7/15/2022

CONTENT
Chapter 3: 2

ASSET PRICING MODELS  1. A conceptual development of the capital asset

pricing model (CAPM)
 2. The security market line (SML)
Lecturer: D r. L I N H D . N G U Y E N  3. Empirical tests of CAPM
FA C U LT Y O F F I N A N CE  4. The market portfolio: theory versus practice
BANKING UNIVERSITY OF HCMC  5. Other asset pricing models

TS. Nguyễn Duy Linh

1 2

REMIND REMIND
3 4

 CAL is the primary result of the capital market theory: Investors

who allocate their money between a riskless security and the risky
portfolio P can expect a return equal to the risk-free rate plus
compensation for the number of risk units (σc) they accept.
 When the risky portfolio P is the market portfolio (M) – contains
all risky assets held anywhere in the marketplace and receives the
highest level of expected return (in excess of the risk-free rate)
per unit of risk for any available portfolio of risky assets, Capital
Allocation Line (CAL) becomes the capital market line (CML)
− −
= + × = + ×
−
= + ×
 CML assume that investors only hold fully diversified portfolios
(the market portfolio)  total risk (σ) = systematic risk
 CML cannot provide an explanation for the risk-return trade-off
for individual risky assets because the standard deviation for
these securities will contain a substantial amount of non-
systematic risk
 This is the limitation of CML

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

3 4

BACKGROUND FOR CAPITAL MARKET THEORY
5 6
Because capital market theory builds on the Markowitz portfolio
model, it requires the same assumptions, along with some additional
ones
 All investors seek to invest in portfolios representing tangent
points on the Markowitz efficient frontier  The exact location
of this tangent point and the specific portfolio selected will
depend on the individual investor’s risk–return utility function.
 Investors can borrow or lend any amount of money at the risk-
free rate of return (RFR).
 All investors have homogeneous expectations  they estimate
identical probability distributions for future rates of return.
TS. Nguyễn Duy Linh
5 6
1. A CONCEPTUAL DEVELOPMENT OF THE CAPM
7 8
 The capital asset pricing model (CAPM) extends capital
market theory in a way that allows investors to evaluate
the risk–return trade-off for both diversified portfolios
and individual securities
 The CAPM:
 Redefines the relevant measure of risk from total volatility to
just the non-diversifiable portion of that total volatility
(systematic risk)
 The risk measure is called the beta coefficient and calculates
the level of a security’s systematic risk compared to that of
the market portfolio
TS. Nguyễn Duy Linh
7 8
7/15/2022
BACKGROUND FOR CAPITAL MARKET THEORY
 All investors have the same one-period time horizon, such as one
month or one year.
 All investments are infinitely divisible  it is possible to buy or
sell fractional shares of any asset or portfolio. This assumption
allows us to discuss investment alternatives as continuous curves.
 There are no taxes or transaction costs involved in buying or
selling assets.
 Either there is no inflation or any change in interest rates, or
inflation is fully anticipated.
 Capital markets are in equilibrium  we begin with all
investments properly priced in line with their risk levels.
TS. Nguyễn Duy Linh
A CONCEPTUAL DEVELOPMENT OF THE CAPM
 The existence of a risk-free asset resulted in deriving a
capital market line (CML) that became the relevant
frontier
 However, CML cannot be used to measure the expected
return on an individual asset
 For individual asset (or any portfolio), the relevant risk
measure is the asset’s covariance with the market
portfolio. That is, for an individual asset i, the relevant
risk is not σi, but rather σi ρiM, where ρiM is the correlation
coefficient between the asset i and the market
TS. Nguyễn Duy Linh
 7/15/2022

A CONCEPTUAL DEVELOPMENT OF THE CAPM A CONCEPTUAL DEVELOPMENT OF THE CAPM

9 10

 Recall that the CML expresses the risk–return trade-off for  Let βi = (σi ρiM)/σM be the asset beta measuring the relative
fully diversified portfolios as follows: risk with the market – the systematic risk, the CAPM can be
written as follows:
−
= + × = + × −

 Inserting the product σC = σi ρiM into the CML and adapting  The CAPM indicates what should be the expected or
the notation for the ith individual asset: required rates of return on risky assets
 This helps to value an asset by providing an appropriate
− discount rate to use in dividend valuation models
= + ×

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

9 10

A CONCEPTUAL DEVELOPMENT OF THE CAPM 2. THE SECURITY MARKET LINE – SML

11 12

 Note: ( , )  A. Determining the Expected Rate of Return for a Risky

= = =
Asset
 Beta (βi) of a security captures the non-diversifiable portion  B. Identifying Undervalued and Overvalued Assets
of that stock’s risk relative to the market as a whole.  C. Calculating Systematic Risk
 Beta can be thought of as indexing the asset’s systematic
risk to that of the market portfolio.
 If stock X has:
 Beta = 1.20: The level of systematic risk of X is 20 percent greater than
the average for the entire market,
 Beta = 0.70: The level of systematic risk of X is 30 percent less risky
than the market.
 The market portfolio itself will always have a beta of 1.00.

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

11 12
 7/15/2022

THE SECURITY MARKET LINE – SML THE SECURITY MARKET LINE – SML
13 14

 SML is a graphical form of the CAPM = + × − (SML)

 SML shows the trade-off between risk and expected E(R)
− (CML)
return as a straight line intersecting the vertical axis = + ×
(zero-risk point) at the risk-free rate
M
E(RM)
Beta âm
Rf

0 1.0 βi
TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

13 14

A. DETERMINING THE EXPECTED RATE OF RETURN

THE SECURITY MARKET LINE – SML
FOR A RISKY ASSET
15 16

 The CML vs. the SML: Two important differences  Example: Determining the expected rate of return for a
 First, the CML measures total risk by the standard risky asset
deviation (σ) of the investment while the SML considers Stock Beta E(Ri)
only the systematic component (β) of an investment’s A 0.70
volatility. B 1.00
C 1.15
D 1.40
 Second, because of the first point, the CML can be applied E -0.30

only to portfolio holdings that are already fully diversified, Risk-free rate (rf) 5%
whereas the SML can be applied to any individual asset or Market return (RM) 9%
collection of assets.

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

15 16
 7/15/2022

B. IDENTIFYING UNDERVALUED AND IDENTIFYING UNDERVALUED AND

OVERVALUED ASSETS OVERVALUED ASSETS
18 19

 In equilibrium, all assets and all portfolios of assets  Example:

should plot on the SML  Compare the required rate of return (following
 Any security with an estimated return that plots above CAPM) to the estimated rate of return (of yourself)
the SML is underpriced => should BUY for a specific risky asset using the SML over a specific
 Any security with an estimated return that plots below investment horizon to determine if it is an appropriate
the SML is overpriced => should SELL investment.
 A superior investor must derive value estimates for
assets that are consistently superior to the consensus
market evaluation to earn better risk-adjusted rates of  The required rate of return: derived from the CAPM (SML)
return than the average investor  The estimated rate of return: derived from either fundamental
or technical analysis
TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

18 19

IDENTIFYING UNDERVALUED AND IDENTIFYING UNDERVALUED AND

OVERVALUED ASSETS OVERVALUED ASSETS
20 22

Expe cted Price Expe cted Estimated Future

Stock Current Price (Pt )
(Pt+1) Dividend (Dt+1)
Rate of Return E(R)
(%)
A 25 26 1.00
.22
B 40 42 0.50 6.25%
C 33 37 1.00 .18
D 64 66 1.10 4.84% C
E 50 53 0.00 6.00% .14

Required Return, .10 A

Stock Beta Estimated Return Evaluation
E(Ri)
A 0.70 7.80% E .06 B
B 1.00 9.00% 6.25%
.02
D
C 1.15 9.60%
D 1.40 10.60% 4.84%
E -0.30 3.80% 6.00% -.8 -.6 -.4 -.2 0.0 .2 .4 .6 .8 1.0 1.2 1.4 1.6 1.8 βi

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

20 22
 7/15/2022

C. CALCULATING SYSTEMATIC RISK (BETA) CALCULATING SYSTEMATIC RISK (BETA)

23 24

 A beta coefficient for Security i can be calculated directly from  The Impact of the Time Interval
the following formula:
 The number of observations and time interval used in
× × Cov , the calculation of beta vary widely, causing beta to
= = =
× vary
 Where is the return variance for the market portfolio and Cov (ri, rM)  There is no “correct” interval for analysis
is the covariance between returns to the Security i and the market  Morningstar uses monthly returns over five years
 Security betas can also be estimated as the slope coefficient in a  Reuters Analyticsuses daily returns over two years
regression equation between the returns to the security (rit) over  Bloomberg uses weekly returns over two years although the
time and the returns (rMt) to the market portfolio (the security’s system allows users to change the time intervals
characteristic line):
= + +
TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

23 24

CALCULATING SYSTEMATIC RISK (BETA) CALCULATING SYSTEMATIC RISK (BETA)

25 26

 The Effect of the Market Proxy  Example

 The Standard & Poor’s 500 Composite Index is often used as  The example shows how to estimate a characteristic line for
the proxy because: Microsoft Corp (MSFT) using monthly return data from
 It contains large proportion of the total market value of U.S. January 2016 to December 2016
stocks
 Let calculate beta and alpha for MSFT by using the
 It is a value weighted index
following indexes as the market portfolio
 Theoretically, the market portfolio should include all U.S.
a) The S&P 500 (SPX)
and non-U.S. stocks and bonds, real estate, coins, stamps,
art, antiques, and any other marketable risky asset from b) The MSCI World Equity (MXWO) index
around the world

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

25 26
 7/15/2022

CALCULATING SYSTEMATIC RISK (BETA) CALCULATING SYSTEMATIC RISK (BETA)

27 28

(RS PX-Avg.R) x (RMXWO-Avg.R)

Date SPX MXWO MSFT RS PX-Avg.R RMXWO -Avg.R RMS FT - Avg.R
(RMSFT - Avg.R) x (RMSFT - Avg.R) Cov ,
(1) (2) (3) (4) (5) (6) (7) (8) (9) =
Jan-16 -4.96 -5.95 -0.70 -5.95 -6.65 -2.05 12.16 13.61
Feb-16 -0.13 -0.68 -6.99 -1.12 -1.38 -8.34 9.31 11.54
Mar-16 6.78 6.86 8.55 5.79 6.16 7.21 41.74 44.35
Apr-16 0.39 1.64 -9.70 -0.60 0.94 -11.05 6.59 -10.34
May-16 1.80 0.65 7.03 0.81 -0.05 5.69 4.62 -0.31
Jun-16 0.26 -1.07 -3.45 -0.73 -1.77 -4.80 3.48 8.51 = + +
Jul-16 3.69 4.25 10.77 2.70 3.55 9.43 25.48 33.42
Aug-16 0.14 0.14 2.01 -0.85 -0.56 0.67 -0.56 -0.38
Sep-16 0.02 0.58 0.24 -0.97 -0.12 -1.11 1.07 0.14  Because the expected value of firm-specific surprises is zero,
Oct-16 -1.82 -1.91 4.03 -2.81 -2.61 2.69 -7.54 -7.02
Nov-16 3.70 1.51 1.23 2.71 0.81 -0.12 -0.31 -0.09 the expected return of stock i would be:
Dec-16 1.97 2.43 3.12 0.98 1.73 1.78 1.75 3.06
Average 0.99 0.70 1.35 Total 97.79 96.49 ( )= +
Standard Deviation 2.84 3.05 5.80

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

27 28

CALCULATING SYSTEMATIC RISK (BETA)

30

TS. Nguyễn Duy Linh 29 TS. Nguyễn Duy Linh

29 30
 7/15/2022

3. EMPIRICAL TESTS OF CAPM EMPIRICAL TESTS OF CAPM

31 32

 A. Stability of Beta  When testing the CAPM, there are two major
 B. Relationship between Systematic Risk and questions
Return 1. How stable is the measure of systematic risk (beta)?
2. Is there a positive linear relationship as hypothesized
 C. Additional Issues
between beta and the rate of return on risky assets?

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

31 32

EMPIRICAL TESTS OF CAPM EMPIRICAL TESTS OF CAPM

STABILITY OF BETA RELATIONSHIP BETWEEN SYSTEMATIC RISK AND RETURN
33 34

 Numerous studies have examined the stability of beta
and generally concluded that the risk measure was not
stable for individual stocks but was stable for portfolios
of stocks
 The larger the portfolio and the longer the period, the more
stable the beta estimate
 The betas tended to regress toward the mean
 High-beta portfolios tended to decline over time toward 1.00,
whereas low beta portfolios tended to increase over time
toward unity
 The ultimate question regarding the CAPM is whether it
is useful in explaining the return on risky assets
 Specifically, is there a positive linear relationship
between the systematic risk and the rates of return on
these risky assets?
 Study (Jensen) shows that:
 Most of the measured SMLs had a positive slope
 The slopes change between periods
 The intercepts are not zero
 The intercepts change between periods
 Exhibit 7.9

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

33 34
 7/15/2022

EMPIRICAL TESTS OF CAPM EMPIRICAL TESTS OF CAPM

RELATIONSHIP BETWEEN SYSTEMATIC RISK AND RETURN RELATIONSHIP BETWEEN SYSTEMATIC RISK AND RETURN
35 36

 Effect of a Zero-Beta Portfolio

 The characteristic line using a zero-beta portfolio instead of
RFR should have a higher intercept and a lower slope
coefficient
 Several studies have tested this model with its higher
intercept and flatter slope and found conflicting results

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

35 36

EMPIRICAL TESTS OF CAPM EMPIRICAL TESTS OF CAPM

RELATIONSHIP BETWEEN SYSTEMATIC RISK AND RETURN RELATIONSHIP BETWEEN SYSTEMATIC RISK AND RETURN
37 38

 Effect of Size, P/E, and Leverage  Effect of Book-to-Market Value

 Size and P/E are additional risk factors that need to be  Fama and French (1992) concluded that size and book-to-
considered along with beta market equity capture the cross-sectional variation in
 Expected returns are a positive function of beta, but average stock returns associated with size, E/P, book-to-
investors also require higher returns from relatively small market equity, and leverage
firms and for stocks with relatively low P/E ratios
 Two variables, BE/ME, appear to subsume E/P and leverage
 Bhandari (1988) found that financial leverage also helps
explain the cross section of average returns after both beta
and size are considered

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

37 38
 7/15/2022

EMPIRICAL TESTS OF CAPM EMPIRICAL TESTS OF CAPM

ADDITIONAL ISSUES SUMMARY
39 40

 Effect of Transaction Costs  Early evidence supported the CAPM; there was evidence
 With transactions costs, the SML will be a band of securities,
that the intercepts were generally higher than implied by the
rather than a straight line RFR that prevailed, which is either consistent with a zero-
beta model or the existence of higher borrowing rates
 Effect of Taxes
 To explain unusual returns, size, the P/E ratio, financial
 Differential tax rates could cause major differences in the
leverage, and the book-to-market value ratio are found to
CML and SML among investors
have explanatory power regarding returns beyond beta

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

39 40

EMPIRICAL TESTS OF CAPM 4. THE MARKET PORTFOLIO:

SUMMARY THEORY VERSUS PRACTICE
41 42

 Further studies; (Intentionally blank slide)

 Kothari, Shanken, and Sloan (1995) measured beta with annual
returns and found substantial compensation for beta risk, which
suggested that the results obtained by Fama and French may have
been time-period specific
 Jagannathan and Wang (1996) employed a conditional CAPM that
allows for changes in betas and in the market risk premium and
found that this model performed well in explaining the cross
section of returns
 Reilly and Wright (2004) examined the performance of 31
different asset classes with betas computed using a broad market
portfolio proxy; the risk–return relationship was significant and as
expected by theory
TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

41 42
 7/15/2022

THE MARKET PORTFOLIO: THE MARKET PORTFOLIO:

THEORY VERSUS PRACTICE THEORY VERSUS PRACTICE
43 44

 The true market portfolio should  The beta intercept of the SML will differ if
 Included all the risky assets in the world  Thereis an error in selecting the risk-free asset
 In equilibrium, the assets would be included in the portfolio  There is an error in selecting the market portfolio
in proportion to their market value  Using the incorrect SML may lead to incorrect
 Using U.S. Index as a market proxy evaluation of a portfolio performance
 Most studies use an U.S. index (S&P 500)
 The U.S. stocks constitutes less than 15% of a truly global
risky asset portfolio

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

43 44

THE MARKET PORTFOLIO:

5. OTHER ASSET PRICING MODELS
THEORY VERSUS PRACTICE
45 46

True SML  A. The Single Index Model (SIM)

E(R) True M Portfolio
 B. Arbitrage Pricing Theory
Measured SML
Portfolio Being  C. Multifactor Models of Risk and Return
Evaluated

Proxy M Portfolio

RFRE

RFRT

1.0 βi
TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

45 46
 7/15/2022

A. THE SINGLE-INDEX MODEL (SIM) A. THE SINGLE-INDEX MODEL (SIM)

47 48

 Because the systematic factor affects the rate of return on all  The Regression Equation of the Single-Index Model
stocks, the rate of return on a broad market index can plausibly  Denote:
proxy for that common factor. This approach leads to an  The market index by M, with excess return of RM = rM − rf
equation similar to the single-factor model, which is called a  The excess return of stock i: Ri = ri − rf
single-index model because it uses the market index to stand
 The pair of excess returns in month t by Ri(t) and RM(t)
in for the common factor.
= + + Eq (1)

 Note: Practitioners often use a “modified” index model that is

similar to Eq (1) but that uses total rather than excess returns. This
practice is most common when daily data are used. In this case,
the rate of return on bills is on the order of only about 0.01% per
day, so total and excess returns are almost indistinguishable
TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

47 48

A. THE SINGLE-INDEX MODEL (SIM) A. THE SINGLE-INDEX MODEL (SIM)

49 50

 The Security Characteristic Line for Ford  CAPM: = + × −

− = × −
Excess return of security i
( )= × (1)

= + & +  The Single-Index Model: = + +

( )= + (2)
Zero-mean, firm-specific
Expected excess return  an overvalued stock has NEGATIVE alpha
surprise in security i‘s
when the market
return in month t.
excess return is zero  Comparing Eqs. 1 and 2: the prediction of the CAPM is that for
(the residual)
every stock, the equilibrium value of αi is 0.
Sensitivity of security i‘s Expected excess  The logic of the CAPM: the only reason for a stock to provide a
return to changes in the return of the market
return of the market premium over the risk-free rate is that the stock imposes
systematic risk for which the investor must be compensated
TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

49 50
 7/15/2022

THE SINGLE-INDEX MODEL (SIM) THE SINGLE-INDEX MODEL (SIM)

51 52

 Correlation of Ford with the S&P 500 is 0.6280

 Returns on Ford generally track those of the market index

 Adjusted R-square = 0.3839

 The model explains about 38% of the variation in Ford

 Intercept (alpha) = -0.98% per month, but not statistically

significant
 Ford's beta is 1.3258,
 Ford’s share price tended to move 1.3258% for every 1% move in
the market index

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

51 52

ARBITRAGE PRICING THEORY

B. ARBITRAGE PRICING THEORY
INTRODUCTION
53 56

 Introduction  CAPM is criticized because of

 Security Valuation with the APT: An Example  The many unrealistic assumptions

 The difficulties in selecting a proxy for the market portfolio

as a benchmark
 An alternative pricing theory with fewer
assumptions was developed: Arbitrage Pricing
Theory (APT)

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

53 56
 7/15/2022

ARBITRAGE PRICING THEORY ARBITRAGE PRICING THEORY

INTRODUCTION INTRODUCTION
57 58

 Three major assumptions:
1. Capital markets are perfectly competitive
2. Investors always prefer more wealth to less wealth with
certainty
3. The stochastic process generating asset returns can be
expressed as a linear function of a set of K factors or indexes
 In contrast to CAPM, APT does not assume:
1. Normally distributed security returns
2. Quadratic utility function
3. A mean-variance efficient market portfolio
 The APT requires that in equilibrium the return on a zero-
investment, zero-systematic-risk portfolio is zero when the
unique effects are fully diversified
 This assumption implies that the expected return on any
Asset i can be expressed as:
where:
E  Ri    0  1bi1   2bi 2     k bik  APT
E(Ri) = expected return for Asset i if all the risk factors have zero changes
λ0 = expected return on an asset with zero systematic risk
λj = risk premium related to the jth common risk factor
bij = pricing relationship between the risk premium and the asset; that is, how
responsive Asset i is to the jth common factor. (These are called factor betas
or factor loadings.)

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

57 58

ARBITRAGE PRICING THEORY ARBITRAGE PRICING THEORY

INTRODUCTION AN EXAMPLE
59 60

 Suppose that three stocks (A, B, and C) and two common

systematic risk factors (1 and 2) have the following relationship
(for simplicity, it is assumed that the zero-beta return [λ0] equals
zero):
E(RA) = (0.80)λ1 + (0.90)λ2
E(RB) = (−0.20)λ1 + (1.30)λ2
E(RC) = (1.80)λ1 + (0.50)λ2
 If λ1 = 4% and λ2 = 5%, then the returns expected by the market
over the next year can be expressed as:
E(RA) = (0.80)(4%) + (0.90)(5%) = 7.7%
E(RB) = (−0.20)(4%) + (1.30)(5%) = 5.7%
E(RC) = (1.80)(4%) + (0.50)(5%) = 9.7%

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

59 60
 7/15/2022

ARBITRAGE PRICING THEORY ARBITRAGE PRICING THEORY

AN EXAMPLE AN EXAMPLE
61 62

 Assuming that all three stocks are currently priced at  According to your forecasts, Stock A will not reach a price
$35 and do not pay a dividend, the following are the level in one year consistent with investor return
expected prices a year from now: expectations. Accordingly, you conclude that at a current
E(PA) = $35(1.077) = $37.70 price of $35 a share:
 Stock A is overvalued.
E(PB) = $35(1.057) = $37.00
 Stock B is undervalued and Stock C is (slightly) undervalued.
E(PC) = $35(1.097) = $38.40

 Now, suppose your own fundamental analysis suggests that in one

 The idea of riskless arbitrage is to assemble a portfolio that
year the actual prices of stocks A, B, and C will be $37.20,  (1) requires no net wealth invested initially and

$37.80, and $38.50. How can you take advantage of what you  (2) will bear no systematic or unsystematic risk but

consider to be a market mispricing?  (3) still earns a profit.

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

61 62

ARBITRAGE PRICING THEORY ARBITRAGE PRICING THEORY

AN EXAMPLE AN EXAMPLE
63 64

 Shortsell two shares of Stock A, buy one share of B and one share of C.  If in one year prices actually do rise to the levels that you initially
Notice that this portfolio meets the net investment and risk mandates of “knew” they would, the net profit from covering the short position and
an arbitrage-based trade: selling the long holdings will be:

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

63 64
 7/15/2022

ARBITRAGE PRICING THEORY

C. MULTIFACTOR MODELS OF RISK AND RETURN
AN EXAMPLE
65 66

 If everyone else in the market today begins to believe (Intentionally blank slide)
the future price levels of A, B, and C—but they do not
revise their forecasts about the expected factor returns or
factor betas for the individual stocks—then the current
prices for the three stocks will be adjusted by arbitrage
trading to:
PA = ($37.20) ÷ (1.077) = $34.54
PB = ($37.80) ÷ (1.057) = $35.76
PC = ($38.50) ÷ (1.097) = $35.10
 Thus, the price of Stock A will be bid down, while the prices of
Stocks B and C will be bid up
TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

65 66

MULTIFACTOR MODELS OF RISK AND RETURN

C. MULTIFACTOR MODELS OF RISK AND RETURN
FAMA AND FRENCH THREE-FACTOR MODEL
67 68

 In a multifactor model, the investor chooses the exact  Fama and French (1993) developed a multifactor model
number and identity of risk factors. Examples, market specifying the risk factors in microeconomic terms
return, GDP, expected inflation, interest rates… using the characteristics of the underlying securities
= + + + ⋯+ +
 Rit  RFRt    i  bi1  RMt  RFRt   bi 2 SMBt  bi3 HMLt  eit
where:
 Fit = Period t return to the jth designated risk factor  SMB (i.e. small minus big) = return to a portfolio of small
 Rit = Security i’s return that can be measured as either a nominal or capitalization stocks less the return to a portfolio of large
excess return to Security i capitalization stocks (firm size)
 ai = the intercept of the regression  HML (i.e. high minus low) = return to a portfolio of stocks with
 eit = the random error term that accounts for Security i’s unsystematic high ratios of book-to-market values less the return to a portfolio
risk of low book-to-market value stocks (book-to-market ratio)
TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

67 68
 7/15/2022

MULTIFACTOR MODELS OF RISK AND RETURN

FAMA AND FRENCH FIVE-FACTOR MODEL
69

 Fama and French (2015) developed their own extension of

the original three-factor model by adding two additional
terms to account for company quality: a corporate
profitability risk exposure and a corporate investment risk
exposure
 Rit  RFRt    i  bi1  RMt  RFRt   bi 2 SMBt  bi 3 HMLt  bi 4 RMWt  bi 5CMAt  eit
 Where
 RMW (robust minus weak) = return to a portfolio of high profitability
stocks less the return to a portfolio of low profitability stocks
 CMA (conservative minus aggressive) = return to a portfolio of stocks of
low-investment firms (low total asset growth) less the return to a
portfolio of stocks in companies with rapid growth in total assets
TS. Nguyễn Duy Linh

69