EQUITY RESEARCH & STOCK TRADING (Professional Certificate Level - II - FIN)

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OST (On Screen Text) Objectives At the end of this module, you will be able to: Appreciate Portfolio Management concepts and theories CAPM and APM

Graphics/interactivity Specs The objectives of the module will be displayed one by one.

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Capital asset pricing model 25.1 Capital Asset Pricing Modal (CAPM) When investing in a share of a company, an investor expects a bare minimum of risk free return and a compensation for the risk of investing in that share which is also known as risk premium. Expected Return = Risk Free Rate + Risk Premium The most widely used method to determine the expected return is known as capital asset pricing modal (CAPM). CAPM is given by: Expected Return = Rf + (Rm Rf) Where: Rf = A return commensurate with a risk free security. It relates to the yield associated with long-term government bonds. Rm = A return that incorporates the market risk associated with common stocks as a whole. It relates to what market returns are currently available and what risks are associated with the stocks in general. Beta () = A return that incorporates the business and financial risks specific to the stock of the company. Beta is a measure of volatility or systematic risk of a security in
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comparison to the market as a whole. It signifies the relationship of the share with market movements, i.e. if the beta of a company is (1) it will react in the equal proportion to the movement in market. If beta is (2) the responsiveness to the change in market is twice. For example, if the index moves by 2% the share will move by 4%. Share with a beta value greater than one refer to as aggressive share and the one with beta less than one is called the defensive share. Beta () is equal to the covariance of the returns of the stock with the returns of the market, divided by the variance of the returns of the market. Covariance is the measure of how much two variables vary together. i = Covarianceim/ Variancem = {(nxy (x)(y)} /{ nx-(x)} Where, n = number of data points x = the index returns y = the investment returns 25.2 Capital Asset Pricing Modal (CAPM) (Contd.) Capital Asset Pricing Model (CAPM) explains the risk-return relationship. The risk premium reflects in the market price of the security, higher the market risk, the higher will be the risk premium. CAPM provides for a measure of risk and the method of estimating the markets risk-return relationship. A securitys market risk depends upon its sensitivity to the market movements. This sensitivity is known as Beta. Beta reflects the market risk and as we have learnt the same cannot be reduced.

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The required rate of return under the CAPM helps in arriving at the value of the asset. By comparing the expected /estimated rate of return with that of required rate return, we can assess whether the asset is properly priced or otherwise. The CAPM is based on a number of restrictive assumptions: Market efficiency: Share prices reflect all the available information. Individual investors are unable to affect the prices of securities (they are supposed to hold small amounts spread across large numbers). Risk aversion: Investors are risk averse. They prefer the highest expected returns for a given level of risk. Homogeneous expectations: All investors have the same expectations regarding the expected returns and risks of securities. Single time period: All decisions are based on a single time period. Risk free rate: All lending and borrowings happen at risk free rate of interest. It is assumed that the market price reflects compensation for a securitys market (systematic) risk as captured fully by the securitys beta. However, it is to be noted that the betas of securities do not fully explain the differences in securities returns. 25.3 Understanding Capital and Security Market Line The CML represents the risk premiums of efficient portfolios as a function of portfolio standard deviation. The SML on the other hand represents the risk premium of an individual security as a function of security risk as measured by securitys beta. It exemplifies the relationship between an assets risk and the required rate of return, as

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shown in the following figure.

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Implications of the CAPM Investors will always combine a risk free asset with a market portfolio of risky assets and that they will invest in risky assets in proportion to their market value. Investors are compensated for the non diversifiable (market) risk which is measured by beta. (Beta= covariance between the asset returns and the market returns / market variance). Investors can expect returns according to the risk, which indicates that there is linear relationship between the assets expected returns and its beta. Limitations of CAPM Unrealistic assumptions: There are a number of unrealistic assumptions under the CAPM. It is difficult to find a totally risk free security as even a short term government security suffers from the uncertainty about the real rate of return. Investors may not hold a highly diversified portfolio. Thus CAPM may not accurately explain the behaviour of the investor and beta fails to capture the entire risk of investment.

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Difficulty in testing validity: The empirical evidence has been mixed. Some results indicate that there is a positive relation between returns and betas. However, the relationship is not as strong as predicted under the CAPM. Others did not find any relationship between betas and returns. Results also showed that the returns were related to other macro factors as well as firm specific risks. There is also the problem of testing CAPM as the data required pertains to expected returns whereas the researchers generally have access to the past data. Stability of betas over time: Beta is measure of securitys future risk. However, the investors have access to the past data and therefore, there is only an estimate of beta available, based on the past data. Over time, this value of the beta is not stable. Despite all these limitations, the CAPM has an intuitive appeal and offers a useful model to understand the risk and return relationship.

Arbitrage Pricing Theory 26.1 Arbitrage Pricing Theory The exploitation of security mispricing in such a way that risk-free economic profits may be earned is called arbitrage. It involves the simultaneous purchase and sale of equivalent securities in order to profit from discrepancies in their price relationship. The concept of arbitrage is central to the theory of capital markets. Perhaps the most basic principle of capital market theory is that equilibrium market prices are rational in that they rule out (riskfree) arbitrage opportunities. Pricing relationships that guarantee the absence of

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arbitrage possibilities are extremely powerful. If actual security prices allow for arbitrage, the result will be strong pressure to restore equilibrium. Only a few investors need be aware of arbitrage opportunities to bring about a large volume of trades, and these trades will bring prices back into balance. The CAPM gave us the security market line, a relationship between expected return and risk as measured by beta. Arbitrage pricing theory, or APT, also stipulates a relationship between expected return and risk, but it uses different assumptions and techniques. An arbitrage opportunity arises when an investor can construct a zero investment portfolio that will yield a sure profit. To construct a zero investment portfolio one has to be able to sell short at least one asset and use the proceeds to purchase (go long on) one or more assets. Borrowing may be viewed as a short position in the risk-free asset. Clearly, any investor would like to take as large a position as possible in an arbitrage portfolio. An obvious case of an arbitrage opportunity arises when the law of one price is violated. When an asset is trading at different prices in two markets (and the price differential exceeds transaction costs), a simultaneous trade in the two markets can produce a sure profit (the net price differential) without any investment. One simply sells short the asset in the high-priced market and buys it in the low-priced market. The net proceeds are positive, and there is no risk because the long and short positions offset each other. In modern markets with electronic communications and instantaneous execution, arbitrage opportunities have become rare but not extinct. The same technology that enables the market to absorb new information quickly also enables fast

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operators to make large profits by trading huge volumes the instant an arbitrage opportunity appears. 26.2 Arbitrage Pricing Theory (Contd.) The idea that market prices will move to rule out arbitrage opportunities is perhaps the most fundamental concept in capital market theory. Violation of this restriction would indicate the grossest form of market irrationality. The critical property of a risk-free arbitrage portfolio is that any investor, regardless of risk aversion or wealth, will want to take an infinite position in it. Because those large positions will force prices up or down until the opportunity vanishes, we can derive restrictions on security prices that satisfy a no-arbitrage condition, that is, prices for which no arbitrage opportunities are left in the marketplace. There is an important difference between arbitrage and riskreturn dominance arguments in support of equilibrium price relationships. A dominance argument holds that when an equilibrium price relationship is violated, many investors will make portfolio changes. Individual investors will make limited changes, though, depending on their degree of risk aversion. Aggregation of these limited portfolio changes is required to create a large volume of buying and selling, which in turn restores equilibrium prices. By contrast, when arbitrage opportunities exist each investor wants to take as large a position as possible; hence it will not take many investors to bring about the price pressures necessary to restore equilibrium. Therefore, implications for prices derived from no-arbitrage arguments are stronger than implications derived from a riskreturn dominance argument. The CAPM is an example of a dominance

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argument, implying that all investors hold mean-variance efficient portfolios. If a security is mispriced, then investors will tilt their portfolios toward the underpriced and away from the overpriced securities. Pressure on equilibrium prices results from many investors shifting their portfolios, each by a relatively small rupee amount. The assumption that a large number of investors are mean-variance sensitive is critical; in contrast, the implication of a no-arbitrage condition is that a few investors who identify an arbitrage opportunity will mobilize large rupee amounts and restore equilibrium. Practitioners often use the terms arbitrage and arbitrageurs more loosely than our strict definition. Arbitrageur often refers to a professional searching for mispriced securities in specific areas such as mergertarget stocks, rather than to one who seeks strict (risk-free) arbitrage opportunities. Such activity is sometimes called risk arbitrage to distinguish it from pure arbitrage. 26.3 APM The APM (based on the Arbitrage Pricing Theory) assumes that many macro-economic factors may affect the market (system) risk of a security and tries to capture various such factors. Thus, APM is a multi-factor model. Such factors could be growth in GDP, interest rates, inflation, default premium and the real rate of return, etc. Some other external factors such as the price to book value of a security may also affect its risk return relationship. Under the APM, the return is assumed to have predictable /expected and unpredictable/uncertain components. Predictable component is based on the information available to the investors and the unpredictable component arises from the future information. Such future information

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may be market related or firm specific. Whereas, the CAPM is a single factor model beta for the market risk, APM is a multi factor model (beta for each of the factors). Mainly, there are three main steps under APM: Determining the factors that affect the return of an asset: Factors such as the industrial production, changes in default premium, changes in the structure of interest rates, inflation rates, changes in real rate of return, etc are found to have important bearing on the expected return. Estimation of risk premium for each of the factors: Risk premium is the compensation over and above the risk free return which can be estimated by from the past data available on the forecasted and actual returns to find out the risk premium. Factor beta: It represents the sensitivity of the assets return to the changes in the factor. For example, to determine inflation beta, a firms returns can be regressed to inflation rates (by using regression). However, due to the large number of factors involved, the APM has mathematical limitations. Summary S1 Summary In this module, you learned that: The most widely used method to determine the expected return is known as capital asset pricing modal (CAPM). CAPM is given by: Expected Return = Rf + (Rm Rf) The APM (based on the Arbitrage Pricing Theory) assumes that many macro-economic factors may affect the market (system) risk of a security and tries to capture various such factors.

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