CHAPTER 4

Models of Risk and returns

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Capital Asset Pricing Models

9-2

Capital Asset Pricing Model (CAPM)

• It is the equilibrium model that underlies all modern financial

theory
• Derived using principles of diversification with simplified
assumptions
• Markowitz, Sharpe, Lintner and Mossin are researchers
credited with its development

9-3
 Assumptions

• Individual investors are price • Information is costless and

takers available to all investors
• Single-period investment • Investors are rational mean-
horizon variance optimizers
• Investments are limited to • There are homogeneous
traded financial assets expectations
• No taxes and transaction
costs

9-4

Resulting Equilibrium Conditions

• All investors will hold the same portfolio for risky assets –
market portfolio

• Market portfolio contains all securities and the proportion

of each security is its market value as a percentage of total
market value

9-5

Resulting Equilibrium Conditions

• Risk premium on the market depends on the average

risk aversion of all market participants

• Risk premium on an individual security is a function of its

covariance with the market

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Figure 9.1 The Efficient Frontier and the
Capital Market Line

9-7

Market Risk Premium

• The risk premium on the market portfolio will be

proportional to its risk and the degree of risk aversion of
the investor:

E (rM ) − rf = A M2
where  M2 is the variance of the market portolio and
A is the average degree of risk aversion across investors

9-8

Return and Risk For Individual Securities

• The risk premium on individual securities is a function of

the individual security’s contribution to the risk of the
market portfolio.
• An individual security’s risk premium is a function of the
covariance of returns with the assets that make up the
market portfolio.

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 GE Example
• Covariance of GE return with the market portfolio:

 n
 n
Cov ( rGE , rM ) = Cov  rGE ,  wk rk  =  wk Cov (rk , rGE )
 k =1  k =1
• Therefore, the reward-to-risk ratio for investments in GE
would be:

GE's contribution to risk premium wGE  E ( rGE ) − rf  E ( rGE ) − rf

= =
GE's contribution to variance wGE Cov( rGE , rM ) Cov( rGE , rM )

9-10

GE Example
• Reward-to-risk ratio for investment in market portfolio:

Market risk premium E ( rM ) − rf

=
Market variance  M2
• Reward-to-risk ratios of GE and the market portfolio should
be equal:

E (rGE ) − rf E (rM ) − rf
=
Cov (rGE , rM )  M2

9-11

GE Example

• The risk premium for GE:

COV (rGE , rM )
E (rGE ) − rf =
 2M
E (r ) − r 
M f

• Restating, we obtain:


E (rGE ) = rf + GE E (rM ) − rf 

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Expected Return-Beta Relationship
• CAPM holds for the overall portfolio because:

E (rP ) =  wk E (rk ) and

k

 P =  wk  k
k
• This also holds for the market portfolio:

E ( rM ) = r f +  M  E ( rM ) − r f 

9-13

beta

βi: đo lường rủi ro hệ thống

DMTT có β = 1
βi > 1: TS có rủi ro hệ thống lớn hơn rủi ro DMTT, i.e nó sẽ biến
động nhiều hơn DMTT
βi < 1: TS có rủi ro hệ thống thấp hơn rủi ro DMTT, i.e nó sẽ biến
động ít hơn DMTT
βi = 1: TS có rủi ro hệ thống bằng rủi ro DMTT, i.e nó sẽ biến
động bằng với DMTT

9-
14

Figure 9.2 The Security Market Line

9-15
Figure 9.3 The SML and a Positive-Alpha Stock

9-16

Alpha

9-
17

CAPM
• Xác định TLLT kỳ vọng thích hợp cho 1 TS có rủi ro → CAPM
Ý nghĩa: - Giúp NĐT định giá TS bằng việc cung cấp TLCK được
sử dụng trong bất kỳ mô hình định giá nào
- So sánh TLLT ước tính với TLLT yêu cầu được xác định
bởi CAPM → xác định TS được định giá cao hay thấp hay thích
hợp
• Đường SML: thể hiện MQH giữa rủi ro và TLLT kỳ vọng hay yêu
cầu của 1TS.
Đo lường rủi ro liên quan đối với 1 TS rủi ro riêng lẻ là hiệp
phương sai của TS đó với DMTT (Covi,M)
9-
18
 Example
Stock β E(Ri) %
A 0,7 10,2
RFR = 6% B 1 12
and RM = 12%
C 1,15 12,9
D 1,4 14,4
E -0,3 4,2

Stock Pt Pt+1 Dt+1 Expected

return %
A 25 27 0,5 10
B 40 42 0,5 6,2
Price, dividend
and expected C 33 39 1 21,2
return D 64 65 1,1 3,3
E 50 54 -- 8
9-
19

The Index Model and Realized Returns

• To move from expected to realized returns, use the index model in
excess return form:

Ri =  i +  i RM + ei
• The index model beta coefficient is the same as the beta of the CAPM
expected return-beta relationship.

9-20

Is the CAPM Practical?

• CAPM is the best model to explain returns on risky assets.
This means:

• Without security analysis, α is assumed to be zero.

• Positive and negative alphas are revealed only by
superior security analysis.

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 Is the CAPM Practical?

• We must use a proxy for the market portfolio.

• CAPM is still considered the best available description

of security pricing and is widely accepted.

9-22

Econometrics and the Expected Return-

Beta Relationship

• Statistical bias is easily introduced.

• Miller and Scholes paper demonstrated how
econometric problems could lead one to reject the
CAPM even if it were perfectly valid.

9-23

Extensions of the CAPM

• Zero-Beta Model
• Helps to explain positive alphas on low beta stocks
and negative alphas on high beta stocks
• Consideration of labor income and non-traded assets

9-24
 Extensions of the CAPM

• Merton’s Multiperiod Model • Consumption-based CAPM

and hedge portfolios • Rubinstein, Lucas, and
• Incorporation of the effects Breeden
of changes in the real rate of • Investors allocate wealth
interest and inflation between consumption today
and investment for the future

9-25

Liquidity and the CAPM

• Liquidity: The ease and speed with which an asset can be sold
at fair market value
• Illiquidity Premium: Discount from fair market value the seller
must accept to obtain a quick sale.
• Measured partly by bid-asked spread
• As trading costs are higher, the illiquidity discount will be
greater.

9-26

Figure 9.5 The Relationship Between

Illiquidity and Average Returns

9-27
 Liquidity Risk

• In a financial crisis, liquidity can unexpectedly dry up.

• When liquidity in one stock decreases, it tends to decrease
in other stocks at the same time.
• Investors demand compensation for liquidity risk
• Liquidity betas

9-28

Arbitrage Pricing Theory and Multifactor Models

of Risk and Return

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Single Factor Model

• Returns on a security come from two sources:
• Common macro-economic factor
• Firm specific events
• Possible common macro-economic factors
• Gross Domestic Product Growth
• Interest Rates

10-30
 Single Factor Model Equation
ri = E ( ri ) +  i F + ei
ri = Return on security
βi= Factor sensitivity or factor loading or factor beta
F = Surprise in macro-economic factor
(F could be positive or negative but has expected
value of zero)
ei = Firm specific events (zero expected value)

10-31

Multifactor Models

• Use more than one factor in addition to market return

• Examples include gross domestic product, expected
inflation, interest rates, etc.
• Estimate a beta or factor loading for each factor using
multiple regression.

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Multifactor Model Equation

ri = E (ri ) +  iGDP GDP +  iIR IR + ei
ri = Return for security i
βGDP = Factor sensitivity for GDP
βIR = Factor sensitivity for Interest Rate
ei = Firm specific events

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 Multifactor SML Models

E (ri ) = rf + iGDP RPGDP + iIR RPIR

i GDP = Factor sensitivity for GDP

RPGDP = Risk premium for GDP
i IR = Factor sensitivity for Interest Rate
RPIR = Risk premium for Interest Rate

10-34

Interpretation

1.The risk-free rate

2.The sensitivity to GDP times the
The expected return on a risk premium for bearing GDP
security is the sum of: risk
3.The sensitivity to interest rate
risk times the risk premium for
bearing interest rate risk

10-35

Arbitrage Pricing Theory

• Arbitrage occurs if there is a Since no investment is

zero investment portfolio required, investors can
with a sure profit. create large positions to
obtain large profits.

10-36
 Arbitrage Pricing Theory

• Regardless of wealth or risk • In efficient markets,

aversion, investors will want profitable arbitrage
an infinite position in the opportunities will quickly
risk-free arbitrage portfolio. disappear.

10-37

APT & Well-Diversified Portfolios

rP = E (rP) + PF + eP
F = some factor

• For a well-diversified portfolio, eP

• approaches zero as the number of securities in the
portfolio increases
• and their associated weights decrease

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Figure 10.1 Returns as a Function of the

Systematic Factor

10-39
Figure 10.2 Returns as a Function of the
Systematic Factor: An Arbitrage Opportunity

10-40

Figure 10.3 An Arbitrage Opportunity

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Figure 10.4 The Security Market Line

10-42
 APT Model

• APT applies to well diversified portfolios and not necessarily to

individual stocks.
• With APT it is possible for some individual stocks to be
mispriced - not lie on the SML.
• APT can be extended to multifactor models.

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APT and CAPM

APT CAPM
• Equilibrium means no arbitrage • Model is based on an inherently
opportunities. unobservable “market”
• APT equilibrium is quickly portfolio.
restored even if only a few
• Rests on mean-variance
investors recognize an arbitrage
opportunity. efficiency. The actions of many

• The expected return–beta

small investors restore CAPM
relationship can be derived equilibrium.
without using the true market • CAPM describes equilibrium for
portfolio.
all assets.
10-44

Multifactor APT
• Use of more than a single systematic factor
• Requires formation of factor portfolios
• What factors?
• Factors that are important to performance of the
general economy
• What about firm characteristics?

10-45
 Two-Factor Model

ri = E ( ri ) +  i1 F1 +  i 2 F2 + ei

• The multifactor APT is similar to the one-factor case.

10-46

Two-Factor Model
• Track with diversified factor portfolios:
• beta=1 for one of the factors and 0 for all other factors.

• The factor portfolios track a particular source of

macroeconomic risk, but are uncorrelated with other
sources of risk.

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Where Should We Look for Factors?

• Need important systematic risk factors
• Chen, Roll, and Ross used industrial production, expected
inflation, unanticipated inflation, excess return on corporate
bonds, and excess return on government bonds.
• Fama and French used firm characteristics that proxy for
systematic risk factors.

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 Fama-French Three-Factor Model

• SMB = Small Minus Big (firm size)

• HML = High Minus Low (book-to-market ratio)
• Are these firm characteristics correlated with actual (but
currently unknown) systematic risk factors?

rit =  i +  iM RMt +  iSMB SMBt +  iHML HMLt + eit

10-49

The Multifactor CAPM and the APT

• A multi-index CAPM will inherit its risk factors from sources

of risk that a broad group of investors deem important
enough to hedge
• The APT is largely silent on where to look for priced sources
of risk

10-50