Capital Asset Pricing Model

&
Arbitrage Pricing Theory

Capital Asset Pricing Model

The CAPM was developed in mid-1960s by three
researchers William Sharpe, John Linter & Jan Mossin.
The model is often referred to as Sharpe-Linter-Mossin
capital asset pricing model.
The CAPM derives the relationship between the expected
return & risk of individual securities & portfolios in
capital markets.

Contd.
Investors attempt to reduce the variability of returns
through diversification of investment. This results in the
creation of Portfolio.
The real risk of a security is the market risk which cannot
be eliminated through diversification.
Higher the risk, higher the return.
CAPM gives the nature of relationship between the
expected return & the systematic risk of a security.

Assumptions of CAPM
Investors make their investment decisions on the basis of
risk-return assessments measured in terms of expected
returns & standard deviation of returns.
Purchases & sales by a single investor cannot affect prices.
This means that there is perfect competition where
investors in total determine prices by their actions.
There are no transaction costs.
There are no personal income taxes.

Contd.
The investor can lend & borrow any amount of funds
desired at a rate of interest equal to the rate of riskless
securities.
Investors share homogeneity of expectations this means
that investors have identical expectations with regard to
the decision period & decision inputs.

Efficient frontier with riskless lending &

borrowing
The portfolio theory deals with portfolios of risky securities.
According to the theory, an investor faces an efficient frontier
containing the set of efficient portfolios of risky assets.
Now it is assumed that there exists a riskless asset available
for investment.
A riskless asset is one whose return is certain such as
government security.
Since the return is certain, the variability of return or risk is
zero.

Contd.
The investor can invest a portion of his funds in the riskless
asset which would be equivalent to lending at the risk free
assets rate of return, namely Rf.
He would then be investing in a combination of risk free asset
& risky assets.
Similarly, it may be assumed that an investor may borrow at
the same risk free rate for the purpose of investing in a
portfolio of risky assets.
The efficient frontier arising from a feasible set of portfolios of
risky assets is concave in shape.

Efficient frontier with lending (Graph 1)

C
B
Portfolio
return(Rp)
A
Portfolio risk

Efficient frontier with borrowing & lending

(Graph 2)
C
B
Portfolio
return(Rp)
A
Portfolio risk

Contd.
The following formulae are used to calculate risk &
return.
Let us consider borrowing funds by the investor for
investing in the risky portfolio an amount which is larger
than his own funds.

Contd.
If W is the proportion of investors funds invested
in the risky portfolio, then there are three
situations:
If w=1, the investors funds are fully committed to the
risky portfolio.
If W<1, only a fraction of funds is invested in the risky
portfolio & the remainder is lend at the risk free rate.
If W>1, it means the investor is borrowing at the risk
free rate & investing an amount larger than his own
funds in he risky portfolio.

Capital Market Line

All investors are expected to have identical expectations.
Hence all of them will face the same efficient frontier
shown in Graph 2.
Every investor will seek to combine the same risky
portfolio B with different levels of lending & borrowing
according to his desired level of risk.
This portfolio of all risky securities is referred to as the
market portfolio M.

Contd
All investors will hold combinations of only two assets,
the market portfolio & a riskless security.
All these combinations will lie along the straight line
representing the efficient frontier.
The line is formed by the action of all investors mixing
the market portfolio with the risk free asset is known as
Capital Market Line(CML).
All efficient portfolios of all investors lie along this capital
market line.

Contd.
The relationship between the return & risk of any
efficient portfolio on the capital market line can be
expressed in the form of the following equation:

Security Market Line

The CML does not describe the risk-return relationship
of inefficient portfolios or of individual securities.
The CAPM specifies the relationship between expected
risk & return for all securities & all portfolios, whether
efficient or inefficient.
The relationship between expected return & beta of a
security can be determined graphically.

Contd.
Let us consider an XY graph where expected returns are
plotted on Y axis & beta on X axis.
A risk free asset has an expected return equivalent to Rf
& beta = zero.
The market portfolio has beta coefficient as one &
expected return equivalent to Rm.
A straight line joining these two points is known as
Security Market Line(SML).
The SML provides the relationship between the expected
return & beta of a security or portfolio.

Contd.
SML
M
Expected
return

Rm

Rf

1.0

2.0

beta

Arbitrage Pricing Theory

Arbitrage pricing theory is one of the tools used by the
investors & portfolio managers.
The capital asset pricing theory explains the returns of
securities on the basis of expected return & variance.
The alternative model developed in asset pricing by Stephen
Ross is known as arbitrage pricing theory.
The APT theory explains the nature of equilibrium in the asset
pricing in a less complicated manner with fewer assumptions
compared to CAPM.

arbitrage
Arbitrage is a process of earning profit by taking
advantage of differential pricing for the same asset. The
process generates riskless profit.
In the security market, it is of selling security at a high
price & the simultaneous purchase of the same security at
a relatively lower price.
Since the profit earned through arbitrage is riskless, the
investors have the incentive to undertake this whenever
an opportunity arises.
In general, some investors indulge more in this type of
activities than others. However, the buying & selling
activities of the arbitrageur reduces & eliminates the
profit margin, bringing the market price to the
equilibrium level.

assumptions of apt
1) The investors have homogeneous expectations.
2) The investors are risk averse & utility
maximisers.
3) Perfect competition prevails in the market &
there is no transaction cost.

arbitrage portfolio
According to the APT theory an investor tries to find out the
possibility to increase returns from his portfolio without
increasing the funds in the portfolio. He also keeps the risk at
the same level.
For example, the investor holds A, B & C securities & he wants
to change the proportion of the securities without any
additional financial commitment.
Now the change in proportion of securities can be denoted by
XA, XB & XC.
The increase in the investment in security A could be carried
out only if he reduces the proportion of investment either in B
or C because it has already stated that the investor tries to
earn more income without increasing his financial
commitment.

.contd
Thus, the changes in different securities will add up to zero. This is
the basic requirement of an arbitrage portfolio.
If X indicates change in proportion
Then
XA+XB+XC=0.
The factor sensitivity indicates the responsiveness of a securitys
return to a particular factor.
The sensitiveness of the securities to any factor is the weighted
average of the sensitiveness of the securities, weights being the
changes made in the proportion.
For example, bA, bB & bC are the sensitiveness, in an arbitrage
portfolio the sensitiveness becomes zero.
I,e
bAXA+bBXB+bCXC=0.

apt & Capm

The simplest form of APT model is consistent with the simple
form of the CAPM model.
It is similar to the capital market line equation which is
similar to CAPM.
APT is more general & less restrictive than CAPM.
In APT, the investor has no need to hold the market portfolio
because it does not make use of the market portfolio concept.
The portfolios are constructed on the basis of the factors to
eliminate arbitrage profits.

.contd
The APT model takes into account of the impact of numerous
factors on the security. The macro economic factors are taken
into consideration & it is closer to reality than CAPM.
In APT model, factors are not well specified. Hence, the
investor finds it difficult to establish equilibrium relationship.
The well defined market portfolio is a significant advantage of
the CAPM leading to the wide usage of the model in the stock
market.
The factors that have impact on one group of securities may
not affect another group of securities. There is a lack of
consistency in the measurement of APT model.