Capital Asset Pricing and Arbitrage Price Theory

Asset
Pricing and
Arbitrage
Price
Theory
Explaining The Capital Asset
Pricing Model (CAPM)
No matter how much you diversify your investments, some

level of risk will always exist.
Investors naturally seek a rate of return that compensates for

that risk.
The capital asset pricing model (CAPM) helps to calculate

investment risk and what return on investment an investor
should expect.
The CAPM Formula
CAPM evolved as a way to measure this systematic risk.
Sharpe found that the return on an individual stock, or a

portfolio of stocks, should equal its cost of capital.
The standard formula remains the CAPM, which describes the

relationship between risk and expected return.
Ra=Rrf+βa∗(Rm−Rrf)
Ra=Rrf+βa∗(Rm−Rrf)
where: Ra=Expected return on a security
Rrf=Risk-free rate
Rm=Expected return of the market
βa=The beta of the security
(Rm−Rrf)=Equity market premium

The CAPM Formula
» CAPM's starting point is the risk-free rate–typically a 10-year

government bond yield.
» A premium is added, one that equity investors demand as
compensation for the extra risk they accrue.
» 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."
Beta's Role in CAPM
» According to CAPM, beta is the only relevant measure of a

stock's risk.
» It measures a stock's relative volatility–that is, it shows how
much the price of a particular stock jumps up and down
compared with how much the entire stock market 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
Beta's Role in CAPM
» Due to uncertain economic environment, questions always
remain on what is the best investment strategy. Should I
pick high CAPM Beta stocks or Low CAPM Beta Stocks. It is
normally understood that cyclical stocks have high Beta and
defensive sectors have low Beta.
» Cyclical stocks are those whose business performance and

stock performance is highly correlated with the economic
activities.
» If the economy is in recession, then these stock exhibit poor

results and thereby stock performance takes a beating.
Likewise, if the economic is on a high growth trajectory,
cyclical stocks tend to be highly correlated and demonstrate
Beta's Role in CAPM
» Take for example, General Motors, its CAPM Beta is 1.43.
This implies if the stock market moves up by 5%, then
General Motors stock will move up by 5 x 1.43 = 7.15%
» Following sectors can be classified as cyclical sectors and

tend to exhibit High Stock Betas.
» Automobiles Sector
» Materials Sector
» Information Technology Sector
» Consumer Discretionary Sector
» Industrial Sector
» Banking Sector
Beta's Role in CAPM
» Low Beta is demonstrated by stocks in defensive sector.
» Defensive stocks are stocks whose business activities and

stock prices are not correlated with the economic activities.
» Even if the economy is in recession, these stocks tend to

show stable revenues and stock prices.
» For example PepsiCo, its stock beta is 0.78. If the stock

market moves down by 5%, then Pepsico stock will only
move down by 0.78×5 = 3.9%.
Beta's Role in CAPM
» Following sectors can be classified as defensive sectors and
tend to exhibit Low Stock Betas-
» Consumer Staples
» Beverages
» HealthCare
» Telecom
» Utilities
Continuing the CAPM
» A stock’s beta is then multiplied by the market risk
premium, which is the return expected from the market
above the risk-free rate.
» The risk-free rate is then added to the product of the stock’s

beta and the market risk premium.
» The result should give an investor the required

return or discount rate they can use to find the value of an
asset.
» The goal of the CAPM formula is to evaluate whether a stock

is fairly valued when its risk and the time value of money
are compared to its expected return.
Continuing the CAPM
» Imagine an investor is contemplating a stock worth $100
per share today that pays a 3% annual dividend. The stock
has a beta compared to the market of 1.3, which means it is
riskier than a market portfolio. Also, assume that the risk-
free rate is 3% and this investor expects the market to rise
in value by 8% per year.
Continuing the CAPM
» Imagine an investor is contemplating a stock worth $100
per share today that pays a 3% annual dividend. The stock
has a beta compared to the market of 1.3, which means it is
riskier than a market portfolio. Also, assume that the risk-
free rate is 3% and this investor expects the market to rise
in value by 8% per year.
Calculating Beta
» The Formula for calculating Beta
Beta= Covariance
Variance
where:
Covariance=Measure of a stock’s return relative

to that of the market
Variance=Measure of how the market moves relative

to its mean
Calculating Beta
Calculating Beta
Security Market Line
SML gives the graphical representation of the Capital asset

pricing model to give expected returns for systematic or market
risk.
Fairly priced portfolios lie on the SML while undervalued and

overvalued portfolio lies above and below the line respectively.
A risk-averse investor’s investment is more often to lie close to

y-axis or the beginning of the line whereas risk-taker investor’s
investment would lie higher on the SML.
SML provides a good method for comparing two investments or

securities, however, the same depends on assumptions of
market risk, risk-free rates, and beta coefficients.
Example
Let’s assume the current risk-free rate is 4.75%, and the expected market return is 15.50%.
Thus, the SML equation will be as follows:

E(Ri) = 4.75 + βi × (15.50 - 4.75) = 4.75 + 10.75 × β i
Suppose that Security A has a beta of 0.6, and Security B has a beta of 1.2. The expected return of
Security A is 11.20%, and the expected return of Security B is 17.65%.
E(RA) = 4.75 + 10.75 × 0.6 = 11.20%

E(RB) = 4.75 + 10.75 × 1.2 = 17.65%
So, lower risk (lower beta) means lower expected return and vice versa.
Arbitrage Pricing Theory (APT)
Arbitrage pricing theory (APT) is a multi-factor asset pricing
model based on the idea that an asset's returns can be
predicted using the linear relationship between the asset’s
expected return and a number of macroeconomic variables that
capture systematic risk.
It is a useful tool for analyzing portfolios from a value

investing perspective, in order to identify securities that may be
temporarily mispriced.
How the Arbitrage Pricing Theory
Works
Arbitrage pricing theory (APT) is a multi-factor asset pricing

model based on the idea that an asset's returns can be
predicted using the linear relationship between the asset’s
expected return and a number of macroeconomic variables that
capture systematic risk.
It is a useful tool for analyzing portfolios from a value

investing perspective, in order to identify securities that may be
temporarily mispriced.
Works
However, this is not a risk-free operation in the classic sense

of arbitrage, because investors are assuming that the model is
correct and making directional trades—rather than locking in
risk-free profits.
What the arbitrage pricing theory offers traders is a model for

determining the theoretical fair market value of an asset.
Having determined that value, traders then look for slight

deviations from the fair market price, and trade accordingly.
Works
For example, if the fair market value of stock A is determined,

using the APT pricing model, to be $13, but the market price
briefly drops to $11, then a trader would buy the stock, based
on the belief that further market price action will quickly
“correct” the market price back to the $13 a share level.
Mathematical Model of the
APT
E(rj) – Expected return on the asset j
rf – Risk-free rate of return
ßn – The level of volatility of an asset’s price with

respect to factor n, which is a macroeconomic
variable causing systemic risk; how sensitive the
asset is to factor n
RPn – Risk premium of factor n

.
Example of How Arbitrage Pricing
Theory Is Used
The following four factors have been identified as explaining a

stock's return and its sensitivity to each factor and the risk
premium associated with each factor have been calculated:
» Gross domestic product (GDP) growth: ß = 0.6, RP = 4%

» Inflation rate: ß = 0.8, RP = 2%
» Gold prices: ß = -0.7, RP = 5%
» Standard and Poor's 500 index return: ß = 1.3, RP = 9%
» The risk-free rate is 3%
Example of How Arbitrage Pricing
Theory Is Used
Using the 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%) = 15.2%
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Asset

No matter how much you diversify your investments, some

Investors naturally seek a rate of return that compensates for

The capital asset pricing model (CAPM) helps to calculate

CAPM evolved as a way to measure this systematic risk.

Sharpe found that the return on an individual stock, or a

The standard formula remains the CAPM, which describes the

Rm​=Expected return of the market

βa​=The beta of the security

(Rm​−Rrf​)=Equity market premium​

» CAPM's starting point is the risk-free rate–typically a 10-year

» According to CAPM, beta is the only relevant measure of a

» Cyclical stocks are those whose business performance and

» If the economy is in recession, then these stock exhibit poor

» Following sectors can be classified as cyclical sectors and

» Defensive stocks are stocks whose business activities and

» Even if the economy is in recession, these stocks tend to

» For example PepsiCo, its stock beta is 0.78. If the stock

» The risk-free rate is then added to the product of the stock’s

» The result should give an investor the required

» The goal of the CAPM formula is to evaluate whether a stock

Covariance=Measure of a stock’s return relative

Variance=Measure of how the market moves relative

SML gives the graphical representation of the Capital asset

Fairly priced portfolios lie on the SML while undervalued and

A risk-averse investor’s investment is more often to lie close to

SML provides a good method for comparing two investments or

Thus, the SML equation will be as follows:

E(RA) = 4.75 + 10.75 × 0.6 = 11.20%

It is a useful tool for analyzing portfolios from a value

Arbitrage pricing theory (APT) is a multi-factor asset pricing

It is a useful tool for analyzing portfolios from a value

However, this is not a risk-free operation in the classic sense

What the arbitrage pricing theory offers traders is a model for

Having determined that value, traders then look for slight

For example, if the fair market value of stock A is determined,

E(rj) – Expected return on the asset j

rf – Risk-free rate of return

ßn – The level of volatility of an asset’s price with

RPn – Risk premium of factor n

The following four factors have been identified as explaining a

» Gross domestic product (GDP) growth: ß = 0.6, RP = 4%

Using the APT formula, the expected return is calculated as:

Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%)

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Rm=Expected return of the market

βa=The beta of the security

(Rm−Rrf)=Equity market premium