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Capital Asset Pricing Model (CAPM) A model that describes the relationship between risk and expected return

and that is used in the pricing of risky securities.If this expected return does not meet or beat the required return, then the investment should not be undertaken.

The general idea behind CA ! is that investors need to be compensated in two ways" time value of money and risk. The time value of money is represented by the risk#free $r f% rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure $beta% that compares the returns of the asset to the market over a period of time and to the market premium $&m#rf%. Assumptions of Capital Asset Pricing Model (CAPM) '. All investors think in terms of a single period, and they choose among alternative portfolios on the basis of each portfolios expected return and standard deviation over that period. (. All investors can borrow or lend an unlimited amount of money at a given risk free rate of interest and there are no restrictions on short sales of any asset. ). All investors have homogeneous expectations. *. All assts are perfectly divisible and are perfectly marketable at the going price. +. There are no transaction costs. ,. There are no taxes. -. All investors are price taker. .. The quantities of all assets are given and fixed.

Limitation of the CAPM

The model assumes that asset returns are $/ointly% normally distributed random variables. The model assumes that the variance of returns is an adequate measurement of risk. The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets

The model assumes that the probability beliefs of investors match the true distribution of returns.

The model does not appear to adequately explain the variation in stock returns. 0mpirical studies show that low beta stocks may offer higher returns than the model would predict.

The model assumes that given a certain expected return investors will prefer lower risk $lower variance% to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones

The model assumes that there are no taxes or transaction costs, The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitali1ation. This assumes no preference between markets and assets for individual investors, and that investors choose assets solely as a function of their risk# return profile

The market portfolio should in theory include all types of assets that are held by anyone as an investment $including works of art, real estate, human capital.

Capital Market line (CML) The capital market line $C!2% is a line used in the capital asset pricing model to show the rates of return for efficient portfolios depending on the risk#free rate of return and the level of risk $standard deviation% for a particular portfolio. All combinations of the risk#free asset and risky portfolio ! are on C!2, and in equilibrium, all investors will end up with portfolios somewhere on the C!2.

The C!2 is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk#free asset in the portfolio.

Security Market Line (SML) The security market line is a line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities.

The 3!2 essentially graphs the results from the capital asset pricing model $CA !% formula. The x#axis represents the risk $beta%, and the y#axis represents the expected return. The market risk premium is determined from the slope of the 3!2. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the 3!2 graph. If the security4s risk versus expected return is plotted above the 3!2, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the 3!2 is overvalued because the investor would be accepting less return for the amount of risk assumed.

Difference between CML and SML Capital Market Line (CML) Security Market Line (SML)

The C!2 is a line that is used to show the 3!2, which is also called a Characteristic rates of return, which depends on risk#free 2ine, is a graphical representation of the rates of return and levels of risk for a specific market4s risk and return at a given time. portfolio. 5hile standard deviation is the measure of risk 6eta coefficient determines the risk factors of in C!2. the 3!2. 5hile the Capital !arket 2ine graphs define The 3ecurity !arket 2ine graphs define both efficient portfolios. efficient and non#efficient portfolios. C!2 is the basis of the capital market theory. The equation of Capital !arket 2ine" 3!2 is the basis of the CA ! The equation of 3ecurity !arket 2ine"

Arbitrage Pricing heory 3tephen &oss has proposed an approach called the arbitrage pricing theory $A T% n which many factors are required to specify the equilibrium risk7return relationship rather than /ust one or two. The A T can include any number of risk factors, so the required return could be a function of three, four or even more factors. The equation of A T #

!" !rf# $%f% # $&f&''''''''''''# $nfn

Assumptions of Arbitrage Pricing heory (AP ) '. The A T can include any number of risk factors, so the required return could be a function of three, four or even more factors. (. A T is based on complex mathematical and statistical theory.

). A T concept depends on only three risk factors, inflation, industrial production and the aggregate degree of risk aversion. *. A T does not identify the relevant factors beforehand. +. A T does not require that all investors hold the market portfolio. Difference between CAPM and AP (

)*+S ,-.S %( 6riefly describe the similarities and difference between CA ! and A T. &( 3hort notes" 3ecurity !arket 2ine $3!2%, Capital !arket 2ine $C!2%. /( 8escribe both CA ! and the A T and identify the factors determines return in each. 0( 5hat is CA !9 :ow is the A T model consistent with the CA !9 1( 3how the ma/or differences between 3!2 and C!2.