Chapter 9

AN INTRODUCTION TO ASSET
PRICING MODELS
 Chapter 9 Questions
What are the assumptions of the capital asset
pricing model?
What is a risk-free asset and what are its risk-
return characteristics?
What is the covariance and correlation
between the risk-free asset and a risky asset
or portfolio of risky assets?
What is the expected return when we
combine the risk-free assets and a portfolio of
risky assets?
 Chapter 9 Questions
What is the standard deviation when we
combine the risk-free asset and a portfolio of
risky assets?
When you combine the risk-free asset and a
portfolio of risky assets on the Markowitz
efficient frontier, what does the set of possible
portfolios look like?
Given the initial set of portfolio possibilities
with a risk-free asset, what happens when
you add financial leverage (that is, borrow)?
 Chapter 9 Questions
What is the market portfolio, what assets are
included in this portfolio, and what are the
relative weights for the alternative assets
included?
What is the capital market line (CML)?
What do we mean by complete
diversification?
How do we measure diversification for an
individual portfolio?
What are systematic and unsystematic risk?
 Chapter 9 Questions
Given the capital market line (CML), what is
the separation theorem?
Given the CML, what is the relevant risk
measure for an individual risky asset?
What is the security market line (SML) and
how does it differ from the CML?
What is beta and why is it referred to as a
standardized measure of systematic risk?
 Chapter 9 Questions
How can we use the SML to determine the
expected (required) rate of return for a risky
asset?
Using the SML, what do we mean by an
undervalued and overvalued security, and
how do we determine whether an asset is
undervalued or overvalued?
What is an asset’s characteristic line and how
do we compute the characteristic line for an
asset?
 Chapter 9 Questions
What is the impact on the characteristic
line when we compute it using different
return intervals (such as weekly versus
monthly) and when we employ different
proxies (that is, benchmarks) for the
market portfolio (for example, the S&P
500 versus a global stock index)?
 Chapter 9 Questions
What is the arbitrage pricing theory
(APT) and how does it differ from the
capital asset pricing model (CAPM) in
terms of assumptions?
How does the APT differ from the
CAPM in terms of risk measure?
Capital Market Theory:
An Overview
Capital market theory extends portfolio theory
and seeks to develops a model for pricing all
risky assets based on their relevant risks
Asset Pricing Models
 Capital asset pricing model (CAPM) allows for the
calculation of the required rate of return for any
risky asset based on the security’s beta
 Arbitrage Pricing Theory (APT) is a multi-factor
model for determining the required rate of return
 Assumptions of
Capital Market Theory
All investors are Markowitz efficient investors
who invest on the efficient frontier.
Investors can borrow or lend any amount of
money at the risk-free rate of return (RFR).
Investors have homogeneous expectations;
that is, they estimate identical probability
distributions for future rates of return.
All investors have the same one-period time
horizon such as one-month, six months, or
one year.
 Assumptions of
Capital Market Theory
All investments are infinitely divisible, which
means that it is possible to buy or sell
fractional shares of any asset or portfolio.
There are no taxes or transaction costs
involved in buying or selling assets.
There is no inflation or any change in interest
rates, or inflation is fully anticipated.
Capital markets are in equilibrium.
 Making Assumptions
Some of these assumptions are clearly
unrealistic
Relaxing many of these assumptions would
have only minor influence on the model and
would not change its main implications or
conclusions.
The primary way to judge a theory is on how
well it explains and helps predict behavior,
not on its assumptions.
 Capital Market Theory
and a Risk-Free Asset
Perhaps surprisingly, there are rather large
implications for capital market theory when a
risk-free asset exists.
What is a risk-free asset?
 An asset with zero variance
 Provides the risk-free rate of return (RFR)
 It will be an “intercept” value on a portfolio graph
between expected return and standard deviation.
Since it has zero variance, it will also have
zero correlation with all other risky assets
 Risk-Free Asset
Covariance between two sets of returns is
n
Cov ij [R i - E(R i )][R j - E(R j )]/n
i 1
Because the returns for the risk free asset are certain,

RF 0 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.
 Combining a Risk-Free
Asset with a Portfolio
Expected return is the weighted average
of the two returns
E(R port ) WRF (RFR) (1 - WRF )E(R i )

This is a linear relationship

 Combining a Risk-Free
Asset with a Portfolio
Standard deviation: The expected variance for a
two-asset portfolio is
2 2 2 2 2
E( port ) w 1 1 w 2 2 2w 1 w 2 r1,2 1 2
Substituting the risk-free asset for Security 1, and the risky
asset for Security 2, this formula would become
2
E( port ) w 2RF 2
RF (1 w RF ) 2 i
2
2w RF (1 - w RF )rRF,i RF i

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
2
E( port ) (1 w RF ) 2 i
2
 Combining a Risk-Free
Asset with a Portfolio
2
Given the variance formula E( port ) (1 w RF ) 2 i
2

the standard deviation is E( (1 w RF ) 2 2

port ) i

(1 w RF ) i

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.
 Combining a Risk-Free
Asset with a 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.
Portfolio Possibilities Combining
the Risk-Free Asset and Risky
Portfolios on the Efficient
E(R ) Frontier
port

D
M
C B
A
RFR

E( port )
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
Portfolio Possibilities Combining
the Risk-Free Asset and Risky
Portfolios on the Efficient
E(R ) Frontier
port

RFR

E( port )
 The Market Portfolio
Portfolio M lies at the point of tangency, so it
has the highest portfolio possibility line
This line of tangency is called the Capital
Market Line (CML)
Everybody will want to invest in Portfolio M
and borrow or lend to be somewhere on the
CML (the CML is a new efficient frontier)
 Therefore this portfolio must include all risky
assets (or else some assets would have no
demand)
 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
 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
 Factors Affecting
Systematic Risk
Systematic risk factors are those
macroeconomic variables that affect the
valuation of all risky assets
 Variability in growth of the money supply
 Interest rate volatility

 Variability in aggregate industrial

production
 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
 Diversifying Away
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, but not to disappear since
correlations are not perfectly negative.
About how many securities must you add to
obtain a completely diversified portfolio?
 About 90% of the benefit after 12-18 stocks
 Maximum benefit needs between 30 and 40
 The Portfolio Standard
Deviation
Standard Deviation of Return
Unsystematic
(diversifiable)
Risk
Total
Risk Standard Deviation of
the Market Portfolio
(systematic risk)
Systematic Risk

Number of Stocks in the Portfolio

 The CML and the
Separation Theorem
The CML leads all investors to invest in the M
portfolio (The Investment Decision)
Individual investors should differ in position
on the CML depending on risk preferences
(which leads to the Financing Decision)
 Risk averse investors will lend part of the portfolio
at the risk-free rate and invest the remainder in the
market portfolio (points left of M)
 Aggressive investors would borrow funds at the
RFR and invest everything in the market portfolio
(points to the right of M)
 A Risk Measure for the
CML
If…
the relevant risk in a portfolio is the average
covariance with all other assets in the portfolio,
and …
the only relevant portfolio is the market portfolio (M),
then it follows that …
the covariance with the market portfolio is the
relevant (systematic) risk of an asset.
 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:
Rit = ai +biRMt +
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
 The Capital Asset
Pricing Model
The existence of a risk-free asset resulted in
deriving a capital market line (CML) that
became the relevant frontier
An asset’s covariance with the market
portfolio is the relevant risk measure
This can be used to determine an appropriate
required rate of return on a risky asset - the
capital asset pricing model (CAPM)
 The Capital Asset
Pricing Model
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
You can compare an expected rate of return
to the required rate of return implied by
CAPM - over/ under valued?
 The Security Market
Line (SML)
The relevant risk measure for an
individual risky asset is its covariance
with the market portfolio (Covi,m)
This is shown as the risk measure
The return for the market portfolio
should be consistent with its own risk,
which is the covariance of the market
with itself - or its variance
The Security Market
Line (SML)
R M - RFR
E(R i ) RFR 2
(Cov i,M )
M
Cov i,M
RFR 2
(R M - RFR)
M

We then define
Cov i,M as beta ( i)
2
M

E(R i ) RFR i (R M - RFR)

 Graph of SML
E(R i )
SML

Rm
Negative
Beta
RFR

0 1.0 Beta(Cov im/ 2 )

M
 Determining the
Expected Return
E(R i ) RFR i (R M - RFR)

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)
 Determining the
Expected Return
In equilibrium, all assets and all portfolios of
assets should plot on the SML
 The SML gives the market “going rate of return” or
what you should earn as a return for a security
 Any security with an expected return that plots
above the SML is underpriced
 Any security with an expected return that plots
below the SML is overpriced
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 expected
return for the securities provide price
and dividend outlooks
 Calculating Beta: The
Characteristic Line
The systematic risk input of an individual asset is derived
from a regression model, referred to as the asset’s
characteristic line with the model portfolio:
R i,t i i R M, t
where:
Ri,t = the rate of return for asset i during period t
RM,t = the rate of return for the market portfolio M during t
i Ri - iRm
i Cov i,M
2
M

the random error term

 Issues in Beta
Estimation
The Impact of the Time Interval
 Number of observations and time interval used in
regression vary
 Value Line Investment Services (VL) uses weekly rates
of return over five years
 Merrill Lynch, Pierce, Fenner & Smith (ML) uses monthly
return over five years
 There is no “correct” interval for analysis
 Weak relationship between VL & ML betas due to
difference in intervals used
 Interval effect impacts smaller firms more
 Issues in Beta
Estimation
The Effect of the Market Proxy
 A measure of the market portfolio is needed
 S&P 500 Composite Index is most often used
 Includes a large proportion of the total market value of
U.S. stocks
 Value weighted series
 Weaknesses of Using S&P 500
as the Market Proxy
 Includes only U.S. stocks
 The theoretical market portfolio should include all types
of assets from all around the world
Arbitrage Pricing Theory
(APT)
CAPM is criticized because of 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
 Assumptions of
Arbitrage Pricing Theory
Capital markets are perfectly
competitive
Investors always prefer more wealth to
less wealth with certainty
The stochastic process generating
asset returns can be presented as a k-
factor model
 Assumptions of CAPM
Not Required by APT
APT does not assume
A market portfolio that contains all risky
assets, and is mean-variance efficient
Normally distributed security returns
Quadratic utility function for investors
Arbitrage Pricing Theory
Rt Et bi1 i bi 2 i ... bik k i
For i = 1 to N where:
Ri = return on asset i during a specified time period
Ei = expected return for asset i
bik = reaction in asset i’s returns to movements in a
common factor
= a common factor with a zero mean that influences
k the returns on all assets

i = a unique effect on asset i’s return that, by

assumption, is completely diversifiable in large
portfolios and has a mean of zero
N = number of assets
Arbitrage Pricing Theory
Multiple factors expected to have an impact on
all assets:
Inflation
Growth in GNP
Major political upheavals
Changes in interest rates
And many more….
Contrast with CAPM assumption that only beta
is relevant
Arbitrage Pricing Theory
(APT)
bik measure how each asset (i) reacts to a
common factor (k)
Each asset may be affected by a factor, but
the effects will differ
In application of the theory, the factors are not
identified
Similar to the CAPM, the unique effects are
independent and will be diversified away in a
large portfolio
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:
 Arbitrage Pricing Theory
(APT)
Ei 0 b
1 i1 b
2 i2 ... b
k ik
where:
0= the expected return on an asset with zero
systematic risk where
0 E 0
1= the risk premium related to each of the common
factors - for example the risk premium related to
interest rate risk
1 E i E 0
bik = the pricing relationship between the risk premium and
asset i - that is how responsive asset i is to this common
factor K
Example of Two Stocks
and a Two-Factor Model
= changes in the rate of inflation. The risk premium
1 related to this factor is 1 percent for every 1
percent change in the rate ( .01)
1

= percent growth in real GNP. The average risk premium

2related to this factor is 2 percent for every 1 percent
change in the rate (2 .02)
= the rate of return on a zero-systematic-risk asset (zero
3beta: b =0) is 3 percent
oj ( 3 .03)
Example of Two Stocks
and a Two-Factor Model
bx1= the response of asset X to changes in the rate of
inflation is 0.50 (bx1 .50)
by1= the response of asset Y to changes in the rate of inflation
is 2.00 (by1 .50)

bx 2 = the response of asset X to changes in the growth rate of

real GNP is 1.50 (bx 2 1.50)
b y 2= the response of asset Y to changes in the growth rate of
real GNP is 1.75 (by 2 1.75)
Example of Two Stocks
and a Two-Factor Model
Ei 0 b
1 i1 b
2 i2

= .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%
Empirical Tests of the
APT
Studies by Roll and Ross and by Chen
support APT by explaining different rates of
return with some better results than CAPM
Reinganum’s study indicated that the APT
does not explain small-firm results
Dhrymes and Shanken question the
usefulness of APT because it was not
possible to identify the factors and therefore
may not be testable