Investment Strategies - Asset Pricing Models

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).

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