ECF350/BAS430

o Models of Asset returns

o Capital Asset Pricing Model (CAPM)
 Assumptions of the CAPM
 Principal results of the CAPM
 Limitations of the CAPM
o Arbitrage Pricing Theory model (APT)
 Assumptions of the APT
 Principal results of the APT
 Limitations of the APT
o Calculations using the CAPM
Readings: (1) CT8 Exam Prep Manual Unit 7
 Recall that for a single investor, given his own
estimates of security returns, variances and
covariances can apply portfolio theory
 The CAPM is the equilibrium model of price for the
entire asset market
 The CAPM assumptions include those of the Modern
Portfolio Theory
 The CAPM tells us about the relationship between
risk and return for security markets as a whole
 In short CAPM is a model that describes the
relationship between the expected return and risk of
investing in a security
 All expected returns, variances and covariances of
pairs of assets are known
 Investors make their decisions purely on the basis of
expected return and variance
 Investors are non-satiated
 Investors are risk-averse
 All investors have a fixed single-step time period
 There are no taxes or transaction costs
 Assets may be held in any amounts
 All investors can borrow or lend unlimited amounts
at the same risk-free rate
 Perfect market for risky securities
 Investors have the same estimates of the expected
returns, standard deviations and covariances of
securities over the one-period horizon
 All investors measure in the same “currency” eg
Kwacha or dollars or in “real” or “money” terms.
 There are many buyers and sellers, so that no one
individual can influence the market price.
 All investors are perfectly informed.
 Investors all behave rationally.
 There is a large amount of each type of asset.
 Assets can be bought and sold in very small
quantities, i.e. perfect divisibility.
 There are no taxes.
 There are no transaction costs.
 The model is actually presented as follows
𝐸 𝑅𝑖 = 𝑟𝑓 + 𝛽 × 𝑃𝑅
Where
 𝐸 𝑅𝑖 is the expected return on security 𝑖
 𝑟𝑓 is the risk free rate
 𝛽 is the beta of the security
 𝑃𝑅 is the risk premium or expected excess market
return, and 𝑃𝑅 = 𝑅𝑚 − 𝑟𝑓

𝐸 𝑅𝑖 = 𝑟𝑓 + 𝛽(𝑅𝑚 − 𝑟𝑓 )
 𝑅𝑚 is the expected return on the market
Risk Free Rate (𝒓𝒇 )
 𝑟𝑓 is the rate of return of a hypothetical investment
with scheduled payment over a fixed period of time
that is assumed to meet all payment obligations
 It can be a yield on bonds or treasury bills
 It is a rate with zero standard deviation
Beta (𝜷)
 The 𝛽 is the stock’s sensitivity to market risk
 It is a measure of a stock’s risk (volatility of
returns) reflected by measuring the fluctuation of
its price changes relative to the overall market
 If a company’s 𝛽 is 1.5, then the security has 150%
of the volatility of the market average
 However, if the 𝛽 is equal to 1, the expected return
on a security is equal to the average market return
 A 𝛽 of -1 means security has a perfect negative
correlation with the market
Beta (𝜷)
 The 𝛽 can independently be calculated as
𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑚 )
𝛽=
𝑉𝑎𝑟(𝑅𝑚 )

 𝑅𝑖 is the return on security 𝑖

 𝑅𝑚 is the return on the market
 𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑚 ) is the covariance between security 𝑖
and market m
 𝑉𝑎𝑟(𝑅𝑚 ) is the variance of market return
Market Risk Premium
 The market risk premium represents the additional
return over and above the risk-free rate, which is
required to compensate investors for investing in a
riskier asset class
 This means that the more volatile a market or an
asset class is, the higher the market risk premium will
be
Example 1
 Consider a security with a sensitivity of 1.3. If the
risk free rate is 1% and the risk premium is 7%, find
the expected return of the security
Solution
𝐸 𝑅𝑖 = 𝑟𝑓 + 𝛽(𝑅𝑚 − 𝑟𝑓 )
or
𝐸 𝑅𝑖 = 𝑟𝑓 + 𝛽 × 𝑅𝑃

𝐸 𝑅𝑖 = 1% + 1.3 × 7%

𝐸 𝑅𝑖 = 1% + 9.1%

𝐸 𝑅𝑖 = 10.1%
Example 2
Consider Security A, which has a standard deviation of
investment returns of 4%. If
 the standard deviation of the market return is 5%
 the correlation between A’s return and that of the
market is 0.75
 the risk-free rate is 5%
 and the expected return on the market is 10%
then calculate:
(i) the beta of Security A
(ii) Security A’s expected return.
Solution
i. Here we need the knowledge of unit 5. Recall that

𝐶𝑜𝑣(𝑅𝐴 , 𝑅𝑚 )
𝛽=
𝑉𝑎𝑟(𝑅𝑚 )

First find the covariance btn security and market returns

𝐶𝑜𝑣 𝑅𝐴 , 𝑅𝑚 = ρ𝜎𝑖 𝜎𝑚
𝐶𝑜𝑣 𝑅𝐴 , 𝑅𝑚 = 0.75(4%)(5%)
𝐶𝑜𝑣 𝑅𝐴 , 𝑅𝑚 = 15%%
Solution
i. Second find the variance of market returns
𝑉𝑎𝑟 𝑅𝑚 = 𝜎2𝑚
𝑉𝑎𝑟 𝑅𝑚 = (5%)2
𝑉𝑎𝑟 𝑅𝑚 = 25%%

Hence

𝐶𝑜𝑣(𝑅𝐴 , 𝑅𝑚 ) 15%%
𝛽= = = 0.6
𝑉𝑎𝑟(𝑅𝑚 ) 25%%
Solution
ii. To get expected return of security A we use
𝐸 𝑅𝐴 = 𝑟𝑓 + 𝛽(𝑅𝑚 − 𝑟𝑓 )
𝐸 𝑅𝐴 = 5% + 0.6(10% − 5%)
𝐸 𝑅𝐴 = 5% + 0.6(5%)
𝐸 𝑅𝐴 = 5% + 3%
𝐸 𝑅𝐴 = 8%
i. It can be used to price assets, both financial
securities and other assets such as capital projects
ii. If the beta of an asset can be estimated from past
data, then the security market line can be used to
estimate the prospective return that the asset should
offer given its systematic risk (element of the
unpredictability of investment returns that cannot be
eliminated by diversification)
iii. If use (ii) holds, then the prospective return can
then be used to discount projected future cash flows
and so price the asset
 The Arbitrage Pricing Theory (APT) is a theory of
asset pricing that holds that an asset’s returns can
be forecasted with the linear relationship of an
asset’s expected returns and the macroeconomic
factors that affect the asset’s risk
 It is an equilibrium market model that is based upon
the assumption of an investment world that is
arbitrage-free
 Arbitrage relates to the act of buying a security in
one market and simultaneously selling it in another
market at a higher price, thereby enabling investors
to make a profit
 APT makes grater use of
i. No Arbitrage principle
ii. Multi-factor models
 According to the no-arbitrage principle,
 The process of arbitrage ensures that when a
market is in equilibrium there should be just one
price for a given asset
 Two items that are identical cannot have different
prices – if they did, the forces of supply and
demand created by arbitrageurs would quickly
remove the price anomaly
 The APT requires that asset returns be linearly
related to a set of indices as shown below:
𝑅𝑖 = 𝛼𝑖 + 𝑏𝑖,1 𝐼1 + 𝑏𝑖,2 𝐼2 + ⋯ + 𝑏𝑖,𝐿 𝐼𝐿 + 𝜀𝑖
Where,
 𝑅𝑖 is the return on security 𝑖
 𝛼𝑖 is the constant
 𝑏𝑖,𝑘 is the sensitivity of security 𝑖 to factor 𝑘
 𝐼𝑘 is the change in the kth factor which explain
the variation of 𝑅𝑖 about the expected return 𝛼𝑖
 𝜀𝑖 is the random term
Assumptions
 Investors diversify their portfolios
 Investors choose their own individual profile of risk
and returns based on the premiums and sensitivity
of the macroeconomic risk factors
 Risk-taking investors will exploit the differences in
expected and real returns on the asset by using
arbitrage
 𝐸 𝜀𝑖 = 0
 𝐶𝑜𝑣 𝜀𝑖 , 𝜀𝑗 = 0, 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑖 ≠ 𝑗
 𝐶𝑜𝑣 𝜀𝑖 , 𝐼𝑘 = 0 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑠𝑡𝑜𝑐𝑘𝑠 𝑎𝑛𝑑 𝑖𝑛𝑑𝑖𝑐𝑒𝑠
Example 1
Assume a well-diversified portfolio of equities. Suppose
that
 The riskless rate of return is 2%. Two similar
assets/indices are the Zambeef (ZA) and Legana
(LE) and two factors are inflation and GDP. The
betas of inflation and GDP on ZA are 0.5 and 3.3,
respectively. The betas of inflation and GDP on LE
are 1 and 4.5, respectively. ZA’s expected return is
10%, and LE’s expected return is 8%.
Calculate the expected arbitrage pricing theory return.
Solution
To answer this question, we first need to formulate the
respective expected returns linear functions for ZA & LE
Zambeef
𝐸 𝑍𝐴 = 𝑟𝑓 + 𝛽1 𝜋 + 𝛽2 𝐺𝐷𝑃
10% = 2% + 0.5𝜋 + 3.3𝐺𝐷𝑃
8% = 0.5𝜋 + 3.3𝐺𝐷𝑃

Legana
𝐸 𝐿𝐸 = 𝑟𝑓 + 𝛽1 𝜋 + 𝛽2 𝐺𝐷𝑃
8% = 2% + 𝜋 + 4.5𝐺𝐷𝑃
6% = 𝜋 + 4.5𝐺𝐷𝑃
Solution
Next we need to solve the simultaneous equation for 𝜋
and 𝐺𝐷𝑃
8% = 0.5𝜋 + 3.3𝐺𝐷𝑃
6% = 𝜋 + 4.5𝐺𝐷𝑃
Doing so will give us
𝜋 = −0.154285
𝐺𝐷𝑃 = 0.0476189

We now formulate our required model

Solution

𝐸 𝑅𝐴𝑃𝑇 = 𝑟𝑓 + 𝛽1 𝜋 + 𝛽2 𝐺𝐷𝑃

𝐸 𝑅𝐴𝑃𝑇 = 2% + 𝛽1 (−0.154285) + 𝛽2 (0.0476189)

𝐸 𝑅𝐴𝑃𝑇 = 2% − 0.154285𝛽1 + 0.0476189𝛽2

Example 2
 Suppose that just two factors, 𝐼1 and 𝐼2 , are needed to
describe the returns from assets. Asset A is heavily
influenced by 𝐼1 , whereas Asset B is heavily influenced
by 𝐼2 . Suppose also that the expected returns from each
of A and B are given by the following equations:
𝐸 𝑅𝐴 = 4 + 2𝐼1 + 𝐼2
𝐸 𝑅𝐵 = 5 + 𝐼1 + 2𝐼2
 Asset C has equal weighting on the two factors. Write
down the equation for the expected return on Asset C.
Solution

𝐸 𝑅𝐶 = 0.5𝐸 𝑅𝐴 + 0.5𝐸 𝑅𝐵

𝐸 𝑅𝐶 = 0.5 4 + 2𝐼1 + 𝐼2 + 0.5 5 + 𝐼1 + 2𝐼2

𝐸 𝑅𝐶 = 2 + 𝐼1 + 0.5𝐼2 + 2.5 + 0.5𝐼1 + 𝐼2

∴ 𝐸 𝑅𝐶 = 4.5 + 1.5𝐼1 + 1.5𝐼2

 The theory does not suggest what factors for a
particular stock or asset to include
 The investors have to perceive the risk sources or
estimate factor sensitivities
 In practice, one stock would be more sensitive to
one factor than another
i. The theory can be used for both passive and active
portfolio management
 Passive portfolio management involves holding a
portfolio of assets in order to meet a specified
investment objective and only changing that portfolio
reactively in response to a change in the objective
 Active portfolio management involves actively
identifying and trading mispriced assets in order to
make excess risk-adjusted returns, eg returns in
excess of a particular index
ii. APT can be used to find a smaller sample of shares with
the same sensitivities to the same factors as the index
iii. by using APT to estimate the exposure of a portfolio
to different risk factors, the extent of that exposure
can be managed as required
iv. APT can be used to estimate the expected return on
a financial security given its exposure to the various
risk factors modelled
v. The return in (iv) can then be used to discount
projected future cash flows and so price the security
and determine if it appears to be under-valued or
over-valued.
THE END