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- The risk associated with a common stock is interpreted in terms of the variability of its return. The most common measures of riskiness of security are standard deviation and variance of returns.
- The concept of Security Market Line is developed by the modern portfolio theory. SML represents the average or normal trade-off between risk and return for a group of securities. Here, the risk is measured typically in terms of the beta values. The ex-post SML is used to evaluate the performance of portfolio manager; tests of asset-pricing theories, such as the CAPM and to conduct tests of market efficiency. The ex-ante SML is used to identify undervalued securities and determine the consensus and price of risk implicit in the current market prices.
- Ross explained the pricing of risky assets in the Arbitrage Pricing Theory based on the law of one price.
- The APT takes into account several assumptions like - investors have homogenous expectations, there are no market imperfections, the return on assets can be shown in the form of a linear function, etc.
- APT views several economic forces as the systematic determinants of actual returns on the asset. It is the first model to challenge the CAPM and has gained more and more acceptance among the decision-makers.
- Fama and Ken French developed a three factor model describing "value", size" and market size to be the significant factor for explaining the realized return of publicly traded stocks.
- The APT has wide ranging applications not only in portfolio management but also in corporate finance. It helps a lot of active and passive management of portfolios.
- Under the passive management strategy, a stock portfolio is created so that its performance closely replicates the performance of the underlying index. This method helps the fund manager to track the benchmark performance of the underlying index. It also helps the fund manager to track the benchmark performance in a better manner.
- Another application of the APT model is identification of mispriced securities. Using APT, if categorization can be made effectively between overpriced and underpriced assets, a zero risk portfolio can be constructed with a positive return.