CAPITAL ASSET PRICING THEORY AND ARBITRAGE PRICING THEORY

M N SHAFI 10CB 14

CAPM THEORY
The CAPM theory helps the investor to understand the risk and return relationship of the securities .

A model that describes relationship b/w risk and expected return on an invmt

The general idea behind the CAPM is investor can mix risk
free assets with the risky assets in a portfolio to obtain desired rate of risk-return combination

In CAPM cash is investing in 2 ways

1. Time value of money / risk free
invmt for over a period of time

2. Risk
amount of compensation the investor needs for taking on additional risk. Is calculating by risk measure beta

Expected return should equal the rate on a risk free + risk premium

If the expected return does not meet or exceed the required return , the investment should not be undertaken

Under the theory of the CAPM total risk is partitioned into two parts:
Systematic risk / Non Diversifiable Risk Unsystematic risk / diversifiable risk

Total Risk of the Investment

Systematic Risk

Unsystematic Risk

The beta coefficient measures systematic risk

Expected rate on the combination of risky and risk free investments

Rp = Rf Xf + Rm (1- Xf) Rp = portfolio return Xf = the proportion of funds invested in risk free assets 1-Xf = the proportion of funds invested in risky assets Rf = Risk free rate return Rm = Return on risky assets

Exercise
Investor is investing in risk free & risky assets Let assume , Borrowing and lending rate to be 12.5% Return on risky asset to be 20 % Case.1 if he invest 50% in risk free and 50% risky asset His expected return of the portfolio would be,,,,,,, Rp = Rf Xf + Rm (1- Xf) = 12.5 .5 + 20 ( 1- .5) = 6.25 + 10 = 16.25%

Case.2
If there is a zero invnmt in riskfree asset and 100% in risky, the return is,,,, Rp = Rf Xf + Rm (1- Xf) = 0 + 20% = 20%

Case.3
If - .5 in risk free asset and 1.5 in risky asset , the return is Rp = Rf Xf + Rm (1- Xf)

= (12.5 - .5) + 20 1.5 = - 6.25 + 30 = 23. 75

Calculating portfolio risk

Variance of the risk free asset is zero . i e, portfolio risk solely depends on the portion on investments on risky assets The variance of the risky asset is assumed to be 15.
Proportion in risky asset (1-Xf) 0.5 1.0 1.5 PORTFOLIO RISK 7.5 15 22.5

Capital Market Line. (CML)

A line used in the CAPM to illustrate the rates of return for

efficient portfolios depending on the risk -free rate of return and the level of risk ()for a particular portfolio

Capital Market Line. (CML)

ER
Expected return on A

Required Return on C

CML

C B a portfolio that A is an overvalued undervalued offers and Expected portfolio. Expected expected return is greater than equal to the less than required return. the required return. Selling pressure will Demand for Portfolio cause the price A will increase to fall and the yield price, driving up theto rise until expected equals and therefore the the required return. expected return will fall until expected equals required (market equilibrium condition is achieved.)

A C

Required return on A

B
Expected Return on C

RF

BETA
Most popular risk indicator for stock Measure the volatility of price in the mkt it gives a fair idea on how the stock will react for the mkt movements in other words how does the stock price move relative to overall mkt If is 1 , it will fluctuate in price at the same rate of mkt Greater than 1 have greater price volatility than the overall mkt & more risky Less than 1 of stocks have less price volatility than the mkt & are less risky

Beta & Risk

If you are accepting more risk, you should expect more reward

For eg. If a stock with of 1 is expected to return 8%, while a stock with of 1.5 should return 12%

For short term investors is a good measure of risk , but for long term carefully consider company's fundamentals.

Security market line (SML)

Relationship b/w Risk expected rate of return and

For individual securities.

If the unsystematic risk is eliminated, then the matter of concern is systematic risk alone. This 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)

ER

Expected return

M ERM

SML

RF

M = 1

Risk (beta)

ARBITRAGE PRICING THEORY (APT)

What is Arbitrage ???

The purchase of currencies, securities, or commodities in one

mkt for immediate resale in others to profit from unequal prices Simultaneous purchase and sale Is a practice of taking advantage of a price

difference b/w two or more markets

ARBITRAGE PRICING THEORY (APT)

According to APT theory investor tries to find out the possibilities to increase returns from his portfolio without increasing the funds in the portfolio. Basic requirement of an Arbitrage portfolio. Wants to change the proportion of the securities without any additional financial commitments. For eg. The investor holds A, B, and C securities and he want to change the proportion of securities without any additional financial commitments. (X a, X b& X c ). Increase in the invt in the security A could be carried out only if he reduces the propotion of invt either in B or C.

Exercise
The investor holds the A, B, and C stocks with the following returns and sensitivity to changes in the industrial production. The total amount ib Rs. 150,000 /-

R
Stock A Stock B 20% 15%

b
.45 1.35

Original weights .33 .33 0.53 0.355 0.115

Stock C

12%

.55

.34

the investor would increase his investment in stock A and B by selling C. The new composition of weights are,

From the APT analysis it can be concluded that

The return in the arbitrage portfolio is higher than the old portfolio The arbitrage and the old portfolio sensitivity remains the same

EFFECT ON PRICE. To buy stock A and B the investor has to sell stock C The buying pressure on stock A and B would lead to increase in their price Selling of stock C may result in fall in the price of the stock C