Capital Assets Pricing Model (CAPM)

Capital Assets Pricing Model (CAPM)
Markowitz portfolio theory suggests that the investment decision should be based on the total risk and price of assets should be also determined on the basis of total risk. But the CAPM suggests that, any investor can create a portfolio of assets that will eliminate all diversifiable risk (as undiversifiable risk can’t be diversify away .) Therefore the only relevant risk is non-diversifiable risk. Thus the investment decision and the pricing of capital assets should be based on the undiversifiable risk, The relationship between an asset’s return and its systematic risk can be expressed by the CAPM. The CAOM tries to quantify the required rate of return at a given level of systematic risk. In other word CAPM gives idea about, how much return (required rate of return - RRR) should be necessary for given level of systematic risk beta. For this we us following equation.

RRR = Rf + ( Rm – Rf ) . ąβ

Where, RRR = Required rate of return or expected rate of return
Rf = Risk free rate of return
Rm = Market return
B= Beta coefficient
( Rm – Rf ) = Slope of CAPM





CAPM is also known as security Market Line (SML) . SML is the line showing the relationship between the systematic risk index (beta) and the required rate of return.




Arbitrage Pricing Theory (APT)
Chapter 11
APT (Based on ‘ Law of one price’)

Arbitrage opportunity refers to buying of the same securities in the less costlier market and selling it in the expensive market with zero initial cash outlay and zero incremental risk (often known as risk free investment)

Arbitrage is the process of earning risk less profits by taking advantage of differential pricing for the same physical asset or security. As a widely applied investment tactic, arbitrage typically entails the sale of a security at a relatively high price and the simultaneous purchase of the same security at a relatively low price. Fundamentally there wouldn’t be different price of same underlying stock in the different market while market being perfect but if there are two prices for the same security one can have the arbitrage opportunity.
Arbitrage opportunity can also be used to compare the required rate of return & expected return, therefore one short sale the overpriced security or portfolio and also purchase the under price portfolio from the same proceed which was realize from short selling.

Three conditions should be needed in order to grab the arbitrage opportunity
1. In-order to invest, the security or portfolio should be undervalued (Under priced)
2. There should be zero initial cash outlay.
3. There should be zero incremental risk.


Regression Line or equation for arbitrage opportunity
Arbitrage pricing model is similar with the CAPM model. CAPM assume only one risk factor (systematic risk factor or beta) for pricing the assets but APT assumes multiple factors which affects security’s return while pricing the assets. Therefore in APT while pricing the security or determining the required rate of return all those factors need to be consider. These various risk factor are called the macro economic systematic risk factors. The general equation for arbitrage opportunity can be categorized into two parts.