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Investment Management and Capital Markets

Lecture 3: CAPM and APT

- CAPM and the SML

- the Market Model
- Relationship between the CML and the SML
- Arbitrage Pricing Theory

The Capital Asset Pricing Model

Portfolio theory showed that addition of several risky assets has a

`risk-reduction effect.’


Market Risk / covariant risk / systematic risk

`n’ securities in a portfolio

As the number of risky assets increases ( typically > 15 random securities) the risk of
the portfolio tends to the average covariance, or how the return on the stocks move with
respect to each other (the majority of stocks have positive covariance with each other).

Beyond a point, therefore adding new securities to the portfolio does not result in
further risk reduction.

The risk which can be diversified away by increasing the number of securities is the
Specific risk.

The risk which cannot be eliminated further is the market risk.

The portfolio which has the highest excess return per unit of risk or Sharpe ratio is the
Market portfolio. By implication it is clear that the risk of the Market Portfolio is made
up only of market risk.

Equivalent terms

Market risk, systematic risk, unspecific, undiversifiable risk,

onmarket risk, specific risk, unique risk, unsystematic risk, diversifiable risk.

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The Beta of a stock

The total risk on a stock can be expressed as the sum of the squares of
the systematic risk and its unsystematic risk

ie σi2 = σsys 2 + σunsys2

The systematic part of the risk is the portion which is related to the market.

Beta is the sensitivity of the expected return on the stock to the expected return on the
Market portfolio. It is the covariance of the return on the security i with the return on
the market portfolio divided by the variance of the market portfolio.

Beta `β’ = cov (Ri,Rm) / σm2

= ρim. σm. σi. / σm2 = ρim σi / σm

= sys risk of stock / risk of market portfolio

ie σsys2 = β2 σm2 = ρim2 . σ i 2

So when ρim2 = R2 is close to 1; the stock’s risk is almost entirely systematic risk,
and it has very little specific or unsystematic risk.

In lay terms, β is a measure of the market risk (systematic risk) of an asset.

The Market portfolio is designated to have a β of 1 (its risk is only market risk).

The Security Market Line

The Capital Asset Pricing Model (CAPM), gives us the Security Market Line as a basis
to price assets by the amount of market risk (or systematic risk) which comprises the
total risk of returns on the asset.

The CAPM implies that there is no premium for the nonmarket related risks that an
asset may have (also called specific risk), as all specific risk can be diversified away.

ERi = Rf + βi ( ERm-Rf )

Security Market Line

ERi Underpriced securities

Rm overpriced securities


β=1 β

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Relationship between the CML and the SML

The Capital Market Line (CML) shows us portfolios of different risk made up
only of the riskfree asset and the Market portfolio with the highest excess return per
unit of risk (Sharpe ratio).

These portfolios only have different amounts of market risk.

The relationship between the CML and the SML are as below:



rf rf

0 σm σj = β j σm β=1 βj
σ β


(i) how the SML prices only the market (systematic) component of a security

(ii) the CML shows how an equivalent portfolio with only market risk can be made
from a combination of the risk free asset and market portfolio.

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Finding Beta by the Market Model

The CAPM is an equilibrium asset pricing model. It states that in equilibrium

assets pricing will be as follows:

E(Ri) - Rf = βi. (E(Rm) -Rf)

In practice the β of an asset can be found by regressing the returns on the asset against
the returns on the market portfolio over a suitable period of time: such a model is called
the market model of the CAPM.

Rai = α + β Rmi

( ie Rai = α + β Rmi + e )

Rai = predicted return on share `a’ when return on the market index is Rmi

( Rai = actual return when ” )

`α‘ is the intercept on the `y’ axis and

`β‘ is the slope of the line Rai = α + β Rmi

where `e’ is an error term representing the difference between the actual
return and the return predicted by the model. ( e = Rai- Rai)

In linear regression, a relationship as at (1) above is arrived at by the `OLS’

or ordinary least squares method, whereby the sum of the squares of the error terms is

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Tests of the CAPM

The CAPM is an equilibrium asset pricing model.

According to CAPM theory, the market portfolio is mean variance efficient and the
SML equation is a correct predictor of returns on various securities:

Rp = Rf + (Rm-Rf)βp

Empirical tests of the CAPM are based on testing expost data through reclassifying the
CAPM equation as below:

Rp-Rf = γo + γ1 βp + ε p

The betas of stocks or portfolios of stocks are ascertained over a period in the first
stage; then in the second stage, these betas are plotted regressed against the excess
return on the share/portfolio.

If the CAPM is valid then clearly,

(i) the intercept must be zero; beta should be the only factor fully able to explain the
excess return on the share.

(ii) the slope of the empirical market line so obtained must equal the market risk

Several tests have been done, and they show that

- γo is significantly different from zero;

- the empirical line is flatter than the predicted line.

When γo is significantly different from zero, and the empirical line is flatter, it implies
there are possibly other variables which can also explain the returns of an asset and not
only the market portfolio ( eg P/E; M/B; Size, D/Y).

Roll’s basic critique is that a share index is not the market portfolio, which has to
include all the risky assets in the market and not only securities ( coins, property etc… ).

Hence, Roll developed an alternative theory the Arbitrage Pricing Model, according to
which security returns are sensitive to a set of factors ( hence this a multiple beta

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Arbitrage pricing theory

The APT assumes that individuals believe that security returns are determined by a K-
factor generating model

Rj = E(Rj) + Σ bjk Fk + εj


Rj is the actual return on the jth security,

E(Rj) is the expected return on the jth asset

bjk is the sensitivity of the jth asset’s return to the kth factor

Fk is the kth factor common to the returns of all assets under consideration.

εj is the noise term for the jth asset ( random, zero mean)

Like the CAPM, the APT assumes that risk is composed of a diversifiable(non-
systematic) and systematic components. In APT the systematic components are
measureable through the sensitivity of the asset’s return to various factors which affect
all assets.

Ross then formulated the concept of `arbitrage portfolio.’

(a portfolio that has no risk, requires no capital investment and yet earns a positive
return). Such a portfolio cannot exist in equilibrium as all such profits would have been
arbitraged away.

ie : Σ xj = 0 ; (no capital investment)

Σ bjk. xj = 0; (no risk)

∆ rp = Σ rj. xj is +ve. (net positive return)

Under these circumstances at equilibrium the APT can written as:

E(Rj) = Rf + Σ ( δ k - Rf) bj k

`δ k’ is the expected return on a portfolio which has a sensitivity of 1 to the kth factor
and zero sensitivity to all other factors.

`bj k ’ is the sensitivity of the jth asset to the kth factor.

`Rf’ is the return on a riskfree asset which has no sensitivity to any factor.

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According to APT at Market equilibrium no (riskless) arbitrage profits are available by
holding different combinations of securities. ( In efficient markets correct pricing of
various assets takes place through elimination of arbitrage opportunities.)

In equilibrium, the factor sensitivities `bjk’ can be likened to `β’ in the CAPM.

bjk = COV ( Rj, δk) ( `β’ = cov ( rj, rm) )

VAR (δk) var ( rm)

Research by Chen, Roll and Ross in the US has shown that the following five
macroeconomic variables are significant `factors’–

1. Industrial production
2. Changes in the default risk premium
3. Return on short-term and long-term government bonds
4. Inflation
5. Changes in the real rate of interest


The factors found significant in APT tests are in the manner of economy wide risks
affecting the returns of all assets to different degrees. The CAPM, however, is thus a
special case of the APT where one factor, the expected return on the market portfolio
explains the return on an asset.

CAPM is thus not as effective as the APT, for predicting returns on assets not properly
represented in the reference index. ( commodities, savings and loans, electric utilities).

Earlier, it was also stated that empirical tests have found that the empirical market
line is flatter, with an intercept possibly explainable in terms of
P/E, MTBR, Dividend yield, Size.

On the other hand the CAPM conveniently prices assets on the basis of a single factor
which encapsulates economy wide variables. It is useful for determining the cost of
capital required for valuation and for capital budgeting, for the majority of stocks.

CAPM versus DVM

Compared to the DVM, the CAPM is a single period model, dependent on past Betas,
whereas the DVM is forward looking, based on expectations of Dividends in several
future periods. The DVM however is also dependent on past growth rates of dividends..
A good discussion on the CAPM versus the Dividend Valuation Model appears in Steve
Lumby’s Investment Appraisal and Financial Decisions, 5th ed. Note also that the DVM
in its bare form is a total risk model.

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