An Introduction to Asset

Pricing Models – Chapter 8

Concerning: Reilly & Brown: Investment

Analysis and Portfolio Management

Dick Marcus 229-4103

marcus@uwm.edu
1
 Generally, the higher the risk, the higher
the return
 But we want both high return and low risk
 To achieve this, we diversify over many
assets and various asset classes
 Stocks (both domestic and foreign)

 Bonds (both domestic and foreign)

Slide 2
 Risk - Return Tradeoffs:
Stocks
RETURNS 100% Small Cap
.13 Growth Stocks

100% Foreign Stocks

.10
Least Risk at 90% US Core Stocks
& 10% Foreign Stocks*
.08
100% Large Cap Value

standard deviation as the measure of risk

Slide 3
*For illustration purposes. The risk-return trade-offs change over time.
 Risk - Return Tradeoffs:
Bonds
RETURNS 100% Foreign
Bonds
.09

.07 Least Risk at 70% US Bonds and

30% Foreign Bonds*

.05 100% US Bonds

standard deviation as the measure of risk

Slide 4
*For illustration purposes. The risk-return trade-offs change over time.
 Risk is reduced by using a
combination of both stocks and bonds

RETURNS
STOCKS & BONDS
EAFE STOCKS ONLY
.15
Balanced
EAFE (Europe, Australia,
.10 & the Far East)
World World Stocks Only
.05 Balanced US Stocks Only
US Balanced
standard deviation as the measure of risk
Slide 5
*For illustration purposes. The risk-return trade-offs change over time.
Markowitz portfolio model
P =  wi2I2 + wiwj Covij eqn 7.6 on page 219

 Requires extensive information:

 We need variances, covariances, and weights
for all the assets
 CAPM is more compact and efficient
in data requirements:
1. We need betas
2. We need a risk free return
3. We need the market return

Then we can estimate the rate of return and the Slide 6

standard deviation of the portfolio

 E(RP) = RF + bP (RM-RF)
 Beta on a risk free asset is bF =0
 Beta on the market is bM =1
 Let w be the weight of money invested in the
market and (1-w) in the risk free return
 The portfolio beta (bP ) will be a weighted average
of 0 and 1, so the Beta of the Portfolio is also w.
 bP = (1-w) bF + w bM = (1-w)0 + w•1 = w
 E(RP) = (1-w)RF + w RM = RF + bP (RM-RF)
 This is essentially Equation 8.6, page 248 Slide 7
 Assumptions of
Capital Market Theory
1. Investors seek to 5. Infinitely divisible
be on the efficient investments
frontier 6. There are no taxes
2. Borrow or lend at and no transaction
the risk-free rate costs
3. Homogeneous 7. No inflation (or
expectations fully anticipated)
4. One-period 8. Capital markets
horizon are in equilibrium

Slide 8
 Review of some statistic stuff
pagers 241-242

 There is zero covariance between a risk

free asset and an asset
 Combining (1-w) of a risk free asset with w
of a risky asset Ri forms a portfolio
 E(RP) = (1-w)RF + w Ri

 Standard deviation of this portfolio is:

1. P = w  i

2. Because P2 = w2•i2

3. The square root of the equation in (2) is (1).
Slide 9
 CML – The Capital Market Line
 Ex 8.2 on page 243 E(RP) CML
 Can achieve M
 When all money is
invested in the
market portfolio Efficient frontier
 Can achieve RF M
When all money is • •
•• • •

lent a the risk
free rate RF
 Or anything along
the CML
 When levering
the portfolio, we
achieve more risk
and more return P
on the CML Slide 10
 Diversification &
Unsystematic Risk
 If total risk is
P
22%, and
systematic risk
is 18%, then 4%
.22
is unsystematic
risk
Unsystematic Risk
 More securities,
then total risk
.18

Systematic Risk approaches

market risk of
Number of Stocks in the Portfolio
about 17.8% Slide 11
 Optimal Portfolio Choice on
the CML
 Indifference E(RP) CML
curves for a
“good” and a
“bad”
Efficient frontier
 Select the M
highest utility • •
on the CML A •• • •
 Can invest RF
part in risk-
free and part
in the market
at Point A
P
Slide 12
 The Separation Theorem

 The CML comes from the investment

decisions of all investors
 The financing question is where to be
on the CML
 Hence, the optimal investment
decision is separate from the financing
question.

Slide 13
Decompose Risk Components

 Each asset is a part of the market portfolio

 Market Model for finding beta is
 Ri = ai + bi RM + i
 Take the variance of both sides
 Var(Ri) = Var(ai + bi RM + i ) =
 Var(Ri) = Var(bi RM ) + Var(i ) =
 Var(Ri) = bi 2 2M +  2
i

 Risk = systematic risk + unsystematic risk

 Page 247
Slide 14
 Security Market Line - SML
Expected return
 The risk of an
asset is its
covariance
with the
market SML
portfolio RM
 If little RF
covariance,
then less risk
 If a lot of
covariance,
2M
then more risk Covariance
Slide 15
 SML – as Beta and Return
Expected return
 Beta = Cov/Var Exhibit 8.6 page 249
 So normalizing
all by the •C SML
variance of the
market we RM •A
RF
have the usual •B
SML

0.0 1.0 Beta

E(Ri) = RF + bi (RM-RF) or risk-free rate with a risk premium Slide 16
 Assets above the SML are expected to earn
more than predicted by their risk
 These are under-valued & are a buy such as point C
 Assets below the SML are expected to earn less
than predicted by their risk
 These are over-valued & are a sell such as point B
 Assets on the SML are expected to earn in line
with their risk
 Such as point A
Slide 17
 The Characteristic Line
 Also called the “market model,” the regression
of returns on market return is:
Ri = a i + b i RM +  i
 Traditionally, this is 60 months of returns
 Five years covers a business cycle, but not so long
as to change the firm over-much.
 Suppose we use daily, weekly, or annual data?
 Shorter time intervals tend to cause larger betas for
big firms with weekly data and smaller betas for
small firms with weekly data
 The market is usually the S&P 500 Composite
Index, versus a global market return. Slide 18
 Do you borrow & lend at
different rates?
Exhibit 8.14 on page 257
E(RP)
 If you do,
the rate of CML
lending is
often lower Efficient frontier
than
borrowing. Rb • •
 The slope •• • •
RF
of the CML
varies
from RF to
M, than
beyond M. P
Slide 19
 Zero-beta Model

 CAPM can be developed without a

risk-free asset, with limited success.
 Instead, consider a zero-beta asset
 The return on the zero-beta asset
substitutes for the risk-free one
 The market premium is the difference
with the zero-beta asset
 E(Ri) = Rz + bi(RM-Rz)
Slide 20
 CAPM with Transaction Costs

Expected return
 Forming a
market
portfolio may
be costly
SML
RM  The likely
RF result that the
SML will be
‘thick’.
2M Covariance
Slide 21
 Taxes!

 While many investments are tax-sheltered

(IRS, Keogh, 401-k, 403-b, etc.) many assets
suffer taxes
 This adjusts the rates of return to be after-tax
rates of return
 The problem is that different people pay
different taxes.
 In practice, finance theorists and practitioners
tend to assume zero taxes for these reasons.
Slide 22
 CAPM – Empirical Evidence

 OK in theory, but how does it work in

practices. Questions:
1. Are betas stable, so that PAST betas describe
risk for the future?
2. Do stocks with higher betas achieve higher
returns?
1. Individual stock betas are volatile, but
portfolio betas are more stable. Also,
various published data vary on betas.
 Some use ‘adjustments’ to measured market
betas for greater stability.

Slide 23
 Is CAPM Useful?

 Given what we know of betas, the

most positive results involve
PORTFOLIO betas and return
 Black, Jensen, & Scholes, 1972 show
that higher beta portfolios hear higher
returns in 1931 – 1957, but when looking
at 1957 – 1965, they didn’t!
 So, big beta stocks don’t always pay
higher returns.
Slide 24
 Other factors that seem to affect
returns other than systematic risk
1. Skewness – return distributions aren’t
normal, they are right-skewed.
 Low beta stocks do well
2. Size Effect – larger stocks seemed to have
higher betas, but do less well
 The origin of the small firm effect, perhaps
3. P/E Effect – value stocks do well, if betas are
smaller than they should be
4. Leverage – even after holding other factors
constant, leverage is a significant variable in
explaining cross-sectional returns
Slide 25
Fama & French JF 1992

 Fama was famous in his support for CAPM

 But Fama & French showed how other
factors other than beta mattered much
more. Beta was insignificant in 1963-1990.
 Size
 Leverage
 E/P ratio
 Book-to-market equity (BE/ME) – Tobin’s Q

Slide 26
 Fama-French techniques

 One variable at a time tests (Univariate tests):

 Sort all stocks in sample by beta (or book-to-market
ratio, or leverage, etc.)
 Group stocks into deciles (10 groups)
 See if the average ROR moves with beta (or book-to-
market, etc.)
 No clear pattern of beta & ROR
 Multivariate tests are shown on Exhibit 8.18.
 ROR = a + b•Beta +c•ln(ME) + d•ln(BE/ME) + etc.
 “b” was insignificant, “c” was negative, “d” was positive
Slide 27
 The Market Portfolio: RM
 Benchmark error – Expected Return TRUE
what if our tests of SML
CAPM use the wrong
market portfolio? True M

 Then measures of Actual Portfolio

performance will be
incorrectly specified Estimated
SML
 A good example of Proxy M
this is Exhibit 8.21 on
page 268 RF
 The actual portfolio is
below the true SML,
but will appear to
have beaten the Beta
estimated one. Slide 28
 Questions to consider…

 Page 272 (1) Why a straight line?

 Page 272 (4) What assets are in M?
 Page 273 (7) Std Dev of 4, 10, 20 stocks?
 Page 273 (13) Three criticisms of beta?
 Page 273 (14) Two portfolios of beta =1.
 Page 275 (24) What stocks should you
pick according to Fama-French?
Slide 29
 Problems to work…

 #2 p. 274. Find E(RU) = .10+.85(.04)=.134

 What is it if beta = 1? What if beta = 1.25?
 #3 p. 274, should you buy stock U?
 RORU = [24.75/22] – 1 = .125 which is less than that
expected by the CAPM.
 #14b p. 276. Compute the alphas for X & Y
 ax = .12 - CAPMx = .12 – (.05 + 1.3(.10 - .05)) = +.005
 CAPMx = .05 + 1.3(.10 - .05) = .115
 aY = .09 - CAPMY = .09 – (.05 + .7(.10 - .05)) = +.005
 CAPMx = .05 + .7(.10 - .05) = .085
 Both should be ABOVE the SML offering better return than expected.
Slide 30