Irfan Haider

MMS203009

Assignment#04

Financial Analytics

Submitted to

Dr. Jaleel Ahmed

 Assignment 4
Describe the Capital Asset Pricing Model and Arbitrage Pricing Theory in detail. Give examples
of how these notions vary. It is also necessary to provide information on risk-free assets and a
market portfolio, as an example in Pakistan. The CAPM idea is founded on a number of
assumptions. Give specifics on these assumptions, as well as instances.

Capital Asset Pricing Model (CAPM)

A method for calculating the required rate of return, discount rate or cost of capital.

What is CAPM?

Capital market theory is an extension of the portfolio theory of Markowitz. The portfolio theory
explains how rational investors should build efficient portfolio based on their risk-return
preferences. Capital Market Asset Pricing Model (CAPM) incorporates a relationship, explaining
how assets should be priced in the capital market.

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
the expected return and risk of investing in a security. It shows that the expected return on a
security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security. Below is an illustration of the CAPM concept.

CAPM Formula and Calculation

CAPM is calculated according to the following formula:

Ra = Rrf+ βa (Rm- Rrf)

Where:

Ra = Expected return on a security

Rrf = Risk-free rate
βa = Beta of the security
Rm = Expected return of the market

Note: “Risk Premium” = (Rm – Rrf)

The CAPM formula is used for calculating the expected returns of an asset. It is based on the
idea of systematic risk (otherwise known as non-diversifiable risk) that investors need to be
compensated for in the form of a risk premium. A risk premium is a rate of return greater than
the risk-free rate. When investing, investors desire a higher risk premium when taking on more
risky investments.
Expected Return
The “Ra” notation represents the expected return of a capital asset over time, given all of the
other variables in the equation. “Expected return” is a long-term assumption about how an
investment will play out over its entire life.

Risk-Free Rate
The “Rrf” notation is for the risk-free rate, which is typically equal to the yield on a 10-year US
government bond. The risk-free rate should correspond to the country where the investment is
being made, and the maturity of the bond should match the time horizon of the investment.
Professional convention, however, is to typically use the 10-year rate no matter what, because
it’s the most heavily quoted and most liquid bond.

Beta
The beta (denoted as “βa” in the CAPM formula) is a measure of a stock’s risk (volatility of
returns) reflected by measuring the fluctuation of its price changes relative to the overall market.
In other words, it is the stock’s sensitivity to market risk. For instance, if a company’s beta is
equal to 1.5 the security has 150% of the volatility of the market average. However, if the beta is
equal to 1, the expected return on a security is equal to the average market return. A beta of -1
means security has a perfect negative correlation with the market.

Market Risk Premium

From the above components of CAPM, we can simplify the formula to reduce “expected return
of the market minus the risk-free rate” to be simply the “market risk premium”. The market risk
premium represents the additional return over and above the risk-free rate, which is required to
compensate investors for investing in a riskier asset class. Put another way, the more volatile a
market or an asset class is, the higher the market risk premium will be.

Why CAPM is Important

The CAPM formula is widely used in the finance industry. It is vital in calculating the weighted
average cost of capital (WACC), as CAPM computes the cost of equity.

WACC is used extensively in financial modeling. It can be used to find the net present value
(NPV) of the future cash flows of an investment and to further calculate its enterprise value and
finally its equity value.

CAPM Example – Calculation of Expected Return

Let’s calculate the expected return on a stock, using the Capital Asset Pricing Model (CAPM)
formula. Suppose the following information about a stock is known:
 It trades on the NYSE and its operations are based in the United States
 Current yield on a U.S. 10-year treasury is 2.5%
  The average excess historical annual return for U.S. stocks is 7.5%
 The beta of the stock is 1.25 (meaning its average return is 1.25x as volatile as the
S&P500 over the last 2 years)
What is the expected return of the security using the CAPM formula?
Let’s break down the answer using the formula from above in the article:
 Expected return = Risk Free Rate + [Beta x Market Return Premium]
 Expected return = 2.5% + [1.25 x 7.5%]
 Expected return = 11.9%

Arbitrage Pricing Theory

Forecasting the linear relationship between an asset’s returns and macroeconomic factors.

What is the Arbitrage Pricing Theory?

The Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset’s returns
can be forecasted with the linear relationship of an asset’s expected returns and the
macroeconomic factors that affect the asset’s risk. The theory was created in 1976 by American
economist, Stephen Ross. The APT offers analysts and investors a multi-factor pricing model for
securities, based on the relationship between a financial asset’s expected return and its risks.
The APT aims to pinpoint the fair market price of a security that may be temporarily incorrectly
priced. It assumes that market action is less than always perfectly efficient, and therefore
occasionally results in assets being mispriced – either overvalued or undervalued – for a brief
period of time.
However, market action should eventually correct the situation, moving price back to its fair
market value. To an arbitrageur, temporarily mispriced securities represent a short-term
opportunity to profit virtually risk-free.
The APT is a more flexible and complex alternative to the Capital Asset Pricing Model (CAPM).
The theory provides investors and analysts with the opportunity to customize their research.
However, it is more difficult to apply, as it takes a considerable amount of time to determine all
the various factors that may influence the price of an asset.

Assumptions in the Arbitrage Pricing Theory

The Arbitrage Pricing Theory operates with a pricing model those factors in many sources of risk
and uncertainty. Unlike the Capital Asset Pricing Model (CAPM), which only takes into account
the single factor of the risk level of the overall market, the APT model looks at several
macroeconomic factors that, according to the theory, determine the risk and return of the specific
asset.
These factors provide risk premiums for investors to consider because the factors carry
systematic risk that cannot be eliminated by diversifying.
The APT suggests that investors will diversify their portfolios, but that they will also choose
their own individual profile of risk and returns based on the premiums and sensitivity of the
macroeconomic risk factors. Risk-taking investors will exploit the differences in expected and
real returns on the asset by using arbitrage.

Arbitrage in the APT

The APT suggests that the returns on assets follow a linear pattern. An investor can leverage
deviations in returns from the linear pattern using the arbitrage strategy. Arbitrage is the practice
of the simultaneous purchase and sale of an asset on different exchanges, taking advantage of
slight pricing discrepancies to lock in a risk-free profit for the trade.
However, the APT’s concept of arbitrage is different from the classic meaning of the term. In the
APT, arbitrage is not a risk-free operation – but it does offer a high probability of success. 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.
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

The Arbitrage Pricing Theory can be expressed as a mathematical model:
ER(x) = Rf+ β1RP1 + β1RP1+ β2RP2+…….+ βnRPn
Where:
ER(x) – Expected return on asset
Rf – Riskless rate of return
βn (Beta) – The asset’s price sensitivity to factor
RPn – The risk premium associated with factor

Historical returns on securities are analyzed with linear regression analysis against the
macroeconomic factor to estimate beta coefficients for the arbitrage pricing theory formula.

Inputs in the Arbitrage Pricing Theory Formula

The Arbitrage Pricing Theory provides more flexibility than the CAPM; however, the former is
more complex. The inputs that make the arbitrage pricing model complicated are the asset’s
price sensitivity to factor n (βn) and the risk premium to factor n (RPn).
Before coming up with a beta and risk premium, the investor must select the factors that they
believe affect the return on the asset; it can be done through fundamental analysis and a
multivariant regression. One method to calculate the beta of the factor is by analyzing how that
beta’s affected many similar assets/indices and obtain an estimate by running a regression on
how the factor’s affected the similar assets/index.
The risk premium can be obtained by equating the similar assets’/indices’ historical annualized
return to the riskless rate, added to the betas of the factors multiplied by the factor premiums, and
solve for the factor premiums.

Example
Assume that:
 You want to apply the arbitrage pricing theory formula for a well-diversified portfolio of
equities.
 The riskless rate of return is 2%.
 Two similar assets/indices are the S&P 500 and the Dow Jones Industrial Average
(DJIA).
 Two factors are inflation and gross domestic product (GDP).
 The betas of inflation and GDP on the S&P 500 are 0.5 and 3.3, respectively*.
 The betas of inflation and GDP on the DJIA are 1 and 4.5, respectively*.
 The S&P 500 expected return is 10%, and the DJIA expected return is 8%*.
*Betas do not represent actual betas in the markets. They are only used for demonstrative
purposes.
*Expected returns do not represent actual expected returns. They are only used for demonstrative
purposes.

Examples of how Capital Asset Pricing Model and Arbitrage Pricing Theory vary
1. The Capital Asset Pricing Model (CAPM) assumes systematic risk because investors only
focus on the variance of the return on assets. At this point, the market equilibrium can only
be explained by the sensitivity of the market returns. On the other hand, the Arbitrage Pricing
Theory (APT) assumes that other factors influence returns and the investors are aware of
these factors. Thus, the equilibrium expected return on assets is determined by the sensitivity
of the factors influencing returns. As the return on assets moves further away from balance,
investors will consider them arbitraged because they are the factors that influence returns.
2. Additionally, the Capital Asset Pricing Model (CAPM) adopts a single factor sensitive to
market changes, while the Arbitrage Pricing model has multiple factors excluding the beta
within CAPM.
3. The arbitrage pricing model is also considered a 'supply side' factor because it entails most
macroeconomic factors. The Capital Asset Pricing Model is viewed as the 'demand side'
since it forms a basis on the aggregate of individual investors' maximization of utility in the
market.
4. The CAPM lets investors quantify the expected return on investment given the risk, risk-free
rate of return, expected market return, and the beta of an asset or portfolio.
5. The arbitrage pricing theory is an alternative to the CAPM that uses fewer assumptions and
can be harder to implement than the CAPM.
6. While both are useful, many investors prefer to use the CAPM, a one-factor model, over the
more complicated APT, which requires users to quantify multiple factors.

Information on risk-free assets and a market portfolio, as an example in Pakistan

Information on risk-free assets and a market portfolio in Pakistan: Pakistan's equity gives
extensive diversification advantages if brought to developed marketplace portfolios. However,
located huge returns come collectively.

Pakistan: a study of market's returns

Above figure presents year-by-year returns that the investors earned in the leading PSX index
over the last 27 years. Remarkably, the equity market experienced fast growth following
liberalization and deregulation. For instance, in 2002, in the midst of a global market meltdown,
the index increased by 112%, and Pakistan's market was reported as the best performing market
in the world by US news magazine Business Week. Beyond, over a five-year period from 2002 to
2007, Pakistan's equity market earned an impressive average annualized return of 52.62%. Only
in 2008 did Pakistan record a steep drop in equity prices in wake of the global financial crises.
Even, a floor rule was imposed on PSX in August 2008 resulting in a near-total paralysis of
Pakistan's equities market for more than three months and the removal of the market from the
Morgan Stanley Capital International (MSCI) and Standard & Poor's (S&P) emerging markets
indices.
CAPM assumptions
1. Investors are expected to make decisions based solely on risk-return assessments
(expected returns and standard deviation measures).
2. The purchase and sale transactions can be undertaken in infinitely divisible units.
3. Investors can sell short any number of shares without limit.
4. There is perfect competition and no single investor can influence prices, with no
transactions costs, involved.
5. Personal income taxation is assumed to be zero.
6. Investors can borrow/lend the desired amount at riskless rates.

Efficient Frontier:
The above assumptions, although some of them are unrealistic provide a basis for an efficient
frontier line common to all. Different expectations lead to different frontier lines. If borrowing
and lending is introduced the efficient frontier line can be thought of as a straight line. Lending is
like investing in a riskless security say of Rf in the Fig.1.

Rf = Risk free investment. If he places part of his funds in Risk free assets (Rf) and part of his
funds in risky securities (B) along the efficient frontier, he would generate portfolios along the
straight line segment RfB.
Introduction of both borrowing and lending has given us an efficient frontier that is a straight line
throughout as shown in the Fig. 2. M is the optimal portfolio of risky investments. The decision
to purchase at M is the investment decision and the decision to buy some riskless asset (lend) or
to borrow (leverage the portfolio) is the financing decision.
Security Market Line:
In case of portfolios involving complete diversification, where the unsystematic risk tends to
zero, there is only systematic risk measured by Beta (β) the only dimension of a security, which
concerns us are expected return and Beta. All portfolios of investments lie along a straight line in
the return to Beta space. To determine this line we need to connect the Intercept (where Beta is
zero as it is riskless security), and the market portfolio (Beta of one and return of R M).
These points are Rf and Rm in the graph below. The equation of that straight line is
Security Market Line (SML):