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# Capital Asset Pricing and Arbitrage Pricing Theory

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## Capital Asset Pricing Model (CAPM)

Assumptions
Individual investors are price takers
Single-period investment horizon Investments are limited to traded financial assets No taxes, and transaction costs
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Assumptions (cont.)
Information is costless and available to all investors Homogeneous expectations

## Resulting Equilibrium Conditions

All investors will hold the same portfolio for risky assets market portfolio Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value

## Slope and Market Risk Premium

M rf E(rM) - rf E(rM) - rf = = = = Market portfolio Risk free rate Market risk premium Market price of risk

sM

## Expected Return and Risk on Individual Securities

E (ri ) rf i E (rM ) rf

M = Market portfolio rf = Risk free rate E(ri) - rf = Risk premium on security i E(rM) - rf = Market risk premium
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## Determine the equation of the SML and plot it when:

E (r

) rf 0.08

and

r f 0.03

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Application
You are in an economy where Rf=9%, E(Rm)=20%. Determine the equation of the SML line in this economy. A stock has a beta=1.5. Determine the required rate of return. Give your recommendation when you think its expected return will be 22%. Do the same analysis when beta=-0.5 and investor expect the return to be 7%

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## Estimating the Index Model

Using historical data on T-bills, S&P 500 and individual securities Regress risk premiums for individual stocks against the risk premiums for the S&P 500 Slope is the beta for the individual stock

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## Security Characteristic Line for GM: Summary Output

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Multifactor Models

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## Market Portfolio is not directly observable

Research shows that other factors affect returns

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## Fama French Research

Returns are related to factors other than market returns Size Book value relative to market value Three factor model better describes returns Example : GM
E (rGM ) rf GM , M E (rM ) rf GM , SMB E (rSMB ) rf GM , HML E (rHML ) rf

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## Arbitrage Pricing Theory

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Arbitrage - arises if an investor can construct a zero beta investment portfolio with a return greater than the risk-free rate If two portfolios are mispriced, the investor could buy the low-priced portfolio and sell the high-priced portfolio In efficient markets, profitable arbitrage opportunities will quickly disappear
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E (rP ) r f P E (rM ) r f

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## 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 in that it gets to an expected return and beta relationship without the assumption of the market portfolio

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