CHAPTER EIGHT
CHAPTER OVERVIEW
This chapter presents the capital asset pricing model, which is an equilibrium model for the pricing of
assets based upon risk.
This model rules out the possibility of arbitrage profits, that is, the exploitation
of mispriced securities.
In addition, the chapter presents arbitrage pricing theory, which uses a no
arbitrage argument to derive the same expected return/risk relationship.
LEARNING OBJECTIVES
After studying this chapter, the student should have a thorough understanding of the development and the
theory of the capital asset pricing model (CAPM), to be able to construct and use the security market
line.
The student should also have a thorough understanding of arbitrage pricing theory (APT) and to be
able to use the theory to identify mispriced securities.
The student should also understand the similarities
and differences between the two concepts and the limitations of each.
PRESENTATION OF MATERIAL
1. Development of the Capital Asset Pricing Model
The introduction of the CAPM starts with an overview of the importance of the model and the
assumptions that underlie it.
T 82 Capital Asset Pricing Model (CAPM)
T 83 Assumptions
T 84 Assumptions (cont.)
The implications or conditions that will result from the CAPM are contained in T 85 and T 86.
Discussion of the equilibrium conditions that will result from the model is very important before the
analytical development of the CAPM.
T 85 Resulting Equilibrium Conditions
T 86 Resulting Equilibrium Conditions (cont.)
Once the major implications and conditions have been discussed, the Capital Market Line can be
examined. The line in shown in T 87 and the market risk premium and slope are displayed in T 88.
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 Spring '09
 MARTIN
 Management, Pricing, Arbitrage, Capital Asset Pricing Model, SML, capital asset pricing, Arbitrage Pricing Theory, security characteristic line

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