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Chapter
Capital Asset Pricing and

7 Arbitrage Pricing Theory
Bodie, Kane, and Marcus

Essentials of Investments
Tenth Edition
7.1 The Capital Asset Pricing Model
• Capital Asset Pricing Model (CAPM)
• Security’s required rate of return relates to
systematic risk measured by beta
2
𝐸 𝑟𝑀 − 𝑟𝑓 = 𝐴𝑜𝑀
• Market Portfolio (M)
• Each security held in proportion to market value
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2
7.1 The Capital Asset Pricing Model: Assumptions
Market Assumptions Investor Assumptions

All investors are price takers(no Investors plan for the same (single-
investor can singlehandedly period) horizon
influence the market movement)
All information relevant to secrity Investors are efficient users of
analysis is free and publicly analytical methods  investors have
available. homogeneous expectations.
All securities are publicly owned Investors are rational, mean-
and traded. variance optimizers.
No taxes on investment returns.
No transaction costs.(brokerage
and spread)
Lending and borrowing at the same
risk-free rate are unlimited.
• Hypothetical Equilibrium
• All investors choose to hold market portfolio( a
demand function which is determined by the
mean, deviation and correlation between
securities in the portfolio)
• Market portfolio is on efficient frontier, optimal
risky portfolio
• Hypothetical Equilibrium
• Risk premium on market portfolio is proportional to
variance of market portfolio and investor’s risk
aversion
• Risk premium on individual assets
• Proportional to risk premium on market portfolio
• Proportional to beta coefficient of security on
market portfolio
Figure 7.1 Efficient Frontier and Capital Market Line
• 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?
• 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
• Expected Returns on Individual Securities
• Expected return-beta relationship
• Implication of CAPM that security risk
premiums (expected excess returns) will be
proportional to beta
𝐸 𝑟𝐷 = 𝑟𝑓 + β𝐷 [𝐸 𝑟𝑀 − 𝑟𝑓 ]
• 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)
Figure 7.2 The SML and a Positive-Alpha Stock
• Applications of CAPM
• Use SML as benchmark for fair return on risky
asset
• SML provides “hurdle rate” for internal projects
7.2 CAPM and Index Models
• Index Model, Realized Returns, Mean-Beta
Equation
• 𝑟𝑖𝑡 − 𝑟𝑓𝑡 = 𝛼𝑖 + 𝛽𝑖 𝑟𝑀𝑡 − 𝑟𝑓𝑡 + 𝑒𝑖𝑡
• 𝑟𝑖𝑡 : HPR
• i: Asset
• t: Period
• 𝛼𝑖 : Intercept of security characteristic line
• 𝛽𝑖 : Slope of security characteristic line
• 𝑟𝑀 : Index return
• 𝑒𝑖𝑡 : Firm-specific effects
• 𝐸 𝑟𝑖𝑡 − 𝑟𝑓𝑡 = 𝛼𝑖 + β𝑖 [𝐸 𝑟𝑀𝑡 − 𝑟𝑓𝑡 ]
• Estimating Index Model
• 𝑅𝐺𝑡 = α𝐺 + β𝐺 𝑅𝑀𝑡 + 𝑒𝐺𝑡
• 𝑅𝐺 = 𝑟𝐺 − 𝑟𝑓 , excess return
• Residual = Actual return − Predicted return for
Google
• 𝑒𝐺𝑡 = 𝑅𝐺𝑡 − (α𝐺 + β𝐺 𝑅𝑀𝑡 )
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.
Figure 7.3A: Monthly Returns
30 T-bills
SP 500
Google
Monthly returns (%)
20
10
-10
-20
Figure 7.3B Monthly Cumulative Returns
T-bills
60.00 SP 500
Google
Cumulative returns (%)
40.00
20.00
0.00
-20.00
-40.00
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
Linear Regression
Regression Statistics
R 0.5914
R-square 0.3497
Adjusted R-square 0.3385
SE of regression 8.4585
Total number of
observations 60
Regression equation: Google (excess return) = 0.8751 + 1.2031 × S&P 500 (excess return)
Coefficients Standard Error t-Statistic p-value LCL UCL

Intercept 0.8751 1.0920 0.8013 0.4262 -1.7375 3.4877
S&P 500 1.2031 0.2154 5.5848 0.0000 0.6877 1.7185
Estimated Value - Hypothesis Value

t
Does Google’s beta differ Standard Error of the Estimate
significantly from the market beta? Example :
1.2031  1
t  .94
0.2154
7.2 CAPM and Index Models: SCL
• Security Characteristic Line (SCL)

• Plot of security’s expected excess return over
risk-free rate as function of excess return on
market
• Required rate = Risk-free rate + β x Expected
excess return of index
• 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
7.3 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
7.4 Multifactor Models and CAPM
• Multifactor models
• Models of security returns that respond to several
systematic factors
• Two-index portfolio in realized returns
• 𝑅𝑖𝑡 = α𝑖 + β𝑖𝑀 𝑅𝑀𝑡 + β𝑖𝑇𝐵 𝑅𝑇𝐵𝑡 + 𝑒𝑖𝑡
• Two-factor SML
• 𝐸 𝑟𝑖 = 𝑟𝑓 + β𝑖𝑀 𝐸 𝑟𝑀 − 𝑟𝑓 + β𝑖𝑇𝐵 [𝐸 𝑟𝑇𝐵 − 𝑟𝑓 ]
7.4 Multifactor Models and CAPM
• Fama-French Three-Factor Model
• 𝑟𝐺 − 𝑟𝑓 = α𝐺 + β𝑀 𝑟𝑀 − 𝑟𝑓 + β𝐻𝑀𝐿 𝑟𝐻𝑀𝐿 + β𝑆𝑀𝐵 𝑟𝑆𝑀𝐵 + 𝑒𝐺
• Estimation results
• Three aspects of successful specification
• Higher adjusted R-square
• Lower residual SD
• Smaller value of alpha
Table 7.3 Monthly Rates of Return, 01/06-12/10
Monthly Excess Return % * Total Return

Standard Geometric Cumulative
Security Average Deviation Average Return
T-bill 0 0 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.
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 FF 3-Factor Specification
Estimate 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
7.5 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
• Calculating APT
•
• Returns on well-diversified portfolio

•
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.
Table 7.6 Largest Capitalization Stocks in S&P 500
Stock Weight
Stock Apple (AAPL) 1.39 Weight Stock 4.05 Weight
ExxonMobil (XOM) 2.04
Microsoft (MSFT) 1.93
Johnson & Johnson (JNJ) 1.52
Berkshire Hathaway (BRK.B) 1.45
Wells Fargo (WFC) 1.39
General Electric (GE) 1.35
Procter & Gamble (PG) 1.24
JP Morgan Chase (JPM) 1.19
Pfizer (PFE) 1.17
Total for 10 largest firms 17.33
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 Annualized

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
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
Figure 7.5 Security Characteristic Lines
• 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
•
Table 7.9 Constructing an Arbitrage Portfolio
Constructing an arbitrage portfolio with two systemic factors

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Chapter

Capital Asset Pricing and

Bodie, Kane, and Marcus

Market Assumptions Investor Assumptions

Statistic (%) T-Bills S&P 500 Google

Coefficients Standard Error t-Statistic p-value LCL UCL

Estimated Value - Hypothesis Value

• Security Characteristic Line (SCL)

Monthly Excess Return % * Total Return

T-bill 0 0 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.

Monthly returns January 2006 - December 2010

• Arbitrage Pricing Theory (APT)

• Returns on well-diversified portfolio

Steps to convert a well-diversified portfolio into an arbitrage portfolio:

Adjusted R-square 0.9864 Annualized

Total number of observations 60

S&P 500 = - 0.1909 + 0.9337 × Benchmark

Period Real Rate Inflation Rate Nominal Rate

Constructing an arbitrage portfolio with two systemic factors

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