Topic 4 Investment Analysis

Topic
Equilibrium
Models and
Applications
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain risk-free asset;
2. Calculate the return and risk of a portfolio;
3. Explain the importance of the Capital Asset Pricing Model (CAPM) in
investment decision-making;
4. Review the concept of systematic risk or Beta; and
5. Explain the concept of Arbitrage Pricing Theory.
X INTRODUCTION
In Topic 3, the discussion of portfolio theory showed how an efficient portfolio
was formed using a combination of risky assets. In this topic, we will extend the
analysis of portfolio as well as the usage of some tools derived from Topic 3. We
will be introduced to risk-free assets and changes observed in the shape of an
efficient frontier.
Next, we will discuss the concept of equilibrium condition and how assets are
being priced in these conditions. As a result, we will derive two equilibrium
models, namely the Capital Asset Pricing Model (CAPM) and the Arbitrage
Pricing Theory (APT).
TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS
4.1
W 49
RISK-FREE ASSETS
A risk-free asset is an asset with zero variance.
Technically, the asset will provide a return that is equal to its expected return.
Thus, there is no variability in the returns. An example of a risk-free asset is a
fixed deposit in the bank. If the bank promises to pay a fixed amount of interest
within a stated period, then the bank would normally fulfil its promise.
Therefore, the investor will neither expect the return to be lower nor expect the
bank to increase the return. Since this type of arrangement has no risk, the return
offered is normally low.
4.2
RISK-FREE AND RISKY ASSETS
An investor can choose to invest 100% in a risk-free asset (RF) or divide his funds
into risk-free assets and risky assets. For example, if RF is offering a return of 8%
and the expected return of risky Asset A is 10%, what is the expected return from
the portfolio? Risky Asset A has a standard deviation of 6% and the investor
places 40% of funds in RF . The correlation between the risky asset and risk-free
asset is zero, that is AF = 0. From Topic 3, we know that portfolio return (ERp) is:
ERP = wFRF + wAERA.
Where:
wF
=
wA =
ERA =
Weights in RF
Weights in Asset A
Expected return of Asset A.
Thus, ER(P) for the above example is:

ER(P) = (0.4 x 8) + (0.6 x 10)
= 9.2
The risk (P) of the above portfolio is:
VR
y H4V H4 y C4V C4 4y H y C U CH V H V C
2064 *2+ 2084 *84 + 4*206+*208+*2+2*8+
508
Notice that the risk of Asset A made up the whole risk of the portfolio, in
proportion to the amount of funds invested in the asset. As mentioned earlier, we
50 X
can shift funds from RF to Asset A and build a set of portfolios and a range of
returns and risks.
Table 4.1 shows the range of portfolio returns and risks when funds are shifted
from RF to Asset A.
Table 4.1: Calculation of Portfolio Return and Risk between Asset A and Risk-Free Asset
RF = 8
ERA = 10
wRF
wA
VRF
ERp
=
=
0 VA
6
w2RFs2RF
UARF = 0
w2AV2A
2wRFwAPRFAVRFVA
V2P
VP
1.0
8.0
0.9
8.2
0.36
0.36
0.6
0.8
8.4
1.44
1.44
1.2
0.7
8.6
3.24
3.24
1.8
0.6
8.8
5.76
5.76
2.4
0.5
9.0
9.00
9.00
3.0
0.4
9.2
12.96
12.96
3.6
0.3
9.4
17.64
17.64
4.2
0.2
9.6
23.04
23.04
4.8
0.1
9.8
29.16
29.16
5.4
10.0
36.00
36.00
6.0
Note: Please refer to Topic 3 for explanation on the calculations and symbols.
If the expected return and risk are plotted on a graph, we will get a straight line
as shown in Figure 4.1.
W 51
Figure 4.1: Portfolio return and risk of risk-free and asset A
Let us say there is another investment asset, Asset B for our investment
consideration. The expected return for Asset B is 11.6% and the standard
deviation is 5.3%. What is the portfolio combination of RF and Asset B? Figure 4.2
shows the portfolio combination that can be made between RF and Asset B. The
line is derived from the calculations in Table 4.2.
Figure 4.2: Combinations of RFA and RFB
52 X
Table 4.2: Portfolio Returns and Risks for Combinations between Risk-Free Asset (RF)
and Risky Asset A and Risky Asset B
wRF
ERP1
VP1
ERP2
VP2
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
8.2
8.4
8.6
8.8
9
9.2
9.4
9.6
9.8
10
8.4
8.7
9.1
9.4
9.8
10.2
10.5
10.9
11.24
11.6
0.5
1.1
1.6
2.1
2.6
3.2
3.7
4.2
4.8
5.3
RF
VRF
0.6
1.2
1.8
2.4
3
3.6
4.2
4.8
5.4
6
0
RF
VRF
URE
RF
VRF
5.3
UARF
Portfolio P1 is combination of RP and asset A

Portfolio P2 is combination of RP and asset B
If we also plot the portfolio return and risk (risk-free asset and Asset A as in
Figure 4.2), you can see that the combination of RF and Asset B are more efficient
than the combination of RF and Asset A. At the same risk level (point 2 and point
1), the combination of RF and Asset B offers a higher return compared to the
combination of RF and Asset A.
In the last topic, it was shown that if all risky assets were to be combined to form
portfolios, then an efficient set of portfolios could be found. This efficient set is
located on the efficient frontier. We can combine RF with any portfolios in the
efficient set. Figure 4.3 shows the combinations that can exist between RF and the
efficient frontier.
W 53
Figure 4.3: Combinations of RF with any assets on the efficient frontier
Using the previous discussion, the line RFA are portfolios that are less efficient
than RFB. We can move upwards until a line is obtained that gives the highest
return with a given level of risk. This line just touches the efficient frontier at
point P. Asset P is known as the optimal portfolio. It is the portfolio that gives the
best sets of returns within its specific risk level. It is also the highest line or the
line with the greatest slope.
An investor now will not want to consider any other portfolios other than P,
since combinations of RF and this portfolio give him the best returns and risk
compared with any other combination below the line. Therefore, we can ignore
any portfolios or assets that are not on the RFP line. The investment selection now
shifts from the curve of the efficient frontier to the straight line. Figure 4.4 shows
the complete strategies an investor can choose.
At point RF, an investor invests 100% in the risk-free asset. At point P, he invests
100% in portfolio P. Between RF and P, he combines RF with P. Any position on
the line is where the investor lends some of his funds to RF and also invests some
portion in P.
54 X
The investor can extend his choice by borrowing and invest in P. This is shown
by the extended line PP1. The investor will expect a higher return but the risk will
increase. He will also need to pay interest on the borrowed funds. The interest
rate is RF.
Figure 4.4: Combinations of RF and optimal portfolio P; lending and borrowing positions
W 55
Table 4.3 shows the calculations for the RF PP1 line.

RF
= 8
VRF
ER P = 16
Lending
Borrowing
UPRF ?" 2
= 0
VP = 7
ERPortfolio w2Ps2P
w2Ps2P
2wRFwPrRFPsRFsP s2Portfolio
sPortfolio
wRF
wP
0.9
0.8
0.1
0.2
8.8
9.6
0
0
0.5
1.9
0
0
0.5
1.9
0.7
1.4
0.7
0.6
0.3
0.4
10.3
11.1
0
0
4.2
7.5
0
0
4.2
7.5
2.1
2.7
0.5
0.4
0.5
0.6
11.9
12.7
0
0
11.8
17.0
0
0
11.8
17.0
3.4
4.1
0.3
0.2
0.7
0.8
13.4
14.2
0
0
23.1
30.2
0
0
23.1
30.2
4.8
5.5
0.1
0
0.9
1
15.0
15.8
0
0
38.2
47.1
0
0
38.2
47.1
6.2
7
-0.1
-0.2
1.1
1.2
16.6
17.3
0
0
57.0
67.9
0
0
57.0
67.9
7.6
8.2
-0.3
-0.4
1.3
1.4
18.1
18.9
0
0
79.7
92.4
0
0
79.7
92.4
8.9
9.6
-0.5
1.5
19.7
106.1
106.1
10.3
When the investor has 10% of his investment using borrowed funds, he is
investing 110% in P. The return from the portfolio is:
GTRqtvhqnkq
y H TH y R GTR
* 203 u : + *303 u 38+
380:
The risk of the portfolio is:
V Rqthqnkq
y H4V H4 y R4V R4 4y H y r U rH V H V R
2034 *2+ 3034 *94 + 4* 203+*303+*2+2*9+
909
56 X
SELF-CHECK 4.1
You have two types of assets to be considered for investment. Asset A
is risk-free but only offers a return of 6% while Asset B is a risky asset
which offers 10% returns. Which asset would you invest in? Why?
4.3
THE MARKET PORTFOLIO
In the previous section, we discussed optimal portfolio P, the most efficient

portfolio. To maximise returns with the best risk level, the investor will not
consider any other risky assets. All investors would prefer to hold this portfolio
P. Therefore, this portfolio must include all risky assets. If not, there would be no
demand for that asset and therefore, it would not have any value (price).
If we consider an equilibrium situation and all assets are included, then the
optimal portfolio P is the market portfolio. All assets will be represented in
this market.
A portfolio consists of a combination of assets according to their respective
weights. Therefore, in this market portfolio, each asset will be represented by its
value in proportion to the total value of the market.
Efficiency is an important characteristic of this market portfolio. An efficient
portfolio will be a fully diversified portfolio. A fully diversified portfolio is where
all unique risks of the individual asset have been diversified away. The
remaining risk is the systematic risk of the individual asset. This systematic risk
is measured by the covariance of an individual asset with the market portfolio.
Take note that a market portfolio is a combination of all risky assets. An
individual asset in the market portfolio will therefore have a covariance with
every other single asset in the market. In the next section, we will find that this
covariance of an asset with the market will become a very significant
contribution to an asset return.
If we redraw Figure 4.4 and replace portfolio P with market portfolio M, we will
obtain Figure 4.5, the Capital Market Line.
W 57
Figure 4.5: Capital market line
The straight line is known as the Capital Market Line (CML). CML now becomes
the relevant efficient frontier. The vertical and horizontal lines represent the
expected returns and risks of portfolios respectively. The CML shows the
relationship between the expected returns and risks of portfolios. This
relationship, which is a straight line, is shown below:
GTR TH
*GTO TH +
VO
The risk of the portfolio is:
VR0
*GTO TH +
VO
The above equation shows that expected returns (ERP) will be high when the
risks (P) of the portfolio are high. The value of the slope will be the same at any
point along the line. This slope represents the price of the risk that an investor
will face. The price will increase when the risk increases.
SELF-CHECK 4.2
If a portfolio is what an investor has when he divides his funds
and invests in more than one asset, what is a market portfolio?
58 X
4.4
THE CAPITAL ASSET PRICING MODEL
Capital Asset Pricing Model (CAPM) is a model that shows the relationship
between returns and risks of individual assets.
In the previous section, the CML provides the return-risk relationship of
portfolios. Though there are numerous risky assets in the market portfolio, the
most efficient is the market portfolio. There will be numerous risky assets in this
market portfolio. Now, we will examine the relationship of an individual asset
with this market portfolio.
CAPM was derived by using many assumptions. These assumptions are stated
below:
(a)
There are many investors and they are all price takers. This situation is
similar to perfect competition where nobody has any influence on the
market.
(b)
All investors have one holding period.
(c)
All assets are in the market. Investors can borrow or lend any amount at a
fixed risk-free rate.
(d)
There are no taxes and no transaction costs.
(e)
All investors make decisions based on mean and variance.
(f)
All investors have homogeneous expectations. Thus, they will behave the
same way if faced with the same situation.
In the last topic, we saw how a portfolio risk is determined. Portfolio risk is a
combination of individual assets variance and covariance with other assets. As
the number of assets in a portfolio increases, the number of covariance also
increases. The number of covariance will finally be more than the variance of
individual assets. This will indicate that the covariance between assets will be
more important than the variance as the number of assets in the portfolio
increases. The covariance between assets will contribute a major portion of the
portfolio risk. Therefore, the only risk that is relevant is the covariance of an
individual asset with other assets in the portfolio.
We also have stressed that the only efficient portfolio is the market portfolio.
Therefore, the only risk that is relevant to an individual asset (i) in the market
portfolio is its covariance with the market portfolio (iM).
W 59
Again, this return-risk relationship can be interpreted through Figure 4.6. We

have used the same format as in Figure 4.5. However, the vertical and horizontal
lines have been replaced with expected returns (ERi) and risk (covariance
between i and M, iM) of individual assets. The line is known as the Security
Market Line (SML).
Figure 4.6: The security market line (SML) representing the capital asset pricing model
Firstly, observe that the covariance of the market with itself is the variance of the
market, (MM) = (2M).
The slope of the SML is therefore:
*GTO TH +
V O4
The equation for the SML is shown below:

GTk
TH
*GTO TH +
V O4
V kO qt GTk TH
V kO
*GTO TH +
V O4
Secondly, we can replace the term with a standardised format known as Beta (i)
or systematic risk. The equation of the SML can be shown as:
GTk
TH E k *GTO TH +0
60 X
This equation is known as the Capital Asset Pricing Model (CAPM). It states that
the expected return of an individual asset i is related to its systematic risk (i).
The investor should demand a reward to incur this risk. The general price of the
risk is the market risk premium (ERM RF). This risk premium is the same for all
assets. However, the amount of reward for each risky asset is the risk premium
multiplied by the systematic risk (i). Note that the amount of reward for each
risky asset together with the risk-free rate will determine the total expected
return.
Notice that if the covariance of the market with itself is the variance of the
market, (MM) = (2M), then the Beta of the market is equal to one. Figure 4.6 will
then change to Figure 4.7.
Figure 4.7: The capital asset pricing model
4.5
ESTIMATING BETA
The systematic risk or Beta can be estimated using the equation below:
Tkv D k E k TOv H
where:
Rit
RMt
i
i

=
=
=
=
=
the return for asset i during period t;

the return of the market portfolio during period t;
the constant term or the intercept of the regression line;
the beta of asset; and
the random error for the line.
W 61
The above equation is similar to any time series regression model, where the
independent variable is RM and the dependent variable is Ri. Ri is assumed to
change when RM changes. The amount of change in Ri will be determined by i,
with some level of error, . The equation will give you a straight line. In this
context, we can call it a characteristic line. Please take note that the above
equation is not the CAPM.
The actual market portfolio cannot be observed since it is impossible to include
all risky assets. A complete market will have to include all financial and physical
assets as well as human assets, arts, properties, raw materials, natural resources
and others. The alternative is to use a proxy of the market. The accepted
procedure is to use a market index. In Malaysia, we can use the Bursa Malaysia
Composite Index.
Table 4.4 shows an example of how beta is calculated. We have used monthly
price data from Yeo Hiap Seng (YHS) and YTL Power (YTLPWR). The prices
have to be converted into returns. For example, the return for January 2002 is
obtained by taking the price for that month minus the price from December 2001
and divided by the December price. Hence, the return for YHS is
RM2.03 RM2
u 100 1.50 . Columns four and five as indicated in Table 4.4

RM2
are products of two deviations. For YHS, it will be (R KLCI R KLCI )(RYHS RYHS )
for each month.
Figure 4.8 shows the scatter plot for returns of YHS against the KLCI. The x-axis
represents the returns of the KLCI. Each dot represents the returns of the share
against the KLCI on a particular month. A line can be drawn across the dots to
show a general relationship between YHS returns against the KLCI.
In a regression model, this line is known as the line of best fit. We can call this
line the characteristic line. The slope of the line is the measure for Beta. Figure 4.9
shows the line for YTLPWR. Do you notice that the slope for YHS is steeper than
YTLPWR? This indicates that the beta (risk) for YHS is higher than YTLPWR.
ACTIVITY 4.1
Refer to the Bursa Malaysia website at http://www.bursamalaysia. com.
Select at least three shares from the same industry listed in the Bursa
Malaysia and determine their beta. What can you conclude from the
results obtained? You can also obtain the data required for your
calculation from the newspapers.
62 X
Table 4.4: Beta Calculation for YHS and YTLPOWER

Tgvwtp"
Fcvg"
KLCI YHS YTLPWR
RKLCI
"
RYHS
RYTLPWR
Fge/23" 883074" 4"
406"
Lcp/24" 8;9033" 4025"
4059"
Hgd/24" 92908:" 4029"
4049"
3074"
30;9
/6044"
Oct/24" 963094" 4026"
407"
60:3"
/3067
32035"
705:"
"
"
3072
/3047"
*3+*4+?" *3+*5+?"
RKLCI - RKLCI *3+ RYHS - RYHS *4+ RYTLPWR - RYTLPWR *5+"

"
7078"
"
"
*6+"
*7+"
"
"
5065"
/4065"
3;026" /35075"
308;"
50;2"
/7062"
8082"
/;037"
60;;"
206:"
:0;7"
405:"
66085"
Crt/24" 983064" 4034"
40:;"
4088"
50;4
37082"
40:5"
70:7"
36064"
38079"
620:7"
Oc{/24" 9:;0;5" 4045"
40:9"
5096"
703;
/208;"
50;4"
9033"
/30::"
490;2"
/9058"
Lwp/24" 977043" 30;7"
40::"
/6062" /34078
2057"
/6044"
/32085"
/20:6"
660:5"
5074"
Lwn/24" 966084" 30;3"
40:4"
/3062"
/4027
/402:"
/3044"
/2035"
/5049"
2037"
6022"
Cwi/24" 943087" 30;4"
4097"
/502:"
2074
/406:"
/40;3"
4067"
/5089"
/9034"
32088"
Ugr/24" 8;602;" 30:"
4096"
/50:4"
/8047
/2058"
/5086"
/6054"
/3077"
37097"
7086"
Qev/24" 86402;" 308;"
4077"
/906;"
/8033
/80;5"
/9053"
/603;"
/:034"
52083"
7;05:"
4035"
4059
90:6"
4053"
604;"
8088"
;0;2"
37058"
/7092" /3504;
5049"
/7074"
/33059"
402;"
Pqx/24" 877098" 3095"
4097"
Fge/24" 83:059" 307"
40:6"
Lcp/25" 848039" 3068"
40:"
3048"
/4089
/3063"
3066"
/2096"
/407;"
/3029"
/5095"
Hgd/25" 883047" 306:"
40:"
7082"
3059
2022"
709:"
5052"
/303:"
3;027"
/80:6"
Oct/25" 857088" 3068"

40:"
/50:9"
"
"
" Cxgtcig" T /203:"
/3057
/30;5
2022"
303:"
/508;"
"
2079"
"
/303:"
Vqvcn,"
70:6"
"
"
"
"
"
"
"
"
"
"
6054" 7074
UF"*V +
Xctkcpeg""
3:08:" 52069
4
*V +
Eqxctkcpeg"
"
39074
*Vko+
"
20;6
Dgvc"*E +
Cnrjc"*D+
"
/3098
56035"
;095"
840:2" /33076"
/4034"
6059"
46704:" 358048"
"
"
"
"
"
2074"
"
"
"
"
"
304:"
"
"
"
"
"
x"Eqnwop"6"ku"eqnwop"4"ownvkrnkgf"ykvj"eqnwop"3"
x"Eqnwop"7"ku"eqnwop"5"ownvkrnkgf"ykvj"eqnwop"3"
x"Vqvcn,"ku"vjg"vqvcn"hqt"vjg"Eqnwop"6"cpf"70"
x"Eqxctkcpeg""?""Vqvcn,"y36"*"36"ku"vjg"pwodgt"qh"qdugtxcvkqp"nguu"3."vjcv"ku"37"oqpvju"nguu"3+0"
x"Dgvc"ku"*Vko y V2MNEK +0"Cnrjc"hqt"[JU"ku" T[JU * E[JU u T MNEK + "cpf"ceeqtfkpin{"hqt"[VNRYT0"
Figure 4.8: YHS characteristic line
Figure 4.9: YTLPWR characteristic line
W 63
64 X
EXERCISE 4.1
1. Using a rough sketch, determine the beta for Share A and B.
Year
Market Return
Return Share A
Return Share B
3%
16
-5
20
18
-20
25
14
2. Currently the share price of Fatbody Corp is RM3. The firm is

experiencing a growth rate of 6% annually. Last years EPS (E0) is
RM0.40, and the dividend payout ratio is 50%. The risk-free rate is
5% and the market return is 10%. Determine the required return
and the beta of Fatbody.
4.6
APPLYING THE CAPM
Let us assume that we are able to obtain the following data for a set of shares
from an investment analyst:
Stock
A
B
C
D
E
Beta
0.8
1
1.2
1.8
-0.5
Also assume that the investment analyst has predicted that the market is
expected to provide a return (ERM) of 10% and the current risk-free rate (RF) of
4%. The market risk premium will be 6%.
With this scenario, the expected return (ERi) of each share will be calculated as in
Table 4.5.
W 65
Table 4.5: Expected Return

Beta Risk Premium
Stock
Expected Return ERi
Risk-free RF
8.8%
4%
0.8 (10% 4%)
10%
4%
1 (10% 4%)
11.2%
4%
1.2 (10% 4%)
14.8%
4%
1.8 (10% 4%)
1%
4%
-0.5 (10% 4%)
I (ERM RF)
At equilibrium, all the shares should provide the returns as shown in Table 4.5.
This will also mean that the returns will depend on the SML. Figure 4.10 depicts
this situation. All shares will be in line with their respective betas.
Figure 4.10: Asset returns with their betas
Sometimes, you may face a situation where the expected returns are not in line
with the estimated returns. For instance, an investor may have his/her own
speculation on the selling price of each share, and this will result in an estimated
return that is different from the expected returns. For further elaboration, lets
say that the current price is P0 price and the investor expects to sell the shares at
P1 prices. The analysis for this scenario is described in Table 4.6.
66 X
Table 4.6: Analysis of Prices

Stock
Current
Price P0
(RM)
Estimated
Price P1
(RM)
Estimated
Return
(%)
Expected
Return
ERi (%)
Price
Situation
Actual
Value
P0"(RM)
3.5
3.81
8.8
8.8
Correct
3.50
4.6
5.50
19.5
10
Undervalued
5.00
2.5
2.61
4.5
11.2
Overvalued
2.35
2.1
2.18
4.0
14.8
Overvalued
1.90
1.22
1.24
2.0
Close
1.23
The estimated return is obtained by taking the percentage change in price

P1 P0
u 100 . This estimated return is compared against the expected return
P0
from the CAPM. If the estimated return is equal to the expected return, then the
share is in equilibrium. The actual value P0 is the same as the current price, P0.
For stock B, the estimated return is higher than the equilibrium or the expected
return. Investors might think that the share can offer a higher return than
expected. Thus, there will be an increase in demand, since in equilibrium all
investors will have the same information and behaviour. The increase in demand
will increase the current price P0. As we can see, the current price, P0 of RM4.60 is
considered undervalued. The actual value P0 is RM5.00. With this increase, the
estimated return will converge to the expected return.
The situation for shares C and D is in reverse. In this case, investors estimate
returns that are below expectations. They are unlikely to hold these shares and
probably try to sell them if they are holding them. This will create less demand
and over supply of those shares. As a result, the price will decrease. Share D, for
example, is overpriced at P0 RM2.1. The actual value is only RM1.90. With the
decrease, the estimated return will converge to the expected return.
Figure 4.10 shows the relationship of the estimated return against the expected
return. The expected returns lie on the SML. All shares with estimated returns
above the SML are considered undervalued. The reverse is true for the
overvalued shares.
W 67
ACTIVITY 4.2
1. We often hear that investors speculations can affect the price of
shares listed in the share market. How do speculations affect the
price? Explain.
2. Visit the Bursa Malaysias website at http://www.bursamalaysia.
com to review some of the share prices available. And also review
business analysis in the newspapers to get input about why
speculations happened and how it affects share prices.
4.7
ARBITRAGE PRICING THEORY
Arbitrage Pricing Theory (APT) is another model that shows returns are also
related to risks. However, the model uses different assumptions and techniques.
According to APT, an opportunity exists when the investor is able to
generate profit without any risk and uses no capital.
However, in reality this situation is unlikely to occur. Firstly, in an equilibrium

market condition, there will be no such opportunity. Therefore, returns will
always be related to risk and some capital investment is needed before returns
can be obtained. If such a situation did arise, market forces will react quickly to
restore equilibrium.
Secondly, according to the APT, returns will be generated from the following
process:
where:
Tk
The expected return of security i
I1Ij
ei
=
=
=
bi1.bij
The value of index or factors that can influence security i.

The expected value of the index or factor.
A random error that resembles the portion of returns from an
unsystematic risk.
The sensitivities of the security to each of the index. This is
similar to Beta in the CAPM. In CAPM, the factor is the market.
However, in APT, we have not specified the nature of the factor.
Thirdly, in order for APT to take effect, we need a large number of assets in the
market. The investor can then find a combination of assets that can eliminate
68 X
risks. These risks include all systematic risks measured by betas (b1..bj) and
unsystematic risks. Then, the investor is able to combine assets in such a way that
he/she does not have to use any capital. (The details and exact processes are
available from any advance book in finance and investment listed at the back of
this module.)
As mentioned earlier, in an equilibrium situation, the above condition cannot
exist because the investor will then obtain zero returns. Take note that a
relationship exists between expected returns and risks where an investment with
zero risk should provide zero returns. At this point, the investor will not even
earn the risk-free rate because he did not invest any capital.
Since unsystematic risks can be diversified away, investors will only need to be
compensated from systematic risks or the beta of the factors. As the factors are
general factors and will affect all assets, the price of risks for each factor will be
the same. The amount of this price for each asset will be determined by the value
beta related to that factor. If we let the price of this risk be , then APT can be
generalised into the following.
GTk O2 E k 3O3 E k 4 O4 00000000000000000 E kl O l

Where:
ERi
i1, i2 ij
0
1, 2 j
= the expected return of asset i.

= the systematic risks for each factor 1 to j;
= the risk-free rate; and
= the price of risk or risk premium that is required by investors
to bear the risk from factors 1 to j.
Different assets will have different returns based on their level of betas for each
factor. For example, lets assume there are two general factors and investors
perceive factor one should have a risk premium 1 of 5% and factor two 2 with
10% and the risk-free rate is 4%. Then, the APT model will look like this:
GTk
6 E k 3 7 E k 4 32
Asset A with 1 which is equal to 0.5 and 2 which is equal to 0.8 will have an
expected return of 14.5%. Asset B with 1 which is equal to 2 and 2 which is
equal to 0.5 will have an expected return of 19%.
The APT did not specify the number of factors and the nature of these factors.
Previous empirical tests have found several economic variables to be significant.
Among them are index of industrial production, default risk premium (the
difference between the yield of AAA and BBB bonds), difference in yield curve
W 69
(the difference between short-term and long-term rates of government bonds)

and unanticipated inflation.
EXERCISE 4.2
1. Your analyst has provided the following information. The expected
market return is 12% while the risk-free rate is 4%. The standard
deviation of the market is 8%. You are required to draw the capital
market line and the security market line.
2. Using the information from Question 1, what will happen to a
share with a beta of 1, if it is offering a return of 14%?
3. Assume that the risk=free rate is 6% and the expected rate of return
of the market is 16%. A share that sells for RM5.00 today is
expected to pay a dividend of RM0.60 per share at the end of the
year. Its beta is 1.2. At what price do investors expect to sell at the
end of the year?
Efficiency is an important characteristic of a market portfolio. An efficient

portfolio will be a fully diversified portfolio where all unique risks of the
individual have been diversified away.
CAPM is a model that shows the relationship between returns and risks of
individual assets. It states that the expected return of an individual asset is
related to its systematic risk (beta).
According to APT, an opportunity exists when the investor is able to generate

profit, without any risk and uses no capital.

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TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

A risk-free asset is an asset with zero variance.

RISK-FREE AND RISKY ASSETS

Thus, ER(P) for the above example is:

2064 *2+  2084 *84 +  4*206+*208+*2+2*8+

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

Figure 4.1: Portfolio return and risk of risk-free and asset A

Figure 4.2: Combinations of RFA and RFB

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

Portfolio P1 is combination of RP and asset A

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

Figure 4.3: Combinations of RF with any assets on the efficient frontier

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

Table 4.3 shows the calculations for the RF PP1 line.

The risk of the portfolio is:

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

THE MARKET PORTFOLIO

In the previous section, we discussed optimal portfolio P, the most efficient

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

Figure 4.5: Capital market line

The risk of the portfolio is:

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

THE CAPITAL ASSET PRICING MODEL

All investors have one holding period.

There are no taxes and no transaction costs.

All investors make decisions based on mean and variance.

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

Again, this return-risk relationship can be interpreted through Figure 4.6. We

The equation for the SML is shown below:

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

Figure 4.7: The capital asset pricing model

the return for asset i during period t;

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

u 100 1.50 . Columns four and five as indicated in Table 4.4

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

Table 4.4: Beta Calculation for YHS and YTLPOWER

KLCI YHS YTLPWR

Fge/23" 883074" 4"

Lcp/24" 8;9033" 4025"

Hgd/24" 92908:" 4029"

Oct/24" 963094" 4026"

RKLCI - RKLCI *3+ RYHS - RYHS *4+ RYTLPWR - RYTLPWR *5+"

Crt/24" 983064" 4034"

Oc{/24" 9:;0;5" 4045"

Lwp/24" 977043" 30;7"

Lwn/24" 966084" 30;3"

Cwi/24" 943087" 30;4"

Ugr/24" 8;602;" 30:"

Qev/24" 86402;" 308;"

Pqx/24" 877098" 3095"

Fge/24" 83:059" 307"

Lcp/25" 848039" 3068"

Hgd/25" 883047" 306:"

Oct/25" 857088" 3068"

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

Figure 4.8: YHS characteristic line

Figure 4.9: YTLPWR characteristic line

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

2. Currently the share price of Fatbody Corp is RM3. The firm is

APPLYING THE CAPM

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS

2064 2+ 2084 84 + 4206+208+2+28+

RKLCI - RKLCI 3+ RYHS - RYHS 4+ RYTLPWR - RYTLPWR *5+"

GTk O2 E k 3O3 E k 4 O4 00000000000000000 E kl O l