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Asset Pricing

The document discusses Arbitrage Pricing Theory (APT) and the Single Index Model (SIM). APT assumes multiple factors influence asset returns rather than just one factor as in CAPM. It states returns are related to a set of indices and factors may include inflation, GDP growth, political events, and interest rates. SIM is a simplified version of the market model that decomposes returns into market and residual components. It expresses stock returns as a function of market returns and assumes residuals are uncorrelated once the market return is removed.

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Brian Dhliwayo
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61 views23 pages

Asset Pricing

The document discusses Arbitrage Pricing Theory (APT) and the Single Index Model (SIM). APT assumes multiple factors influence asset returns rather than just one factor as in CAPM. It states returns are related to a set of indices and factors may include inflation, GDP growth, political events, and interest rates. SIM is a simplified version of the market model that decomposes returns into market and residual components. It expresses stock returns as a function of market returns and assumes residuals are uncorrelated once the market return is removed.

Uploaded by

Brian Dhliwayo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Arbitrage Pricing Theory

Learning outcomes
After the lecture students are expected to:
Understand the APT model and critique
it
Compute the price of a security using
APT
Understand the SI model and critique it
Compute the price of a security using
SIM.
Arbitrage Pricing Theory
The CAPM was criticized by Richard Roll and
others on the basis that it is entirely dependent on
the existence of a "market Portfolio" of risky
assets. They contended that this such a portfolio
does not exist in practice. Ross and others
developed an alternative based on the following
simplifying assumptions:
1. Capital markets are perfectly competitive,
2. Investors always prefer more wealth to less
wealth,
APT

 In APT, the assumption of investors utilizing a


mean-variance framework is replaced by an
assumption of the process of generating security
returns.
 APT requires that the returns on any stock be
linearly related to a set of indices.
 In APT, multiple factors have an impact on the
returns of an asset in contrast with CAPM model
that suggests that return is related to only one
factor, i.e., systematic risk
Factors that have an impact the returns of
all assets may include inflation, growth in
GNP, major political upheavals, or changes
in interest rates
ri = ai + bi1F1 + bi2F2 + …+bikFk + ei
Given these common factors, the bik terms
determine how each asset reacts to this
common factor.
 While all assets may be affected by growth in
GNP, the impact will differ.
 Which firms will be affected more by the growth
in GNP?
 The APT assumes that, in equilibrium, the return
on a zero-investment, zero-systematic risk
portfolio is zero, when the unique effects are
diversified away:
 E(ri) = 0 + 1bi1 + 2bi2 + … + kbik
Examples of such factors include:
· inflation,
· growth rate in the GDP,
· major political upheavals,
· changes in interest rates,
· etc,
Example from module
Single Index Model(Excess R)

 The single-index model (SIM) is a simple asset


pricing model to measure both the risk and the
return of a stock, commonly used in the finance
industry
 It is a Simplified version of Sharpe’s Market
Model
 Decompose returns into market and active
components.
 Postulate that active components are
uncorrelated.
SIM cont

Mathematically the SIM is expressed as:


Rit - rf = α + β (Rm – rf ) + ε
where:rit is return to stock i in period t
rf is the risk free rate (i.e. the interest rate on
treasury bills)
rmt is the return to the market portfolio in
period t is the stock's alpha, or abnormal
return
SIM cont

 β is the stock`s beta co efficient, or


responsiveness to the market return.
 Note that Rm – rf is called the excess return on
the market, Rit - rf the excess return on the
stock are the residual (random) returns.
 This can be reduced to a linear function:
Y = α + βX + ε
SIM cont

 These equations show that the stock return is


influenced by the market (beta), has a firm
specific expected value (alpha) and firm-specific
unexpected component (residual). Each stock's
performance is in relation to the performance of a
market index (such as the All Ordinaries).
Security analysts often use the SIM for such
functions as computing stock betas, evaluating
stock selection skills, and conducting event
studies.
Assumptions SIM

To simplify analysis, the single-index


model assumes that there is only 1
macroeconomic factor that causes the
systematic risk affecting all stock returns
and this factor can be represented by the
rate of return on a market index, such as
the ZSE.
Assumptions SIM

 According to this model, the return of any stock


can be decomposed into the expected excess
return of the individual stock due to firm-specific
factors, commonly denoted by its alpha
coefficient (α), the return due to macroeconomic
events that affect the market, and the unexpected
microeconomic events that affect only the firm.
 Most stocks have a positive covariance because
they all respond similarly to macroeconomic
factors.
Assumptions SIM

 However, some firms are more sensitive to these factors


than others, and this firm-specific variance is typically
denoted by its beta (β), which measures its variance
compared to the market for one or more economic
factors.
 Covariances among securities result from differing
responses to macroeconomic factors. Hence, the
covariance of each stock can be found by multiplying
their betas and the market variance:
 The single-index model assumes that once the market
return is subtracted out the remaining returns are
uncorrelated:
The Market Model
E  Ri   R f  i  E  Rm   R f  Single-index model

The difference between expected

Ri  R f  i  Rm  R f   ei
returns and realized returns is
attributable to an error term, ei.

The market model: the intercept, αi, and slope


coefficient, βi, can be estimated by using
Ri  i  i Rm  ei historical security and market returns. Note αi
= Rf(1 – βi).
Decomposition of Total Risk for a
Single-Index Model
R i  R f  i R m  R f   e i

Total variance = S ystematic variance + Nonsystematic variance

i2  i2 m2  ei2  2Cov R m , e i   i2 m2  ei2

Zero
Example - see handout
Risk Reduction with
Diversification
St. Deviation
Unique Risk
2(eP)=2(e) / n

P2M2
Market Risk

Number of
Securities
Single Factor Model

Solves the number of parameters problem:


– For N assets, it requires N+1 parameters.
– N active risks, 1 market volatility.
Problem with this model: it doesn’t
capture observed correlation structure in
the market. Are EWZ and Delta correlated
only through their market exposure?
Advantage: simplicity makes this useful
for back-of-the-envelope calculations.
The CAPM and the Index Model

 Actual Returns vs Expected Returns


– CAPM is a statement about ex ante or expected
returns whereas all we can observe are actual or
realized holding period returns.
– To make a leap from expected to realized returns, we
can employ the index model.
– The index model beta turns out to be the same beta of
CAPM expected return-beta relationship, except we
place an observable market index instead of the
theoretical market portfolio.
The CAPM and the Index Model

The Index model and the expected return-


beta relationship.
– CAPM:
E(ri)-rf= ßi[E(rm)- rf]
– If the index M is the true market portfolio, we
can take the expectation of each side of the
equation Ri = αi + ßi(Rm) + ei.

E(ri)-rf= αi +ßi[E(rm)- rf]


The CAPM and the Index Model

 If we compare it with CAPM equation the only


difference is αi. CAPM predicts that αi should be
zero for all assets. The alpha of a stock is
expected return in excess of the fair expected
return as predicted by CAPM. If the stock is
fairly priced, its alpha must be zero.
 If we estimate the index model for several firms,
using regression equation, we should find expost
(realized) alphas average will be zero.
The CAPM and the Index Model

CAPM states that the expected value of


alpha is zero for all securities.
Index model states that realized value of
alpha should average zero.
Jensen examine the alphas realized by
mutual funds and found that frequency
distribution of these alphas seem to be
distributed around zero.
Example

See hand out

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