CHAPTER 8

CAPITAL MARKET THEORY

Table of Contents
CAPITAL MARKET THEORY ................................................................................................... 89
Table of Contents ...................................................................................................................... 89
Chapter Overview ...................................................................................................................... 90
Learning objectives: .................................................................................................................. 90
8.1 The Capital Asset Pricing Model (CAPM)....................................................................... 90
8.1.1 Lending and borrowing at the riskless rate ................................................................ 91
8.1.2 The Capital Market Line ........................................................................................... 93
8.1.3 The Security Market Line (SML) .............................................................................. 94
8.1.4 The CML vs the SML (CAPM)................................................................................. 97
8.2 The Arbitrage Pricing Theory ........................................................................................... 98
8.3.1 Arbitrage Pricing For One Risk Factor..................................................................... 98
8.2.2 Two factor arbitrage pricing .................................................................................... 100
Checklist .................................................................................................................................. 102
Study Questions ....................................................................................................................... 103

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Chapter 8 Capital market theory

Chapter Overview

Capital Market Theory

• Security market
line
• Capital market
Capital Assets Pricing Models line

Arbitrage Pricing Theory

Learning objectives:

After studying this chapter, students should be able to:

1.List the assumptions of the capital asset pricing model

2.Desribe the risk-free asset and the risk-return characteristics
3.Discuss on the capital market line (CML)
4.Discuss on the securities market line (SML)

8.1 The Capital Asset Pricing Model (CAPM)

The CAPM explains the relationship that should exist between security expected returns and their
risks in term of the mean and standard deviations about security returns. This model is the
extension of portfolio model developed by Markowitz. Using a set of simplifying, the CAPM is
an equation that expresses the equilibrium relationship between a security’s (or portfolio’s)
expected return and its systematic risk.

The set of assumptions in the CAPM are as follow:

i. Investors are risk-adverse and thus have a preference for expected return and
dislike for risk.

ii. Investors act as if they make investment decision on the basis of the expected
return and the variance (standard deviation) about security return distributions.

iii. Investors behave in a normative sense and desire to hold a portfolio that lies
along the efficient frontier.

iv. There is a riskless asset that earns a risk-free rate of return. Furthermore, the
investor can lend or invest at this rate and also borrow at this rate.

v. All investments are perfectly divisible. This means that every security and
portfolio is equivalent to a mutual fund and that fractional shares for any
investment can be purchased.

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vi. All investors have homogeneous expectations with regard to investment horizons
or holding periods and to forecast expected returns and risk level on securities.
This means that investors form their investment portfolios and revise them at the
same interval of time. Furthermore, there is complete agreement among investors
as to the return distribution for each security or portfolio.

vii. There is no imperfections or frictions in the market to impede investor buying

and selling. Specifically, there are no taxes or commission involved with security
transactions. Thus there are no costs involved in diversification and there is no
differential tax treatment of capital gains and ordinary income.

viii. There is no uncertainty about expected inflation; or, alternatively, all security
prices fully reflect all changes in future inflation expectations.

ix. Capital markets are in equilibrium. That is, all investment decision have been
made and there is no further trading without new information.

8.1.1 Lending and borrowing at the riskless rate

With the riskless asset and the ability to borrow or lend (invest) at its rate (RFR), it is possible to
form a portfolio that have risky assets as well the risk-free asset.

E(r)

Borrowing
B
M

Lending
A
rf

Diagram above illustrates borrowing and lending at the risk-free rate and portfolio M is the best
efficient portfolio. Every investor should choose to hold portfolio M, and portfolio M contains all
securities available in the market. Such portfolio is called the market portfolio. Under CAPM
assumption, investors not only can divide their investment between the riskless asset and some
risky, but they can also invest all their money in the risky portfolio and borrow additional funds at
the interest rate of risk-free rate and invest these borrowing funds in the risky portfolio. Investor
A’s optimal portfolio calls for lending, whereas investor B’s optimal position is one of borrowing.
This separation of the investing and financing decisions is called the separation theorem.

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The portfolio expected return for any portfolio that combines risk-free asset and risky asset
(lending portfolio) is:

rp = ∑ wi,j ri,j

= wrf rrf + (1-wrf ) rM

and portfolio variance is:

σ2p = Σ Σ wiwj ρij σiσj

= w2rfσ2rf + w2Mσ2M + 2wrfwMρrf,M σrfσM

Since rf is riskless, σrf = 0’

σ2p = (1- wrf)2σ2M

or

σp = (1- wrf)σM

Example.

Suppose you are interested in investing 60 percent of your wealth in the market portfolio and 40
percent in the risk-free asset. Assume the market portfolio has an expected return of 15 percent
and a standard deviation of 25 percent. The risk-free rate is 6 percent. What is the expected return
and risk of the lending portfolio?

rp = wrf rrf + (1-wrf ) rM

= 0.4(6) + (1- 0.4)(15)

= 11.4%

σp = (1- wrf)σM

= (1- 0.4)(25)
= 15%

Formula for the expected return and standard deviation of borrowing additional money at risk-
free rate and invest in risky asset ( borrowing portfolio) is:

rp = - wrf rrf + (1+ wrf ) rM

σp = (1+ wrf)σM

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Example.

Suppose the standard deviation of the market portfolio is 20 percent, its expected return is 14
percent and the risk-free asset is 7 percent. If you borrow at risk-free rate so that wrf is –0.5 and
invested 1.5 times your wealth in the market portfolio. So that wM = 1.5, what will be your
expected return and risk of the borrowing portfolio?

rp = - wrf rrf + (1+ wrf ) rM

= -0.5(7) + (1 + 0.5)(14)
= 17.5%

σp = (1+ wrf)σM

= (1 + 0.5)(20)
= 30%

8.1.2 The Capital Market Line

With the ability to borrow and lend at the risk-free rate, in conjunction with an investment in
Market Portfolio M, the old curve efficient frontier is transformed into a new efficient frontier,
which is a line passing from rf through M. This new linear efficient frontier is called the Capital
Market Line (CML). The CML not only represents the new efficient frontier, but it also
expresses the equilibrium pricing relationship between E(r) and σ for all efficient portfolios lying
along the line. The CML relationship for any efficient portfolio i is provided in equation:

E(ri) = rf + {[ E(rm) - rf]/ σM })σi

The equation states that the expected return on any efficient portfolio i , E(r) is the sum of two
components: 1) the return on the risk-free investment, rf , and 2) a risk premium,
{[ E(rm) - rf]/ σM })σi , that is proportional to the portfolio’s standard deviation. The slope of
CML, E(rm) - rf]/ σM , is called the market price of risk, and this component is the same for all
portfolios lying along the CML.

E(r)

E(rm) - rf]/ σM CML

rf

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It is important to recognize that the CML pricing equation holds only for efficient portfolios that
lie along its line. That is, only the most efficient, in term of risk-reducing potential, portfolios
that are constructed of combinations of risk-free asset and market portfolio lie along the CML.
All individual securities and inefficient portfolio lie under the curve.

8.1.3 The Security Market Line (SML)

For very well-diversified portfolios, non-systematic risk tends to go to zero and the only relevant
risk is systematic risk measured by Beta. Non-systematic risk can be eliminated by
diversification. Given the assumptions of homogenous expectations and unlimited riskless
lending and borrowing, all investor will hold the market portfolio or very well-diversified
portfolio. Under CAPM, investor is concerned only with expected return and risk (Beta). The
relationship between the expected return on any two assets (or portfolio) can be related simply to
their difference in Beta. The higher Beta is for any security, the higher must be its expected
return.

Thus the CAPM which is also called the Security Market Line (SML) is an equilibrium model
for measuring risk-return tradeoff for all assets including both inefficient and efficient portfolios.
In equilibrium, all securities and portfolios’ plots should lie on the SML.

E(r)

SML

rm

rf

1.0 β

As with the CML, the theoretical relationship is linear. All investments and portfolios must lie
along a straight line in return-beta space. The equation of a straight line is:

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y = a + bx

One point on the line is the riskless asset with a beta of 0. Thus,

y = a + (0)x
rf = a

A second point on the line is the market portfolio with a Beta of 1. Thus,

rm = a + b(1)
b = rm - a
= rm – rf

Putting these together, the SML equation is

rm = rf + β( rm – rf )

or

Recognizing CovM,M = σ2M, CAPM can be expressed by this way:

E(ri) = rf + {[ E(rm) - rf]/ σ2M } Covi,m

Since, β = Covi,m / σ2M

Thus SML equation is

rm = rf + β( rm – rf )

Overpriced and underpriced securities. One of the most valuable contribution of the SML is its
usefulness in gauging the ex ante (expected ) pricing of securities and portfolios. If all securities
are properly priced, their expected return should lie along the SML.

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E(r)

SML

• U
rm

ƒ O

rf

1.0 β
Diagram above depicts two assets, U and O, that are not equilibrium on the CAPM. Asset U is
undervalued and therefore, a very desirable asset to own. U’s price will rise in the market as more
investors purchase it. However, as U’s price goes up, its return falls. When U’s return fall’s to the
return consistent with its beta on the SML, equilibrium is attained. With O, just the opposite way.
Investor will attempts to sell O, since it is overvalued, and, therefore, put downward pressure on
O’s price. When the return on asset O increases to the rate that is consistent with the beta risk
level given by the SML, equilibrium will be achieved and downward price pressure will cease.

Problem 1.

Assume rf = 6%, E(rm) = 12% and β = 1.2 for the security A.

i) Determine the expected return for security A.

ii) What happens to E(rA) if E(rm) increase to 14% (other data do not change)?
iii) What happens to E(rA) if beta fall to 0.8 and everything else stays the same?

Solution

i) rA = rf + β( rm – rf )

= 6 + 1.2(12 – 6)
= 13.2%

ii) rA = 6 + 1.2 ( 14 – 6 )
= 15.6%

iii) rA = 6 + 0.8 ( 12 – 6 )
= 10.8%

Problem 2.

The expected returns and betas are given below for four stocks:

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Stock Exp. return Beta

P 14% 1.2
Q 16% 0.7
R 22% 1.5
S 15% 1.0

Assume rf = 5% and E(rm) = 14%, which stock(s) is/are overvalued? undervalued? properly
valued?

Solution
ri = rf + β( rm – rf )

rP = 5 + 1.2(14 – 5) = 15.8%
rQ = 5 + 0.7(14 – 5) = 11.3%
rR = 5 + 1.5(14 – 5) = 18.5%
rS = 5 + 1.0(14 – 5) = 14%

Stock P is overvalued because Exp. Return (14%) < Eq. Return (15.8%).
Stock Q is undervalued because Exp. Return (16%) > Eq. Return (11.3%).
Stock R is undervalued because Exp. Return (22%) > Eq. Return (18.5%).
Stock S is correctly priced because Exp. Return (14%) = Eq. Return (14%).

8.1.4 The CML vs the SML (CAPM)

The CML set forth the relationship between expected return and risk for efficient, well-diversified
portfolios, whereas the CAPM is a pricing relationship that is applicable for all securities and
portfolios, both efficient and inefficient.

The CML and the CAPM measure systematic risk which portion of total risk. Even though the
CML take total risk (σI ) for its measure of risk, is the same as systematic risk, since there is no
unsystematic risk present in well-diversified portfolios. The CAPM utilizes the beta ( β ) or
Covariance (COVi,m ) as its systematic risk.

Finally, the CML relationship is special case of the CAPM. To see this, consider equation for the
CAPM:

ri = rf + β( rm – rf )

Recall that βi = Covi,M/σ2M M= ρi,σiσM/σ2M

Inserting this in the CAPM equation,

E(ri ) = rf + [ E(rm) – rf ] ρi,M,σi / σM

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For portfolios whose returns are perfectly positively correlated with the market
(ρi,M = 1), and thus lie along the CML.

Therefore,

E(ri ) = rf + { [ E(rm) – rf ]/ σM }σi

This is the CML relationship. Thus, the CAPM is the general risk/expected return pricing
relationship for all assets, whereas the CML is a special case of the CAPM and represents an
equilibrium pricing relationship that holds only for widely diversified, efficient portfolios.

8.2 The Arbitrage Pricing Theory

Arbitrage Pricing Theory is a new and different approach to determining asset prices. It is based
on the law of one price: two items that are the same can’t sell at different prices. If there are two
securities or portfolios that have the same risk and difference expected returns, investors will
arbitrage, by buying the security with the higher expected return (or lower price) and selling the
one with the lower expected return (or higher price) and make a riskless profit. This process of
buying and selling the two securities by investors will cause the price of security of the higher
expected return to rise relatively to the one with the lower expected return. This trading will
continue until the two securities have the same expected returns.

The APT requires that the returns on any stock be linearly related to a set of indices as shown in
equation below:

E(ri) = λ0 + λ1 βi,1+ λ2 βi,2 + ……….+ λj βi,j + εi

Where,
λ0 = the expected return on Asset i if all the indexes or factors have a
return of zero.
λj = the value of jth index that impacts the return on stock i; j = 1,2,3,..M.
βi,j = the sensitivity of stock i’s return to the jth index
εi = a random error term with mean equal to zero and variance = σ2ie

The error term associated with the equation above is assumed to have the following properties:

E(ε i ,εI ) = 0 for all securities i and j where i ≠ j.

E [εi (λj -E(λj )] = 0 for all securities and indexes.

8.3.1 Arbitrage Pricing For One Risk Factor

The Arbitrage Pricing Line for one risk factor can be written as

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E(ri) = λ0 + λ1 βi

Where E(ri) is the expected return on security i, λ0 is the return for a zero beta portfolio, βi is the
sensitivity of the ith asset to the risk factor and λ1 is the factor’s risk premium.

The one-factor model, is equivalent to the Capital Asset Pricing Model where λ0 is equal to the
risk-free rate (rf). Both models assume investors (1) prefer more wealth to less, (2) are risk-
averse, (3) have homogenous expectations and, (4) that capital markets are perfect. However, the
APT, unlike the CAPM, does not assume (1) a one period horizon, (2) return are normally
distributed, (3) a particular type of utility function, (4) a market portfolio, or (5) that the investors
can borrow or lend at the risk-free rate. The one assumption unique to the APT is that unrestricted
short selling exists.

Example.

Assume that one factor APT model applies. Determine the equilibrium arbitrage pricing line that
is consistent with the following two equilibrium-priced portfolios:

Equilibrium Expected Portfolio

Portfolio return Beta
M 20% 1.5
N 15% 1.0

Solution:
E(ri) = λ0 + λ1 βi

Portfolio M: 20 = λ0 + λ1 (1.5)
Portfolio N: 14 = λ0 + λ1 (1.0)

Applying simultaneous solving, subtract equation for portfolio N from portfolio M.

6 = λ1 (0.5)
λ1 = 12 %

20 = λ0 + λ1 (1.5)
20 = λ0 + (12) (1.5)
λ0 = 2 %

Therefore the equilibrium APT equation is

E(rP) = 2 + 12βP

Suppose that portfolio P existed with E(rP) = 18% and βP = 1.2

E(rP) = 2 + 12βP

= 2 + 12(1.2)
= 16.4 %

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Arbitrage profit could be made because the expected return for asset P is higher than the
equilibrium return suggested by the APT line ( 18% > 16.4%). Riskless profit could be obtained
by selling short a portfolio composed of A and B with the same level of risk as asset P.
βP = wMβM + (1 – wM) βN where, (wM + wN = 1)
1.2 = wM (1.5) + ( 1 – wM ) (1.0)
1.2 = 1.5 wM + 1 - wM
wM = 0.4

wN = 1 – 0.4
= 0.6

A new portfolio called Q will be created that will be percent invested in M and 60 percent invest
in N. Portfolio Q will have beta of 1.2 as same as P. So, the expected return of portfolio Q is

rQ = 0.4(rM) + 0.6(rN)

= 0.4(20) + 0.6(15)
= 17%

If we sell portfolio Q short for RM1000 and use the fund from the short sale to purchase Portfolio
P.

Portfolio Initial Outflow Ending Cash Portfolio Beta

flow
Q (short) + RM1000 - RM1700 -1.2
P (Long) - RM 1000 + RM1800 +1.2
0 +RM100 0

A shown above, the investor who recognized this opportunity would make a riskless profit of
RM100 with a zero commitment of funds. This is arbitrage. When more investors recognized this
situation, the price of portfolio Q will rise and as return will fall until equilibrium return of 17
percent is reach.

8.2.2 Two factor arbitrage pricing

The equation for two-factor model is:

E(ri) = λ0 + λ1 βi,1+ λ2 βi,2

Where, λ2 is the risk premium associated with risk factor 2 and βi,2 is factor
beta coefficient for factor 2 and factor 1 and 2 are uncorrelated.

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Example 1. Assume the following three equilibrium-priced exist:

Portfolio Ex. Return βi,1 βi,2

Q 16 1.0 0.8
Z 12 0.6 0.5
T 18 0.9 1.1

What is the equilibrium two-factor APT model for these three portfolio?

Solution.

Solve λ0 , λ1 and λ2 using simultaneous equation.

E(ri) = 16% = λ0 + λ1 (1.0) + λ2 (0.8) ----- (1)

E(ri) = 12% = λ0 + λ1 (0.6) + λ2 (0.5) ----- (2)
E(ri) = 18% = λ0 + λ1 (0.9) + λ2 (1.1) ----- (3)

(1) – (2) 4 = 0.4λ1 + 0.3λ2 ----------- (4)

(3) – (2) 6 = 0.3λ1 + 0.6λ2 ----------- (5)
(4) X 2 8 = 0.8λ1 + 0.6λ2 ----------- (6)
(6) – (5) 2 = 0.5λ1
λ1 = 4

Substituting λ1 = 4, in (4) 4 = 0.4 (4) + 0.3λ2

λ2 = 8

Substituting λ1 = 4 and λ2 = 8 in (2)

12% = λ0 + (4)(0.6) + (8)(0.5)

λ0 = 5.6

The equilibrium equation for two-factor model is

E(ri) = 5.6 + 4 βi,1+ 8 βi,2

Example 2. A two-factor model applies as follow:

E(ri) = λ0 + λ1 βi,1+ λ2 βi,2

Where λ0 = 7% , λ1= 4% and λ2 = 3%

The stock of MB Bhd. has the following risk factor coefficients:

βM,1 = -05 βM,2 = 1.5

Determine the MB Bhd.’s equilibrium return.

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E(rG) = λ0 + λ1 βi,1+ λ2 βi,2

= 7 + 4(-0.5) + 3(1.5)
= 9.5%

Checklist

Now are you able to:

List the assumptions of the capital asset pricing model

Describe the risk-free asset and the risk-return characteristics

Discuss on the capital market line (CML)

Discuss on the securities market line (SML)

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Study Questions

1. The following information describes the expected return and risk relationship for the following
stocks:

Expected Return Standard Deviation Beta

Stock A 15 25 1.5
Stock B 10 15 0.9
Market Index 8 12 1.0
Risk Free 5.0

Using the data given above, answer the following questions:-

a. Draw the Securities Market Line (SML) and show the position of stock A and B

b. Compute the Alpha for both stock A and B

c .Suppose that your risk free rate is now 8%, identify which stock will give a higher expected
risk-adjusted return and give reasons for your answer.

d. How does Arbitrage Pricing Theory differs from the Capital Asset Pricing Model in terms of
risk measures?

2.a) Discuss and explain a measure of diversification for a portfolio in relation to Capital Market
Theory.

b). Assume that the risk-free rate is 6% and expected market return is 12%. An investor is
estimating the value of six different companies. Determine which company is undervalued
or overvalued.

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Company Beta Return

ECG 0.75 14
Cocolee 0.8 12
Jenlop 1.0 15
Britty 1.25 10
Ricky 1.25 18
Bardou 1.35 10

3. Discuss briefly the difference between Capital Asset Pricing Model (CAPM) and Arbitrage
Pricing Theory (APT).

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