Page 298 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 11: Capital Market Theory

CAPM tells us that all investors will want to hold “capital-weighted” portfolios of global Notes
wealth.
The CAPM equation describes a linear relationship between risk and return.

Risk, in this case, is measured by beta.
We may plot this line in mean and space: The Security Market Line (SML) expresses the
basic theme of the CAPM, i.e., expected return of a security increases linearly with risk, as
measured by ‘beta’. The SML is an upward sloping straight line with an intercept at the
risk-free return securities and passes through the market portfolio.

The efficiency boundary that arises out of this assumption of the identical risk free lending
and borrowing rates leads to some very important conclusions and is termed as ‘Capital
Market Line’ (CML).
A rational investor would not invest in an asset that does not improve the risk-return
characteristics of his existing portfolio.

Since a rational investor would hold the market portfolio, the asset in question will be
added to the market portfolio. MPT derives the required return for a correctly priced asset
in this context.
The alpha coefficient (a) gives the vertical intercept point of the regression line.
In a perfect world, the alpha for an individual stock should be zero and the regression line
should go through the graph’s origin where the horizontal and vertical axis crosses.
Beta coefficient is a measure of the volatility of stock price in relation to movement in
stock index of the market, therefore, beta is the index of systematic risk.

APT holds that the expected return of a financial asset can be modelled as a linear function
of various macro-economic factors or theoretical market indices, where sensitivity to
changes in each factor is represented by a factor specific beta coefficient.
The model-derived rate of return will then be used to price the asset correctly – the asset
price should equal the expected end of period price discounted at the rate implied by
model.
In the APT context, arbitrage consists of trading in two assets – with at least one being
mispriced. The arbitrageur sells the asset, which is relatively too expensive and uses the
proceeds to buy one that is relatively too cheap.
The APT differs from the CAPM in that it is less restrictive in its assumptions.

It allows for an explanatory (as opposed to statistical) model of asset returns.
It assumes that each investor will hold a unique portfolio with its own particular array of
betas, as opposed to the identical “market portfolio”.

In some ways, the CAPM can be considered a “special case” of the APT in that the securities
market line represents a single-factor model of the asset price, where Beta is exposure to
changes in value of the market.
Harry Markowitz is regarded as the father of modern portfolio theory.
According to him, investors are mainly concerned with two properties of an asset: risk
and return, but by diversification of portfolio, it is possible to trade off between them.
The essence of his theory is that risk of an individual asset hardly matters to an investor.

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