Mean-Free Asset Pricing Model Case Study

The beginning of modern asset pricing models is founded by Markowitz (1952), he presented a new perspective on portfolio selection called Modern Portfolio Theory. Markowitz argues that it is possible to reduce the total portfolio risk by adding more securities to the portfolio and as a result diversifying away idiosyncratic risk of the assets in the portfolio (Appendix 1). A fundamental item of his diversification strategy is adding assets with a low or even negative correlation across the portfolio. Consequently, the strategy in portfolio selection changed from a focus on the individual risks and returns of assets to a mean-variance optimization model. The key concept of the mean-variance optimization model is to build a portfolio with the

The risk-free rate has zero volatility in its returns and is uncorrelated with the other assets in the portfolio as well. A tangent line called the capital market line is drawn through the risk-free rate and touches the efficient frontier, the point where the tangent line touches the efficient frontier is called the tangency portfolio (Appendix 2). The combination of the risk-free asset with the tangency portfolio has a superior risk-expected return compared to the other portfolios on the efficient frontier. Using the risk-free asset, investors should make a trade-off between the risk-free asset and the tangency portfolio. The more risk-averse an investor is, the more he invests in the risk-free asset, the more risk-seeking an investor is, the more he invests in the tangency portfolio or even goes short on the risk-free asset to use the proceeds for an additional investment in the tangency

The low Price-to-Earnings portfolios have, on average, higher returns than the high Price-to-Earnings portfolios. As a consequence, Basu argues that publicly available Price-to-Earnings ratios seem to have an information content since according to the efficient market hypothesis all asset prices fully reflect available information in a rapid and unbiased way. Stattman (1980) built further on the findings of Basu a found evidence for a value effect as well, however, his theory was based on the B/M-equity ratio of the firm. He concludes that high B/M-equity firms (value stocks) are realizing a higher expected return than low B/M-equity firms (growth stocks). Rosenberg, Reid and Lanstein (1985) and Chan, Hamao and Lakonishok (1991) showed similar evidence of the persistence of the value effect on respectively the US and Japanese stock markets. Other academics state that the value effect finds its origin in exogenous macroeconomic factors since value stocks are dealing worse with economic downturns or negative external shocks. As a result, including value stocks in a portfolio increases the risk of the portfolio since the performance is poorer during economic downturns in contrast to growth stocks. Because of this additional risk, the investor requires a higher expected return, the difference in expected return between value stocks and growth