...place and the arbitrageurs buy the cheaper goods and sell the higher priced goods till all the prices of the goods are equal. Arbitrage Pricing Theory describes a mechanism used by investors to identify an asset, such as a share of common stock, which is incorrectly priced. On the other hand the Capital Asset Pricing Model is based on a comparison or the systematic risk/market risk of individual investment with the risk of all shares in the market. It is also used to calculate cost of equity and incorporates risk. ARBITRAGE PRICING THEORY Arbitrage Pricing Theory was developed by the economist Stephen Ross in 1976. Arbitrage Pricing Theory assumes that each stock’s return to the investor is influenced by several independent factors. The APT model also states that the risk premium of a stock depends on two factors: The risk premium associated with each of the factors The stock’s sensitivity to the factors similar to the beta concept This theory does not tell the investor what those factors are for a particular stock or asset; in theory one stock might be more sensitive to one factor than another. Arbitrage leaves it up for the investor or fund manager to identify each factor for a particular stock. Hence the real challenge is for the fund manager to identify Each of the factors affecting a particular stock The expected returns for each of these factors The sensitivity of the stock to each of the factors( Note: the sensitivity of a stock is likely to change...
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...market (ISM) has interesting characteristics. Over 40% of the shares, in a sample of 30 shares, together with the Mibtel market index, are normally distributed. This suggests that the returns distribution of the ISM as a whole may be normal, in contrast to the findings of Mandelbrot (1963) and Fama (1965). Empirical tests in this study suggest that the relationships between β and return in the ISM over the period January 1990 – June 2001 is weak, and the Capital Asset Pricing Model (CAPM) has poor overall explanatory power. The Arbitrage Pricing Theory (APT), which allows multiple sources of systematic risks to be taken into account, performs better than the CAPM, in all the tests considered. Shares and portfolios in the ISM seem to be significantly influenced by a number of systematic forces and their behaviour can be explained only through the combined explanatory power of several factors or macroeconomic variables. Factor analysis replaces the arbitrary and controversial search for factors of the APT by “trial and error” with a real systematic and scientific approach. The behaviour of share prices, and the relationship between risk and return in financial markets, have long been of interest to researchers. In 1905, a young scientist named Albert Einstein, seeking to demonstrate the existence of atoms, developed an elegant theory based on Brownian motion. Einstein explained Brownian motion the same year he proposed the theory of relativity. At that time his results were considered...
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...smart to know what to expect when they invest. Due to this, different statistical models have emerged to attempt to scientifically measure the potential returns on an investment. The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are two of such models. The purpose of this essay is to critically compare the Arbitrage Pricing Theory with the Capital Asset Pricing Model as used by fund managers in the United Kingdom. Captial Asset Pricing Model (CAPM) When Sharpe (1964) and Lintner (1965) proposed the Capital Asset Pricing Model (CAPM), it was seen as a leading tool in measuring if an investment will yield in positive or negative returns. It attempts to explain the relationship between investment risk and expected reward of risky securities (Ushad, 2011; Reilly and Brown, 2011; Heshmat, 2012). The CAPM helps to determine the required rate of return for any risky asset (Reilly and Brown, 2011). “The CAPM states that the expected return on a security or a portfolio equals the rate on a risk-free security plus a risk premium” (Heshmat, 2012: 504). It indicates that the expected return on an asset has a positive linear relationship with the non-diversifiable risk of the security (beta) (Heshmat, 2012). Ushad (2011) explains that the CAPM is based on the premise that higher returns should be associated with higher beta risks. It is usually calculated as follows: E(Ri)= Rf + βi (E(Rm) - Rf). (Ushad, 2011). Where, E(Ri) = return required on financial...
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...and the expected rate of returns. Investors have several questions before investing his money in any stock or in any other commodity that is what should be the accuracy of prices of selling or buying the stocks, what could be the risk, what are the factors should be considered that ignores uncertainty and the expected returns of the stock. The Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) both are well known pricing model determines the risk factor for analyzing the appropriate returns for the investors in their own unique ways. CAPM model uses the whole market environment as one factor but on the other hand APT uses five different economics factor which is more detailed in describing risk which accelerates for these factors. The adoption of CAPM is in practice but other hand its various criticisms are documented on it as well and academics are working on the new approaches of it such as APT and others is discussed in later paragraphs. In this assignment I will discuss the assumptions of CAPM and APT model and their pros and cons and the limitations of CAPM over APT models. CAPM and its Shortcomings Hary Markowitz (1952) and Tobin (1958) first introduced the idea of asset pricing model. Markowitz (1952) observed that “when two risky assets are combined, their deviations from the mean are not additive, provided the returns from the two assets are not perfectly correlated and when portfolio of risky...
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...___________ a relationship between expected return and risk. A. APT stipulates B. CAPM stipulates C. Both CAPM and APT stipulate D. Neither CAPM nor APT stipulate E. No pricing model has found Both models attempt to explain asset pricing based on risk/return relationships. Difficulty: Easy 2. ___________ a relationship between expected return and risk. A. APT stipulates B. CAPM stipulates C. CCAPM stipulates D. APT, CAPM, and CCAPM stipulate E. No pricing model has found APT, CAPM, and CCAPM models attempt to explain asset pricing based on risk/return relationships. Difficulty: Easy 3. In a multi-factor APT model, the coefficients on the macro factors are often called ______. A. systemic risk B. factor sensitivities C. idiosyncratic risk D. factor betas E. B and D The coefficients are called factor betas, factor sensitivities, or factor loadings. Difficulty: Easy 6. Which pricing model provides no guidance concerning the determination of the risk premium on factor portfolios? A. The CAPM B. The multifactor APT C. Both the CAPM and the multifactor APT D. Neither the CAPM nor the multifactor APT E. None of the above is a true statement. The multifactor APT provides no guidance as to the determination of the risk premium on the various factors. The CAPM assumes that the excess market return over the risk-free rate is the market premium in the single factor CAPM. Difficulty: Moderate 7. An arbitrage opportunity exists...
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...All of the models to be discussed, i.e. Markowitz, Single Index, CAPM, and APT, have one single goal that is accomplished by using them. This goal is to make a portfolio, or individual securities, as efficient and well performing as possible by finding the optimal weights, highest return, and lowest risk. The Harry Markowitz model of 1952, or the mean-variance model, was one of the earliest models created to compare and contrast securities outcomes. This model uses the weights, standard deviation, and covariance for each security, creating a weighted covariance matrix, therefore forecasting a very accurate estimate of what return and risk the securities or portfolio would give. The Single-Index model, introduced by William Sharpe in 1963, is a simplified variation of the Markowitz model. Using the same premise of estimating in order to forecast optimal portfolios and securities, the single-index model instead uses beta and alpha substitutes for the standard deviation and covariance portions. Beta, measures the volatility of the portfolio or security comparatively to the market as a whole, i.e. the sensitivity to the market, and alpha, measures risk-adjusted performance (comparative to the appropriate benchmarks). These two combined simplify the process of the Markowitz model, while still gaining a result of the optimal portfolio. The Capital Asset Pricing model, or ‘CAPM’, produced by John Lintner in 1965, is a product that branched from the Single-Index model. While it does...
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... 4. Capital Asset Pricing Model 4 5.1 Limitations of CAPM 4 5.2 The APT Model 4 5.3 The Three-Factor Model 4 5.4 Required Rate of Return using APT or Three-Factor 5 Model 5. Bonds 5 6.5 How bond prices are determined 5 6.6 The Rate of Return on the bonds 6 6. Conclusion 7. Appendices 6.1 Appendix 1 – after tax rate of return on bonds 7 6.2 Appendix 2 – Excel Working and screen shot 8. References 9. Bibliography 1. Introduction Naturally Fresh Plc are considering converting a number of their farms in Southern Europe into campsites following difficult trading conditions. This report will look at the required rate of returns on the equity as well as the bonds, whilst explaining the models used to calculate the returns and also provide a recommendation on whether the investment opportunity should be accepted by Naturally Fresh Plc. 2. Required Rate of Return on Equity Key | | E(R) | Expected/Required Rate of Return | R(f) | Risk Free Rate | B | Beta | R(m) | Market Return | R(m)-R(f) | Market Premium | Capital Asset Pricing Model (CAPM): E(R) = Rf + B(Rm-Rf) E(R) = 2% + 0.8(12%-2%) E(R) = 10% The required rate of return, which is the minimum yield that investors require in order to select a particular investment, was calculated using the CAPM. The CAPM is a model that describes the relationship between risk and return and...
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...Members of the board, As a publicly traded company we have a responsibility to our shareholders to do everything within our power to reward them for investing in us. Investors have experienced so much volatility in domestic equity markets over the past twelve years that we need to make them very comfortable investing in Under Armour. We are still a very young organization compared to a “blue chip” companies like Johnson and Johnson or Proctor and Gamble. It is extremely difficult to gauge just how much investors expect on an annual return from us. Given all the circumstances that go in to making an investment decision for individuals I am going to use the Capital Asset Pricing Method to calculate what type of return we need to generate in order to make our shareholders feel like they made a wise investment. When trying to accurately value the stock of a company and expected returns there are three common methods of doing so. One method is the dividend growth model. This model tries to “value a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.” For some investors this could be a reasonable way to try to calculate what type of returns they could expect. With Under Armour, this would not help at all. Currently we do not pay any dividend. We use all the capital and cash we have in order to grow our business. There are numerous companies that entice investors because they pay a quarterly dividend from the revenue...
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... CAPM Yasmeen Iman Snow Deforest Thompson Gary Oha CAPM Contents Overview of CAPM 1 Advantages and Limitations 3 Breakthroughs and Setbacks 4 Works Cited 6 Overview of CAPM The CAPM was introduced by Jack Treynor , William F. Sharpe , John Lintner and Jan Mossin in 1964, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory (Fama & French, 1982). Sharpe, Markowitz and Merton Miller jointly received the 1990 Nobel Memorial Prize in Economics for this contribution to the field of financial economics. Fischer Black developed another version of CAPM, called Black CAPM or zero-beta CAPM that does not assume the existence of a riskless asset. This version was more robust against empirical testing and was influential in the widespread adoption of the CAPM (Fama & French, 1982). CAPM has become very attractive as a tool that measures risk to possible in relation to expected return, although it is still widely used for estimating the cost of capital for firms and evaluating the performance of managed portfolios. While CAPM is accepted academically, there is empirical evidence suggesting that the model is not as profound as it may have first appeared to be. CAPM’s empirical fallings arise theoretically from many over simplified assumptions made by the model. This has made it difficult to implement valid test for this model (Kristina Zucchi, 2015). For example according to the CAPM model the risk...
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...ASET PRICING AND FINANCIAL STATEMENT INFORMATION PENDAHULUAN Tujuan investor dalam berinvestasi adalah memaksimalkan return. Return merupakan salah satu faktor yang memotivasi investor berinvestasi dan juga merupakan imbalan atas keberanian investor menanggung resiko atas investasi yang dilakukannya. Investor atau orang-orang yang ingin berinvestasi di bursa saham harus memperhitungkan secara hati-hati keuntungan maksimal yang mungkin akan diterima. Agar dapat memperoleh keuntungan, para investor harus mengestimasi semua faktor penting seperti return saham, resiko dan ketidakpastian saham, jumlah waktu dan faktor lain yang berhubungan dengan aktivitas investasi di pasar modal yang mempengaruhi pengembalian investasi di masa mendatang. Di samping memperhitungkan return, investor juga perlu mempertimbangkan tingkat resiko suatu investasi sebagai dasar pembuatan keputusan investasi. Berbagai faktor penting ini membutuhkan banyak informasi yang digunakan untuk estimasi, ketentuan, dan menawarkan harga yang cocok dalam perdagangan saham. Untuk melakukan penilaian terhadap harga saham di bursa saham, penggunaan model sangat penting untuk menilai harga saham dan membantu para investor untuk merencanakan dan memutuskan investasi dengan benar dan efektif. Model penilaian harga aset adalah cara pemetaan harga aset keuangan seperti saham dan obligasi. Di dalam model penilaian aset, harga selalu dilihat sebagai variabel endogen bukan sebaliknya. Burton (1998) menyebutkan...
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...Finance 3300 - Exam 2 Name _________________________________ Formulas Two risky assets E(Rp) = w1 R1 + w2 R2 σp2 = w12 σ12 + w22 σ22 + 2w1w2 ρ12 σ1σ2 ; note to find σp, take square root of σp2 One risk-free and One Risky Asset E(Rp ) = Rf + σp[(Rm-Rf)/σ2] E(Rp) = w1 Rf + w2 Rm w1 + w2 = 1 where w1 is % in risk-free asset and w2 is % in risky asset. σp = w2 σ2 CAPM: E(Rp) = rf + β(Rm-rf) σi2 = Σ[Ri - E(Ri)]2/(n-1) σi,m = Σ{[Ri - E(Ri)][Rm - E(Rm)]}/n-1 β = (ρi,m * σi)/σm or β = σi,m / σm2 ρim = σim/σiσm ρ2 or r-square = Explained Var./Total Var. = (βi2 * σm2)/σi2 Multiple Choice Use the following for the next 3 questions You are looking at two risky assets, the expected returns, standard deviations, and correlation between the two assets are given below: E(RA) = 7%, Standard deviation = 12%. E(RB) = 12%, Standard deviation = 18%. Correlation between the two assets is 1.0. 1. If you put 50% of your wealth in asset A and the other 50% in asset B, what is the expected return of your portfolio? A. 18% B. 9.5% C. 10.5% D. 5.4% 2. If you put 50% of your wealth in asset A and the other 50% in asset B, what is the standard deviation of your portfolio? A. Greater than 18% B. Greater than 12% but less than 18% C. Less than 12% 3. All else equal, if the correlation between the two assets became slightly negative, A. the standard deviation of the portfolio would be zero. B. the standard deviation of the portfolio would be unaffected...
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...EViews Workshop Program: MSc in Finance 2011-2012 Instructor: Dimitris Tsouknidis, MSc, MBA, PhD Email: dtsouknidis@gmail.com Course Description • Workshop 1 – Introduction, Regression Analysis, Multiple Regression Analysis • Workshop 2 – Issues with the Classical Linear Regression Model and Univariate Time-series Modeling in Finance • Workshop 3 – Multivariate Time-Series Modeling in Finance and Modeling Long-run Relationships in Finance MSc Finance - EViews Workshop 1 - 2012 2 Workshop 1 Introduction, Classical Linear Regression Analysis and Multiple Regression Analysis 19 January 2012 Agenda • • • • • • • Introduction to EViews Importing Data Loading and Saving Datasets Graphical and Statistical Analysis Regression Analysis Multiple Linear Regressions Case Studies – January Effect MSc Finance - EViews Workshop 1 - 2012 4 Introduction • EViews is a menu-driven econometric software. • Open EViews requires: – Start/All Programs/EViews 7 • EViews organizes data, graphs, output, etc. as objects. • Each of these objects can be copied, saved and/or cut-andpasted. • EViews is not case sensitive e.g. INDEX = index. • EViews is producing workfiles (.wf1). • You can import data from Microsoft Excel (.xls) and create workfiles (.wf1). MSc Finance - EViews Workshop 1 - 2012 5 Creating a Workfile • Click: File/New/Workfile. • You can select the type of your workfile (Dated – regular frequency, Balanced panel, Unstructured/Undated ), the frequency...
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...VALUATION Portfolio tracking is monitoring a collection of stocks, for the purpose of learning how the prices move and/or profiting from those movements. The market price of a combination of financial investments that track the future cash flows of the project should be the same as the value of the projects future cash flows. Analyst’s need to generate tracking portfolio’s with tracking error (a measure of how closely a portfolio follows the index to which it is benchmarked), PV=0 in order to value projects in these cases, i.e. Tracking Error = Cash Flows of Tracking Portfolio – Cash Flows of Project. When tracking error exists, analysts use Asset Pricing Models, Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT), to derive projects PV. If the CAPM holds, the tracking portfolio is a combination of the market portfolio and a risk free asset. How to use tracking portfolio valuation The idea is that we are trying to find the future cash flows of the project using a tracking portfolio Assume there is perfect correlation between the Market Portfolio and the Project. 1. Value project using probabilities 2. Assume Tracking Portfolio with mix of Market Portfolio and Risk Free Asset 3. Calculate how much investment is required to track portfolio 4. Conclusion: Since portfolio of financial assets...
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...requirements as well as thinness and discontinuity of trading. It is generally assumed that the emerging markets are less efficient than the developed markets. Raihan, et al (2007) found that in Chittagong Stock Exchange (CSE) in Bangladesh, stock return series do not follow random walk model and the significant autocorrelation co-efficient at different lags do not accept the hypothesis of weak form efficiency. Mobarek and Keasay (2000) also found the same result after conducting research in Dhaka Stock Exchange (DSE) of Bangladesh. Conducting research in Dhaka Stock Exchange (DSE) Rahman, et al (2006) found the negative correlation between the beta and stock return, which is reason for inefficiency of market where the assumptions behind the CAPM model is not supported....
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...MODERN PORTFOLIO THEORY A N D INVESTMENT ANALYSIS EIGHTH EDITION INTERNATIONAL STUDENT VERSION EDWIN J. ELTON Leonard N. Stern School of Business New York University MARTIN J. GRUBER Leonard N. Stern School of Business New York University STEPHEN J. BROWN Leonard N. Stern School of Business New York University WILLIAM N. GOETZMANN Yale University WILEY John Wiley & Sons, Inc. Contents About the Authors Preface Part 1 Chapter 1 ix vii INTRODUCTION INTRODUCTION Outline of the Book 2 The Economic Theory of Choice: An Illustration Under Certainty Conclusion 8 Multiple Assets and Risk 8 Questions and Problems 9 Bibliography 10 4 1 2 Chapter 2 FINANCIAL MARKETS Trading Mechanics 11 Margin 14 Markets 18 Trade Types and Costs 25 Conclusion 27 Bibliography 27 1 1 Chapter 3 FINANCIAL SECURITIES Types of Marketable Financial Securities 2 8 The Return Characteristics of Alternative Security Types Stock Market Indexes 3 8 Bond Market Indexes 3 9 Conclusion 4 0 36 28 Part 2 Section I Chapter 4 P O R T F O L I O ANALYSIS MEAN VARIANCE PORTFOLIO THEORY THE CHARACTERISTICS OF THE OPPORTUNITY SET UNDER RISK Determining the Average Outcome 4 5 A Measure of Dispersion 4 6 Variance of Combinations of Assets 4 9 Characteristics of Portfolios in General 51 Two Concluding Examples 61 Conclusion 6 4 XIII 41 43 44 XIV CONTENTS Questions and Problems Bibliography 6 6 Chapter 5 64 DELINEATING EFFICIENT PORTFOLIOS Combinations...
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