FINANCIAL MARKET AND PRODUCT RISK - Essay Example

The two of the stylized financial asset pricing model is Capital Asset Pricing Model (CAPM) and Arbitrage Pricing theory (APT). The paper will be focusing on the critical evaluation of these two asset pricing models and will be analyzing the justification of its use with that of a fund manager in the United Kingdom. Let us begin our discussion with the notion of these two models before plunging into their critical evaluation. Mechanics of CAPM The capital asset pricing model (CAPM) developed by Sharp (1964), Linter (1965) and Mossin (1966) (Zhang & Wihlborg, 2004, p.1) assumes that stock returns are usually evolved from one factor model which represents the market portfolio of all the risky assets.

The theory is structured on the notion that it is an aggregation of the Portfolio theory and some additional ones. In the CAPM model, the concept of risk free asset resulted in the derivation of Capital Market Line which is referred to as the new efficient frontier. The equation for the CAPM model can be stated as follows: is the required rate of return on a risky asset and it is a function of risk free rate and risk premium . The market risk premium is the difference between the return on the market and the risk free return.

is crucial as it determines the sensitivity of the stock market to that of the market which shows by what amount the price of a stock will fluctuate in specific fluctuations to that of the stock market (Zubairi et al, 2011, p.441). But the critical point in the estimation of the CAPM. The model assumes that the return on a stock is dependent on whether the price of the stock follows the prices in the market as a whole. It is useful as it represents a statistical representation of the past risk.

Although there is no certainty but a high probability will be attached to infer the statement that the companies which strong stock price history will also performs in the future. The critical point in the estimation of the CAPM is the difficulty of measuring the true market portfolio (Donovan, 2007, p.3). The APT theory is a modified version of CAPM which is discussed in the following segment. Mechanics of APT Developed by Ross (1976) APT states that a large number of sources for risk are present in the economy which cannot be eliminated by the process of diversification (Iqbal & Haider, 2005, p. 121). The risks are thought to be of the factors like inflation, output fluctuations, fiscal and monetary shocks.

APT is modified than CAPM in the sense that it focuses on the measurement of a large number of Betas () than a single Beta which was calculated in CAPM model. The Betas are calculated by the estimation of the sensitivity of the return of the assets with respect to change in each factor. It possesses a linear relationship between the returns on risky assets and a small set of economy wide common factor. The equation is given as follows: Here, is the expected return of the ith stock. Fj represent the unobserved economic factors and bij represent the sensitivity of the security i to that of the economic factors j and ?

I is the stochastic parameter known as the uncontrolled factor (Donovan, 2007, p.3). Now let us analyze which model a fund manager sitting in the UK will be adapting. Characteristics of the shares traded in the London Stock exchange The companies whose shares are traded in the London Stock Exchange vary largely where the smallest companies are valued