Investment Analysis and

Portfolio Management

-Asset Pricing:
Capital Asset Pricing Model
Arbitrage Pricing Theory
 Pricing of Risky Assets
• What attribute is priced at the market
place?
• How is that attribute translated into
market price?

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Capital Asset Pricing Model
Assumptions:
 Investors can choose between portfolios on
the basis of expected return and variance
 All investors are in agreement as to
investment horizon of one time period and
the distribution of security returns
 No friction in the capital market –
financially or informationally

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Capital Asset Pricing Model
 How risky assets are priced in the market
place with respect to their risks if investors
make their investment choices based on
portfolio theory
 Beta – the slope of characteristic line - is
the standard measure of risk
 Prediction is rather simple: Market Portfolio
is efficient

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Attributes of Market Portfolio
 Portfolio of all risky assets
 Not without risk, but that is only systematic
risk – unsystematic risk is eliminated
 Risk of an individual asset is measured by
its contribution to riskiness of market
portfolio
 Variance of returns of an asset is the
aggregate of variation explained by the
market and the residual error– the latter is
not priced
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CAPM is valid
 With no risk-free asset
 With a risk-free asset that cannot be sold
 With lending at risk-free rate, but
borrowing at a higher rate
 With narrow range of transaction costs
CAPM is invalid
 If there is disagreement among investors
 If short-selling is disallowed
 If tax impact on investors differs

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 Empirical Testing of CAPM
 Early tests produced excellent results but were
flawed; portfolios were diversified and likely to be
on MVF – that would produce a linear SML even if
the market portfolio is not on MVF
 Need to test MP being on MVF to prove CAPM
validity – MP of all risky assets is undeterminable
 A correlated market proxy may be used; however,
the correlation is usually unknown
 Individual betas have been found to be unstable and
regress towards mean
 CAPM has turned out to be untestable
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 Factor Models
 Security returns are driven by one (Single Index
Model – impact of all economy-wide factors like
unexpected change in inflation rate, oil price
shock, widespread crop failure etc. are captured
in Market Portfolio) or more (Multi Index Model
– economic factors are reckoned separately)
underlying factors to which each security has
different degree of sensitivity
 Residuals driven by micro factors are
uncorrelated with one another; industry factors
are ignored 8
 Factor Models contd. …..
 Factors themselves are uncorrelated with one
another
 Reduces parameter estimation needs drastically
 Using multiple economic factors make return
estimates stable as the underlying economic
variables are not subject to drastic change
 Identification of factors difficult
 Used in a variety of ways to estimate risk and
return through micro and macro variables
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Arbitrage Pricing Theory
 Arising out of limitations of CAPM
 Less restriction on Investors’ preference
 Empirically testable (arguably)
 Permits existence of one or multiple factors
for determining asset prices
 Not inconsistent with CAPM

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 APT - Assumptions
 Security returns are generated by single or
multiple factor(s)
 Number of securities exceed the number of factors
 Relationship between security returns and factors
(i.e., factor betas and factor prices) is linear
 No restriction on short selling
 Factor Price and Factor Sensitivity determine the
security returns.

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 APT continued…..
* Factor price depends upon the risk-aversion of
investors and how important the factor is as a
source of stock variability.
* Multiple factors - expected to have an impact on
all assets - have not been specified. Examples are
– 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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 Empirical Testing of APT
 Initialtesting through factor analysis found
promising and yielded at the most 5 factors
 APT is silent about the identity of the factors -
Different sets of factors are identified with different
data sets and therefore, fail to explain difference in
returns
 Not explaining the securities returns through certain
factors is not taken as a rejection of APT, but if
explained, it is taken as a proof of APT ( Head I
win, Tail u Loss!)
 Riskless arbitrage with risky securities impossible –
estimation of covariances for the next period is
always done with error only 13