CAPITAL MARKET THEORY

AND ARBITRAGE PRICING

THEORY
Submitted by:
MANASVI SURI 21MBA18
PIYUKSHA PARGAL 37MBA18
SIMRAN KALSEE 56MBA18
CAPITAL MARKET
THEORY
▸
▸

▸
“
The capital market theory is a major extension of the portfolio theory of Markowitz.
Portfolio theory is a description of how rational investors should built efficient
portfolios.
Capital market theory tells how assets should be priced in the capital markets if,
indeed, everyone behaved in the way portfolio theory suggests. The capital asset
pricing model (CAPM) is a relationship explaining how assets should be priced in the
capital markets.
▸ Capital market theory is a positive theory in that it hypothesis how investors do
behave
rather than, how investors should behave, as, in the case of Modem Portfolio Theory
(MPT). 
 Assumptions

1.All investors can borrow or lend money at the risk-free rate of return.
2. The capital assets are infinitely divisible. The investors may borrow or lend without limit in
infinitely divisible units regardless of their size of wealth.
3. All assets must be divisible
4. There are no transaction costs.
5. There are no personal income taxes---investors are indifferent between capital gains
and dividends.
6. There is no inflation.
7. There are many investors, and no single investor can affect the price of a stock
through his or her buying 
and selling decisions. Investors are price takers and act as if
prices are unaffected by their own trades.
 Role of Capital Market Theory

▸ Capital market theory attempts to explain the relationship between investment

returns and risks.
▸ Addresses both individual investments and portfolios of multiple investments.
▸ Uses: –
Portfolio construction: How should a portfolio of assets be constructed given the
variety of different assets available for investment?
Asset valuation: How much is an asset worth given the characteristics of the other
assets in market?
Performance measurement: How did an asset perform historically relative to the
other assets in similar markets? How are risk and return attributed?
 ARBITRAGE
PRICING THEORY
 EVOLUTION OF APT

INDIVIDUAL VS PORTFOLIO BANZ (1981)

BASU (1977)

IN AN EFFICIENT MARKET THE SCENARIO DOES NOT OCCUR,

REASONS:
• MARKET IS NOT PARTICULARLY EFFECEINT
• SOMETHING WRONG WITH THE SINGLE FACTOR MODEL OF CAPM
 Meaning of Arbitrage Pricing Theory

APT provides investors with an estimated required rate of return on risky

securities.

Instead of just a single beta value, there is a whole set of beta values that affect
the price of an asset.

Beta is the degree of reaction a security gives to a factor.

 Assumptions of Arbitrage Pricing Theory

▸ The investors have homogeneous beliefs

▸ The markets are perfect so that the factors like transaction cost are
not relevant.
▸ The security returns are generated according to the factor model.
▸ Risk return analysis is not the basis.
“ APT states that the expected return on investment is
dependent upon how that investment react to a set of
individual macro-economic factors and the risk
premium associated with each of those macro
economic factor.
 APT AND ITS FORMULATION

R = E (R1 )+ B1f1 + B2f2 + B3f3 +….. + e

Where,
(R1) = Actual return on asset one
E (R1)= Expected return on asset one if all the risk
factor is zero change
B1= security’s sensitivity to change in factor
f1 = a set of common factors
e = random error which has a unique affect on the
asset’s return
Arbitrage Pricing Theory, return on an asset is dependent on various macro-
economic factors like

• Inflation
• Exchange rates
• Market indices
• Market sentiments
• Changes in interest rates
 Expected return on asset = E + f1b1 + f2b2 + e

2 FACTORS
1. Unexpected changes in E(Rx) = 0.04 + 0.03*1.5 + 0.02*0.5
inflation = 0.04 + 0.045 + 0.01
2. Unexpected changes in level = 0.0950 = 9.5%
of GDP

2 Assets – x and y E(Ry) = 0.04 + 0.03*1.75 + 0.02*2.0

= 0.04 + 0.525 + 0.04
Bx1 1.5
= 0.605 = 13.25%
Bx2 0.5
By1 1.75
By2 2.0

F1 3% ( 0.03)
F2 2% (0.02)
E 4%
14
 Security Valuation with the APT

▸ APT says that by active trading of securities with different

sensitivities to the important factors, investors trade away the
opportunities of excessive gains.
▸ Advantage of Arbitrary profit can only be taken by selling some
assets and buying some in the portfolio therefore insulating it
from risk and eliminating excess returns.
 Security valuation with APT

▸ Assume 3 securities (A,B and C) and 2 factors (1 and 2) and the returns
expected be 4% and 5%
E(RA) = (0.80)*f1 + (0.90)*f2
E(RB) = (-0.20)*f1 + (1.30)*f2
E(RB) = (1.80)*f1 + ( 0.50 )*f2

E(RA) = (0.80)*4% + (0.90)* 5% =7.7%

E(RB) = (-0.20)* 4% + (1.30)* 5%=5.7%
E(RB) = (1.80)* 4% + ( 0.50 )* 5%=9.7%
Assume the current price of these securities is Rs. 35

Expected prices after a year Actual prices after a year

PA 35*1.077= 37.70 37.20 Overvalued

PB 35*1.057 = 37.00 37.80 Undervalued
PC 35*1.097= 38.40 38.50 Undervalued

Riskless Arbitrage

Actual portfolio
No net investment No risk involved return is positive
 Wa = -1.0 Short sell 2 shares @35 = 70
Wb = +0.5 Net Investment
Buy 1 share @35 = 35 = 70-35-35 = 0
Wc = +0.5 Buy 1 share @35 = 35

Net Exposures to risk factors

Assets Factor1(w*bi) Factor2(w*bi)

A -1*0.8 = -0.8 -1*0.9 = -0.9

B 0.5*-0.2 = -0.1 0.5*1.3 = 0.65

C 0.5*1.8 = 0.9 0.5*0.5 = 0.25

19

Net Profit

[ 2*35 – 2*37.20 ] + [ 37.80 – 35 ] + [ 38.50 – 35 ] = Rs. 1.90

What would happen when everyone today believes the way you do about the future
price levels of A,B and C ?
 EMPIRICAL TESTS OF THE APT

Roll and Ross Study

▸ Estimate expected returns and factor coefficients from time-series data on
individual asset returns.
▸ Use these estimates to test basic cross sectional pricing conclusion.

H0 : There exists non-zero constants such that for any asset I

[ E(Ri) – E ] = f1b1 + f2b2 + f3b3 + ………fkbk

▸ Statistical technique of factor analysis was used

▸ 42 portfolios with 30 stocks each was tested
▸ Tesrs were however not conclusive
Dhrymes, Friend and Gultekin
▸ As the no. of securities increase from 15 to 60, no. of
significant factors increases from 3 to 7.
▸ These initial tests prove that APT difficult to test by factor
analysis.
 Chen, Roll and Ross

▸ An alternative to using factor analysis, investor can hypothesis a set

of factors to explain covariance among securities
▸ 4 specific factors
1. Difference between yield on a long term and a short term risk free security
2. The risk of inflation
3. The growth rate in industrial production
4. The difference between yields of high rated securities and risk free securities.
 ARBITRAGE PRICING THEORY
BENEFITS

Multi factor model allows specific

selection of factors

Assumptions lead to fair assumption of

return on risky asset

Can be applied to cost of capital and

capital budgeting decisions
ARBITRAGE PRICING THEORY
LIMITATIONS

Shortlisting of factors

Expected rate of returns not always available

Calculating sensitivities not feasible

Factors may change over a period of time

THANKS!
Any questions?