A Chartered Financial Analyst, Jeffrey Bruner, uses the Capital Asset Pricing Model (CAPM) to help identify mispriced securities. However, a consultant suggests Bruner to use Arbitrage Pricing Theory (APT) instead. As the following, it will mention the role of CAPM in the modern portfolio management; to clarify the APT faction and explain the reasons why should Bruner use APT to help identify mispriced securities. In modern portfolio management, the role of Capital Asset Pricing Model (CAPM) is a model that attempts to describe the relationship between the risk and the expected return on an investment and that is used in the pricing of risky securities. The assumption behind the CAPM is that there is only one risk-free rate in the model, investors can borrow and lend unlimited amounts under the risk rate of interest; the perfect information is freely available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and desire to maximise their own utility; and the capital market is characterised by perfect competition, there are broadly diversified across a range of investments and the investors will only require a return for the systematic risk of their portfolio, since unsystematic risk has been removed and can ignored. It also assumes all investors choose their portfolio according to the mean-variance criterion which ignores practical considerations such as trade without transaction or taxation costs. Under these assumptions, the market portfolio lies on the efficient frontier. The CAPM is represented as: E(Ri) = Rf + βi [E(RM)- Rf] The CAPM is remarkable because it tell us what should be the expected or required rates of return on all risky assets. The Security Market Line (SML) represents this relationship. Where E(Ri) is the appropriate expected rate of return on securities or portfolio I, Rf is the risk-free rate, E(RM) is the expected return on the market, and βi (beta) is the sensitivity of the...

...
How far the CapitalAssetPricingModel has been successful in explaining asset returns, defining its approach and assumptions.
Semester 2013
Department of Accounting and Finance
Lord Ashcroft International Business School
Anglia Ruskin University
Table of Contents
Introduction…………………………………………………………………………......... 3
What’s CapitalAssetPricingModel…………………………………………………..... 3 1. Definition………………………………………………………………………………...3 2. Terminology……………………………………………………………………………...3
Risk and CapitalAssetPricingModel………………………………………………….. 3 1. Systematic Risk…………………………………………………………………………..3 2. Unsystematic Risk………………………………………………………………………..3
Asset Returns and CapitalAssetPricingModel……………………………………….. 3
CapitalAssetPricingModel...

...CAPITALASSETPRICINGMODEL
The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk [pic]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).
Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).
THE CAPM MODEL
A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
[pic]
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 [pic]formula and compensates the investors for placing money in any investment over a period of time. The other half of the 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...

...CapitalAssetPricingModel: The Indian Context
R Vaidyanathan
T
he CapitalAssetPricingmodel is based on two parameter portfolio analysis
model developed by Markowitz (1952). This model was simultaneously and
independently developed by John Lintner (1965), Jan Mossin (1966) and
William Sharpe (1964). In equation form the model can be expressed as follows:
E (Ri) = Rf + (i [E(rm) – Rf] = Rf +(im / (m (E(Rm) – Rf / (m)
Where E(Ri) is expected return on asset i, Rf is the risk-free rate of return, E(Rm) is expected return on market proxy and (i; is a measure of risk specific to asset i. This relationship between expected return on asset i and expected return on market portfolio is also called the security market line. If CAPM is valid, all securities will lie in a straight line called the security market line in the E(R), (i frontier. The security market line implies that return is a linearly increasing function of risk. Moreover, only the market risk affects the return and the investor receive no extra return for bearing diversifiable (residual) risk.
The set of assumptions employed in the development of the CAPM can be summarized as follows [Sears and Trennepohl (1993)]:
1. Investors are risk-averse and...

...1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
Undiversifiable (market )risk:
Market risk is the variability in all risky assets caused by macroeconomic variables. This risk cannot be avoided, regardless of the amount of diversification. Systematic risk (Market risk) factors are those macroeconomic variables that affect the valuation of all risky assets such as variability in the growth of the money supply, interest rate volatility, variability in aggregate industrial production, and natural shocks like drought, earth quake, hurricane, etc.
Diversifiable (unique )risk:
Many of the risks faced by an individual company are peculiar to its activity, its management, etc. These are the unique risks and can be diversified away. Examples of unique risks are a company winning a large contract, wildcat strikes hitting a company, litigation hitting a company or the company facing a governmental investigation.
a. A large fire severely damages three major U.S. cities.
Diversifiable risk
The entire economy will not be affected by a large fire in three major US cities. In fact some companies in cities not affected by fire will benefit as they will meet the demand not being met by companies in the three cities that are...

...CapitalAssetPricingModel (CAPM): Pros and Cons.
CAPM defines the relationship between risk and return. The premise of the model is that the expected investment return varies in direct proportion to its risk, i.e., the riskier the investment - the higher the return you should expect.
Shows:
• how much risk you are taking when investing in an instrument?
• whether the instrument is rightly priced
• whether you are getting sufficient return for the risk you are taking
CAPM calculates the risk-adjusted discount rate with the risk-free rate, the market risk premium, and beta (mathematical formula):
Return (R) = Rf + beta x (Rm - Rf)
Rf is the rate of risk-free investments
Beta - the risk of loss associated with your investments.
Rm is the expected market return.
(Rm-Rf) – market risk premium
beta x (Rm - Rf) – risk premium of specific company
Investments are good if the expected return from the investment equals/exceeds required return.
Market Risk Premium [Rm-Rf]
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk
Its size depends on the perceived risk of the overall stock market and investors’ degree of risk aversion
Varies across time. Usually ranged between 4-8%
BETA in CAPM measures a stock’s degree of systematic or market risk. It can also be thought of as the stock’s contribution to the risk of a...

...CAPITALASSETPRICINGMODEL (CAPM) The capitalassetpricingmodel (CAPM) is an important model in finance theory. CAPM is a theory or model use to calculate the risk and expected return rate of an investment portfolio (normally refer to stocks or shares). All stocks have 2 risks: Systematic Risk (also called Market Risk which affect every stocks) and Unsystematic Risk (also called Specific or Unique Risk that only affects individual stocks). To diversify unsystematic risk, we selected and combined different stocks, which are negatively correlated with one another into one portfolio. In this way risk are eliminated greatly. See diagram below.
CAPM Equation The general formula used for CapitalAssetPricingModel is: re = rf + [ ß (rm - rf) ] where the components are as follows: re = Expected return rate of the investment portfolio rf = Risk free rate of return ß = Beta (correlation between the shares and the market) rm = Expected market return which also means: rm - rf = Market risk (systematic risk) ß (rm - rf) = Risk premium *Beta is overall risk value for investing in the stock market. The higher the beta, the more the risk.
CAPM Example Assume there is two Investment portfolio (stocks) or project - A & B. With the information given below, we...

...Chapter 10
ArbitragePricingTheory and Multifactor Models of Risk and Return
Multiple Choice Questions
1. ___________ a relationship between expected return and risk.
A. APT stipulates
B. CAPM stipulates
C. Both CAPM and APT stipulate
D. Neither CAPM nor APT stipulate
E. No pricingmodel has found
Both models attempt to explain assetpricing based on risk/return relationships.
Difficulty: Easy
2. ___________ a relationship between expected return and risk.
A. APT stipulates
B. CAPM stipulates
C. CCAPM stipulates
D. APT, CAPM, and CCAPM stipulate
E. No pricingmodel has found
APT, CAPM, and CCAPM models attempt to explain assetpricing based on risk/return relationships.
Difficulty: Easy
3. In a multi-factor APT model, the coefficients on the macro factors are often called ______.
A. systemic risk
B. factor sensitivities
C. idiosyncratic risk
D. factor betas
E. B and D
The coefficients are called factor betas, factor sensitivities, or factor loadings.
Difficulty: Easy
6. Which pricingmodel provides no guidance concerning the determination of the risk premium on factor portfolios?
A. The CAPM
B. The multifactor APT
C. Both the CAPM and the multifactor APT
D. Neither the CAPM...

...09
Student: ___________________________________________________________________________
1.
In the context of the CapitalAssetPricingModel (CAPM) the relevant measure of risk is
A. unique risk.
B. beta.
C. standard deviation of returns.
D. variance of returns.
E. none of the above.
2.
In the context of the CapitalAssetPricingModel (CAPM) the relevant risk is
A. unique risk.
B. systematic risk.
C. standard deviation of returns.
D. variance of returns.
E. none of the above.
3.
In the context of the CapitalAssetPricingModel (CAPM) the relevant risk is
A. unique risk.
B. market risk.
C. standard deviation of returns.
D. variance of returns.
E. none of the above.
4.
According to the CapitalAssetPricingModel (CAPM) a well diversified portfolio's rate of return is a
function of
A. market risk.
B. unsystematic risk.
C. unique risk.
D. reinvestment risk.
E. none of the above.
5.
According to the CapitalAssetPricingModel (CAPM) a well diversified portfolio's rate of return is a
function of
A. beta risk.
B. unsystematic risk.
C. unique risk.
D. reinvestment risk.
E. none of the above.
6.
According to the Capital...

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