# Unit 11: Capital Market Theory

Unit 11: Capital Market Theory

CAPM explains the behaviour of security prices and provides a mechanism whereby investors could assess the impact of a proposed security investment on the overall portfolio risk and return.

CAPM suggests that the prices of securities are determined in such a way that the risk premium or excess returns are proportional to systematic risk, which is indicated by the beta coefficient.

The model is used for analysing the risk-return implications of holding securities.

CAPM refers to the way in which securities are valued in line with their anticipated risks and returns.

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 tradeoff between them.

The essence of his theory is that risk of an individual asset hardly matters to an investor.

Arbitrage: The practice of taking advantage of a state of imbalance between two (or possibly more) markets and thereby making a risk-free profit, Rational Pricing.

Beta: The measure of asset sensitivity to a movement in the overall market.

CAPM: A model that explains relative security prices in terms of a security's contribution to the risk of the whole portfolio, not its individual standard deviation.

Security Characteristic Line (SCL): It represents the relationship between the market return (rM) and the return of a given asset i(ri) at a given time t.