Nama Mahasiswa : Indah Olivia Ambarita

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Asset Pricing Principles

Capital Market Theory Assumptions, a set of predictions concerning equilibrium expected
returns on risky assets. It typically is derived by making some simplifying assumptions in order
to facilitate the analysis and help us to more easily understand the arguments without
fundamentally changing the predictions of asset pricing theory.
A Risk-Free Asset, defined as one with a certain-to-be-earned expected return and variance of
the return of zero. Since variance ¼ 0, the nominal risk-free rate in each period will be equal to
its expected value. The true risk-free asset is best thought of as a Treasury security, which has
little or no practical risk of default, with maturity matching the holding period of the investor.
Risk-Free Borrowing and Lending :
1. Lending Possibilities, refers to the purchase of a riskless asset such as Treasury bills
because by making such a purchase, the investor is lending money to the issuer of the
securities, the U.S. government. We can think of this risk-free lending simply as risk-free
investing.
2. Borrowing Possibilities, the investor is no longer restricted to his or her wealth when
investing in risky assets. Technically, by short-selling the riskless asset. By buying stocks
on margin, which has a current initial margin requirement of 50 percent.
The Equilibrium Return-Risk Tradeoff, predictions concerning equilibrium expected returns
and risk.
1. Capital market line specifies the equilibrium relationship between expected returnand risk
for efficient portfolios.
2. The security market line specifies the equilibrium relationship between expected return
and systematic risk. It applies to individual securities as well as portfolios.
The Capital Market Line and the Components
The slope of the CML is the market price of risk for efficient
portfolios. It is also called the equilibrium market price of
risk.4 It indicates the additional return that the market
demands for each percentage increase in a portfolio’s risk,
that is, in its standard deviation of return.
The Equation for the CML
the expected return for any portfolio on the
CML is equal to the risk-free rate
plus a risk premium. The risk premium is the
product of the market price of risk and the
amount of risk for the portfolio under
consideration.

The Market Portfolio, It is the highest point of tangency between RF and the efficient frontier
and is the optimal risky portfolio, often proxied by the portfolio of all common stocks, which, in
turn, is proxied by a market index such as the Standard & Poor’s 500 Composite Index, which
has been used throughout the text.
The Separation Theorem, that the investment decision (which portfolio of risky assets to hold)
is separate from the financing decision (how to allocate investable funds between the risk-free
asset and the risky asset).
The Security Market Line, depicts the risk-return tradeoff in the financial markets in
equilibrium. The major conclusion of the CAPM is: The relevant risk of any security is the
amount of risk that security contributes to a well-diversified portfolio. We could relate the
expected return on a stock to its covariance with the market portfolio.

Beta, relates the covariance of an asset with the market portfolio to the variance of the market
portfolio, and is defined as …
If the security’s returns move more (less) than the market’s returns as the latter changes, the
security’s returns have more (less) volatility (fluctuations in price) than those of the market.
The Capital Asset Pricing Model (CAPM) formally relates the expected rate of return for any
security or portfolio with the relevant risk measure. The CAPM’s expected return–beta
relationship is the most-often cited form of the relationship. Beta is the relevant measure of risk
that cannot be diversified away in a portfolio of securities and, as such, is the measure that
investors should consider in their portfolio management decision process.
The risk premium should reflect all the uncertainty involved in the asset.

It formalizes the basis of

investments, which is that the greater the risk assumed, the greater the expected (required)
return should be. This relationship states that an investor requires (expects) a return on a risky
asset equal to the return on a risk-free asset plus a risk premium, and the greater the risk
assumed, the greater the risk premium.
Over-and-Undervalued Securities, SML can be fitted to a sample of securities to determine the
required return-risk tradeoff that exists. Knowing the beta for any stock, we can determine the
required return from the SML. Then, independently estimating the expected return from, say,
fundamental analysis, an investor can assess a security in relation to the SML and determine
whether it is under- or overvalued.
Estimating Beta
The market model equation can be expressed as

The market model produces an estimate of return for any stock. To estimate the market model,
the TRs for stock i can be regressed on the corresponding TRs for the market index. Estimates
will be obtained of αi (the constant return on security that is earned regardless of the level of
market returns) and βi (the slope coefficient that indicates the expected increase in a security’s
return for a 1 percent increase in market return). This is how the estimate of a stock’s beta is
often derived.
The conclusions of the CAPM are entirely sensible:
1. Return and risk are positively related—greater risk should carry greater return.
2. The relevant risk for a security is a measure of its effect on portfolio risk.
THE LAW OF ONE PRICE
APT is based on the law of one price, which states that two otherwise identical assets cannot sell
at different prices. APT assumes that asset returns are linearly related to a set of indexes, where
each index represents a factor that influences the return on an asset.
ASSUMPTIONS OF APT
Unlike the CAPM, APT does not assume :
1. A single-period investment horizon
2. The absence of taxes
3. Borrowing and lending at the rate RF
4. Investors select portfolios on the basis of expected return and variance
APT, like the CAPM, does assume that :
1. Investors have homogeneous beliefs
2. Investors are risk-averse utility maximizers
3. Markets are perfect
4. Returns are generated by a factor model
FACTOR MODELS
A factor model is based on the view that there are underlying risk factors that affect realized and
expected security returns.
UNDERSTANDING THE APT MODEL

The equation for expected return on a security is given by: