Asset Pricing Models

CAPM
Capital Asset Pricing Model 1964, Sharpe, Linter quantifies the risk/return tradeoff

Basic Assumptions
The CAPM is based on the following assumptions: Investors aim to maximize economic utilities. Individual investors are rational and riskaverse. Individual investors have homogenous expectations. Investors are price takers, i.e., they cannot influence prices.

Basic Assumptions
Investors can lend and borrow unlimited amounts under the risk free rate of interest. Market is frictionless there are no taxation costs, no transaction cost; the market is competitive. Deal with securities that are all highly divisible into small parcels. Assume all information is available at the same time to all investors.

Basic Assumptions
Looking at the assumptions, one may feel that the CAPM is unrealistic. The value of a model depends not on the realism of its assumptions, but on the validity of its conclusions. Extensive empirical analysis suggests that there is a lot of merit in CAPM.

implication
expected return is a function of
beta risk free return market return

E( R ) R f [ E( R m ) R f ]
or

E( R ) R f [ E( R m ) R f ]
where

E( R ) R f is the portfolio risk premium

E( R m ) R f

is the market risk premium

so if >1,
E( R ) R f

>

E( R m ) R f

E( R )

> E( R m )

portfolio exp. return is larger than exp. market return riskier portfolio has larger exp. return

so if <1,
E( R ) R f

<

E( R m ) R f

E( R )

< E( R m )

portfolio exp. return is smaller than exp. market return less risky portfolio has smaller exp. return

so if 1,
E( R ) R f

E( R m ) R f

E( R )

= E( R m )

portfolio exp. return is same than exp. market return equal risk portfolio means equal exp. return

so if 0,
E( R ) R f

=0 =
Rf

E( R )

portfolio exp. return is equal to risk free return

example
Rm = 10%, Rf = 3%, = 2.5

E( R ) R f [ E( R m ) R f ]

E( R ) 3% 2.5[10% 3%] E( R ) 3% 17.5% E( R ) 20.5%

 CAPM tells us size of risk/return tradeoff CAPM tells us the price of risk

Testing the CAPM

CAPM overpredicts returns
return under CAPM > actual return

relationship between and return?

some studies it is positive some recent studies argue no relationship (1992 Fama & French)

 other factors important in determining returns

January effect day-of-the-week effect firm size effect ratio of book value to market value

Arbitrage Pricing
Based on the law of one price. Two items that are the same cannot sell at different prices If they sell at a different price, arbitrage will take place in which arbitrageurs buy the good which is cheap and sell the one which is higher priced till all prices for the goods are equal

Arbitrage Pricing Theory (APT)

In Finance the theory has become influential in the pricing of stocks. APT holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors. where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.

Arbitrage Pricing Theory (APT)

The model-derived rate of return will then be used to price the asset correctly The asset price should equal the expected end of period price discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back into line.

APT
The theory is proposed by Ross in 1976 It is less restrictive in its assumptions than CAPM The APT relies on the following assumptions: 1. Returns are generated according to a linear factor model. 2. The number of assets are close to infinite. 3. Investors have homogenous expectations (same as CAPM) 4. Capital markets are perfect (i.e. perfect competition, no transactions costs [same as CAPM])

 implications
E(R) is a function of several factors, F each with its own

E( R ) R f 1F1 2 F2 3F3 .... N FN

APT vs. CAPM

APT is more general
many factors

CAPM is a special case of the APT

1 factor factor is market risk premium

testing the APT

how many factors? what are the factors? 1980 Chen, Roll, and Ross
industrial production Growth in GNP Major political turmoil inflation yield curve slope other yield spreads