CHAPTER 7

Asset Pricing
Models

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-2
posted to a publicly accessible website, in whole or in part.
7.1.1 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 riM, where riM is the correlation
coefficient between the asset and the market

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-3
posted to a publicly accessible website, in whole or in part.
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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-4
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-5
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 2 of 18)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-6
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 3 of 18)

• Determining the Expected Rate of Return for a

Risky Asset
• Example:

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-7
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 4 of 18)

• Risk-free rate is 5% and the market return is 9%

• This implies a market risk premium of 4%

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-8
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-9
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-10
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 7 of 18)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-11
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 8 of 18)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-12
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 9 of 18)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-13
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (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):

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-14
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-15
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-16
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-17
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 14 of 18)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-18
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 15 of 18)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-19
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 16 of 18)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-20
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 17 of 18)

• Industry Characteristic Lines

• The characteristic line used to estimate beta
value can be computed for sector indexes
• Exhibit 7.8

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-21
posted to a publicly accessible website, in whole or in part.
7.1.2 The Security Market Line (slide 18 of 18)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-22
posted to a publicly accessible website, in whole or in part.
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?

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-23
posted to a publicly accessible website, in whole or in part.
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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-24
posted to a publicly accessible website, in whole or in part.
7.2.2 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?
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-25
posted to a publicly accessible website, in whole or in part.
7.2.2 Relationship Between Systematic Risk and
Return (slide 2 of 5)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-26
posted to a publicly accessible website, in whole or in part.
7.2.2 Relationship Between Systematic Risk and
Return (slide 3 of 5)
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-27
posted to a publicly accessible website, in whole or in part.
7.2.2 Relationship Between Systematic Risk and
Return (slide 4 of 5)
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-28
posted to a publicly accessible website, in whole or in part.
7.2.2 Relationship Between Systematic Risk and
Return (slide 5 of 5)
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-29
posted to a publicly accessible website, in whole or in part.
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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-30
posted to a publicly accessible website, in whole or in part.
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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-31
posted to a publicly accessible website, in whole or in part.
7.3 The Market Portfolio: Theory versus
Practice
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-32
posted to a publicly accessible website, in whole or in part.
7.3 The Market Portfolio: Theory versus
Practice (slide 2 of 4)
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-33
posted to a publicly accessible website, in whole or in part.
7.3 The Market Portfolio: Theory versus
Practice (slide 3 of 4)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-34
posted to a publicly accessible website, in whole or in part.
7.3 The Market Portfolio: Theory versus
Practice (slide 4 of 4)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-35
posted to a publicly accessible website, in whole or in part.
7.4 Arbitrage Pricing Theory

• 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)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-36
posted to a publicly accessible website, in whole or in part.
7.4 Arbitrage Pricing Theory (slide 2 of
5)
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-37
posted to a publicly accessible website, in whole or in part.
7.4 Arbitrage Pricing Theory (slide 3 of
5)
• Theory assumes that the return-generating
process can be represented as a K factor
model of the form:

where:

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-38
posted to a publicly accessible website, in whole or in part.
7.4 Arbitrage Pricing Theory (slide 4 of
5)
• 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:

• Exhibit 7.12

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-39
posted to a publicly accessible website, in whole or in part.
7.4 Arbitrage Pricing Theory (slide 5 of
5)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-40
posted to a publicly accessible website, in whole or in part.
7.4.1 Using the APT
• 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:

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-41
posted to a publicly accessible website, in whole or in part.
7.4.1 Using the APT (slide 2 of 3)
• Assume also that there are two assets (x and y) that have the
following sensitivities to these common risk factors:

• Exhibit 7.13

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-42
posted to a publicly accessible website, in whole or in part.
7.4.1 Using the APT (slide 3 of 3)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-43
posted to a publicly accessible website, in whole or in part.
7.4.2 Security Valuation with the APT: An
Example
• 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):

• If λ1 = 4 percent and λ2 = 5 percent, then the returns expected

by the market over the next year can be expressed as:

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-44
posted to a publicly accessible website, in whole or in part.
7.4.2 Security Valuation with the APT: An
Example (slide 2 of 3)
• 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:

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-45
posted to a publicly accessible website, in whole or in part.
7.4.2 Security Valuation with the APT: An
Example (slide 3 of 3)
• 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:

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-46
posted to a publicly accessible website, in whole or in part.
7.4.3 Empirical Tests of the APT
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-47
posted to a publicly accessible website, in whole or in part.
7.4.3 Empirical Tests of the APT (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
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-48
posted to a publicly accessible website, in whole or in part.
7.4.3 Empirical Tests of the APT (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-49
posted to a publicly accessible website, in whole or in part.
7.4.3 Empirical Tests of the APT (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-50
posted to a publicly accessible website, in whole or in part.
7.4.3 Empirical Tests of the 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
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-51
posted to a publicly accessible website, in whole or in part.
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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-52
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-53
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (slide 2 of
12)
• Macroeconomic-Based Risk Factor Models
• Chen, Roll, and Ross (1986):

Where:

• Exhibit 7.14

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-54
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (slide 3 of
12)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-55
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-56
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (slide 5 of
12)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-57
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-58
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (slide 7 of
12)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-59
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-60
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-61
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-62
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (slide 11 of
12)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-63
posted to a publicly accessible website, in whole or in part.
7.5.1 Multifactor Models in Practice (slide 12 of
12)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-64
posted to a publicly accessible website, in whole or in part.
7.5.2 Estimating Risk in a Multifactor Setting:
Examples
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-65
posted to a publicly accessible website, in whole or in part.
7.5.2 Estimating Risk in a Multifactor Setting:
Examples (slide 2 of 7)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-66
posted to a publicly accessible website, in whole or in part.
7.5.2 Estimating Risk in a Multifactor Setting:
Examples (slide 3 of 7)
• 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:

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-67
posted to a publicly accessible website, in whole or in part.
7.5.2 Estimating Risk in a Multifactor Setting:
Examples (slide 4 of 7)
• 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

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-68
posted to a publicly accessible website, in whole or in part.
7.5.2 Estimating Risk in a Multifactor Setting:
Examples (slide 5 of 7)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-69
posted to a publicly accessible website, in whole or in part.
7.5.2 Estimating Risk in a Multifactor Setting:
Examples (slide 6 of 7)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-70
posted to a publicly accessible website, in whole or in part.
7.5.2 Estimating Risk in a Multifactor Setting:
Examples (slide 7 of 7)

©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 7-71
posted to a publicly accessible website, in whole or in part.