Portfolio Theories1

Investment Portfolio Management
MS and M.Phil. Accounting and Finance

School of Accounting and Finance
Capital Asset Pricing Model
 The capital asset pricing model (CAPM) is a model that describes the
relationship between systematic risk and expected return for assets,
particularly stocks. CAPM is widely used throughout finance for the
pricing of risky securities, generating expected returns for assets
given the risk of those assets and calculating costs of capital.
CAPM Calculations
The formula for calculating the expected return of an asset

given its risk is as follows:
Required Rate = Rf + β(Rm -Rf)
CAPM
 The general idea behind CAPM is that investors need to be

compensated in two ways: time value of money and risk. The time
value of money is represented by the risk-free (Rf) rate in the formula
and compensates the investors for placing money in any investment
over a period of time. The risk-free rate is customarily the yield on
government bonds like T-Bonds.
 The other half of the CAPM formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk.
 This is calculated by taking a risk measure (beta) that compares the returns of the asset to
the market over a period of time and to the market premium (Rm-Rf): the return of the
market in excess of the risk-free rate.
 Beta reflects how risky an asset is compared to overall market risk and is a function of
the volatility of the asset and the market as well as the correlation between the two.
 For stocks, the market is usually represented as the S&P 500 but can be represented by
more robust indexes as well.
 The CAPM model says that the expected return of a security or a
portfolio equals the rate on a risk-free security plus a risk premium. If
this expected return does not meet or beat the required return, then the
investment should not be undertaken. The security market line plots
the results of the CAPM for all different risks (betas).
Security Market Line-SML
 The security market line (SML) is a line drawn on a chart that serves as a
graphical representation of the capital asset pricing model (CAPM), which shows
different levels of systematic, or market, risk of various marketable securities
plotted against the expected return of the entire market at a given point in time.
Also known as the "characteristic line," the SML is a visual of the capital asset
pricing model (CAPM), where the x-axis of the chart represents risk in terms of
beta, and the y-axis of the chart represents expected return. The market risk
premium of a given security is determined by where it is plotted on the chart in
relation to the SML
Example of CAPM
 Using the CAPM model and the following assumptions, we can compute the
expected return for a stock:
 The risk-free rate is 2% and the beta (risk measure) of a stock is 2. The expected
market return over the period is 10%, so that means that the market risk premium
is 8% (10% - 2%) after subtracting the risk-free rate from the expected market
return. Plugging in the preceding values into the CAPM formula above, we get an
expected return of 18% for the stock:
18% = 2% + 2 x (10%-2%)
Arbitrage Pricing Theory - APT
 Arbitrage Pricing Theory is an asset pricing model based on the idea

that an asset's returns can be predicted using the relationship between
that asset and many common risk factors. Created in 1976 by Stephen
Ross, 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 macroeconomic variables.
Arbitrage Pricing Theory - APT
 The Arbitrage Pricing Theory (APT) describes the price where a mispriced asset
is expected to be. It is often viewed as an alternative to the capital Asset Pricing
Model (CAPM), since the APT has more flexible assumption requirements.
Whereas, the CAPM formula requires the market's expected return, APT uses the
risky asset's expected return and the risk premium of a number of macroeconomic
factors. Arbitrageurs use the APT model to profit by taking advantage of
mispriced securities, which have prices that differ from the theoretical price
predicted by the model. By shorting an overpriced security, while concurrently
going long in the portfolio the APT calculations were based on, the arbitrageur is
in a position to make a theoretically risk-free profit.
Arbitrage Pricing Theory Equation and
Example
APT states that the expected return on a stock or other security must
adhere to the following relationship:
 Expected return = Rf + β1RP(1) + β2RP(2) + ………. + βnRP(n)
 Where,
 Rf = the risk-free interest rate
 β = the sensitivity of the asset to the particular factor
 RP = the risk premium associated with the particular factor
The number of factors will range depending on the analysis. There can be a few or
dozens; it depends on which factors an analyst chooses for the analysis. In addition, the
exact factors do not have to be the same across analyses. As an example calculation,
assume a stock is being analyzed. The following four factors have been identified, along
with the stocks sensitivity to each factor and the risk premium associated with each
factor:
o Gross domestic product growth: β = 0.6, RP = 4%
o Inflation rate: β = 0.8, RP = 2%
o Gold prices: β = -0.7, RP = 5%
o Standard and Poor's 500 index return: β = 1.3, RP = 9%
o The risk-free rate is 3%.
Using the above APT formula, the expected return is calculated as:
Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15%
Fama and French 3 Factor Model
Return is a function of three factors:

Market Risk Premium
Risk Premium of Small Minus Big-SMB (Small are called the
value stocks and Big are the Growth stocks)
Risk Premium of High Minus Low-HML (High and Low refers to
Book Value to Market Value)
R = Rf + β1 (Rm-Rf) + β2 (SMB) + β3 (HML) + ε
Value Vs Growth Stocks
 Investors who purchase growth stocks receive returns from future

capital appreciation (the difference between the amount paid for
a stock and its current value), rather than dividends. ... Value
stocks are those that tend to trade at a lower price relative to their
fundamentals (including dividends, earnings, and sales).
Fama and French 4 Factor Model
 The four factor model includes one more factor to the Fama and
French’s three factors i.e. Momentum
 Momentum is the difference or premium of Winners and Losers
 Winners Minus Losers-WML
 Winners means those stocks whose price goes up and losers are those
whose price goes down
 The following is the link of Fama and French Model Video:
https://www.youtube.com/watch?v=HFTOX6a4FAQ

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Investment Portfolio Management

MS and M.Phil. Accounting and Finance

The formula for calculating the expected return of an asset

 The general idea behind CAPM is that investors need to be

 Arbitrage Pricing Theory is an asset pricing model based on the idea

Return is a function of three factors:

 Investors who purchase growth stocks receive returns from future

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