TOPIC 3: THEORY FOR
INVESTMENT
PORTFOLIO
AFU 08609: INVESTMENT
AND PORTFOLIO ANALYSIS
Facilitator: Ms.Sogorya
Capital Asset Pricing Model
( CAPM)
CAPM is a model that describes the
relationship between the expected
return and risk of investing in a security.
CAPM is an Economic model for valuing
stock, securities, derivatives and/or
asset by relating risk and expected
returns.CAPM is based on the idea that
investors demand additional expected
return (call the risk premium) if they are
asked to accept additional risk.
Measuring Risk in CAPM is based on the identification of two
key components of total risk (as measured by variance or
standard deviation of return)
Systematic risk is that associated with the market
(purchasing power risk, interest rate risk, liquidity risk, etc.)
Investment Analysis and Portfolio Management
Unsystematic risk is unique to an individual asset (business
risk, financial risk, other risks, related to investment into
particular asset). Unsystematic risk can be diversified away
by holding many different assets in the portfolio, however
systematic risk can’t be diversified.
In CAPM investors are compensated for taking only
systematic risk. Though, CAPM only links investments via
the market as a whole.
CAPM Assumptions
All investors are rational i.e. they make
investment based on risk and return.
All investors have homogenous expectations
with respect to risk and return;
Investors can borrow or lend at the same risk
free rate.
Investors plan for only one period.
Taxes and transaction costs are irrelevant.
Information is freely and instantly available
to all investors i.e. it assume market is
perfect.
E(r j) = Rf + β(j) * ( E(rM) - Rf ),
E(r j) - expected return on stock j;
Rf - risk free rate of return;
E(rM) - expected rate of return on the market
β(j) - coefficient Beta, measuring undiversified risk
of security j
Cov (Ri,Rm)
βJ = -------------------
δ²m
Limitations of CAPM
Not always investors have same
expectations regarding risk and return.
Investors don’t always borrow or lend at
the same risk free rate.
The model ignores multi period
considerations.
It ignore taxes and transaction cost.
Market is not perfect.
It is based upon unrealistic assumptions
It difficult to test CAPM.
Applications of CAPM
Used to measure cost of capital
i.e. cost of equity.
Used to determine the rate of
return required by investors.
Measuring portfolio performance.
Portfolio selection.
Used in valuation of securities
such as common stock.
Example 1
Company A and Company B has an
equal risk free rate of 10% and the
current average market rate of
return is 14% . The beta value for
company A is 1.5 and for Company B
is 0.5. what is the required return
from both companies according to
CAPM.
Arbitrage Pricing Theory
(APT)
Is a theory of asset pricing that holds that an
asset’s return can be forecasted with the linear
relationship of an Asset’s expected returns and the
macroeconomics factors that affect the asset’s risk.
The theory was created in 1976 by American
economist, Stephen Ross.
The APT offers analyst and investors a multi
factor pricing model for securities, based on the
relationship between a financial asset’s expected
return and its risk.
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 over valued or
under valued for a brief period of time.
The APT is a more flexible and complex alternative
to the CAPM.
The theory provides investors and analyst with the
opportunity to customize their research. However,
its 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 assets.
APT Assumptions
Allsecurities have finite
expected values and
variables
Some Agents can form well
diversified portfolios
There are no taxes
There no transaction cost
How APT differs from
CAPM
CAPM has a single non company factor and a
single beta where APT model separates out non
company factors into as many as proves
necessary
The potentially large number of factors means
more betas to be calculated
No guarantee that all the relevant factors have
been identified
This added complexity is the reason APT is far
less widely used than CAPM
Detailed formula
ER(X) = Rf + β1RP1 + β2RP2 + …. βnRPn
Where:
ER(X)= Expected return on assets
Rf = Riskless rate of return
Βn(Beta) = The assets price sensitivity to factor
RPn = The risk premium associated with factor
Market efficiency theory
The concept of market efficiency was proposed by
Eugene Fama in 1965, when his article “Random Walks
in Stock Prices” was published in Financial Analyst
Journal.
Market efficiency means that the price which investor
is paying for financial asset (stock, bond, other
security) fully reflects fair or true information about the
intrinsic value of this specific asset or fairly describe
the value of the company – the issuer of this security.
The key term in the concept of the market efficiency is
the information available for investors trading in the
market.
There are 3 forms of market effeciency
• Weak form of efficiency;
• Semi- strong form of efficiency;
• Strong form of the efficiency.
Weak form of efficiency
Stock prices are assumed to reflect any
information that may be contained in the
past history of the stock prices.
So, if the market is characterized by weak
form of efficiency, no one investor or any
group of investors should be able to earn
over the defined period of time abnormal
rates of return by using information about
historical prices available for them and by
using technical analysis
semi-strong form
All publicly available information is presumed to be
reflected in stocks’ prices.
This information includes information in the stock
price series as well as information in the firm’s
financial reports, the reports of competing firms,
announced information relating to the state of the
economy and any other publicly available
information, relevant to the valuation of the firm.
Note that the market with a semi strong form of
efficiency encompasses the weak form of the
hypothesis because the historical market data are
part of the larger set of all publicly available
information.
Strong form of efficiency
which asserts that stock prices fully
reflect all information, including
private or inside information, as well as
that which is publicly available.
This form takes the notion of market
efficiency to the ultimate extreme.
Under this form of market efficiency
securities’ prices quickly adjust to
reflect both the inside and public
information.
THE END
