FINC3017 Investments and Portfolio Management Tutorial 6 Solutions Alternative Asset Pricing Models

1.

Compare and contrast the CCAPM, arbitrage pricing theory, the Fama-French 3factor model and the international CAPM.

The models differ in their definition of what constitutes a risk factor. The CCAPM models expected returns as a function of consumption. The APT describes the expected return relation in terms of multiple risk factors. Similarly, the Fama and French (3-factor) model describes expected return in terms of a market premium, size premium and book-to-market premium. Finally, the ICAPM models returns assuming there are no national boundaries to investment and hence the expected return for any asset is a function of the world market risk premium. All except FF are theoretical models, whereas FF is based on empirical patterns in equity prices and is therefore subject to criticisms of data mining.

2.

Explain why the APT should hold.

The Ross (1976) approach is based on the argument that if a portfolio which is formed with no risk and requires no investment it will have zero expected return. It is argued that arbitrage portfolios can be formed whose returns are not correlated with the underlying factors. This means there is no systematic risk associated with the arbitrage portfolios and so no systematic return is earned by these arbitrage portfolios. Further, the large number of securities used in the construction of the arbitrage portfolios ensures there is no residual risk. If an arbitrage portfolio is formed with these characteristics the portfolio expected return must be equal to zero.

3.

Why is it suggested that the Ross (1976) form of the APT is not an exact pricing model?

Given the formation of arbitrage portfolios based on a large number of assets, it is possible for one or more assets to be mispriced while the total arbitrage portfolio still provides essentially a zero expected return. The difficulty lies in the assumption that the variance of the asset pricing errors reduce to zero, given arbitrage. Errors in pricing are on average zero but this need not occur uniformly across all assets in an arbitrage portfolio.

4.

Small firms will have relatively high loadings (high betas) on the SMB (small minus big) factor. a) Explain why. b) Now suppose two unrelated small firms merge. Each will be operated as an independent unit of the merged company. Would you expect the stock market behaviour of the merged firm to differ from that of a portfolio of the two previously independent firms? How does the merger effect market capitalisation? What is the prediction of the Fama-French three-factor model for the risk premium on the combined firm? Is there a flaw in the Fama-French model? a. The Fama-French (FF) three-factor model holds that one of the factors driving returns is firm size. An index with returns highly correlated with firm size (i.e., firm

capitalization) that captures this factor is SMB (Small Minus Big), the return for a portfolio of small stocks in excess of the return for a portfolio of large stocks. The returns for a small firm will be positively correlated with SMB. Moreover, the smaller the firm, the greater its residual from the other two factors, the market portfolio and the HML portfolio, which is the return for a portfolio of high book-to-market stocks in excess of the return for a portfolio of low book-to-market stocks. Hence, the ratio of the variance of this residual to the variance of the return on SMB will be larger and, together with the higher correlation, results in a high beta on the SMB factor. b. This question appears to point to a flaw in the FF model. The model predicts that firm size affects average returns, so that, if two firms merge into a larger firm, then the FF model predicts lower average returns for the merged firm. However, there seems to be no reason for the merged firm to underperform the returns of the component companies, assuming that the component firms were unrelated and that they will now be operated independently. We might therefore expect that the performance of the merged firm would be the same as the performance of a portfolio of the originally independent firms, but the FF model predicts that the increased firm size will result in lower average returns. Therefore, the question revolves around the behavior of returns for a portfolio of small firms, compared to the return for larger firms that result from merging those small firms into larger ones. Had past mergers of small firms into larger firms resulted, on average, in no change in the resultant larger firms stock return characteristics (compared to the portfolio of stocks of the merged firms), the size factor in the FF model would have failed. Perhaps the reason the size factor seems to help explain stock returns is that, when small firms become large, the characteristics of their fortunes (and hence their stock returns) change in a significant way. Put differently, stocks of large firms that result from a merger of smaller firms appear empirically to behave differently from portfolios of the smaller component firms. Specifically, the FF model predicts that the large firm will have a smaller risk premium. Notice that this development is not necessarily a bad thing for the stockholders of the smaller firms that merge. The lower risk premium may be due, in part, to the increase in value of the larger firm relative to the merged firms.

5.

You work for a company that is considering undertaking a new project. The CAPM says that the cost of equity is 8%. The Fama-French 3-factor model provides a cost of equity of 9%. The macro-factor model of Chen, Roll and Ross (1986) provides a cost of equity of 10%. What are the implications for the valuation of the investment?

If the Fama and French is the correct cost of capital but the CAPM was used instead, then the lower discount rate would understate the risk of the companys cash flows and therefore overstate the value of the project. This error results from the omission of the relevant risk factors of size and book-to-market. If the CRR model is correct then the value of the project would be overstated even more if the CAPM cost of equity had been used. The point is that different models of the risk-return relationship provide different results on the valuation of investments and therefore the valuation of companies. This highlights the reason that we need to find appropriate asset pricing models. 6. Given a one-factor economy, determine whether the three assets below are correctly priced and indicate an arbitrage transaction that could be used to profit from this pricing situation. The risk free return is 2%, while the factor 1 premium is 5%. Asset A Factor 1 (Beta) 1.0 Observed return 0.07

B C

2.0 0.5

0.12 0.06

Under the APT, an arbitrage portfolio consists of a portfolio with zero net investment and zero risk. To enforce zero net investment Wa + Wb + Wc = 0 To enforce zero risk Wa x 1 + Wb x 2 + Wc x 0.5 = 0 Set Wa to one and solve: 1 + Wb + Wc = 0 (1) 1 + Wb x 2 + Wc x 0.5 = 0 (2) From (1) Wb = (1+Wc) (3) substitute (3) in (2) gives: 1 (1+Wc) x 2 + Wc x 0.5 = 0 1 Wc x 1.5 = 0 Wc = 2/3 (4) in (3) gives: Wb = (12/3) = 1/3 Note: The weights sum to zero (1 2/3 1/3 = 0) and so there is zero net investment in the portfolio. The sum of the value weighted sensitivities of the portfolio assets to factor 1 equals zero. (1 x 1 1/3 x 2 2/3 x 0.5 = 0). Thus the systematic risk of the portfolio is zero. The expected return for this arbitrage portfolio is: 1 x 0.07 1/3 x 0.12 2/3 x 0.06 = 0.01 which is not equal to zero. Using the APT model Asset Factor 1 sensitivity A 1.0 B 2.0 C 0.5

Factor 1 premium 0.05 (1 x 0.05) 0.10 (2 x 0.05) 0.025 (0.5 x 0.05)

Risk free return 0.02 0.02 0.02

Expected return 0.07 or 7% 0.12 or 12% 0.045 or 4.5%

It would appear that Asset C is incorrectly priced and that its expected return should be 4.5%, not 6%. If 4.5% is used in the arbitrage portfolio, the portfolio expected return is zero as predicted: 1 x 0.07 1/3 x 0.12 2/3 x 0.045 = 0.0 as required under APT Thus an arbitrage opportunity exists given the current expected return for asset C. Buying asset B and asset C and short selling asset A will generate an arbitrage profit of 1% which will tend to drive up the price of asset C and thus reduce the expected return for this asset to the predicted 4.5% expected under the one factor APT model. In other words if a portfolio is created by short selling one unit of asset A and buying one third of a unit of asset B and two thirds of a unit of asset C then this portfolio has zero systematic risk and involves zero net investment yet it generates a profit of 1% or: 1 x 0.07 + 1/3 x 0.12 + 2/3 x 0.06 = 0.01 or 1% This is not a long term solution and so it is expected that traders will quickly act on this arbitrage profit by trading in this arbitrage portfolio. As assets A and B are correctly priced only the asset C price will change with the arbitrage trading and it will rise until the expected return of 6% (currently observed) drops down to the equilibrium value of 4.5%.