The Capital Asset Pricing Model uses various assumptions about markets and investor behavior to give a set

of equilibrium conditions that allow us to predict the return of an asset for its level of systematic (or non- diversifiable) risk. Capital Asset Pricing Model (CAPM) is a linear model that describes the relationship between risk and expected return of a risky asset. The CAPM formula states that the return on each risky security or portfolio is the risk free rate plus some risk premium for investing in the risky security. The risk premium is the return provided by the "market" less the risk free return. It is the amount of extra return on top the of the risk free rate that you should be compensated for exposing yourself to securities riskier than the risk free asset. Bets ,Systemic risk, or market risk, represents the sensitivity of the security's returns to the market's returns i.e. the beta measures the amount of riskiness of each security.

Various assumptions in CAPM model: Investors maximize expected utility of wealth. Investors have homogenous expectations and use the same input list. Markets are frictionlessthe borrowing rate is equal to the lending rate. There are many investors, each with an endowment of wealth which is small compared to the total endowment of all investors (investors are price-takers). All investors plan for one identical holding period. There are no taxes or transaction costs.

Considering the assumptions ; building the CAPM Model: First, all investors will choose the market portfolio, M, as their optimal portfolio. M includes all assets in the economy, with each asset weighted in the portfolio in proportion to its weight in the economy. Since all investors have the same expectations and use the same input list, they will each choose an identical risky portfolio, which is the portfolio on the efficient frontier that lies on the tangency line drawn from the risk free asset. If any asset were left out of that portfolio its demand would be zero and therefore its price would approach zero. Seeing this, all investors would adjust their portfolio to include this asset until it had a price that would reflect its amount of risk. Thus we can see that all assets will be included in M.

 The market portfolio, M, lies on the efficient frontier and is the tangent asset to the risk-free asset. Since investors all have identical input lists and all hold M, all information about assets in the market is incorporated into M, resulting in an efficient portfolio. Each individual investor will then choose to allocate his wealth between M and the risk free asset, or in other words it is called as the Capital Allocation Line that runs between the risk free asset and the portfolio M. the risk premium on the market portfolio will be proportional to its own risk and the degree of risk aversion of the average investor.

Equation of the CML: r = rf+ (rm rf ) Slope of the CML = rm rf m = price of risk of an efficient portfolio. This indicates how much the expected rate of return must increase if the standard deviation increases by one unit.

Factors that determine the CAPM line: 1. Risk free rate: it is the return on a security or portfolio that is free from default risk and is uncorrelated with returns from anything else in the economy. E.g. rate on government securities and bonds. 2. Market Risk Premium: risk premium is the difference between average return on stocks and the average risk free rate. 3. Beta: The beta for a stock is defined as follows: i = im 2 m where im = the Covariance between the returns on asset i and the market portfolio and 2m = the Variance of the market portfolio. the beta of the market portfolio equals 1 and the beta of the risk-free asset equals 0. An asset's systematic risk, therefore, depends upon its covariance with the market portfolio. The market portfolio is the most diversified portfolio possible as it consists of every asset in the economy held according to its market portfolio weight.

TheSecurityMarketLine(SML)

The SML equation is expressed as follows: E[Ri] = Rf + (E[Rm] Rf ) bi where E[Ri] = the expected return on asset i, Rf = the risk-free rate, E[Rm] = the expected return on the market portfolio, bi = the Beta on asset i, and E[Rm] - Rf = the market risk premium.

Difference between CML and SML: The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the markets risk and return at a given time. The CML measures the risk through standard deviation, or through a total risk factor. On the other hand, the SML measures the risk through beta, which helps to find the securitys risk contribution for the portfolio. The CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for individual stocks.

Arbitrage Pricing Theory (APT)

We have seen total risk of any one individual security as: Total Risk = Systematic risk + unsystematic (diversifiable) risk The Capital Asset Pricing Model assumes any assets systematic or macroeconomic risk is captured by one risk factor the market risk factor. In a well-diversified portfolio, firm specific or diversifiable risk of the various stocks cancel out one another and is essentially eliminated in any well-diversified portfolio.

The Arbitrage Pricing Theory or APT assumes that: 1. Only the systematic risk is relevant in determining expected returns (similar to CAPM). However, there may be several non-diversifiable risk factors (different from CAPM, since CAPM assumes only one risk factor) that are systematic or macroeconomic in nature and thus affect the returns of all stocks to some degree. 2. Firm specific risk, since it is easily diversified out of any welldiversified portfolio, is not relevant in determining the expected returns of securities (similar to CAPM).

The APT model: 1. Does not require investors to hold any particular portfolio. There is no special role for any market portfolio. 2. Only systematic or non-diversifiable risk matters, but there may be several of these macroeconomic risk factors that affect the returns of well diversified portfolios. It is up to the researcher to identify the risk factors. Such risk factors might happen to be unexpected changes in industrial production, inflation, real interest rates, etc. 3. Investors must agree on what the relevant risk factors are. There must be a linear relationship between the risk exposure or sensitivity (its loadings on the risk factors) and expected return of a security. 4. If any asset offers an expected return that is out of equilibrium with respect to the risk factors, then investors can build a zero wealth portfolio in order to exploit the mispricing of the security. This is known as an arbitrage in expectations.

Zero wealth portfolio: it requires that some assets be sold short and the proceeds used to purchase (go long on) other assets. Short selling is the borrowing and selling of an asset that you do not own. You must later repurchase and return the asset. You make a profit when you are able to buy back the asset for a lower price than you sold it for

A representation of a three factor APT model for IBM common stock (this one assumes that there are three economy-wide or systematic risk factors driving the returns of stocks in a well diversified portfolio) would look like the following: E(Ribm) = Rf + ibm,1[R1 - Rf] + ibm,2[R2- Rf] + ibm,3[R3 - Rf] , where E(Ribm) = expected or required return on IBM common stock. Rf= risk-free rate of return (typically Treasury Bills) ibm,1 = IBMs sensitivity (its loading or Beta with respect to risk factor number 1. [R1 - Rf] = the risk premium of any asset having a Beta = 1 with respect to risk factor number 1 and Beta = 0 with respect to risk factors number 2 and 3.