Chapter 7

Capital Asset Pricing and Arbitrage Pricing Theory

McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

7.1 The Capital Asset Pricing Model

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Capital Asset Pricing Model (CAPM)

Equilibrium model that underlies all modern financial theory Derived using principles of diversification, but with other simplifying assumptions Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development

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Simplifying Assumptions
Individual investors are price takers

Single-period investment horizon

Investments are limited to traded financial assets No taxes and no transaction costs

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Simplifying Assumptions (cont.)

Information is costless and available to all investors

Investors are rational mean-variance optimizers

Homogeneous expectations

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Resulting Equilibrium Conditions

All investors will hold the same portfolio for risky assets; the market portfolio

Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value

Market price of risk or return per unit of risk depends on the average risk aversion of all market participants

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Capital Market Line

E(r)
M = The value weighted Market Portfolio of all risky assets.

E(rM) rf

CML
Efficient Frontier

sm

s
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Slope and Market Risk Premium

M = Market portfolio rf = Risk free rate E(rM) - rf = Excess return on the
E(rM) - rf

sM

= =

market portfolio Optimal Market price of risk Slope of the CML

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Expected Return and Risk on Individual Securities

The risk premium on individual securities is a function of the individual securitys contribution to the risk of THE market portfolio __________________________________________ What type of individual security risk will matter, systematic or unsystematic risk? An individual securitys total risk (s2i) can be partitioned into systematic and unsystematic risk

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Expected Return and Risk on Individual Securities

Individual securitys contribution to the risk of the market portfolio is a function of the __________ of covariance the stocks returns with the market portfolios returns and is measured by BETA With respect to an individual security, systematic risk can be measured by bi = [COV(ri,rM)] / s2M

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Individual Stocks: Security Market Line

Slope SML = (E(rM) rf )/ M = price of risk for market

E(r)

Equation of the SML (CAPM)

E(ri) = rf + bi[E(rM) - rf]

SML

E(rM) rf
M = 1.0
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Sample Calculations for SML

Equation of the SML

E(ri) = rf + bi[E(rM) - rf]

E(rm) - rf = .08

rf = .03

Return per unit of systematic risk = 8% & the return due to the TVM = 3%

bx = 1.25 E(rx) = 0.03 + 1.25(.08) = .13 or 13% by = .6 E(ry) = 0.03 + 0.6(0.08) = 0.078 or 7.8%

If b = 1?
If b = 0?
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Graph of Sample Calculations

E(r) SML Rx=13% RM=11% Ry=7.8% 3% .08
If the CAPM is correct, only risk matters in determining the risk premium for a given slope of the SML.

.6 1.0 1.25 y M x

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Alpha and beta

E(rM) = 14% S = 1.5 rf = 5% Required return = rf + S [E(rM) rf] = 5 + 1.5 [14 5] = 18.5% If you believe the stock will actually provide a return of 17% ____, what is the implied alpha? = 17% - 18.5% = -1.5% A stock with a negative alpha plots below the SML & gives the buyer a negative abnormal return
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Portfolio Betas
Wi i P = If you put half your money in a stock with a beta of 1.5 and ___ 30% ____ of your money in a stock with a beta of 0.9 ___and the rest in T-bills, what is the portfolio beta?

P = 0.50(1.5) + 0.30(0.9) + 0.20(0) = 1.02

All portfolio beta expected return combinations should also fall on the SML. All (E(ri) rf) / i should be the same for all stocks.
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Measuring Beta
Concept: We need to estimate the relationship between the security and the Market portfolio. Method Can calculate the Security Characteristic Line or SCL using historical time series excess returns of the security, and unfortunately, a proxy for the Market portfolio.

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7.2 The CAPM and Index Models

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Security Characteristic Line (SCL)

Excess Returns (i)
Dispersion of the points around the line measures ______________. unsystematic risk

SCL

. .. . Slope = b . .. . . The statistic is . . called s . . .. . . . .. . . . . . Excess returns . on market index .. .. . . . . . . . .. . . . . . . .. . . . R = + R + e

e

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7.4 Multifactor Models and the CAPM

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7.5 Factor Models and the Arbitrage Pricing Theory

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Arbitrage Pricing Theory (APT)

Arbitrage: Arises if an investor can construct a zero investment portfolio with a sure profit Since no net investment outlay is required, an investor can create arbitrarily large positions to secure large levels of profit

Zero investment:

Efficient markets:

With efficient markets, profitable arbitrage opportunities will quickly disappear

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