BFF5520 Chap.3 Asset Pricing Models
Asset Pricing Models
Asset-pricing models translate risk exposures into required expected returns. CAPM prices systematic market exposure because diversified investors can remove firm-specific risk. Beta measures covariance with the market relative to market variance, not total volatility. The security market line adds the beta-scaled market risk premium to the risk-free rate.
Empirical regressions estimate beta and alpha, while multifactor models test whether returns attributed to abnormal performance under CAPM are better explained by size, value, momentum, profitability, investment or other systematic exposures.
What this chapter covers
- 01
Systematic and idiosyncratic risk
- 02
Beta from covariance
- 03
Security market line
- 04
CAPM required return
- 05
Alpha and mispricing
- 06
Time-series regression
- 07
Coefficient precision
- 08
Multifactor exposures
Worked example · free
Compute beta before required return
- +2Beta = 0.50 × (30%/20%) = 0.75.
- +1Market risk premium = 10% - 4% = 6%.
- +1CAPM required return = 4% + 0.75(6%) = 8.5%.
- +1Forecast alpha = 11% - 8.5% = 2.5 percentage points.
- +1Interpret the positive alpha as conditional on the forecast, beta estimate and benchmark model.
Key terms
- Systematic risk
- Systematic risk is exposure to common market movements that remains in a diversified portfolio.
- Idiosyncratic risk
- Idiosyncratic risk is firm-specific variation that broad diversification can substantially reduce.
- Beta
- Beta is covariance with the market divided by market variance and measures market-premium sensitivity.
- Security market line
- The security market line relates beta to CAPM required expected return.
- Alpha
- Alpha is return beyond the amount predicted by a stated asset-pricing benchmark.
- Factor loading
- A factor loading measures return sensitivity to a systematic factor while other included factors are held fixed.
Asset Pricing Models FAQ
What is the difference between beta and volatility?
Volatility measures total variation in an asset's return. Beta measures only the component associated with market co-movement, scaled by market variance. A volatile security can have modest beta when much of its movement is firm specific.
How does CAPM calculate required return?
CAPM adds the risk-free rate to beta multiplied by the market risk premium. The model compensates market exposure, not diversifiable risk. Every return input must refer to the same period and convention.
What does positive alpha mean?
Positive alpha means return exceeds what the chosen model predicts for measured exposures. It is benchmark dependent and does not automatically prove manager skill, because forecasts, factor omissions and beta error can change the estimate.
How should a regression beta be interpreted?
A beta coefficient gives the change in asset excess return associated with a one-unit change in market excess return within the model. Its standard error or t-statistic must be examined separately to judge estimation precision.
Why add factors beyond the market?
Additional factors test whether persistent return patterns reflect systematic exposures that CAPM omits. If alpha shrinks after adding economically defensible factors, the original result may have been compensation for those exposures rather than unexplained performance.
Exam move
Practise the full chain from correlation and volatilities to beta, from beta to CAPM required return, and from required return to forecast alpha. State percentage points rather than percent change when subtracting return rates. For regressions, always provide an economic interpretation and a precision statement; coefficient magnitude and statistical significance answer different questions.
Learn why market return is converted to an excess return while zero-investment long-short factors are already return spreads. Finish by identifying benchmark risk: alpha can change when the proxy or factor set changes. Create a beta worksheet with three routes: covariance divided by market variance, correlation times the volatility ratio, and direct regression output.
For any data set where two routes are possible, verify that they agree before applying CAPM. Plot a security with positive beta, zero beta and negative beta on the security market line and explain the required-return ordering without appealing to total volatility. Separate the model calculation from the investment judgment by listing forecast uncertainty, estimation error and model misspecification after computing alpha.
When reading multifactor output, make one row per factor with loading, economic exposure, standard error and sign interpretation. A high loading is not automatically a significant loading, and a significant exposure is not alpha. Test limiting cases as well: beta one should require the market return, beta zero should require the risk-free rate under CAPM, and a zero market premium should flatten the line.
Finish each performance claim with the named benchmark and sample period so that evidence is not presented as a permanent characteristic of the asset.
Working through Asset Pricing Models in BFF5520? Sia is AskSia’s AI Finance tutor — ask any BFF5520 Asset Pricing Models question and get a clear, step-by-step explanation grounded in how BFF5520 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
