CAPM

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CAPM

MEANING
Was developed by William Sharpe (1964), John Lintner (1965) and Jan
Mossin (1966).
It is based on the foundations of Modern Portfolio Management laid by
Harry Markowitz in 1952.
CAPM predicts the relationship between the risk of an asset and its expected
return
It helps in the identification of different securities (individual asset or
portfolio) as overpriced or underpriced by assigning values (not exact) to
these securities
This would help in selection of securities to be included in the portfolio by
the risk-averse investors.
Assumptions of Capital Asset Pricing Model
• The investors are risk averse i.e. they attempt to avoid risk.
• Investors seek to maximize the expected utility of their portfolio
• Each security has only two attributes - mean returns and variances of
such returns representing the risk.
• The market is perfect, there are no taxes, there are no transaction
costs, securities are completely divisible, and markets are
competitive.
• The quantity of risky securities in the market is given.
• Market it efficient
Security market line
• The SML shows the relationship between risk measured by beta and
expected return. The model states that the stock’s expected return is
equal to the risk free rate plus a risk premium obtained by the price
of the risk multiplied by the quantity of the risk

Capital Market Line


• A line used in the capital asset pricing model to illustrate 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.
Security Market Line

• SML forms the efficient frontier for the identification of undervalued


and overvalued securities.
• The securities lying above the SML are considered to be undervalued
whereas those lying below the SML are considered to be overvalued.
• All the correctly priced securities lie exactly on the SML. The
difference between the actual expected return and the fair return as
per SML is called the security’s alpha, denoted as α
• Beta (β) is the measure of assets sensitivity to movements in the overall market.
• Beta more than 1 devotes more than average risk and beta less than 1 denotes
less than average risk.
• 𝐸(𝑅𝑀) − expected return on market portfolio,
• 𝑅𝑓 – risk free return the historically observed excess return of market over the
risk free rate.
• 𝐸(𝑅𝑀) − 𝑅f – Market Risk Premium
Capital Martket Line
Arbitrage Pricing Theory
• Arbitrage Pricing Theory (APT) model developed by economist
Stephen Ross in 1976.
• key point behind APT is a logical statement that security returns are
not based on one single factor of the market, rather it is influenced by
multiple macro-economic factors where sensitivities to each factor is
represented by a factor specific beta coefficient.
• there exists a linear relationship between the return on asset and the
number of risk factors.
• a security’s long run return is “directly related to its sensitivities to
unanticipated changes in the four macroeconomic variables – (i)
inflation, (ii) industrial production, (iii) risk premium, and (iv) the
scope of the term structure of interest rates.
Assumptions of APT Model
• The arbitrage pricing theory relies on three assumptions:
• i. A factor model can be used to describe the relation between risk
and return of a security,
• ii. There are sufficient securities to diversify away idiosyncratic risk,
and
• iii. Efficient and well-functioning security markets do not allow for
persisting arbitrage opportunities.
APT MODEL
Principle of APT
• APT also emphasizes the Law of One Price which implies that the two
securities will command the market price given that they are
equivalent in all economically relevant respects.
• In other words, in an equilibrium market (with no arbitrage
condition), the two identical securities having same degree of risk will
have same price i.e. will have same return in the market in the long
run.
• However, in the short run disequilibrium, there may be differences in
the market price of securities having same amount of risk. This would
induce arbitrage activities by the arbitrageurs, until the arbitrage
opportunities are eliminated.

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