Asset Pricing Theories

Mary-Anne Nathalia Lai Kong Ling MSc Financial Economics

Table of contents
Page Number Introduction... CAPM.... Assumption of CAPM.. Advantages and Disadvantages of the CAPM. Assigning values to CAPM variables.... Using the CAPM in investment appraisal.. Conclusion on the CAPM.... Arbitrage Pricing Theory (APT).. FAMA and FRENCH 3 Factor Model. The SMB Factor: Accounting for the Size Premium.. The HML Factor.... Interpretations of the Factors...... Constructing the Three Factor Model.... Conclusion. 1 2 3 4 4 5 5 6 8 8 9 9 9 10

Introduction Asset pricing theory tries to understand the prices or values of claims to uncertain payments. A low price implies a high rate of return, so one can also think of the theory as explaining why some assets pay higher average returns than others.

To value an asset, we have to account for the delay and for the risk of its payments. The effects of time are not too difficult to work out. However, corrections for risk are much more important determinants of many assets values.

Asset pricing theory shares the positive versus normative tension present in the rest of economics. Does it describe the way the world does work, or the way the world should work? We observe the prices or returns of many assets. We can use the theory positively, to try to understand why prices or returns are what they are. If the world does not obey a models predictions, we can decide that the model needs improvement. However, we can also decide that the world is wrong, that some assets are mispriced and present trading opportunities for the shrewd investor. This latter use of asset pricing theory accounts for much of its popularity and practical application. Also, and perhaps most importantly, the prices of many assets or claims to uncertain cash flows are not observed, such as potential public or private investment projects, new financial securities, buyout prospects, and complex derivatives. We can apply the theory to establish what the prices of these claims should be as well; the answers are important guides to public and private decisions. Asset pricing theory all stems from one simple concept, presented in the first page of the first chapter of this book: price equals expected discounted payoff. The rest is elaboration, special cases, and a closet full of tricks that make the central equation useful for one or another application.

Capital Asset Pricing Model (CAPM) In finance, the CAPM is a model for pricing an individual security or a portfolio. It is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already welldiversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. For individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

where:

is the expected return on the capital asset is the risk-free rate of interest such as interest arising from government bonds (the beta) is the sensitivity of the expected excess asset returns to the expected excess market

returns, or also

is the expected return of the market is sometimes known as the market premium (the difference between the expected market rate of return and the risk-free rate of return).

is also known as the risk premium

Restated, in terms of risk premium, we find that:

which states that the individual risk premium equals the market premium times . Note 1: the expected market rate of return is usually estimated by measuring the Geometric Average of the historical returns on a market portfolio.

Note 2: the risk free rate of return used for determining the risk premium is usually the arithmetic average of historical risk free rates of return and not the current risk free rate of return. Assumption of CAPM The CAPM is often criticised as being unrealistic because of the assumptions on which it is based, so it is important to be aware of these assumptions and the reasons why they are criticised. The assumptions are as follows: 1. Investors hold diversified portfolios This assumption means that investors will only require a return for the systematic risk of their portfolios, since unsystematic risk has been removed and can be ignored.

2. Single-period transaction horizon A standardised holding period is assumed by the CAPM in order to make comparable the returns on different securities. A return over six months, for example, cannot be compared to a return over 12 months. A holding period of one year is usually used.

3. Investors can borrow and lend at the risk-free rate of return This is an assumption made by portfolio theory, from which the CAPM was developed, and provides a minimum level of return required by investors. The risk-free rate of return corresponds to the intersection of the security market line (SML) and the y-axis. The SML is a graphical representation of the CAPM formula.

4. Perfect capital market This assumption means that all securities are valued correctly and that their returns will plot on to the SML. A perfect capital market requires the following: that there are no taxes or transaction costs; that perfect information is freely available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and desire to maximise their own utility; and that there are a large number of buyers and sellers in the market.

While the assumptions made by the CAPM allow it to focus on the relationship between return and systematic risk, the idealised world created by the assumptions is not the same as the real world in which investment decisions are made by companies and individuals. For example, real-world capital markets are clearly not perfect. Even though it can be argued that well-developed stock markets do, in practice, exhibit a high degree of efficiency, there is scope for stock market securities to be priced incorrectly and, as a result, for their returns not to plot on to the SML. The assumption of a single-period transaction horizon appears reasonable from a real-world perspective, because even though many investors hold securities for much longer than one year, returns on securities are usually quoted on an annual basis. The assumption that investors hold diversified portfolios means that all investors want to hold a portfolio that reflects the stock market as a whole. Although it is not possible to own the market portfolio itself, it is quite easy and inexpensive for investors to diversify away specific or unsystematic risk and to construct portfolios that track the stock market. Assuming that investors are concerned only with receiving financial compensation for systematic risk seems therefore to be quite reasonable. A more serious problem is that,

in reality, it is not possible for investors to borrow at the risk-free rate (for which the yield on short-dated Government debt is taken as a proxy). The reason for this is that the risk associated with individual investors is much higher than that associated with the Government. This inability to borrow at the risk-free rate means that the slope of the SML is shallower in practice than in theory. Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent an idealised rather than real-world view, there is a strong possibility`y, in reality, of a linear relationship existing between required return and systematic risk.

Advantages of the CAPM The CAPM has several advantages over other methods of calculating required return, explaining why it has remained popular for more than 40 years. It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated.

Moreover, it generates a theoretically-derived relationship between required return and systematic risk which has been subject to frequent empirical research and testing.

It is generally seen as a much better method of calculating the cost of equity than the dividend growth model (DGM) in that it explicitly takes into account a companys level of systematic risk relative to the stock market as a whole.

Disadvantages of the CAPM The CAPM suffers from a number of disadvantages and limitations that should be noted in a balanced discussion of this important theoretical model.

Assigning values to CAPM variables In order to use the CAPM, values need to be assigned to the risk-free rate of return, the return on the market, or the equity risk premium (ERP), and the equity beta. The yield on short-term Government debt, which is used as a substitute for the risk-free rate of return, is not fixed but changes on a daily basis according to economic circumstances. A short-term average value can be used in order to smooth out this volatility. Finding a value for the ERP is more difficult. The return on a stock market is the sum of the average capital gain and the average dividend yield. In the short term, a stock market can provide a negative rather than a positive return if the effect of falling share prices outweighs the dividend yield. It is therefore usual to use a long-term average value for the ERP, taken from empirical research, but it has been found that the ERP is not stable over time. In the UK, an ERP value of between 2% and 5% is currently seen as reasonable. However, uncertainty about the exact ERP value introduces uncertainty into the calculated value for the required return. Beta values are now

calculated and published regularly for all stock exchange-listed companies. The problem here is that uncertainty arises in the value of the expected return because the value of beta is not constant, but changes over time.

Using the CAPM in investment appraisal Problems can arise when using the CAPM to calculate a project-specific discount rate. For example, one common difficulty is finding suitable proxy betas, since proxy companies very rarely undertake only one business activity. The proxy beta for a proposed investment project must be disentangled from the companys equity beta. One way to do this is to treat the equity beta as an average of the betas of several different areas of proxy company activity, weighted by the relative share of the proxy company market value arising from each activity. However, information about relative shares of proxy company market value may be quite difficult to obtain. A similar difficulty is that the ungearing of proxy company betas uses capital structure information that may not be readily available. Some companies have complex capital structures with many different sources of finance. Other companies may have debt that is not traded, or use complex sources of finance such as convertible bonds. The simplifying assumption that the beta of debt is zero will also lead to inaccuracy in the calculated value of the project-specific discount rate. One disadvantage in using the CAPM in investment appraisal is that the assumption of a single-period time horizon is at odds with the multi-period nature of investment appraisal. While CAPM variables can be assumed constant in successive future periods, experience indicates that this is not true in reality.

Conclusion on the CAPM Research has shown the CAPM to stand up well to criticism, although attacks against it have been increasing in recent years. Until something better presents itself, however, the CAPM remains a very useful item in the financial management toolkit.

Arbitrage Pricing Theory (APT) In finance, the APT is a general theory of asset pricing that holds that the expected return of a financial asset can be modelled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The model-derived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back into line. Risky asset returns are said to follow a factor structure if they can be expressed as:

where aj is a constant for asset j Fk is a systematic factor bjk is the sensitivity of the jth asset to factor k, also called factor loading, and is the risky asset's idiosyncratic random shock with mean zero.

Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors. The APT states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities:

where RPk is the risk premium of the factor, rf is the risk-free rate,

That is, the expected return of an asset j is a linear function of the assets sensitivities to the n factors. Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: There must be perfect competition in the market, and the total number of factors may never surpass the total number of assets (in order to avoid the problem of matrix singularity),

The APT along with the capital asset pricing model (CAPM) is one of two influential theories on asset pricing. The APT differs from the CAPM in that it is less restrictive in its assumptions. It allows for an explanatory (as opposed to statistical) model of asset returns. It assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio". In some ways, the CAPM can be considered a "special case" of the APT in that the securities market line represents a single-factor model of the asset price, where beta is exposed to changes in value of the market. Additionally, the APT can be seen as a "supply-side" model, since its beta coefficients reflect the sensitivity of the underlying asset to economic factors. Thus, factor shocks would cause structural

changes in assets' expected returns, or in the case of stocks, in firms' profitability. On the other side, the capital asset pricing model is considered a "demand side" model. Its results, although similar to those of the APT, arise from a maximization problem of each investor's utility function, and from the resulting market equilibrium (investors are considered to be the "consumers" of the assets).

APT does not rely on measuring the performance of the market. Instead, APT directly relates the price of the security to the fundamental factors driving it. The problem with this is that the theory in itself provides no indication of what these factors are, so they need to be empirically determined. Obvious factors include economic growth and interest rates. For companies in some sectors other factors are obviously relevant as well - such as consumer spending for retailers. The potentially large number of factors means more betas to be calculated. There is also no guarantee that all the relevant factors have been identified. This added complexity is the reason arbitrage pricing theory is far less widely used than CAPM.

FAMA and FRENCH 3 Factor Model Renowned researchers Eugene Fama and Ken French have done extensive research in this area and found factors describing value and size to be the most significant factors, outside of market risk, for explaining the realized returns of publicly traded stocks. To represent these risks, they constructed two factors: SMB to address size risk and HML to address value risk. Fama and French first published their findings on these factors in 1992 and have continued to refine their work since. CAPM uses a single factor, beta, to compare a portfolio with the market as a whole. But more generally, you can add factors to a regression model to give a better r-squared fit. The best known approach like this is the three factor model developed by Gene Fama and Ken French. Fama and French started with the observation that two classes of stocks have tended to do better than the market as a whole: (i) small caps and (ii) stocks with a high book-value-to-price ratio (customarily called "value" stocks; their opposites are called "growth" stocks). They then added two factors to CAPM to reflect a portfolio's exposure to these two classes: r - Rf = beta3 x ( Km - Rf ) + bs x SMB + bv x HML + alpha where, r is the portfolio's return rate Rf is the risk-free return rate Km is the return of the whole stock market. The "three factor" beta is analogous to the classical beta but not equal to it, since there are now two additional factors to do some of the work. SMB and HML stand for "small [cap] minus big" and "high [book/price] minus low"; they measure the historic excess returns of small caps and "value" stocks over the market as a whole. By the way SMB and HML are defined, the corresponding coefficients bs and bv take values on a scale of roughly 0 to 1: bs = 1 would be a small cap portfolio, bs= 0 would be large cap, bv = 1 would be a portfolio with a high book/price ratio, etc. The SMB and HML Factors The SMB Factor: Accounting for the Size Premium SMB, which stands for Small Minus Big, is designed to measure the additional return investors have historically received by investing in stocks of companies with relatively small market capitalization. This additional return is often referred to as the size premium. In practice, the SMB monthly factor is

computed as the average return for the smallest 30% of stocks minus the average return of the largest 30% of stocks in that month. A positive SMB in a month indicates that small cap stocks outperformed large cap stocks in that month. A negative SMB in a given month indicates the large caps outperformed. As with the CAPM, when performing historical analysis, we use computed SMB factors for each time period, most commonly monthly; and for predictive purposes (computing an alpha excess return), we 8

use either the historical average of the factor or a well informed guess as to the current size premium. The HML Factor HML, which is short for High Minus Low, has been constructed to measure the value premium provided to investors for investing in companies with high book-to-market values (essentially, the value placed on the company by accountants as a ratio relative to the value the public markets placed on the company, commonly expressed as B/M). Constructed in a fashion similar to that of SMB, HML is computed as the average return for the 50% of stocks with the highest B/M ratio minus the average return of the 50% of stocks with the lowest B/M ratio each month. A positive HML in a month indicates that value stocks outperformed growth stocks in that month. A negative HML in a given month indicates the growth stocks outperformed. Interpretations of the Factors In reality, the SMB and HML factors first drew attention and continue to be the most commonly used simply because they workthey have the greatest predictive power of any two additional factors that researchers have tested often yielding an R2 value of approximately 0.95. That being said, causal explanations for SMB are appealing from a theoretical perspective, but for HML, the labelling of it as a risk factor has spurred much discussion. For SMB, which is a measure of size risk, small companies logically should be expected to be more sensitive to many risk factors as a result of their relatively undiversified nature and their reduced ability to absorb negative financial events. On the other hand, the HML factor suggests higher risk exposure for typical value stocks (high B/M) versus growth stocks (low B/M). This makes sense intuitively because companies need to reach a minimum size in order to execute an Initial Public Offering; and if we later observe them in the bucket of high B/M, this is usually an indication that their public market value has plummeted because of hard times or doubt regarding future earnings. Since these companies have experienced some sort of difficulty, it seems plausible that they would be exposed to greater risk of bankruptcy or other financial troubles than their more highly valued counterparts. Constructing the Three Factor Model By combining the original market risk factor and the newly developed factors, we have the commonly used Fama French Three Factor Model. Analogous to the CAPM, this model describes the expected return on an asset as a result of its relationship to three risk factors: market risk, size risk, and value risk. rA= rf+ A(rM rf)+ sASMB + hAHML The coefficients in this model have similar interpretations to beta in the CAPM above. Ais a measure of the exposure an asset has to market risk (although this beta will have a different value from the beta in a CAPM model as a result of the added factors), SA measures the level of exposure to size risk and hA measures the level of exposure to value risk. One thing that is interesting is that Fama and French still see high returns as a reward for taking on high 9

risk; in particular that means that if returns increase with book/price, then stocks with a high book/price ratio must be more risky than average. The difference comes from whether you believe in the efficient market theory. The business analyst doesn't believe it, so he would say high book/price indicates a buying opportunity: the stock looks cheap. But if you do believe in EMT then you believe cheap stocks can only be cheap for a good reason, namely that investors think they are risky Fama and French are not particular about why book/price measures risk, although they and others have suggested some possible reasons. For example, high book/price could mean a stock is "distressed", temporarily selling low because future earnings look doubtful. Or, it could mean a stock is capital intensive, making it generally more vulnerable to low earnings during slow economic times. Those both sound plausible; but they seem to be describing completely different situations (and what happens when a company that is not capital intensive becomes "distressed"?) It may be that the success of this model at explaining past performance isn't due to the significance of any of the three factors taken separately, but in their being different enough that taken together they do an effective job of "spanning the dimensions" of the market. There's actually another interpretation that's so much less cerebral that it's probably correct. The broad market index weights stocks according to their market capitalization, making it size-biased and valuation blind; so maybe the extra two factors in this model are just a couple of tweaks to adjust for these two problems. This also explains why momentum is sometimes used as yet another factor: market capitalization shows where the market has been putting its money for years, while momentum shows where it has been putting it lately; so if you want to take advantage of market efficiency you start with the index and then tweak it a little with momentum. Like CAPM, the Fama and French model is used to explain the performance of portfolios via linear regression; only now the two extra factors give you two additional axes, so instead of a simple line the regression is a big flat thing that lives in the fourth dimension. Conclusion We have examined two tools to help investors understand the risk/reward trade off which they face when making investments. We first introduced the CAPM, with its inherent simplicity, linking market covariance risk to expected returns. Its simplicity helps to build intuition around the concept of modelling return as a function of risk. The CAPMs simplicity is also its greatest shortcoming, as the underlying assumptions limit its ability to explain and predict actual returns. The Fama-French Three-Factor Model expands the capabilities of the model by adding two company specific risk factors - SMB and HML. The three factors in concert explain most of the returns due to risk exposure. Both models have many important uses. Two uses discussed in this note are the ability to categorize investments depending on how their returns vary with different risk factors and to evaluate an active managers performance independent of her funds risk exposure. With these tools, investors are able to make more informed investment decisions with respect to personal preference regarding the risk/reward trade off.

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A study of FAMA and French Three Factor Model and Capital Asset Pricing Model in the Stock Exchange of Thailand. (2009) BY: Nopbhanon Homsud Jatuphon Wasunsakul Sirina Phuangnark Jitwatthana Joonpong

The main aim of the paper was to measure the accuracy of the Fama and French Three factor Model in the Stock Exchange of Thailand over the period July 2002 to May 2007. The authors selected 421 companies and were divided into 6 groups; BH, BL, SH, SM and SL. The study made use of the return of portfolio and the return of market as variable. The said 421 securities were listed by market equity or market value. To be able to apply the Fama and French Three Factor Model to the stock exchange of Thailand, standard multivariate regression framework method was used. Consequently in order to present the appropriate of each factor in the Fama and French Three Factor Model, the Davison and Mackinnon Equation and Residual Analysis were also used.

Results were classified according to the Fama and French model. It was found that out of 421 securities most were categorised as mostly medium and small securities. In large portfolio, the Book to Market Value Ratio has quite low value.

The study found that Fama and French Three Factor Model has a greater advantage in describing the Thailands Stock Exchange rather than the CAPM but however, the Three Factor Model has no financial theory support in new variable effect to return rate and risk of both variable that put in CAPM but only found from the study hat keep the relation of both variable and return rate. Moreover, the risk in Stock Exchange might have other variable that appropriate or involve more than size effect and value effect.

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