Capital market theory

EQUILIBRIUM PRICING MODELS

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Portfolio theory and Capital markets theory

depict the theoretical relationship between the risk and expected return of an asset Portfolio theory
A selection of portfolios that maximizes expected returns consistently within acceptable levels of risk

Capital markets theory

Deals with the effects of investors decisions on security prices
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Capital Asset Pricing Model (CAPM)

Equilibrium model that underlies all modern financial theory Derived using the principles of diversification (portfolio theory) with simplified assumptions (capital market theory) Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development

E ( Ri ) R f i [ E ( Rm ) R f ]
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Assumptions
Individual investors are price takers Single-period investment horizon Investments are limited to traded financial assets (risk-free asset exists) No taxes, and transaction costs Information is costless and available to all investors Homogeneous expectations Investors are rational mean-variance optimisers

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Components of Risk
Specific risk
The variability in return due to factors unique to the individual firm Usually eliminated by diversifying the portfolio

Systematic risk
The variability in return due to dependence on factors which influence the return on all securities Not diversifiable Often called market risk (Beta)

Total risk = Systematic + Unsystematic

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Beta (Market risk)

Beta indicates how the return of a particular share is expected to vary for given variations in the return on the overall stock market i.e. how E(Ri) and E(Rm) are systematically related

Individual securities:

[COV (ri , rm )] i m2

i
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Corri ,m i m

Corri ,m i

m
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The Security Market Line (SML) E(Ri) Market portfolio M

Security market line

E(Rm)

Rf

E ( Ri ) R f i [ E ( Rm ) R f ]

m = 1

Beta

SML describes the relationship between risk and return when all securities are correctly priced i.e. when the capital market is in equilibrium. SML indicates the appropriate required return on individual assets and inefficient portfolios.

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Example (I)
The expected return on the market portfolio is 15% and the risk-free rate is 7%. In light of this info, determine whether the following securities are under-, over- or correctly priced? Estimated (Ri) Beta A 21% 2.0 B 19% 1.3 C 11% 0.5
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Example (I)
E ( Ri ) R f i [ E ( Rm ) R f ] E ( Ri ) 7 i (15 7) 7 8i
For share A:

E(R)

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Example (I)
E ( Ri ) R f i [ E ( Rm ) R f ] E ( Ri ) 7 i (15 7) 7 8i
For share B:

E(R)

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Example (I)
E ( Ri ) R f i [ E ( Rm ) R f ] E ( Ri ) 7 i (15 7) 7 8i
For share C:

E(R)

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Empirical evidence (I)

Sharpe & Cooper (1972)
Examined whether there is a positive relationship between expected return and beta (as stated by CAPM) Data of shares on the NYSE from 1931 to 1967 Shares were ranked according to their betas and grouped into 10 deciles Findings CAPM does apply i.e. shares with lower beta gained lower returns relative to shares with higher beta which gained higher returns
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Empirical evidence (II)

Fama & MacBeth (1973)
Investigated the relationship between risk and return using a regression analysis Findings Statistics failed to reject the hypotheses that the relationship between risk and return is linear and beta is the relevant measure of portfolio risk Positive risk & return trade-off CAPM does apply

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Empirical evidence (III)

Fama & French (1992)
Examined the relationship of returns to size, E/P ratios, book to market value ratios (BV/MV), gearing (D/E) and beta Findings did not explain returns, coefficient was small and not significantly different from zero Size was important, negative coefficient; large companies earned lower returns than their smaller counterparts Book to market was also important; lower market to book companies earned higher returns Low P/E companies earned higher returns
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Empirical evidence (IV)

Basu (1983)

Banz (1981)

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Arbitrage Pricing Theory (APT)

An alternative model to the CAPM (Ross, 1976) A securitys expected return is influenced by a variety of factors as opposed to the single market index of CAPM Based on purely arbitrage arguments (where an investor can construct a zero investment portfolio with sure profit)
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APT formula

E ( Ri ) R f 1bi1 2bi 2
where:
E(Ri) = expected return; Rf = the risk-free rate 1 = the risk premium related to each of the common factors e.g. inflation, etc b1 = the sensitivity of the asset to each of the common factors
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 Ross (1976)

APT

Actual returns differ from expected returns because of shocks to macroeconomic variables e.g. Actual(Ri) E(Ri) 20% 15% - Individuals will arbitrage away the difference (very profitable opportunities) - Using returns generating formula as follows:

Ri E ( Ri ) bi1 F1 bi 2 F2 bik Fk ei
where Ri is the actual return on asset i
E(Ri) is the expected return on asset i Fk is the kth shock to factors common to all assets bik is the sensitivity of asset i to changes in factor k
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Example II
Consider the following stocks, X and Y, in a twofactor model environment: 1 = 0.01; changes in the rate of inflation 2 = 0.02; percent growth in real GDP Rf = 0.03; risk free rate The two stocks have the following sensitivities to these factors: bX1 = 0.50; bX2 = 1.50 bY1 = 2.00; bY2 = 1.75
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Example II
(a) What are their respective expected returns? (b) Which is the riskier stock?
E ( Ri ) R f 1bi1 2bi 2 E(R X ) E(R Y )

(a)

(b)
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Example III
Suppose that the following two factor model describes returns: Ri = E(Ri) + bi1 F1 + bi2 F2 The following data is available:
Portfolio A B Estimated (r%) 17 14 bi1 1.0 0.5 bi2 0.6 1.0

C
E

8
15

0.3
0.6

0.2
0.6

(a) Determine which of A, B and C are correctly priced if Rf =7.75%, 1=5% and 2=3.75%?

(b) Contrast portfolio E against a portfolio constructed of 1/3 of funds in A, B & C.

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Example III
(a) APT : E(R ) 7.75 5 b 3.75 b i i1 i2
A Alpha B Alpha C Alpha
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Example III
(b) New portfolio: 1/3 funds in each A, B & C E(Rn) = 1/3 (15) + 1/3 (14) + 1/3 (10) = 13 Type b1 risk = = Type b2 risk = = E(R) 15% b1 0.6 b2 0.6
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Portfolio E Portfolio N
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Empirical evidence (V)

Roll & Ross (1980)
Tested for factors which explained returns using factor analysis technique Investigated whether sensitivity to these factors are priced Findings In over 38% of the groups, there was a less than 10% chance that a sixth factor had explanatory power Over 50% chance that the 5 factors were significant About 3 out of 5 appeared to be priced by the market and helped explain returns earned by securities When Beta was added to the equation, Beta did not affect price Support APT and not CAPM
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Empirical evidence (VI)

Chen, Roll & Ross (1986)
Argued that the return on shares should be influenced by any factor that affects either the future cashflow from holding these shares or the present value of these cashflows Tested 5 factors; inflation, unexpected inflation, term structure of interest rates, risk premia, industrial production Examined whether the sensitivity to these factors are priced by the market
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Empirical evidence (VI)

Findings A strong relationship existed between the factors examined and returns, which persisted over several periods The sensitivities to these factors are significant When Beta was introduced as another variable, it was not significant

Cochrane (1999a;b) Carhart (1997)

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APT v CAPM v Multifactors?

Assumptions Models Risks Empirical evidence and tests Implications for portfolio management and security analysis

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