Nottingham Trent University

Nottingham Business School

Corporate Policy & Investment Strategy

Module: ECON40320

Corporate Policy & Investment Strategy Coursework

Student ID: 0664026

Word Count:

PART A:
CPIS 2015-16, Student ID Number: N0664026

Question 1:
Standard
Portfol.
1
2
3
4
5

EXP. Return
8%
10 %
15 %
20 %
25 %

deviation
5%
6%
8%
13 %
18 %

Sharpe ratio
1,00
1,17
1,50
1,31
1,22

; rf = 3%;

(i)

The correct answer is the third portfolio as it has the highest

Sharpe ratio. The bigger the value of the Sharpe ratio is, the
bigger the attractive risk-adjustment return is (Estrada, 2005).
(ii)
0,1 = 0,15y + 0.03 0.03y
Y= 58.33%
1-y = 41.66%
cp = 0.5833 x 0.08 = 4.67%
Building a portfolio with such parameters would be impossible.
The Sharpe ratio is higher than the values in the portfolios ,
therefore it is not possible to obtain the wanted rate of return of
10% with a standard deviation of 4%.
(iii)

According to our case, we are going to use the instance in which

the Sharpe ratio is equal to 1.5. So, in order to be able to
calculate the portfolios expected return that has a 12% standard
deviation,

we

will

adjust

CPIS 2015-16, Student ID Number: N0664026

the

Sharpe

ratio

equation:

 Once we put the information we have:

E(rp) = 1.5 x 12% + 3%
E(rp) = 21%
The expected return will be 21%, if we have a standard
deviation of 12%.
(iv)

For this part we are going to put together all the portfolios into
one larger portfolio, including all 5 of them. The equation for
calculating the expected rate of return for the newly created
portfolio in this case will be:

The expected rate of return for the above mentioned new

portfolio will be the combined weighted rate of each portfolio.
E(rp) = (0.08.0,2) + (0.1x0.2) + (0.15x0.2) + (0.2x0.2) +
(0.25x0.2) = 15.60%
The standard formula for the standard deviation of a portfolio
is:

Nonetheless, for this particular case, we lack the information for

the covariance b/n the portfolios and the correlation coefficient.
Question 2:

= 0.52 x 0.04 + 0.52 x 0.04 + 2 x 0.5 x 0.5 x 0.2 x 0.2 x

0.85 = 0.037
Standard deviation -

CPIS 2015-16, Student ID Number: N0664026

= 0.1924

= 0.52 x 0.04 + 0.52 x 0.04 + 2 x 0.5 x 0.5 x 0.2 x 0.2 x

0.6 = 0.032
Standard deviation -

= 0.1798

= 0.52 x 0.04 + 0.52 x 0.04 + 2 x 0.5 x 0.5 x 0.2 x 0.2 x

0.4 = 0.028
Standard deviation -

= 0.1673

As the Correlation Coefficient calculates the degree to which the two

variables movements are related, the right answer for this case would be
-16.73% since it is the lowest one.

Question 3:
(i)

= 0.22 x 0.052 + 0.22 x 0.12 + 0.32 x 0.22 + 0.32 x 0.32

+ 2 x 0.2 x 0.2 x 0.2 x 0.05 x 0.1 + 2 x 0.2 x 0.3 x 0.1 x
0.05 x 0.2
+ 2 x 0.2 x 0.3 x (-0.1) x 0.05 x 0.3 + 2 x 0.2 x 0.3 x 0.3
x 0.1 x 0.2
+2 x 0.2 x 0.3 x 0.15 x 0.1 x 0.3 + 2 x 0.3 x 0.3 x 0.5 x
0.2 x 0.3
CPIS 2015-16, Student ID Number: N0664026

= 0.0122 + 0.0008 + 0.00012 + (-0.0018) + 0.00072 +

0.00054 + 0.0054
= 0.01726
= 0.01726

= 0.1315 = 13.15%

(ii)

= 0.02 + 0.07-0.02/0.1313 =0.4008 > 40.08%

The equation for CML is the following:
=> rp = 2 +

5/13.73
Rp = 2 + 0.36
The Capital market line is used to illustrate the behavior of the
(iii)

(iv)

investors about portfolios.

SML =

>

= 2 +

. (7 2)
The CML equation > 5=2 + 0.36p > p = 5 2/ 0.36 = 8.33%
=> 5 = 2 + . (7-2) =>

=3/5 =0.6
If the fund is on the SML and CML lines, then the and the
might be measured. In order for us to be able to assimilate how
the funds are going to be invested, we calculate the % of portfolio
and the risk-free asset. So, in this case it is 60% in the MP and
40% go to the risk-free assets.
CPIS 2015-16, Student ID Number: N0664026

(v)

The investor would need to borrow additional funds if he wants to

gain the required return of 10%. The best solution would be to try
to find some at risk-free rate.

1.0 Introduction
The financial markets comprise of various financial asset, which includes equities, hybrid,
debt, and derivatives. The securities require a price tagged to them. Asset pricing is the study
on how the financial assets are priced. Asset pricing evaluates the expected returns and the
possible losses linking to those financials assets. Financial derivatives are a more liquid form
or intangible assets as compared to the tangible assets. They include bank deposits, stocks,
and bonds. Asset pricing entails the determination of expected return and the possible losses
on the investment. According to Sharpe (1964), it is worthy to note that the higher the risk of
the asset, the higher the expected returns from the asset.
CPIS 2015-16, Student ID Number: N0664026

In calculating the anticipated returns and risks, the financial analyst uses various methods.
The commonly used methods are the Capital Asset Pricing Model and the Arbitrage Pricing
Theory. Models of asset pricing are mathematical formulae used in the calculation of a
theoretically appropriate rate of return of an asset. They recount the association between risk
and expected return, hence used in the pricing of the risky derivatives. The discourse will
evaluate the assumptions made while applying the two primary financial models used in
calculating the expected returns and uncertainty. Further, it will elaborate the similarities
between the models and the significant differences isolated.
2.0 Discussion
The asset pricing models operate in a market portfolio. A portfolio is a range of investments
held by a company or an investor. Market portfolios consist of the portfolios of all risky assets
traded in a market. The weights determine the market portfolio in each risky asset and refer
them to as the market capitalization. Suppose there i=1, 2.n risky asset,
Market capitalization of each asset MCAP i= (Price per share)i*(share outstanding )i
Therefore, the market capitalization of all risky assets is
MCAPm= i=1MCAPi where i= 1n.
Thus, the market portfolio with weights in risky asset (i) is
wi= MCAPi / MCAPm
The Expected return from a wallet is the amount an investor expects in return from an
investment in securities. In other words, it is the expected profit from a portfolio.
Further, the risk is the possible loss resulting from factors that affect the overall
production of the financial market. The risk can be categorized into systematic or undiversifiable risk and the unsystematic or diversifiable risk. Furthermore, systematic risk is a
risk that affects the overall market and not just a particular investment or industry. It is neither
predictable nor avoidable as it is caused by natural disasters, which result in the decline of the
market. Additionally, the risk would emanate from other downturns in the market arising from
political instabilities, terrorism, and interest rate change. The risk is contained through
CPIS 2015-16, Student ID Number: N0664026

hedging and not diversification of portfolio as it affects the whole market. Unsystematic risks
result from the performance of a particular security and are avoided through diversification of
the investments. The risk may arise from a company being declared bankrupt.
The Capital Asset Pricing Model requires equilibrium, where the total asset holdings
of all investments equal the total supply of the goods, that is, WM=WT. According to Fama and
French (2004), the model imparts an attractive association between the possible loss and the
asset repayment. The Arbitrage Pricing Theory, assert that the market should be free from
arbitrage. An empirical test of the theory involves a procedure to establish attributes of the
underlying factors rather than a collection of mean and variance that satisfies the linear
relation (Huberman, 2005). Arbitrage is a state in the market where an investor could buy and
sell a currency, security, or derivatives in different markets taking the advantage of different
prices for the same asset. According to (Shleifer & Vishny, 1997) arbitrage in the market
occurs as a result from mispricing an asset.
2.0.1 Assumptions for Asset Pricing Models.
2.0.1.1 The Capital Asset Pricing Model (C.A.P.M).
The model is based on various assumptions, which enable its application in a market
portfolio. It assumes that all the capitalists aim at maximizing economic utility, that is the
ability of the asset to satisfy one or more wants of a customer. Secondly, it assumes that they
are sensible and risk-averse. Risk aversion implies that investors detest possible loss, unlike
risk-taker investors, who takes the risks. Risk-averse investors will avoid adding high-risk
investments in their portfolio despite the expected higher return. Risk-averse investors would
consider a low-risk stock such as the government bonds. Contrary, the risk-takers investors
would consider taking a high-risk investment, for example, the corporate bonds, which
depend on the performance of the company.

CPIS 2015-16, Student ID Number: N0664026

Further, the model assumes that the capitalist diversify their Portfolios across a range of
derivatives.
Additionally, the model assumes that investors are price takers, which mean that they
cannot influence prices of investment. They can also loan and borrow any amounts at the riskfree interest rate. The model also assumes that investors would trade without the transaction
or taxation costs. Capital asset pricing model further assumes that the investors deal with an
investment that is highly divisible into smaller part. The assets should be divisible and liquid.
Consequently, it presumes the consistent expectations and all information is available to all
investors simultaneously avoid taking advantages over others.
Capital Asset Pricing Models supposes that each additional asset in a portfolio
similarly diversifies the portfolio thus reducing the unsystematic risk. Subsequently, the
model determines the expected excess returns. The excess returns are the returns from an
investment in a portfolio that is above the benchmark with the same level of possible loss. It
determines the value added by the collection, or the manager's ability to beat the market,
known as the alpha. Capital Asset Pricing Model is, therefore, able to build up a diversified
portfolio through the availability of information to the investors. Nonetheless, there are
limitations in using the CAPM as the model supposes that all the investors have similar
preferences, hold the same investments, and same information regarding the market. It is also
difficult to establish and determine the market return, as the model bases on too many
assumptions.
2.0.1.2 The Arbitrage Pricing Theory (APT).
Arbitrage is the process of drawing positive expected return from overvalued or undervalued
investments. It assumes that the portfolio market is inefficient, and there is no increase in risk
and additional investment. The Arbitrage model would, therefore, explain the unsystematic
risk. From the definition of arbitrage, the model presumes that there is no investment addition.

CPIS 2015-16, Student ID Number: N0664026

It does not diversify the securities, although some investors could diversify their portfolio.
The Arbitrage Pricing Model indicates a pricing association with some systematic factors.
The model calculates the asset price based on the law of one price and no arbitrage in the
security market. In a mathematical technique, there is no need to assume that all investors are
homogenous. As a result, the Arbitrage Pricing Theory is more acceptable to use as compared
the Capital Asset Pricing Model.
The assumptions made in using APT are: firstly, all the investments have an explicit
expected value and variances. Additionally, it assumes that some capitalists can form a
diversified portfolio, with no taxes and transaction costs. Therefore, APT would price an asset
in relation, to other assets. The linear factor model framework of Arbitrage Pricing Theory is
used as the principle of many commercial risk systems embraced by most asset managers due
to its calculations simplicity.
3.0 The Similarities and the Differences of the Models.
3.0.1 The Similarities between CAPM and APT.
The Arbitrage Price Theory and Capital Asset Pricing Model depict some similarities. Firstly,
the two models on asset pricing are the most dominating in the security markets. Further, both
theories suppose that there are no tariffs imposed on the securities. Additionally, they presume
that the investors are alike and incline towards risk aversions. The models take an assumption
that there would be no transactional charges on the securities. Besides, the models deduce that
there are no restrictions on investing in a particular portfolio.

3.0.2 The Differences between CAPM and APT.

The difference between APT and CAPM is that APT is derived from a statistical model,
unlike CAPM, which is an equilibrium asset pricing model. Further, APT differs from CAPM
since it is unrestrictive in its assumptions. It grants for an explanatory model of asset returns

CPIS 2015-16, Student ID Number: N0664026

as opposed to the mathematical model. ATP further holds that each investor would hold an
original investment with specific factors. APT could be seen as supply model, as the
coefficients indicate the sensitivity of the underlying asset to economic factors. These factors
would result in a change in the assets' expected returns. Contrary, Capital Market Pricing
Model is regarded as the demand side model. In CAPM, the elements specific betas are
calculated using a linear regression of the past securities returns. As opposed to CAPM, APT
does not expose the status of it priced items, as the number and character of the elements are
bound to change between economies.
4.0 The Choice of Model a Portfolio Manager Would Adopt.
As a portfolio manager, the Arbitrage Pricing Theory is the best model to take in asset pricing.
The theory is easy to use and apply since it has few assumptions. Further, it uses a statistical
model, unlike the Capital Asset Pricing Model, which applies if there is market equilibrium.
The Arbitrage theory allows pricing an asset in relation, to other assets. It operates on a linear
factors framework thus the basis for many commercial risk systems.
Additionally, the model does not expose it priced factors. It is, therefore, easy and
simple to understand, as well as to apply in any security investments. Unlike Arbitrage theory,
in Capital pricing model, it is hard to pinpoint the market portfolios. Arbitrage Theory can
also expand the market risk model to allow for more inclusion of risks. It is, therefore, the
best model to work with on a market portfolio.
Conclusion
It is vital for any investor to understand the pricing for the intended financial investments.
Additionally, investors would like to establish the possible loss that would result from
investing into a particular derivative. The Capital Asset Pricing Model determines the riskreturn trade-off. It invests only in the risk-free asset and market portfolios with a beta
component determine the systematic risk where the expected rate of return is proportional to
beta. The model builds on modern portfolio theory and distinguishes systematic and nonCPIS 2015-16, Student ID Number: N0664026

systematic risk. The Arbitrage Pricing Theory gives a description of the proceeds and risks.
However, the theory does not suggest the factors that are right, but generally, the level of risk
is determined by macroeconomic factors.

CPIS 2015-16, Student ID Number: N0664026

References
1. Fama, E.F., and French, K.R., 2004. The capital asset pricing model: Theory and
evidence. Journal of Economic Perspectives, 18, pp.25-46.
2. Huberman, G., 2005. Arbitrage pricing theory (No. 216). Staff Report, Federal
Reserve Bank of New York.
3. Sharpe, W.F., 1964. Capital asset prices: A theory of market equilibrium under
conditions of risk*. The journal of finance, 19(3), pp.425-442.
4. Shleifer, A. and Vishny, R.W., 1997. The limits of arbitrage. The Journal of Finance,
52(1), pp.35-55.

CPIS 2015-16, Student ID Number: N0664026