Investment Management

Chapter 06 An Introduction to Asset

Pricing Models

Chapter 6 - An Introduction to
Asset Pricing Models
• Capital Market Theory (CMT)
• Capital Market Line (CML)
• Capital Assets Pricing Model (CAPM)
• Security Market Line (SML)
• Arbitrage Pricing Theory (APT)

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 Capital Market Theory:
An Overview
• Capital market theory extends portfolio
theory and develops a model for pricing all
risky assets
• Capital asset pricing model (CAPM) will
allow you to determine the required rate of
return for any risky asset

Assumptions of
Capital Market Theory
1. All investors are Markowitz efficient
investors who want to target points on the
efficient frontier.
– The exact location on the efficient frontier and,
therefore, the specific portfolio selected, will
depend on the individual investor’s risk-return
utility function.

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 Assumptions of
Capital Market Theory
2. Investors can borrow or lend any amount of
money at the risk-free rate of return (RFR).
– Clearly it is always possible to lend money at
the nominal risk-free rate by buying risk-free
securities such as government T-bills. It is not
always possible to borrow at this risk-free rate,
but assuming a higher borrowing rate does not
change the general results.

Assumptions of
Capital Market Theory
3. All investors have homogeneous
expectations; that is, they estimate identical
probability distributions for future rates of
return.
– Again, this assumption can be relaxed. As long
as the differences in expectations are not vast,
their effects are minor.

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 Assumptions of
Capital Market Theory
4. All investors have the same one-period
time horizon such as one-month, six
months, or one year.
– The model will be developed for a single
hypothetical period, and its results could be
affected by a different assumption. A
difference in the time horizon would require
investors to derive risk measures and risk-free
assets that are consistent with their time
horizons.

Assumptions of
Capital Market Theory
5. All investments are infinitely divisible,
which means that it is possible to buy or sell
fractional shares of any asset or portfolio.
– This assumption allows us to discuss
investment alternatives as continuous curves.
Changing it would have little impact on the
theory.

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 Assumptions of
Capital Market Theory
6. There are no taxes or transaction costs
involved in buying or selling assets.
– This is a reasonable assumption in many
instances. Neither pension funds nor religious
groups have to pay taxes, and the transaction
costs for most financial institutions are less than
1 percent on most financial instruments. Again,
relaxing this assumption modifies the results,
but does not change the basic thrust.

Assumptions of
Capital Market Theory
7. There is no inflation or any change in
interest rates, or inflation is fully
anticipated.
– This is a reasonable initial assumption, and it
can be modified.

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 Assumptions of
Capital Market Theory
8. Capital markets are in equilibrium.
– This means that we begin with all investments
properly priced in line with their risk levels.

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Assumptions of
Capital Market Theory
• Some of these assumptions are unrealistic
• Relaxing many of these assumptions would
have only minor influence on the model and
would not change its main implications or
conclusions.
• A theory should be judged on how well it
explains and helps predict behavior, not on
its assumptions.

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 Risk-Free Asset
• An asset with zero standard deviation
• Zero correlation with all other risky assets
• Provides the risk-free rate of return (RFR)
• Will lie on the vertical axis of a portfolio graph
• This assumption of a risk-free asset allows us to derive a
generalized theory of capital asset pricing under conditions
of uncertainty from the portfolio theory.
• This achievement is generally attributed to William Sharpe
(1964), who received a Nobel Prize for it, but Lintner
(1965) and Mossin (1966) derived similar theories
independently.

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Developing the Capital Market

Line
• Risky asset can be defined as one from which future
returns are uncertain, and uncertainty is measured by the
standard deviation of expected returns.
• Because the expected return on a risk-free asset is entirely
certain, the standard deviation of its expected return is
zero.

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 Risk-Free Asset
Covariance between two sets of returns is

Because the returns for the risk-free asset are certain,

Thus Ri = E(Ri), and Ri - E(Ri) = 0
Consequently, the covariance of the risk-free asset with any
risky asset or portfolio will always equal zero. Similarly, the
correlation between any risky asset and the risk-free asset
would be zero.

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Combining a Risk-Free Asset

with a Risky Portfolio
Expected return
the weighted average of the two returns

This is a linear relationship

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 Combining a Risk-Free Asset
with a Risky Portfolio
Standard deviation
The expected variance for a two-asset portfolio is

Substituting the risk-free asset for Security 1, and the risky

asset for Security 2, this formula would become

Since we know that the variance of the risk-free asset is

zero and the correlation between the risk-free asset and any
risky asset i is zero, we can adjust the formula

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Combining a Risk-Free Asset

with a Risky Portfolio
Given the variance formula
the standard deviation is

Therefore, the standard deviation of a portfolio that

combines the risk-free asset with risky assets is the
linear proportion of the standard deviation of the risky
asset portfolio.

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 Combining a Risk-Free Asset
with a Risky Portfolio

• Investors who allocate their money between a riskless security

and the risky Portfolio M can expect a return equal to the risk-
free rate plus compensation for the number of risk units they
accept.
• Investors perform two functions in the capital markets for which
they can expect to be rewarded.
– First, they allow someone else to use their money, for which
they receive the risk-free rate of interest.
– They bear the risk that the returns they have been promised
in exchange for their invested capital will not be repaid. 2nd
part represents the expected risk premium per unit of risk.
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Combining a Risk-Free Asset

with a Risky Portfolio
Since both the expected return and the standard deviation
of return for such a portfolio are linear combinations, a
graph of possible portfolio returns and risks looks like a
straight line between the two assets.

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 Combining a Risk-Free Asset
with a Risky Portfolio
• The capital market line (CML) represents
portfolios that optimally combine risk and
return. It is a theoretical concept that
represents all the portfolios that optimally
combine the risk-free rate of return and the
market portfolio of risky assets.

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Portfolio Possibilities Combining the Risk-Free Asset

and Risky Portfolios on the Efficient Frontier

Exhibit 8.1

D
M
C B
RFR A

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Risk-Return Possibilities with Leverage
To attain a higher expected return than is
available at point M (in exchange for
accepting higher risk)
• Either invest along the efficient frontier
beyond point M, such as point D
• Or, add leverage to the portfolio by
borrowing money at the risk-free rate and
investing in the risky portfolio at point M

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Portfolio Possibilities Combining the Risk-Free Asset

and Risky Portfolios on the Efficient Frontier

Exhibit 8.2
M

RFR

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 Risk, Diversification, and the
Market Portfolio
• Because portfolio M lies at the point of
tangency, it has the highest portfolio
possibility line
• Everybody will want to invest in Portfolio
M and borrow or lend to be somewhere on
the CML
• Therefore this portfolio must include ALL
RISKY ASSETS

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Risk, Diversification, and the

Market Portfolio
• Because the market is in equilibrium, all
assets are included in this portfolio in
proportion to their market value
• Because it contains all risky assets, it is a
completely diversified portfolio, which
means that all the unique risk of individual
assets (unsystematic risk) is diversified
away

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 Systematic Risk
• Only systematic risk remains in the market
portfolio
• Systematic risk is the variability in all risky
assets caused by macroeconomic variables
• Systematic risk can be measured by the
standard deviation of returns of the market
portfolio and can change over time

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Examples of Macroeconomic
Factors Affecting Systematic Risk
• Variability in growth of money supply
• Interest rate volatility
• Variability in industrial production,
corporate earnings

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 How to Measure Diversification
• All portfolios on the CML are perfectly
positively correlated with each other and
with the completely diversified market
Portfolio M
• A completely diversified portfolio would
have a correlation with the market portfolio
of +1.00

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Diversification and the

Elimination of Unsystematic Risk
• The purpose of diversification is to reduce the
standard deviation of the total portfolio
• As you add securities, you expect the average
covariance for the portfolio to decline
• How many securities must you add to obtain a
completely diversified portfolio?

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 Number of Stocks in a Portfolio and the
Standard Deviation of Portfolio Return
Standard Deviation of Return
Exhibit 8.3
Unsystematic
(diversifiable)
Risk
Total
Risk Standard Deviation of
the Market Portfolio
(systematic risk)
Systematic Risk

Number of Stocks in the Portfolio

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The CML and the Separation Theorem

• The CML leads all investors to invest in the M
portfolio
• Individual investors should differ in position
on the CML depending on risk preferences
• How an investor gets to a point on the CML is
based on financing decisions

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 The CML and the Separation Theorem
• Risk averse investors will lend part of the
portfolio at the risk-free rate and invest the
remainder in the market portfolio
• Investors preferring more risk might borrow
funds at the RFR and invest everything in
the market portfolio

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The CML and the Separation Theorem

The decision of both investors is to invest in
portfolio M along the CML (the investment
decision)

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 The CML and the Separation Theorem
• The decision to borrow or lend to obtain a
point on the CML is a separate decision
based on risk preferences (financing
decision)
• Tobin (1958) refers to this separation of the
investment decision from the financing
decision, the separation theorem

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A Risk Measure for the CML

Because all individual risky assets are part of the M portfolio, an
asset’s rate of return in relation to the return for the M
portfolio may be described using the following linear model:

where:
Rit = return for asset i during period t
ai = constant term for asset i
bi = slope coefficient for asset i
RMt = return for the M portfolio during period t
= random error term

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 Variance of Returns for a Risky Asset

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The Capital Asset Pricing Model

• Capital market theory is an incomplete explanation for the
relationship that exists between risk and return.
• CML defined the risk an investor bears by the total
volatility (σ) of the investment. However, since investors
cannot expect to be compensated for any portion of risk
that they could have diversified away (i.e., unsystematic
risk), the CML must be based on the assumption that
investors only hold fully diversified portfolios, for which
total risk and systematic risk are the same thing.
• The limitation is thus that the CML cannot provide an
explanation for the risk-return trade-off for individual risky
assets because the standard deviation for these securities
will contain a substantial amount of unique risk.

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 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.
• CAPM redefines the relevant measure of risk from total
volatility to just the nondiversifiable portion of that total
volatility (i.e., systematic risk).
• This new risk measure is called the beta coefficient, and it
calculates the level of a security’s systematic risk
compared to that of the market portfolio.

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The Capital Asset Pricing Model

•

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 The Capital Asset Pricing Model

• The expected rate of return of a risk asset is

determined by the RFR plus a risk premium
for the individual asset
• The risk premium is determined by the
systematic risk of the asset (beta) and the
prevailing market risk premium (RM-RFR)

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The Capital Asset Pricing Model

• A stock with a beta of 1.20 has a level of systematic risk
that is 20 percent greater than the average for the entire
market, while a stock with a beta of 0.70 is 30 percent less
risky than the market.
• By definition, the market portfolio itself will always have a
beta of 1.00.

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 The Security Market Line (SML)
• The CAPM can also be illustrated in
graphical form as the security market line
(SML).

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The Security Market Line (SML)

• There are two important differences between the CML and
the SML.
– First, the CML measures risk by the standard deviation
(i.e., total risk) of the investment while the SML
considers only the systematic component of an
investment’s volatility.
– Second, as a consequence of the first point, CML can
be applied only to portfolio holdings that are already
fully diversified, whereas the SML can be applied to
any individual asset or collection of assets.

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 Determining the Expected
Rate of Return for a Risky Asset
Assume: RFR = 6% (0.06)
RM = 12% (0.12)
Implied market risk premium = 6% (0.06)

E(RA) = 0.06 + 0.70 (0.12-0.06) = 0.102 = 10.2%

E(RB) = 0.06 + 1.00 (0.12-0.06) = 0.120 = 12.0%
E(RC) = 0.06 + 1.15 (0.12-0.06) = 0.129 = 12.9%
E(RD) = 0.06 + 1.40 (0.12-0.06) = 0.144 = 14.4%
E(RE) = 0.06 + -0.30 (0.12-0.06) = 0.042 = 4.2%

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Determining the Expected

Rate of Return for a Risky Asset
• 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

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 Identifying Undervalued and
Overvalued Assets
• Compare the required rate of return to the
expected rate of return for a specific risky
asset using the SML over a specific
investment horizon to determine if it is an
appropriate investment
• Independent estimates of return for the
securities provide price and dividend
outlooks

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Price, Dividend, and

Rate of Return Estimates
Exhibit 8.7

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Comparison of Required Rate of Return
to Estimated Rate of Return
Exhibit 8.8

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Plot of Estimated Returns

on SML Graph Exhibit 8.9
.22
C SML
.20
.18
.16
.14
.12
Rm
.10
E A
.08
.06 B
.04
D
.02

-.40 -.20 .20 .40 .60 .80 1.20 1.40 1.60 1.80

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 Arbitrage Pricing Theory (APT)
• Arbitrage pricing theory (APT) was
developed by Stephen Ross.
• The chief difference between the CAPM
and the APT is that the latter specifies
several risk factors, thereby expanding the
definition of systematic investment risk
compared to that implied by the CAPM’s
single market portfolio.

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Arbitrage Pricing Theory (APT)

• Some of the empirical studies cited point out deficiencies in the CAPM
model as an explanation of the link between risk and return.
• For example, tests of the CAPM indicated that the beta coefficients for
individual securities were not stable but that portfolio betas generally
were stable.
• There was mixed support for a positive linear relationship between
rates of return and systematic risk for portfolios of stock, with some
recent evidence indicating the need to consider additional risk variables
or a need for different risk proxies.
• In addition, other papers criticized the tests of the model and its
usefulness in portfolio evaluation because of a dependence on a market
portfolio that is not currently available.

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 Arbitrage Pricing Theory (APT)
• Three major assumptions:
– Capital markets are perfectly competitive.
– Investors always prefer more wealth to less
wealth with certainty.
– The stochastic process generating asset returns
can be expressed as a linear function of a set of
K risk factors (or indexes), and all unsystematic
risk is diversified away

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Arbitrage Pricing Theory (APT)

•

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 Arbitrage Pricing Theory (APT)
• δ terms are the multiple risk factors that are
expected to impact the returns to all assets.
• Examples of these factors might include inflation,
growth in gross domestic product (GDP), major
political upheavals, or changes in interest rates.
• The APT contends that there are many such
factors that affect returns, in contrast to the
CAPM, where the only relevant risk to measure is
the covariance of the asset with the market
portfolio (i.e., the asset’s beta).

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Arbitrage Pricing Theory (APT)

• b terms determine how each asset reacts to
particular common factor.
• Although all assets may be affected by
growth in GDP, the impact (i.e., reaction) to
a factor will differ. For example, stocks of
cyclical firms will have larger bij terms for
the “growth in GDP” factor than will
noncyclical firms, such as grocery store
chains.
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 Arbitrage Pricing Theory (APT)
•

57

Arbitrage Pricing Theory (APT)

• APT assumes that, in equilibrium, the
return on a zero-investment, zero-
systematic-risk portfolio is zero when the
unique effects are diversified away
• The expected return on any asset i (Ei) can
be expressed as:

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 Arbitrage Pricing Theory (APT)

where:
= the expected return on an asset with zero systematic
risk where

= the risk premium related to each of the common

factors - for example the risk premium related to
interest rate risk

bi = the pricing relationship between the risk premium and

asset i - that is how responsive asset i is to this common
factor K

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Example of Two Stocks

and a Two-Factor Model
= changes in the rate of inflation. The risk premium
related to this factor is 1 percent for every 1 percent
change in the rate

= percent growth in real GNP. The average risk premium

related to this factor is 2 percent for every 1 percent
change in the rate

= the rate of return on a zero-systematic-risk asset (zero

beta: boj=0) is 3 percent

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 Example of Two Stocks
and a Two-Factor Model
= the response of asset X to changes in the rate of inflation
is 0.50

= the response of asset Y to changes in the rate of inflation

is 2.00

= the response of asset X to changes in the growth rate of

real GNP is 1.50

= the response of asset Y to changes in the growth rate of

real GNP is 1.75

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Example of Two Stocks

and a Two-Factor Model

= .03 + (.01)bi1 + (.02)bi2

Ex = .03 + (.01)(0.50) + (.02)(1.50)
= .065 = 6.5%
Ey = .03 + (.01)(2.00) + (.02)(1.75)
= .085 = 8.5%

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 Multifactor Models and Risk
Estimation
• In a multifactor model, the investor
chooses the exact number and identity of
risk factors
• Multifactor Models in Practice
– Macroeconomic-Based Risk Factor Models
– Microeconomic-Based Risk Factor Models
– Extensions of Characteristic-Based Risk Factor
Models

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Thank You!

Chapter 06 An Introduction to Asset

Pricing Models

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