CAPM and APT

Capital Asset Pricing Model (CAPM)

It is the equilibrium model that underlies all
modern financial theory

Derived using principles of diversification with

simplified assumptions

Markowitz, Sharpe, Lintner and Mossin are

researchers credited with its development

CAPM 2
Assumptions

CAPM 3

CAPM derivation
These assumptions guarantee that the mean-
variance efficient frontier is linear and is the
same for every investor

By the two-fund separation theorem, all

investors invest in the same tangency
portfolio and the risk-free asset (with
different weights).

In equilibrium, this tangency portfolio

coincides with the “market portfolio”

CAPM 4
Efficient frontier – CAL and CML

CAPM 5

Expected returns
CML shows that for all “efficient” portfolios

But what about an arbitrary portfolio (or an

asset) that is not on CML?

CAPM 6
Diversifiable vs. systematic risk
A (efficient) and B (not efficient) have the
same expected return but different volatility
• B contains more diversifiable risk than A, but has
the same systematic risk as A

Portfolio
expected
return A B
Diversifiable risk

Portfolio volatility

CAPM 7

Systematic risk and return tradeoff

Systematic risk earns risk premium
• Holding more systematic risk improves expected
returns

Diversifiable risk does not earn a risk

premium

CAPM 8
Expected returns …
One can derive an equation for expected
returns for any asset using tangency portfolio

where , is the beta of portfolio with

respect to the tangency portfolio

We have now identified the tangency portfolio

as the market portfolio

CAPM 9

CAPM formula

CAPM 10
Beta again
Volatility refers to total risk, sum of
• Diversifiable/Idiosyncratic risk
• Non-diversifiable/Systematic risk

Systematic risk is related to the contribution

to the optimal diversified portfolio aka the
market portfolio

Market beta is related to this systematic risk

Only beta matters

Nothing else matters

CAPM 11

Diversification again

CAPM 12
Security market line

CAPM 13

CAPM inputs
Same for all projects
 : Risk-free return
 : Market risk premium (aka
equity premium)

Project-specific
 : Beta with respect to market

CAPM 14
CAPM implications
Expected return depends only on beta
• Not on whether the project is in hi-tech sector or
utility sector
• Not on whether project size is big or small

Expected return does not depend on volatility

There is a risk-return tradeoff for individual

stocks as long as you measure risk properly
through market betas

CAPM 15

CAPM implications …
Expected return on a risky project that has
zero-beta is equal to the risk-free return
• Because it is assumed that investors can and do
diversify this project’s risk away completely
• What if you, as an individual do not?

CAPM 16
Market betas
What do the betas mean?

CAPM 17

Market beta calculation

Can be calculated using regression

Collect historical data on returns

• Stock,
• Risk-free,
• Market,

Dependent variable,
Independent variable,

Regress
CAPM 18
Wal-Mart beta
Monthly returns from 2010 to 2014
Date S&P500 Rfree WMT Y X
Jan-10 -3.58% 0.01% -0.04% -0.04% -3.58%
Feb-10 3.04% 0.01% 1.20% 1.19% 3.03%
Mar-10 6.10% 0.01% 3.39% 3.38% 6.09%
Apr-10 1.60% 0.01% -3.53% -3.54% 1.58%
May-10 -8.01% 0.01% -5.18% -5.19% -8.02%
Jun-10 -5.35% 0.01% -4.92% -4.93% -5.36%
Jul-10 7.05% 0.01% 6.49% 6.48% 7.03%
Aug-10 -4.54% 0.01% -1.46% -1.47% -4.56%
Sep-10 9.04% 0.01% 6.74% 6.73% 9.03%
Oct-10 3.87% 0.01% 1.21% 1.20% 3.86%
Nov-10 -0.01% 0.01% -0.15% -0.16% -0.02%
Dec-10 6.71% 0.01% 0.26% 0.25% 6.69%
Jan-11 2.33% 0.01% 3.97% 3.96% 2.32%
…

CAPM 19

Wal-Mart beta …
SUMMARY OUTPUT

egression Statistics
Multiple R 0.3936
R Square 0.1549
Adjusted 0.1404
Standard 0.0409
Observat 60

ANOVA
df SS MS F gnificance F
Regressio 1 0.0178 0.0178 10.633 0.0019
Residual 58 0.0969 0.0017
Total 59 0.1146

Coefficientandard Err t Stat P-value ower 95%

Upper 95%
ower 95.0%
pper 95.0%
Intercept 0.005 0.0056 0.904 0.3697 -0.006 0.0162 -0.006 0.0162
X Variabl 0.4612 0.1414 3.2608 0.0019 0.1781 0.7443 0.1781 0.7443

Beta is 0.46
• What does the intercept mean?
CAPM 20
Wal-Mart beta …

CAPM 21

Practical issues in using CAPM

Which risk-free rate?

How to get beta?

What is the equity premium?

CAPM 22
(1) Risk-free rate
CAPM has no concept of multiple periods, and
therefore of different risk-free rates based on
horizon

In practice, choose a risk-free rate with

similar duration to your project
• For valuing stocks, a 10- or 20-year rate is often
used

CAPM 23

(2) Beta
Beta should be the beta of your project
• If the firm engages in a project different from its
core competency, do not use firm beta to
evaluate the project

In M&A, use the beta of the target firm, not

that of the acquirer, to determine how much
to pay

In international projects, calculate beta with

respect to local (foreign) market index
• Especially for emerging, segmented markets
CAPM 24
Beta estimation tips
Get estimates for your company from
websites such as Bloomberg, Yahoo, or
Google

Get estimates for comparables (adjusting for

differences, e.g. leverage) from websites

Estimate your own

Take averages
If estimate too far from 1.0, shrink it closer to 1.0
CAPM 25

Average betas
Betas add-up

If a firm has two divisions, A and B, with

betas, and , and relative weights
(values) of and

CAPM 26
Arbitrage pricing theory (APT)
APT of Ross (1976) is a philosophically
different theory in that it does not rely on
equilibrium but only on the absence of
arbitrage
• More powerful since it does not rely on
assumptions about investor preferences
• Less powerful since it sacrifices economic
identification

APT 27

Factor model
Returns are assumed to be generated from a
factor model with factors

Returns of assets consist of two components

• Systematic Risk: Small number of common
factors that proxy for economic events (changes
in interest rates, inflation, and productivity)
• Non-systematic Risk: Unique to each asset (new
product innovations, changes in management,
lawsuits, labor strikes, etc.)

APT 28
Factor model …
Factor model is just a statistical description of
data

Describes the time-series variation in returns

of a single security

The intercept ( ) in the model (time-series

regression) is left as a free parameter

APT 29

Asset pricing model

Need theory to go from a factor model to an
asset pricing model

APT is one such theory. It says that if the

time-series of returns is described by

then the cross-section of average returns is

described by

APT 30
APT
Essentially, the absence of arbitrage is
enough to ensure that the intercept (alpha) in
the factor model equation is zero
• Strictly speaking, Ross’ APT does not require the
intercept to be zero but only to be “small”
▪ Additional equilibrium conditions need to be imposed to
get strict equality. In this sense, to get a return
equation, one still needs the absence of arbitrage and
equilibrium

APT 31

APT …
Note that the key is the absence of alpha.
Unlike the free intercept in the time-series
regression, the theory imposes the constraint
that the should be zero for all firms

is called as the factor premium

• Need not be equal to . For example, if
, then
• However, if represents excess returns on a
traded factor, then . For example, if
, , , then

APT 32
CAPM and market model
CAPM Market model
Says that Says that
E[r  rf ]   E[rM ]  rf  rt  rft     rMt  rft   et
• This is a statement • This is a statement
about expected about returns every
returns month

Implies that Implies that

rt  rft   rMt  rft   et E[r  rf ]     E[rM ]  rf 
• This is a statement • This is a statement
about returns every about expected
month returns
Difference is in alpha 33

How to choose factors?

1. Factor analysis (purely statistical)
• Factor analysis constructs a limited set of
abstract factors that best replicate the estimated
variances and covariances
• Throws no light on underlying economic
determinants of the covariances
2. Use of macroeconomic variables
• Business cycle risk
• Confidence risk
• Term premium risk
3. Use of firm specific attributes: size, B/M
ratio
APT 34
Example of an APT model
Chen, Roll, and Ross (1985) examine the
following 5 macro variables

Industrial Production (IP), risk premium on corporate bonds

(CG), unanticipated inflation (UI) appear to be factors that have
significant explanatory power

APT 35

Risk decomposition
Factor models can be used for risk
decomposition

where
= total variance
= systematic (factor related) variance
= unsystematic (firm-specific) variance

APT 36
Example

, , , , ,

(why?)
Systematic risk =
= 0.932(3.92)2 = 13.20 (30%)

Unsystematic risk =
= (5.53)2 = 30.62 (70%)

Total risk = 43.82

Standard deviation of MSFT = 6.62%
APT 37

Risk decomposition with factors

If there are factors, represent the
loadings by vector and the factors by
vector

where is the covariance matrix of the

factors

APT 38
Factor models & mv-analysis
Assume 1,000 listed stocks

MV analysis requires 500K numbers

• 1,000 means
• 1,000 variances
• 499,000 covariances

With 1 factor, you need only 3,001 numbers

• 1,000 means
• 1,000 variances
• 1,000 betas
• 1 factor variance
APT 39

Factor models and covariances

Consider two stocks
RA   A   A  F  eA
RB   B   B  F  eB

Then the covariance between the two stocks

is
cov( A, B )   A   B  var( F )

The variance of factors and the covariance

between factors are more robust, statistically
speaking, than the variance of individual
assets and the covariance between assets
APT 40