Week 7: Asset Pricing Models
CAPM (Capital Asset Pricing Model)
Multi- factor Models
Arbitrage Pricing Theory (APT)
relationship between risk and expected return
evaluating possible investments for companies (benchmark)
all investors hold the market portfolio
relevant risk: contribution of an asset to the risk of the market portfolio
systematic risk is market risk
Tangency portfolio of the CML
M is the market portfolio, contains all risky assets (stocks, bonds, real estate, etc) held according to their relative market value
Stock market index is used as an approximation
From CML to CAPM
Investor hold an efficient portfolio (whose return is given by the CML)
Individual securities will typically be inefficient (below CML)
Security Market Line (SML): relationship between individual asset returns and its relevant risk
pricing example: page 19
higher return => lower price => undervalued (alpha > 0 => good)
alpha = expected return (actual data) - expected return (SML)
alpha is abnormal return
CAPM and SML
CAPM only prices non- diversify risk
SML deals with systematic risk
Limitations of CAPM (p.23)
CAPM and the index model (p.24)
Adjusted betas (p.30)
works with expected returns not the actual returns
A critique on the CAPM (p.32)
company
size
book value
liquidity factor models
spread (bid and ask) => higher the spread => less liquid
arbitrage
efficient markets
zero investment
example (p.44)