The asset pricing models that this section of the study guide treats are born of modern portfolio theory. Though the test booklets during your exam will offer the formulas for reference, a knowledge of their construction is important to gain a better understanding of them and the significance of their input into the portfolio management process.

The Capital Asset Pricing Model (CAPM)
A cornerstone of modern portfolio theory, the capital asset pricing model attributes stock returns to the individual security's volatility, relative to the market and the volatility of the market itself. Investors have similar expectations concerning the risk/return relationship of risky assets, they can borrow and lend at the risk-free rate and transaction costs and taxes equal zero. The model could determine the portfolio on the efficient frontier that is the market portfolio. The CAPM formula reads as follows:


Exam Tips and Tricks
E(r)=Rf + β(Rm- Rf) where E(r) is the expected return; β is the volatility of the market and Rm is the return of the market.

The Arbitrage Pricing Theory (APT)
In contrast to the CAPM, which explains stock returns as resulting from two variables, APT is a multi-factor model, positing that stock returns are attributable to several factors, some of which are systematic, others industry specific and other still unique to a particular company. The formula is stated thus:


Exam Tips and Tricks
R=a0 + b1F1+ b2F2...+bnFn + e where R=the security\'s return; a0=the expected return; bn=the sensitivity of the security to factor Fn=factors affecting the security (GDP, inflation).

The Black-Scholes Option Valuation Model

Related Articles
  1. Investing

    The Capital Asset Pricing (CAPM) Model: Pros and Cons

    CAPM, while criticized for its unrealistic assumptions, provides a more useful outcome than either the DDM or WACC in many situations.
  2. Investing

    The Capital Asset Pricing Model: an Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  3. Investing

    Valuation Models: Apple’s Stock Analysis With CAPM

    The capital asset pricing model, or the CAPM, estimates the expected return of an asset based on the systematic risk of the asset’s return.
  4. Investing

    Taking Shots At CAPM

    Find out why many investors think the capital asset pricing model is full of holes.
  5. Investing

    Is Apple's Stock Over Valued Or Undervalued?

    Despite several drawbacks, the CAPM gives an overview of the level of return that investors should expect for bearing only systematic risk. Applying Apple, we get annual expected return of about ...
  6. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    Investors still follow an old set of principles that reduce risk and increase returns through diversification.
  7. Investing

    Reduce Your Risk With ICAPM

    Avoid unnecesary risks involved in CAPM calculations by also incorporating ICAPM into the mix.
  8. Investing

    Introduction To International CAPM

    ICAPM is one of several models used to determine the required return on an asset, discover its limitations and how to use it.
Frequently Asked Questions
  1. How can the price-to-earnings (P/E) ratio mislead investors?

    A low P/E ratio doesn't automatically mean a stock is undervalued, just like a high P/E ratio doesn't necessarily mean it ...
  2. What are the main differences between compound annual growth rate (CAGR) and internal rate of return (IRR)?

    The compound annual growth rate (CAGR), measures the return on an investment over a certain period of time. The internal ...
  3. What are the differences between gross profit and gross margin?

    Learn how gross profit and gross margin are calculated and how each is used in fundamental analysis. Generally, these numbers ...
  4. How do I calculate the adjusted closing price for a stock?

    When trading is done for the day on a recognized exchange, all stocks are priced at close. The price that is quoted at the ...
Trading Center