CAPM & APT

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 Capital Market Theory:
An Overview
 Capital market theory extends portfolio
theory and develops a model for pricing all
risky assets
 Capital asset pricing model (CAPM) will
allow you to determine the required rate of
return for any risky asset

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 Capital Asset Pricing Model (CAPM)

 The asset pricing models aim to use the concepts of

portfolio valuation and market equilibrium in order
to determine the market price for risk and
appropriate measure of risk for a single asset.
 Capital Asset Pricing Model (CAPM) has an
observation that the returns on a financial asset
increase with the risk. CAPM concerns two types of
risk namely unsystematic and systematic risks. The
central principle of the CAPM is that, systematic
risk, as measured by beta, is the only factor affecting
the level of return.
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 Capital Asset Pricing Model
 Introduction
 Systematicand unsystematic risk
 Fundamental risk/return relationship
revisited

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 Introduction
 The Capital Asset Pricing Model (CAPM)
is a theoretical description of the way in
which the market prices investment assets
• The CAPM is a positive theory

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 Systematic and
Unsystematic Risk
 Unsystematic risk can be diversified and is
irrelevant

 Systematic risk cannot be diversified and is

relevant
• Measured by beta
– Beta determines the level of expected return on a
security or portfolio (SML)
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 CAPM
 Themore risk you carry, the greater the
expected return:
E ( Ri )  R f   i  E ( Rm )  R f 
where E ( Ri )  expected return on security i
R f  risk-free rate of interest
 i  beta of Security i
E ( Rm )  expected return on the market
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 CAPM (cont’d)
 The CAPM deals with expectations about
the future

 Excess returns on a particular stock are

directly related to:
• The beta of the stock
• The expected excess return on the market

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 CAPM (cont’d)
 CAPM assumptions:
• Variance of return and mean return are all
investors care about
• Investors are price takers
– They cannot influence the market individually
• All investors have equal and costless access to
information
• There are no taxes or commission costs
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 CAPM (cont’d)
 CAPM assumptions (cont’d):
• Investors look only one period ahead

• Everyone is equally adept at analyzing

securities and interpreting the news

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 SML and CAPM
 Ifyou show the security market line with
excess returns on the vertical axis, the
equation of the SML is the CAPM
• The intercept is zero

• The slope of the line is beta

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 Market Model Versus CAPM
 The market model is an ex post model
• It describes past price behavior

 The CAPM is an ex ante model

• It predicts what a value should be

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 Market Model
Versus CAPM (cont’d)
 The market model is:
Rit   i   i ( Rmt )  eit
where Rit  return on Security i in period t
 i  intercept
 i  beta for Security i
Rmt  return on the market in period t
eit  error term on Security i in period t
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 Note on the
CAPM Assumptions
 Several assumptions are unrealistic:
• People pay taxes and commissions
• Many people look ahead more than one period
• Not all investors forecast the same distribution

 Theory is useful to the extent that it helps us learn

more about the way the world acts
• Empirical testing shows that the CAPM works
reasonably well
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 Diversification and the
Elimination of Unsystematic Risk
 The purpose of diversification is to reduce the
standard deviation of the total portfolio
 This assumes that imperfect correlations exist
among securities
 As you add securities, you expect the average
covariance for the portfolio to decline
 How many securities must you add to obtain a
completely diversified portfolio?
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 Diversification and the
Elimination of Unsystematic Risk
Observe what happens as you increase the
sample size of the portfolio by adding
securities that have some positive
correlation

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 Determining the Expected Rate of
Return for a Risky Asset
Stock Beta
Assume: RFR = 6% (0.06)
A 0.70 RM = 12% (0.12)
B 1.00
Implied market risk premium = 6% (0.06)
C 1.15
D
E
1.40
-0.30
E(R i )  RFR   i (R M - RFR)
E(RA) = 0.06 + 0.70 (0.12-0.06) = 0.102 = 10.2%
E(RB) = 0.06 + 1.00 (0.12-0.06) = 0.120 = 12.0%
E(RC) = 0.06 + 1.15 (0.12-0.06) = 0.129 = 12.9%
E(RD) = 0.06 + 1.40 (0.12-0.06) = 0.144 = 14.4%
E(RE) = 0.06 + -0.30 (0.12-0.06) = 0.042 = 4.2% 17
 Price, Dividend, and Rate of Return
Estimates

Current Price Expected Dividend Expected Future Rate

Stock (Pi ) Expected Price (Pt+1) (Dt+1) of Return (Percent)
A 25 27 0.50 10.0 %
B 40 42 0.50 6.2
C 33 39 1.00 21.2
D 64 65 1.10 3.3
E 50 54 0.00 8.0

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Comparison of Required Rate of Return
to Estimated Rate of Return

Required Return Estimated Return

Stock Beta E(Ri ) Estimated Return Minus E(Ri ) Evaluation
A 0.70 10.2% 10.0 -0.2 Properly Valued
B 1.00 12.0% 6.2 -5.8 Overvalued
C 1.15 12.9% 21.2 8.3 Undervalued
D 1.40 14.4% 3.3 -11.1 Overvalued
E -0.30 4.2% 8.0 3.8 Undervalued

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 Arbitrage Pricing Theory
 APT background
 The APT model
 Comparison of the CAPM and the APT

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 Arbitrage Pricing Theory
 Arbitrage Pricing Theory was developed by Stephen Ross
(1976). His theory begins with an analysis of how investors
construct efficient portfolios and offers a new approach for
explaining the asset prices and states that the return on any
risky asset is a linear combination of various
macroeconomic factors that are not explained by this theory
namely.
 Similar to CAPM it assumes that investors are fully
diversified and the systematic risk is an influencing factor in
the long run. However, unlike CAPM model APT specifies
a simple linear relationship between asset returns and the
associated factors because each share or portfolio may have
a different set of risk factors and a different degree of
sensitivity to each of them.

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 APT Background
 Arbitragepricing theory (APT) states that a
number of distinct factors determine the
market return
• Roll and Ross state that a security’s long-run
return is a function of changes in:
– Inflation
– Industrial production
– Risk premiums
– The slope of the term structure of interest rates

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 APT Background (cont’d)
 Not
all analysts are concerned with the
same set of economic information
• A single market measure such as beta does not
capture all the information relevant to the price
of a stock

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 Arbitrage Pricing Theory (APT)
 CAPM is criticized because of the
difficulties in selecting a proxy for the
market portfolio as a benchmark
 An alternative pricing theory with fewer
assumptions was developed:
 Arbitrage Pricing Theory

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 Arbitrage Pricing Theory - APT
Three major assumptions:
1. Capital markets are perfectly competitive
2. Investors always prefer more wealth to
less wealth with certainty
3. The stochastic process generating asset
returns can be expressed as a linear function
of a set of K factors or indexes

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Arbitrage Pricing Theory (APT)
Rt  Et  bi1 i  bi 2 i  ...  bik  k   i
For i = 1 to N where:
Ri = return on asset i during a specified time period
Ei = expected return for asset i
= reaction in asset i’s returns to movements in a common
bik factor
k = a common factor with a zero mean that influences the
returns on all assets


= a unique effect on asset i’s return that, by assumption, is
i completely diversifiable in large portfolios and has a
mean of zero
N = number of assets
 k
Multiple factors expected to have an impact on all assets
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 Arbitrage Pricing Theory (APT)
Multiple factors expected to have an impact
on all assets:
• Inflation
• Growth in GNP
• Major political upheavals
• Changes in interest rates
• And many more….
Contrast with CAPM insistence that only beta
is relevant
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 Arbitrage Pricing Theory (APT)
Bik determine how each asset reacts to this common
factor
Each asset may be affected by growth in GNP, but
the effects will differ
In application of the theory, the factors are not
identified
Similar to the CAPM, the unique effects are
independent and will be diversified away in a
large portfolio
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 Arbitrage Pricing Theory (APT)
 APT assumes that, in equilibrium, the return
on a zero-investment, zero-systematic-risk
portfolio is zero when the unique effects are
diversified away
 The expected return on any asset i (Ei) can
be expressed as:

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 Example-market risk
 Suppose the risk free rate is 5%, the average investor
has a risk-aversion coefficient of A* is 2, and the st.
dev. Of the market portfolio is 20%.
 A) Calculate the market risk premium.
 B) Find the expected rate of return on the market.
 C) Calculate the market risk premium as the risk-
aversion coefficient of A* increases from 2 to 3.
 D) Find the expected rate of return on the market
referring to part c.

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 Answer-market risk

 A) E(rm-rf)=A*σ2m
 Market Risk Premium =2(0.20)2=0.08
 B) E(rm) = rf +Eq. Risk prem
 = 0.05+0.08=0.13 or 13%
 C) Market Risk Premium =3(0.20)2=0.12
 D) E(rm) = rf +Eq. Risk prem
 = 0.05+0.12=0.17 or 17%

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 Example-risk premium

 Suppose an av. Excess return over Treasury

bill of 8% with a st. dev. Of 20%.

 A) Calculate coefficient of risk-aversion of

the av. investor.

 B) Calculate the market risk premium as the

risk-aversion coefficient is 3.5

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 Answer-risk premium
 A) A*= E(rm-rf)/ σ2m =0.085/0.202=2.1

 B) E(rm)-rf =A*σ2m =3.5(0.20)2=0.14 or 14%

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 Example-Portfolio beta and risk premium
Risk Portfolio  Consider the following
Asset Beta prem. Weight
portfolio:
X 1.2 0.5
 A) Calculate the risk
9%
premium on each portfolio
Y 0.8 6 0.3  B) Calculate the total
portfolio if Market risk
Z 0.0 0 0.2 premium is 7.5%.
Port. 0.84  1.0

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 Answer-Portfolio beta and risk premium

 A) (9%) (0.5)=4.5
 (6%) (0.3)=1.8
 =6.3%
 B) 0.84(7.5)=6.3%

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 Example-risk premium
 Suppose the risk premium of the market portfolio
is 8%, with a st. dev. Of 22%.

 A) Calculate portfolio’s beta.

 B) Calculate the risk premium of the portfolio
referring to a portfolio invested 25% in x motor
company with beta 0f 1.15 and 75% in y motor
company with a beta of 1.25.

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 Answer-risk premium
 A) βy= 1.25, βx= 1.15
 βp=wy βy+ wx βx
 =0.75(1.25)+0.25(1.15)=1.225
 B) E(rp)-rf=βp[E(rm)-rf]
 =1.225(8%)=9.8%

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