• Systematic risk :

 Risk that influences a large number of assets.

• Also called market risk.
 Uncontrollable; Undiversifiable
 Cannot be eliminated

 Unsystematic Risk :
 Risk that influences a single company or a small
group of companies
 Controllable; Diversifiable
 Can be mitigated through diversification
• No matter how much we diversify our
investments, it's impossible to get rid
of all the risk. As investors, we
deserve a rate of return that
compensates us for taking on risk.

• The capital asset pricing

model (CAPM) helps us to calculate
investment risk and what return on
investment we should expect.
• The feasible set of portfolios represents
all portfolios that can be constructed
from a given set of stocks.

• An efficient portfolio is the one that offers:

– the most return for a given amount of risk,
• Or
– the least risk for a give amount of return.

• The collection of efficient portfolios is

called the efficient set or efficient
frontier.
• Indifference curves reflect an investor’s
attitude toward risk as reflected in his or
her risk/return tradeoff function. They
differ
among investors because of differences
in risk aversion.

• An investor’s optimal portfolio is defined

by the tangency point between the
efficient set and the investor’s
indifference curve
 CAPM

• Jack Treynor, William Sharpe, John Litner and

Jan Mossin devlp this model independently.
• Based on the work of Harry Markowitz.
• The CAPM is an equilibrium model
that specifies the relationship between risk and
required rate of return for assets held in well
diversified portfolios. i.e relationship between Rp &
β value( diversifiable and undiversifiable risk)
• It is based on the premise that only
one factor affects risk.

• What is that factor?

• CAPM:
• Required Return for Stock i: bi=0.9,
rRF=6.8%, the market risk premium is
6.3%,
• ri = rRF + (rM - rRF) βi
• Where
• ri = Return on Ith stock
• rRF= risk free return
• rM = Return on market
• ri = 6.8% + (6.3%)(0.9)
• = 12.47%
 Assumptions of the CAPM

• Investors all think in terms of a single holding

period.
• All investors have identical expectations.
• Investors can borrow or lend unlimited
amounts at the risk-free rate.
• All assets are perfectly divisible.
• There are no taxes and no transactions
costs.
• All investors are price takers, that is,
investors’ buying and selling won’t influence
stock prices.
• Quantities of all assets are given and fixed.
• CAPM equation – CAPM shows a linear
relationship btw the reqd rate of return of
security and the mkt related and unavoidable
risk or beta.
• Rp = rF + (rM - rF) βi
•
 What impact does Rf have on
the efficient frontier?
• When a risk-free asset is added to the
feasible set, investors can create
portfolios that combine this risk-free
asset with a portfolio of risky assets.
• The straight line connecting Rf with M, the
tangency point between the line and the
old efficient set, becomes the new
efficient frontier.
 What is the Capital Market Line

• The Capital Market Line (CML) is all

linear combinations of the risk-free
asset and Portfolio M.
• Portfolios below the CML are inferior.
• The CML defines the new efficient set.
• All investors will choose a portfolio on
the CML.
 Expected Return = Risk free Return +
E (Rp) = Rf + (Rm – Rf)
----------- σp
Where, σM
E (Rp) = Portfolio’s expected rate of Return

σ M= Std Deviation of a mkt portfolio

σ p = Std Deviation of the portfolio

(Rm – Rf ) = Risk premium of the mkt portfolio represented by

slope of CML( Capital Mkt Line)
 What does the CML tell us

• The expected rate of return on any

efficient portfolio is equal to the
risk-free rate plus a risk premium.
• The optimal portfolio for any
investor is the point of tangency
between the CML and the
investor’s indifference curves.
 Security Market Line (SML)
• The CML gives the risk/return
relationship for efficient portfolios.

• The Security Market Line (SML), also

part of the CAPM, gives the risk/return
relationship for individual stocks
• The measure of risk used in the SML is the beta coefficient of company i, β i.

• The SML equation:

• Ri = Rf + (Rm - Rf) βi
• The market risk premium is determined from the slope of the SML.

• The relationship between β and required return is plotted on the securities

market line (SML) which shows expected return as a function of β
 How are betas calculated?

• The regression line of past returns on

Stock i versus returns on the market, is
called the characteristic line.
• The slope coefficient of the
characteristic line is defined as the
beta coefficient.
• The systematic risk can be measured by Beta.
Beta analysis is useful for individual and portfolios
whether efficient or inefficient.

• If beta = 1.0, stock is equal to Mkt average Index

risk.
• If beta > 1.0, stock is riskier than
Mkt average Index.(Aggressive Security)
• If beta < 1.0, stock is less risky than
Mkt average Index.(Defensive security)
• Most stocks have betas in the range
of 0.5 to 1.5.
 Interpreting Regression Results

• The R2 ( Square of coeff of correlation = Coeff of determination)

measures the percent of a
stock’s variance that is explained by
the market. The typical R2 is:
• 0.3 for an individual stock
• over 0.9 for a well diversified portfolio
What are two potential tests that can
be conducted to verify the CAPM
• Beta stability tests
• Tests based on the slope
of the SML
 Tests of the SML indicate:
• A more-or-less linear relationship between
realized returns and market
risk.
• Slope is less than predicted.
• Irrelevance of diversifiable risk
specified in the CAPM model can be
questioned.
 Tests of the SML indicate:

• Betas of individual securities are not

good estimators of future risk.
• Betas of portfolios of 10 or more
randomly selected stocks are
reasonably stable.
• Past portfolio betas are good
estimates of future portfolio
volatility.
 Are there problems with the
CAPM tests?

• Yes.
• Richard Roll questioned whether it
was even conceptually possible to test
the CAPM.
• Roll showed that it is virtually
impossible to prove investors behave
in accordance with CAPM theory.
 What are our conclusions
regarding the CAPM?
• It is impossible to verify.
• Recent studies have questioned its
validity.
• Investors seem to be concerned with
both market risk and stand-alone
risk. Therefore, the SML may not
produce a correct estimate of rp.
• CAPM/SML concepts are based on
expectations, yet betas are calculated
using historical data. A company’s
historical data may not reflect investors’
expectations about future riskiness.

• Other models are being developed

that will one day replace the CAPM, but it
still provides a good framework for
thinking about risk and return.
 Problems of CAPM
• assumes that the variance of returns is an
adequate measurement of risk. This might be
justified under the assumption of Normally
Distributed returns.
• homogeneous expectations
• no taxes or transaction costs
• Assumes rational and risk-averse investors
• Does not adequately explain the variation in
stock returns. Empirical studies show that low
beta stocks may offer higher returns than the
model would predict.
 What is the difference between the
CAPM and the Arbitrage
Pricing Theory (APT)?
• The CAPM is a single factor model.
• The APT proposes that the
relationship between risk and return
is more complex and may be due to
multiple factors such as GDP
growth, expected inflation, tax rate
changes, and dividend yield
• Required Return for Stock i
under the APT

ri = rRF + (r1 - rRF)b1 + (r2 - rRF)b2

• + ... + (rj - rRF)bj.
• bj = sensitivity of Stock i to economic
Factor j.
• rj = required rate of return on a portfolio
sensitive only to economic Factor j.
 What is the status of the APT?
• The APT is being used for some real
world applications.
• Its acceptance has been slow because
the model does not specify what
factors influence stock returns.
• More research on risk and return
models is needed to find a model that
is theoretically sound, empirically
verified, and easy to use.
Measurement of the risk premium
• The risk premium is the premium that
investors demand for investing in an average
risk investment, relative to the riskfree rate.
 As a general proposition, this premium should
be
 greater than zero
 increase with the risk aversion of the investors in
that market
 increase with the riskiness of the “average” risk
investment
 APT
• Developed as an alternative to the CAPM
by Stephen Ross
• Reasonably intuitive
• Required limited assumptions
• Allowed for multiple dimensions of
investment risk
 arbitrage
• Arbitrage refers to the process of earning
profit by taking advantage of differential
pricing of the same asset.
• The process generate risk free profit
• In security mkt, it implies selling the security
at higher price and the simultaneous purchase
of the same security at a relatively lower
price.
 Assumptions
• APT is based on fwg assumptions
• Investors have homogenous expectations
• They are risk averse and utility maximisers
• Perfect competition exist in the mkt.
• There is no transaction cost.
• It does not assume – single pd investment
horizon, no taxes, selection of portfolio based on
mean –variance, investor can borrow and lend at
the risk free rate of interest. These are the
assumptions of CAPM theory
 Arbitrage Pricing Theory
• The objective of asset pricing Model is to identify the equilibrium
asset price for an expected return and risk. If the asset prices
are not equal, there is a scope for arbitrage.

 Arbitrage portfolio is constructed without any additional financial
commitments
 An Arbitrage opportunity
 arises if an investor can construct a zero investment
portfolio with no risk, but with a positive profit

 Investor indulge in arbitrage, moving the prices upwards if

securities are held long and driving down the price of securities
if held in short position, till the elimination of the arbitrage
opportunity.

 In an efficient market, profitable arbitrage opportunities

will quickly disappear
 APT Model
• Acc to Ross, The returns of the securities are influenced by macroeco factors .
• These factors are growth rates of industrial sectors, rate of inflation, risk premia and
rate of interest etc
• If arbitrage opportunities are not existing, then the expected return on the asset are
approx linearly related to factor loadings.
• In a single factor model of APT, the linear relationship btw Ri and bi can be given in
the fwg form E(Ri)  0 1 bi1
• The Arbitrage theory is represented by equation

• E(Ri)  0 1 b 2 b ...kb

i1 i2 ik

where:
E(Ri) = Avg expected return
• 0 = the expected return on an asset with zero
systematic risk

1 = sensitivity of return to bi1

• bi1 ( beta coefficient )= Sensitivity of the stock 1 to the corresponding risk factor.

• The factor sensitivity in the arbitrage model indicates the responsiveness of a security’s return to a
particular factor.
• The eqn is derived from the model

E(Ri) = Rf + b1 (R1-Rf) + b2 (R2-Rf)

((R2-Rf) = risk premium for factor 2)

For a two factor model- Arbitrage pricing Eqn

E(Ri) = 0 1 bi1 2 bi 2
In a well diversified portfolio, unsystematic risk tend to be zero and
systematic risk is represented by b
i1 and b
i2
 APT and CAPM Compared
• APT applies to well diversified portfolios, and not
necessarily to individual stocks

 With APT, it is possible for some individual stocks to

be mispriced - not lie on the SML

 APT is more general as it gets to an expected

return and beta relationship without the assumption of
the market portfolio

 Unlike CAPM, APT does not assume mean-variance

decisions, riskless borrowing or lending, and
existence of a market portfolio

 APT can be extended to multifactor models

 APT and CAPM
• Simple form of APT model is consistent with simple
form of CAPM Model
APT Can be stated as Ri = 0 1 b i1 Similar to
CML eqn of CAPM Ri = Rf + (Rm - Rf) βi
• APT is more general and less restrictive than
CAPM.
• In APT the investor need not have to hold the mkt
portfolio.
• The portfolios are constructed on the basis of
selected factors to eliminate profits from arbitrage.
 APT and CAPM
• APT model takes into acct the impact of numerous
factors on the security. The macro eco factors are
considered and closer to reality than CAPM.
• Mkt portfolio is well defined. In APT factors are not well
specified.
• The well defined mkt portfolio is a significant advantage
of CAPM and led to wide use of this model in stk mkt.
• The factors which may effect one group of securities
may not effect another. Thus, there is a lack of
consistency in APT model.
• The influence of factors are not independent of each
other and thus diff to identify the influence
corresponding to each factor.
• Not all factors that exert an influence are measurable.