Security Analysis and Portfolio Management (SAPM)

e-Lecture Notes (for MBA)

IMS, MGKVP, Session 2020

Unit III

Security Analysis is the analysis of trade-able financial instruments called securities. It deals
with finding the proper value of individual securities (i.e., stocks and bonds). These are usually
classified into debt securities, equities, or some hybrid of the two. Commodities or futures
contracts are not securities.

There are many objectives of Security Analysis. They are - Capital appreciation, Regular
Income, the Safety of Capital, Hedge against Inflation, and Liquidity.

Fundamental analysis
It is a method of evaluating the intrinsic value of an asset and analyzing the factors that could
influence its price in the future. This form of analysis is based on external events and influences,
as well as on financial statements and industry trends. Fundamental Analysis is essential because
it provides consistent and reliable information. With its help, we can evaluate a security's
intrinsic value. The discounted cash flow model is a common valuation method used to
determine a company's intrinsic value. Fundamental analysis consists of three main parts:
Economic analysis, Industry analysis, Company analysis.

Objectives of Fundamental Analysis

✓ To conduct an asset valuation and predict where its price will go
✓ To make a projection on its business performance
✓ To evaluate the management of the property and make internal financial decisions
✓ To help determine future prices and market developments

Steps in Fundamental Analysis

Step 1: Economic and Market Analysis
Step 2: Analysis of Financial Statements
Step 3: Forecasting relevant payoffs
Step 4: Formulating a security value
Step 5: Making a recommendation

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In security selection process, a traditional approach of Economic- Industry- Company analysis
is employed. EIC analysis is the abbreviation of Economic, Industry, and Company. In this,
finally the most attractive companies within the attractive industries are pointed out by the
analyst.

1) Economic Analysis
Stock prices react favorably to the low inflation, earnings growth, a better balance of trade,
increasing Gross National Product (GNP) and other positive macroeconomic news. Indications
that unemployment is rising, inflation is picking up or earnings estimates are being revised
downward, negatively affects the stock prices. Thus, the implications of market risk should be
clear to the investor. When there is recession in the economy, the prices of stocks moves
downward. All the companies suffer the effects of recession despite of the fact that those are
high performing companies or low performing ones. Conversely, the stock prices are positively
affected by the boom period of the economy.

2) Industry Analysis
It is clear there is certain level of market risk faced by every stock and the stock price decline
during recession in the economy. Another point to be remembered is that the defensive kind of
stock is affected less by the recession as compared to the cyclical category of stock. In
the industry analysis, such industries are highlighted that can stand well in front of adverse
economic conditions.

In 1980, Michael Porter proposed a standard approach to industry analysis which is referred to
as competitive analysis frame work.

Threats of new entrants evaluate the expected reaction of current competitors to new
competitors and obstacles to entry into the industry. In certain industries it is quite difficult for
new company to compete successfully. The growth in the industry is slowed down through the
rivalry among the current competitors. Profits of the company are reduced when it tries to
cover more market share because under existing rivalry the company has to invest a large portion
of its earnings in this enhancing market share. Another threat faced by company in industry is the
threat of substitutes which prevents the companies to enhance the price of their products. When
there is much increase in the price of particular product, then the consumer simply switches to
other alternative product which has lower price.

Another aspect of the industry analysis is the bargaining power of buyers which can greatly
influence the large percentage of sales of seller. In this condition the profit margins are lower.
Concessions are necessary to be offered by the seller because it is not affordable for him to lose
customer. Finally, the bargaining power of suppliers has also substantial influence over the

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profitability of the company. The supplies for manufacturing products are required by the
company and it does not have sufficient control over the costs. It is not possible for the company
to increase the price of its finished products in order to cover the increased costs due to the
presence of powerful buyer groups in market of substitute products. So while conducing industry
analysis, the presence of powerful suppliers should be considered as negative for the company.

3) Company Analysis
Company analysis is a process carried out by investors to evaluate securities, collecting
information related to the company's profile, products and services as well as profitability. In
company analysis different companies are considered and evaluated from the selected industry so
that most attractive company can be identified.

Company analysis is also referred to as security analysis in which stock picking activity is done.
Different analysts have different approaches of conducting company analysis like:

1. Value Approach to Investing

2. Growth Approach to Investing

In company analysis, analysts consider the basic financial variables for the estimation of the
intrinsic value of the company. These variables contain sales, profit margin, tax rate,
depreciation, asset utilization, sources of financing and other factors. A common method
to analyzing a stock is studying its price-to-earnings ratio.

We can calculate the P/E ratio by dividing the stock's market value per share by its earnings per
share. To determine the value of a stock, investors compare a stock's P/E ratio to those of its
competitors and industry standards.

The reference points used for Company Analysis are:

1) Price-to-Earnings Ratio (P/E)
2) PEG Ratio.
4) Price-to-Book Ratio (P/B)
5) Dividend Yield.
6) Dividend Payout Ratio.
7) Return on Assets (ROA)
8) Return on Equity (ROE)
9) Profit Margin.

4) Technical Analysis

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Technical analysis existed and was practiced before computers were common, and some of the
pioneers in technical analysis were long-term investors and traders, not day traders. Technical
analysis is used by traders on all time frames, from 1-minute charts to weekly and monthly
charts.

Charles Dow (1851-1902) was the first to reintroduce and comment on it in recent times. He is
considered the father of “modern” technical analysis.

A core principle of technical analysis is that a market's price reflects all relevant information
impacting that market. A technical analyst therefore looks at the history of a security or
commodity's trading pattern rather than external drivers such as economic, fundamental and
news events.

Hence, 1) while Fundamental Analysis aims at ascertaining the true intrinsic value of the
stock, Technical Analysis is used to identify the right time to enter or exit the market, and 2)
Fundamental Analysis is based on financial statements, whereas Technical Analysis is based on
charts with price movements. 3) Fundamental analysis is most often used when determining the
quality of long-term investments in a wide array of securities and markets, while Technical
Analysis is used more in the review of short-term investment decisions such as active trading of
stocks.

A major premise of fundamental analysis is that a stock's price is based on its past cash flows,
rather than on anticipated future cash flows. Using a "Bottom Up" Approach for Fundamental
Analysis means beginning your analysis on a microeconomic level right from the start, typically
starting with a particular company itself. You would then move to consecutive wider economic
levels until you reach global economic analysis.

5) Efficient Market Theory

Efficient Market Theory holds that markets operate efficiently because at any given time, all
publicly known information is factored into the price of any given asset. This means that an
investor can't get ahead of the market by trading on new information because every other trader
is doing the same thing.

The Efficient Market Hypothesis (EMH), alternatively known as the efficient market theory, is
a hypothesis that states that share prices reflect all information and consistent alpha generation is

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impossible. According to the EMH, stocks always trade at their fair value on exchanges, making
it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.
Therefore, it should be impossible to outperform the overall market through expert stock
selection or market timing, and the only way an investor can obtain higher returns is by
purchasing riskier investments.

Highlights of EMT
• The efficient market hypothesis (EMH) or theory states that share prices reflect all
information.
• The EMH hypothesizes that stocks trade at their fair market value on exchanges.
• Proponents of EMH posit that investors benefit from investing in a low-cost, passive
portfolio.
• Opponents of EMH believe that it is possible to beat the market and that stocks can
deviate from their fair market values.

Proponents of the Efficient Market Hypothesis conclude that, because of the randomness of the
market, investors could do better by investing in a low-cost, passive portfolio.

There are three forms of EMH: weak, semi-strong, and strong.

1) Weak Form EMH: Suggests that all past information is priced into securities.
Fundamental analysis of securities can provide an investor with information to produce
returns above market averages in the short term, but there are no "patterns" that exist.
Therefore, fundamental analysis does not provide long-term advantage and technical
analysis will not work.
2) Semi-Strong Form EMH: Implies that neither fundamental analysis nor technical
analysis can provide an advantage for an investor and that new information is instantly
priced in to securities.
3) Strong Form EMH: Says that all information, both public and private, is priced into
stocks and that no investor can gain advantage over the market as a whole. Strong Form
EMH does not say some investors or money managers are incapable of capturing
abnormally high returns because that there are always outliers included in the averages.

If you believe that the stock market is unpredictable with random movements in price up and
down, you would generally support the efficient market hypothesis. However, a short-term trader
might reject the ideas put forth from EMH because they believe that an investor can predict
movements in stock prices. Hence, for most investors, a passive, buy-and-hold, long-term
strategy is appropriate because capital markets are mostly unpredictable with random
movements in price up and down.

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 Unit IV

1) Portfolio Management
Portfolio Management is defined as the art and science of making decisions about the
investment mix and policy, matching investments to objectives, asset allocation for
individuals and institutions, and balancing risk against performance. It is mainly concerned
with allocating assets while downsizing risk.

TYPES OF PORTFOLIO MANAGEMENT

1) Active Portfolio Management

The aim of the active portfolio manager is to make better returns than what the market
dictates. Active managers buy stocks when they are undervalued and start selling when
they climb above the norm.
Active portfolio management involves the quantitative analysis of companies to
determine the cost of stock in relation to its potential. To do this, the active manager
shuns the efficient market hypothesis and instead relies on ratios to support his claim. To
downsize risk, the active manager prefers to diversify investments amongst the various
sectors.
The issue with active portfolio management is that it all comes down to the manager's
skill. But should you find one with the necessary know how, the value investing method
will likely bring in good gains.

2) Passive Portfolio Management

At the opposite end of active management comes the passive investing strategy. Those
who subscribe to this theory believe in the efficient market hypothesis. The claim is that
the fundamentals of a company will always be reflected in the price of the stock.
Therefore, the passive manager prefers to dabble in index funds which have a low
turnover, but good long-term worth. With index funds, your cash is invested percentage-
wise in proportion to the market capitalization. The point of opting for the lower yield is
to combat the cost of management fees, while profiting through stability.

3) Discretionary Portfolio Management

A discretionary manager is given full leeway to make decisions for the investor. While
the individual goals and time-frame are taken into account, the manager adopts
whichever strategy he thinks best. Once the cash has been handed to the professional, the
investor sits back and trusts that the profits will roll in.

4) Non-Discretionary Portfolio Management

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 The non-discretionary manager is simply a financial counselor. He advises the investor in
which routes are best to take. While the pros and cons are clearly outlined, it is up to the
investor to choose his own path. Only once the manager has been given the go ahead,
does he make a move on the investor's behalf. Whether you decide to use a portfolio
manager or you choose to take on the role yourself, it is important to opt for a viable
strategy and ensure that it is put forward in a logical way. The merit of maintaining a
sensible portfolio is that it cuts down the confusion while providing investments that fit
the individual's goals.

2) Capital Market Theory

The Capital Market Theory (CMT) is a major extension of the Modern Portfolio Theory of
Markowitz. Portfolio theory is a description of how rational investors should built efficient
portfolios. Capital market theory tells how assets should be priced in the capital markets if,
indeed, everyone behaved in the way portfolio theory suggests.

Assumptions made regarding Capital Market Theory include:

✓ All investors are Markowitz efficient investors who choose investments on the basis of
expected return and risk.
✓ Investors can borrow or lend any amount at a risk-free rate of interest.
✓ All investors have homogeneous expectations for returns.
✓ All investments are infinitely divisible.
✓ No transactions costs or taxes, no inflation or any change in interest rates and capital
markets are in equilibrium.

3) Portfolio Selection and its Models

Portfolio Selection, as a theory, was published in March 1952 in The Journal of Finance, by the
American Finance Association. In it, Markowitz argued that portfolios should optimize
expected return relative to volatility. He considered volatility could be measured as the variance
of return. He also suggested a limit to it, that he called the "efficient frontier."

The Portfolio Theory deals with portfolios of risky assets. According to the theory, an investor
faces an efficient frontier containing the set of efficient portfolios of risky assets.

Now it is assumed that there exists a riskless asset available for investment. A riskless asset is
one whose return is certain such as a government security. Since the return is certain, the
variability of return or risk is zero. The investor can invest a portion of his funds in the riskless

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asset which would be equivalent to lending at the risk free asset’s rate of return. He would then
be investing in a combination of risk free asset and risky assets.

Similarly, it may be assumed that an investor may borrow at the same risk free rate for the
purpose of investing in a portfolio of risky assets. He would then be using his own funds as well
as some borrowed funds for investment.

The fundamental notions of Portfolio Theory are as under:

1) Return and risk are two important characteristics of every investment. Investors base their
investment decisions on the expected return and risk of investments. Risk is measured by
the variability in returns.
2) Investors attempt to reduce the variability of returns through diversification of
investment. This results in creation of a portfolio. With a given set of securities, any
number of portfolios may be created by altering the proportion of funds invested in each
security. Among these portfolios some dominate others, or some are more efficient than
the vast majority of portfolios because of lower risk or higher returns. Investors identify
this efficient set of portfolios.
3) Diversification helps to reduce risk, but even a well diversified portfolio does not become
risk free. If we construct a portfolio including all the securities in the stock market, that
would be the most diversified portfolio. Even such a portfolio would be subject to
considerable variability. This variability is undiversifiable and known as the market risk
or systematic risk because it affects all the securities in the market.
4) The real risk of a security is the market risk which cannot be eliminated through
diversification. This is indicated by the sensitivity of a security to the movements of the
market and is measured by the beta coefficient of the security.

4) Markovitz Portfolio theory

Modern Portfolio Theory is Markowitz's theory regarding maximizing the return investors could
get in their investment portfolio considering the risk involved in the investments. MPT asks the
investor to consider how much the risk of one investment can impact their entire portfolio.

Modern Portfolio Theory (MPT) was first espoused by American economist Harry
Markowitz. For his work, Markowitz was awarded the Nobel Prize in Economics in 1990. In his
1952 paper published by The Journal of Finance, he first proposed the theory as a means to
create and construct a portfolio of assets to maximize returns within a given level of risk, or to
devise one with a desired, specified, and expected level of return with the least amount of risk.
Markowitz theorized that investors could design a portfolio to maximize returns by accepting a
quantifiable amount of risk.

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In other words, investors could reduce risk by diversifying their assets and asset allocation
of their investments using a quantitative method. MPT is a mathematical justification for
asset allocation within a portfolio, as it amounts to a weighted average of the expected returns on
individual assets.

To begin with, Markowitz assumed that most investors are risk-averse. That means they are
more personally comfortable with less risk, and nervous and anxious with increased risk. This
also translates into the belief that it is better to not lose money than to find or gain it. So, given a
choice between a higher return possibility with greater risk, and a lower return possibility with
less risk, most people will naturally prefer the portfolio with the least risk, even if it means a
lower return.

This gets to the heart of Markowitz's theory. Given two portfolios, an investor will naturally
prefer one that indicates the highest return possibility with the least risk.

Criticism:
▪ Critics contend MPT doesn't deal with the real world, because all the measures used by
MPT are based on projected values, or mathematical statements about what is expected
rather than real or existing.
▪ Investors have to use predictions based on historical measurements of asset returns and
volatility in the equations, which means they are subject to be changed by variables
currently not known or considered at the time of the equation.
▪ Investors have to estimate from past market data because MPT tries to model risk in
terms of the likelihood of losses, without a rationale for why those losses could occur.
That makes the risk assessment probabilistic, but not structural.
▪ The mathematical model of MPT makes investing appear orderly when its reality is far
less so.

5) Efficient Frontier

The Efficient Frontier is the set of optimal portfolios that offer the highest expected return for a
defined level of risk or the lowest risk for a given level of expected return.
Portfolios that lie below the efficient frontier are sub-optimal because they do not provide
enough return for the level of risk. The Efficient Frontier arising from a feasible set of
portfolios of risky assets is concave in shape.

The efficient frontier is curved because there is a diminishing marginal return to risk. Each
unit of risk added to a portfolio gains a smaller and smaller amount of return.

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When an investor is assumed to use riskless lending and borrowing in his investment activity
the shape of the efficient frontier transforms into a straight line.

6) Sharpe Single Index Model

The Single-Index Model (SIM) is a simple asset pricing model to measure both the risk and the
return of a stock. The model has been developed by William Sharpe in 1963.

Markowitz Model had serious practical limitations due to the rigors involved in compiling the
expected returns, standard deviation, variance, covariance of each security to every other security
in the portfolio.

Sharpe Model has simplified this process by relating the return in a security to a single Market
Index. Firstly, this theoretically reflects all well-traded securities in the market. Secondly, it
reduces and simplifies the work involved in compiling elaborate matrices of variances as
between individual securities.

Thus, if the Market Index is used as a surrogate for other individual securities in the portfolio,
the relation of any individual security with the Market Index can be represented in a Regression
line or characteristic line.

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This optimal portfolio of Sharpe is called the Single Index Model. The method involves
selecting a cut-off rate for inclusion of securities in a portfolio. For this purpose, excess return to
Beta ratio given above has to be calculated for each stock and rank them from highest to lowest.

The Simple Index Model is based on the following assumptions:

• Most stocks have a positive covariance because they all respond similarly to macroeconomic
factors.
• However, some firms are more sensitive to these factors than others, and this firm-specific
variance is typically denoted by its beta (β), which measures its variance compared to the
market for one or more economic factors.
• Co-variances among securities result from differing responses to macroeconomic factors.
Hence, the covariance of each stock can be found by multiplying their betas and the market
variance

Casual observation of the stock prices over a period of time reveals that most of the stock prices
move with the market index. When the Sensex increases, stock prices also tend to increase and
then vice – versa. This indicates that some underlying factors affect the market index as well as
the stock prices. Sharpe assumed that the return of a security is linearly related to a single index
like the market index. Stock prices are related to the market index and this relationship could be
used to estimate the return of stock.

7) Capital Assets Pricing Model

The Capital Asset Pricing Model (CAPM) was developed in mid-1960s by three researchers
William Sharpe, John Lintner and Jan Mossin independently. Consequently, the model is often
referred to as Sharpe-Lintner-Mossin Capital Asset Pricing Model.

The Capital Asset Pricing Model (CAPM) is a relationship explaining how assets should be
priced in the capital markets. It gives the nature of the relationship between the expected return
and the systematic risk of a security.

The relationship between risk and return established by the Security Market Line (SML) is
known as the Capital Asset Pricing Model. It is basically a simple linear relationship. The higher
the value of beta, higher would be the risk of the security and therefore, larger would be the
return expected by the investors.

In other words, all securities are expected to yield returns commensurate with their riskiness.
This relationship is valid not only for individual securities, but is also valid for all portfolios

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whether efficient or inefficient. The expected return on any security or portfolio can be
determined from the CAPM formula if we know the beta of that security or portfolio.

The specific assumptions underlying Capital Asset Pricing Model are:

1) Investors make decisions based solely upon risk-and-return assessments. These
judgments take the form of expected values and standard deviation measures.
2) The purchase or sale of a security can be undertaken in infinitely divisible units. Investors
can short sell any amount of shares without limit.
3) Purchases and sales by a single investor cannot affect prices i.e. there is perfect
competition where investors in total determine prices by their actions. Otherwise,
monopoly power could influence prices (returns).
4) There are no transaction costs. Where there are transaction costs, returns would be
sensitive to whether the investor owned a security before the decision period.
5) The purchase or sale of securities is done in the absence of personal income taxes i.e.
investors are indifferent to the form in which the return is received (dividends or capital
gains).
6) The investor can borrow or lend any amount of funds desired at an identical riskless rate
(example: the Treasury bill rate).
7) Investors share identical expectations with regard to the relevant decision period, the
necessary decision inputs, their form and size. Thus investors are presumed to have
identical planning horizons and to have identical expectations regarding expected returns,
variances of expected returns, and covariances of all pairs of securities. Otherwise, there
would be a family of efficient frontiers because of differences in expectations.

CAPM describes the expected return for all assets and portfolios of assets in the
economy. The difference in the expected returns of any two assets can be related to the
difference in their betas. The model postulates that systematic risk is the only important
ingredient in determining expected return. As investors can eliminate all unsystematic
risk through diversification, they can be expected to be rewarded only for bearing
systematic risk. Thus, the relevant risk of an asset is its systematic risk and not the total
risk.

The CAPM lets investors quantify the expected return on investment given the risk, risk-
free rate of return, expected market return, and the beta of an asset or portfolio.
The Arbitrage Pricing Theory is an alternative to the CAPM that uses fewer
assumptions and can be harder to implement than the CAPM.

The CAPM has serious limitations in real world, as most of the assumptions, are
unrealistic. Many investors do not diversify in a planned manner. Besides, Beta

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 coefficient is unstable, varying from period to period depending upon the method of
compilation. They may not be reflective of the true risk involved.

8) Characteristic Lines

1) Capital Market Line (CML): It is the graph of the required return and risk (as measured by
standard deviation) of a portfolio of a risk-free asset and a basket of risky assets that offers
the best risk-return trade-off.

All investors are assumed to have identical (homogeneous) expectations. Hence, all of them
will face the same efficient frontier. Every investor will seek to combine the same risky
portfolio with different levels of lending or borrowing according to his desired level of risk.
Because all investors hold the same risky portfolio, then it will include all risky securities in
the market. This portfolio of all risky securities is referred to as the market portfolio M. Each
security will be held in the proportion which the market value of the security bears to the
total market value of all risky securities in the market. All investors will hold combinations
of only two assets, the market portfolio and a riskless security. All these combinations will
lie along the straight line representing the efficient frontier.

This line formed by the action of all investors mixing the market portfolio with the risk free
asset is known as the capital market line (CML). All efficient portfolios of all investors will
lie along this capital market line.

The CML provides a risk return relationship and a measure of risk for efficient portfolios.
The appropriate measure of risk for an efficient portfolio is the standard deviation of return
of the portfolio. There is a linear relationship between the risk as measured by the standard
deviation and the expected return for these efficient portfolios.

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 CML shows the risk-return relationship for all efficient portfolios. They would all lie along
the capital market line. All portfolios other than the efficient ones will lie below the capital
market line. The CML does not describe the risk-return relationship of inefficient portfolios
or of individual securities.

2) Security Market Line (SML): It is a line drawn on a chart that serves as a graphical
representation of the Capital Asset Pricing Model (CAPM), which shows different levels of
systematic, or market, risk of various marketable securities plotted against the expected
return of the entire market at a given point in time.

The Capital Asset Pricing Model specifies the relationship between expected return and risk
for all securities and all portfolios, whether efficient or inefficient. The total risk of a security
as measured by standard deviation is composed of two components: systematic risk and
unsystematic risk or diversifiable risk. As an investment is diversified and more and more
securities are added to a portfolio, the unsystematic risk is reduced. For a very well
diversified portfolio, unsystematic risk tends to become zero and the only relevant risk is
systematic risk measured by beta. Hence, it is argued that the correct measure of a security’s
risk is beta.

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 It follows that the expected return of a security or of a portfolio should be related to the risk
of that security or portfolio as measured by Beta which is a measure of the security’s
sensitivity to changes in market return.

Beta value greater than one indicates higher sensitivity to market changes, whereas beta
value less than one indicates lower sensitivity to market changes. A value of one indicates
that the security moves at the same rate and in the same direction as the market.

It is necessary to contrast SML and CML. Both postulate a linear (straight line) relationship
between risk and return.
1) In CML the risk is defined as total risk and is measured by standard deviation, while in
SML the risk is defined as systematic risk and is measured by beta.
2) Capital market line is valid only for efficient portfolios while security market line is valid
for all portfolios and all individual securities as well.
3) CML is the basis of the Capital Market Theory while SML is the basis of the Capital Asset
Pricing Model.

9) Optimum Portfolio
An Optimal Portfolio is one that minimizes your risk for a given level of return or maximizes
your return for a given level of risk. The optimal portfolio concept falls under the portfolio
theory. The theory assumes that investors fanatically try to minimize risk while striving for the
highest return.

Optimal portfolio is a term used in portfolio theory to refer to the one portfolio on the Efficient
Frontier with the highest return-to-risk combination given the specific investor's tolerance for
risk. It's the point where the Efficient Frontier (supply) and the Indifference Curve (demand)
meet.

10) Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT) is a general theory of asset pricing that holds that the
expected return of a financial asset can be modeled as a linear function of various factors
or theoretical market indices, where sensitivity to changes in each factor is represented by a
factor-specific beta coefficient. The theory was proposed by the economist Stephen Ross in
1976.

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The model-derived rate of return will then be used to price the asset correctly - the asset price
should equal the expected end of period price discounted at the rate implied by the model. If the
price diverges, arbitrage should bring it back into line.

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.

Assumptions of APT:
1) Asset returns are explained by systematic factors.
2) Investors can build a portfolio of assets where specific risk is eliminated through
diversification.
3) No arbitrage opportunity exists among well-diversified portfolios

The lack of clarity for the risk factors is a major weakness of the APT. Unsystematic risk can be
completely diversified away. This implies that unsystematic risk is not priced (has zero
premium).

A big difference between CAPM and the Arbitrage Pricing Theory (APT) is that APT does
not spell out specific risk factors or even the number of factors involved. While CAPM uses the
expected market return in its formula, APT uses the expected rate of return and the risk premium
of a number of macroeconomic factors.

The APT focuses on risk factors rather than assets, so it has an advantage over the CAPM in
that it does not have to create an equivalent portfolio to assess risk. The CAPM assumes that
there is a linear relationship between the assets, whereas the APT assumes that there is a linear
relationship between risk factors.

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