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    Capital Asset Pricing Theory Capital Asset Pricing Theory

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    Capital Asset Pricing Theory outlines several key concepts: 1) Portfolio theory holds that investors can reduce risk by holding a diversified portfolio of securities, with risk defined as the standard deviation of returns. 2) The Capital Asset Pricing Model (CAPM) proposes that the expected return of an asset is determined by its sensitivity (beta) to non-diversifiable market risk. 3) While CAPM and its emphasis on beta was influential, the model faced empirical criticisms and the Arbitrage Pricing Theory emerged as a multifactor alternative for predicting returns.

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    Capital Asset Pricing Theory Capital Asset Pricing Theory

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    agrawalrohit_228384
    55 views29 pages
    Capital Asset Pricing Theory outlines several key concepts: 1) Portfolio theory holds that investors can reduce risk by holding a diversified portfolio of securities, with risk defined as the standard deviation of returns. 2) The Capital Asset Pricing Model (CAPM) proposes that the expected return of an asset is determined by its sensitivity (beta) to non-diversifiable market risk. 3) While CAPM and its emphasis on beta was influential, the model faced empirical criticisms and the Arbitrage Pricing Theory emerged as a multifactor alternative for predicting returns.

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    Capm Theory (Rohit)

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    Capital Asset Pricing Theory outlines several key concepts: 1) Portfolio theory holds that investors can reduce risk by holding a diversified portfolio of securities, with risk defined as the standard deviation of returns. 2) The Capital Asset Pricing Model (CAPM) proposes that the expected return of an asset is determined by its sensitivity (beta) to non-diversifiable market risk. 3) While CAPM and its emphasis on beta was influential, the model faced empirical criticisms and the Arbitrage Pricing Theory emerged as a multifactor alternative for predicting returns.

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    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    55 views29 pages

    Capital Asset Pricing Theory Capital Asset Pricing Theory

    Uploaded by

    agrawalrohit_228384
    Capital Asset Pricing Theory outlines several key concepts: 1) Portfolio theory holds that investors can reduce risk by holding a diversified portfolio of securities, with risk defined as the standard deviation of returns. 2) The Capital Asset Pricing Model (CAPM) proposes that the expected return of an asset is determined by its sensitivity (beta) to non-diversifiable market risk. 3) While CAPM and its emphasis on beta was influential, the model faced empirical criticisms and the Arbitrage Pricing Theory emerged as a multifactor alternative for predicting returns.

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    of 29

    Chapter 13

    Capital Asset Pricing


    Theory
    Theory
    CHAPTER 13 OVERVIEW

    13.1 Portfolio Theory


    13.2 Capital Asset Pricing Model
    13.3 Expected Return and Risk
    13.4 Empirical Criticisms of Beta
    13.5 Arbitrage Pricing Theory
    Portfolio Theory

     Investment Portfolio:
    collection of securities that
    together provide an investor
    with an attractive trade-off
    between risk and return
     Portfolio Theory: concept of
    making security choices based
    on portfolio expected returns
    and risks
    PORTFOLIO THEORY
    Basic Assumptions
     Expected Return: anticipated profit over some relevant
    holding period
     Risk: return dispersion, usually measured by standard
    deviation of returns
     Probability Distribution: apportionment of likely
    occurrences
     Utility: positive benefit
     Disutility: psychic loss
     Risk Averse: desire to avoid risk
    PORTFOLIO THEORY
    Three Fundamental Assertions

     Investors seek to maximize utility.

     Investors are risk averse: Utility rises with


    expected return and falls with an increase in
    volatility.
     The optimal portfolio has the highest expected
    return for a given level of risk, or the lowest
    level of risk for a given expected return.
    Portfolio Expected Rate
    of Return and Risk
    Expected rate of return:

    E  Rp    Wi E  Ri 
    N

    i 1

    Standard deviation (risk):

    SD  R p    VAR  Ri    Wi  W j  COV  Ri R j 
    N N N

    W
    2
    1
    i 1 i 1 j 1
    Figure 13.2 (c)
    INVESTMENT
    INVESTMENT OPPORTUNITY
    OPPORTUNITY FUNDAMENTALS
    FUNDAMENTALS
    Expected Rate of Return & Risk
    Portfolio risk increases with the
    volatility of individual holdings
    and the extent to which holding
    have high covariance.
    Optimal Portfolio Choice

     Zero-Risk Portfolio: constant return portfolio


     Efficient Portfolio: portfolio with maximum expected
    return for a given level of risk, or minimum risk for a
    given expected return
     Efficient Frontier: collection of all efficient portfolios
     Optimal Portfolio: collection of securities that provides
    an investor with the highest level of expected utility
     Market Portfolio: all tradable assets
    Capital Asset Pricing Model
    (CAPM)

    Method for predicting


    how investment returns
    are determined in an
    efficient capital market
    KEY TERMS
    Capital Asset Pricing Model
     capital market line (CML)  positive abnormal returns
     security market line (SML)  negative abnormal return
     systematic risk  market index bias
     unsystematic risk  model specification bias
     diversifiable risk  time interval bias
     nondiversifiable risk  nonstationary beta problem
     security characteristic line  arbitrage pricing theory (APT)
    (SCL)  arbitrage
    CAPITAL ASSET PRICING MODEL
    Basic Assumptions
     Investors hold efficient portfolios; higher expected returns
    involve higher risk.
     Unlimited borrowing and lending are available at the risk-
    free rate.
     Investors have homogeneous expectations.
     There is a one-period time horizon.
     Investments are infinitely divisible.
     No taxes or transaction costs exist.
     Inflation is fully anticipated.
     Capital markets are in equilibrium.
    CAPM & Market
    Efficiency

     CAPM can test Efficient Market Hypothesis.

     Market is efficient if only risk-free assets give risk-


    free rates of return (e.g., Treasury bills).
     Deviations may indicate opportunities.

     Modeling predictions can suggest improvements to


    market functioning.
    Lending & Borrowing Under
    the CPM
     Assumption of unlimited lending and borrowing at
    risk-free rate.
     Lending if portion of portfolio held in risk-free
    assets.
     Borrowing (leverage) if more than 100% of
    portfolio is invested in risky assets.
     Superior returns made possible with lending and
    borrowing; creates spectrum of risk preference for
    different investors.
    CAPITAL ASSET PRICING MODEL
    Three Linear Relationships

     Capital Market Line: linear risk-return trade-off for


    all investment portfolios
     Security Market Line: linear risk-return trade-off
    for individual stocks
     Security Characteristic Line: linear relation
    between the return on individual securities and the
    overall market at every point in time
    CAPITAL ASSET PRICING MODEL
    Three Linear Relationships

     Capital Market Line: linear risk-return trade-off for


    all investment portfolios
    E(R)
    M
    Rf
     = market 

    Standard Deviation (total portfolio risk)


    EXPECTED RETURN & RISK
    The Capital Market Line (CML)

    Linear risk-return trade-off for all investment portfolios given by

    E  RM   RF
    E  RP   RF  SD RP 
    SD RM 
    SD RP 
     RF 
    SD RM 
     E  RM   RF 
    Figure 13.4
    EXPECTED RETURN & RISK
    The Capital Market Line (CML)
    Security Market Line (SML)

     Security Market Line: linear risk-return trade-off for


    individual stocks
     Systematic Risk: return volatility tied to overall
    market; also called nondiversifiable risk
     Unsystematic Risk: return volatility tied specifically to
    an individual company; also called diversifiable risk
     Beta: sensitivity of a security’s returns to the
    systematic market risk factor
    CAPITAL ASSET PRICING MODEL
    Three Linear Relationships

     Security Market Line: linear risk-return trade-off


    for all individual stocks
    E(R)
    M
    Rf
    =1

    Systematic Risk
    Figure 13.5

    The BETA Factor


    The Security
    Characteristic Line
     Linear relation between the return on individual securities and
    the overall market at every point in time, given by:

    Rit   i  i RMt  i
     Positive Abnormal Returns: above-average returns that can’t
    be explained as compensation for added risk
     Negative Abnormal Returns: below-average returns that
    cannot be explained by below-market risk
    Empirical Implications of
    CAPM

     Optimal portfolio choice depends on market risk-return trade-offs


    and individual investors’ differences in risk preferences.
     Relation between expected return and risk is linear for all
    portfolios and individual assets.
     Expected rate of return is risk-free rate plus relative risk (ßp)
    times market risk premium.
     High beta portfolios earn high risk premiums.
     Low beta portfolios earn low risk premiums.
     Stock price  measures relevant risk for all securities.
    EMPIRICAL CRITICISMS OF BETA
    MODEL
    MODEL SPECIFICATION
    SPECIFICATION PROBLEMS
    PROBLEMS

     CAPM provides only incomplete description of return volatility


    —volatility in individual issues can only be described as a
    function of overall market volatility.
     Overall market volatility very difficult to measure
     Market Index Bias: distortion to beta estimates due to fact that
    indexes are imperfect proxies for overall market
     No single index includes all capital assets, including stocks,
    bonds, real estate, collectibles, etc.
     Model Specification Bias: distortion to beta estimates because
    SCL fails to include other important systematic influences on
    stock market volatility
    EMPIRICAL CRITICISMS OF BETA
    Data
    Data Interval
    Interval && Nonstationary
    Nonstationary Beta
    Beta Problems
    Problems

     Data Interval Problem: beta


    estimation problem derived
    from the fact that beta
    estimates depend on data
    interval studied
     Nonstationary Beta Problem:
    difficulty tied to the fact that
    betas are inherently unstable
    Testable Limitations Of
    CAPM

     ß, the slope of the regression of a security’s return on


    the market return, is the only risk factor needed to
    explain expected return.
     ß captures a positive expected return premium for risk.

     Other risk factors emerge:


     firm size
     low P/E, price/cash flow, P/B, and sales growth
    Arbitrage Pricing Theory
    (APT)

     Multifactor asset-pricing model that allows


    market ßs to represent only one of the firm’s
    many risk factors.
     Arbitrage: simultaneous buying and selling of
    the same asset at different maturities
     APT suggests that asset returns might be
    affected by N risk factors.
    APT vs. CPM

     Volatile returns attributable to six-factor APT


    models are very unstable—explain very little of
    variation in average returns.
     Though both CAPM and APT theory and
    evidence confirm relationship between risk and
    return, neither approach gives precise estimates.
     Neither provides foolproof test of EMF.
    KEY TERMS
    Capital Asset Pricing

     investment portfolio  risk averse

     portfolio theory  zero-risk portfolio

     expected return  efficient portfolio


     efficient frontier
     risk
     optimal portfolio
     probability distribution
     market portfolio
     utility
     capital asset pricing
     disutility model

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