Capital asset pricing model

this theory has been propounded by William Sharpe

(1964) which is extension of harry Markowitz
portfolio theory
CAPM establishes the linear relation ship b/w the
required rate of return on asset and the beta of the
asset
William Sharpe shared the Nobel prize in economics
with Markowitz & Merton miller

This theory indicate the behavior pattern of investor

pricing of assets on the capital market

It has been observed that investor takes a

combination of securities consisting of risk free and
risky assets
This theory can help the investor in finding
out the if securities are underpriced and over
priced to form a portfolio

Through the investor can measure the risk of

each security with his portfolio. Each
security has a different level of systematic
risk that affects it and varies from one
security to another based on the sensivity of
particular security to market fluctuation
CAPM shows the risk and return relationship of an investment in
the formula given below:
E ( R) = Rf + i (Rm Rf)
Where,
E ( R) = Expected rate of return on any individual
security or portfolio of securities.
Rf = Risk free rate of return
Rm = Expected rate of return on the market portfolio
Rm Rf = Risk Premium
i = Market sensitivity index of individual security or
portfolio of securities.
Assumptions
An individual seller or buyer cannot affect the prices of a stock.
All investors operate under perfect competition

Investors make their decisions only on the basis of the expected

returns , standard deviations and covariance of all pairs of
securities

Investors have homogenous expectations during the decision

making period

An investor can lend or borrow any amount of funds at the risk

free rate of interest. This rate of interest is the one offered for
treasury bills or government securities

Assets are infinitely divisible units and can be freely purchased

and sold in the market therefore , an investor has a choice of
shifting into any security that is desired
 Shares can be sold short at any time in the stock
market and without any limit

There is no transaction cost i.e. no cost is involved in

the buying and selling of stocks

There is no personal income tax. Hence investor is

indifferent to the form of return, whether it accrues
as a capital gain or dividend

Unlimited quantum of short sales is allowed .an

individual can sell any amount of shares short
Security market line
Security market line shows the trade off between systematic
risk and return for individual portfolio or assets

It is the graphical version of CAPM

Security market line indicate that there is a linear
relationship between the expected return and standard
deviation of the port folio

The security market line is a useful tool for determining whether an asset
being considered for a portfolio offers a reasonable expected return for
risk. Individual securities are plotted on the SML graph. If the security's
risk versus expected return is plotted above the SML, it is undervalued
because the investor can expect a greater return for the inherent risk. A
security plotted below the SML is overvalued because the investor would
be accepting less return for the amount of risk assumed
Expected SML
Return
-----------------------------------------------------

---------------------------------------
R3
E (Rm) ------------------------------------- Risk Premium

-------------------------------
R2
-------------------- -------------------------
R1
Rf

Risk free return

0 0.5 1.0 1.5

Risk (Beta)
 In the figure the required rate of return is depicted as
R1, R2 , R3 with respective beta factor B1,B2,B3
Here beta factor zero it is represented by the intercept
OR or the risk free rate of return
Here beta factor increase the premium on return on
increase there fore low beta provide low risk and low
ret
The Capital Market Line (CML) defines the relationship between
total risk and expected return for portfolios consisting of the risk
free asset and the market portfolio. If all the investors hold the same
risky portfolio, then in equilibrium it must be the market portfolio.
CML generates a line on which efficient portfolio can lie. Those
which are not efficient will however lie below the line. It is worth
mentioning here the CAPM risk return relationship is separate and
distinct from risk return relationship of individual securities as
represented by CML. An individual securitys expected return and
systematic risk statistics should lie on the CAPM but below CML.
In contrast the risk less end ( R) statistics of all portfolios, even the
inefficient ones should plot on the CAPM. The CML will never
include all points, if efficient portfolios, inefficient portfolio and
individual securities are placed together on one graph. The
individual assets and inefficient portfolios should plot as points
below the CML because their total risk includes diversifiable risk.
 The assumption in the CAPM approach that investor have
no transaction cost in purchase and sale of securities is not
realistic
It measures only market risk and gives importance to beta
or systematic risk and examine the historical returns to the
market portfolio . Therefore beta is difficult to measure for
future returns until it is updated
The capm theory assumes that the investor can borrow or
lend at the risk free rate at any time and for any amount
,this not realistic
Every investor has equal information and is available to all
the investors. This is possible when the market is in the
strong from of efficiency ,there fore information is uneven
and cannot exist at the same level for every investor
 This theory is useful for investor and portfolio
manager for evaluate the securities the CAPM iS
explained through beta that show the return on the
securities .Stephen Ross developed the arbitrage
theory to explain the nature of equilibrium in pricing
the of assets in simple manner
when you are engaged in arbitrage, you are taking
advantage of a market where a product sells for
different prices.
 An asset pricing model based on the idea that an
assets return can be predicted using the
relationship between that same asset and many
common risk factors.
These several factors appear to have been identified as
being important such as inflation, interest rate,
personal consumption, money supply, industrial
production, demand, population factor or other
economic factor. Some stocks are more sensitive to
some factors than other stocks.
 this theory predicts a relationship between the
returns of a portfolio and the returns of a single
asset through a linear combination of many
independent macro-economic variables.
APT is an alternative to CAPM based on the law
of one price.
Uses less restrictive assumptions than CAPM
Requires that return on any stock be linearly related to
a set of indexes
Downside is that it doesn't tell us what the indexes
should be ( for CAPM its the return of the market)
 All investor have homogenous expections
Investors are generally interested in maximizing their
utility at minimum risk
There is perfect competition in the market
There are no transaction cost in the marker
 Ri = o + 1b1 + 2b2 + 3b3..+ jbj
Where, Ri = Average expected return
bi = beta co-efficient relevant to the particular factor
1 = sensitivity of return to bi