Presentation topic:-

CML,SML& Arbitraging pricing

model
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Capital Asset Pricing Model
Focus on the equilibrium relationship between
the risk and expected return on risky assets

Builds on Markowitz portfolio theory

Each investor is assumed to diversify his or her
portfolio according to the Markowitz model
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THE CAPM ASSUMPTIONS
NORMATIVE ASSUMPTIONS
expected returns and standard deviation cover a
one-period investor horizon
nonsatiation
risk averse investors
assets are infinitely divisible
risk free asset exists
no taxes nor transaction costs
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THE CAPM ASSUMPTIONS
ADDITIONAL ASSUMPTIONS
one period investor horizon for all
risk free rate is the same for all
information is free and instantaneously available
homogeneous expectations
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THE CAPITAL MARKET LINE
THE CAPITAL MARKET LINE (CML)
the new efficient frontier that results from risk
free lending and borrowing
both risk and return increase in a linear fashion
along the CML
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THE CAPITAL MARKET LINE
THE CAPITAL MARKET LINE
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M
r
P

o
P

CML
rfr
THE CAPITAL MARKET LINE
THE SEPARATION THEOREM
James Tobin identifies:
the division between the investment decision and the
financing decision
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THE CAPITAL MARKET LINE
THE SEPARATION THEOREM
to be somewhere on the CML, the investor initially
decides to invest and
based on risk preferences makes a separate financing
decision either
to borrow or
to lend
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THE MARKET PORTFOLIO
DEFINITION: the portfolio of all risky assets
which contains
complete diversification
a central role in the CAPM theory which is the
tangency portfolio (M) with the CML
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THE SECURITY MARKET LINE (SML)
FOR AN INDIVIDUAL RISKY ASSET
the relevant risk measure is its covariance with the
market portfolio (o
i, M
)
DEFINITION: the security market line expresses
the linear relationship between
the expected returns on a risky asset and
its covariance with the market returns
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THE SECURITY MARKET LINE (SML)
THE SECURITY MARKET LINE


or

where
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m i
m
rf m
rf
r r
r r
,
2
o
o
(
(

+ =
M i rf rf
i
r r r r
, 2
) ( | + =
2
,
,
M
M i
M i
o
o
| =
THE SECURITY MARKET LINE (SML)
THE SECURITY MARKET LINE
THE BETA COEFFICIENT
an alternative way to represent the covariance of a
security

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THE SECURITY MARKET LINE (SML)
THE SECURITY MARKET LINE
THE BETA COEFFICIENT
of a portfolio
is the weighted average of the betas of its component
securities


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=
=
N
i
M i i M P
X
1
, ,
| |
THE SECURITY MARKET LINE (SML)
THE SECURITY MARKET LINE
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SML
|
E(r)
r
rf

r
M

| =1.0
THE MARKET MODEL

assumed return on a risky asset was related to the
return on a market index

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iI I i iI i
r r c | o + + =
1
THE MARKET MODEL
DIFFERENCES WITH THE CAPM
the market model is a single-factor model
the market model is not an equilibrium model like
the CAPM
the market model uses a market index,
the CAPM uses the market portfolio
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THE MARKET MODEL
MARKET INDICES
the most widely used and known are
S&P 500
NYSE COMPOSITE
AMEX COMPOSITE
RUSSELL 3000
WILSHIRE 5000
DJIA
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THE MARKET MODEL
MARKET AND NON-MARKET RISK
Recall that a securitys total risk may be expressed
as

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2 2 2 2
i i iI i c
o o | o + =
THE MARKET MODEL
MARKET AND NON-MARKET RISK
according to the CAPM
the relationship is identical except the market portfolio
is involved instead of the market index
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THE MARKET MODEL
MARKET AND NON-MARKET RISK
Why partition risk?
market risk
related to the risk of the market portfolio and to the beta of
the risky asset
risky assets with large betas require larger amounts of market
risk
larger betas mean larger returns
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THE MARKET MODEL
MARKET AND NON-MARKET RISK
Why partition risk?
non-market risk
not related to beta
risky assets with larger amounts of o
cI
will not have larger
E(r)
According to CAPM
investors are rewarded for bearing market risk not non-
market risk

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Arbitrage Pricing Theory
Is one of the tools used by the investors and
portfolio managers. According to the previous
models, the investor chooses the investment on
the basis of expected return and variance. The
alternative model developed in asset pricing by
Stephen Ross is known as Arbitrage Pricing
Theory.

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Arbitrage is a process of earning profit by taking
advantage of differential pricing for the same
asset. The process generate riskless profit. In the
security market, it is selling security at a high
price and the simultaneous purchase of the same
security at a relative lower price.
Since the profit is riskless, the investors have the
incentive to undertake this whenever an
opportunity arises.

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Factors
APT assumes returns generated by a factor
model
Factor Characteristics
Each risk must have a pervasive influence on
stock returns
Risk factors must influence expected return
and have nonzero prices
Risk factors must be unpredictable to the
market
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APT Model
Most important are the deviations of the factors
from their expected values
The expected return-risk relationship for the
APT can be described
as: E(R i ) =RF +b i1 (risk premium for factor 1)
+b i2 (risk premium for factor 2) +
+b in (risk premium for factor n)
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Problems with APT
Factors are not well specified ex ante
To implement the APT model, the factors that
account for the differences among security
returns are required CAPM identifies market
portfolio as single factor

Neither CAPM or APT has been proven superior
Both rely on unobservable expectations
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Conclusion

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