Asset Pricing Theories:

Presented By:
Nithish Sebastian Vivian Subramanya Mahesh Vinod

CAPM Overview:

conclusions

CAPM Model: Assumptions

CAPM
Practical Use of the CAPM CAPM formulae

Limitations of CAPM

Securities Market line

 Markowitz, William Sharpe, John Linter and Jan Mossim provided basic structure for CAPM model.  The Capital Asset Pricing Model(CAPM) helps us to calculate investment risk and what return on investment we should expect.  This model describes the relationship between risk and expected return  This model starts with the idea that individual investment contains two types of risk:  Systematic Risk (or Market risk)  Unsystematic Risk (or Specific risk)

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 CAPM considers only systematic risk and assumes that unsystematic risk can be eliminated by diversification. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves.

Beta

No of shares.

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 Beta is used as a measure of systematic risk  In this theory, The required rate of return of an asset is having a linear relationship with assets beta value  All investor hold only the market portfolio and riskless securities.  Market portfolio consists of the investment in all securities of the market. Each assets is held in proportion to its market value to the total value of all risky assts. For Say if Reliance industry share represents 20% of all risky assets, then the market portfolio of all individual investors contains 20% of Reliance industry shares  CAPM is based on the idea that investors demand additional expected return (called the risk premium) if they are asked to accept additional risk.  This model tells us the fair (risk-adjusted) expected return for every individual asset. Click Here

 A market equilibrium model i.e SML equation.

Finally to sum up:

It explains how assets should be priced in the capital market.

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CAPM Model: Assumptions

 Risk averse, utility-maximizing investors  Single-period horizon  Investors make there decision on the basis of Risk and expected returns, and Risk is measured by mean and variance..  Homogeneous Expectations during Decision making period.  The investor can borrow or lend any amount of funds at the riskless rate of interest ( treasury bills or Govt securities).  No personal income tax Hence investor is indifferent to form of return either capital gain or dividend.  Unlimited quantum of short sales is allowed. Any amount of shares an individual can sell short.  Information is freely and simultaneously available to investors.

 The perfect market assumption There are no taxes or transaction costs or information costs Stocks can be bought and sold in any quantity (even fractions) There is one risk-free asset and all investors can borrow or lend at that rate

Capital Asset Pricing Model CAPM formulae

The standard formula remains the CAPM, which describes the relationship between risk and expected return. Rs =

CAPM's starting point is the risk-free rate - typically a 10-year government bond yield. To this is added a premium that equity investors demand to compensate them for the extra risk they accept. This equity market premium consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta."

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Beta :
 According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's relative volatality - that is, it shows how much the price of a particular stock jumps up and down compared with how much the stock market as a whole jumps up and down.  If a share price moves exactly in line with the market, then the stock's beta is 1.  A stock with a beta of 1.5 would rise by 15% if the market rose by 10%, and fall by 15% if the market fell by 10%. Interpreting F

if F! asset is risk free if F! asset return = market return if F" asset is riskier than market index F  asset is less risky than market index

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The Security market Line:

 The SML line helps to determine the expected return for a given Security beta.  In other words, when beta are given, we can generate expected return for the given securities.  Positive relationship between systematic risk and return of a portfolio  The line which gives the expected returns-systematic risk combinations of assets is called the security market line  The overvaluation and undervaluation of stock can be seen.  CAPM is called a single-factor model because the slope of the SML is caused by a single measure of risk the beta.

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Plot the Risk-Free Rate

Return %

Rf

1.0

Beta Coefficient

Plot Expected Return on the Market Portfolio

Return %
km =12%

Rf = 4%

1.0

Beta Coefficient

Draw the Security Market Line

Return %
km =12%

SML

Rf = 4%

1.0

Beta Coefficient

Plot Required Return

(Determined by the formula = Rf + Fs[kM - Rf]

Return %
R(k) = 13.6% km =12%

SML

R(k) = 4% + 1.2[8%] = 13.6%

Rf = 4%

1.0

1.2 Beta Coefficient

Limitations of CAPM  It is not realistic in the world.  This assumes that all investors are risk averse and higher the risk, the higher is the return.  Investors ignore the Transactions cost, information cost. Brokerage, taxes etc and make decision on single period time horizon.  The investor are given a choice on the basis of risk- return characteristics of an investment and they can buy at the going rate in the market.  There are many buyers and sellers and the market is competitive and free forces of supply and demand determine the prices.  CAPM Empirical tests and analyses used ex-post i.e Past data only.  The historical data regarding the market return, risk free rate of return and betas vary differently for different periods. The various methods used to estimate these inputs also affect beta value. Since the inputs cannot be estimated precisely, the expected return found out through the CAPM model is also subjected to criticisms.

 CAPM establishes a measure of risk premium and is measured by F(Rm Rf) Beta coefficient is the non diversifiable risk of the asset, relative to the risks of the asset.  Suppose Tisco company has a beta equal to 1.5 and the risk free rate is say 6% .The required rate of return on the market (Rm) is 15%. Then adopting this equation, we have

 If the market rate is 15% then the return on Tisco should 19.5% because the larger risk on tisco than on market.  When return on market is zero this model doesn t work accurately .

Practical Use of the CAPM

 It is helpful for finance manager has to keep in mind the expected return to the shareholders and the returns he provides should be commensurate with the risk. This risk is reflected in his investment and financing decision.  Used to price initial public offerings (IPOs)  Used to identify over and under value securities  Used to measure the riskiness of securities/companies  Used to measure the company s cost of capital. (The cost of capital is then used to evaluate capital expansion proposals).  The model helps us understand the variables that can affect stock prices and this guides managerial decisions.  SML provides a benchmark reflecting the equilibrium position in the relationship between the risk and return.

 Focuses on the Market Risk. Thus makes investors to think about riskiness of the assets in general.  It has been useful in the selection of securities and portfolios. Securities with higher returns are considered to be undervalued and attractive for buy. The below normal expected return yielding securities are considered to be overvalued and suitable for sale.  In the CAPM it has been assumed that investor consider only the market risk , Given the estimate of the risk free rate, the beta of the firm, stock and required market rate of return, one can find out the expected returns for the firms security. This expected return can be used as an the cost of retained earnings.

Conclusions: CAPM
 It is called a pricing model because it can be used to help us determine appropriate prices for securities in the market.  The CAPM suggests that investors demand compensation for risks that they are exposed to and these returns are built into the decision-making process to invest or not.  The CAPM is a fundamental analyst s tool to estimate the intrinsic value of a stock.  The analyst needs to measure the beta risk of the firm by using either historical or forecast risk and returns.  The analyst will then need a forecast for the risk-free rate as well as the expected return on the market.  These three estimates will allow the analyst to calculate the required return that rational investors should expect on such an investment given the other benchmark returns available in the economy.

Introduction

Assumptions

Arbitrage Portfolio

Arbitage One Factor Model

Factors affecting the return

The APT model

APT and CAPM

Introduction
 This model developed in asset pricing by Stephen Ross  Arbitrage pricing theory is one of the tools used by the investors and portfolio managers.  The capital asset pricing theory explains the returns of the securities on the basis of their respective betas.  The investor chooses the investment on the basis of expected return and variance.

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Arbitrage: Meaning
 Arbitrage is a process of earning profit by taking advantage of differential pricing for the same asset. The process generates riskless 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.  The profit earned through arbitrage is riskless.  The buying and selling of the arbitrageur reduces and eliminates the profit margin. Thus bringing the market price to the equilibrium level.

Arbitrage Pricing Theory

Arbitrage Mechanism

For same risks Asset U has higher return than Asset O Asset U is underpriced and assets O is overpriced. Sell asset O or go short on O Buy asset U or go long on U @Investor makes Riskless profit Impact Demand on asset U goes up and supply of O also goes up @Price of U increases and price of O decreases Thus, Arbitrage goes on till prices are traded at same level.

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Assumptions
 The investors have homogeneous expectation.  The investors are risk averse and utility maximizes.  Perfect competition prevails in the market and there is no transaction cost

Arbitrage doesn t assume

 Single period investment horizon.  No taxes  Investors can borrow and lend at risk free rate of interest.  The selection of the portfolio is based on the mean and variance analysis.

Arbitrage Portfolio  According to the APT theory an investor tries to find out the possibility to increase return from his portfolio without increasing the funds in the portfolio. He also likes to keep the risk at the same level.  For eg:-, the investor holds A, B and C securities and he wants to change the proportion of the securities without any additional financial commitment. Now the change in proportion of securities can be denoted by by XA , XB , and XC. The increase in the investment in security A could be carried out only if he reduces the proportion of investment either in B or C because it has already stated that the investor tries to earn more income without increasing his financial commitment.  Thus, the changes in different securities will add up to zero. This is the basic requirement of an arbitrage portfolio.

 If X indicates the change in proportion,

XA+ XB+ XC=0  The factor sensitivity indicates the responsiveness of a security s return to a particular factor. The sensitiveness of the securities to any factor is the weighted average of the sensitivities of the securities, weights being the changes made in the proportion  For eg:-bA, bB, Bc are the sensitivities, in an arbitrage portfolio the sensitivities become zero. bA XA + bB XB + bC XC =0

The APT model:

 According to Stephen Ross, returns of the securities are influenced by a number of macro economic factor.  The macro economic factors are:     Growth rate of industrial production, Rate of inflation, Spread between long term and short term interest rates and Spread between low grade and high grade bonds.

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Arbitrage Pricing Theory

The arbitrage theory is represented by the equation:

APT
Ri =

P0 + P1 Fi1 + P2 Fi2 + P3 Fi3

+ . +

Pk Fik

Where, Ri = Expected Return on asset i.e. on well diversified portfolio = Expected Return on asset with zero systematic risk = The risk premium related to each of the common factor e.g. the risk premium related to interest rate risk. = the pricing relationship between the risk premium and asset i i.e. how responsive asset i is to this common factor j i.e. sensitivity or beta coefficient for security i that is associated with index j

P0 P1
Fij

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 If the portfolio is well diversified one, unsystematic risk tends to be zero and systematic risk is represented by F 1 and F 2 F n in the equation.

Factors Affecting The Return

The specification of the factors is carried out by many financial analysts. Chen, Roll and Ross have taken four macro economic variables and tested them. According to them the factors are  Inflation,  Inflation affects the discount rate or the required rate of return and the size of the future cash flows.  The term structure of interest rates,  Risk premia and  Industrial production.

Burmeister and McElroy have estimated the sensitivities with some other factors. They are  Default risk  Time premium  Deflation  Change in expected sales  The market return not due to the first four variables.

Contn .

The default risk is measured by the difference between the return on long term government bonds and the return on long term bonds issued by corporate plus one half of one %. Time premium is measured by the return on long term government bonds minus one month treasury bill rate one month ahead. Deflation is measured by expected inflation at the beginning of the month minus actual inflation during the month.

Salomon Brothers identified 5 factors in their fundamental factor model.

 Growth rate in gross national product  Rate of interest  Rate of change in oil prices  Rate of change in defence spending.

ONE FACTOR MODEL

Arbitrage Pricing Theory

In a single factor model, the linear relationship between the return Ri and sensitivity bi can be given in the following form.
Assume, there is only one factor which generates returns on asset i, APT Model boils down to E(ri) = Fio + FijP1 Fio = Risk Free Return or Zero Beta Security

Slope of arbitrage price line is P and intercept is Fio. The arbitrage price line shows the equilibrium relation between an assets systematic risk and expected return.

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 The risk is measured along the horizontal axis and the return on the vertical axis. The A, B and C stocks are considered to be in the same risk class. The arbitrage pricing line interests the Y axis on lamda 0, which represents riskless rate of interest i e the interest offered for the treasury bills. Here, the investments involve zero risk and it is appealing to the investors who are highly risk averse.  Lamda i stands for the slope of arbitrage pricing line. It indicates market price of risk and measures the risk return trade off in the security markets. The beta i is the sensitivity coefficient or factor beta that shows the sensitivity of the asset or stock A to the respective risk factor.

APT and CAPM

 In APT model, factors are not well specified . Hence investors finds it difficult to establish equilibrium relationship.  The well defined market portfolio is a significant advantage of the CAPM leading wide usage in the stock exchange.  Lack of consistency in the measurements of the APT model.  Further , the influence of factor are not independent to each other because it is difficult to identify the influence that corresponds exactly to each factor.

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