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What does r  r
 Can it be quantified? What we talk about here is economic risk. Risk is created
by the odds stacked against the performance of company stocks that you have invested in. It certainly can
be quantified through research. Risk management is the prime business of investment managers. If you
really think about it, stock exchange working has similarities with betting business. You are betting on the
performance of companies by buying their stock. Every investment in stocks, bonds and other securities
that you make is a gamble.

Sometimes the gamble pays off and sometimes it doesn't; depending on what your investment strategy is.
So it is the business of every stock investor to study the risk involved in his endeavors. Let us have a look
at two prime types of risk that you absolutely have to consider while investing in stocks.

Definition of Systematic Risk and Unsystematic Risk

Let me define systematic and unsystematic risk before going ahead and comparing the difference between
he two. Every stock market is connected with the local economy, which in turn is affected by its
connection with the global economy.

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  arises due to the changes in local and global macroeconomic parameters which include
economic policy decisions made by governments, decisions of central banks that affect the lending
interest rates and even waves of economic recession. These are some of the systematic risk examples.
They arise due to the inherent dynamic nature of an economy and the flow of resources around the world.

Definition 2:
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed
to risk associated with any one individual entity, group or component of a system. It can be defined as
"financial à àtem instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or
conditions in financial intermediaries". It refers to the risks imposed
by interlinkageà and interdependencieà in a system or market, where the failure of a single entity or
cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire
system or market. It is also sometimes erroneously referred to as "systematic risk".

or example, consider an individual investor who purchases $10,000 of stock in 10 biotechnology
companies. If unforeseen events cause a catastrophic setback and one or two companies' stock prices
drop, the investor incurs a loss. On the other hand, an investor who purchases $100,000 in a single
biotechnology company would incur ten times the loss from such an event. The second investor's
portfolio has more unsystematic risk than the diversified portfolio. Finally, if the setback were to affect
the entire








 
 
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industry instead, the investors would incur similar losses, due to systematic risk. Systematic risk is
essentially dependent on macroeconomic factors such as inflation, interest rates and so on. It may also
derive from the structure and dynamics of the market.

Now that you know what systematic risk is, knowing what unsystematic risk is is simple. Unsystematic
risk is connected with specific sectors and arises due to problems that are endemic to a particular
company that you are invested in.

Some of the unsystematic risk examples are
    
 

  
problem which ariàeà due to human level error in judgment at the managerial level, that affectà our
àtock or àecuritieà inveàtment.

Difference between Systematic Risk and Unsystematic Risk:

Let us now have a look at the prime difference between systematic and unsystematic risk. Systematic risk
affects the entire market as a whole, while unsystematic risk may affect a certain company or sector.
Therefore, unsystematic risk is avoidable, while systematic risk isn't.

One can diversify an investment portfolio to eliminate the endemic or unsystematic risk that plagues a
certain sector. However, one cannot eliminate systematic risk as its effects sweep the entire economy, as
well as the market. To really anticipate systematic risk, one needs to study the dynamics of an economy
and the effects of policy decisions quite deeply. While this may not help you entirely eliminate systematic
risk, it may help you brace for it.

These were some of the prime differences between systematic risk and unsystematic risk that any investor
in the stock exchange should know about. As I said before, one can keep unsystematic risk to a minimum
with thorough stock research and spreading out investment over diverse sectors, but unsystematic risk
simply cannot be eliminated entirely. It cannot be taken out of the equation entirely and therefore, it
should never be ignored. Make your investments smartly, by taking systematic and unsystematic risk into
consideration.

CAPM FORMULA
The linear relationship between the return required on an investment (whether in stock market securities
or in business operations) and its systematic risk is represented by the CAPM formula, which is given in
the Paper.

ormulae Sheet:

! ri) = Rf + ȕi ! rm) - Rf)

! ri) = return required on financial asset i
Rf = risk-free rate of return
ȕi = beta value for financial asset i
! rm) = average return on the capital market

The CAPM is an important area of financial management. In fact, it has even been suggested that finance
only became µa fully-fledged, scientific discipline¶ when William Sharpe published his derivation of the
CAPM in 19861.








 
 
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CAPM ASSUMPTIONS
The CAPM is often criticised as being unrealistic because of the assumptions on which it is based, so it is
important to be aware of these assumptions and the reasons why they are criticised. The assumptions are
as follows:

Investors hold diversified portfolios

This assumption means that investors will only require a return for the systematic risk of their portfolios,
since unsystematic risk has been removed and can be ignored.

Single-period transaction horizon

A standardised holding period is assumed by the CAPM in order to make comparable the returns on
different securities. A return over six months, for example, cannot be compared to a return over 12
months. A holding period of one year is usually used.

Investors can borrow and lend at the risk-free rate of return

This is an assumption made by portfolio theory, from which the CAPM was developed, and provides
a minimum level of return required by investors. The risk-free rate of return corresponds to the
intersection of the security market line (SML) and the y-axis (see Figure 1). The SML is a graphical
representation of the CAPM formula.

Perfect capital market

This assumption means that all securities are valued correctly and that their returns will plot on to the
SML. A perfect capital market requires the following: that there are no taxes or transaction costs; that
perfect information is freely available to all investors who, as a result, have the same expectations; that
all investors are risk averse, rational and desire to maximise their own utility; and that there are a large
number of buyers and sellers in the market.

While the assumptions made by the CAPM allow it to

focus on the relationship between return and systematic
risk, the idealized world created by the assumptions is
not the same as the real world in which investment
decisions are made by companies and individuals.

For example, real-world capital markets are clearly not

perfect. Even though it can be argued that well-
developed stock markets do, in practice, exhibit a high
degree of efficiency, there is scope for stock market
securities to be priced incorrectly and, as a result, for
their returns not to plot on to the SML.

The assumption of a single-period transaction horizon appears reasonable from a real-world perspective,
because even though many investors hold securities for much longer than one year, returns on securities
are usually quoted on an annual basis.

The assumption that investors hold diversified portfolios means that all investors want to hold a portfolio
that reflects the stock market as a whole. Although it is not possible to own the market portfolio itself, it
is quite easy and inexpensive for investors to diversify away specific or unsystematic risk and to construct
portfolios that µtrack¶ the stock market. Assuming that investors are concerned only with receiving
financial compensation for systematic risk seems therefore to be quite reasonable.








 
  
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A more serious problem is that, in reality, it is not possible for investors to borrow at the risk-free rate (for
which the yield on short-dated Government debt is taken as a proxy). The reason for this is that the risk
associated with individual investors is much higher than that associated with the Government. This
inability to borrow at the risk-free rate means that the slope of the SML is shallower in practice than in
theory.

Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent an idealized
rather than real-world view, there is a strong possibility, in reality, of a linear relationship existing
between required return and systematic risk.

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In economics and finance, arbitrage the practice of taking advantage of a price difference between two
or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit
being the difference between the market prices. When used by academics, an arbitrage is a transaction
that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at
least one state; in simple terms, it is the possibility of a risk-free profit at zero cost.
In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, it
may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage,
some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of
a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price
of a àingle asset or identical cash-flows; in common use, it is also used to refer to differences
between àimilar assets (relative value or convergence trades), as in merger arbitrage.
People who engage in arbitrage are called arbitrageurs such as a bank or brokerage firm. The term is
mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities
and currencies.
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Differences APT and CAPM;

  


p? CAPM is an equilibrium model and derived from individual portfolio optimization.
p? APT is a statistical model which tries to capture sources of systematic risk.

Relation between sources determined by no Arbitrage condition;

 
 
p? APT difficult to identify appropriate factors.
p? CAPM difficult to find good proxy for market returns.
p? APT shows sensitivity to different sources. Important for hedging in portfolio formation.
p? CAPM is simpler to communicate, since everybody agrees upon.
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Arbitrage pricing theory (APT) is a valuation model. Compared to CAPM, it uses fewer assumptions but
is harder to use.

The basis of arbitrage pricing theory is the idea that the price of a security is driven by a number of
factors. These can be divided into two groups: macro factors, and company specific factors. The name of
the theory comes from the fact that this division, together with the assumption can be used to derive the
following formula:








 
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r = rf + ȕ1f1 + ȕ2f2 + ȕ3f3 + §§§

where r is the expected return on the security,

rf is the risk free rate,
Each f is a separate factor and
each ȕ is a measure of the relationship between the security price and that factor.

Thià ià a recognizabl àimilar formula to CAPM.

The difference between CAPM and arbitrage pricing theory is that CAPM has a single non-company
factor and a single beta, whereas arbitrage pricing theory separates out non-company factors into as many
as proves necessary. Each of these requires a separate beta. The beta of each factor is the sensitivity of the
price of the security to that factor.

Arbitrage pricing theory does not rely on measuring the performance of the market. Instead, APT directly
relates the price of the security to the fundamental factors driving it. The problem with this is that the
theory in itself provides no indication of what these factors are, so they need to be empirically
determined. Obvious factors include economic growth and interest rates. For companies in some sectors
other factors are obviously relevant as well - such as consumer spending for retailers.

The potentially large number of factors means more betas to be calculated. There is also no guarantee that
all the relevant factors have been identified. This added complexity is the reason arbitrage pricing theory
is far less widely used than CAPM.

APT and CAPM generally address the same basic issues:

p? how àhould we meaàure the riàk of a riàk aààet?

p? how àhould we compute required return?

CAPM takes an oversimplified view of economy-wide news; consider a stock , according to the CAPM
,every time economy-wide news makes the market go up by 1%,we expect this stock to go up by 1%
times beta of this stock. What type of economy-wide news made the market go up does not matter. The
stock reacts the same way to all types of economy-wide news.

But According to the APT, what type of economy-wide news it is should matter. For example; BP would
be more sensitive to an oil factor than Coca-Cola.

CAPM assumes that a given stock is equally sensitive to different type of economy-wide news.APT
assumes that a given stock has a different sensitivity to different types of economy-wide news. In the
CAPM all economy-wide news is lumped together into one single equation, and stock¶s beta is the
sensitivity to all types of economy-wide news. The APT assumes that random returns are given by the kth
factor model instead of the market model. The single term representing economy-wide news in CAPM
has been broken in to k separate terms. So there are k different types of economy wide-news. bi1 is the








 
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stock i¶s sensitivity to type 1 news, bi2 is stock i¶s sensitivity to type 2 news. Each of these Betas are
different. CAPM lumps all systematic risk together into one term; so there is a single risk premium. APT
says there are k types of systematic risk, so there are k risk premiums, one for each type of systematic
risk.Ȝi1bi1 is the risk premium for type 1 risk.Ȝi2bi2 is the risk premium for type 2 risk. Just like CAPM, bi1
is the amount of type1 risk this stock has, and Ȝ1 is the market price for type 1 risk. The risk of a stock is
measured jointly by its k betas, and then the required return is determined by the equation.

It is clear from all of our discussion that conceptually APT is an improved version of the CAPM, but why
do we still use CAPM as well? Because, in practise, APT does not work better than CAPM. That happens
because of estimation error. APT does not tell us how many factors we should use and it does not tell us
what the factors are.

The CAPM is more simple-minded model but we can estimate ȕi and RM a lot more precisely, so the
required return is reasonably accurate. The APT may be more advanced conceptually, but this is cancelled
out by the greater estimation error. In practise, the required return we come up with is not more accurate
than the CAPM.

The CAPM is simpler to understand, easier to use. The APT is more difficult to understand much harder
to use. APT is rarely used for computing required return, but it has useful applications in investment
management.

After seeing both models, we can say that if we choose one against the other, then in each one
unfortunately you win some and you lose some. Neither can the two models outperform each other
completely. Rather than trying to persuade each other, one is better than the other. We should thoroughly
understand their weakness as well as their strengths, so that we will know when and how, which model
we can rely on in making financial decision.








 
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A pricing model that seeks to calculate the appropriate price of an asset while taking into
account systemic risks common across a class of assets. The APT describes a relationship between a
single asset and a portfolio that considers many different macroeconomic variables. Any security with a
price different from the one predicted by the model is considered mispriced and is an arbitrage
opportunity. An investor may use the arbitrage pricing theory to find undervalued securities and assets
and take advantage of them. The APT is considered an alternative to the capital asset pricing model.

A special case of the arbitrage pricing theory that is derived from the one-factor model by
using diversification and arbitrage. It shows that the expected return on any risky asset is a linear function
of a single factor.

Arbitrage and the APT

Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more)
markets and thereby making a risk-free profit; sees rational pricing.
Arbitrage in expectations
The capital asset pricing model and its extensions are based on specific assumptions on investors¶ asset
demand. For example:

o? Investors care only about mean return and variance.

o? Investors hold only traded assets.

Arbitrage mechanics
In the APT context, arbitrage consists of trading in two assets ± with at least one being mispriced. The
arbitrageur sells the asset which is relatively too expensive and uses the proceeds to buy one which is
relatively too cheap.
Under the APT, an asset is mispriced if its current price diverges from the price predicted by the model.
The asset price today should equal the sum of all future cash flows discounted at the APT rate, where the
expected return of the asset is a linear function of various factors, and sensitivity to changes in each factor
is represented by a factor-specific beta coefficient.
A correctly priced asset here may be in fact a à nthetic asset - a portfolio consisting of other correctly
priced assets. This portfolio has the same exposure to each of the macroeconomic factors as the mispriced
asset. The arbitrageur creates the portfolio by identifying x correctly priced assets (one per factor plus
one) and then weighting the assets such that portfolio beta per factor is the same as for the mispriced
asset.
When the investor is long the asset and short the portfolio (or vice versa) he has created a position which
has a positive expected return (the difference between asset return and portfolio return) and which has a
net-zero exposure to any macroeconomic factor and is therefore risk free (other than for firm specific
risk). The arbitrageur is thus in a position to make a risk-free profit:








 
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The implication is that at the end of the period the portfolio would have appreciated at the
rate implied by the APT, whereas the mispriced asset would have appreciated
at more than this rate. The arbitrageur could therefore:
Toda :
1.? 1 short sell the portfolio
2.? 2 buy the mispriced asset with the proceeds.
At the end of the period:
1.? 1 sell the mispriced asset
2.? 2 use the proceeds to buy back the portfolio
3.? 3 pocket the difference.

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The implication is that at the end of the period the portfolio would have appreciated at the
rate implied by the APT, whereas the mispriced asset would have appreciated at leàà than
this rate. The arbitrageur could therefore:
Toda :
1.? 1 short sell the mispriced asset
2.? 2 buy the portfolio with the proceeds.
At the end of the period:
1.? 1 sell the portfolio
2.? 2 use the proceeds to buy back the mispriced asset
3.? 3 pocket the difference.


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