Chapter 8

CAPITAL ASSET PRICING AND

ARBITRAGE PRICING THEORY
The Risk Reward Relationship
 OUTLINE
• Key Issues
• Basic Assumptions
• Capital Market Line
• Security Market Line
• Inputs Required for CAPM
• Calculation of Beta
• Empirical Evidence on CAPM
• Arbitrage Pricing Theory
 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?

CAPM produces a benchmark for evaluating investment

Helps in assessing return for investment not traded.

 BASIC ASSUMPTIONS

• RISK - AVERSION

• MAXIMISATION . . EXPECTED UTILITY – Over a single period

plan Horizon

• HOMOGENEOUS EXPECTATION – mean , variance and

covariance among returns
•FREE LENDING & BORROWING AT RISK FREE RATE OF
INTEREST
•PERFECT MARKET -NO TAXES, NO TRANSATION COST
•QUANTITY OF RISKY SECURITIES IS GIVEN IN MARKET
 BASIC ASSUMPTIONS

•Looking at assumptions, one may feel that the CAPL is unrealistic

•However the value of a model depends not on realism of

assumptions but on the Validity of its conclusions
 CAPITAL MARKET LINE

• FOR EFFICIENT PORTFOLIO, THERE IS LINEAR

RELATIONSHIPBETWEEN EXPECTED RETURNS AND SD.
•FOR INEFFICIENT PORTFOLIOS, EXPECTED RETURNS &
SD WILL BE BELOW CML.

•Equation of Capital market Line

• E(Rj) = Rf + λ * σ j
•Where: E(Rj) is expected return on portfolio j, Rf is Risk free rate,
λ is slope of the capital market and σ j is SD of portfolio j.

•: λ = E(Rm)-Rf/ σ m
•Slope may be regarded as “Price of risk”
 CAPITAL MARKET LINE
EXPECTED
RETURN, E(Rp) Z

•
L
M •

• K

Rf

STANDARD DEVIATION, σp
E(Rj) = Rf + λ σj
E(RM) - Rf
λ =
 CAPITAL MARKET LINE

• CML differs fron efficient Frontier as it includes risk free

investments. The Efficient Frontier is made up of investment
portfolios that offer the highest expected return for a specific level of
risk.

•The intercept point of CML and efficient frontier would result in

the most efficient portfolio, called the TANGENCY PORTFOLIO.

• CML primarily shows the trade off between risk and return for
functioning portfolios. It efficiently depicts the combined risk free
returns of all the portfolios.
•
•
 SINGLE INDEX MODEL VS CAPM

■ Sharpe (1963) defined SIM as an asset pricing model which is purely

arithmetical. The returns on a security can be represented as a linear
relationship with any economic variable relevant to the security, for
example in stocks the single factor is the market return. According to
Sharpe the Single index model for return on stocks is shown by the
formulae shown below;
■Rs= α + β Rm +ε. α . alpha represents abnormal returns for stock. Β
Rm represents the markets movement. ε represents the unsystematic risk
of the security.
■The Capital Asset Pricing Model (CAPM) describes the relationship
between systematic risk and expected return for assets, particularly
stocks. CAPM is widely used throughout finance for pricing risky 
securities and generating expected returns for assets given the risk of
those assets and cost of capital.
 SECURITY MARKET LINE

• Security Market line is a line drawn on Chart which

serves as a representation of CAPM.

•It shows different levels of Systematic , or market risk, of

various securities plotted against the expected return of the
Entire market.
 SECURITY MARKET LINE

• There is linear relationship between Expected Returns and SD of

Efficient portfolios
•Expected Returns and SD of individual securities and inefficient
portfolios will be below CML, reflecting the inefficiency of
undiversified holdings.
•However, there is linear relationship between their expected returns
and covariance with the Market portfolio.

•Equation of Capital market Line

• E(Rj) = Rf + λ * σ j
•Where: E(Rj) is expected return on portfolio j, Rf is Risk free rate,
λ is slope of the capital market and σ j is SD of portfolio j.

•: λ = E(Rm)-Rf/ σ m
 SECURITY MARKET LINE

Where E(Ri) is the expected Return on Security I, Rf is Risk free

Rerurn, E(Rm) is the expected return on Market portfolio, σ 2 m is
the variance of return on market portfolio and Cim is the covariance
of returns between Security I and Market
As per SML
Expected Return on Security i= Risk Free Return + Market risk
premium * Beta of Security i
 SECURITY MARKET LINE
Underpriced Securities are above SML, Fairly Priced Securities
are on SML and overpriced are below SML.
The difference between the actual expected return on Security
and its fair return as per SML is called Secutity Alpha

Example: The risk Free rate is 8 % and the expected Return on

market portfolio is 14%. The Beta of Stock Q is 1.25. Investors
believe that the stock will provide an expected return of 17%.

The Fair Return as per SML is

RQ = 8 + 1.25(14-8)
= 15.5%

Alpha of Stock Q = 17-15.5 = 1.5%.

 RELATIONSHIP BETWEEN SML AND CML

E(RM ) - Rf
E(Ri) = Rf + σi
σM

FORMULA FOR CAPITAL ASSET PRICING MODEL (CAPM) -

CAPITAL MARKET LINE
 RELATIONSHIP BETWEEN SML AND CML
SML
E(RM ) - Rf
E(Ri) = Rf + σiM
σM 2

SINCE σiM = ρiM σi σM

E(RM ) - Rf
E(Ri) = Rf + ρiM σi
σM

IF i AND M ARE PERFECTLY CORRELATED ρiM = 1. SO

E(RM ) - Rf
E(Ri) = Rf + σi
σM
 Comparative SML AND CML

Basically, SML tells about the market risk in an investment or

identifies a point beyond which an investor may run into risk. Or,
we can say it tells the relation between the required rate of return
of security as a function of the non-diversifiable risk (or 
systematic risk)

On the other hand, CML is a graphical representation that tells

the rate at which the securities are providing a return. In simple
words, it helps to determine the degree of profit an investor
makes as per their investment. Or, we can say that CML shows
the rate of returns on the basis of risk-free rates and the risk
level in a portfolio. We also call it a Characteristic Line.
 Comparative SML AND CML
The SML helps an investor to determine the market risk in their
investment. On the other hand, CML enables an investor to
determine an average rate of success or loss in the market
share.
Portfolios        
SML defines both functioning and non-functioning portfolios, or
we can say efficient and non-efficient portfolios. CML defines
only functioning or efficient portfolios.
Functioning    
SML is known to be less efficient than CML.
Objective        
SML’s objective is to illustrate all security factors. On the other
hand, CML describes only the market portfolios and risk-free
investments.
 Comparative SML AND CML
How Risk is Measured?
SML uses the beta coefficient to calculate the risk, which, in turn,
assists in determining how much security contributes to the
overall risk. CML, on the other hand, uses SD (standard
deviation) to calculate the risk.

Graph
In SML, the Y-axis represents the return of securities, while X-
axis shows the beta of security. In CML, on the other hand, Y-
axis represents the expected return of the portfolio, while the X-
axis indicates the standard deviation of the portfolio.
 Comparative SML AND CML
Portfolio or Individual Securities
SML determines only all the security-related factors or the risk or
return for individual stocks. On the other hand, CML determines
market portfolio and risk-free assets, or the risk or return for
efficient portfolios.

Superior
When it comes to measuring the risk factors, CML is superior to
SML.
 INPUTS REQUIRED FOR
APPLYING CAPM

RISK-FREE RETURN – that is free from Default risk and

is uncorrelated with returns from anything else in the
Economy.
• RATE ON A SHORT-TERM GOVT SECURITY –T Bills
• RATE ON A LONG TERM GOVT BOND -15 to 20 years

MARKET RISK PREMIUM

• HISTORICAL
• DIFFERENCE BETWEEN THE AVERAGE RETURN ON
STOCKS AND THE AVERAGE RISK - FREE RETURN

PERIOD : AS LONG AS POSSIBLE

 Factors driving Market Risk premium

- Variance in underlying economy – Premium is more, if

economy is more volatile , like emerging economies

- Political Risk – premium is high if there is political

unstability, as it causes economic uncertainty.

- - Market Structure- If the companies listed on the

market are mostly large, stable and diversified, Market
risk premium is small.
 DETERMINANTS OF RISK PREMIUM
• VARIANCE IN THE UNDERLYING ECONOMY
• POLITICAL RISK
• MARKET STRUCTURE

* Source : Aswath Damodaran Corporate Finance Theory and Practice, John Wiley.
 BETA

- The beta (β) of an investment security (i.e., a stock) is a

measurement of its volatility of returns relative to the entire
market. It is used as a measure of risk and is an integral part of
the Capital Asset Pricing Model (CAPM). A company with a
higher beta has greater risk and also greater expected returns.

The beta coefficient can be interpreted as follows:

β =1 exactly as volatile as the market
β >1 more volatile than the market
β <1>0 less volatile than the market
β =0 uncorrelated to the market
β <0 negatively correlated to the market
 CALCULATION OF BETA

Rit = αi + βi RMt + eit

σiM
βi =……………..
σM 2

Where σiM is the covariance between return on stock I and the return on the market portfolio and σM
2

Is the variance of the return on market portfolio from its mean.

 Compute Beta
Period Return on Stock A Return on market portfolio
1 10 12
2 15 14
3 18 13
4 14 10
5 16 9
6 16 13
7 18 14
8 4 7
9 -9 1
10 14 12
11 15 -11
12 14 16
13 6 8
14 7 7
15 -8 10
CALCULATION OF BETA
 CALCULATION OF BETA
Covariance = 221/14=15.79
Variance= 624/14= 44.57

Beta = 15.79/44.57= 0.354

When covariance and variance are computed on the basis of
a sample of observed returns, the divisor is n-1 and nor n.

The reason for substracting 1 is to correct for what is technically

called the loss of 1 degree of freedom. N-1 makes the average of the
estimated variance equal to true variance. As mean is computed
from sample. If true mean is known, then n is used and not n-1.
 ESTIMATION ISSUES
• ESTIMATION PERIOD
• A LONGER ESTIMATION PERIOD PROVIDES MORE
DATA BUT THE RISK PROFILE .. FIRM MAY CHANGE
• 5 YEARS – Reasonable period
• RETURN INTERVAL
DAILY, WEEKLY, MONTHLY
• MARKET INDEX
STANDARD PRACTICE – calculate Beta in relation to INDEX
ADJUSTING HISTORICAL BETA
• HISTORICAL ALIGNMENT … CHANCE FACTOR
• A COMPANY’S BETA MAY CHANGE OVER TIME
MERILL LYNCH … 0.66 … HISTORICAL BETA
O.34 … MARKET BETA
 BETAS BASED ON
FUNDAMENTAL INFORMATION
If Stock not traded

KEY FACTORS EMPLOYED ARE

• INDUSTRY AFFILIATION – Betas vary due to variations in

business risks across industries

• CORPORATE GROWTH – stronger the growth , higher the Beta

• EARNINGS VARIABILITY –greater the variability of earning,

higher the beta

• FINANCIAL LEVERAGE – Greater the Financial leverage,

Higher the Beta

• SIZE – Larger the size of a Company, smaller the beta.

 BETAS BASED ON
FUNDAMENTAL INFORMATION

Fundamental Beta has more advantages as compared to

historical Beta
-Has stronger intuitive appeal as rules of predicting are
consistent with general understanding of Company’s risk
-Are ideal for analysis of non trading assets, like individual
projects, Strategic business units etc
-Seem to outperform Historical Betas
-Can be based on future descriptors, Historical Beta is
based on past data.
 BETAS BASED ON
ACCOUNTING EARNINGS
REGRESS THE CHANGES IN COMPANY EARNINGS
(ON A QUARTERLY OR ANNUAL BASIS) AGAINST
CHANGES IN THE AGGREGATE EARNINGS OF ALL
THE COMPANIES INCLUDED IN A MARKET INDEX.
LIMITATIONS
• ACCOUNTING EARNINGS .. GENERALLY SMOOTHED

OUT .. RELATIVE .. VALUE OF THE COMPANY

• ACCOUNTING EARNINGS … INFLUENCED BY NON -
OPERATING FACTORS
 BETAS FROM CROSS
SECTIONAL REGRESSIONS- For unlisted Companies

1. ESTIMATE A CROSS - SECTIONAL REGRESSION

RELATIONSHIP FOR PUBLICLY TRADED FIRMS:

2. PLUG THE CHARACTERISTICS OF THE PROJECT,

DIVISION, OR UNLISTED COMPANY IN THE
REGR’N REL’N TO ARRIVE AT AN ESTIMATE OF
BETA
 EMPIRICAL EVIDENCE
ON CAPM
1. Best way to test CAPM would be to observe investor’s
expectations of Betas and expected returns on
individual securities and market portfolio and then
compare the expected return on each security with
return predicted by CAPM – But not practical as
information on Investor expectations is sketchy.
2. Researchers have tested CAPM on Ex post facto data.
 EMPIRICAL EVIDENCE
ON CAPM

1. SET UP THE SAMPLE DATA

Rit , RMt , Rft - 75 securities for 60 month, market
portfolio, risk free return = 77 * 60 = 4620 rates of return

2. ESTIMATE THE SECURITY CHARACTER-

-ISTIC LINES
Rit - Rft = ai + bi (RMt - Rft) + eit, Excess return on security I is
regressed on excess return on Market portfolio.

3. ESTIMATE THE SECURITY MARKET LINE

 EVIDENCE

IF CAPM HOLDS
• THE RELATION … LINEAR ..
• γ 0 ≃ Rf

• γ 1 ≃ RM - Rf

• NO OTHER FACTORS, SUCH AS COMPANY SIZE

OR TOTAL VARIANCE, SHOULD AFFECT Ri

• THE MODEL SHOULD EXPLAIN A SIGNIFICANT

PORTION OF VARIATION IN RETURNS AMONG
SECURITIES
 GENERAL FINDINGS

• THE RELATION … APPEARS .. LINEAR

• γ 0 > Rf
• γ 1 < RM - Rf
• IN ADDITION TO BETA, SOME OTHER FACTORS,
SUCH AS STANDARD DEVIATION OF RETURNS
AND COMPANY SIZE, TOO HAVE A BEARING ON
RETURN
• BETA DOES NOT EXPLAIN A VERY HIGH
PERCENTAGE OF THE VARIANCE IN RETURN
 CONCLUSIONS

PROBLEMS
• STUDIES USE HISTORICAL RETURNS AS PROXIES
FOR EXPECTATIONS
• STUDIES USE A MARKET INDEX AS A PROXY

POPULARITY
• SOME OBJECTIVE ESTIMATE OF RISK PREMIUM
.. BETTER THAN A COMPLETELY SUBJECTIVE
ESTIMATE
• BASIC MESSAGE .. ACCEPTED BY ALL
• NO CONSENSUS ON ALTERNATIVE
 ARBITRAGE - PRICING THEORY

Studies suggest that it is possible to rely on security

characteristics and earn superior profits even after
adjustment of risk as measured by beta.
It was found that low P/E stocks outperformed high P/E
stocks, small cap stocks outperformed large cap stocks,
Stocks with high Value stocks (having book to market
price ratios) generated more returns than Growth stocks
( having low book to market ratios).
In efficient market such variations should not be there.
Either market are not efficient for a longer period or
CAPM is not capturing risk adequately.
 ARBITRAGE - PRICING THEORY

Stephen Ross developed Arbitrage pricing

Theory that can include any number of Risks.
APT ia a multi factor asset pricing model based on
the idea that an asset’s returns can be predicted
using the linear relationship between the asset’s
expected return and a number of macroeconimic
variables that capture systematic risk.
Although APT is technically superior to CAPM but
not widely used.
 APT VS CAPM

APT is theoretically superior to CAPM because:

- APM allows for several economic factors to determine individual
stock returns, whereas CAPM assumes that the effect of all
factors is captured in a single measure i.e. the volatility of the
stock in relation to the market portfolio.
- APT assumes only that the capital market is perfectly competitive
and that investors prefer more wealth to less wealth with
certainty.
- i

-
 Multifactor Models

Given the practical difficulties in using the above approach,

researchers have followed a different approach that captures the
essence of the APT. In this approach, the researcher chooses a priori
the exact number and identify of risk factors and specifies the
multifactor model of the following kind.
Rit = ai + [bit F1t + bi2 F2t +….. + bik Fkt] + eit
where Rit is the return on security i in period t, and Fjt is the return
associated with the j th risk factor in period t.
 The advantage of a factor model like this is that the researcher
can specify the risk factors; the disadvantage of such a model is that
there is very little theory to guide it. Hence, developing a useful
factor model is as much an art as science.

The variety of multifactor models employed in practice may be

divided into two broad categories: macro-economic based risk factor
models and micro-economic based risk factor models.
 Macroeconomic Based Risk Factor Models
These models consider risk factors that are macroeconomic in
nature. Typical of this approach is the following model proposed by
Chen, Roll, and Ross in their classic paper, "Economic Forces and
the Stock Market," published in the April 1986 issue of Journal of
Business.

Rit = ai + bi1 Rmt + bi2 MPt + bi3DEIt + bi4UIt + b5UPRt + bi6 UTSt + eit
Where Rm is the return on a value weighted index of NYSE – listed stocks, MP
is the monthly growth rate in the US industrial production, DEI is the change in
inflation, measured by the US consumer price index, UI is the difference between
actual and expected levels of inflation, UPR is the unanticipated change in the
bond credit spread (Baa yield – RFR), and UTS is the unanticipated term
structure shift (long term RFR – short term RFR).
 Microeconomic Based Risk Factor Models
Instead of specifying risk in macroeconomic terms, you can delineate
risk in microeconomic terms. Typical of this approach is the
following model proposed by Fama and French in their celebrated
paper "Common Risk Factors in the Returns on Stocks and Bonds,"
published in the January 1993 issue of the Journal of Financial
Economics:

(Rit – RFRt) =αi + bi1 (Rmt – RFRt) + bi2SMBt + bi3HMLt + eit

In this model, in addition to (Rmt – RFRt), the excess return on a

stock market portfolio, there are two other microeconomic risk
factors: SMBt and HMLt. SMBt (i.e.,

contd…
contd..

small minus big) is the return to a portfolio of small capitalisation stocks less
the return to a portfolio of larg capitalisation stocks and HMLt (i.e., high
minus low) is the return to a portfolio of stocks with high ratios of book-to-
market values less the return to a portfolio of low book-to-market value
stocks.

In this model, SMB is intended to capture the risk associated with firm
size while HML is meant to reflect risk differentials associated with "growth"
(i.e., low book-to-market ratio) and "value" (i.e., high book-to-market ratio).
 Stock Market as a Complex
Adaptive System
To understand what a complex adaptive system is let us begin with a
simple situation where two people are put in a room and asked to
trade a commodity. What happens? Hardly anything. If a few
more people are added, the activity picks up, but the interactions
remain somewhat subdued. The system remains static and lifeless
compared to what we see in the capital markets. As more and more
people are added to the system, something remarkable happens: it
acquires lifelike characteristics. As Mauboussin put it: “In a tangible
way, the system becomes more complex than the pieces that it
comprises. Importantly, the transition – often called ‘self-organised
criticality’ – occurs without design or help from outside agent.
Rather, it is a direct function of the dynamic interactions among the
agents in the system.”
 Properties of a Complex Adaptive System
Aggregation The collective interactions of many less-complex agents
produces complex, large-scale behaviour.
Adaptive Decision Rules Agents in the system take information from
the environment and develop decision rules. The competition
between various decision rules ensures that eventually the most
effective decision rules survive.
Non-Linearity Unlike a linear system, wherein the value of the whole
is equal to the sum of its parts, a non-linear system is one wherein
the aggregate behaviour is very complex because of interaction
effects.
contd...
contd…

Feedback Loops In a system that has feedback loops the output of

one interaction becomes the input of the next. A positive feedback
can magnify an effect, whereas a negative feedback can dampen an
effect.
 Implications of the New Model
The important implications of the new model for investors and
corporate practitioners are as follows:

1. While the CAPM is still probably the best available estimate

of risk for most corporate investment decision, managers
must recognise that their stock price may fluctuate more than
what the standard theory suggests.

2. The market is usually smarter than the individual. Hence

managers should weight the evidence of the market over the
evidence of experts.

3. Markets function well when participants pursue diverse

decision rules and their errors are independent. Markets,
however, can become very fragile when participants display
herd-like behaviour, imitating one another.
4. It may be futile to identify the cause of a crash or boom
because in a non- linear system small things can cause large-
scale changes.

5. The discounted cash flow model provides an excellent

framework for valuation. Indeed, it is the best model for
figuring out the expectations embedded in stock prices.

Mauboussin summed up the implications of the new model as

follows: “From a practical standpoint, managers who
subscribe to standard capital market theory and operate on
the premise of stock market efficiency will probably not go
too far astray. However, complex adaptive systems may
provide a useful perspective in areas like risk management
and investor communication.”
 Summing Up
• The relationship between risk and expected return for
efficient portfolios, as given by the capital market line, is:
E (Ri) = Rf + λ σi
• The relationship between risk and expected return for an
inefficient portfolio or a single security as given by the
security market line is:
E (Ri) = Rf + [E (RM) – Rf ] x βi
• The beta of a security is the slope of the following
regression relationship:
Rit = αi + βi RMt + eit
• The commonly followed procedure for testing CAPM involves
two steps. In the first step, the security betas are estimated. In
the second step, the relationship between security beta and
return is examined.

• Empirical evidence is favour of CAPM is mixed.

Notwithstanding this, the CAPM is the most widely used risk-
return model
• The APT is much more general in that asset prices can be
influenced by factors beyond means and variances. The APT
assumes that the return on any security is linearly related to a
set of systematic factors.
 Numerical

• The Following information is availabl:

•Expected Return for the market – 14%
•Standard deviation of market return – 20%
•Risk free return – 6%
•Correlation coefficient between Stock A & Market – 0.7
•Correlation coefficient between Stock B & market – 0.8
•Standard Deviation of Stock A – 24%
•Standard deviation of Stock B – 32%

•A) Calculate the beta for Stock A and Stock B

•B) Calculate the required return for each stock
Beta A = 0.7 * 24 * 20/20 * 20 = 0.84

Beta B = 0.8 * 32 * 20/ 20 * 20 = 1.28

Required return Stock A = Rf + Beta A( (E(Rm) –Rf))

= 6 + 0.84 ( 14 – 6) = 12.72%

Requried return Stock B = Rf + Beta B (( E (Rm) – Rf ))

= 6 + 1.28 (14 – 6) = 16.24%
 Numerical

•
 Numerical