Multi-Factor asset pricing

And more on the homework

Review item

Define beta.

Answer
Rate of return on asset j is R j
Rate of return on the market
portfolio is
R
M

Cov ( R j , RM )
Var ( RM )

jM
2
M

My project: AOL

Regression: y = a + bx + e
where a and b are constants
y is to be explained
x is an explanatory variable
e is a random error term

For Beta

Rj = a + bRM + e

e = idiosyncratic risk (diversifiable risk)

b = beta
a = alpha = sample average advantage
over the market

if statistically significant

Components of risk
Diversifiable risk is unique,
idiosyncratic, or unsystematic risk
Market risk is systematic or portfolio
risk

Diversifiable risk
It is eliminated by buying other assets,
i.e.,
can be "diversified away."

Arbitrage pricing theory

Side-issue: Arbitrage is interesting in options,

bonds, CAPM, and this course.
Notion: There are several factors (indexes).
They are found by regression analysis.
More notion: Each factor has its own beta.
Risk unrelated to the factors can be
diversified away, leaving only systematic risk.

The K-Factor Model

The unexpected systematic return is explained by
surprise in factors.

Surprise in factors: F1, F2, ,Fk

Ri = E(Ri) + i1F1 + i2F2 + + iKFk + i

Arbitrage pricing theory is like

CAPM,
Factor risk (previously market risk)
remains even when the portfolio is fully
diversified.
Factor risk is undiversifiable.
For any asset, the betas of factors
measure factor risk.
Required return is linear in the factor
betas.

The market rewards the

investor
not for bearing diversifiable risk but
only for bearing factor (or market) risk.

The market rewards the

investor
not for all the risk ( ) of an asset
but only for its betas.

Do low P/E firms contradict

CAPM?

Price at t = Earnings at t+1/r-g

Price/Earnings = (1+g)/r-g
Low growth and or high risk imply low
P/E
High risk implies high expected return.
Therefore low P/E means, on average,
high return. Doesnt contradict CAPM.

How many assets in a

diversified portfolio?
Not many.
About 30 well-chosen ones.

Statman JFQA Sept 87

Diversification for an Equally

Weighted Portfolio
Total risk2

Unsystematic
risk
Systematic
risk
Number of
Securities

Investors need only two funds.

Figures 10.4, 10.5, and 10.6.

Diversification, minimum
variance
B

E(R)

MV

1
MV

1
MV

Diversification with a risk-free

asset
B

E(R)

Diversification, minimum
variance
B

E(R)

A=
risk-free
asset

MV

MV

MV

1
MV

ve

Capital Market Line

en
c

cu
r

Expected return
of portfolio

.
.
.

e
ef

In
di
ffe
r

pr
d
rre

Risk-free
rate (Rf )

.
X

Capital market line

.
Standard
deviation of
portfolios return.

Argument for the security

market line
Only beta matters
A mix of T-Bills and the market can
produce any beta.
An asset with that beta is no better or
worse than the two-fund counterpart
Hence it has the same return.

Security Market Line

Expected return
on security (%)

T is undervalued.
Its price rises

..
.
.

Security market
line (SML)

T
Rm

Rf

S is overvalued.
Its price falls

0.8

Beta of
security

Review item
Asset A has a beta of .8.
Asset B has a beta of 1.5.
Consider a portfolio with weights .4 on
asset A and .6 on asset B.
What is the beta of the portfolio?

Answer

Portfolio beta is .4*.8+.6*1.5 = 1.22.

Work it out this way:
DevP = .4 DevA + .6 Dev B
E[DevP*DevM] = .4 E[DevA*DevM] + .
6*E[DevB*DevM].
Divide by E[DevP squared].