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CAPM and APT With Solutions

The document discusses the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). It provides an example of using the CAPM to derive the security market line and expected return for an asset with a beta of 2. It also illustrates an arbitrage opportunity between two similar assets priced differently. The document then discusses the APT, showing how to derive the pricing plane from multiple factor models and illustrate an arbitrage opportunity between two portfolios with similar factor exposures priced differently.

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Chinmayee Choudhury
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725 views

CAPM and APT With Solutions

The document discusses the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). It provides an example of using the CAPM to derive the security market line and expected return for an asset with a beta of 2. It also illustrates an arbitrage opportunity between two similar assets priced differently. The document then discusses the APT, showing how to derive the pricing plane from multiple factor models and illustrate an arbitrage opportunity between two portfolios with similar factor exposures priced differently.

Uploaded by

Chinmayee Choudhury
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 6

Capital Asset Pricing Model

1. Assume that the following assets are correctly priced according to the security market
line. Derive the security market line.
Ŕ1= 6% β1 = 0.5
Ŕ2 = 12% β2 = 1.5
What is the expected return on an asset with a Beta of 2?
Assume that an asset exists with Ŕ3 = 15% and β3 = 1.2. Design the arbitrage
opportunity.
Sol: To compute expected return on an asset with a beta of 2, inputs required under
CAPM:
= Rf+β(Rm-Rf)

Since Stocks 1 and 2 are in equilibrium,

Ŕ1 = Rf+β1(Rm-Rf) = Rf+ 0.5×(Rm-Rf) = 6% Eq 1


Ŕ2 = Rf+β2(Rm-Rf) = Rf+ 1.5×(Rm-Rf) = 12% Eq 2
Simplify Eq 1 and 2,
- (Rm-Rf) = -6%
Rm-Rf = 6%
By substituting Rm-Rf = 6% in the equation 1,

Rf+ 0.5×(Rm-Rf) = 6%
Rf = 3%
Rm= 9%

Expected return on an asset with a beta of 2,

Rf+β(Rm-Rf) = 3%+ 2×6% = 15%

Similarity in terms of risk


Asset 3 has risk of 1.2 by giving return of 15%
If asset 1 and 2 are combined to create asset 4 with the similar risk characteristics as
asset 3,

W1 ×β1+W2 ×β2 = 1.2


W1 ×0.5+(1- W1) ×1.5 = 1.2
Solving for W1 = 0.3 and W2 = 0.7
Beta of Asset 4 = 0.3×0.5+ 0.7×1.5 = 1.2
Asset 3 and asset 4 are similar as their betas are same
Expected return from asset 4 when beta is 1.2,
Rf+β4(Rm-Rf) = 3% +1.2×(6%) = 10.2%
Expected return of Asset 4 with beta of 1.2 is 10.2%
Expected return of Asset 3 with beta of 1.2 is 15%
Since there are two assets which are similar in terms of risk, returns from such assets
are to be same. In the given case, as Asset 3 provides more return than asset 4 for the
same risk, it is underpriced. Hence, there is a scope for arbitrage, where asset 3 can be
bought and asset 4 can be sold.

1
Assets Cash Invested Beta Expected Return
(%)
3 (Buy) 100 1.2 15%
4 (Sell) -100 - 1.2 -10.2%
0 0 4.8%
Arbitrage involves simultaneous purchase and sale of similar assets with zero
investment and zero risk but for positive profit of 4.8%.

Sharpe-Linter-Mossin form of Capital Asset Pricing Model (CAPM):

Assumptions of CAPM: Already provided in the material sent earlier

Arbitrage Pricing Theory


1. Assume the following two index model describes the returns:
Ri=ai +bi 1 I 1 +bi 2 I 2 +e i

Multi factor model:


Consider the following three portfolios

Portfolio Expected Return (%) bi1 bi2


A 12.0 1.0 0.5
B 13.4 3.0 0.2
C 12.0 3.0 -0.5
Find the equation of the plane that must describe equilibrium returns.
Illustrate the arbitrage opportunities that would exist if a portfolio called D with the
following properties were observed:
Ŕ D= 10% bD1=2 bD2=0
Sol:
Ŕi = λ0 + λ1 bi1 + λ2 bi2
12 = λ0 + λ1 + 0.5 λ2 …….. eq1

13.4 = λ0 + 3 λ1 + 0.2 λ2 …….. eq2


12 = λ0 + 3λ1 - 0.5 λ2 …….. eq3

By solving eq 2 an eq 3
1.4 = 0.7 λ2
λ2 = 1/4/0.7 = 2
Substituting λ2 = 2

11 = λ0 + λ1 …….. eq1
13 = λ0 + 3λ1 …….. eq3
-2 = -2 λ1
λ1 = 1
By substituting λ1 = 1 and λ2 = 2,

2
12 = λ0 + λ1 + 0.5 λ2 …….. eq1
12= λ0 + 1+0.5×2
λ0 =10
Equation for equilibrium plance,

Ŕi = λ0 + λ1 bi1 + λ2 bi2


Ŕi = 10+ bi1 + 2 bi2
Illustrate the arbitrage opportunities that would exist if a portfolio called D with the
following properties were observed:
Ŕ D= 10% bD1=2 bD2=0
Create an asset called E (by combing A, B and C) similar to D in terms of beta values
bE1=2 and bE2=0
bE1= XA bA1 + XB bB1 + XC bC1 = 2
bE2= XA bA2 + XB bB2 + XC bC2 = 0
XA+ XB + XC = 1
XC = 1- XA- XB
bE1= XA bA1 + XB bB1 + (1- XA- XB) bC1 = 2 Eq1
bE2= XA bA2 + XB bB2 + (1- XA- XB) bC2 = 0 Eq 2
By substituting beta values
XA + 3 XB + 3 (1- XA- XB) = 2 Eq3
0.5 XA + 0.2 XB - 0.5 (1- XA- XB) = 0 Eq 4
XA + 3 XB + 3 -3 XA-3 XB = 2
-2 XA = -1
XA = 0.5
0.5+ 3 XB +3-1.5-3XB =2
XB = 0
XC = (1- XA- XB) = 1- 0.5-0 = 0.5

By investing XA = 0.5, XB = 0 and XC = 0.5, portfolio E which replicates portfolio D


in terms of risk can be developed
Expected return from portfolio E = Ŕi = λ0 + λ1 bi1 + λ2 bi2

= 10+ 1×2 + 2×0 = 12%


By comparing similar assets i.e. portfolio D and E, it is observed that portfolio E
provides more return than portfolio D for similar risk features. Hence, portfolio E is
said to be underpriced. Hence we can go long on portfolio E and short on portfolio D.

Portfolio Expected Return bi1 bi2


E (long) 12% 2 0
D (Sell) -10% -2 -0
2% 0 0
Arbitrage return of 2% can be derived by eliminating risk exposure to the two factors
under consideration.

3
2. Consider the following three portfolios:
Portfolio Expected Return (%) bi1 bi2
A 12.0 1.0 0.5
B 13.4 3.0 0.2
C 12.0 3.0 -0.5
If ( Rm −R F )=4
, λ0 = 10, λ1 = 1 and λ2 = 2, find the values for the following
variables that would make the given expected returns consistent with equilibrium
determined by the simple (Sharpe-Lintner-Mossin) CAPM
a. βλ1 and βλ2 b. βp for each of the three portfolios c. RF
Sol:
λ1 = 1 = (Rm-Rf) bλ1 = 1
Solving for bλ1 = ¼ = 0.25 i.e. sensitivity of factor 1 to market
λ2 = 2 = (Rm-Rf) bλ2 = 2
Solving for bλ2 = 2/4 = 0.5 i.e. sensitivity of factor 2 to market

F1 F2 F1 F2
Sensitivity A 1 0.5 Sensitivity 0.25 0.50 Sensitivity BA =1×
of of factor to of 0.25+0.5×0.
portfolio Market portfolio 5 = 0.50
returns to returns to
factors market
(CAPM)
B 3 0.2 0.25 0.50 BB=3×
0.25+0.2×0.
5 = 0.85
C 3 -0.5 0.25 0.50 BC=3× 0.25-
0.5×0.5 =
0.5

Return from Portfolio A = Rf+ βA (Rm-Rf) = 12%


= Rf +0.5(4) = 12%
Rf = 10%

Price form of CAPM

1 cov (Y i Y M )
Pi=
[
rF
Ý i−( Ý M −r F P M )
]
Var Y M
Pi = Present price of asset i
PM = Present price of the market portfolio (all assets)
Ý i = Expected dollar value on asset next year

4
Ý M = Expect dollar value on market next year
rF = 1+RF

Zero Beta CAPM (In the absence of risk free lending and borrowing)

Ŕi = Ŕ Z+ βi ( Ŕ M - Ŕ Z)

Ŕ Z = Return on zero beta portfolio

Arbitrage Pricing Model


Multi factor return generating process
Ri = ai + bi1I1+bi2I2+……bijIj+ei
ai = Expected level of return for stock I if all indices have a value of zero
Ij = Value of the jth index that impacts the return on stock i
bij = Sensitivity of stock i’s return to the jth index
ei = A random error with a mean of zero and variance equal to σei2
E(ei, ej) = 0 for all i and j where i is not equal to j

APT model that arises from this return generating process

Ŕi = λ0 + bi1λ1 + bi2λ2 + …….. bij λj


λ0 = RF
λj = Increase in expected return a one unit increase in bij (i.e. expected risk premium
associated with jth factor i.e. Ŕ j−¿RF

Factors considered by various models:


Chen, Roll and Ross (1986):
• Inflation
• Term structure of interest rates
• Risk premia (difference between return on safe bonds and risky bonds)
• Industrial production
Fama and French (1993):
• Difference in return on a portfolio of small stocks and a portfolio of large stocks
(small minus large), i.e. small firm effect (spread)
• Difference in return between a portfolio of high book to market stocks and a portfolio
of low book to market stocks (high minus low)
• Difference in return between the monthly long term government bond return and one
month Treasury bill return (spread for term structure)
• Difference in the monthly return on a portfolio of long-term corporate bonds and a
portfolio of long-term government bonds (credit spread)

Fama and French Three Factor Model (1993):


Ri = Rf + βmkt (Rmkt -Rf) + βSMB SMB + βHML HML + ε

Fama and French Five Factor Model (1993):


Ri = Rf + βmkt (Rmkt -Rf) + βSMB SMB + βHML HML + βTS TS+ βCR CR + ε

Carhart Four-Factor Model (1997):

5
Ri = Rf + βmkt (Rmkt -Rf) + βSMB SMB + βHML HML + βMOM MOM + ε

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