ASSET PRICING MODEL

NAME : ALI ABBAS BANATWALA

ID : 17035
PRESENTED TO : SABEEN ANWAR

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 Learning Objectives
Understand how risk and return are defined and
measured.
Understand the concept of risk aversion by
investors.
Explain how diversification reduces risk.

Understand the importance of covariance between

returns on assets to determine the risk of a portfolio.
Explain the concept of efficient portfolios.

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 Learning Objectives (cont.)
Understand distinction between systematic and
unsystematic risk and significance of systematic risk.
Explain the relationship between returns and risk
proposed by the capital asset pricing model
(CAPM).
Understand the relationship between CAPM and the
Fama-French three-factor model.
Explain the development of the Fama-French three-
factor model.

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Return
There is uncertainty associated with returns on shares. Assume we can
assign probabilities to the possible returns given the following set of
circumstances, the expected return is:
Example Solution

n
Percentage Probability, E R R P i i
Return, Ri Pi i 1

9 0.1 (0.09 x 0.1) (0.10 x 2421)

10 0.2 (0.11x 0.4) (0.12 x 0.2)
11 0.4 (0.13 x 0.1)
12 0.2 E R 11%
13 0.1

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Risk
Risk is present whenever investors are not certain about the outcome an
investment will produce.
Risk measured by variance how much a particular return deviates from
an expected return. Use standard deviation to measure risk, which is simply the
square root of the variance:
n
Ri E R Pi
2 2

i 1

Using previous example, risk is given by:

Variance:
2 = 0.09-0.11 0.1 0.10-0.11 0.2
2 2

0.11-0.11 0.4 0.12-0.11 0.2

2 2

0.13-0.11 0.1
2

= 0.000 12

Standard Deviation: = 0.000 12 0.01095 1.095%

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 Risk Attitudes
Risk-neutral investor: (p. 175, Figure 7.3)
One whose utility is unaffected by risk; when chooses to invest,
investor focuses only on expected return.
Risk-averse investor: (p. 175, Figure 7.3)
One who demands compensation in the form of higher expected
returns in order to be induced into taking on
more risk.
Risk-seeking investor: (p. 175, Figure 7.3)
One who derives utility from being exposed to risk, and hence, may
be willing to give up some expected return
in order to be exposed to additional risk.

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 Risk Attitudes (cont.)
The standard assumption in finance theory is all investors are
risk averse.
This does not mean an investor will refuse to bear any
risk at all.
Rather, investors regards risk as something undesirable,
but may take up on board if compensated with sufficient return;
trade-off between risk and return.
Investors risk preferences
Indifference curve which represents those combinations of
expected return and risk that result
in a fixed level of expected utility for an investor.
(p. 177, Figure 7.5 Risk averse investor)

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 Risk of Assets and Portfolios
We now know that the risk of an individual asset is
summarised by standard deviation (or variance) of
returns.
Investors usually invest in a number of assets (a
portfolio) and will be concerned about the risk of
their overall portfolio.
Now concerned about how these individual risks
will interact to provide us with overall portfolio
risk.

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Portfolio Theory
Assumptions:
Investors perceive investment opportunities in terms of a
probability distribution defined by expected return and risk.
Investors expected utility is an increasing function of return
and a decreasing function of risk (risk aversion).
Measuring return of portfolio:
Portfolio return (Rp) is a weighted average of all the expected
returnsnof the assets held in the portfolio:

E Rp wjE Rj where:
w = the proportion of the portfolio
j
j 1
invested in asset j
n= the number of securities in the portfolio

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Portfolio Risk
Portfolio (comprising two assets) risk depends on:
The proportion of funds invested in each asset (w).
The riskiness of the individual assets (2).
The relationship between each asset in the portfolio
with respect to risk, correlation (.
For a two-asset portfolio the variance is:

2
p w1 1
2 2
w2 2
2 2
2w1w2 1, 2 1 2
where:
wi = the proportion of the portfolio
invested in asset i
i = the standard deviation of asset i
ij correlation between asset i and j returns

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 Portfolio Risk and Return
Measurement
Assume 60% of the portfolio is invested in
security 1 and 40% in security 2. If variances of
security 1 and security 2 are 0.0016 and 0.0036,
respectively, and the correlation (p1,2) is 0.5:
Find expected return and risk of portfolio.
The expected returns of the securities are 0.08
and 0.12 respectively.
The standard deviation is 0.024.

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Relationship Measures
Covariance:
Statistic describing the relationship between two variables.
If positive, when one of the variables takes on a value above its
expected value, the other has a propensity to do the same.
If the covariance is negative, the deviations tend to be of an
opposite sign.
Correlation coefficient:
Is another measure of the strength of a relationship between
two variables? The correlation is equal to the covariance divided
by the product of the assets standard deviations.
covx, y
xy
x y
It is simply a standardisation of the covariance, and for this reason is
bounded by the range +1 to 1.

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 Gains from Diversification
Diversification gain is related to correlation coefficient value.
The degree of risk reduction increases as the correlation between the
rates of return on two securities decreases.
r = +1, Risk reduction does not occur by combining securities whose
returns are perfectly positively correlated.
r = 1, Risk reduction occurs by combining securities whose returns are
less than perfectly positively correlated.
0 < r < 1, If the correlation coefficient is less than 1, the third term in
the portfolio variance equation is reduced, reducing portfolio risk.
r = 1 If the correlation coefficient is negative, risk is reduced even
more, but this is not a necessary prerequisite for diversification gains.

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 Diversification with Multiple Assets
The more assets we incorporate into the portfolio, the
greater the diversification benefits are.
The key is the correlation between each pair of assets in
the portfolio.
With n assets, there will be an n n covariance matrix.
The properties of the variance-covariance matrix are:
It will contain n2 terms.
The two covariance terms for each pair of assets are identical.
It is symmetrical about the main diagonal that contains
n variance terms.

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 Diversification with Multiple Assets
(cont.)
For a diversified portfolio, the variance of the
individual assets contributes little to the risk of
the portfolio.
For example, in a 50-asset portfolio there are 50
(n) variance terms and 2450 (n2 n) covariance
terms.

The risk depends largely on the covariances

between the returns on the assets.

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Systematic and Unsystematic Risk
Intuitively, we should think of risk as comprising:

Total Risk = Systematic Risk + Unsystematic Risk

Systematic risk: Component of total risk that is due to economy-wide

factors. (non-diversifiable risk)
Unsystematic risk: Component of total risk that is unique to firm and
is removed by holding a well-diversified portfolio.
The returns on a well-diversified portfolio will vary due to the effects of
market-wide or economy-wide factors.
Systematic risk of a security or portfolio will depend on its sensitivity to
the effects of these market-wide factors.

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 Risk of an Individual Asset
The risk contribution of an asset to a portfolio is largely determined by
the covariance between the return on that asset and the return on the
holders existing portfolio:

Cov Ri , R p i, p i p
Well-diversified portfolios will be representative of the market as a
whole. Thus, the relevant measure of risk is the covariance between the
return on the asset and the return on the market:

CovRi , RM

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 Beta
Beta is a measure of a securitys systematic risk, describing
the amount of risk contributed by the
security to the market portfolio.
Cov(Ri , RM) can be scaled by dividing it by the
variance of the return on the market. This is the
assets beta (i): where:
RM = return on the market portfolio
Ri = return on the particular asset

Cov Ri , RM
i
M2

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 Construction of a Portfolio
The opportunity set:
The set of all feasible portfolios that can be constructed from
a given set of risky assets.

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 Construction of a Portfolio (cont.)
The efficient frontier:
Investor will try to secure a portfolio on the efficient frontier.
The efficient frontier is determined on the basis of
dominance.
A portfolio is efficient if:
No other portfolio has a higher return for the same risk, or
No other portfolio has a lower risk for the same return.
Investors are a diverse group and, therefore, each investor
may prefer a different point along the efficient frontier.
Investor risk preferences will determine the preferred
portfolio on the efficient frontier.

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 The Pricing of Risky Assets
What determines the expected rate of return on an
individual asset?
Risky assets will be priced such that there is a
relationship between returns and systematic risk.
Investors need to be sufficiently compensated for
taking on the risks associated with the investment.

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 The Capital Market Line
Combining the efficient frontier with preferences,
investors choose an optimal portfolio.
This can be enhanced by introducing a risk-free asset:

The opportunity set for investors is expanded and results

in a new efficient frontier capital market line
(CML).

The CML represents the efficient set of all portfolios

that provides the investor with the best possible
investment opportunities when a risk-free asset is
available.

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 The Capital Market Line (cont.)
The CML links the risk-free asset with the
optimal risky portfolio (M): p. 191, Figure 7.11.
Investors can then vary the riskiness of their portfolio
investment by changing weights in the
risk-free asset and portfolio M.
This changes their return according to the CML:

E RM R f
E Rp R f p
M

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 The CAPM and the Security Market
Line (SML)
In equilibrium, the expected return on a risky asset i (or an
inefficient portfolio), is given by the security market line:

where:
E ( Ri ) = the expected return on the ith risky asset
Cov( Ri , RM ) = the covariance between returns
on ith risky asset and the market portfolio

E RM R f
E Ri R f covRi , RM
M

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 The CAPM and the SML (cont.)
The covariance term is the only explanatory factor in the equation
that is specific to asset i.
As Cov(Ri,RM) is the risk of an asset held as part of the market
portfolio, and M is the risk of the market portfolio, beta
measures the risk of i relative to the risk of the market as a whole.
We can thus write the Security Market Line (SML) as the
Capital Assets Pricing Model (CAPM) equation:

E Ri R f i E RM R f
See p.193, Figure 7.12 for graphical depiction of the CAPM and
the SML.

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 Portfolio Beta
The systematic risk (beta) of a portfolio is calculated as
the weighted average of the betas of the individual assets
in the portfolio:
n
p wi i
i 1
where:
n number of assets in the portfolio
wi = proportion of the current market value
of portfolio p constituted by the i th asset

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 Implementation of the CAPM
The three components of the CAMP: Rf, e and E(Rm)
Rf: The government securities current yield whose term
to maturity matches the life of the proposed project.
e: Use market model to estimate beta by obtaining time
series data on the rates of return on shares and market
portfolio. Hence, number of years and the length of period
is significant over which returns are calculated.
E(Rm): Two ways to calculate:
(1) Use average return in share market index over a long period of
time.
(2) Estimate market risk premium directly over a long period of time.
However, test and empirical studies have found problems with CAPM
implementation, and concerns have led to introducing new model
introduction.

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 Risk, Return and the CAPM
The capital market will only reward investors for
bearing risk that cannot be eliminated by
diversification.
Unsystematic risk can be diversified away, so capital
market will not reward investors for taking this type of
firm specific risk.
However, CAPM states the reward for bearing
systematic risk is a higher expected return, consistent
with the idea of higher risk requires higher return.

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 Tests of the CAPM
Early empirical evidence was supportive of CAPM
in explaining asset pricing.
Rolls critique (1977) criticised methodology of testing
CAPM empirically.
Most tests of the CAPM can only determine whether the
market portfolio used is efficient.
In response, researchers implemented methodological
refinements CAPM seems untestable, given Rolls
critique.
However, CAPM is a useful tool when thinking about asset
returns.

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Fama-French Three-Factor Model
Fama and French (1992) provide evidence on factors that
explain asset returns no support for CAPM, support for
firm size, leverage, P/E, BV/MV, though not definitive.
Fama and French (1995) leads to the most common three-
factor model:

E Rit R ft i M E RMt R ft i S E SMB + i h E HML

Includes the CAPM, market factor, a small minus large

portfolio factor (SML) and a high minus low market to book
portfolio (HML).

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Fama-French Three-Factor Model
(cont.)
This model is supported by Australian data relative to
CAPM: Gaunt (2004).
While the three-factor model is empirically robust, it
suffers from difficult economic interpretation Why
do company size and BV/MV explain asset returns?
The fact that Fama-French includes market factor, along
with ambiguity of role of other factors is supportive of
CAPM.
The three-factor model is now very common in
empirical research.

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 Summary
Portfolio theory: diversification reduces risk.
Diversification works best with negative or low positive correlations
between assets and asset classes.
Risk can be divided into two categories:
Systematic risk cannot be diversified away.

Unsystematic risk can be diversified away.

Systematic risk of an asset is measured by the assets beta. Risk of

asset is relative to market.
CAPM provides the relationship between risk and expected
return for risky assets.

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 Summary (cont.)
CAPM uses assets beta and assumes linear relationship
between expected return and risk relative to market,
measured by beta.
FamaFrench three-factor model is a contemporary
version of the multi-factor (APT) model.
Key factors are the market excess return, return on
a small minus large portfolio, return on a high minus
low market to book portfolio.
Although CAPM has its shortfall, it does provides some
important insights into the link between risk and return.
Hence, there is no perfect model.

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