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Chapter 24 (13th Edition)

Portfolio Theory, Asset
Pricing Models, and
Behavioral Finance

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 3-2
Portfolio Theory, Asset Pricing Models,
and
Behavioral Finance
 Capital Asset Pricing Model (CAPM)
Capital Market Line (CML)
Security Market Line (SML)
Beta calculation
 Fama-French 3-factor model

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 3-3
Comparing expected returns
and beta coefficients
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87

Riskier securities have higher returns, so the

rank order is OK.

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 3-4
The Security Market Line (SML):
Calculating required rates of return

SML: ri = rRF + (rM – rRF) bi

ri = rRF + (MRP) bi

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 3-5
Comparing expected returns
and beta coefficients
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87
Assume the yield curve is flat and that r RF = 5.5%
and MRP = 5.0%. Calculate required rate of return.

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 3-6
Calculating required rates of
return
 rHT = 5.5% + (5.0%)(1.32) = 12.10%

 rM = 5.5% + (5.0%)(1.00) = 10.50%

 rUSR = 5.5% + (5.0%)(0.88) = 9.90%

 rT-bill = 5.5% + (5.0%)(0.00) = 5.50%

 rColl = 5.5% + (5.0%)(-0.87) = 1.15%

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 3-7
Illustrating the
Security Market Line
SML: ri = 5.5% + (5.0%) bi
ri (%)
SML

HT
.. .
rM = 10.5

rRF = 5.5 . T-bills USR

-1
. 0 1 2
Risk, bi
Coll.
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 3-8

Expected vs. Required returns

Security r

HT 12.4% 12.1% Undervalued

Market 10.5 10.5 Fairly Valued
USR 9.8 9.9 Overvalued
T-Bills 5.5 5.5 Fairly Valued
Coll. 1.0 1.15 Overvalued

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 3-9
How is market equilibrium
established?
 If expected return exceeds required
return …
The current price (P0) is “too low”
and offers a bargain.
Buy orders will be greater than sell
orders.
P0 will be bid up until expected
return equals required return
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 3 - 10

Beta Portfolio
 The beta for a portfolio is simply a
weighted average of the individual
stock betas in the portfolio.

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An example:
Equally-weighted two-stock portfolio
 Create a portfolio with 50% invested in
HT and 50% invested in Collections.
 The expected return of a portfolio is the
weighted average of each of the stock’s
expected returns.

^ ^ ^
rP = wHT rHT + wColl rColl
^
rP = 0.5 (12.4) + 0.5 (1)
^
r P = 6.7
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 3 - 12
An example:
Equally-weighted two-stock portfolio
 Create a portfolio with 50% invested in
HT and 50% invested in Collections.
 The beta of a portfolio is the weighted
average of each of the stock’s betas.

bP = wHT bHT + wColl bColl

bP = 0.5 (1.32) + 0.5 (-0.87)
bP = 0.225
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 3 - 13
Calculating portfolio required
returns
 The required return of a portfolio is the weighted
average of each of the stock’s required returns.
rP = wHT rHT + wColl rColl
rP = 0.5 (12.10%) + 0.5 (1.15%)
rP = 6.63%
 Or, using the portfolio’s beta, CAPM can be used
to solve for expected return.
rP = rRF + (RPM) bP
rP = 5.5% + (5.0%) (0.225)
Copyright © 2002rP = 6.63%
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 3 - 14
Comparing expected returns
and beta coefficients
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87
Create a portfolio with 30% invested in HT and
30% in USR and 40% invested in Collections and
calculate expected rate of return and beta for the
three stock portfolio.
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Lets assume we want to replace a less
riskier asset with high riskier asset.

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 3 - 17
Lets assume we want to replace a less
riskier asset with high riskier asset.
 Invest in stock A with beta of 2.
Purchase of new security
Bp2= 0.648
Bp3 = 0.648 + (0.4 x 2)
Bp3 = 0.648 + 0.8
Bp3 = 1.448

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r= rf + MRP (b)
rp= rf + MRP (bp)
Rp = 5.5 + 5 (1.448)
Rp= 12.74%

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Factors that change the SML

 What if investors raise inflation expectations by

3%, what would happen to the SML?
ri (%)
 I = 3% SML2
SML1
13.5
10.5
8.5
5.5
Risk, bi
0 0.5 1.0 1.5
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Factors that change the SML

 What if investors’ risk aversion increased,

causing the market risk premium to increase by
3%, what would happen to the SML?
ri (%) SML2
 RPM = 3%

13.5 SML1
10.5

5.5
Risk, bi
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1.0 1.5 All rights reserved.
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What are our conclusions

regarding the CAPM?
 The CAPM has not been verified completely.
 Recent studies have questioned its validity.
 Statistical tests have problems that make
verification almost impossible.
 Some argue that there are additional risk factors,
other than the market risk premium, that must be
considered.

(More...)
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 3 - 22

More thoughts on the CAPM

 Investors seem to be concerned with both
market risk and total risk. Therefore, the
SML may not produce a correct estimate
of ri.
ri = rRF + (rM – rRF) bi + ???

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 3 - 23

More thoughts on the CAPM

 CAPM/SML concepts are based on
expectations, yet betas are calculated
using historical data. A company’s
historical data may not reflect investors’
expectations about future riskiness.
 Other models are being developed that
will one day replace the CAPM, but it still
provides a good framework for thinking
about risk and return.

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 3 - 24

Criticisms on CAPM
 In 1992, Fama and French published a study hypothesizing
that the SML should have three factors rather than just beta as
in the CAPM.
 The first factor is the stock’s CAPM beta, which measures the
market risk of the stock.
 The second is the size of the company, measured by the
market value of its equity (MVE).
 The third factor is the book-to-market (B/M) ratio, defined as
the book value of equity divided by the market value of
equity.
.

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The Fama-French Three-
Factor Model
 The first factor is the market risk premium, which is the
market return, rM, minus the risk-free rate, rRF. Thus, their
model begins like the CAPM.

 The return on, S, a portfolio of small firms minus the return

on B, a portfolio of big firms. This return is called rSMB, for
S minus B.

 The return on, H, a portfolio of firms with high book-to-

market ratios minus the return on L, a portfolio of firms
with low book-to-market ratios. This return is called rHML,
for H minus L.
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 3 - 26
The Fama-French Three-
Factor Model
 To form the second factor, they ranked all actively
traded stocks by size and then divided them into two
portfolios, one consisting of small stocks and one
consisting of big stocks.
 They calculated the return on each of these two
portfolios and created a third portfolio by subtracting the
return on the big portfolio from that of the small one.
 They called this the SMB (small minus big) portfolio.
This portfolio is designed to measure the variation in
stock returns that is caused by the size effect.

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The Fama-French Three-
Factor Model
 To form the third factor, they ranked all stocks
according to their book-to-market (B/M) ratios.
 They placed the 30% of stocks with the highest ratios
into a portfolio they called the H portfolio (for high
B/M ratios) and placed the 30% of stocks with the
lowest ratios into a portfolio called the L portfolio (for
low B/M ratios).
 Then they subtracted the return of the L portfolio from
that of the H portfolio to derive the HML (high minus
low) portfolio.

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Book value of equity = common stock

+ Retained earnings

Market value of equity= market price

per share x total shares outstanding

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 3 - 29
Required Return for Stock i
under the Fama-French 3-Factor Model

ei,t = error term (The predicted value of the error term in the
Fama-French model, is equal to zero.)

ri = rrf+ ai + bi (rM - rrf ) + (ci rSMB,) + di (rHML )

ri = rrf+ ai + bi (Mrp ) + (ci rSMB,) + di (rHML )

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 ri,t = realized rate of return on the stock i

 rrf,t = risk-free rate of return
 rm,t = realized rate of return on the market
 Mrp = rm,t-rrf,t = market risk premium
 rSMB,t =size premium (return on small minus big size portfolio)
 rHML,t = value premium (return on high minus low B/M portfolio)
 ai = Vertical axis intercept term for Stock i
 bi, ci, and di = Slope coefficients for Stock i
 ei,t = error term (The predicted value of the error term
in the Fama-French model, ei t, is equal to zero.)

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 3 - 31

Required Return for Stock i

under the Fama-French 3-Factor Model

ri = rrf+ ai + bi (rM - rrf ) + ci (rSMB,) + di (rHML )

bi = sensitivity of Stock i to the market

return.
ci = sensitivity of Stock i to the size
factor.
di = sensitivity of Stock i to the book-to-
market factor.
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 3 - 32
Importance of Fama-
French Three-Factor
Model
 This model explains the positive return with over 90% of
the diversified portfolio’s returns, unlike CAPM with a
70% return.
 The Fama French Model measures the outperformance
tendency. In accordance with it, over a long span of
time, small-cap stocks tend to outperform the large-cap
companies, and value stocks beat the growth stocks.
 Like the CAPM model, this model is based on the
assumption of former, high-risk investments require
high returns.

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Importance of Fama-
French Model
 Further, the model extends to the five-factor in the year
2014.
 The fourth variable added to the model is that the
companies reporting high future earnings have high
returns in the stock market (profitability).
 At the same time, the fifth variable is an investment which
relates to the concept of internal investment and returns
and suggests that companies, while directing profit
towards growth projects, are likely to experience losses in
the market.

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 3 - 34

Required Return for Stock i

under the Fama-French 3-Factor Model
If bi=0.9, kRF=6.8%,
market risk premium is 6.3%,
ci=- 0.5,
expected value for the size factor or size
premium = 4%, di=- 0.3, and
expected value for the book-to-market
factor or value premium = 5%.
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 3 - 35
Required Return for Stock i under CAPM
& the Fama-French 3-Factor Model
CAPM: ki = kRF + (kM - kRF)bi
kMRP = (kM - kRF)

ki = 6.8% + (6.3%)(0.9)
= 12.47%
Fama-French
ki = kRF + (kMRP)bi + (kSMB)ci + (kHML)di

ki = 6.8% + (6.3%)(0.9) + (4%)(-0.5) + (5%)(-0.3)

k i = 8.97%
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Book to Market Ratio

Book to Market Ratio = Book Value of Equity
Market Value of Equity
where,
Book value of equity = Based on accounting conventions
The market value of equity = Market capitalization

Market Capitalization = (Price x number of shares outstanding)

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Book to Market Ratio

 XYZ Inc., a Nasdaq-listed company, is currently trading at $11.25
per share. The firm had a book value of assets of $110 million and a
book value of liabilities of $65 million at the end of 2019. Based on
the recent filing with the exchange and the SEC, the company has 4
million shares outstanding. As an analyst, determine the Book-to-
Market ratio for XYZ and assume everything is constant interpret
how the ratio influences investment decisions.
 book value of assets of $110 m
 book value of liabilities of $65 million
 Book value of equity = BV Assets – BV of liabilities
 BV of equity = 45 million
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 3 - 38

Book to Market Ratio

Mv of equity = price per share x # of shares outstanding
MV of equity = 11.25 x 4m
MV of equity = 45m
Book to Market Ratio = Book Value of Equity
Market Value of Equity
B/M ratio = 1

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24-1
The standard deviation of stock returns for Stock A is
40%. The standard deviation of the market return is
20%. If the correlation between Stock A and the market
is 0.70, then what is Stock A’s beta?

bA = sdA / sdm (correlation coefficient AM)

= 40 / 20 (0.7)
bA= 1.4

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24-3
An analyst has modeled the stock of a company using the
Fama-French three factor model. The risk-free rate is 5%, the
required market return is 10%, the risk premium for small
stocks (rSMB) is 3.2%, and the risk premium for value stocks
(rHML) is 4.8%. If ai= 0, bi = 1.2, ci = −0.4, and di = 1.3, what is
the stock’s required return?

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 3 - 41

ri = rrf+ ai + bi (Mrp ) + (ci rSMB,) + di (rHML )

ri = rrf+ ai + bi (rm - rrf ) + (ci rSMB,) + di (rHML )

Ri= 5 + 0 + 1.2 (10 -5) + -0.4 (3.2) + 1.3 (4.8)
ri = 15.96%

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24-6
Suppose you are given the following information: The beta of
Company i, bi, is 1.1; the risk-free rate, rRF, is 7%; and the expected
market premium, rM − rRF, is 6.5%. Assume that ai = 0.0.
a)Use the Security Market Line (SML) of the CAPM to find the
required return for this company.
b)Because your company is smaller than average and more
successful than average (that is, it has a low book-to-market ratio),
you think the Fama-French three factor model might be more
appropriate than the CAPM. You estimate the additional coefficients
from the Fama-French three-factor model: The coefficient for the size
effect, ci, is 0.7, and the coefficient for the book-to-market effect, di,
is −0.3. If the expected value of the size factor is 5% and the
expected value of the book-to-market factor is 4%, what is the
required return using the Fama-French three-factor model?

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24-10
Suppose you are given the following information:
The beta of a company, bi, is 0.9; the risk-free rate, rRF, is 6.8%;
and the expected market premium, rM − rRF, is 6.3%. Because
your company is larger than average and more successful than
average (that is, it has a lower book-to-market ratio), you think the
Fama-French three-factor model might be more appropriate than
the CAPM. You estimate the additional coefficients from the Fama-
French three-factor model: The coefficient for the size effect, ci, is
−0.5, and the coefficient for the book-to-market effect, di, is −0.3. If
the expected value of the size factor is 4% and the expected value
of the book-to-market factor is 5%, then what is the required return
using the Fama-French three-factor model? (Assume that ai = 0.0.)
What is the required return using CAPM?

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24-10
 The Fama-French model:
ri = rRF + (mrp)bi + (rsmb)ci + (rhml)di
ri = 6.8% + (6.3%)(0.9) + (4%)(-0.5) + (5%)(-0.3)
ri = 8.97%
 The CAPM:
ri = rRF + (rm - rRF)bi
ri = 6.8% + (6.3%)(0.9)
ri = 12.47%
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