Chapter Topic 5

7 CAPM, APT, FF3 & FF5

models

Bodie, Kane, and Marcus

Essentials of Investments
Eleventh Edition

FBIM 602
 7.1 The Capital Asset Pricing Model
• Capital Asset Pricing Model (CAPM)

• Security’s required rate of return relates to systematic risk

measured by beta

• Risk premium on the market portfolio = variance of the

market portfolio and investor’s typical degree of risk aversion.
• Market Portfolio (M)

• Each security held in proportion to market value

• Everyone holds M in varying proportions depending on risk

aversion (as it will be optimal risky portfolio, the tangency
point of the CAL to the efficient frontier)

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 7.1 The Capital Asset Pricing Model: Assumptions
Market Assumptions Investor Assumptions
All investors are price takers Investors plan for the same (single-
period) horizon

All information relevant to security Investors are efficient users of

analysis is free and publicly analytical methods  investors have
available. homogeneous expectations.

All securities are publicly owned Investors are rational, mean-

and traded. variance optimizers.

No taxes on investment returns.

No transaction costs.
Lending and borrowing at the
same risk-free rate are unlimited.

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 7.1 The Capital Asset Pricing Model
• Hypothetical Equilibrium
• All investors choose to hold market portfolio
• Market portfolio is on efficient frontier, optimal risky portfolio

• Risk premium on market portfolio is proportional to variance

of market portfolio and investor’s risk aversion
(Equation : ) - = )
• Risk premium on individual assets:

• Proportional to risk premium on market portfolio

• Proportional to beta coefficient of security on market
portfolio

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 Figure 7.1 Efficient Frontier and Capital Market Line

If all investors hold an identical risky portfolio, this portfolio

must be the market portfolio. Thus, CAL becomes CML.
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 7.1 The Capital Asset Pricing Model
• Passive Strategy is Efficient
• Mutual fund theorem: All investors desire same portfolio of
risky assets, can be satisfied by single mutual fund (market
index) composed of that portfolio (related to the separation
property in portfolio selection:
• technical side – choice of an efficient mutual fund by professional
management
• personal side – allocation of complete portfolio based on risk
aversion
• If passive strategy is costless and efficient, why follow active
strategy?
• If no one does security analysis, what brings about
efficiency of market portfolio?
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 7.1 The Capital Asset Pricing Model
• Risk Premium of Market Portfolio
• Demand drives prices (buy), lowers expected rate
of return/risk premiums
• When premiums fall, investors move funds into
risk-free asset
• Equilibrium risk premium “fair compensation for
risk” of market portfolio proportional to
• Risk of market
• Risk aversion of average investor

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 EXAMPLE

If rf = 5%; the coefficient of risk aversion of an average investor

= 2 and the standard deviation of the market portfolio is 20%.
The expected rate of return on the market must be:

Answer: use equation 7.1: ) - =

)= + Use decimal form rather than %
= 0.05 + (2 x 0.22) = 0.13 = 13%

If the average degree of risk average was 3, the expected

return would be ….
0.05 + (3 x 0.22) = 0.17 = 17%

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 7.1 The Capital Asset Pricing Model
• Expected Returns on Individual Securities
• Expected return-beta relationship
• Implication of CAPM that security risk premiums
(expected excess returns) will be proportional to
beta

Example: Suppose the risk premium of the South African market portfolio is 9%,
and we estimate the beta of RMB as = 1.3. What is the RMB expected return, if risk
free rate is 5%?

Solution:
E(RRMB) = 16.7%
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 7.1 The Capital Asset Pricing Model
• The Security Market Line (SML) Beta for the individual security = [Cov (ri,rm)]/Var rm.
• Represents expected return-beta relationship of CAPM

• Graphs individual asset risk premiums as function of asset risk

• Alpha

• Abnormal rate of return on security in excess of that predicted by equilibrium

model (CAPM)
• The difference between fair and actual expected return rates of returns

E.g. Suppose the return on the market is expected to be 14% and the T-bill rate
is 6%. What is the alpha of a stock that has a beta of 1.2 and expected return of
17%.
According to SML: E(r) = 6 + 1.2(14 - 6) = 15.6%
17% - 15.6% = 1.4% (see Figure 7.2 on the next slide)

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 Figure 7.2 The SML and a Positive-Alpha Stock

Is the stock overpriced or

under-priced?

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 7.1 The Capital Asset Pricing Model
• Applications of CAPM
• Use SML as benchmark for fair return on risky
asset
• SML provides “hurdle rate” (cutoff IRR) for
internal projects
• See example in the book

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 7.2 CAPM and Index Models
• Index Model, Realized Returns, Mean-Beta
Equation

• : HPR
• i: Asset
• t: Period
• : Intercept of security characteristic line
• : Slope of security characteristic line
• : Index return
• : Firm-specific effects
•

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 7.2 CAPM and Index Models
• Estimating Index Model

• , excess return
• Residual = Actual return Predicted return for
Google

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 Figure 7.4 Scatter Diagram/SCL: Google vs. S&P 500, 01/06-12/10

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 7.2 CAPM and Index Models: SCL
Estimation results
• Security Characteristic Line (SCL)
• Plot of security’s expected excess return over
risk-free rate as function of excess return on
market

• Required rate = Risk-free rate + β x Expected

excess return of index

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Table 7.2 - SCL for Google (S&P 500), 01/06-12/10
Linear Regression

Regression Statistics
R 0.5914
R-square 0.3497
Adjusted R-square 0.3385
SE of regression 8.4585
Total number of
observations 60
Regression equation: Google (excess return) = 0.8751 + 1.2031 × S&P 500 (excess return)

  Coefficients Standard Error t-Statistic p-value LCL UCL

Intercept 0.8751 1.0920 0.8013 0.4262 -1.7375 3.4877
S&P 500 1.2031 0.2154 5.5848 0.0000 0.6877 1.7185

Estimated Value - Hypothesis Value

t
Does Google’s beta differ Standard Error of the Estimate
significantly from the market beta? Example :
1.2031  1
t  .94
0.2154

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 7.2 CAPM and Index Models
• Predicting Betas

• According to the CAPM, a stock’s expected return is driven by beta,

which measures how much the stock and market move together.
Since beta cannot be observed directly, we must estimate its value.

• The most common regression used to estimate a company’s raw beta

is the market model: Ri  a  βRm  
• Mean reversion

• Betas move towards mean over time

• To predict future betas, adjust estimates from historical data to
account for regression towards 1.0
Market beta = 1
High beta: > 1 (riskier than the market index)
Low beta: <1 (less risky than the market index)
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 7.3 CAPM and the Real World
• CAPM is false based on validity of its
assumptions
• Useful predictor of expected returns
• Untestable as a theory
• Principles still valid
• Investors should diversify
• Systematic risk is the risk that matters
• Well-diversified risky portfolio can be suitable
for wide range of investors

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 7.3 Summary of CAPM (own reading)
CAPM determines risk-return trade-off:
• Invest only in the risk-free asset and the market portfolio.

• Beta measures systematic risk.

• Required rate of return is proportional to beta.

CAPM is simple and sensible:

• It is built on modern portfolio theory.

• It distinguishes systematic risk and non-systematic risk.

• It provides a simple pricing model.

CAPM is controversial:
• It is difficult to test (to identify the market portfolio).

• Empirical evidence is mixed.

• Alternative pricing models might do better. – Multiple risks.

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 7.4 Multifactor Models and CAPM
• Multifactor models
• Models of security returns that respond to several
systematic factors
• Two-index portfolio in realized returns

• Two-factor SML

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 7.4 Fama and French’s Three Factor Model
• In 1992, Based on prior research and their own comprehensive
regressions, Fama and French concluded that their tests did not
support the most basic prediction of the CAPM that average stock
returns are positively related to market betas but that:
• Equity returns are inversely related to the size of a company (as
measured by market capitalization) (higher risk premium are
demanded).

• Equity returns are positively related to the ratio of the book value to
market value of the company’s equity.

• With this model, a stock’s excess returns are regressed on three

factors: excess market returns, the excess returns of small stocks over
big stocks (SMB), and the excess returns of high book-to-market
stocks over low book-to-market stocks (HML).
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 7.4 Multifactor Models and CAPM
• Fama-French Three-Factor Model

• Estimation results
• Three aspects of successful specification
• Higher adjusted R-square
• Lower residual SD
• Smaller value of alpha

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 Table 7.2 Multifactor Models and CAPM
Interpret these estimation results

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 7.4 Fama-French Five factor Model
• The Fama-French five-factor model builds on the three-
factor model and introduces two more factors – Profitability
(RMW) and Investment (CMA).
• It uses the return of stocks with high operating profitability
minus the return of stocks with low or negative operating
profitability.
• The investment factor recognizes the level of capital
investment used to maintain and grow the business.
• It is typically negatively correlated with the value factor.
Given the number of factors, the Fama-French five-factor
model is, at times, not practical to be implemented in certain
economies.

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 7.4 Fama-French Five factor Model
• The five-factor model:

• Rit–RFt = ai+ bi(RMt–RFt) + siSMBt+ hiHMLt+riRMWt+ ciCMAt+ eit

• Five factors

1. RMt–RFt = Value-weight market portfolio return – Risk-free return

2. Size = SMBt (Small stock Minus Big stock)
3. B/M ratio = HMLt (High B/M stock Minus Low B/M stock)
4. O/P = RMWt (Robust profitability stock Minus Weak profitability
stock)
5. Inv = CMAt (Low investment firm Minus High investment firm

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 7.5 Arbitrage Pricing Theory
• Arbitrage
• Relative mispricing creates riskless profit

• Arbitrage Pricing Theory (APT)

• Risk-return relationships derived from no-arbitrage
considerations in large capital markets
• Well-diversified portfolio
• Nonsystematic risk is negligible (w is small)
• Arbitrage portfolio
• Positive return, zero-net-investment, risk-free portfolio

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 7.5 Arbitrage Pricing Theory
• Given the impossibility of empirically verifying the CAPM, an alternative
model of asset pricing is the Arbitrage Pricing Theory (APT).
• We can extend the market-risk model to include multiple risks:

• APT holds that the expected return of a financial asset can be modelled
as a linear function of various macroeconomic factors, where sensitivity to
changes in each factor is represented by a factor-specific beta coefficient.
• APT is thus:
Note:
β here is the correlation sensitivity
between asset return and the factor

β in the CAPM is the correlation between

asset return to market.
• λ0 - is the expected return on an asset with zero systematic risk (the risk-
free rate)
• λj - is the risk premium associated to each factor chosen

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 7.5 Arbitrage Pricing Theory
• Calculating APT (single factor APT)

• Returns on well-diversified portfolio

•

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 Table 7.5 Portfolio Conversion

Steps to convert a well-diversified portfolio into an arbitrage portfolio:

*When alpha is negative, you would reverse the signs of each portfolio weight
to achieve a portfolio A with positive alpha and no net investment.

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 Figure 7.5 Security Characteristic Lines

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 7.5 Arbitrage Pricing Theory
• Multifactor Generalization of APT and CAPM
• Factor portfolio
• Well-diversified portfolio constructed to have
beta of 1.0 on one factor and beta of zero on
any other factor
• Two-Factor Model for APT
•

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 Table 7.9 Constructing an Arbitrage Portfolio

Constructing an arbitrage portfolio with two systemic factors

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 Example
Go through example 7.8 on page 211 (11th edition)
• Using the factor portfolios in example 7.8 find the
fair rate of return on a security with = 0.2 and = 1.4
Rf = 4%, ER1 = 10% and ER2 =12%
Answer

ERp = 4 + (0.2 x (10-4))+(1.4x(12-4)) =16.4%

• Remember to use risk premiums

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 Class Examples
1. In a simple CAPM world which of the following statements is (are)
correct?
I. All investors will choose to hold the market portfolio, which includes all
risky assets in the world.
II. Investors' complete portfolio will vary depending on their risk aversion.
III. The return per unit of risk will be identical for all individual assets.
IV. The market portfolio will be on the efficient frontier, and it will be the
optimal risky portfolio.
A. I, II, and III only
B. II, III, and IV only
C. I, III, and IV only
D. I, II, III, and IV

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 2. In the context of the capital asset pricing model, the systematic
measure of risk is captured by _________.
A. unique risk
B. beta
C. the standard deviation of returns
D. the variance of returns

3. In a well-diversified portfolio, __________ risk is negligible. 

A. nondiversifiable
B. unsystematic
C. market
C. Systematic

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 4. According to the capital asset pricing model, a fairly priced security will
plot _________.
A. above the security market line
B. below the security market line
C. along the security market line
D. at no relation to the security market line

5.The graph of the relationship between expected return and beta in the
CAPM context is called the _________. 
A. CML
B. CAL
C. SML
D. SCL

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 6. Consider the CAPM. The risk-free rate is 6%, and the
expected return on the market is 18%. What is the expected
return on a stock with a beta of 1.3?

7. Consider the CAPM. The risk-free rate is 5%, and the

expected return on the market is 15%. What is the beta on a
stock with an expected return of 17%? 

8. You have a $50,000 portfolio consisting of Intel, GE, and Con

Edison. You put $20,000 in Intel, $12,000 in GE, and the rest in
Con Edison. Intel, GE, and Con Edison have betas of 1.3, 1, and
.8, respectively. What is your portfolio beta? 

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 9. Stock XYZ has an expected return of 12% and a beta
equal to 1. Stock ABC is expected to return 13% with a beta
of 1.5. The market’s expected return is 11% and risk-free rate
of 5%. According to the CAPM, which stock is a better buy?
What is the alpha of each stock? Plot the SML and the two
stocks. Show the alphas of each on the graph.

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