Chapter 7 Capital Asset Pricing and Arbitrage Pricing Theory

Capital Asset Pricing Model
Equilibrium model that underlies modern financial theory
± Developed by Sharpe, Lintner and Mossin ± Useful benchmark for the expected return of an asset ± ³Expected rate of return (or risk premium) is determined by a security¶s risk as measured by beta´

Builds on Markowitz portfolio theory
± Each investor is assumed to diversify his or her portfolio according to the Markowitz model ± In this case, each asset¶s risk can be measured by its contribution to the risk (³beta´) of the market portfolio
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and transaction costs 3 .Assumptions Individual investors can borrow or lend money at the risk-free rate of return Investors are rational mean-variance optimizers Homogeneous expectations Single-period investment horizon Investments are limited to traded financial assets Information is costless and available to all investors No taxes.

and everyone will find it optimal to hold the market portfolio since it gives the highest reward-to-risk ± Simply buying an index mutual fund. a passive strategy. it is optimal among all risky assets. market portfolio containing all assets in proportion to its market value will be on the efficient frontier..Resulting Equilibrium Conditions In equilibrium.g. would be optimal: ³Mutual Fund Theorem´ 4 . e. and at the tangent point of the capital market line ± Therefore.

Resulting Equilibrium Conditions (cont.) Risk premium on an individual security is proportional to the risk premium on the market portfolio and the beta coefficient E(ri) ± rf = Fi [ E(rM) ± rf ] Risk premium on the market portfolio depends on the average risk aversion of all market participants E(rM) ± rf = A×WM2 5 .

Capital Market Line (CML) E(r) CML E(rM) rf M Wm W 6 ‡ CML equation only applies to markets (M) in equilibrium and efficient portfolios .

but proxied by S&P 500 ± Contains worldwide assets ± Contains financial and real assets ± Difficult to test whether CAPM is right or not 7 .Market Risk Premium M rf E(rM) ± rf E(rM) ± rf = = = = Market portfolio Risk free rate Market risk premium Market price of risk (Slope of the CML) WM Market portfolio is unobservable.

investors want to be compensated only for bearing systematic risk ± Individual security¶s risk premium is a function of the individual security¶s contribution to the risk of the market portfolio.Risk Premium on Individual Securities Due to the diversification effect. [ E(ri) ± rf ] / Fi = [ E(rM) ± rf ] / 1 @E(ri) = rf + Fi [ E(rM) ± rf ] Security Market Line (SML) Cf. CML equation only applies to markets (M) in equilibrium and efficient portfolios 8 . which is measured by beta Thus. the ratio of risk premium to beta must be the same for all securities in equilibrium ± Comparing this ratio with the market portfolio (Fm = 1).

Security Market Line (SML) E(ri) E(ri) = rf + Fi [ E(rM) ± rf ] E(rM) rf Slope = E(rM) ± rf = market risk premium ß M = 1.0 ßi 9 .

03 + 1.6 E(ry) = 0.11 or 11% ± If Fy = 0.08) = 0.078 or 7.03 + 0.0 E(rx) = 0.25(0.08) = 0.08 and rf = 0.rf = 0.25 E(rx) = 0.13 or 13% ± If Fx = 1.0(0.Sample Calculations for SML E(rm) .8% 10 .08) = 0.6(0.03 ± If Fx = 1.03 + 1.

Graph of Sample Calculations E(r) SML E(rx)=13% E(rm)=11% E(ry)=7.6 1.08 ß 11 ßy ßm ßx .0 1.8% rf =3% 0.25 0.

Disequilibrium Example E(r) 15% E(Rm)=11% rf=3% 1.0 1.25 underpriced SML ß 12 ßm ßx .

25 is offering expected return of 15% According to SML. because it is offering too high of a rate of return for its level of risk 13 . it should be 13% ± That is.Disequilibrium Example : Underpriced Suppose a security with a F of 1. it is underpriced.

and deals with expected returns as opposed to actual returns. we cast it in the form of an index model.CAPM and Index Models CAPM relies on a hypothetical market portfolio. where actual index portfolio are used as a proxy for the market portfolio: ri ± rf = Ei + Fi (rm ± rf) + Ii 14 . ± For implementation.

. .. .. . . .. ... . . . .Estimating an index model Excess returns on a security (Ri) . . . . . . on market index (R ) . . . .. . . . . . . .. . . . . Excess returns . . . . . R = E + ßR + e m SCL(Security Characteristic Line) i i i m i 15 . . . . . . .

93 . 5.76 3.41 -3. .60 5. 2.19 Excess Mkt. 3. .24 0. Ret. .Estimation Example Excess GM Ret. Dec Mean Std Dev Estimate (rGM ± rf ) = E + ß (rm .rf) + I .43 -0.44 . 7.46 16 Jan Feb .90 1.

59) (0.591 1.rf) + I E ß Estimated coefficient -2.rf = E + ß(rm .136 Std error of estimate (1.Estimation Results rGM .548 R-SQR = 0.585 Std dev of residuals = 3.309) Variance of residuals = 12.575 17 .

Decomposition of total variance Taking variance on both sides of the index model gives the following: ri ± rf = Ei + Fi (rm ± rf) + Ii Wi2 = Fi2 Wm2 + WI2 = Systematic + unsystematic components 18 .

equilibrium prices adjust to eliminate all arbitrage opportunities Arbitrage opportunity ± arises if an investor can construct a zero investment portfolio with no risk. profitable arbitrage opportunities will quickly disappear 19 . but with a positive profit ± Since no investment is required.Arbitrage Pricing Theory Based on the Law of One Price ± Since two otherwise identical assets cannot sell at different prices. an investor can create large positions in long and short to secure large levels of profits In an efficient market.

5 Standard Dev.Arbitrage Example Current Stock Price$ A B C D 10 10 10 10 Expected Return% 25.% 29.58 33.58 Can we find an Arbitrage opportunity here? 20 .0 32.0 20.91 48.15 8.5 22.

Correlation Return Dev.83 6.) than those of the asset D alone ± How to exploit this opportunity? 21 .B.Arbitrage Example (Cont.) Consider an equally-weighted portfolio of the first three stocks Mean Std. dev.C 25.94 D 22.25 8. Of Returns EW Portfolio of A.40 0.58 ± This portfolio yields higher returns and lower risk (std.

Short 3 shares of D.Arbitrage Example (Cont. and buy 1 share of A.) Exp.Dev. B & C to form P ± You can earn a higher return than you pay on the short sale 22 . * P * D Std. Ret.

..APT Model APT assumes returns generated by a factor model Factor Characteristics ± Each risk factor must have a pervasive influence on stock returns ± Risk factors must have nonzero prices ± Risk factors must be unpredictable to the market The expected return-risk relationship for the APT: E(Ri) = RF + bi1 (risk premium for factor 1) + bi2 (risk premium for factor 2) + . + bin (risk premium for factor n) 23 .

and not necessarily to individual stocks ± With APT. it is possible for some individual stocks to be mispriced . APT does not assume mean-variance decisions. riskless borrowing or lending.APT and CAPM Compared APT applies to well diversified portfolios. and existence of a market portfolio APT can be extended to multifactor models 24 .not lie on the SML APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio ± Unlike CAPM.

which defines the unobservable market portfolio as a single factor Neither CAPM or APT has been proven superior ± Both rely on unobservable expectations 25 . we need the factors that account for the differences among security returns ± This is a similar problem with the CAPM.Problems with APT Factors are not well specified ex ante ± To implement the APT model.

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