Chap 007

Capital Asset Pricing and
Arbitrage Pricing Theory

Bodie, Kane, and Marcus
Essentials of Investments,
9th Edition
McGraw-Hill/Irwin
Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
7.1 The Capital Asset Pricing Model
7-2

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
7-3

Hypothetical Equilibrium
All investors choose to hold market portfolio
Market portfolio is on efficient frontier, optimal
risky portfolio
7-4

Hypothetical Equilibrium
Risk premium on market portfolio is proportional to
variance of market portfolio and investors risk
aversion
Risk premium on individual assets
Proportional to risk premium on market portfolio
Proportional to beta coefficient of security on
market portfolio
7-5
Figure 7.1 Efficient Frontier and Capital Market Line
7-6

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?
7-7

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
7-8
7-9

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)
7-10
Figure 7.2 The SML and a Positive-Alpha Stock
7-11

Applications of CAPM
Use SML as benchmark for fair return on risky
asset
SML provides hurdle rate for internal projects
7-12
7.2 CAPM and Index Models
7-13
7-14
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.
7-15
Figure 7.3A: Monthly Returns
7-16
Figure 7.3B Monthly Cumulative Returns
7-17
Figure 7.4 Scatter Diagram/SCL: Google vs. S&P 500, 01/06-12/10
7-18
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
60
Total number of observations
Regression equation: Google (excess return) = 0.8751 + 1.2031 S&P 500 (excess return)
ANOVA
df
SS
MS
p-level
2231.50
2231.50
31.19
0.0000
Residual
58
4149.65
71.55
Total
59
6381.15
Regression
Intercept
S&P 500
t-Statistic (2%)
Coefficie
nts
0.8751
1.2031
2.3924
Standard
Error
1.0920
0.2154
tStatisti
c
0.8013
5.5848
pvalue
0.4262
0.0000
LCL
-1.7375
0.6877
UCL
3.4877
1.7185
7-19

Estimation results
Security Characteristic Line (SCL)
Plot of securitys expected excess return over
risk-free rate as function of excess return on
market
Required rate = Risk-free rate + x Expected
excess return of index
7-20

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
7-21
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
7-22
7.4 Multifactor Models and CAPM
7-23
7.4 Multifactor Models and CAPM
7-24
Table 7.3 Monthly Rates of Return, 01/06-12/10
Security
Monthly Excess Return % *

Standard
Average
Deviation
T-bill
Total Return
Geometric
Cumulative
Average
Return
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.
7-25
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
Estimate
FF 3-Factor Specification
S&P 500
Broad Market 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
7-26
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
7-27

Calculating APT
Returns on well-diversified portfolio
7-28
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.
7-29
Table 7.6 Largest Capitalization Stocks in S&P 500
Stock
Weight Stock
Weight
7-30
Table 7.7 Regression Statistics of S&P 500 Portfolio on

Benchmark Portfolio, 01/06-12/10
Linear Regression
Regression
Statistics
R
0.9933
R-square
0.9866
Adjusted R-square
0.9864
Annualiz
ed
Regression SE
0.5968
2.067
Total number of observations
60
S&P 500 = - 0.1909 + 0.9337 Benchmark

Standard
Coefficients
Error
t-stat
p-level
Intercept
-0.1909
0.0771
-2.4752
0.0163
Benchmark
0.9337
0.0143
65.3434
0.0000
7-31
Table 7.8 Annual Standard Deviation
Period
Real Rate
Inflation Rate Nominal Rate
1/1 /06 - 12/31/10
1.46
1.46
0.61
1/1/96 - 12/31/00
0.57
0.54
0.17
1/1/86 - 12/31/90
0.86
0.83
0.37
7-32
Figure 7.5 Security Characteristic Lines
7-33

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
7-34
Table 7.9 Constructing an Arbitrage Portfolio

Constructing an arbitrage portfolio with two
systemic factors
7-35

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Capital Asset Pricing and

Arbitrage Pricing Theory

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

7.1 The Capital Asset Pricing Model

7.1 The Capital Asset Pricing Model

rational, mean-variance optimizers

7.1 The Capital Asset Pricing Model

7.1 The Capital Asset Pricing Model

Figure 7.1 Efficient Frontier and Capital Market Line

7.1 The Capital Asset Pricing Model

7.1 The Capital Asset Pricing Model

7.1 The Capital Asset Pricing Model

7.1 The Capital Asset Pricing Model

that predicted by equilibrium model (CAPM)

Figure 7.2 The SML and a Positive-Alpha Stock

7.1 The Capital Asset Pricing Model

7.2 CAPM and Index Models

7.2 CAPM and Index Models

Table 7.1 Monthly Return Statistics 01/06 - 12/10

Average rate of return

Average excess return

Cumulative total 5-year return

Gain Jan 2006-Oct 2007

Gain Nov 2007-May 2009

Gain June 2009-Dec 2010

* 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

Total number of observations

7.2 CAPM and Index Models

Required rate = Risk-free rate + x Expected

excess return of index

7.2 CAPM and Index Models

7.3 CAPM and the Real World

Investors should diversify

for wide range of investors

7.4 Multifactor Models and CAPM

7.4 Multifactor Models and CAPM

Table 7.3 Monthly Rates of Return, 01/06-12/10

Monthly Excess Return % *

*Total return for SMB and HML

Table 7.4 Regression Statistics: Alternative Specifications

1.A Single index with S&P 500 as market proxy

Broad Market Index

with Broad Market Index

Residual SD = Regression SE (%)

Alpha = Intercept (%)

SMB (size) beta

HML (book to market) beta

Standard errors in parenthesis

7.5 Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT)

7.5 Arbitrage Pricing Theory

Returns on well-diversified portfolio

Table 7.5 Portfolio Conversion

Table 7.6 Largest Capitalization Stocks in S&P 500

Table 7.7 Regression Statistics of S&P 500 Portfolio on