ASSUMPTIONS :

1. An individual seller or buyer cannot affect the price of a stock. This the
basic assumption is that it is a perfectly competitive market.
2. Investors make their decisions only on the basis of the expected returns
i.e. standard deviations and covariances of all pairs of securities.
3. Investors are assumed to have homogenous expectations during the
decision making period.
4. The investor can lend or borrow any amount of fund at the risk-less rate
of interest. The risk-less rate of interest is the rate of interest offered for
the treasury bills or Government securities.
5. Assets are infinitely divisible. According to this assumption, investor
could buy any quantity of share i.e. they can even buy ten rupees worth
of Reliance Industry shares.
6. There is no transaction cost i.e. not cost involved in buying and selling of
stocks.
7. There is no personal income tax. Hence, the investor is indifferent to the
form of return either capital gain or dividend.
8. Unlimited quantum of short sales, is allowed. Any amount of shares an
individual can sell short.
 LENDING AND BORROWING
Here, it is assumed that the investors could borrow or lend any
amount of money at risk-less rate of interest. When this
opportunity is given to the investors, they can mix risk free
assets with the risky assets in a portfolio to obtain a desired rate
of risk-return combination.
Rp = Portfolio return
Xf = The proportion of funds invested in risk free assets
1- Xf = The proportion of funds invested in risky assets
Rf = Risk free rate of return
Rm = Return of risky assets

The expected return on the combination of risky and risk free

Combination of risky and risk free combination is
Rp = Rf Xf + Rm (1- Xf )
Rp Rp

CML
C S
B

Rf
A
0 p 0 p
Fig (1.a): Efficient Frontier Fig (1.b) : The Capital Market Line
 Rf + (Rm Rf )
E(Rp) = m x p

E(Rp) = portfolios expected rate of return

Rm = expected return on market portfolio
m = standard deviation of market portfolio
p = standard deviation of the portfolio
 COVim [Rm Rf]
Ri Rf =
2m E(Ri) = Rf + iE(Rm) - Rf

Y
Rp

SML
Rm S

Rf

X
1 Beta
Fig 2 : Security Market Line
 Rp
T
S x
R
x
x C
B x
A
x SML
x
x
Rf x
x W
V
U

0 0.9 1.0 1.1 1.2

X
Beta
Fig. 3 : Evaluation of Securities with SML

Pi + Po + Div
Ri = Po
 Y
Rp

Rf

X
1 2 Beta

Fig. 4 : SML in Imperfect Market

 VALIDITY OF CAPM
1. The CAPM focuses on the market risk.
2. The CAPM has been useful in the selection of securities and
portfolios.
3. In the CAPM, it has been assumed that investors consider
only the market risk. Given the estimate of the risk free rate,
the beta of the firm, stock and the required market rate of
return, one can find out the expected returns for a firms
security. This expected return can be used as an estimate of
the cost of retained earnings.
4. Even though CAPM has been regarded as a useful tool to
financial analysts. Empirical tests and analyses have used ex-
post i.e. past data only.
5. The historical data regarding the market return, risk free
rate of return and betas vary differently for different periods.
 ARBITRAGE PRICING THEORY
Arbitrage pricing theory is one of the tools used
by the investors and portfolio managers. The
capital assets pricing theory explains the return
of the securities on the basis of their respective
betas. According to the previous model, the
investors 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. The APT
theory explains the nature of equilibrium in the
asset pricing in a less complicated manner with
fewer assumptions compared to CAPM.
 ARBITRAGE
Arbitrage is a process of earning profit by taking
advantage of differential pricing for the same asset.
The process generates risk-less profit. In the security
market, it is of selling security at a high price and the
simultaneous purchase of the same security at a
relatively lower price. Since the profit earned through
arbitrage is risk-less, the investors have the incentive
to undertake this whenever an opportunity arises. In
general, some investors indulge more in this type of
activities than others. However, the buying and selling
activities of the arbitrageur reduces and eliminates the
profit margin, bringing the market price to the
equilibrium level.
 THE ASSUMPTIONS
1. The investors have homogenous expectations.
2. The investors are risk averse and utility maximisers.
3. Perfect competition prevails in the market and there is no
transaction cost.
The APT theory does not assume (1) single period
investment horizon, (2) no taxes (3) investors can borrow and
lend at risk free rate of interest and (4) the selection of
portfolio is based on the mean and variance analysis. This
assumptions are present in the CAPM theory.

bA XbB XbC XC = 0
The variance of the new portfolios change is only
due to the changes in its non-factor risk. Hence,
the change in the risk factor is negotiable. From
the analysis it can be concluded that :

1. The return in the arbitrage portfolio is higher

than the old
portfolio.
2. The arbitrage and old portfolio sensitivity
remains the same.
3. The non-factor risk is small enough to be ignored
in an arbitrage portfolio.
Arbitrage pricing equation in a single model, the linear
relationship between the return Ri and sensitivity bi can
be given in the following form.
Ri ibi

Ri = return from stock A

= risk-less rate of return

bi = the sensitivity related to the factor

i = slope of the arbitrage pricing line

 APT One Factor Model
Ri Y

A
i
B

X
 Burmeister and McElroy have
estimated the sensitivities with some
other factors. They are given below:
Default risk
Time premium
Deflation
Change in expected sales
The market return not due to
the first four variables.
Salomon Brothers identified five
factors in their fundamental
factor model. Inflation is the
only common factor identified
by others. The other factors are
given below :

Growth rate in gross national

product
Rate of interest
Rate of change in oil prices
Rate of change in defence spending
 CONCLUSION
The CAPM model is based on specific assumptions. The
investor could borrow or lend any amount of money at risk-
less rate of interest.
All investors hold only the market portfolio and the risk-less
securities.
Market portfolio consists of the investments in all securities
of the market. The proportion invested in each security is
equal to the percentage of the total market capitalisation
represented by the security.
The capital market line represents the relationship between
the expected return and the standard deviation of the
portfolio.
The risk of the security is indicated by its covariance with
the market portfolio.
 Security market line shows the linear relationship between
the expected returns and betas of the securities.
The objective of the asset pricing model is to identify the
equilibrium asset price for expected return and risk. If the
asset prices are not equal, there is a scope for arbitrage.
An arbitrage portfolio is constructed without any additional
financial commitment.
Investors indulge in arbitrage, moving the price upwards if
securities are held long and driving down the price of
securities if held in short position, till the elimination of the
arbitrage possibilities.
The factor sensitivity in arbitrage model indicates are the
responsiveness of a securitys return to a particular factor.