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CHAPTER 7
ASSET PRICING MODELS: CAPM and APT
I. Capital Market Theory: An Overview
A. Background for Capital Market Theory
1. Assumptions of Capital Market Theory
a. All investors are Markowitz efficient investors in that they seek to invest in
tangent points on the efficient frontier
b. Investors can borrow or lend any amount of money at the risk-free rate of return
2. Development of Capital Market Theory
Concept of risk-free asset (asset with zero variance). Such an asset would have
zero correlation with all other risky assets
B. Developing the Capital Market Line
1. Covariance with a Risk-Free Asset with any risky asset or portfolio of assets will
always equal zero
2. Combining a Risk-Free Asset with a Risky Portfolio
a. Expected return for a portfolio that includes a risk-free asset is the weighted
C. Risk, Diversification, and the Market Portfolio
1. All risky assets are included in the market portfolio M
2. Systematic and Unsystematic Risk – since the market portfolio includes all risky
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5. The CML and the Separation Theorem – Investment decision versus financing
decision
6. A Risk Measure for the CML
II. The Capital Asset Pricing Model (CAPM)
A. A Conceptual Development of the CAPM
B. The Security Market Line (see Exhibit 7.5)
1. Beta – standardized measure of systematic risk
2. Determining the Expected Return for a Risky Asset – determined by the risk-free rate
III. Relaxing the Assumptions
A. Differential Borrowing and Lending Rates – the ability of investors to borrow unlimited
amounts at the T-bill rate is questionable (Exhibit 7.9)
B. Zero Beta Model – does not require a risk-free asset (Exhibit 7.10)
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V. Arbitrage Pricing Theory (APT)
A. From CAPM to APT
Deficiencies in the Capital Asset Pricing Model led Professor Ross in the mid-1970s to
develop the Arbitrage Pricing Theory as an alternative. It requires only three
assumptions – simpler than the Capital Asset Pricing Model.
They are:
1. Capital markets are perfectly competitive.
An illustration of how APT works assuming there are only two known factors.
VI. Multifactor Model in Practice
A. Macroeconomic-Based Risk Factor Models (Exhibits 7.15 and 7.16)
Security returns are governed by a set of broad macroeconomic influences.