ReillyBrown IAPM 11e PPT Ch07

CHAPTER 7
Asset Pricing
Models
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posted to a publicly accessible website, in whole or in part. 7-1
7.1 The Capital Asset Pricing Model
• 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 nondiversifiable 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
7.1.1 A Conceptual Development of the
CAPM (slide 1 of 2)
• 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 riM, where riM is the correlation
coefficient between the asset and the market
7.1.1 A Conceptual Development of the
CAPM (slide 2 of 2)
• Inserting this product into the CML and adapting the
notation for the ith individual asset:
• Let βi=(σi riM) / σM be the asset beta measuring the relative

risk with the market, the systematic risk
• The CAPM indicates what should be the expected or

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
7.1.2 The Security Market Line
(slide 1 of 18)
• The SML
• Is a graphical form of the CAPM
• Shows the trade-off between risk and expected
return as a straight line intersecting the vertical
axis (zero-risk point) at the risk-free rate
• Considers only the systematic component of an
investment’s volatility
• Can be applied to any individual asset or
collection of assets
• Exhibit 7.1
(slide 2 of 18)
(slide 3 of 18)
• Determining the Expected Rate of Return for
a Risky Asset
• Example:
Stock Beta
A 0.70
B 1.00
C 1.15
D 1.40
E −0.30
(slide 4 of 18)
• Risk-free rate is 5 percent and the market return is 9 percent
• This implies a market risk premium of 4 percent
(slide 5 of 18)
• Identifying Undervalued and Overvalued
Assets
• In equilibrium, all assets and all portfolios of assets
should plot on the SML
• Any security with an estimated return that plots
above the SML is underpriced
• Any security with an estimated return that plots
below the SML is overpriced
• 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 return than the average investor
(slide 6 of 18)
• Example:
• Compare the required rate of return to the
estimated rate of return for a specific risky asset
using the SML over a specific investment horizon
to determine if it is an appropriate investment
• Exhibits 7.2, 7.3, 7.4
(slide 7 of 18)
(slide 8 of 18)
(slide 9 of 18)
(slide 10 of 18)
• Calculating Systematic Risk
• A beta coefficient for Security i can be calculated
directly from the following formula:
• Security betas can also be estimated as the slope

coefficient in a regression equation between the
returns to the security (Rit) over time and the returns
(RMt) to the market portfolio (the security’s
characteristic line):
(slide 11 of 18)
• The Impact of the Time Interval

• The number of observations and time interval
used in the calculation of beta vary widely,
causing beta to vary
• There is no “correct” interval for analysis
• Morningstar uses monthly returns over five years
• Reuters Analytics uses daily returns over two years
• Bloomberg uses weekly returns over two years
although the system allows users to change the
time intervals
(slide 12 of 18)
• The Effect of the Market Proxy

• The Standard & Poor’s 500 Composite Index
is often used as the proxy because:
• It contains large proportion of the total market
value of U.S. stocks
• It is a value weighted index
• Theoretically, the market portfolio should
include all U.S. and non-U.S. stocks and
bonds, real estate, coins, stamps, art,
antiques, and any other marketable risky
asset from around the world
(slide 13 of 18)
• Computing a Characteristic Line: An

Example
• The example shows how to estimate a
characteristic line for Microsoft Corp (MSFT)
using monthly return data from January 2016
to December 2016
• Betas for MSFT are calculated using:
• The S&P 500 (SPX)
• The MSCI World Equity (MXWO) index
• Exhibits 7.5, 7.6, 7.7
(slide 14 of 18)
(slide 15 of 18)
(slide 16 of 18)
(slide 17 of 18)
• Industry Characteristic Lines

• The characteristic line used to estimate beta
value can be computed for sector indexes
• Exhibit 7.8
(slide 18 of 18)
7.2 Empirical Tests of the CAPM
• When testing the CAPM, there are two

major questions
1. How stable is the measure of systematic risk
(beta)?
2. Is there a positive linear relationship as
hypothesized between beta and the rate of
return on risky assets?
7.2.1 Stability of Beta
• 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
7.2.2 Relationship Between Systematic Risk
and Return (slide 1 of 5)
• 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
• 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
• Effect of Size, P/E, and Leverage
• Size and P/E are additional risk factors that
need to be considered along with beta
• Expected returns are a positive function of
beta, but investors also require higher returns
from relatively small firms and for stocks with
relatively low P/E ratios
• Bhandari (1988) found that financial leverage
also helps explain the cross section of
average returns after both beta and size are
considered
• Effect of Book-to-Market Value

• Fama and French (1992) concluded that size
and book-to-market equity capture the cross-
sectional variation in average stock returns
associated with size, E/P, book-to-market
equity, and leverage
• Two variables, BE/ME, appear to subsume
E/P and leverage
7.2.3 Additional Issues
• Effect of Transaction Costs

• With transactions costs, the SML will be a
band of securities, rather than a straight line
• Effect of Taxes
• Differential tax rates could cause major
differences in the CML and SML among
investors
7.2.4 Summary of Empirical Results for the
CAPM
• Early evidence supported the CAPM; there was evidence that the intercepts
were generally higher than implied by the RFR that prevailed, which is either
consistent with a zero-beta model or the existence of higher borrowing rates
• To explain unusual returns, size, the P/E ratio, financial leverage, and the
book-to-market value ratio are found to have explanatory power regarding
returns beyond beta
• Further studies;
• 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
7.3 The Market Portfolio: Theory versus
Practice (slide 1 of 4)
• The true market portfolio should

• Included all the risky assets in the world
• In equilibrium, the assets would be included in
the portfolio in proportion to their market value
• Using U.S. Index as a market proxy

• Most studies use an U.S. index
• The U.S. stocks constitutes less than 15% of
a truly global risky asset portfolio
• The beta intercept of the SML will differ if

• There is an error in selecting the risk-free
asset
• There is an error in selecting the market
portfolio
• Using the incorrect SML may lead to
incorrect evaluation of a portfolio
performance
• Exhibits 7.10, 7.11
7.4 Arbitrage Pricing Theory (slide 1 of 5)
• CAPM is criticized because of

• 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)
• 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
• 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
• 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:
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.)
• Exhibit 7.12
7.4.1 Using the APT (slide 1 of 3)
• Two-stock and a two-factor model example:

• Assume that there are two common factors: one
related to unexpected changes in the level of inflation
and another related to unanticipated changes in the
real level of GDP
• Risk factor definitions and sensitivities:
δ1 = unanticipated changes in the rate of inflation. The risk premium related to this
factor is 2 percent for every 1 percent change in the rate (λ = 0.02).
δ2 = unexpected changes in the growth rate of real GDP. The average risk premium
related to this factor is 3 percent for every 1 percent change in the rate growth
(λ2 = 0.03).
λ0 = rate of return on a zero-systematic risk asset (zero-beta) is 4 percent (λ 0 = 0.04).
• Assume also that there are two assets (x and y) that
have the following sensitivities to these common 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
• Exhibit 7.13
7.4.2 Security Valuation with the APT: An
Example (slide 1 of 3)
• 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 percent and λ2 = 5 percent, 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%

• Assuming that all three stocks are currently
priced at $35 and do not pay a dividend, the
following are the expected prices a year from
now:
E(PA) = $35(1.077) = $37.70
E(PB) = $35(1.057) = $37.00
E(PC) = $35(1.097) = $38.40
• If everyone else in the market today begins to believe
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
7.4.3 Empirical Tests of the APT
(slide 1 of 5)
• Roll-Ross Study (1980)
• Methodology followed a two-step procedure:
1. Estimate the expected returns and the factor
coefficients from time-series data on individual
asset returns
2. Use these estimates to test the basic cross-
sectional pricing conclusion implied by the APT
• The authors concluded that the evidence
generally supported the APT but
acknowledged that their tests were not
conclusive
(slide 2 of 5)
• Extensions of the Roll–Ross Tests
• Cho, Elton, and Gruber (1984) examined the
number of factors in the return-generating
process that were priced
• Dhrymes, Friend, and Gultekin (1984)
reexamined techniques and their limitations and
found the number of factors varies with the size
of the portfolio
• Roll and Ross (1984) pointed out that the
number of factors is a secondary issue compared
to how well the model can explain the expected
return
(slide 3 of 5)
• Connor and Korajczyk (1993) developed a
test that identifies the number of factors in a
model that allows the unsystematic
components of risk to be correlated across
assets
• Harding (2008) also showed the connection
between systematic and unsystematic risk
factors
(slide 4 of 5)
• The APT and Stock Market Anomalies
• An alternative set of tests of the APT considers how
well the theory explains pricing anomalies: the small-
firm effect and the January effect
• APT Tests of the Small-Firm Effect
• Reinganum: Results inconsistent with the APT
• Chen: Supported the APT model over CAPM
• APT Tests of the January Effect
• Gultekin and Gultekin: APT not better than CAPM
• Burmeister and McElroy: Effect not captured by model but
still rejected CAPM in favor of APT
(slide 5 of 5)
• Is the APT Even Testable?
• Shanken (1982)
• APT has no advantage because the factors need not be
observable, so equivalent sets may conform to different
factor structures
• Empirical formulation of the APT may yield different
implications regarding the expected returns for a given set
of securities
• Thus, the theory cannot explain differential returns
between securities because it cannot identify the relevant
factor structure that explains the differential returns returns
• A number of subsequent papers, such as Brown and
Weinstein (1983), Geweke and Zhou (1996), and
Zhang (2009), have proposed new methodologies for
testing the APT
7.5 Multifactor Models and Risk Estimation
• In a multifactor model, the investor

chooses the exact number and identity of
risk factors, while the APT model does not
specify either of them
where:
Fit = Period t return to the jth designated risk factor
Rit = Security i’s return that can be measured as either a nominal
or excess return to Security i
7.5.1 Multifactor Models in Practice
(slide 1 of 12)
• A wide variety of empirical factor
specifications have been employed in
practice
• Alternative models attempt to identify a set
of economic influences
• Two approaches:
• Risk factors can be viewed as
macroeconomic in nature
• Risk factors can also be viewed at a
microeconomic level
(slide 2 of 12)
• Macroeconomic-Based Risk Factor Models
• Chen, Roll, and Ross (1986):
Where:
RM = return on a value-weighted index of NYSE-listed stocks
MP = monthly growth rate in U.S. industrial production
DEI = change in inflation; measured by the U.S. consumer price index
UI = difference between actual and expected levels of inflation
UPR = unanticipated change in the bond credit spread (Baa yield − RFR)
UTS = unanticipated term structure shift (long-term less short-term RFR)
• Exhibit 7.14
(slide 3 of 12)
(slide 4 of 12)
• Burmeister, Roll, and Ross (1994) analyzed
the predictive ability of a model based on the
following set of macroeconomic factors:
1. Confidence risk
2. Time horizon risk
3. Inflation risk
4. Business cycle risk
5. Market timing risk
• Exhibit 7.15
(slide 5 of 12)
(slide 6 of 12)
• Fama and French (1993) developed a multifactor
model specifying the risk factors in microeconomic
terms using the characteristics of the underlying
securities
• SMB (i.e. small minus big) = return to a portfolio of small

capitalization stocks less the return to a portfolio of large
capitalization stocks
• HML (i.e. high minus low) = return to a portfolio of stocks with
high ratios of book-to-market values less the return to a portfolio
of low book-to-market value stocks
• Exhibit 7.16
(slide 7 of 12)
(slide 8 of 12)
• Carhart (1997), based on the Fama-

French three-factor model, developed a
four-factor model by including a risk factor
that accounts for the tendency for firms
with positive past return to produce
positive future return
Where
MOMt = the momentum factor
(slide 9 of 12)
• 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
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
(slide 10 of 12)
• Extensions of Characteristic-Based Risk Factor
Models
• One type of security characteristic-based method for
defining systematic risk exposures involves the use of
index portfolios (e.g. S&P 500, Wilshire 5000) as
common risk factors, such as the one by Elton,
Gruber, and Blake (1996), who rely on four indexes:
• The S&P 500
• The Barclays Capital aggregate bond index
• The Prudential Bache index of the difference between large-
and small-cap stocks
• The Prudential Bache index of the difference between value
and growth stocks
• Exhibits 7.17, 7.18
(slide 11 of 12)
(slide 12 of 12)
7.5.2 Estimating Risk in a Multifactor
Setting: Examples (slide 1 of 7)
• Estimating Expected Returns for Individual
Stocks
• One direct way to employ a multifactor risk model is
to use it to estimate the expected return for an
individual stock position
• In order to do this, the following steps must be taken:
• A specific set of K common risk factors (or their proxies)
must be identified
• The risk premia (Fj) for the factors must be estimated
• The sensitivities (bij) of the ith stock to each of those K
factors must be estimated
• The expected returns can be calculated by combining the
results of the previous steps
• Exhibit 7.19
• Whichever specific factor risk estimates

are used, the expected return for any
stock in excess of the risk-free rate (the
stock’s expected risk premium) can be
calculated with either the three-factor or
four-factor version of the formula:
• Comparing Mutual Fund Risk Exposures

• To get a better sense of how risk factor
sensitivity is estimated at the portfolio level,
consider the returns produced by two popular
mutual funds: Fidelity’s Contrafund (FCNTX)
and T. Rowe Price’s Mid-Cap Value Fund
(TRMCX)
• Exhibit 7.20, 7.2, 7.22

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CHAPTER 7

• The capital asset pricing model (CAPM) extends

• Let βi=(σi riM) / σM be the asset beta measuring the relative

• The CAPM indicates what should be the expected or

• Security betas can also be estimated as the slope

• The Impact of the Time Interval

• The Effect of the Market Proxy

• Computing a Characteristic Line: An

• Industry Characteristic Lines

• When testing the CAPM, there are two

• Numerous studies have examined the

• Effect of a Zero-Beta Portfolio

• Effect of Book-to-Market Value

• Effect of Transaction Costs

• The true market portfolio should

• Using U.S. Index as a market proxy

• The beta intercept of the SML will differ if

• CAPM is criticized because of

• Three major assumptions:

• Theory assumes that the return-generating

• The APT requires that in equilibrium the return on a zero-

λ0 = expected return on an asset with zero systematic risk

• Two-stock and a two-factor model example:

bx1 = response of Asset x to changes in the inflation factor is 0.50

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 percent and λ2 = 5 percent, then the returns expected by the

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%

PA = ($37.20) ÷ (1.077) = $34.54

• In a multifactor model, the investor

• SMB (i.e. small minus big) = return to a portfolio of small

• Carhart (1997), based on the Fama-

• Whichever specific factor risk estimates

• Comparing Mutual Fund Risk Exposures

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