CAPITAL ASSET PRICING

THEORY

The required rate of return of an asset is

having a linear relationship with asset’s
beta value. i.e. Undiversifiable or
systematic risk.
ASSUMPTIONS
1.An individual seller or buyer cannot affect the price of a
stock. This assumption is the basic assumption of the
perfectly competitive market.
2.Investors make their decisions only on the basis of the
expected returns, standard deviations and co variances of all
pairs of securities.
3. Investor are assumed to have homogenous expectations
during the decision-making period.
4. The investor can lend or borrow any amount of funds at
the riskless rate of interest. The riskless rate of interest is the
rate of interest offered for the treasury bills or Government
securities.
5. Assets are infinitely divisible. According to
this assumption, investor could buy any
quantity of share i.e. they can even buy ten
rupees worth of Reliance Industry shares.
6. There is no transaction cost i.e. no cost
involved in buying and selling of stocks.
7.There is no personal income tax. Hence, the
investor is indifferent to the form of return
either capital gain or dividend.
8.Unlimited quantum of short sales, is allowed.
Any amount of shares an individual can sell
short.
The expected return on the combination
of risky and risk free combination is
Rp=Rf Xf + Rm(1-Xf)
Rp=Portfolio return
Xf= The proportion of funds invested in
risky assets.
1-Xf=The proportion of funds invested in
riskless assets.
Rf = Riskless rate of return
Rm=Return on risky assets.
ARBITRAGE PRICING
THEORY
 The capital asset pricing theory explains the returns of
the securities on the basis of their respective betas.
 The alternative model developed in asset pricing by
Stephen Ross is known as Arbitrage pricing theory.
 The APT theory explains the nature of equilibrium in
the asset pricing in a less complicated manner with
fewer assumptions compared to CAPM.
 Arbitrage is a process of earning profit by taking
advantage of differential pricing for the same asset.
The process generates riskless profit. In the security
market, it is of selling security at a high price and the
simultaneous purchase of the same security at a
relatively lower price.
THE ASSUMPTIONS
1. The investors have homogenous expectations.
2. The investors are risk averse and utility
maxi misers.
3. Perfect competition prevails in the market and
there is no transaction cost.
The APT theory does not assume
(1) Single period investment horizon,
(2) No taxes
(3) Investors can borrow and lend at risk free rate
of interest and
(4) The selection of the portfolio is based on the
mean and variance analysis. This assumptions are
present in the CAPM theory.
Graham and Dodd’s Investor Ratio
 Graham and Dodd’s Model is described below
 P=M(D+E/3)+A
 Under this model, the dividends of a firm determine
market value of a company’s equity.
 P=Share price
 M=Earnings of firm paying a normal dividend
 D=Dividend’s per share
 E=Earnings per share
 A= Adjustment for asset values.