Capital Market Theory:

An Overview
• Capital market theory extends portfolio
theory and develops a model for pricing all
risky assets
• Capital asset pricing model (CAPM) will
allow you to determine the required rate of
return for any risky asset

E(R i )  RFR   i (R M - RFR)

 Capital Market Theory:
An Overview
• CAPM (1964)
E(R i )  RFR   i (R M - RFR)
• Fama and French 3-factor model (1992)

• Carhat 4-factor model (1997)

 Arbitrage Pricing Theory (APT) 1976

Multiple factors expected to have an impact

on all assets:
– Inflation
– Growth in GNP
– Major political upheavals
– Changes in interest rates
– And many more….
 Arbitrage Pricing Theory (APT)
Ei  0  1bi1  2bi 2  ...  k bik
where:
0 = the expected return on an asset with zero systematic
risk where
1 = the risk premium related to each of the common
factors - for example the risk premium related to
interest rate risk

bi = the pricing relationship between the risk premium and

asset i - that is how responsive asset i is to this common
factor K
 Example of Two Stocks
and a Two-Factor Model
1 = changes in the rate of inflation. The risk premium
related to this factor is 1 percent for every 1 percent
change in the rate (1  .01)
2 = percent growth in real GNP. The average risk premium
related to this factor is 2 percent for every 1 percent
change in the rate (  .02)
2

3 = the rate of return on a zero-systematic-risk asset (zero

beta: boj=0) is 3 percent (3  .03)
 Example of Two Stocks
and a Two-Factor Model
bx1= the response of asset X to changes in the rate of
inflation is 0.50 (bx1  .50)

by1= the response of asset Y to changes in the rate of inflation

is .50 (by1  .50)

bx 2 = the response of asset X to changes in the growth rate of

real GNP is 1.50 (bx 2  1.50)
by 2 = the response of asset Y to changes in the growth rate of
real GNP is 1.75 (by 2  1.75)
 Example of Two Stocks
and a Two-Factor Model
Ei  0  1bi1  2bi 2
= .03 + (.01)bi1 + (.02)bi2
Ex = .03 + (.01)(0.50) + (.02)(1.50)
= .065 = 6.5%
Ey = .03 + (.01)(.50) + (.02)(1.75)
= .085 = 8.5%