Security Analysis and

Portfolio Management

Equilibrium Asset Pricing Models:

Capital Asset Pricing Model
Arbitrage Pricing Theory
 Pricing of Risky Assets
• What attribute is priced at the
market place?
• How is that attribute translated
into market price?

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 Capital Asset Pricing Model
Assumptions:
 Investors can choose between portfolios
on the basis of expected return and
variance
 All investors are in agreement as to
investment horizon of one time period
and the distribution of security returns
 No friction in the capital market –
financially or informationally
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 Capital Asset Pricing Model
 Answer to the question as to how risky
assets are priced in the market place
with respect to their risks if investors
make their investment choices based on
portfolio theory
 Beta – the slope of characteristic line -
is the standard measure of risk
 Prediction is rather simple: Market
4 Portfolio is efficient
 Attributes of Market Portfolio
 Portfolio of all risky assets
 Not without risk, but that is only
systematic risk – unsystematic risk is
eliminated
 Risk of an individual asset is measured by
its contribution to riskiness of market
portfolio
 Variance of returns of an asset is the
aggregate of variation explained by the
5 market and the residual error– the latter is
not priced
 Risk of an individual asset
 2 (rj )   j  2 (rM )   2 ( j )
2

 2 ( j )is diversifiable and therefore, is not priced.

Riskyness of an asset is its contribution to portfolio risk.
Cov(rj , rM )
Portfolio risk is simply weighted average of covariances with individual assets.
M
 (rM )  Cov(rM , rM )   x j Cov(rj , rM )
2

j 1
M
Cov(rM , rM )
M   x j  j  1
j 1  (rM )
2

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 Position of assets with same βs

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 Position of asset with same ρ
 E (rM )  rF 
E (rJ )  rF    J , M  (rJ )
  (rM ) 

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 Market forces to bring about
equilibrium

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 Theoretical validity
CAPM is valid
 With no risk-free asset

 With a risk-free asset that cannot be

sold
 With lending at risk-free rate, but

borrowing at a higher rate

 With narrow range of transaction costs

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 Validity contd. …..
CAPM is invalid
 If there is disagreement among

investors
 If short-selling is disallowed

 If tax impact on investors differs

 If even a SINGLE investor behaves sub-

optimally
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 Empirical Testing of CAPM
 Early tests produced excellent results but
were flawed; portfolios were diversified
and likely to be on MVF – that would
produce a linear SML even if the market
portfolio is not on MVF
 Need to test MP being on MVF to prove
CAPM validity – MP of all risky assets is
undeterminable
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 Empirical Test contd. …..
 A correlated market proxy may be used;
however, the correlation is usually
unknown
 Individual asset betas have been found
to be unstable – return interval,
portfolio size, transaction volume and
firm size affects beta – and regress
towards mean
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 CAPM has turned out to be untestable
 Summary
 Only market forces determine security
risk and is measured by beta – other
risks are diversifiable and therefore, not
priced
 Initial supporting empirical findings and
convenience of use resulted in
dominance of the model
 Recent empirical findings cast serious
14 doubts on beta being the measure of risk