Resume CH 7 - 0098 - 0326

LO 1.
Use the implications of capital market theory to estimate security risk premiums
 Capital Asset Pricing Model (CAPM)
A model that relates the required rate of return on a security to its systematic risk as
measured by beta
2
The formula : E ( r M )−r f = Á σ M
Where rM is an expected return of the market and rf is a risk-free rate.
And from (rM – rf) we got a market risk premium
A represents the degree of risk aversion of the average investor.
σM is the standard deviation of the return on the market portfolio
 Market Portfolio (M)
Each security is held in proportion to its total market value.
 Why all investors would hold a risky market
Higher systematic risk = higher expected return
So, investors would hold a risky market because it will lead the investors to achieve the
high expected return
 Assumptions
- The investors are price takers that will buy and sell securities at competitive prices.
When investors sell or buy the securities they don’t incur
 Transaction costs and taxes
 Can rate or borrow at the risk-free rate
- All investors are alike (investors have homogenous expectation)
 Use same inputs (expectation about risk and return should be similar)
 Efficient Frontier and CML
The straight line is called the capital market line. And the point that touches the capital
market line is the tangent portfolio or the market portfolio.
 Passive strategy is efficient
Passive strategy is a powerful alternative to an active strategy
Mutual fund theorem, all investors desire same portfolio of risky assets, can be satisfied
by single mutual fund composed of that portfolio.
There are two question:
- If passive strategy is costless and efficient, why follow active strategy?
Some investors follow the active strategy because this strategy can bring them to the
maximum return even though investors must actively analyze any developments in
information that can lead to decision making errors that have a direct impact on the
returns to be obtained.
- If no one does security analysis, what brings about efficiency of market portfolio?
 The risk premium of the market
- Demand drives prices, lowers expected rate of return/risk premiums
- But when risk premiums fall, investors will move to risk-free asset
- The equilibrium risk premium of the market portfolio is proportional both to the risk
of the market and to the degree of risk aversion of the average investor
 Expected return on individual securities
Expected return (mean return)–beta relationship, Implication of CAPM that security
risk premiums (expected excess returns) will be proportional to beta.
If the mean–beta relationship holds for any individual asset, it must hold for any
combination of assets. The beta of a portfolio is simply the weighted average of the betas
of the stocks in the portfolio, using as weights the portfolio proportion
 The security market line
- Graphical representation of the expected return–beta relationship of the CAPM
- Graphs individual asset risk premiums as function of asset risk
 Application of the CAPM
- One place the CAPM may be used is in the investment management industry.
Suppose the SML is taken as a benchmark to assess the fair expected return on a risky
asset. Then an analyst calculates the return she actually expects
- The CAPM is also useful in capital budgeting decision where the SML provides
(required return demanded) “hurdle rate” (cutoff internal rate of return (IRR) for
internal projects
LO 2 THE CAMP & INDEX MODELS
The CAPM has two limitations: It relies on the theoretical market portfolio, which
includes all assets (such as real estate, foreign stocks, etc.), and it applies to expected as opposed
to actual returns. To implement the CAPM, cast it in the form of an index model and use
realized, not expected, returns. The CAPM predicts relationships among expected returns.
However, all we can observe are realized (historical) holding period returns, which in a particular
holding period seldom, if ever, match initial expectations.
1. The Index Model, Realized Returns, and the Mean-Beta Equation
To move from a model cast in expectations to a realized-return framework, start with the
single-index regression equation in realized excess returns:
r it −r ft =α i + β i ( r Mt −r fr ) +e it
Explanation:
r it = holding-period return (HPR) on asset i in period t.
α i & β i = intercept and slope of the security characteristic line that relates asset i’s realized
excess return to the realized excess return of the index.
r Mt = index portfolio is proxying for the market.
r fr = excess return
e it = firm-specific effects during holding period t.
2. Estimating the Index Model

1. Collecting and processing data
2. Estimation results
3. Predicting Betas
The concept of systematic versus diversifiable risk is useful. Systematic risk is
approximated well by the regression equation beta and non-systematic risk by the residual
variance of the regression. As an empirical rule, it appears that betas exhibit a statistical property
called mean reversion. This suggests that high- b (that is, b. 1) securities tend to exhibit a lower b
in the future, while low- b (that is, b , 1) securities exhibit a higher b in future periods.
A simple way to account for mean reversion is to forecast beta as a weighted average of
the sample estimate with the value 1. Two methods can help improve forecasts of beta. The first
is an application of a technique that goes by the name of ARCH models. The second method
involves an additional step where beta estimates from time series regressions are augmented by
other information about the firm, for example, P/E ratios.
LO 3. The CAPM and the Real World
 The CAPM and the real world
CAPM is false based on validity of its assumptions
- Useful predictor of expected returns in 1972
- Untestable as a theory in 1977
- Principles still valid, such as:
 Investors should diversify
 Systematic risk is the risk that matters
 Well-diversified risky portfolio can be suitable for wide range of investors
LO 4. Take advantage of an arbitrage opportunity with a portfolio that includes mispriced
security
 Multifactor models and the CAPM
Multifactor models, models of security return that respond to several systematic factors
• Models of security returns that respond to several systematic factors
• Two-factor SML (Security Market Line)
In a two-factor economy of Equation 7.5 , the expected rate of return on a security would
be the sum of three terms:
1. The risk-free rate of return
2. The sensitivity to the market index (i.e., the market beta, β ℑ) times the risk
premium of the index [ E ( r M )−r f ]
3. The sensitivity to interest rate risk (i.e., the T-bond beta, β iTB ¿ times the risk
premium of the T-bond portfolio [ E ( r TB )−r f ]
E ( r i ) =r f + β ℑ [ E ( r M )−r f ] + β iTB [ E ( r TB )−r f ]
 The Fama-French Three-Factor models
o r G −r f =α G + β M ( r M −r f ) + β HML r HML + β SMB r SMB + eG
o Estimation results
Three aspects of successful specification
- Higher adjusted R-square
- Lower residual SD
- Smaller value of alpha
LO 5 ARBITRAGE PRICING THEORY
Arbitrage is the act of exploiting mispricing of two or more securities to achieve risk-free
profits. The first to apply this concept to equilibrium security returns was Ross (1976), who
developed the arbitrage pricing theory (APT). APT is A theory of risk-return relationships
derived from no-arbitrage considerations in large capital markets. It depends on the observation
that well-functioning capital markets preclude arbitrage opportunities. The APT avoids the most
objectionable assumptions of the CAPM.
1. Well-diversified Portfolios and Arbitrage Pricing Theory
Well-diversified is A portfolio sufficiently diversified that non-systematic risk is
negligible. Meanwhile, arbitrage portfolios are a zero-net-investment, risk-free portfolio with a
positive return.
2. The APT and the CAPM
The APT serves many of the same functions as the CAPM. Moreover, the APT highlights
the crucial distinction between no diversifiable risk (systematic or factor risk) that requires a
reward in the form of a risk premium and diversifiable risk that does not. The APT is more
general in that it gets us to the expected return–beta relationship without requiring many of the
unrealistic assumptions of the CAPM, particularly the reliance on the market portfolio.
3. Multifactor Generalization of the APT and CAPM
Expanding the single-factor model to a two-factor model:
R1=α i + β i 1 R M 1+ β i 2 R M 2 +e i
Explanation:
R M 1 & R M 2 = excess returns on portfolios that represent the two systematic factors.
This implies that we can form well-diversified factor portfolios, which is a well-
diversified portfolio constructed to have a beta of 1 on one factor and a beta of zero on any other
factor.

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LO 1.

2. Estimating the Index Model

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