppose rf = 6% and a well diversified portfolio P has a beta
of 1.3 and an alpha of 2% when regressed against a
systematic factor S. Another well diversified portfolio Q has
a beta of 0.9 and an alpha of 1%.
Construct portfolio PQ that has return of rf and beta of 0
WP = -2.25 and WQ = 3.25
p =(-2.25 x 2%) + (3.25 x 1%) = - 1.25%

T h e University of W estern Australia

43

Arbitrage pricing model

The result: for a well diversified portfolio
Rp = pRS (Excess returns)
(rp,i rf) = p(rS,i rf)

RS is the excess return on a

portfolio with a beta of 1
relative to systematic factor 'S'

Advantage of the APT over the CAPM:

No particular role for the 'market portfolio', which cant be
measured anyway
Easily extended to multiple systematic factors, for example
(rp,i rf) = p,1(r1,i rf) + p,2(r2,i rf) + p,3(r3,i rf) + ei

T h e University of W estern Australia

44

APT and CAPM

APT applies to well diversified portfolios but not necessarily to
all individual stocks
APT employs fewer restrictive assumptions
APT does NOT specify the systematic factors
Chen, Roll and Ross (1986) suggest:
Industrial production
Yield curve
Default spreads
Inflation
(rp,i rf) = p,1(r1,i rf) + p,2(r2,i rf) + p,3(r3,i rf) + p,4(r4,i rf) + ei
T h e University of W estern Australia

45

Last slide
Quiz
Next week Case study South Carolina
Please read case notes
Meet in your groups to discuss case
Consultant available to help you between 5-7pm Friday. Please
email yuanji.wen@uwa.edu.au for bookings.

T h e University of W estern Australia

49