Unit-4

Asset Pricing Models and Mutual Funds

By Dr. Sarika Rakhyani
The first asset pricing model that we need to discuss is CAPITAL
ASSET PRICING MODEL (CAPM).
Before we discuss CAPM, we need to discuss Capital Market
Theory which provides the necessary groundwork to understand
CAPM.
 CAPITAL MARKET THEORY

• Extension of Markowitz Model.

• Developed by Sharpe in 1964. Lintner (1965) and Mossin (1966)
derived similar theories independently.
• A risk free asset is introduced in the capital market.
• Under Markowitz Portfolio Theory, number of investors=number of
optimal portfolios of risky securities. This problem can be resolved if
a risk free asset is introduced.
• An investor is allowed to lend or borrow at risk free rate.
 What is a Risk-Free Asset?

• An asset that provides risk-free rate of return.

• An asset that has zero covariance/correlation with other risky
assets.
• σRF=0 (Expected return on a risk free asset is certain and hence
standard deviation of its expected return is ZERO).
 What is Risk-Free rate of return?

• The risk-free rate of return is the interest rate an investor can expect to
earn on an investment that carries zero risk.
• In practice, the risk-free rate is commonly considered to be equal to the
interest paid on a 10-year highly rated government Treasure note,
generally the safest investment an investor can make.
• The risk-free rate is a theoretical number since technically all
investments carry some form of risk. Nonetheless, it is common practice
to refer to the T-note rate as the risk-free rate. While it is possible for a
highly rated government to default on its securities, the probability of
this happening is considered very low.
We say the risk-free rate compensates for the time value of money
because it provides a baseline return for postponing the use of money in a
risk-free context. However, it's important to remember that this
compensation is minimal and doesn't always cover the full spectrum of TVM
factors. In real-world conditions, risk-free rates may not fully protect
purchasing power, but they remain a fundamental measure of TVM.

https://blogs.cfainstitute.org/investor/2012/03/20/rethinking-the-risk-free-rate/
A risk free asset is combined with a risky
portfolio
What is a Market Portfolio (Risky Portfolio)?
CML dominates all other feasible combinations that
investors can form.
CML
CML EQUATION
 FROM CAPITAL MARKET THEORY TO
CAPITAL ASSET PRICING MODEL (CAPM)
Markets are
efficient.
CHARACTERISTIC LINE
• ACTUAL /GIVEN ESTIMATED RETURN > REQUIRED/EXPECTED RETURN AS PER
CAPM (UNDERPRICED-BUY)
• ACTUAL RETURN/ /GIVEN ESTIMATED RETURN < REQUIRED/ /EXPECTED
RETURN AS PER CAPM (OVERPRICED-SELL)
Market Adjustment
Through buying and selling pressure:
• Underpriced securities (above the SML) will increase in price, which typically
lowers their expected return (price goes up, return goes down) until they
fall back onto the SML.
• Overpriced securities (below the SML) will decrease in price, which raises
their expected return (price goes down, return goes up) until they also fall
back onto the SML.
This movement helps bring securities toward the equilibrium pricing indicated
by the SML, where they offer a fair return for their risk level.
SOLUTION
CML EQUATION
SOLUTION
 Required Return VS Expected Return

• Required Return:
The minimum return investors demand for investing in a security or
portfolio, considering its risk level.

• Expected Return:
The anticipated return investors expect to earn from a security or
portfolio based on historical data, market conditions, or other factors.
Key differences:

• 1. Perspective: Required Return is investor-driven, while Expected Return is

market-driven.
• 2. Purpose: Required Return sets a minimum threshold, whereas Expected
Return predicts future performance.
• 3.Calculation: Required Return often uses models like CAPM, while
Expected Return uses historical data, analyst forecasts, or other methods.

In summary, Required Return is the minimum return investors require,

whereas Expected Return is the return they anticipate.
In other words,

Required Return is the expected return only but as per models

like CAPM, considering risk.
Whereas
Expected return (in general) is the return investors anticipate
using other methods.
For identification of undervalued/overvalued stocks-

Sometimes the return that is given in the question for comparison is

not actual but the estimated/expected return (general anticipated
return using other methods) which needs to be compared with the
expected return as per CAPM.

• ACTUAL /GIVEN ESTIMATED RETURN >

REQUIRED/EXPECTED RETURN AS PER CAPM
(UNDERPRICED-BUY)
• ACTUAL RETURN/ /GIVEN ESTIMATED RETURN < REQUIRED/
/EXPECTED RETURN AS PER CAPM (OVERPRICED-SELL)
 Please Note:

• SML is primarily used for securities, can be used for portfolios also.
• Overvaluation /undervaluation can be assessed using SML.
• While using CML, you only comment if portfolios are efficient or
inefficient.

https://youtu.be/mNZ4BqXVfjs?si=ggBAid1NVItUKR9a
You may watch this video for more clarification (also sent at SAPM group Id)
Lets look at some previous year questions:
 EQ1 EQ2 AVERAGE C

RM=10.67% RM=9.83% RM=10.25% 12.35% OVERPRICED

RM=20 %
RF=6 %
C=27%
• When portfolio consists risky and risk-free securities:
SD of portfolio = weight of risky securities × risk of risky securities + (1 - w) ×
risk of risk-free securities
A. SD = 0
0=w×0.30 + (1−w)× 0
w= 0, it means the investor will have to invest all 100% money in risk-free
securities.
B. SD = 15%
0.15=w×0.30+(1−w)×0
w=0.15/0.30=0.50, it means the investor will have to invest 50% money in risky
and 50% money in risk-free securities.
C. SD = 30%
0.30=w×0.30+(1−w)×00
w=0.30/0.30=1, it means the investor will have to invest 100% money in risky
securities.

D. SD = 45%
0.45=w×0.30+(1−w)×0
w=0.45/0.30=1.5, it means the investor will invest 100% of his money in risky
securities, and 50% he will borrow at risk-free rate to invest that in the risky
securities.
• Rm=9 %, Rc=19.8 %
• Rm=15 %, Rf =5%, 13%
• 32.5%, 22% (efficient), 17.5%
NEXT ASSET PRICING MODEL IS - APT
 ARBITRAGE PRICING THEORY (APT)

Arbitrage pricing theory (APT) is a multi-factor asset pricing model. It's based
on the idea that an asset's returns can be predicted using the linear relationship
between the asset’s expected return and a number of macroeconomic variables
that capture systematic risk. It is a useful tool for analyzing portfolios from
a value investing perspective, in order to identify securities that may be
temporarily mispriced.

In one line- It is an asset pricing model that predicts a return using the
relationship between an expected return and macroeconomic factors.
 ARBITRAGE PRICING THEORY (APT)

How the Arbitrage Pricing Theory Works

• The arbitrage pricing theory was developed by the economist Stephen
Ross in 1976, as an alternative to the capital asset pricing model
(CAPM). Unlike the CAPM, which assume markets are perfectly
efficient, APT assumes markets sometimes misprice securities, before
the market eventually corrects and securities move back to fair value.
Using APT, arbitrageurs hope to take advantage of any deviations from
fair market value.
Arbitrage Pricing Theory Formula

The APT formula is E(Ri) = Rf + βi1*RP1 + βi2*RP2 + ... + βkn*RPn, where rf is

the risk-free rate of return, β is the sensitivity of the asset or portfolio in relation to
the specified factor and RP is the risk premium of the specified factor.
• Arbitrage pricing theory (APT) is a multi-factor asset pricing model
based on the idea that an asset's returns can be forecasted with the linear
relationship between an asset’s return and a number of macroeconomic
factors that affect the asset’s risk.
• Arbitrage pricing theory assumes that markets sometimes misprice
securities before they are corrected and move back to fair value.
Example of How Arbitrage Pricing Theory Is Used
• For example, the following four factors have been identified as explaining a
stock's return and its sensitivity to each factor and the risk premium associated
with each factor have been calculated:
• Gross domestic product (GDP) growth: ß = 0.6, RP = 4%
• Inflation rate: ß = 0.8, RP = 2%
• Gold prices: ß = -0.7, RP = 5%
• Standard and Poor's 500 index return: ß = 1.3, RP = 9%
• The risk-free rate is 3%
• Using the APT formula, the expected return is calculated as:
• Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) =
15.2%
• While APT is more flexible than the CAPM, it is more complex. The CAPM only
takes into account one factor—market risk—while the APT formula has multiple
factors. And it takes a considerable amount of research to determine how sensitive
a security is to various macroeconomic risks.
• The factors as well as how many of them are used are subjective choices, which
means investors will have varying results depending on their choice. However,
four or five factors will usually explain most of a security's return.
• APT factors are the systematic risk that cannot be reduced by the diversification
of an investment portfolio. The macroeconomic factors that have proven most
reliable as price predictors include unexpected changes in inflation, gross national
product (GNP), corporate bond spreads and shifts in the yield curve. Other
commonly used factors are gross domestic product (GDP), commodities prices,
market indices, and exchange rates.
• What Is the Difference Between CAPM and Arbitrage Pricing Theory?
The main difference is that while CAPM is a single-factor model, the APT is a multi-
factor model. In the CAPM, the only factor considered to explain the changes in the
security prices and returns is the market risk. In the APT, on the other hand, the factors
can be several.
• What Are the Limitations of APT?
The main limitation of APT is that the theory does not suggest factors for a particular
stock or asset. One stock could be more sensitive to one factor than another, and
investors have to be able to perceive the risk sources and sensitivities.
• What Is the Main Advantage of APT?
The main advantage of APT is that it allows investors to customize their research since
it provides more data and it can suggest multiple sources of asset risks.
CAPM VS APT
[Also read from Rohini Singh Ma’am’s book (Page 373 of pdf)]

• At first glance, the CAPM and APT formulas look identical, but the CAPM
has only one factor and one beta. Conversely, the APT formula has multiple
factors that include non-company factors, which requires the asset's beta in
relation to each separate factor. However, the APT does not provide insight
into what these factors could be, so users of the APT model must
analytically determine relevant factors that might affect the asset's returns.
On the other hand, the factor used in the CAPM is the difference between
the expected market rate of return and the risk-free rate of return.
• The APT serves as an alternative to the CAPM, and it uses fewer
assumptions and may be harder to implement than the CAPM. Ross
developed the APT on the basis that the prices of securities are driven by
multiple factors, which could be grouped into macroeconomic or
company-specific factors.
• Unlike the CAPM, the APT does not indicate the identity or even the
number of risk factors. Instead, for any multifactor model assumed to
generate returns, which follows a return-generating process, the theory
gives the associated expression for the asset’s expected return. While the
CAPM formula requires the input of the expected market return, the APT
formula uses an asset's expected rate of return and the risk premium of
multiple macroeconomic factors.
 KEY TAKEAWAYS
• Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on
the idea that an asset's returns can be predicted using the linear relationship
between the asset’s expected return and a number of macroeconomic
variables that capture systematic risk.
• Unlike the CAPM, which assumes markets are perfectly efficient, APT
assumes markets sometimes misprice securities, before the market eventually
corrects and securities move back to fair value.
• Using APT, arbitrageurs hope to take advantage of any deviations from fair
market value.
• MUTUAL FUNDS
JENSEN’S ALPHA
JENSEN’S ALPHA
MF MARKET SHARPE MARKET TREYNORS
RATIO = 1 Ratio = 14
X 0.75 (III) 7.5 (I)
Y 0.80 (II) 6.67 (II)
Z 0.83 (I) 6.25 (III)

ALL MFs have UNDERPERFORMED THE MARKET

on the basis of both ratios.
LET’S LOOK AT A COUPLE OF PREVIOUS YEAR
QUESTIONS
WHAT IS NAV?
CALCULATE EXPENSE RATIO OF THE FUND
Previous Year Question
• NAV = Rs 8.79
• Mutual Fund Theory: Chapter 17 of ROHINI SINGH Ma’am’s book
Links from the internet:
https://www.amfiindia.com/investor-corner/knowledge-
center/etf.html#accordion2
https://www.fincart.com/blog/sip-or-lumpsum-which-is-better/
https://www.bajajfinserv.in/investments/systematic-withdrawal-plan
DIFFERENCE BETWEEN OPEN-ENDED AND
CLOSE-ENDED FUNDS
Feature Open-ended Funds Close-ended Funds
An open ended fund is a type of These are types of mutual funds
mutual fund that allows investors to that issue a fixed number of
Structure buy or sell units at any time at the units for a limited time through
particular NAV of that day. a new fund offer.
Bought and sold directly with the Traded on stock exchanges, like
Trading fund company stocks

When Can Units can be purchased at any time. Units can only be bought for a
They Be specific time period during the
Bought? NFO.
Liquidity depends on market
Highly liquid; investors can redeem demand; A closed ended fund’s
Liquidity shares daily with the fund company units can only be redeemed at
maturity or through the stock
exchange.
 Feature Open-ended Funds Close-ended Funds
Investment can be made through Closed ended funds don’t offer
Investment a lump sum amount or a SIPs, so investment can only be
Options Systematic Investment Plan made through the lump sum route.
(SIP).
Priced at Net Asset Value (NAV), Market price fluctuates based on
Pricing calculated at the end of each supply and demand, may trade at a
trading day premium or discount to NAV
Closed ended funds do have a
Maturity No fixed maturity; operates maturity period, which is generally
Period indefinitely between 3 to 5 years.

Minimum Open ended funds offer more Since investment can only be
Investment accessibility as investors can start made with a lump sum amount,
Amount investing with as little as Rs. 500 the entry barrier is comparatively
through SIPs. higher for closed ended funds.
 Feature Open-ended Funds Close-ended Funds
Requires cash reserves Stable capital base allows
Management of Assets to handle redemptions, managers to make long-term
limiting investment investments
flexibility

Examples SBI Bluechip Fund, SBI Fixed Maturity Plan

HDFC Flexi Cap Fund (FMP), ICICI Prudential
Growth Fund.
THANK YOU ☺

ALL THE BEST!