Capital Asset

Pricing and
Arbitrage
Pricing Theory

7
Bodie, Kane and Marcus
Essentials of Investments
9th Global Edition
 7.1 THE CAPITAL ASSET PRICING MODEL
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 7.1 THE CAPITAL ASSET PRICING MODEL
 Assumptions
 Markets are competitive, equally profitable
 No investor is wealthy enough to individually affect prices
 All information publicly available; all securities public

 No taxes on returns, no transaction costs

 Unlimited borrowing/lending at risk-free rate

 Investors are alike except for initial wealth, risk aversion

 Investors plan for single-period horizon; they are rational, mean-
variance optimizers
 Use same inputs, consider identical portfolio opportunity sets
 7.1 THE CAPITAL ASSET PRICING MODEL
 Hypothetical Equilibrium
 All investors choose to hold market portfolio
 Market portfolio is on efficient frontier, optimal risky
portfolio
 Risk premium on market portfolio is proportional to
variance of market portfolio and investor’s risk
aversion
 Risk premium on individual assets
 Proportional to risk premium on market portfolio

 Proportional to beta coefficient of security on market

portfolio
FIGURE 7.1 EFFICIENT FRONTIER AND
CAPITAL MARKET LINE
 7.1 THE CAPITAL ASSET PRICING MODEL
 Passive Strategy is Efficient
 Mutual fund theorem: All investors desire same portfolio of
risky assets, can be satisfied by single mutual fund
composed of that portfolio
 If passive strategy is costless and efficient, why follow active
strategy?
If no one does security analysis, what

brings about efficiency of market portfolio?
 7.1 THE CAPITAL ASSET PRICING MODEL
 Risk Premium of Market Portfolio
 Demand drives prices, lowers expected rate of return/risk
premiums
 When premiums fall, investors move funds into risk-free
asset
 Equilibrium risk premium of market portfolio proportional
to
Risk of market
Risk aversion of average investor
 7.1 THE CAPITAL ASSET PRICING MODEL
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7.1 THE CAPITAL ASSET PRICING MODEL
 The Security Market Line (SML)
 Represents expected return-beta relationship of CAPM
 Graphs individual asset risk premiums as function of asset
risk
 Alpha
 Abnormal rate of return on security in excess of that
predicted by equilibrium model (CAPM)
FIGURE 7.2 THE SML AND A POSITIVE-
ALPHA STOCK
 7.1 THE CAPITAL ASSET PRICING MODEL
 Applications of CAPM
 Use SML as benchmark for fair return on risky asset
 SML provides “hurdle rate” for internal projects
 In setting pricing for government offerings and tenders
 7.1 THE CAPITAL ASSET PRICING MODEL
What is the expected rate of return for a stock that has a
beta of 1 if the expected return on the market is 15%?
a. 15%.
b. More than 15%.
c. Cannot be determined without the risk-free
rate.
7.2 CAPM AND INDEX MODELS
 7.2 CAPM AND INDEX MODELS
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 TABLE 7.1 MONTHLY RETURN
STATISTICS 01/06 - 12/10
Statistic (%) T-Bills S&P 500 Google
Average rate of return 0.184 0.239 1.125

Average excess return - 0.055 0.941

Standard deviation* 0.177 5.11 10.40

Geometric average 0.180 0.107 0.600

Cumulative total 5-year return 11.65 6.60 43.17

Gain Jan 2006-Oct 2007 9.04 27.45 70.42

Gain Nov 2007-May 2009 2.29 -38.87 -40.99

Gain June 2009-Dec 2010 0.10 36.83 42.36

* The rate on T-bills is known in advance, SD does not reflect risk.

FIGURE 7.3A: MONTHLY RETURNS
FIGURE 7.3B MONTHLY
CUMULATIVE RETURNS
FIGURE 7.4 SCATTER DIAGRAM/SCL: GOOGLE VS.
S&P 500, 01/06-12/10
 TABLE 7.2 SCL FOR GOOGLE (S&P 500),
01/06-12/10
Linear Regression
Regression Statistics
R 0.5914
R-square 0.3497
Adjusted R-square 0.3385
SE of regression 8.4585
Total number of observations 60

Regression equation: Google (excess return) = 0.8751 + 1.2031 × S&P 500 (excess return)
ANOVA
df SS MS F p-level
Regression 1 2231.50 2231.50 31.19 0.0000
Residual 58 4149.65 71.55
Total 59 6381.15

Coefficient Standard
s Error t-Statistic p-value LCL UCL
Intercept 0.8751 1.0920 0.8013 0.4262 -1.7375 3.4877
S&P 500 1.2031 0.2154 5.5848 0.0000 0.6877 1.7185
t-Statistic (2%) 2.3924
LCL - Lower confidence interval (95%)
UCL - Upper confidence interval (95%)
 7.2 CAPM AND INDEX MODELS
• Estimation results
• Security Characteristic Line (SCL)
• Plot of security’s expected excess return over
risk-free rate as function of excess return on
market

• Required rate = Risk-free rate + β x Expected excess return

of index
 7.2 CAPM AND INDEX MODELS
 Predicting Betas
 Mean reversion
Betas move towards mean over time
To predict future betas, adjust estimates

from historical data to account for

regression towards 1.0
 TRUE OR FALSE

 Stocks with a beta of zero offer an expected rate of

return of zero.

 The CAPM implies that investors require a higher

return to hold highly volatile securities.

 You can construct a portfolio with beta of .75 by

investing .75 of the investment budget in T-bills and
the remainder in the market portfolio.
10) The market price of a security is $ 30. Its expected
rate of return is 10%. The risk-free rate is 4%, and the
market risk premium is 8%. What will the market price
of the security be if its beta doubles (and all other
variables remain unchanged)? Assume the stock is
expected to pay a constant dividend in perpetuity.
15) If the CAPM is valid, is the below situation possible?
16) If the CAPM is valid, is the below situation possible?
24) Two investment advisers are comparing performance.
One averaged a 19% return and the other a 16% return.
However, the beta of the first adviser was 1.5, while that
of the second was 1.
a) Can you tell which adviser was a better selector of
individual stocks (aside from the issue of general
movements in the market)?
b) If the T-bill rate were 6% and the market return
during the period were 14%, which adviser would be
the superior stock selector? c. What if the T-bill rate
were 3% and the market return 15%?
22) Assume the risk-free rate is 4% and the expected rate
of return on the market is 15%. I am buying a firm with
an expected perpetual cash flow of $ 600 but am unsure
of its risk. If I think the beta of the firm is zero, when the
beta is really 1, how much more will I offer for the firm
than it is truly worth?
 7.3 CAPM AND THE REAL WORLD
 CAPM is false based on validity of its assumptions
 Useful predictor of expected returns
 Untestable as a theory
 Principles still valid

Investors should diversify

Systematic risk is the risk that matters

Well-diversified risky portfolio can be

suitable for wide range of investors

 7.3 CAPM AND THE REAL WORLD

 Consider the statement: “If we can identify a portfolio

that beats the S& P 500 Index portfolio, then we should
reject the single-index CAPM.” Do you agree or
disagree? Explain.
7.4 MULTIFACTOR MODELS AND CAPM
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 7.4 MULTIFACTOR MODELS AND CAPM
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 TABLE 7.3 MONTHLY RATES OF RETURN,
01/06-12/10
Monthly Excess Return % * Total Return
Standard Geometric Cumulative
Security Average Deviation Average Return

T-bill 0 0 0.18 11.65

Market index ** 0.26 5.44 0.30 19.51
SMB 0.34 2.46 0.31 20.70
HML 0.01 2.97 -0.03 -2.06
Google 0.94 10.40 0.60 43.17

*Total return for SMB and HML

** Includes all NYSE, NASDAQ, and AMEX
stocks.
TABLE 7.4 REGRESSION STATISTICS: ALTERNATIVE
SPECIFICATIONS
Regression statistics
for: 1.A Single index with S&P 500 as market proxy
1.B Single index with broad market index
(NYSE+NASDAQ+AMEX)
2. Fama French three-factor model (Broad
Market+SMB+HML)

Monthly returns January 2006 - December 2010

Single Index Specification FF 3-Factor Specification
Broad Market
Estimate S&P 500 Index with Broad Market Index

Correlation coefficient 0.59 0.61 0.70

Adjusted R-Square 0.34 0.36 0.47
Residual SD = Regression SE
(%) 8.46 8.33 7.61
Alpha = Intercept (%) 0.88 (1.09) 0.64 (1.08) 0.62 (0.99)
Market beta 1.20 (0.21) 1.16 (0.20) 1.51 (0.21)
SMB (size) beta - - -0.20 (0.44)
HML (book to market) beta - - -1.33 (0.37)

Standard errors in parenthesis

 7.5 ARBITRAGE PRICING THEORY
 Arbitrage
 Relative mispricing creates riskless profit
 Arbitrage Pricing Theory (APT)
 Risk-return relationships from no-arbitrage considerations in large
capital markets
 Well-diversified portfolio
 Nonsystematic risk is negligible
 Arbitrage portfolio
 Positive return, zero-net-investment, risk-free portfolio
 7.5 ARBITRAGE PRICING THEORY
 Calculating APT


 Returns on well-diversified portfolio


TABLE 7.5 PORTFOLIO CONVERSION

Steps to convert a well-diversified portfolio

into an arbitrage portfolio

*When alpha is negative, you would reverse the signs of each portfolio
weight to achieve a portfolio A with positive alpha and no net investment.
FIGURE 7.5 SECURITY
CHARACTERISTIC LINES
7.5 ARBITRAGE PRICING THEORY
 Multifactor Generalization of APT and CAPM
 Factor portfolio
 Well-diversified portfolio constructed to
have beta of 1.0 on one factor and beta of
zero on any other factor
 Two-Factor Model for APT

7.5 ARBITRAGE PRICING THEORY
29. Assume a market index represents the common factor
and all stocks in the economy have a beta of 1. Firm-
specific returns all have a standard deviation of 45%.
Suppose an analyst studies 20 stocks and finds that one-
half have an alpha of 3.5%, and one-half have an alpha of
–3%. The analyst then buys $ 1 million of an equally
weighted portfolio of the positive-alpha stocks and sells
short $ 1.7 million of an equally weighted portfolio of the
negative-alpha stocks.
a) What is the expected profit (in dollars), and what is the
standard deviation of the analyst’s profit
b) How does your answer change if the analyst examines
50 stocks instead of 20? 100 stocks?
7.5 ARBITRAGE PRICING THEORY

31) The APT itself does not provide information on the

factors that one might expect to determine risk premiums.
How should researchers decide which factors to
investigate? Is industrial production a reasonable factor to
test for a risk premium? Why or why not?
7.5 ARBITRAGE PRICING THEORY
31) As a finance intern at Pork Products, Jennifer Wainwright’s
assignment is to come up with fresh insights concerning the
firm’s cost of capital. She decides that this would be a good
opportunity to try out the new material on the APT that she
learned last semester. As such, she decides that three
promising factors would be (i) the return on a broad-based
index such as the S& P 500; (ii) the level of interest rates, as
represented by the yield to maturity on 10-year Treasury
bonds; and (iii) the price of hogs, which are particularly
important to her firm. Her plan is to find the beta of Pork
Products against each of these factors and to estimate the risk
premium associated with exposure to each factor. Comment on
Jennifer’s choice of factors. Which are most promising with
respect to the likely impact on her firm’s cost of capital? Can
you suggest improvements to her specification?
7.5 ARBITRAGE PRICING THEORY