Characteristic of “factor model” of the asset pricing and CAPM

The main characteristics of ‘factor models’ of the asset pricing are:

Models of asset pricing describe expected rates of return of financial assets which are traded in financial markets. Financial assets are things like bonds, options, future contract etc. These models of financial economics are based on two core concepts. The first one is “no arbitrage principle” and the second one is “financial market equilibrium”.

The “no arbitrage principle” states that market forces tend to align the prices of financial assets so as to eliminate arbitrage opportunities. This implies there is no such financial asset with zero cost.

The second one is “financial market equilibrium”, condition for financial market equilibrium in a market with no frictions is that the first-order conditions of the investor’s optimization problem are satisfied because Investors’ desired holdings of financial assets are derived from an optimization problem.

Capital Asset Pricing Model (CAPM)

Of the various model of asset pricing, one of the models is the Capital Asset Pricing Model (CAPM). CAPM calculates a required return based on a risk measurement. To do this, the model relies on a risk multiplier called the beta coefficient.

CAPM depends on certain assumptions. Originally, there were nine assumptions, although more recent work in financial theory has relaxed these rules somewhat. The original assumptions were:

1. Investors are wealth maximizers, who select investments based on expected return and standard deviation.
2. Investors can borrow or lend unlimited amounts at a risk-free (or zero risk) rate.
3. There are no restrictions on short sales (selling securities that you don't yet own) of any financial asset.
4. All investors have the same expectations related to the market.
5. All financial assets are fully divisible (you can buy and sell as much or as little as you like) and can be sold at any time at the market price.
6. There are no transaction costs.
7. There are no taxes.
8. No investor's activities can influence market prices.
9. The quantities of all financial assets are given and fixed.

The CAPM formula is sometimes called the Security Market Line formula and consists of the following equation:

r* = kRF + b(kM - kRF)

It is basically the equation of a line, where:

r* = required return

kRF = the risk-free rate

kM = the average market return

b = the beta coefficient of the security (risk attached to the investment)

Simply, the required return will be positively correlated to the risk attached to the investment (b). If risk attached to the investment is greater than that with the market risk than high return is desirable and if the risk attached to the investment is less than that with the market rate then return below the market rate can be acceptable.

The main assumption of this model is such that investors are well diversified with several market portfolios which eliminate the unsystematic part of the whole risk. The only risk left is the systematic risk which is a risk which affects the whole economic environment as a whole, in a modern world there are some techniques developed to minimize the systematic risk but generally it affects the whole economy.