Investment Strategy
Session 5
Chengcheng QU
APM
Office Hour J326 (Green Commons)
Monday/Thursday Period 4
[email protected]Book in advance here 0977-88-6107
Agenda
• CAPM (Capital Asset Pricing Model)
• Factor models
• APT (Arbitrage Pricing Theory)
• Efficient market hypothesis
• Passive strategy
• Active strategy
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CAPM assumptions
• Investor behavior • Market structure
1. Investors are rational, mean- 1. All assets are publicly held and
variance optimizers. trade on public exchanges.
2. Their common planning 2. Investors can borrow or lend at
horizon is a single period. a common risk-free rate, and
3. Investors all use identical input they can take short positions
information and therefore on traded securities.
share the same belief of 3. No taxes.
assets’ value. 4. No transaction costs
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CAPM implications
1. All investors will choose to hold the market
portfolio (M)
2. The market portfolio is the optimal risky portfolio
on the efficient frontier.
3. The risk premium on the market portfolio will be
proportional to the variance of the market portfolio
and investors’ typical degree of risk aversion.
4. The risk premium on individual assets will equal
the product of the risk premium on the market
portfolio (M) and the beta coefficient of the
security on the market portfolio.
4
Expected returns on individual securities
As investors diversify, their exposure to the firm-specific risk of any
individual security steadily diminishes, but their exposure to market wide
movements remains.
As a result, what will matter to diversified investors is the systematic risk of
the portfolio and the contribution each stock makes to that risk.
In equilibrium, the ratio of reward to systematic risk should be equalized
across all stocks.
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Security market line (SML)
SML graphs individual asset risk premiums as
a function of its exposure on systematic risk.
𝐸 𝑟𝑀 − 𝑟𝑓 𝐸 𝑟𝑖 − 𝑟𝑓
=
𝛽𝑀 𝛽𝑖
𝐸 𝑟𝑀 − 𝑟𝑓
𝐸 𝑟𝑖 − 𝑟𝑓 = 𝛽𝑖 .
𝛽𝑀
Given that 𝛽𝑀 = 1, we have the equation:
𝐸 𝑟𝑖 − 𝑟𝑓 = 𝛽𝑖 [𝐸 𝑟𝑀 − 𝑟𝑓 ].
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Factor models
In reality, systematic risk derives from uncertainty in a number of
economywide factors such as business-cycle risk, interest or inflation rate
risk, energy price risk, and so on.
In CAPM, the volatility on the market portfolio return represents systematic
risk.
A multifactor model uses a more explicit representation of systematic risk
and refines CAPM by allowing stocks to exhibit different sensitivities to
various facets of systematic risk.
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Fama-French three-factor model
Standard tool for empirical studies of asset returns with factors
• Market portfolio excess return
• Value factor “HML” (high minus low book-to-market portfolio return)
• Size factor “SMB” (small minus big market capitalization portfolio return)
Fama-French factors and market index return data available at
Kenneth R. French Data Library
8
Fama-French three-factor model
𝑟𝑖,𝑡 − 𝑟𝑓,𝑡 = 𝛽𝑀,𝑖 𝑟𝑀,𝑡 − 𝑟𝑓 + 𝛽𝑆𝑀𝐵,𝑖 𝑟𝑆𝑀𝐵,𝑡 + 𝛽𝐻𝑀𝐿,𝑖 𝑟𝐻𝑀𝐿,𝑡 + 𝜀𝑖,𝑡
9
Smart betas and multifactor models
Smart-beta ETFs are analogous to index ETFs.
However, instead of tracking a broad market index using market
capitalization weights, smart-beta ETFs create exposure to specific
characteristics such as value, growth, volatility, momentum, and etc.
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