136 (Unie MBA Third EMH & Cap 6.1. EMH (aga MARKET HYPOTHESIS) 6.1.1. Introduction The Efficient Market Hypothesis (EMH) is one of the most notable theories of modern financial economics. The term efficient market was first defined by Fama in 1965. In an efficient market, the security prices change instantaneously (o incorporate new information. This ensures that old information may not be used for predicting the future course of action for the security. There are three different forms of efficient markets based on available information which are weak, semi-strong and strong. the ‘As per the EMH, it is not possible to beat the market as the market efficiency leads the stock price to be at the optimum level. Therefore, there are no undervalued or overvalued stocks in the market. The same applies to other securities such as bonds, ete. It implies that it is impossible to beat the overall market by timing the market or by expert stock selection The only way to beat the market is to assume higher risk than the overall risk of the market. The Random Walk Theory is according to the efficient market hypothesis. It may have three forms i.e., weak form, semi-strong form and strong form. 6.1.2. Nature of Stock Market - Efficient Market Hypothesis ‘An efficient stock market is a market where stock price reflects the fundamental information about companies. The stock prices are subjected to frequent changes and vibrancy. In such a case, the changes in the market value of the company are very similar to the changes in intrinsic value of a company. These changes are not consistent with its value and do not restrain the trading pattern of financial assets of the company. The differences in investors’ awareness and uneven ‘transaction costs can prevent changes in value of lee: | poe TORN Chapter 6 Semester (investmmen tal Asset Pricing Moda tely reflects in market pri ny which imme J compa Caraient market hypothesis consist Of ergy assumption as the stock market is compettye fformation is readily accessible, investors rationally, transaction cost IS reasonably low anj five market returns just by chance investors rece! ositive impact of stock market development oy The po aancpmic growth is possible only when the sto market is efficient. In other words, stock marke induces economic growth only when the former is k market is said to be efficien, efficient. The stocl “hen. all the available information is promply broadcasted, absorbed and taken into attention tp reflect it on its price. Ifa stock market is operationally efficient there i lite, or no, friction in the trading process Information regarding prices and volumes of present and past transactionsis widely available. The price Sensitive information is on time and accurate, thus information dissemination is fast and wide. Liquidity is such that it enables market participants to buy ot sell quickly at a price close to the last traded price ‘Additionally, the changes in price between two transactions are not so rapid, unless the significant information is available in the market. According to the Efficient Market Hypothesis (EMH), an operationally efficient stock market 's expected to be external and information efficient thus security prices at any point of time are the unbiased reflection of all the available information about the expected future cash flows and the risk involved in owning such security. Such market provides accurate signals for resource allocation by precisely representing the intrinsic worth of the security. Market prices can be deviate from the tue value of securities, but these deviations are completely random and uncorrelated. In conclusion, price changes are expected to result from the arrival of new information, Given that there is no reason to expect new information to be no” random every time as price changes are expected '° be random and independent, In an efficient market there'is randomness in the sequence.[pMH & Capital Asset Pricing Model (Chapter 6) 6.1.3. Assumptions of — Efficient Market Hypothesis Following are the main assumptions of the e market hypothesis: See 1). Investors are deemed to be rational 2) Markets act ratio ally 3) There are no taxes applicable to the transactions 4). The transactions do not incur any costs 5) An investor does not differentiate between the dividend and capital gains income 6) A company and its investors are indifferent petween additional equity and additional debt. 6.1.4. Forms of Efficient Market Hypothesis The following are three main forms of efficient markets. 1) Weak Form: The weak form EMH suggests that the securities already incorporate past price and volume information. This means that it is, not possible to outperform the market by checking the pervious price movements, However, if 4 spn has superior information which is not Peilable with anyone else. They may use this information for removing superior retums- In this type of market, the Seeurities incorporate all, publicly wailable saramaaton! nn 1G. Pore ae public information includes past prices © ‘well as the aoveriready available in the market including financial statements. presentation and pertinent economic mews. Under this type of Periket, no extra revurn| may Be ‘made U fatormacionsalreadyerelebie ‘Therefore, the analysis of financial ‘statements may not Be used for higher returns. 4) strong Form: This ‘Pe Of 5 )_ Strong Form rae he Pt ee Hectuding the insider informal qui market prices. Thi ‘such as company insider information There is only indirect ms strong market hypothes!s- alysis of the past price moe cements in tbe DASUTPY et mel market is also te "4 jh indirect ‘The strong is may NO Tro superior security analy by Prenagers wit access © nsi0rF 2) Semi-Strong Form: Following figure st ee ae i as {6:: Forms of Market EMiciency Bi 1) In weak efficient market condition, the variance between price and value may be positive oF negative and show large variance 2) In semi-strong efficient market, the variance is relatively smaller. 3) In strong form markets, the pric guilibrium. There is no variance between price and value. 6.1.5. Tests for Different Forms of Efficient Market Hypothesis Security markets have a large number of Bigby ‘balified and intelligent professionals and inves trying to make high retums by buying and selling ne snd overvalued securities. The higher numbet Is to faster dissemination of ‘of participants. lead: orformation which makes the market more efficient es are in the the markets are neither In real life situations, inefficient. All perfectly efficient nor perfectly Frarkets are efficient to some extent ‘Empirical Tests of Weak Form ‘The weak form ‘of the efficient market renders The ital analysis" seless. Following are ne approaches used for testing the weak form of the efficient market hypothesis. This approach looks for fatter inthe security price changes Such changes should be statistically significant. }) Simulation Test: ‘The _ most prominent Siarrion est were, conducted. DY ETT sire Sinwuacon tess, generate 2 Aer of Roper mibers and compare thet 10 he actual fe changes f0F & S6eUry. OF the market. The Pritt pve them may weil) the utility Siriaas 48 tls me lead t0 tring cam ourmbers 10 predict, future sock price movements2) Filter Test: Te 3) 4) 138 (Univ 11) is studies past price movements to predict the future movements, One such technique is filter rule. This strategy states that in case a security increases its price by @ minimum x% then the investors should hold the stock until it drops x% from its subsequent high. Different filter rules are used by different traders. The filter may range from 0.5% to 50% For example, a hypothetical company ABC has the filter 10 be 20%. The price generally fluctuates between $50 and %70, Assume that price starts from %50 and increases 20% to %60. At this price point, the investor should purchase the stock. The stock may continue to rise to %70, The sell signal will occur when stock falls 20% from %70 ic to 256, at which point the trader may take up short position. The exercise will continue with every rise and fall. However, it has found in the studies that average gains, after accounting for transaction costs, are significantly lower than the gains made through y. simple buy and hold strate; Serial Correlation Test: This technique is used for testing the interdependence between successive price changes. This type of correlation measures the correlation co-efficient for a series of numbers with the lagging values of the same series. The price differential in period t+1 or any other period is correlated to the existing price in the immediately preceding period. However, the studies have failed to find any significant correlation. Fama conducted this test for 30 stocks between the period of 1958 ‘and 1962. He kept varying the t periods from t+1 to 1410. The results from autocorrelation are not important. A large portion of the results were in the range of +010 and -0.10. Such low level of correlations shows that the technical analysts may not expect much success in predicting the furuwe ‘course of action for the stocks. Runs Test: Runs test study the movement of security prices, However, it does not pay any attention to the quantum of movement in the stock prices. The continuous increase or decrease in the stock price is noted and is compared with the expected rise or fall in the security price. If the stock prices move randomly than, there will not be any up or down. There will not be any dominating streak as the up streak or down streaks will be almost equal in number. For ‘example, if 101 data series are examined they ae most likely to have 50 positive and 51 negative streaks, MBA Third Semeste ortfolio Managemen «investment Analysis and kn ‘Analysis: Spectral analysis involves th time series data into ig frequency rather than wi if the first differen 5) Spectral decomposition constituents related (0 ; The spectrum of prices may be tested for their flatness and may Prad for showing that the Security price may o, not move in line with the past patterns of pirical Tests of Semi-Strong Form 10 examine the following. ely available information ang ts get incorporate 6.1.5.2. I The tests see 1) Whether the publi ately? lysts receiving such information ar. news im Whether able to use it for generating superior returns? Following are the main empirical studies conducteg in this regard 1) Earnings Announcements: Ball and Brown studied the impact of the annual camings movements. They announcement on the price analysed 261 firms over the period of 20 years. The stock price movements for the companies with good ‘announcements were checked with the stock price movements for the companies with bad ‘announcements. The study found that good announcements made the stock price rise while the opposite happened for bad earnings announcements Joy, Litzenberger and McEnally tested the effect of quarterly earings announcements on the stock price movements, They concluded that positive news did not had immediate impact on the stock price. Discount Rate Change: regarding the impact of discount rate changes show that the average security price will have « marginal change before the announcement of discount rate changes, However, such change is not material enough for a trading profit. Stock Split: The impact of stock split announcement on stock price was studied by Fama, Fisher, Jensen and Roll. They also studied it with regard to the change in dividend policy. The results concluded that the markets were efficient Various studies 2 3) However, following were the main anomalies: i) Price earnings ratio effect. ii) Size effect 6.1.5.3. Empirical Tests of Strong Form While the hypothesis may be disapproved by ‘common sense, the studies haye shown that the people with insider information are able 10 generaleEAH & Capital Asset Pricing Model (Chapter 6) superior information. The positive findings prove ‘hur the hypothesis is not correct. It can be known by the help of following users "| J) Specialists: The specialists working. in a stock SPeange Keep record of limit orders which have ere been fulfilled. They also have access to insider jnformation which may be valuable for speculative profits. Various studies show that in many Eich people may be able to generate more ret 3) Insiders: Insiders are defined as the directors, significant shareholders, officers or any other person who may have access to inside Jnformation about the company, as per Federal faw. in the USA. Research concludes that the insiders may generate trading return on account of their superior knowledge. 3) Professionals: Certain professionals such as mutual fund portfolio managers may also have cess to insider information before it reaches general public. sases 6.1.6. Implications of Efficient Market Hypothesis for Investment Decision ‘The EMH has implied that no one can outperform the market either in security selection or market timing, Thus, it carries huge negative implications for many ieetment strategies and it is difficult to predict Generally, the conclusion of EMH can Pe derived pectives: from two different pers tions of Efficient Market Investment Decision rspective Investors Persp ie themselves the 6.1.6.1. 3 decide s the deviation Ultimately, investors must ket efficienc’ degree of marl h a i jsion. An investor in for inyesunent decision. / ve grounds (ad 2 a ts Ps such deviation as an management may opportunity. Every inves comprehensive knowledge hypothesis (EMS) whether they a" investors, tor is expected efficient e active oF Pass has the: followin} ket implies thi i se 4 making Ue pq security: ‘This perspective First, an efficient ma ~s analysis are at investors and know! 139 The individual may not use public information to achieve superior results in investment because the investment community is already using and acting on that information. If the investment community is not using this information properly for security valuation, then individual can achieve superior result from their investment, It is the known fact that the investment community as a whole is competent where every member of community is trying to beat ich other which further help in creating an efficient nancial market Second, when security market is efficient, such efficiency may not apply to other markets. The non financial assets are not purchase or sell in an efficient security market. This means that the current prices of these assets is not reflecting their intrinsic value — that is, the price is not reflecting the potential flow of. future income or price appreciation. If the markets for assets other than financial assets are dispersed and all transactions are processing through over-the- counter, the dissemination of information regarding prices becomes limited. This tends to reduce the P ficiency of markets which result in price that is 199 high or too low. While, such situation may offer mie lent opportunities for the astute and the know!- edgeable investors, and it can also become disaster for the beginners. ‘The third and perhaps most important implication of the efficient market hypothesis apply to an individual's security portfolio. The efficient market hypothesis seems to suggest an individual investor sabet a diversified portfolio of securities and eam Tetum as per the current market situations. Furthermore, once the portfolio has been selected, there is no need to change its composition. The Strategy then, is to buy and hold. By this way an Svestor can takes an additional advantage after minimising the outgoing fund ie,, commission. ‘The problem with this single dimension strategy is that der the reasons as why an investor vives and acquires securities and other assets, The goals behind the investment are not ‘clearly identified anf portfolios are created without considering the at egies of established goals. Further, the port i srrired co be changed with respeet v0 the changes 19 ols and market conditions. 11s Cot required to alter ihe portfolio for the sake of changes, as result in the payment of additonal commissions ‘but it can be alter it produces equivalent retums. However, when Jon's goals or financial situation change, the it be altered in a way that is consistent oals and conditions. a> wi the inve wifolio shou! with the new BF| | | EMM foilitate an investor to take decision making Plompily. It eonstnicts an environment in whieh an IMvestor Must Make decisions. The hypothesis should nuke that the investor realive that investments in seLuies May Not prodlice superior Fett Rather, the investor should eum return over petted of tine that is consistent with the rer warned by the market ws a whole and the usual amoUnE OF risk is borne by the Investor This means that individual investors should devote nore tine and effort for deciding their investment Is and selecting the securities 10 meet those Is than {0 analysis the individual securities separately 6.1.6.2, Financial Managers Perspective Managers need to keep in mind that the market would either underreact or overteact 10 the latest information in the market, the share price of company helps in identifying such information and \wnderstanding the market response 10 that snformation, ‘he historical share price records can be used as an listrument to measure the performance of company for which the managers are responsible, When share are under-priced, managers should avoid issuing new shares, This will only worsen the situation, In normal circumstances, market efficiency theory provides useful insight of price behaviour, Generally, i Gan Be concluded that investors should only expect normal rate of return, while company should expect \orteccive the fair value for the securities they issue, 6.1.7, Random Walk Hypothesis Random walk theory implies that market prices follow 4 random path for going up and down, Ite main thesis lies in the fet that the price movements are not impacted by any past or present Figure 63: Capital Market Line Preference of each investor would be to creat portfolio having risk-free asset (R,) and a mix of securities presently traded in the market. An ine" can accomplish any point on CML either leveraging on portfolio M or by borrowing investing the funds in M.ye can Asset Pricing Model (Chapter 6) jive of RMB which is formed by the mutual Teg of all invests by merging market poroio sake asset i called as °Captal Market Line’ sta! Market Line may be represented through the fallowing equation; 9, y E(R,)-R B(R,)=R, +| —2-— BR, )=R, [ a where, Fxpected Rate of Return on a Portfolios and its wal risk as measured by standard deviation 6, Risk-Free Rate of Retum xs E Bxpected Rate of Return from the Market Portfolio M) tandard Deviation of Returns of Market Portfolio. ‘The Capital Market Line makes available a risk- return relationship in the perspective of portfolios in tificient markets, The slope shown in the figure represents the price of risk, which is shown as the standard deviation of given portfolio. Example 7: Dummy Lid., an investment company, has invested in equity shares of a blue chip company I's risk-free rate of return (Ro) = 10%, Expected total retum (R,,) = 16%, Market sensitivity index (B) = 1.50 (of individual security). Calculate the expected rate of return on the investment make in the security. Solution: Total expected return (Rm) = 16% Risk-free return (Ry) = 10% Risk premium (Ra ~ Ro = 6% E(R) =Rr+ BIE (Ra) — Rd 0 + 1.50(16 -10) = 19% following E $: Mr. Rakesh provides you Example &: Me expected etm Yi CAPM. Ru = 16%, Rr = 9%. B= 0.8% Solution: The expected return on portfolio: E(R) =Ri+ BIE Bm — Rd ) Ret ie 9) = 146% eh 3.2, Secorty Market Line (SML) 5 ark’GML) is line drawn on @ The Sectrity Mae da the Capital Asset Pricing Model (arm) in a graphics) ere papas: of levels of systematic Or ries vis a vis the expected secure? given point of ime. of he entire MAMA aractrsi line” a 149 east Of ‘the graph represents the risk (beta), Whereas the *Y’ axis represents the expected return. ‘The slope of the graph determines market risk premium, The balanced relationship between the ‘expected return’ and ‘standard deviation’ for efficient Portfolios is shown by the CML, However, it does not specify the manner in which individual assets are priced in a security market, It is true that the security prices undergo changes across portfolios (as put forward by CML), it is purely an abstract idea which n't be used as a basis for investment decisions Another tangible measure is, therefore, required which can be used as a realistic basis for the evaluation of ‘risk-return’ trade-off in respect of individual securities. ‘The total risk is not that material as far as individual securities are concerned, due to the fact that it is possible to diversify away a part thereof. The appropriate reward for carrying ‘systematic risk’ exclusively is given by the systematic risk and market. Applications of Security Market Line William Forsyth Sharpe, an American economist had come out with the famous “Beta Concept’ for the ‘measurement of systematic risk. It can be applied for the evaluation of systematic risk in respect of all assets and portfolios irrespective of their being efficient or inefficient Markowitz Diversification ‘The portfolio theory of Harry Markowitz is considered to be a method for the creation of CAPM. tt essentially envisages finding out those securities which have either low positive co-variance or negative co-variance due to low systematic risk fassociated with them. Individual securities and portfolios with low or negative co-variance of retum With market portfolio are likely to be in high demand, (on the other hand, individual securities and portfolios with high co-variance of retum with market portfolio are likely to be in low demand due to high systematic risk associated with them. It is as simple and logical. The prices of securities with high systematic risks tend to fall and the prices of securities with low systematic risks tend to rise, As the rate of return on any equity is inversely proportional to its price, securities with high co- variance with the market are likely to have‘comparatively low prices and high expected rate of, returns. On the other hand, securities with low and negative co-variance with the market are likely to comparatively high prices and low expected rates. of return, The above relationship is represented as Security Market Line (SML) under the Capital Asset Pricing Model (CAPM), CAPM model entails the relationship between risk and return to be in a linear fashion; E(R)) = Rj + BIE(R,) — Rid) where, E(R) = Expected return on security j Ry = Risk-free return B Beta of security j E(Rq) = Expected return on market portfolio The above relationship is referred to as the Security Market Line (SML). The required retum on a security involves two parts: 1) Risk-Free Retum: Ry 2) Risk-Premium: B, (E (Ra) — Ri] It may be underlined here that the risk premium is a product of the level of risk B, and the compensation Pet unit of risk [E (R,,) ~ Rid Therefore, higher is the beta, the higher is the expected return and vice versa. Security Market Line (SML) may be shown as in the figures 6.4: [24s *] +b om SeovR,Re) SM. (Cov (Ri, Ra) Security Market Line (Based on Covariance) PR) 1 guar = BR) =R,+ [e1e.)-R. } By Security Markct Line (Based on Betas) Figure 64: Security Market Line MBA Third Semester (Investment Analysis and Portfolio Managem, 0 Ady To conclude, according 10 the CAP mos Appropriate rate of return on the asset compy,Y following two constituents: es 1) Time Preference Rate of Return as indica, the intercept value (Ry) ty 2). Market Price of Risk as measured by thes), the CAPM. Pe of 6.3.8.3, Difference between SML and ¢ ML The difference betwe follo’ SML and CML ae Security Market Line (SMI)| Capital Market Line cy, 1) SML, which 18 alsolThe CML is line mere Called a Charactersticlto show the combiatog Line, isa graphical return and risk a optimal oc, fepresentation of the|and CAPM is used ty ys! market's risk and return|the tradeoff between the 1 at a given time. Tt is explained theoreicu,| that all portfolios are 4.) Jcombination of risk-fee oye Jof return and the marie, [portfolio of risky assets 2) Beta coefficient|The CML me determines the _risk| factor through statistical tol, fectort of the | SML-lie, sandard. deviatcn | Which helps in nding MG, andar deviation Get the ak eur |PM68 2 RR al contributed for pon = 3) The security market line] The capital marke Tine gap saps explain both th [define only the efit efficient and non-|porolis. efficient potlios_ | [Security factors — ae] Market portfolio and ik Fe determined by the SML. fasset ae determined by te CML, 5) While calcaaing the| While calculating he eas) returns on security, return] on security, expected tn iS shown on the Y-aris|on secur is shown on te on graph for represeting| ais on graph fr repeeaieg the SML_ the CML 19) The Securgy Market Line) The CML determines the shows the expected tumor return for fies! afindvidval esses. | pottios FA Measure of isk for SMI Measure of Fak for i beta standard deviat Example 9; The rate of risk-free (Treasury Bills) securities is 8.25% and the expected retum for the market is 11.5%. What should be the required rates ML is) of return for each security? Security | A B ic D Beta 1.15 | 0.85 | 1.00 | 1.50 Solution: Security Ri+B (Ru -Rd A 8.25 + 1.15 (11.5 — 8.25) = 11.98% B 8.25 + 0.85 (11.5 —8.25) = 11.01% C /825+1.00(11.5-8.25)=115% | D 8.25 1,50 (11.5 ~ 8.25) = 13.12%pcre det Pre Model (Chapter 6) po yo; You ae given the following nn: i wee rate of interest is 10% 2 Goepany'S expected retum for next year is 18% 2 Gases 2 «the market's expected return for next year? wast 18% = 10% + (Fm — 10%) =014= 14% 11: The CAPM was estimated for some Beal in the market, The actual retum of two pariolios is given below portfolio A: Actual retu portfolio B: Actual rewu 14 % Beta =0.8 = 20 % Beta = 1.2 qpe equation of the CAPM is Ri = 0.07 + 0.10 bi What can be said about the portfolio’s performance? a+$Rm 0.07 + B0.10 Portfolio Rx = 0.07 + (0.8 x 0.10) 0.07 + 0.08 =0.15 x 100 = 15% Portfolio Rs = 0.07 + (1.2.x 0.10) 07 + 0.12 .19 x 100 = 19% Panfolo A's expected retum is 15% but the actual teams is 14%. Its an under performed portfolio. B's capected return is 19%. But actual retum is 20% ‘The performance is higher than the expected rtm Paiolio B has performed well than the portfolio A. =, © Details of Portfolio held by your client ‘which average reuum of 15% are given below: Senses | Cont | Dividend/Interest | Market mee br A | 090 6 ed 5 soa 400 32.000 co N00). 220 16,000 > | 00 2 9,000, \ amo 4900. 52,000 Bent Eas ged reas of each investment using Find oS svcrage renuen f Ce Yontfolio, 151 Cost] Dividend | Market | Capital | Bet oe | awe | Gan Bales | “wa _| Se x] a0 a0 | ean | 42.000 | 2000 | 07 b | nim | sso Samm | 3im| 09 | | c | 15000) 2250| 16.000] 1,000} 08 Stal raga |e am | yon oa'| as capa ars gon tein |Pstoue) 205) | Bond | } saa [astooe |e [as] TBxpected Return = Dividend + Capital Appresiai Investment _19,550+6,000, 145,000 Average Beta = 4.55/5 = 0.91 =17.62% Average Return = Risk Free Return + Average Beta (Expected Return ~ Risk Free Return) 0.15 = Ry+ 0.91 (0.1762 Rd 0,09 Ry = 0.1603 - 0.15 0.09 R= 0.0103 R= 11.44% Expected Rate of Return of Individual Security = Rp =R,+B(Ra- Rd a Tras 07.62— 1144) |B | 11.44 017.62 - 11.44) G 1144 47.62— 11.44) D 11.44 (7.62— 11.44) [ihasarea= nia Ss bond YM lS PRICING! THEORY (APT) 6.4.1-~ Introduction ‘The Arbitrage pricing theory (APT) was first formulated by Stephen Ross in 1970s. It is used to estimate the price of a financial asset and determine if it is undervalued or overvalued in the market. This theory assumes that security returns are related to an unknown number of unknown factors known as risk factors. The asset returns are generated by stochastic or random process which can be represented as linear function of various economic risk factors. Linear function implies that return on an asset depends upon various economic independent variable factors like inflation, interest rate, etc. The degree of the factor affects the return of an asset which depends on the sensitivity of return to that particular factor.i \ Bh seks ~ 152 (Unit) The APT was developed to overcome the deficiencies of Capital Asset Pricing Model (CAPM). Where CAPM assumed that the stock Tetums were affected by a single parameter that had ‘one beta, APT overcomes this limitation and proposes that there are multiple parameters that affect the return and each factor has a specific beta, ‘These specific beta factors measure the impact of @ factor on an asset's return. 6.4.2. Assumptions of APT The assumptions of APT are as follows: 1) The APT assumes that the investors have same ‘expectations and make the same choices given in a particular set of market circumstances. 2) The APT assumes that the investors are risk averse and profit maximisers. 3) The APT assumes that the perfect com present in the market and there is no tr cost Unlike CAPM, the APT theory does not assume following: 1) There is single-period investment horizon. 2) There are no taxes. 3) The investors can borrow and lend at risk-free Tate of interest. The selection of the portfolio is based on the mean and variance analysis. 6.4.3. Equation of APT The pricing theory explains asset ie., stock or portfolio retums as a linear function of the above factors. APT gives the expected return on asset i as: E(Ri) =RF +b; x(ER,)- RA) +b; x(ER,)— Rf) +b; X(B(R,) RA +..+b, x (ER,)- RD where, Rf = Risk free interest rate (ie., interest on Treasury Bonds) bi = Sensitivity of the asset to factor i E(Ri — Rf) = Risk premium associated with factor i where i= 1, 2,..0 Example 12: Calculate the expected rate on asset using the equation for APT model if the Risk Free Rate (Rf) is 7%. Risk Premium of Specific | Beta of specific Factors factor RPI = 1.25 ba15 RP2=0.50 b= -0.75 RP3= 18 bys? folio Manageme MBA Third Semester investment Analysis and Portfolio Managemen ay x Model Solution: Equation for APT Model EAR) PRtt yx RPI + boxRP2+ by RP3 E(Ri) = 7+ 1.25(1.5) + 0:50 0.75) + 1.8 (1 4 4+ 1.875 — 0.375 + 2.16 = 10.66 4) Expected rate of retur of the stock is 10.66% Example 13: From the following information og three securities calculate the equilibrium rate ¢ return oy Tbh] oe 0.75 | -0.5 130 | 0.75 1B lee 2 3) Solution: Risk free interest rate = 4% Risk free interest rate for I factor asset = 3% Risk free interest rate for 2 factor asset Two factor model as applicable = E(r)) diy + 5% bi E (tx) = 4% + 3% (0.75) + 5% (-0.5) = 3.75% E (ty) = 4% + 3% (1.30) + 5% (0.75) E (rz) = 4% + 3% (1) + 5% (1.2) = 1.65% In the graph below, OM is risk free return (i.e. 4%) ‘Actual CAPM line is shown in the graph to vary from zero Beta line to a substantial extent. In the graph below, OM is risk free return. Actual CAPM line is shown in the graph to vary from zero Beta line to a substantial extent. ‘4 Zero Beta CAPM. § ‘Actual : cars 2 | | Riskfee eum —_| ° Beta values x 6.4.4. Advantages of APT The advantages of APT are as follows: 1) The APT model is a multifactor model. The calculation of expected return is done bY calculating various macro-economic factors like GDP, inflation, etc. and their sensitivitis (measured by beta) which might affect the Pace movement of stock. Higher the beta, higher he sensitivity of the factor on the asset's returt I helps in selecting the factors which affects stock price more and specigoicoial A Pricing Model (Chapter 6) yy Te APT model is according to the arbitrage free ring of market equilibrium which assumes to fe certain extent results in proper expectation rahe rate of return on the risky asset pris the multifactor model which is based on AMfaiance between asset returns and external faotors. It is not same like CAPM. The CAPM ives importance to the covariance between asset Returns and external factors. ayis ‘The APT model is effectively used in multi- Kod cases compared to the CAPM which is Fequired only for single period cases. The APT is used to calculate cost of capital and for taking capital budgeting decisions. 6) The APT model does not need any assumption for the empirical distribution of the asset returns which is different from CAPM which Considers that the stock return does not work on normal distribution. So, the APT is less restrictive model bee 3 ry he yal ¢ 4 6.4.5._Factor Model In APT model, the number and nature of risk factors BPanknown, The model does not consider the risk for from before. They have to be identified and defined before the model is being used. 4) 9 ‘The theory itself does not tell the investor what the factors are for a particular stock oF asset. The application of this theory is that one stock is more sensitive to one factor than to another. a share of Exxon Mobil in very reactive to the Colgate Palmolive For example, the price of anol and gas company might be price of erude oil, while a share of Pil not be reactive to the price of oil investor The arbitrage pricing theory also lets the inves! or analyst, ABe Prpnise different factors fo" certain stock. 645.1. One-Factor Model i sins with the assumption theory starts Win an unknown Ve. Lg a a et, orn ee ee ee ka ae 133 r= Rate of return on security, Zero factor, nsitivity of security to the factor, Value of the factor, which in this case is the rate of growth in industrial production, e = Random error term. Example 14: Determine the equilibrium arbitrage pricing line that is consistent with the following two equilibrium-priced portfolios. Assume that the one- factor APT model applies n | Rate of return on portfolio, { Equiibriu Portfolio ae 10% [aS ff Solution: The equilibrium equation is in the form, r2atbiFit & take on values that will make the risk- hip between portfolios X and Y linear n be found by simultaneously solving for RP, and RP: and F; must return relations ‘The solution ca the following two equations 10% =a,+F 0.5) (portfolioX) (1) 15% =a,+F,(15) (portfolio Y) Feea(2) To find a simultaneous solution, first subtract (2) from (1) 1% ‘Substituting F; in (2) yields, 15% =a +5 %( 1.5) =a, + 7.5% a= 7.5% ‘Therefore, the equilibrium APT equation is, 1= 7.5% + (5%) 6.4.5.2: Awo-Factor Model In the following two-factor model, the formula is: E (n) =a, + Fibu + Fabo where, F) = risk premium associated with risk factor 2 and bu = factor beta coefficient for factor 2 and factors | and 2 are uncorrelated. ‘The CAPM only systematic risk has pricis een ly systematic risk has pricing >»