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CMA Final · Strategic Financial Management

Asset Pricing Theories for CMA Final SFM

Asset pricing theories explain how risk decides the return investors should expect. CAPM uses one factor, market beta. APT and multifactor models use several factors. The Efficient Market Hypothesis asks whether prices already reflect information. To solve questions, find beta, apply the formula, compare required and expected return, then decide.

What this chapter covers

This chapter answers one question: what return should a risky asset earn, and is its market price fair? CAPM gives the base answer using the risk-free rate, the market return and beta. The Capital Market Line and Security Market Line show the same idea on graphs. Beta measures the part of risk that diversification cannot remove.

APT and the Fama-French style multifactor models relax the single-factor view. They let several sources of risk drive returns. The Efficient Market Hypothesis then tests whether any model can beat the market consistently, by asking how fast prices absorb information.

The chapter links directly to the rest of Paper 14. Required return from CAPM is the cost of equity used in valuation, capital budgeting and cost of capital. Beta feeds portfolio management and performance evaluation. Market efficiency shapes your view of technical and fundamental analysis. Master this chapter and several other chapters become easier.

This chapter mixes short numerical work with theory, so it suits both the 2-mark MCQs in Section A and the descriptive questions. CAPM and beta sums are quick to solve once the formula is clear, and the theory parts (APT versus CAPM, forms of market efficiency, SML versus CML) are favourite comparison questions. The concepts also support portfolio, valuation and cost of capital questions elsewhere in the paper, so the effort you spend here pays back more than once.

Asset Pricing Theories: topics in the order to study them

  1. 1Capital Asset Pricing Model (CAPM)It is the core model; every other topic in the chapter builds on or is compared with it.
  2. 2Capital Market Line and Security Market LineOnce you know CAPM, you can learn how it is drawn and how CML differs from SML.
  3. 3Beta and Systematic Risk MeasurementNow you learn how beta is estimated and used, including portfolio beta and the link to systematic risk.
  4. 4Arbitrage Pricing Theory (APT)It extends the single-factor idea, so it is easier after you are sure of CAPM and beta.
  5. 5Efficient Market HypothesisThis is mostly theory about whether prices can be beaten, and it reads better after you know the pricing models.
  6. 6Fama-French and Multifactor ModelsIt closes the chapter by showing how empirical factors such as size and value add to market beta.

How to prepare Asset Pricing Theories

Treat this chapter as one formula, one graph and a set of comparisons. Build the calculation habit first, then add the theory.

  1. Write the CAPM formula, E(Ri) = Rf + βi × [E(Rm) − Rf], and solve five or six sums until you can do them without looking.
  2. Practise reading the market risk premium correctly. Check whether the question gives Rm or the premium (Rm − Rf).
  3. Draw the SML and CML by hand. Mark the axes, the intercept and the slope, and note where undervalued and overvalued shares plot.
  4. Solve beta problems: portfolio beta as the weighted average of betas, and beta from covariance and variance of the market.
  5. Make a short comparison table in your notes: CAPM versus APT, CML versus SML, and the three forms of market efficiency.
  6. Learn the factors in multifactor models by name and what each one represents, then attempt past MCQs on the whole chapter.
  7. In the last week, redo mixed sums where you must also state a decision, such as buy, hold or sell, with a one-line reason.

Common mistakes in Asset Pricing Theories

  • Using the market return as the risk premium in CAPM.

    Fix: Always subtract Rf first. Multiply beta by (Rm − Rf), then add Rf.

  • Mixing up CML and SML.

    Fix: Remember the axis: CML uses standard deviation and covers efficient portfolios; SML uses beta and covers any security.

  • Judging a share by comparing its return with the market return instead of its required return.

    Fix: Compute the CAPM required return, then compare it with the expected return to call the share under or overvalued.

  • Calling beta total risk.

    Fix: State clearly that beta captures only systematic risk. Standard deviation captures total risk.

  • Writing vague APT answers that say it is the same as CAPM with more factors.

    Fix: Mention the no-arbitrage basis, the factor sensitivities, and that APT does not specify which factors to use.

  • Mismatching efficiency forms with information types.

    Fix: Link each form to its information set: weak to past prices, semi-strong to all public information, strong to all information including private.

Last-day revision: Asset Pricing Theories

  • CAPM: required return = Rf + β × (Rm − Rf).
  • (Rm − Rf) is the market risk premium.
  • Beta measures systematic risk only; diversification removes unsystematic risk.
  • Market beta is 1; a risk-free asset has beta 0.
  • Portfolio beta is the weighted average of the betas of its securities.
  • Beta of a security = Cov(security, market) ÷ Variance of market.
  • SML plots required return against beta and applies to individual securities and portfolios.
  • CML plots return against total risk (standard deviation) and applies to efficient portfolios only.
  • A share above the SML is undervalued, and one below it is overvalued.
  • APT lets several factors drive returns and rests on no-arbitrage; it does not name the factors.
  • EMH has three forms: weak, semi-strong and strong.
  • Fama-French adds size and value factors to the market factor.

Asset Pricing Theories practice questions

Asset Pricing Theories in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Asset Pricing Theories: frequently asked questions

Is CAPM the most important topic in this chapter?

Yes. It is the base for SML, beta use and comparison with APT. Most numerical questions come from CAPM and beta, so start there.

Do I need to memorise the Fama-French factors?

Learn the factors by name and the idea behind each, such as size and value along with market risk. Be ready to explain how the model extends CAPM.

How is APT different from CAPM in an exam answer?

CAPM uses one factor, the market beta. APT allows several factors and is built on the no-arbitrage idea, but it does not tell you which factors to use.

Is there negative marking in the MCQs?

No. Neither the question papers nor the ICMAI prospectus provide for negative marking, so attempt every MCQ.