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• CAPM

– Capital Asset Pricing Model – 1964, Sharpe, Linter – quantifies the risk/return tradeoff

Basic Assumptions

The CAPM is based on the following assumptions: Investors aim to maximize economic utilities. Individual investors are rational and riskaverse. Individual investors have homogenous expectations. Investors are price takers, i.e., they cannot influence prices.

• • •

•

the market is competitive. no transaction cost. • Assume all information is available at the same time to all investors. .Basic Assumptions • Investors can lend and borrow unlimited amounts under the risk free rate of interest. • Market is frictionless there are no taxation costs. • Deal with securities that are all highly divisible into small parcels.

. but on the validity of its conclusions. Extensive empirical analysis suggests that there is a lot of merit in CAPM. one may feel that the CAPM is unrealistic.Basic Assumptions Looking at the assumptions. The value of a model depends not on the realism of its assumptions.

implication • expected return is a function of – beta – risk free return – market return .

E( R ) R f [ E( R m ) R f ] or E( R ) R f [ E( R m ) R f ] where E( R ) R f is the portfolio risk premium E( R m ) R f is the market risk premium .

so if >1. E( R ) R f > E( R m ) R f E( R ) > E( R m ) • portfolio exp. market return • riskier portfolio has larger exp. return . return is larger than exp.

return is smaller than exp.so if <1. return . E( R ) R f < E( R m ) R f E( R ) < E( R m ) • portfolio exp. market return • less risky portfolio has smaller exp.

market return • equal risk portfolio means equal exp. E( R ) R f = E( R m ) R f E( R ) = E( R m ) • portfolio exp. return is same than exp. return .so if 1.

so if 0. return is equal to risk free return . E( R ) R f =0 = Rf E( R ) • portfolio exp.

example • Rm = 10%.5% .5 E( R ) R f [ E( R m ) R f ] E( R ) 3% 2. Rf = 3%.5[10% 3%] E( R ) 3% 17.5% E( R ) 20. = 2.

• CAPM tells us size of risk/return tradeoff • CAPM tells us the price of risk .

Testing the CAPM • CAPM overpredicts returns – return under CAPM > actual return • relationship between β and return? – some studies it is positive – some recent studies argue no relationship (1992 Fama & French) .

• other factors important in determining returns – January effect – day-of-the-week effect – firm size effect – ratio of book value to market value .

arbitrage will take place in which arbitrageurs buy the good which is cheap and sell the one which is higher priced till all prices for the goods are equal . Two items that are the same cannot sell at different prices • If they sell at a different price.Arbitrage Pricing • Based on the law of one price.

• where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. • APT holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors. .Arbitrage Pricing Theory (APT) • In Finance the theory has become influential in the pricing of stocks.

Arbitrage Pricing Theory (APT) • The model-derived rate of return will then be used to price the asset correctly • The asset price should equal the expected end of period price discounted at the rate implied by the model. . • If the price diverges. arbitrage should bring it back into line.

no transactions costs [same as CAPM]) . Capital markets are perfect (i. perfect competition.e.APT • • • • The theory is proposed by Ross in 1976 It is less restrictive in its assumptions than CAPM The APT relies on the following assumptions: 1. The number of assets are close to infinite. Investors have homogenous expectations (same as CAPM) • 4. • 3. • 2. Returns are generated according to a linear factor model.

..• implications – E(R) is a function of several factors. F each with its own E( R ) R f 1F1 2 F2 3F3 .. N FN .

CAPM • APT is more general – many factors • CAPM is a special case of the APT – 1 factor – factor is market risk premium .APT vs.

testing the APT • how many factors? • what are the factors? • 1980 Chen. and Ross – – – – – – industrial production Growth in GNP Major political turmoil inflation yield curve slope other yield spreads . Roll.

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