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- the Market Model

- Relationship between the CML and the SML

- Arbitrage Pricing Theory

`risk-reduction effect.’

Specific

Risk

As the number of risky assets increases ( typically > 15 random securities) the risk of

the portfolio tends to the average covariance, or how the return on the stocks move with

respect to each other (the majority of stocks have positive covariance with each other).

Beyond a point, therefore adding new securities to the portfolio does not result in

further risk reduction.

The risk which can be diversified away by increasing the number of securities is the

Specific risk.

The portfolio which has the highest excess return per unit of risk or Sharpe ratio is the

Market portfolio. By implication it is clear that the risk of the Market Portfolio is made

up only of market risk.

Equivalent terms

onmarket risk, specific risk, unique risk, unsystematic risk, diversifiable risk.

KVShenai-ia-07 1

The Beta of a stock

The total risk on a stock can be expressed as the sum of the squares of

the systematic risk and its unsystematic risk

The systematic part of the risk is the portion which is related to the market.

Beta is the sensitivity of the expected return on the stock to the expected return on the

Market portfolio. It is the covariance of the return on the security i with the return on

the market portfolio divided by the variance of the market portfolio.

= ρim. σm. σi. / σm2 = ρim σi / σm

So when ρim2 = R2 is close to 1; the stock’s risk is almost entirely systematic risk,

and it has very little specific or unsystematic risk.

The Market portfolio is designated to have a β of 1 (its risk is only market risk).

The Capital Asset Pricing Model (CAPM), gives us the Security Market Line as a basis

to price assets by the amount of market risk (or systematic risk) which comprises the

total risk of returns on the asset.

The CAPM implies that there is no premium for the nonmarket related risks that an

asset may have (also called specific risk), as all specific risk can be diversified away.

ERi = Rf + βi ( ERm-Rf )

ERi Underpriced securities

Rm overpriced securities

Rf

β=1 β

KVShenai-ia-07 2

Relationship between the CML and the SML

The Capital Market Line (CML) shows us portfolios of different risk made up

only of the riskfree asset and the Market portfolio with the highest excess return per

unit of risk (Sharpe ratio).

The relationship between the CML and the SML are as below:

CML SML

ERi M

rf rf

0 σm σj = β j σm β=1 βj

σ β

Note

(i) how the SML prices only the market (systematic) component of a security

and

(ii) the CML shows how an equivalent portfolio with only market risk can be made

from a combination of the risk free asset and market portfolio.

KVShenai-ia-07 3

Finding Beta by the Market Model

assets pricing will be as follows:

In practice the β of an asset can be found by regressing the returns on the asset against

the returns on the market portfolio over a suitable period of time: such a model is called

the market model of the CAPM.

Rai = α + β Rmi

( ie Rai = α + β Rmi + e )

Rai = predicted return on share `a’ when return on the market index is Rmi

where `e’ is an error term representing the difference between the actual

return and the return predicted by the model. ( e = Rai- Rai)

or ordinary least squares method, whereby the sum of the squares of the error terms is

minimised.

KVShenai-ia-07 4

Tests of the CAPM

According to CAPM theory, the market portfolio is mean variance efficient and the

SML equation is a correct predictor of returns on various securities:

Rp = Rf + (Rm-Rf)βp

Empirical tests of the CAPM are based on testing expost data through reclassifying the

CAPM equation as below:

Rp-Rf = γo + γ1 βp + ε p

The betas of stocks or portfolios of stocks are ascertained over a period in the first

stage; then in the second stage, these betas are plotted regressed against the excess

return on the share/portfolio.

(i) the intercept must be zero; beta should be the only factor fully able to explain the

excess return on the share.

(ii) the slope of the empirical market line so obtained must equal the market risk

premium.

When γo is significantly different from zero, and the empirical line is flatter, it implies

there are possibly other variables which can also explain the returns of an asset and not

only the market portfolio ( eg P/E; M/B; Size, D/Y).

Roll’s basic critique is that a share index is not the market portfolio, which has to

include all the risky assets in the market and not only securities ( coins, property etc… ).

Hence, Roll developed an alternative theory the Arbitrage Pricing Model, according to

which security returns are sensitive to a set of factors ( hence this a multiple beta

model.)

KVShenai-ia-07 5

Arbitrage pricing theory

The APT assumes that individuals believe that security returns are determined by a K-

factor generating model

Rj = E(Rj) + Σ bjk Fk + εj

where

bjk is the sensitivity of the jth asset’s return to the kth factor

Fk is the kth factor common to the returns of all assets under consideration.

εj is the noise term for the jth asset ( random, zero mean)

Like the CAPM, the APT assumes that risk is composed of a diversifiable(non-

systematic) and systematic components. In APT the systematic components are

measureable through the sensitivity of the asset’s return to various factors which affect

all assets.

(a portfolio that has no risk, requires no capital investment and yet earns a positive

return). Such a portfolio cannot exist in equilibrium as all such profits would have been

arbitraged away.

E(Rj) = Rf + Σ ( δ k - Rf) bj k

`δ k’ is the expected return on a portfolio which has a sensitivity of 1 to the kth factor

and zero sensitivity to all other factors.

`Rf’ is the return on a riskfree asset which has no sensitivity to any factor.

KVShenai-ia-07 6

According to APT at Market equilibrium no (riskless) arbitrage profits are available by

holding different combinations of securities. ( In efficient markets correct pricing of

various assets takes place through elimination of arbitrage opportunities.)

In equilibrium, the factor sensitivities `bjk’ can be likened to `β’ in the CAPM.

VAR (δk) var ( rm)

Research by Chen, Roll and Ross in the US has shown that the following five

macroeconomic variables are significant `factors’–

1. Industrial production

2. Changes in the default risk premium

3. Return on short-term and long-term government bonds

4. Inflation

5. Changes in the real rate of interest

The factors found significant in APT tests are in the manner of economy wide risks

affecting the returns of all assets to different degrees. The CAPM, however, is thus a

special case of the APT where one factor, the expected return on the market portfolio

explains the return on an asset.

CAPM is thus not as effective as the APT, for predicting returns on assets not properly

represented in the reference index. ( commodities, savings and loans, electric utilities).

Earlier, it was also stated that empirical tests have found that the empirical market

line is flatter, with an intercept possibly explainable in terms of

P/E, MTBR, Dividend yield, Size.

On the other hand the CAPM conveniently prices assets on the basis of a single factor

which encapsulates economy wide variables. It is useful for determining the cost of

capital required for valuation and for capital budgeting, for the majority of stocks.

Compared to the DVM, the CAPM is a single period model, dependent on past Betas,

whereas the DVM is forward looking, based on expectations of Dividends in several

future periods. The DVM however is also dependent on past growth rates of dividends..

A good discussion on the CAPM versus the Dividend Valuation Model appears in Steve

Lumby’s Investment Appraisal and Financial Decisions, 5th ed. Note also that the DVM

in its bare form is a total risk model.

KVShenai-ia-07 7

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