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Capital market pricing model

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and

Arbitrage Pricing Theory

Jan Mossin provided the basic structure for the

CAPM model.

relationship with assets beta value i.e.,

undiversifiable or systematic risk.

Assumptions

of a stock.

Investors make their decisions only on the basis of

the expected returns, standard deviations and

covariances of all pairs of securities.

Investors are assumed to have homogenous

expectations during the decision-making period.

The investor can lend or borrow any amount of funds

at the riskless rate of interest.

Assets are infinitely divisible.

There is no transaction cost.

There is no personal income tax.

Unlimited quantum of short sales, is allowed.

any amount of money at riskless rate of interest.

Rp = Portfolio return

Xf = The proportion of funds invested in risk free assets

1 Xf = The proportion of funds invested in risky assets

Rf = Risk free rate of return

Rm = Return on risky assets

risk free combination is

R p = R f X f + R m (1 X f )

Market Portfolio

the market.

value to the total value of all risky assets.

Rp

CML

Strongly efficient market

All information is

reflected on prices.

Semi strong efficient market

All public information is

reflected on security prices

Weakly efficient market

All historical information

is reflected on security

Rf

portfolio, that is some money is invested in the

riskless asset.

If it crosses the point S, it becomes borrowing

portfolio.

Money is borrowed and invested in the risky asset.

The straight line is called capital market line (CML).

The CML represents linear relationship between the

required rates of return for efficient portfolios and

their standard deviations.

(R m R f )

ER p = R f +

p

m

Rm = expected return on market portfolio

m = standard deviation of market portfolio

p = standard deviation of the portfolio

Return

Expected return =

Price of time + (Price of risk Amount of risk)

Price of risk is the premium amount higher and

above the risk free return

trade off for other portfolios and individual securities.

Standard deviation includes the systematic and

unsystematic risk.

Unsystematic risk can be diversified and it is not

related to the market.

Systematic risk could be measured by beta.

The beta analysis is useful for individual securities

and portfolios whether efficient or inefficient.

The SML helps to determine the expected return for a

given security beta

Rm Rf

Ri Rf =

COVim/m

m

Y

Rp

SML

S

Rrn

Rf

X

1

Beta

SML

Y

Rp

T

S

C

SML

B

A

W

Rf

V

U

X

0.9

1.0

1.1

1.2

Beta

SML (Contd.)

the same level of risk.

They are underpriced compared to their beta value.

Pi Po + Div

Ri =

Po

where

Pipresent price

Popurchase price

Divdividend.

relationship between the expected return and the systematic

risk.

But the slope of the relationship is usually less than that of

predicted by the CAPM.

The risk and return relationship appears to be linear. Empirical

studies give no evidence of significant curvature in the

risk/return relationship.

The CAPM theory implies that unsystematic risk is not

relevant, but unsystematic and systematic risks are positively

related to security returns.

The ambiguity of the market portfolio leaves the CAPM

untestable.

If the CAPM were completely valid, it should apply to all

financial assets including bonds.

fundamental value.

securities and portfolios.

Given the estimate of the risk free rate, the beta of the

firm, stock and the required market rate of return, one

can find out the expected returns for a firms security.

Arbitrage

taking advantage of differential pricing for the

same asset.

at a high price and the simultaneous purchase

of the same security.

The Assumptions

maximisers.

there is no transaction cost.

Arbitrage Portfolio

out the possibility to increase returns from his

portfolio without increasing the funds in the portfolio.

Factor Sensitivity

a securitys return to a particular factor. The

sensitiveness of the securities to any factor is the

weighted average of the sensitivities of the securities.

Weights are the changes made in the proportion. For

example bA, bB and bC are the sensitivities, in an

arbitrage portfolio the sensitivities become zero.

bA DXA + bB DXB + bC DXC = 0

influenced by a number of macro economic factors.

The macro economic factors are: growth rate of

industrial production, rate of inflation, spread between

long term and short term interest rates and spread

between low grade and high grade bonds. The arbitrage

theory is represented by the equation:

Ri = l0 + l1 bi1 + l2 bi2 + lj bij

where Ri = average expected return

l1 = sensitivity of return to bi1

bi1 = the beta co-efficient relevant to the particular factor

In a single factor model, the linear relationship between

the return Ri and sensitivity bi can be given in the

following form

Ri = lo + libi

lo = riskless rate of return

bi = the sensitivity related to the factor

li = slope of the arbitrage pricing line

the simple form of the CAPM model.

APT is more general and less restrictive than CAPM.

The APT model takes into account of the impact of

numerous factors on the security.

The market portfolio is well defined conceptually. In

APT model, factors are not well specified.

There is a lack of consistency in the measurements of

the APT model.

The influences of the factors are not independent of

each other.

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