NAME:
EGUANUKU HARRY EFE
MAT. NO. :
PG-MGS1714779
COURSE TITLE:
SECURITY ANALYSIS AND PORTFOLIO
THEORY
COURSE CODE:
FIN 836
DATE: APRIL, 2019.
SHARPE SINGLE INDEX MODEL
The single-index model (SIM) is a simple asset pricing model to measure both the risk and the
return of a stock. The model has been developed by William Sharpe in 1963 and is commonly
used in the finance industry. Sharpe W.E. (1964) justified that portfolio risk is to be identified
with respect to their return co-movement with the market and not necessarily with respect to
within the security co-movement in a portfolio.
Markowitz Model had serious practical limitations due to the rigours involved in compiling the
expected returns, standard deviation, variance, covariance of each security to every other
security in the portfolio. Sharpe Model has simplified this process by relating the return in a
security to a single Market index. Firstly, this will theoretically reflect all well traded securities in
the market. Secondly, it will reduce and simplify the work involved in compiling elaborate
matrices of variances as between individual securities. Mathematically the SIM is expressed as:
rit ___ rf = αi + β1(RMt - Rft ) + ϵit
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
αi is the stock's alpha, or abnormal return
β1 is the stocks's beta, or responsiveness to the market return
Note that rit ___ rf is called the excess return on the stock, rMt - rft the excess return on
the market
ϵit are the residual (random) returns, which are assumed independent normally
distributed with mean zero and standard deviation .
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 OF SINGLE INDEX MODEL
1. There is only 1 macroeconomic factor that causes systematic risk affecting all stock
returns and this factor can be represented by the rate of return on a market index, such
as the S&P 500.
2. 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
(a), which is the return that exceeds risk-free rate.
3. The return due to macroeconomic events that affect the market, and the unexpected
microeconomic event that affect only the firm.
The term β1(RMt - Rft ) represents the movement of the market modified by the stock's beta,
while ϵit represents the unsystematic risk of the security due to firm-specific factors.
Macroeconomic events, such as changes in interest rates or the cost of labour, causes the
systematic risk that affects the returns of all stocks, and the firm-specific events are the
unexpected microeconomic events that affect the returns of specific firms, such as the death of
key people or the lowering of the firm's credit rating, that would affect the firm, but would
have a negligible effect on the economy. In a portfolio, the unsystematic risk due to firm-
specific factors can be reduced to zero by diversification.
The index model is based on the following:
Most stocks have a positive covariance because they all respond similarly to macroeconomic
factors.
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.
Covariance 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
CAPITAL ASSET PRICING MODEL (CAPM)
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
the expected return and risk of investing in a security. It shows that the expected return on a
security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security.
The Capital Asset Pricing Model
In finance, one of the most important things to remember is that return is a function of risk.
This means that the more risk you take, the higher your potential return should be to offset
your increased chance for loss.
One tool that finance professionals use to calculate the return that an investment should bring
is the Capital Asset Pricing Model which we will refer to as CAPM for this lesson. CAPM
calculates a required return based on a risk measurement. To do this, the model relies on a risk
multiplier called the beta coefficient, which we will discuss later in this lesson.
The formula for calculating the expected return of an asset given its risk is as follows:
ERi = Expected return of investment
Rf = Risk-free rate
βi = Beta of the investment
ERm = Expected return of market
(ERm - Rf) = Market risk premium
Investors expect to be compensated for risk and the time value of money. The risk-free rate in
the CAPM formula accounts for the time value of money. The other components of the CAPM
formula account for the investor taking on additional risk.
The beta of a potential investment is a measure of how much risk the investment will add to a
portfolio that looks like the market. If a stock is riskier than the market, it will have a beta
greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the
risk of a portfolio.
A stock’s beta is then multiplied by the market risk premium, which is the return expected from
the market above the risk-free rate. The risk-free rate is then added to the product of the
stock’s beta and the market risk premium. The result should give an investor the required
return or discount rate they can use to find the value of an asset.
The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and
the time value of money are compared to its expected return.
Like all financial models, the CAPM depends on certain assumptions. Originally there were nine
assumptions, although more recent work in financial theory has relaxed these rules somewhat.
The original assumptions were:
1. Investors are wealth maximizers who select investments based on expected return and
standard deviation.
2. Investors can borrow or lend unlimited amounts at a risk-free (or zero risk) rate.
3. There are no restrictions on short sales (selling securities that you don't yet own) of any
financial asset.
4. All investors have the same expectations related to the market.
5. All financial assets are fully divisible (you can buy and sell as much or as little as you like)
and can be sold at any time at the market price.
6. There are no transaction costs.
7. There are no taxes.
8. No investor's activities can influence market prices.
9. The quantities of all financial assets are given and fixed
Limitations of CAPM
1. It is based on unrealistic assumptions. For example, it is very difficult to find a risk-free
security
2. It is difficult to test the validity of CAPM
3. Betas do not remain stable over time
Problems with the CAPM
There are several assumptions behind the CAPM formula that have been shown not to hold in
reality. Despite these issues, the CAPM formula is still widely used because it is simple and
allows for easy comparisons of investment alternatives.
Including beta in the formula assumes that risk can be measured by a stock’s price volatility.
However, price movements in both directions are not equally risky. The look-back period to
determine a stock’s volatility is not standard because stock returns (and risk) are not normally
distributed.
The CAPM also assumes that the risk-free rate will remain constant over the discounting period.
The market portfolio that is used to find the market risk premium is only a theoretical value and
is not an asset that can be purchased or invested in as an alternative to the stock. Most of the
time, investors will use a major stock index, to substitute for the market, which is an imperfect
comparison.
The most serious critique of the CAPM is the assumption that future cash flows can be
estimated for the discounting process. If an investor could estimate the future return of a stock
with a high level of accuracy, the CAPM would not be necessary.
Capital Asset Pricing Model (CAPM) Summary
The CAPM uses the principles of Modern Portfolio Theory to determine if a security is fairly
valued. It relies on assumptions about investor behaviours, risk and return distributions, and
market fundamentals that don’t match reality. However, the underlying concepts of CAPM and
the associated efficient frontier can help investors understand the relationship between
expected risk and reward as they make better decisions about adding securities to a portfolio.
ARBITRAGE PRICING THEORY
Arbitrage Pricing Theory (APT) is an alternate version of the Capital Asset Pricing Model. (CAPM)
arbitrage pricing theory (APT) is a general theory of asset pricing that holds that the expected
return of a financial asset can be modeled as a linear function of various factors or theoretical
market indices, where sensitivity to changes in each factor is represented by a factor-specific
beta coefficient. The model-derived rate of return will then be used to price the asset
correctly—the asset price should equal the expected end of period price discounted at the rate
implied by the model. If the price diverges, arbitrage should bring it back into line. The theory
was proposed by the economist Stephen Ross in 1976.
The Arbitrage pricing theory based model aims to do away with the limitations of the one-
factor model (CAPM) that different stocks will have different sensitivities to different market
factors which may be totally different from any other stock under observation. In layman terms,
one can say that not all stocks can be assumed to react to single and same parameter always
and hence the need to take multifactor and their sensitivities.
Calculating the Expected Rate of Return of an Asset Using Arbitrage Pricing Theory (APT)
Arbitrage Pricing Theory Formula – E(x) = rf + b1 * (factor 1) +b2 *(factor 2) + ….+ bn *(factor n)
Where,
E(X) = Expected rate of return on the risky asset
Rf = Risk-free interest rate or the interest rate that is expected from a risk-free asset
(Most commonly used in U.S. Treasury bills for the U.S.)
B = Sensitivity of the stock with respect to the factor; also referred to as beta factor 1, 2 …
N = Risk premium associated with respective factor
As the formula shows, the expected return on the asset/stock is a form of linear regression
taking into consideration many factors that can affect the price of the asset and the degree to
which it can affect it i.e. the asset’s sensitivity to those factors.
Arbitrage Pricing Theory Assumptions
The theory is based on the principle of capital market efficiency and hence assumes all market
participants trade with the intention of profit maximization
It assumes no arbitrage exists and if it occurs participants will engage to benefit out of it and
bring back the market to equilibrium levels.
It assumes markets are frictionless, i.e. there are no transaction costs, no taxes, short selling is
possible and an infinite number of securities is available.
Arbitrage Pricing Theory Benefits
APT model is a multi-factor model. So, the expected return is calculated taking into account
various factors and their sensitivities that might affect the stock price movement. Thus, it
allows the selection of factors that affect the stock price largely and specifically.
APT model is based on arbitrage-free pricing or market equilibrium assumptions which to a
certain extent result in a fair expectation of the rate of return on the risky asset.
The apt-based multi-factor model places emphasis on the covariance between asset returns
and exogenous factors, unlike CAPM. CAPM places emphasis on the covariance between asset
returns and endogenous factors.
The APT model works better in multi-period cases as against CAPM which is suitable for single
period cases only.
APT can be applied to the cost of capital and capital budgeting decisions.
The APT model does not require any assumption about the empirical distribution of the asset
returns, unlike CAPM which assumes that stock returns follow a normal distribution and thus
APT a less restrictive model.
Arbitrage Pricing Theory Limitations
The model requires a short listing of factors that impact the stock under consideration. Finding
and listing all factors can be a difficult task and runs a risk of some or the other factor being
ignored. Also, the risk of accidental correlations may exist which may cause a factor to become
substantial impact provider or vice versa.
The expected returns for each of these factors will have to be arrived at, which depending on
the nature of the factor, may or may not be easily available always.
The model requires calculating sensitivities of each factor which again can be an arduous task
and may not be practically feasible.
The factors that affect the stock price for a particular stock may change over a period of time.
Moreover, the sensitivities associated may also undergo shifts which need to be continuously
monitored making it very difficult to calculate and maintain.
Conclusion
Arbitrage Pricing Theory-based models are built on the principle of capital market efficiency
and aim to provide decision-makers and participants with estimates of the required rate of
return on the risky assets. The required rate of return arrived using the APT model can be used
to evaluate, if the stocks are over-priced or under-priced. Empirical tests conducted in the past
have resulted from APT as a superior model over CAPM in many cases. However, in several
cases, it has arrived at similar results as the CAPM model, which is relatively simpler in use.
FAMA–FRENCH THREE-FACTOR MODEL
In asset pricing and portfolio management the Fama–French three-factor model is a model
designed by Eugene Fama and Kenneth French to describe stock returns.
The three factors are;
(1) market risk
(2) the outperformance of small versus big companies
(3) the outperformance of high book/market versus small book/market companies. However,
the size and book/market ratio themselves are not in the model. For this reason, there is
academic debate about the meaning of the last two factors.
The Fama and French Three-Factor Model (or the Fama French Model for short) is an asset
pricing model developed in 1992 that expands on the capital asset pricing model (CAPM) by
adding size risk and value risk factors to the market risk factor in CAPM. This model considers
the fact that value and small-cap stocks outperform markets on a regular basis. By including
these two additional factors, the model adjusts for this outperforming tendency, which is
thought to make it a better tool for evaluating manager performance.
Development
The traditional asset pricing model, known formally as the capital asset pricing model (CAPM)
uses only one variable to describe the returns of a portfolio or stock with the returns of the
market as a whole. In contrast, the Fama–French model uses three variables. Fama and French
started with the observation that two classes of stocks have tended to do better than the
market as a whole.
The Formula for the Fama French Model Is
Rit __ Rft = αit + β1(RMt - Rft ) + β2SMBt + β3HML+ ϵit
Where:
Rit is the total return of a stock or portfolio, i at time t;
Rft is the risk free rate of return at time t;
RMt is the total market portfolio return at time tl
Rit - Rft is expected excess return;
RMt - Rft is the excess return on the market portfolio (index);
SMBt is the size premium (small minus big); and
HMLt is the value premium (high minus low).
β1,2,3 refer to the factor coefficients.
How the Fama French Model Works
Nobel Laureate Eugene Fama and researcher Kenneth French, former professors at the
University of Chicago Booth School of Business, attempted to better measure market returns
and, through research, found that value stocks outperform growth stocks. Similarly, small-cap
stocks tend to outperform large-cap stocks. As an evaluation tool, the performance of
portfolios with a large number of small-cap or value stocks would be lower than
the CAPM result, as the Three-Factor Model adjusts downward for observed small-cap and
value stock out-performance.
The Fama and French model has three factors: size of firms, book-to-market values and excess
return on the market. In other words, the three factors used are SMB (small minus
big), HML (high minus low) and the portfolio's return less the risk free rate of return. SMB
accounts for publicly traded companies with small market caps that generate higher returns,
while HML accounts for value stocks with high book-to-market ratios that generate higher
returns in comparison to the market.
There is a lot of debate about whether the outperformance tendency is due to market
efficiency or market inefficiency. In support of market efficiency, the outperformance is
generally explained by the excess risk that value and small-cap stocks face as a result of their
higher cost of capital and greater business risk. In support of market inefficiency, the
outperformance is explained by market participants incorrectly pricing the value of these
companies, which provides the excess return in the long run as the value adjusts. Investors who
subscribe to the body of evidence provided by the Efficient Markets Hypothesis (EMH) are more
likely to agree with the efficiency side.
Limitations of The Model
1. It is not clear whether HML and SMB capture risk or just persistent mistakes by investors
2. It is difficult to apply
3. There is no theoretical model.
What the Fama French Model Means for Investors
Fama and French highlighted that investors must be able to ride out the extra short-term
volatility and periodic underperformance that could occur in a short time. Investors with a long-
term time horizon of 15 years or more will be rewarded for losses suffered in the short term.
Using thousands of random stock portfolios, Fama and French conducted studies to test their
model and found that when size and value factors are combined with the beta factor, they
could then explain as much as 95% of the return in a diversified stock portfolio.
Given the ability to explain 95% of a portfolio’s return versus the market as a whole, investors
can construct a portfolio in which they receive an average expected return according to the
relative risks they assume in their portfolios. The main factors driving expected returns are
sensitivity to the market, sensitivity to size, and sensitivity to value stocks, as measured by the
book-to-market ratio. Any additional average expected return may be attributed to unpriced or
unsystematic risk.
