Capital Asset Pricing Management

8/8/2019 Capital Asset Pricing Management

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CAPITAL ASSET PRICING THEORYCAPITAL ASSET PRICING THEORY

y

The required rate of return of an asset ishaving a linear relationship with asset·s

beta value. i.e. Undiversifiable or

systematic risk.



ASSUMPTIONSASSUMPTIONS

1.An individual seller or buyer cannot affect the price of astock. This assumption is the basic assumption of the

perfectly competitive market.

2.Investors make their decisions only on the basis of the

expected returns, standard deviations and co variances of all pairs of securities.

3. Investor are assumed to have homogenous expectations

during the decision-making period.

4. The investor can lend or borrow any amount of funds at

the riskless rate of interest. The riskless rate of interest is

the rate of interest offered for the treasury bills or

Government securities.



5. Assets are infinitely divisible. According tothis assumption, investor could buy anyquantity of share i.e. they can even buy tenrupees worth of Reliance Industry shares.

6. There is no transaction cost i.e. no costinvolved in buying and selling of stocks.

7.There is no personal income tax. Hence, theinvestor is indifferent to the form of return

either capital gain or dividend.8.Unlimited quantum of short sales, is allowed.

Any amount of shares an individual can sellshort.



y The expected return on the combination

of risky and risk free combination isRp=Rf Xf + Rm(1-Xf)

Rp=Portfolio return

Xf= The proportion of funds invested inrisky assets.

1-Xf=The proportion of funds invested in

riskless assets.Rf = Riskless rate of return

Rm=Return on risky assets.



ARBITRAGE PRICING THEORYARBITRAGE PRICING THEORY

y The capital asset pricing theory explains the returnsof the securities on the basis of their respectivebetas.

y The alternative model developed in asset pricing byStephen Ross is known as Arbitrage pricing theory.

y The APT theory explains the nature of equilibrium inthe asset pricing in a less complicated manner withfewer assumptions compared to CAPM.

y Arbitrage is a process of earning profit by takingadvantage of differential pricing for the same asset.The process generates riskless profit. In the securitymarket, it is of selling security at a high price and thesimultaneous purchase of the same security at arelatively lower price.



THE ASSUMPTIONSTHE ASSUMPTIONSy

1. The investors have homogenous expectations.y 2. The investors are risk averse and utility

maxi misers.

y 3. Perfect competition prevails in the market andthere is no transaction cost.

The APT theory does not assumey (1) Single period investment horizon,

y (2) No taxes

y (3) Investors can borrow and lend at risk free

rate of interest andy (4) The selection of the portfolio is based on the

mean and variance analysis. This assumptions arepresent in the CAPM theory.



Graham and Dodd·s Investor RatioGraham and Dodd·s Investor Ratio

y Graham and Dodd·s Model is described below

y P=M(D+E/3)+A

y Under this model, the dividends of a firm determine

market value of a company·s equity.y P=Share price

y M=Earnings of firm paying a normal dividend

y D=Dividend·s per share

y

E=Earnings per sharey A= Adjustment for asset values.

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Capital Asset Pricing Management