Asset Pricing Model 1

Asset Pricing 1
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Capital Asset Pricing Model
Assumptions
1 All investors choose portfolios that are mean-variance e¢ cient over a
common holding period
2 There is a riskless asset o¤ering the rate of return of r over the
holding period
3 Fictionless markets: can borrow and lend at the riskless rate; can be
short; no transaction costs; perfectly divisible units
4 Perceives the same (µ, Σ)
Derivation of CAPM
Assumption 1: Every investor allocates wealth between the riskless
asset and the tangency portfolio of n risky assets
Assumption 3 implies that it is feasible to do this
Assumption 4: Same tangency portfolio applies to every investor
Everyone wants to hold risky assets in the same relative proportions
It is as if there were some single mutual fund that everyone desired to
hold, which is called market portfolio
Amount for the market portfolio depends on the investor’s wealth and
risk preference
n
pmj j =1 , pmj = Aj Pj 0 /Wm0 , Wm0 = ∑nj=1 Aj Pj 0 ; Wm0 is the
total value of all risky assets and also the total wealth of all investors
Investor i holds a fraction 1 pi 0 of wealth in the market portfolio;
Wm0 = ∑Ii =1 (1 pi 0 ) Wi 0
Derivation of CAPM
Investor i’s optimization problem:
maxU i Wi 0 1 + r + pi0 (µ r 1) , Wi20 pi0 Σpi
pi
First order condition:

UEi Wi 0 (µ r 1) + 2UVi Wi20 Σp = 0,
γi ( µ r 1) = Wi 0 Σpi
= Wi 0 ( 1 pi 0 ) Σpm ,
UEi
γi
2UVi
Summing over all I investors, equilibrium condition becomes
Wm0
µ r1 = Σpm ,
γm
where γm ∑Ii =1 γi .
Derivation of CAPM
De…ne
0 0
Cov Rj , pm R = E Rj µj pm (R µ) = σj pm σjm ,
then
Wm0
µ r1 = Σpm ,
γm
0 Wm0 0
pm (µ r 1) = p Σpm ,
γm m
Wm0 2
µm r = σ ,
γm m
Wm0 µm r
= .
γm σ2m
Derivation of CAPM
From
Wm0
µ r1 = Σpm
γm
We can express
Wm0
µj r = σjm
γm
µm r
= σjm
σ2m
σjm
µj = r + ( µm r) .
σ2m
Derivation of CAPM
Suppose we model an asset return as follows:
Rjt = µj + βj (Rmt µm ) + ujt ,
where ujt is independent of Rmt . Then
E (Rjt jRmt ) µj = βj (Rmt µm )
σjm E Rjt µj (Rmt µm )
= βj E (Rmt µm )2
βj σ2m
σjm
βj =
σ2m
Security market line (SML) :
µj = r + ( µm r ) βj
Interpretation
In equilibrium, expected rate of return increases linearly with its beta
coe¢ cient assuming that µm r > 0
Beta is a measure of an asset’s risk
Sensitivity of the asset’s return to variation in the market return
Covariance risk of asset j in m measured relative to the average
covariance risk of assets, which is just the variance of the market
return.
σ2m = Cov (Rm , Rm ) = Cov pm

0 0
R, Rm = pm 0
Cov (R, Rm ) = pm βσ2m
In economic terms, βjm is proportional to the risk each dollar invested

in asset j contributes to the market portfolio.
If E (Pj 1 + Dj 1 ) = E (Pk 1 + Dk 1 ) and βk > βj , then µk > µj and
Pk 0 < Pj 0
Interpretation
Given E (Pj 1 + Dj 1 ) , Pj 0 depends only on its beta. Only beta matters
0 1 ∂σ2m
σ2m = pm Σpm ; = σjm
2 ∂pmj
σjm 1 ∂σ2m 1
βj = =
σ2m 2 ∂pmj σ2m
Increment to an asset’s expected return that is required to compensate
for its risk is proportional to its own marginal contribution to the
variance of the market port…lio.
The more an asset contributes to the undesirable riskiness of wealth,
the lower will be its equilibrium price.
The variance of the asset’s own rate of return matters only insofar as
its beta depends on it.
If an asset’s return rate is uncorrelated with the market rate
ρjm = 0 , then it is priced as if it were riskless, no matter how great
its own volatility.
Black’s (1972) zero beta

Without riskless asset but allowed to take long or short positions of
any size in any risky asset, we can derive
E (Rj ) = E (Rz ) + βj [E (Rm ) E (Rz )]
where E (Rz ) the expected return on assets uncorrelated with the

market. The Black version says only that E(RZM) must be less than
the expected market return
Empirical evidence
SML has some testable implications:
n
µj , βj will be a straight line
j =1
intercept = riskless interest rate, slope = average excess rate of return
of the market portfolio
Only beta matters on its expected rate of return
Early cross-section regression:
Rj = a + bbβ j + ej ,
a = Rf ; b = E (RM ) Rf
Problems:
b
βj imprecise and having measurement errors: "errors-in-variable"
problem
Residuals have common source of variaration, for example, industry
e¤ect - positive correlation in the residuals produces downward bias in
OLS estimates of the standard errors of the cross-section regression
slopes.
Empirical evidence
To improve precision of estimated betas, work with portfolios, rather
than individual securities
Grouping shrinks the range of betas and reduces statistical power. To
mitigate this problem, sort securities on betas when forming portfolios
Fama and MacBeth (1973): cross-sectional regression
month-by-month instead of a single regression
Rjt rt = γ + γ b 0tβ + ujt ,1t jt
where b
βjt is estimated by the following time-series regression
Rj τ rτ = δj + βj τ (Rmτ rτ ) + uj τ , τ = t 60, ,t 1
Test whether γ0 = ∑ γ b 0t /T is close to zero and γ1 close to market
portfolio’s average excess return rate.
Can fully capture the e¤ects of residual correlation in the regression
coe¢ cients, but sidesteps the problem of actually estimating the
correlations
Empirical evidence
Empirical evidence
Empirical evidence
Time-series regression: Jensen’s (1968) alpha
Rjt Rft = αj + βj (RMt Rft ) + εjt
Empirical evidence for cross-section regression: the intercept is
greater than the average risk-free rate, and the coe¢ cient on beta is
less than the average excess market return rate E (Rm ) Rf
Empirical evidence for time-series regression: the intercept is positive
with low betas and negative with high betas
Figure 2: Estimate a preranking beta for every stock, using two to
…ve years (as available) of prior monthly returns. Then form ten
value-weight portfolios based on these preranking betas and compute
their returns for the next twelve months. Repeat this process for each
year from 1928 to 2003. Figure 2 plots each portfolio’s average return
against its postranking beta, estimated by regressing its monthly
returns for 1928-2003 on the return on the CRSP value-weight
portfolio of U.S. common stocks
Empirical evidence
Empirical evidence
Testing whether market betas explain expected returns (and other
variables have no explaining power):
Cross-section regression: add additional regressors and see their
explanatory power
Time-series regression: form portfolios and see whether the intercept is
non-zero
Results from early tests:
Black version of the CAPM seems to hold - market betas su¢ ce to
explain expected returns and the risk premium is positive
Sharpe-Lintner CAPM does not hold - the premium per unit of beta is
not equal to E (Rm ) Rf
Empirical evidence
Recent tests:
Starting in the late 1970s, empirical work appears that challenges even
the Black version of the CAPM. Speci…cally, evidence mounts that
much of the variation in expected return is unrelated to market beta.
Basu’s (1977) earnings-price ratios
Banz (1981) a size e¤ect
Bhandari (1988) debt-equity ratios
Statman (1980) and Rosenberg, Reid and Lanstein (1985)
book-to-market equity ratios
Fama and French (1992) use the cross-section regression approach to
con…rm that size, earnings-price, debt-equity and book-to-market ratios
add to the explanation of expected stock returns provided by market
beta
Fama and French (1996) reach the same conclusion using the
time-series regression approach applied to portfolios of stocks sorted on
price ratios.
Empirical evidence
Alternative Asset Pricing Model
Fama and French (1993, 1996) propose a three-factor model for

expected returns
E (Rit ) Rft = βiM [E (RMt ) Rft ] + βis E (SMBt ) + βih E (HMLt )
Though size and book-to-market equity are not themselves state

variables, the higher average returns on small stocks and high
book-to-market stocks re‡ect unidenti…ed state variables that produce
undiversi…able risks (covariances) in returns that are not captured by
the market return and are priced separately from market betas.
Fortunately, for some applications, the way one uses the three-factor
model does not depend on one’s view about whether its average
return premiums are the rational result of underlying state variable
risks, the result of irrational investor behavior or sample speci…c
results of chance.
Fama and French (1993, 1996) 3 factor model:
Momentum e¤ect of Jegadeesh and Titman (1993); Carhart (1997)

PR1YR is constructed as the equal-weight average of …rms with the
highest 30 percent eleven-month returns lagged one month minus the
equal-weight average of …rms with the lowest 30 percent
eleven-month returns lagged one month. The portfolios include all
NYSE, Amex, and Nasdaq stocks and are reformed monthly.
Fama and French (2015) 5 factor model

RMWt is the di¤erence between the returns on diversi…ed portfolios
of stocks with robust and weak pro…tability
Pro…tability (measured with accounting data for the …scal year ending
in t-1) is annual revenues minus cost of goods sold, interest expense,
and selling, general, and administrative expenses, all divided by book
equity at the end of …scal year t-1. We call this variable operating
pro…tability, OP, but it is operating pro…tability minus interest expense
CMAt is the di¤erence between the returns on diversi…ed portfolios of
the stocks of low and high investment …rms, which we call
conservative and aggressive.
Inv is the growth of total assets for the …scal year ending in t-1 divided
by total assets at the end of t-1. In the valuation equation (3), the
investment variable is the expected growth of book equity, not assets.
Fama and French (2015) 5 factor model
Stock valuation
∑∞ E [Yt +τ dBt +τ ] / (1 + r )
τ
Mt
= τ =1 (3)
Bt Bt
Fix everything in (3) except the current value of the stock, Mt , and
the expected stock return, r. Then a lower value of Mt , or
equivalently a higher book-to-market equity ratio, Bt /Mt , implies a
higher expected return.
Next, …x Mt and the values of everything in (3) except expected
future earnings and the expected stock return. The equation then
tells us that higher expected earnings imply a higher expected return.
Finally, for …xed values of Bt , Mt , and expected earnings, higher
expected growth in book equity – investment – implies a lower
expected return. Stated in perhaps more familiar terms, (3) says that
Bt /Mt is a noisy proxy for expected return because the market cap
Mt also responds to forecasts of earnings and investment.
Amihud’s (2002) liquidity factor
Amihud’s (2002) liquidity factor
Pastor and Stanbaugh’s (2003) liquidity factor
Pastor and Stanbaugh’s (2003) liquidity factor

The basic idea is that “order ‡ow,” constructed here simply as
volume signed by the contemporaneous return on the stock in excess
of the market, should be accompanied by a return that one expects to
be partially reversed in the future if the stock is not perfectly liquid.
We assume that the greater the expected reversal for a given dollar
volume, the lower the stock’s liquidity. That is, one would expect γi ,t
to be negative in general and larger in absolute magnitude when
liquidity is lower.
Merton’s (1973) intertemporal capital asset pricing model (ICAPM):
ICAPM investors consider how their wealth at t might vary with future
state variables, including labor income, the prices of consumption
goods and the nature of portfolio opportunities at t, and expectations
about the labor income, consumption and investment opportunities to
be available after t
As a result, optimal portfolios are "multifactor e¢ cient," which means
they have the largest possible expected returns, given their return
variances and the covariances of their returns with the relevant state
variables
Yogo’s (2006) Consumption-based CAPM

Household optimization problem
Stock of the durable good:
Dt = ( 1 δ ) Dt 1 + Et
Savings:
N
∑ Bit = Wt Ct Pt Et
i =0
Intertemporal budget constraints:
N
Wt + 1 = ∑ Bit Ri ,t +1
i =0
Epstein-Zin utility
Equilibrium condition:
Et [Mt +1 (Ri ,t +1 R0,t +1 )] = 0 (10)
Market Proxy Problem
Roll (1977) argues that the CAPM has never been tested and
probably never will be.
It is not theoretically clear which assets (for example, human capital)
can legitimately be excluded from the market portfolio, and data
availability substantially limits the assets that are included.
As a result, tests of the CAPM are forced to use proxies for the
market portfolio, in e¤ect testing whether the proxies are on the
minimum variance frontier.
Roll argues that because the tests use proxies, not the true market
portfolio, we learn nothing about the CAPM.
A major problem for the CAPM is that portfolios formed by sorting
stocks on price ratios produce a wide range of average returns, but
the average returns are not positively related to market betas
Market Proxy Problem
It is always possible that researchers will redeem the CAPM by …nding

a reasonable proxy for the market portfolio that is on the minimum
variance frontier.
However, this possibility cannot be used to justify the way the CAPM
is currently applied.
The problem is that applications typically use the same market proxies
References
Amihud, Y., 2002. Illiquidity and stock returns: Cross-section and

time-series e¤ects. Journal of Financial Markets 5, 31–56.
Black, F., 1972. Capital Market Equilibrium with Restricted
Borrowing. Journal of Business 45(3), 444-455.
Carhart, M., 1997. On Persistence in Mutual Fund Performance.
Journal of Finance 52(1), 57-82.
Epps, T.W., 2009. Quantitative Finance (Chapter 6). Wiley.
Fama, E., K. French, 1993. Common risk factors in the returns on
stocks and bonds. Journal of Financial Economics 33, 3-56.
Fama, E., K. French, 2004. The Capital Asset Pricing Model: Theory
and Evidence. Journal of Economic Perspectives 18(3), 25-46.
Fama, E., K. French, 2015. A Five-Factor Asset Pricing Model.
Journal of Financial Economics 116(1), 1-22..
References
Fama, E., J. MacBeth, 1973. Risk, Return, and Equilibrium: Empirical

Tests. Journal of Political Economy 81(3), 607-636.
Merton, R., 1973. An Intertemporal Capital Asset Pricing Model.
Econometrica 41(5), 867-887.
Pastor, L., R. Stambaugh, 2003. Liquidity Risk and Expected Stock
Returns. Journal of Political Economy 111(3), 642-685.
Yogo, M., 2006. A Consumption-Based Explanation of Expected Stock
Returns. Journal of Finance 61(2), 539-580.

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Asset Pricing 1

First order condition:

σ2m = Cov (Rm , Rm ) = Cov pm

In economic terms, βjm is proportional to the risk each dollar invested

Black’s (1972) zero beta

E (Rj ) = E (Rz ) + βj [E (Rm ) E (Rz )]

where E (Rz ) the expected return on assets uncorrelated with the

Fama and French (1993, 1996) propose a three-factor model for

E (Rit ) Rft = βiM [E (RMt ) Rft ] + βis E (SMBt ) + βih E (HMLt )

Though size and book-to-market equity are not themselves state

Fama and French (1993, 1996) 3 factor model:

Fama and French (1993, 1996) 3 factor model:

Fama and French (1993, 1996) 3 factor model:

Momentum e¤ect of Jegadeesh and Titman (1993); Carhart (1997)

Fama and French (2015) 5 factor model

Amihud’s (2002) liquidity factor

Amihud’s (2002) liquidity factor

Pastor and Stanbaugh’s (2003) liquidity factor

Pastor and Stanbaugh’s (2003) liquidity factor

Yogo’s (2006) Consumption-based CAPM

It is always possible that researchers will redeem the CAPM by …nding

Amihud, Y., 2002. Illiquidity and stock returns: Cross-section and

Fama, E., J. MacBeth, 1973. Risk, Return, and Equilibrium: Empirical

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