Capital Asset Pricing Model

The Capital Asset Pricing Model: An

Overview

• Diversification

• Systematic risk

• CAPM, therefore, evolved as a way to measure this

systematic risk.

• The (CAPM) helps us to calculate investment risk

and what return on investment we should expect.
 KEY ISSUES

Essentially, the capital asset pricing model (CAPM) is

concerned with two questions:

• What is the relationship between risk and return for an

efficient portfolio?

• What is the relationship between risk and return for an

individual security?
 The CAPM Theory

The required rate return of an asset is having a linear relationship

with asset’s beta value i.e., undiversifiable or systematic risk.

The model takes into account the asset's sensitivity to non-

diversifiable risk(also known as systematic risk), often represented
by the quantity beta (β) in the financial industry, as well as the
expected return of the market and the expected return of a
theoretical risk free asset.
A model that describes the relationship between risk and expected
return and that is used in the pricing of risky securities.
• The CAPM says that the expected return of a security or
a portfolio equals the rate on a risk-free security plus a
risk premium.

• If this expected return does not meet or beat the

required return, then the investment should not be
undertaken.

• The security market line plots the results of the CAPM

for all different risks (betas).
 Security Market Line
• Risk- return relationship of an efficient portfolio is measured by the CML.

• Capital market line does not show the risk-return trade off for other
portfolios and individual securities.

• Inefficient portfolios lies below the CML and risk return relationship with
the help of CML cannot be established.

• 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.
• Security market line (SML) is the graphical representation of the CAPM. It displays
the expected rate of return of an individual security as a function of systematic, non
diversifiable risk(its beta).
The x-axis represents the risk (beta), and the y-axis represents the expected return.
The market risk premium is determined from the slope of the SML. The Security
Market Line, seen here in a graph, describes a relation between the beta and the
asset's expected rate of return.
• For individual securities, we make use of the (SML) and its relation to
expected return and systematic risk(beta) to show how the market
must price individual securities in relation to their security risk class.
The SML enables us to calculate the reward-to-risk ratio for any
security in relation to that of the overall market.

• The security market line is a useful tool in determining whether an

asset being considered for a portfolio offers a reasonable expected
return for risk. Individual securities are plotted on the SML graph.

• If the security's risk versus expected return is plotted above the SML,
it is undervalued because the investor can expect a greater return for
the inherent risk. A security plotted below the SML is
overvalued because the investor would be accepting less return for
the amount of risk assumed.
 SECURITY MARKET LINE
E(R M ) - R f
E(R i ) = R f + C iM
M
iM
βi =
 M
E (R i ) = R f + [ E (R M ) - R f ] β i
EXPECTED •P
RETURN SML
14%

8% •0

1.0
βi
Evaluation of Securities with SML
Y
Rp T
S
R C
SML
B
A
W
Rf
V
U

X
0.9 1.0 1.1 1.2
B eta
Find out the under-priced and overpriced
securities
Security Expected return Beta

A 0.33 1.7

B 0.13 1.4

C 0.26 1.1

D 0.12 0.95

E 0.21 1.05

F 0.14 .70

Nifty 0.13 1

T-bills 0.09 0

Expected return > Estimated return = under-priced

Expected return < Estimates return = overpriced
 Difference between CAPM 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 Character-istic Line, is a graphical representation of the market's
risk and return at a given time.
• While standard deviation is the measure of risk in CML, Beta coefficient
determines the risk factors of the SML.
• While the Capital Market Line graphs define efficient portfolios, the Security
Market Line graphs define both efficient and non-efficient portfolios.
• The Capital Market Line is considered to be superior when measuring the risk
factors.
Empirical Tests of the CAPM
The studies generally showed a significant positive
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 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.
Present Validity of CAPM

CAPM provides basic concepts which is truly of

fundamental value.
The CAPM has been useful in the selection of
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
firm’s security.
 Problems of CAPM
• This model presents a very simple theory that delivers a simple result. The theory says
that the only reason an investor should earn more, on average, by investing in one
stock rather than another is that one stock is riskier. Not surprisingly, the model has
come to dominate modern financial theory. But does it really work?

It's not entirely clear. The big sticking point is beta. When professors Eugene Fama
and Kenneth French looked at share returns on the New York Stock Exchange, the
American Stock Exchange and Nasdaq between 1963 and 1990, they found that
differences in betas over that lengthy period did not explain the performance of
different stocks. The linear relationship between beta and individual stock returns
also breaks down over shorter periods of time. These findings seem to suggest that
CAPM may be wrong.
• While some studies raise doubts about CAPM's validity, the model is still widely
used in the investment community. Although it is difficult to predict from beta how
individual stocks might react to particular movements, investors can probably
safely deduce that a portfolio of high-beta stocks will move more than the market
in either direction, and a portfolio of low-beta stocks will move less than the
market.

Conclusion:The capital asset pricing model is by no means a perfect theory. But the
spirit of CAPM is correct. It provides a usable measure of risk that helps investors
determine what return they deserve for putting their money at risk.
 Arbitrage

• The theory was initiated by the economist Stephen Ross in 1976.

• Arbitrage and the APT
Arbitrage is the practice of taking positive expected return from
overvalued or undervalued securities in the inefficient market
without any incremental risk and zero additional investment.
Arbitrage is a process of earning profit by taking advantage of
differential pricing for the same asset.
The process generates riskless profit.
In the security market, it is of selling security at a high price and
the simultaneous purchase of the same security.
Where today's price is too low:
The implication is that at the end of the period the portfolio would have appreciated at the rate
implied by the APT, whereas the mispriced asset would have appreciated at more than this rate.
The arbitrageur could therefore:
Today:
1 short sell the portfolio
2 buy the mispriced asset with the proceeds.
At the end of the period:
1 sell the mispriced asset
2 use the proceeds to buy back the portfolio
3 pocket the difference.

Where today's price is too high:

The implication is that at the end of the period the portfolio would have appreciated at the rate
implied by the APT, whereas the mispriced asset would have appreciated at less than this rate. The
arbitrageur could therefore:
Today:
1 short sell the mispriced asset
2 buy the portfolio with the proceeds.
At the end of the period:
1 sell the portfolio
2 use the proceeds to buy back the mispriced asset
3 pocket the difference
• - Created in 1976 by Stephen Ross, this theory predicts a relationship
between the returns of a portfolio and the returns of a single asset
through a linear combination of many independent macro-economic
variables.

• The arbitrage pricing theory (APT) describes the price where a

mispriced asset is expected to be. It is often viewed as an alternative to
the capital asset pricing model (CAPM), since the APT has more
flexible assumption requirements.
• of a number of macro-economic factors. Arbitrageurs use the
APT model to profit by taking advantage of mispriced securities. A
mispricedWhereas the CAPM formula requires the market's
expected return, APT uses the risky asset's expected return and the
risk premium security will have a price that differs from the
theoretical price predicted by the model.
• By going short an over priced security, while concurrently going
long the portfolio the APT calculations were based on, the
arbitrageur is in a position to make a theoretically risk-free profit.
• APT holds that the expected return of a financial asset can be
modeled as a linear function of various macro-economic factors or
theoretical market indices, where sensitivity to changes in each
factor is represented by a factor-specific beta .
• The basis of arbitrage pricing theory is the idea that the price of a
security is driven by a number of factors. These can be divided into
two groups: macro factors, and company specific 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 name of the theory comes from the fact that this division, together
with the no arbitrage assumption can be used to derive the following
formula:

r = rf + β1f1 + β2f2 + β3f3 + ⋅⋅⋅

where r is the expected return on the security,
rf is the risk free rate,
Each f is a separate factor and
each β is a measure of the relationship between the security price and
that factor.
The Assumptions

The investors have homogenous expectations.

The investors are risk averse and utility maximisers.
Perfect competition prevails in the market and there is no
transaction cost.
 Factor Sensitivity
According to Stephen Ross, returns of the securities are 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 = 0 + 1 bi1 + 2 bi2 … + j bij
where Ri = average expected return
1 = sensitivity of return to bi1
bi1 = the beta co-efficient relevant to the particular factor

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 XA + bB XB + bC XC = 0
APT Model

Securities Return Sensitivity Original weights Change in weights

A 20 0.45 0.33 0.2

B 15 1.35 0.33 0.025

C 12 0.55 0.34 -0.225

Arbitrage Pricing Equation

In a single factor model, the linear relationship

between the return Ri and sensitivity bi can be given
in the following form
Ri = o + ibi
• Ri = return from stock A
• o = riskless rate of return
• bi = the sensitivity related to the factor
• i = slope of the arbitrage pricing line
 Relationship with the capital asset pricing
model
• The APT along with the (CAPM) is one of two influential theories on asset pricing.
• The APT differs from the CAPM in that it is less restrictive in its assumptions. In
some ways, the CAPM can be considered a "special case" of the APT in that the sml
represents a single-factor model of the asset price, where beta is exposed to
changes in value of the market. The difference between CAPM and arbitrage
pricing theory is that CAPM has a single non-company factor and a single beta,
whereas arbitrage pricing theory separates out non-company factors into as
many as proves necessary. Each of these requires a separate beta. The beta of
each factor is the sensitivity of the price of the security to that factor.

• Additionally, the APT can be seen as a "supply-side" model, since its beta
coefficients reflect the sensitivity of the underlying asset to economic factors.
Thus, factor shocks would cause structural changes in assets' expected returns, or
in the case of stocks, in firms' profitabilities.
• On the other side, the CML is considered a "demand side" model. Its results,
although similar to those of the APT, arise from a maximization problem of each
investor's utility function, and from the resulting market equilibrium (investors
are considered to be the "consumers" of the assets).
• Arbitrage pricing theory does not rely on measuring the
performance of the market. Instead, APT directly relates
the price of the security to the fundamental factors driving
it. The problem with this is that the theory in itself provides
no indication of what these factors are, so they need to be
empirically determined. Obvious factors include economic
growth and interest rates. For companies in some sectors
other factors are obviously relevant as well - such as
consumer spending for retailers.
• The potentially large number of factors means more betas to
be calculated. There is also no guarantee that all the
relevant factors have been identified. This added complexity
is the reason arbitrage pricing theory is far less widely used
than CAPM.
 APT and CAPM
The simplest form of APT model is consistent with
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.
 Question
• The beta co-efficient of security ‘A’ is 1.6. The risk free rate of return is 12%
and the required rate of return is 18% on the market portfolio. If the
dividend expected during the coming year is 2.50 and the growth rate of
dividend and earnings is 8%, at what price should the security ‘A’ can be
sold based on the CAPM.
• =12% + 1.6 (18% – 12%) = 12% + 9.6% = 21.6%
Price of security ‘A’ is calculated with the use of dividend growth model formula:

d1
Re=P0 + g
Where,
D1 = Expected dividend during the coming year
Re = Expected rate of return on security ‘A’
g = Growth rate of dividend
P0 = Price of security ‘A’

.216=2.5/ P0+.08
.216=2.5/ P0+.08/1
.216=2.5/ P0+.08 P0 /1
.216 P0-.08 P0 =2.50
.0136P0=2.50
P0 =2.50/.0136=18.38
Chapter Summary

By now, you should have:

Understood the concept of CAPM theory

Learnt to distinguish between CML and SML
Traced the empirical tests of CAPM
Understood the concept of APT