(CAPM)

Chandra Shekar BM Faculty & Research Scholar Dept of Commerce, Bangalore University

The model was developed by three researchers in the mid of 1960s William Sharpe John Lintner and Jan Mossin It is an extension of Portfolio theory of Markowitz Portfolio theory is a description of how rational investors should build efficient portfolios and select the optimal portfolio Capital Asset Pricing model derives the relationship between the expected return and risk of individual securities and portfolios in the capital markets if everyone behaved in the way the portfolio theory suggested.

The model was developed by three researchers in the mid of 1960s William Sharpe John Lintner and Jan Mossin It is an extension of Portfolio theory of Markowitz Portfolio theory is a description of how rational investors should build efficient portfolios and select the optimal portfolio Capital Asset Pricing model derives the relationship between the expected return and risk of individual securities and portfolios in the capital markets if everyone behaved in the way the portfolio theory suggested.

The model was developed by three researchers in the mid of 1960s William Sharpe John Lintner and Jan Mossin It is an extension of Portfolio theory of Markowitz Portfolio theory is a description of how rational investors should build efficient portfolios and select the optimal portfolio Capital Asset Pricing model derives the relationship between the expected return and risk of individual securities and portfolios in the capital markets if everyone behaved in the way the portfolio theory suggested.

Risk and Return are two imp characteristics of every investment Risk is measured by variability in returns Investors attempt to reduce the variability of returns through diversification With a given no of securities you can create any no of portfolios altering proportions Among these some dominate others and some are more efficient Even well diversified portfolios are not risk free Risk = Systematic risk + Unsystematic Risk Systematic risk cannot be eliminated through diversification & affects all securities Systematic risk is measured by Beta All securities do not have same level of systematic risk. Therefore, the required rate of return goes with the level of systematic risk.

Assumes investors are rational Rational investors expect the return on a security to commensurate with its risk Since the relevant risk is market risk / systematic risk, it is implied that the return is expected to be correlated with this risk only.

CAPM gives the nature of the relationship between the expected return and systematic risk of a security

In simple words The relationship between the risk and return established by the security market line . It is basically a simple linear relationship. Expected return on security (Ri) = Rf + Bi (Rm Rf)

Expected return on security = Risk free return + Beta (risk premium)

The model shows that the expected return of a security consists of the risk-free rate of interest and the risk premium. The CAPM, when plotted on a graph paper is known as the Security Market Line (SML).

A major implication of CAPM is that not only every security but valid for all portfolios whether efficient or inefficient. CAPM can be used to estimate the expected return of any portfolio with the following formula. E(Rp) = Rf + p (Rm Rf)
E(Rp) = Expected return of the portfolio Rf = Risk free rate of return Bp = Portfolio beta i.e. market sensivity index E (Rm) = Expected return on market portfolio. E (Rm) Rf = Market risk premium.

CAPM provides a conceptual frame work for evaluating any investment decision where capital is committed with a goal of producing future returns.

(i) The Investors objective is to maximise the utility of terminal wealth; (ii) Investors make choices on the basis of risk and return; (iii) Investors have homogenous expectations of risk and return; (iv) Investors have identical time horizon; (v) Information is freely and simultaneously available to investors; (vi) There is a risk-free asset, and investors can borrow and lend unlimited amounts at the risk-free rate; (vii) There are no taxes, transaction costs, restrictions on short rates, or other market imperfections; (viii) Total asset quantity is fixed, and all assets are marketable and divisible.

CML provides a risk return relationship and a measure of risk for efficient portfolios

A line formed by the action of all investors mixing the market portfolio with the risk free asset is known as Capital Market Line. All efficient portfolios of all investors will lie along this capital market line

The relationship between the return and risk of any efficient portfolio on the CML can be expressed in the form of following equation Re = Rf + e Rm - Rf m Where Re = Return on Efficient portfolio Rf = Risk free rate of return Rm = Return on Market Portfolio e = SD of efficient portfolio m = SD of Market portfolio

Expected Return = Price of time + ( Risk Premium * Amount of Risk)

SML provides the relationship between the expected return and beta of a security or portfolio.

The relationship between the return and risk of any security on the SML can be expressed in the form of following equation

Ri = Rf + i ( Rm Rf )

Where Ri = Return on Security Rf = Risk free rate of return

Rm = Return on Market Portfolio i = Beta of the Security

Expected Return = Price of time + ( Risk Premium * Beta) Risk premium of a security is directly proportional to the risk measured by Beta.

CML

SML

In SML the risk is defined as In CML the risk is defined as total risk systematic risk and is measured by and is measured by Standard Deviation Beta Security Market Line is valid for all Capital Market line is valid only for portfolios and all individual securities efficient portfolios as well

CML is the basis of the Capital Market SML is the basis of the CAPM Theory

1. Based on highly restrictive assumptions a) we made the assumption that investors had identical preferences, had the same information, and hold the same portfolio (the market). b) Also, there is the problem that identifying and measuring the market return is difficult, if not impossible 2. The market factor is not the sole factor influencing the stock returns 3. There are serious doubts about its testability

The APT model was developed as an alternative to the CAPM. Like the CAPM, this model provides implications for the relationship between expected returns and risk on securities. However, the model differs from CAPM in its assumptions, its implications, and in the way that equilibrium prices are reached.

The APT is an approach to determining asset values based on law of one price and no arbitrage. It is a multi-factor model of asset pricing. The APT model was developed as an alternative to the CAPM. Like the CAPM, this model provides implications for the relationship between expected returns and risk on securities. However, the model differs from CAPM in its assumptions, its implications, and in the way that equilibrium prices are reached.

In APT, the assumption of investors utilizing a meanvariance framework is replaced by an assumption of the process of generating security returns. APT requires that the returns on any stock be linearly related to a set of indices. In APT, multiple factors have an impact on the returns of an asset in contrast with CAPM model that suggests that return is related to only one factor, i.e., systematic risk

1. Capital markets are perfectly competitive 2. Investors always prefer more wealth to less wealth with certainty 3. The stochastic process generating asset returns can be presented as a k- factor model 4. Others a) All securities have nite expected values and variances. b) Some agents can form well diversied portfolios c) There are no taxes d) There are no transaction costs

Multiple factors expected to have an impact on all assets: Inflation Growth in GNP Major political upheavals Changes in interest rates And many more. Contrast with CAPM assumption that only beta is relevant

Ri = Rf + 1f1 + 2f2 + 3f3 + ...+ kfk + ei Ri = Return on asset i during a specified time period Rf = Risk free rate of return (Alpha) 1 = Reaction in asset is returns to movements in a common factor 1 f1 = A common factor with a zero mean that influences the returns on all asset ei = unsystematic risk K = Number of factors

 Measurse how each asset (i) reacts to a common factor (k) Each asset may be affected by a factor, but the effects will differ In application of the theory, the factors are not identified Similar to the CAPM, the unique effects are independent and will be diversified away in a large portfolio

 Studies by Roll and Ross and by Chen support APT by explaining different rates of return with some better results than CAPM Reinganums study indicated that the APT does not explain small-firm results Dhrymes and Shanken question the usefulness of APT because it was not possible to identify the factors and therefore may not be testable