Risk and Return, the APT Model - Assignment Example

? Risk and Return The beta of a security measures the risk that cannot be minimized by diversification i.e. the systematic risk of the asset (MacKinlay 1995)t. The beta of the security can be calculated by the formula: Here, ? (Ri,Rm)=correlation of security I to that of the market ?(Ri)=standard deviation of security i And ?(RM)=standard deviation of the market security. By using this formula Beta of security A= =0.27 Beta of security B== 0.75 The capital asset pricing model gives us the formula for determining the expected return of the securities. According to CAPM, r = Rf +? (Km - Rf ) Where r= Expected return of the security Rf = Risk free rate ?=beta of the security Km= expected return of the market RA= 0.06+0.27(0.25-0.06) =0.1113 =11.13% RB =0.06+0.75(0.25-0.06) =0.2025 =20.25% Characteristic Lines of Securities A and B The SCL:Ri,t -Rf =?i +?i (RM,t - Rf ) + diversifiable risk ? is the excess return ?i (RM,t - Rf ) represents the non diversifiable risk The security characteristics line is drawn to show the excess return of the investment over that that of the market. The y-axis represents the excess return over the risk free rate. The x-axis represents the excess return over the market in general. The slope of the SCL represents the beta of the individual security. The main reason for the determination of the security characteristics line is to show the performance of a security relative to that of the market. Investors who want to put their finances in investments are interested in securities that will pose performance that is higher than the market or is at par with that of the market. From the slope of the security characteristics line, it is easier for investors to see the alpha of the security and also to compare the performance of the security relative to others. Moreover, a security characteristics line reveals the quantity of both the systematic and unsystematic risk (Roll & Ross 1980). Systematic risks are those that cannot be minimized through diversification and the investors must avoid investments with higher systematic risk. Likewise, the level of unsystematic risk can also be revealed from the diagram. To interpret the diagrams, the lines with high gradients re taken to have a higher beta factor and are therefore more risky than those with lower gradients. At the same time, the return of securities with higher gradients will exhibit high return level. In the diagram as well, the y-intercept represents the alpha value i.e. the excess of the return of an investments over the risk free rate of return (Roll & Ross 1980). On the other hand, the x-intercept represents the excess of the security return over that of the market. A security with a high value of X-intercept has a higher return than those of the lower x-intercept values. It is therefore clear that a security characteristics line is an important tool that investors rely on when making investment decisions and should be able to help in the making of investment decisions. The security characteristics line therefore reveals the properties of the respective securities. Question 2 The arbitrage pricing theory is an asset pricing model that was developed due to the limitations of the capital asset pricing model. APT is a multifactor model that considers the various macroeconomic factors affecting the pricing of a security (Roll & Ross 1980). In this model, the risk free rate is added to all the macroeconomic factors affecting the pricing of the asset with each factor having its own beta. According to the arbitrage pricing theory, the return of a security is determined by the formula: r= Rf + ?2F2+ ?3F3+…..+ ?nFn Where r=return of a security ? i’s=betas of respective factors Fi’s= macroeconomic factors affecting the returns The APT is therefore a multifactor model and the arbitrage process is the selling of the inefficient securities in inefficient markets in order to maximize the return on the assets. In this process the overvalued assets are sold in order to get the profits and undervalued securities will be purchased in order to maximize the rate of return (Roll & Ross 1980). It is true that the APT is a general case of CAPM. From the formulas used in calculating the return of a security, it can be seen that the difference between the two formulas is that the APT has many factors taken into consideration when determining the return. The APT in this case therefore attempts to solve the drawback of CAPM that the rate of return on a security only depends on the risk premium (Long 1974). In both the two calculation, the betas is used in assessing the systematic risk. The second reason why APT is considered an extension is the fact that APT is a multi-period model. In CAPM, the return on the asset is based on a single period of one year. This is therefore a limitation when it comes to estimating the return for those assets with a period of more than a year. On the other hand, the arbitrage pricing theory is a multi period model which determines the return of the asset of an asset for a period of more than a year, this is therefore simply an extension of the CAPM since it increases the period of measuring the return on an asset to a period exceeding a year. Moreover, APT is seen as a supply side model because it views the return on the security as dependent on the economic factors that are prevailing in the market. On the other hand, CAPM is viewed as a demand model which attempts to emphasis on the investors requirement of increased return on their investment(Brigham 2010). This can therefore be construed to mean that the APT attempts to extend the investors return on the security to other market forces of inflation and changes in the term structure of interest rates. According to APT therefore, the investor will consider both the company factors and industry performance. APT extends the determinants to be encompassed when determining the asset return. The other limitation of the CAPM is that it assumes a normal distribution of return of assets. This assumption is not genuine since the return of the assets are expected to vary depending on the timing and changes in the industrial performance (Baker 2011). APT however does not assume that the return on the asset are not normally distributed but only assumes that the investors are risk averse. Investors will therefore only wish to maximize their returns and increase their wealth. In addition, the APT model is in line with the investors’ need of maximizing their returns. In this model investors will dispose and acquire securities that are incorrectly and inefficiently priced in order to realize profits. By selling the overvalues securities and buying the undervalued securities the investors return will be higher. The fundamental basis of argument of APT is that identical assets should not have different prices and that disparities in the pricing of identical assets is a sign of inefficient market (Baker 2011). Investors will therefore take opportunity of the inefficiency ion maximizing their returns. CAPM only tells us of the assumption that the investors aim at maximizing their returns and fails to consider the arbitrage process as a feasible means of increasing the investors return on the assets. In as much as the APT model is viewed as a more comprehensive method of determining the return of a security, it also suffers some drawbacks. The model fails to find the factors that affect the return on the security (Brigham 2010). The more the factors that determine the return on the security, the more that the model becomes complex to apply as the relationship between each factor and the price of the security has to be determined. This has made CAPM be preferred by investors in their investment decisions determination. More investors have always used CAPM as a way of determining the risk and return of their assets. Question 3 Multifactor models that are used in estimating the return of securities considers the various factors that affect the pricing of a security. The factors that are used in the multifactor models are assumed not to be correlated and therefore the return of the asset is taken as the summation of all the risk factors and the risk free rate. In the arbitrage-pricing model, the factors considered in the security price determination include the changes in expected inflation, unanticipated changes in inflation, term structure of interest rates, unanticipated changes in industrial production and the long term expected growth rate of profits in the economy (Roll & Ross 1980). The factors that have been mentioned affect the security returns in the following manner. To begin with, the changes in the expected inflation rates will have an impact on the security return. Inflation is the increase in the general prices of goods and services over time. An increase in the inflation rates will mean that the real rate of return on the asset is reduced as the purchasing power is robed (Long 1974). In the case of return, a high increase in the expected rate of return will reduce the return on the asset. To shield the effect of the changes in the expected inflation rate, investors will demand higher payments for their investments and therefore the prices of the security are expected to be higher. Secondly, the unexpected changes in the purchasing power are also a factor that will affect the return on the security. The fact that the changes in this case are unanticipated, the investors will demand higher return to cover for the great risk in the adverse change in the unanticipated inflation. It is however difficult to determine the risk beta of the unanticipated change in the inflation rate because the financial experts lack information to peg the unexpected changes in the purchasing power (MacKinlay 1995). Consequently, the results of the precious periods have been used in forecasting the unexpected inflation changes. A change in industrial production is also a factor that affect the security risk and return. In this case, adverse changes in the production will lead to a shock in the security shares in the stock markets. Low production will lead to low supply and low sales turnover and therefore the profit will be adversely affected. Any factor that leads to reduction in the level of industrial production will increase the risk beta thereby making the investors increase the demand and increase in the return required. Moreover, term structure of interest rates is also a factor that is considered in the multifactor models. In this case, the rates of borrowing and lending of finances will either increase or decrease the cost of finances (Long 1974). According to the term structure of interest rates, the interest rates of long term finance is considered high because of the investors forgo the liquidity for a long period of time. The interest rates in the long term as well increases the risk of repayment and is affected by the changes in the inflation rates. In the case of high interest rates, the investors will require a high rate of returns to because of the high risk of incurring losses. Low interest rates promotes increased investment because of the low cost of borrowing money. This will make the investors have a higher expected return because of the low cost of operation. The interest volatility will also have an impact on the risk beta which will force the investors to demand increased return on their security. Notwithstanding, the long term expected growth rate of profits of the economy also affects individual security return. In the case of an economy with low expected growth in profits, the investors will be reluctant to put their investment in securities because of the low or no returns for the risk undertaken in investments. The low expected return on the investment in this instance will make the risk beta of the investment high (Roll & Ross 1980. Higher expected profit growth rate is results into low risk in investments as the economy is expected to perform better. Investors will be willing to put their money in various investment portfolio and take advantage of the prospects of growth. It will be noted that the risk beta for this expected economy will be lower. The determination of the long term expected growth rate may be based on the statistics of the indicators of economic performance and the expected weather conditions. Finally, factors like political instability, infrastructural conditions and government policies can also impact on the beta of the asset. In conclusion, the multifactor models are important in evaluating investments worth as more factors affecting the investments return are integrated. Pricing models are therefore important for investors in determining the investment return and in making investment decisions. List of References Baker, H. K. (2011). Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. New Jersey: John Wiley and Sons Brigham, E. F., & Ehrhardt, M. (2010). Financial Management Theory and Practice. Mason: Cengage Learning Long, J. B. (1974). Stock prices, inflation and the term structure of interest rates. Journal of Financial Ecoomics , 131-170. MacKinlay, C. A. (1995). Multifactor Models Do Not Explain Deviations from the Journal of Financial Economics , 38, 3-28. Roll, R., & Ross, S. (1980). An empirical investigation of the arbitrage pricing Theory. Journal of Finance , 1073-1103. Read More