EMPIRICAL TESTS OF THE CAPM

When testing the CAPM, there are two major questions.

First, How stable is the measure of systematic risk (beta)? It is important to know whether past betas can
be used as estimates of future betas.

Second, Is there a positive linear relationship as hypothesized between beta and the rate of return on risky
assets? That is, how well do returns conform to the SML?

2.1 Stability of Beta

Beta is a more reliable risk measure for groups of stocks (portfolios) than for single stocks. The
stability of beta increases with the number of stocks in the portfolio (ideally more than 50) and the length of
time considered (over 26 weeks). Over time, betas also tend to move towards an average value (1.00). In
other words, very risky portfolios (high beta) become less risky, and very low-risk portfolios (low beta)
become more risky.

2.2 Relationship between Systematic Risk and Return

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?

Sharpe and Cooper (1972) found a positive relationship between return and risk, although it was not
completely linear.

Black, Jensen, and Scholes (1972) examined the risk and return for portfolios of stocks and found a
positive linear relationship between monthly excess return and portfolio beta, although the intercept was
higher than zero. However, their results showed some deviations from CAPM's ideal scenario:

(1) most of the measured SMLs had a positive slope,

(2) the slopes change between periods,

(3) the intercepts are not zero, and

(4) the intercepts change between periods.

Effect of a Zero-Beta Portfolio Black (1972) proposed a wrinkle in CAPM. He said that having a risk-
free asset (like government bonds) isn't crucial as long as you can build a zero-beta portfolio. This portfolio
wouldn't be affected by market swings.
According to Black, using a zero-beta portfolio instead of a risk-free asset in the CAPM formula would result
in a steeper line with a higher starting point (intercept). This makes sense because the zero-beta portfolio
itself would have some return (unlike a risk-free asset with a 0% return).

Effect of Size, P/E, and Leverage how small companies (size effect) and low price-to-earnings ratio stocks
(P/E effect) tend to outperform expectations based on CAPM alone. This suggests that size and P/E are
extra risk factors beyond just beta (market risk).

 CAPM says: Expected return increases with beta (riskier = potentially higher returns).
 Reality says: Investors also want higher returns from smaller companies and stocks with lower P/E
ratios.

Bhandari (1988) added another layer by showing that financial leverage (debt used by the company) also
helps explain why some stocks outperform/underperform CAPM expectations. This paves the way for a
more complex CAPM with three key risk factors:

1. Beta (Market Risk)

2. Size
3. Financial Leverage

Effect of Book-to-Market Value Fama and French threw a wrench into the CAPM world in the 1990s.
They looked at a bunch of factors that might influence stock returns, including the usual suspects (beta,
size, financial leverage, price-to-earnings ratio) and a new one: book-to-market equity (BE/ME).

 For the period 1963-1990, beta alone couldn't explain the difference in average returns between stocks.
 Surprisingly, size, leverage, price-to-earnings (P/E), and BE/ME all seemed to have an impact, and in
the expected way (e.g., smaller companies and lower P/E stocks tended to have higher returns).

Fama and French concluded that size and BE/ME were the key players, capturing the effects of the other
factors as well. Based on this, they proposed a three-factor model that expands CAPM to account for both
size and book-to-market equity ratio.
 ARBITRAGE PRICING THEORY

The Capital Asset Pricing Model (CAPM) is a widely used theory in investment management, but some
studies have shown it has limitations in explaining the relationship between risk and return.

The CAPM faced criticism when studies showed investors could potentially earn higher returns by
considering specific company or investment features, even if they considered the risk level (beta) of those
investments.

Fama and French identified a characteristic that could potentially help investors earn higher returns. They
found that value stocks, which are companies with high book-to-market ratios (meaning their book value, a
measure of net assets, is high relative to their market price), tend to outperform growth stocks (companies
with low book-to-market ratios, typically focusing on future growth potential) even after considering risk
(beta)

In an efficient market, these return differentials should not occur, meaning that either

 Market Inefficiency: The market might not be entirely efficient. Investors have been ignoring profitable
investment opportunities for decades.

 CAPM's Shortcoming: There might be more to risk than CAPM captures with beta. The model might not
fully consider all factors influencing returns.

Implausibility of Market Inefficiency: The idea that investors consistently overlooked profitable
opportunities for decades seemed unlikely.

Need for a Multi-Factor Model: This suggested that CAPM's single risk factor (beta) might be insufficient.
There could be other dimensions of risk impacting returns.

Enter APT: In response, financial economists looked for an alternative theory in the 1970s. Stephen Ross
(mid-1970s) developed the Arbitrage Pricing Theory (APT). This new theory aimed to be more intuitive and
account for multiple factors influencing risk, potentially addressing the limitations of CAPM.

Given the implausibility of the first possibility, in the early 1970s financial economists began to consider the
implications of the second. The academic community searched for an alternative asset pricing theory to the
CAPM that was reasonably intuitive and allowed for multiple dimensions of investment risk. The result was
the APT, which was developed by Ross (1976, 1977) in the mid-1970s and has three major assumptions:

1. Capital markets are perfectly competitive.

2. Investors always prefer more wealth to less wealth with certainty.

3. Asset returns are believed to be explained by a linear relationship with several unidentified
macroeconomic factors (K factors). Unsystematic risk (specific to a company) can be diversified away
through a well-balanced portfolio.
APT's advantages over CAPM in terms of assumptions:

CAPM's Restrictive Assumptions:

Investors have quadratic utility functions: This means their relationship with risk is described by a specific
mathematical formula, which might not be entirely realistic.

 Security returns are normally distributed: This implies returns follow a bell curve pattern, which
may not always hold true in the market.
 Existence of a mean-variance efficient market portfolio: CAPM assumes there's a perfect
portfolio containing all risky assets that minimizes risk for a given level of return. This might not be
achievable in reality.

APT's Advantage: Relaxation of Assumptions

APT does not require these strict assumptions from CAPM. This makes it potentially more adaptable to
real-world scenarios. By relaxing these limitations, APT becomes:

 Simpler: It avoids complex formulas and assumptions about investor behavior and market
structure.
 Potentially Superior: With its broader perspective on risk factors, it might offer a better explanation
for why different securities have different returns.

*While both CAPM and APT are theoretical models, APT's simpler and less restrictive nature makes it an
attractive alternative for understanding the relationship between risk and return in the financial world.

*APT theory assumes that the return-generating process can be represented as a K factor model of the
form:

where:

Ri = actual return on Asset i during a specified time period, i 1, 2, 3, … n

E(Ri) = expected return for Asset i if all the risk factors have zero changes

bij = reaction in Asset i’s returns to movements in a common risk factor j

δk = set of common factors or indexes with a zero mean that influences the returns on all assets

εi = unique effect on Asset i’s return (a random error term that, by assumption, is completely diversifiable in
large portfolios and has a mean of zero)
n= number of assets

Multiple Risk Factors (δ):

 APT introduces multiple factors (δ terms) that can influence the returns of all assets.
 These factors represent various macroeconomic conditions, like inflation, GDP growth, political
events, or interest rates.
 Unlike CAPM's single factor (beta), APT acknowledges a broader range of risk influences.

Asset Sensitivity (bij): Each asset reacts differently to these risk factors. The bij terms represent how
sensitive asset i is to factor j.

 Consider GDP growth as a risk factor (j). Companies' stock prices can be impacted by economic growth.
 Cyclical firms: These companies' fortunes are closely tied to the overall economy. Their stocks (i) will
likely have a higher bij for the GDP growth factor. A strong increase in GDP could significantly boost their
stock prices.
 Non-cyclical firms: Examples include grocery store chains. Their business might be less sensitive to
economic ups and downs. Their stocks might have a lower bij for the GDP growth factor.

Bij and Interest Rates

 Similarly, bij can reflect an asset's sensitivity to changes in interest rates.

 Interest-sensitive stocks: These stocks might be heavily impacted by interest rate fluctuations.
They could have a bij of 2.0 or more.
 Less sensitive stocks: Companies with stable cash flows might be less affected by interest rates.
Their bij for this factor could be around 0.5.

Unidentified Factors and Empirical Studies:

 While the theory acknowledges these factors exist, it doesn't identify them explicitly.
 Empirical studies testing APT might find 2, 3, or 4 factors influencing returns, but they can't pinpoint the
exact nature of these factors.

Unique Effects (εi):

 Similar to CAPM, APT assumes unique effects (εi) are specific to each asset and independent.
These can be diversified away through a well-diversified portfolio.

 In a balanced market (equilibrium), APT suggests a portfolio with no investment and no systematic
risk should have a zero return after diversifying away unique effects.
This assumption (and some mathematical manipulation) implies that the expected return on any Asset i can
be expressed as:

where:

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.)

Equation 7.5 represents the fundamental result of the APT. It is useful to compare the form of the APT’s
specification of the expected return-risk relationship with that of the CAPM in Equation 7.1. Exhibit 7.12
contrasts the relevant features of the two models. The ultimate difference between these two theories lies
in the way systematic investment risk is defined: a single, market-wide risk factor for the CAPM versus a
few (or several) factors in the APT that capture the nuances of that market-wide risk. However, both
theories specify linear models based on the common belief that investors are compensated for performing
two functions: committing capital and bearing risk. Finally, the equation for the APT suggests a relationship
that is analogous to the security market line associated with the CAPM. However, instead of a line
connecting risk and expected return, the APT implies a security market plane with (K 1) dimensions—K risk
factors and one additional dimension for the security’s expected return. Exhibit 7.13 illustrates this
relationship for two risk factors (K 2).

Comparing the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT)
Using the APT

To illustrate how the APT model works, we will assume that there are two common factors:

 δ1: Unexpected changes in inflation

 δ2: Unexpected changes in GDP growth

If the risk premium related to GDP sensitivity is 0.03 and a stock that is sensitive to GDP has a bj (where j
represents the GDP factor) of 1.5, this means that this factor would cause the stock’s expected return to
increase by 4.5 percent (=1.5 X 0.03).

Consider the following example of two stocks and a two-factor model, with these risk factor definitions and
sensitivities:

δ1=The risk premium related to this factor is 2 percent for every 1 percent change in the rate (λ 1= 0.02).

δ2=The average risk premium related to this factor is 3 percent for every 1 percent change in the rate of
growth (λ2= 0.03).

λ0= rate of return on a zero-systematic risk asset (zero-beta) is 4 percent (λ 0=0.04).

The example introduces two assets (x and y) and their sensitivities (bx and by) to the two risk factors.

bx1= response of Asset x to changes in the inflation factor is 0 .50

bx2 =response of Asset x to changes in the GDP factor is 1. 50

by1 =response of Asset y to changes in the inflation factor is 2. 00

by2 = response of Asset y to changes in the GDP factor is 1. 75

Factor sensitivities is the same the beta in the CAPM; that is, the higher the level of bij, the greater the sensitivity of
Asset i to changes in the jth risk factor. Thus, Asset y is a higher risk asset than Asset x, and, therefore, its expected
return should be greater.

 Risk-free rate (λ0)

 Sensitivity to each risk factor (bij)
 Risk premium for each factor (λj)

The overall expected return formula will be:

So, for Assets x and y:

The positions of the factor loadings and expected returns for these two assets are illustrated in Exhibit 7.13. If the
prices of the two assets do not reflect these expected returns, we would expect investors to enter into arbitrage
arrangements selling overpriced assets short and using the proceeds to purchase the underpriced assets until the
relevant prices are corrected.

Empirical Tests of the APT

Roll and Ross Study

Roll and Ross (1980) produced one of the first large-scale empirical tests of the APT. Their methodology
followed a two-step procedure:

1. Estimate expected returns and factor coefficients from time-series data on individual stock returns.

2. Use these estimates to test the basic cross-sectional pricing conclusion implied by the APT. Specifically,
are the expected returns for these assets consistent with the common factors derived in step 1?

The authors tested the following pricing relationship

Assuming a risk-free rate of 6 percent ( λ 0 = 0.06), their analysis revealed the existence of at least three
meaningful factors but probably not more than four.

However, when they allowed the model to estimate the risk-free rate ( λ 0), only two factors were
consistently significant. Roll and Ross concluded that the evidence generally supported the APT but
acknowledged that their tests were not conclusive.
 MULTIFACTOR MODELS AND RISK ESTIMATION

Advantage of CAPM: Well-defined Risk Factor

 CAPM focuses on systematic risk, also known as market risk. This is the risk that cannot be
diversified away through portfolio construction.
 By identifying excess market return (market return minus risk-free rate) as the single factor for
systematic risk, CAPM simplifies the risk assessment process.

Challenge of CAPM:

 Defining the Market Portfolio: The CAPM formula relies on the idea of a perfectly diversified
portfolio that represents the entire market. But constructing such a portfolio in reality is difficult.

 If you use a proxy like the S&P 500 (which is a stock index) to assess a fixed-income portfolio (mostly
bonds), you're comparing apples and oranges. The risk-return dynamics of stocks are different from bonds.
This can lead to a misleading beta (a measure of an investment's volatility relative to the market) and a
distorted expected return.

Erroneous Judgments: With an inaccurate beta, the CAPM formula will provide an inaccurate estimate of
the expected return required for the investment. This can lead to poor investment decisions. An investor
might think a bond is undervalued based on the CAPM analysis, when in reality it's fairly priced considering
its risk profile within the fixed-income market.

once you have a suitable proxy for the market portfolio (RM) that aligns with the asset class you're
evaluating, using CAPM becomes much simpler.

While CAPM struggles with defining the market portfolio, APT presents a different challenge: identifying the
risk factors themselves.

 Unidentified Risk Factors: Unlike CAPM's single factor (market risk), APT acknowledges multiple
factors influencing returns, but it doesn't tell you what those factors are or how many there are. This
lack of clear definition makes it difficult to implement in practice.
 Investor-Specific Factors: APT suggests these risk factors could be macroeconomic (like inflation or
interest rates) or company-specific (like size or profitability). The problem is these factors can vary
depending on the investor's perspective and the specific investment they're analyzing.
 Ad-hoc Specification: Due to the lack of predefined factors, investors using APT have to essentially
guess which factors are most relevant. This "ad-hoc" approach can lead to inconsistencies and make it
difficult to compare results across different analyses.
 Missing Information: This selection process creates a situation where investors are essentially filling
in the blanks. Without a clear theoretical foundation for the factors, it's difficult to be confident in the
APT's ability to accurately capture the risk-return relationship.

In essence, APT offers a more flexible framework by acknowledging multiple risk factors, but this flexibility
comes at the cost of requiring significant additional user input and potentially introducing subjectivity.

An approach to developing an empirical model which is a core concept in the Arbitrage Pricing Theory
(APT) that captures the essence of the APT relies on the direct specification of the form of the relationship
to be estimated. In a multifactor model, the investor chooses the exact number and identity of risk factors in
the following equation:

The equation represents a multifactor model, which is a core concept in the Arbitrage Pricing Theory (APT).
It attempts to capture the relationship between an asset's expected return (Rit) and its exposure to various
risk factors (Fjt).

Where,

Rit: This represents the return on investment i for period t. It can be measured as either a nominal return
(total return) or an excess return (return above the risk-free rate).

Fjt: This represents the return on risk factor j for period t.

bij: This is the beta coefficient, which measures the sensitivity of asset i's return to changes in risk factor j.

αi: This is the alpha coefficient, which represents the unexplained portion of asset i's return. Ideally, in a
perfect APT model, alpha should be zero, indicating that all the risk and return are explained by the
identified factors. In reality, alpha may capture any pricing errors or omitted risk factors.

εit: This is the error term, which represents any random influences on asset i's return that are not captured
by the model.

Advantage: investor knows precisely how many and what things need to be estimated.
Disadvantage: of a multifactor model is that it is developed with little theoretical guidance as to the true
nature of the risk–return relationship. In this sense, developing a useful factor model is as much art form as
theoretical exercise.

Multifactor Models in Practice

There are two main approaches to identify risk factors for multifactor models: macroeconomic and
microeconomic.

 Macroeconomic Factors: This approach focuses on big-picture economic trends that can affect
asset returns over time. Examples include changes in inflation, economic growth (GDP), or interest
rates. These factors reflect broad market movements that impact many investments.
 Microeconomic Factors: This approach focuses on characteristics of the individual investments
themselves. Examples include the size of a company (large-cap vs. small-cap), its profitability, or its
debt-to-equity ratio. These factors capture the unique risk profile of each investment.

In essence, you can zoom out and look at the big economic picture (macro) or zoom in and focus on the
details of the specific investments (micro) to choose factors for your multifactor model.

Macroeconomic-Based Risk Factor Models

One particularly influential model was developed by Chen, Roll, and Ross (1986), who hypothesized that
security returns are governed by a set of broad economic influences in the following fashion

Microeconomic-Based Risk Factor Models

Fama-French three-factor model (1993)

SMB (small minus big) return to a portfolio of small-capitalization stocks less the return to a portfolio of
large-capitalization stocks
HML (high minus low) return to a portfolio of stocks with high ratios of book-to-market ratios less the return
to a portfolio of low book-to-market ratio stocks.

Size (SMB): This factor captures the difference in risk and return between small and large companies
(small-cap vs. large-cap).

Value (HML): This factor captures the difference in risk and return between value stocks (high book-to-
market ratio) and growth stocks (low book-to-market ratio).

Comparison to Single-Index Model: if you remove the size (SMB) and value (HML) factors from the
model, it essentially reverts to the single-index capital asset pricing model (CAPM) which only considers
market risk.

Carhart (1997)

Carhart (1997) directly extended the Fama–French three-factor model by including a fourth common risk
factor to account for the tendency for firms with positive (negative) past returns to produce positive
(negative) future returns.

Fourth Factor: Momentum (MOM): Carhart added a new factor named momentum (MOM) to capture the
tendency for stocks with strong past performance to continue outperforming (and vice versa for stocks with
weak past performance).

Carhart defined the momentum factor by calculating the difference between the average return of a
portfolio of stocks with the best performance over the past year and the average return of a portfolio with
the worst performing stocks.

Carhart's research showed that the factor beta for momentum is typically positive. This implies that a
stock's exposure to momentum (positive or negative) tends to amplify its returns.

Fama and French (2015): Created a 5-factor model by adding more 2 factor

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.
RMW = (Return to High Profitability Portfolio) - (Return to Low Profitability Portfolio)

CMA = (Return to Low Investment Portfolio) - (Return to High Investment Portfolio)

RMW (robust minus weak) / profitability premium: It's calculated as the difference between the return on
a portfolio of high profitability stocks (robust) and the return on a portfolio of low profitability stocks (weak).

CMA (conservative minus aggressive)/ investment premium: It's calculated as the difference between
the return on a portfolio of companies with low investment (conservative, typically slow or no growth in
assets) and the return on a portfolio of companies with high investment (aggressive, typically rapid growth
in assets).