CAPITAL ASSET PRICING MODEL

INTRODUCTION
No

matter how much we diversify our investments, it's impossible to get rid of all the risk. As investors, we deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM) helps us to calculate investment risk and what return on investment we should expect.

Birth of a Model
WILLIAM SHARPE, SET OUT IN HIS 1970 BOOK "PORTFOLIO THEORY AND CAPITAL MARKETS."

Types of Risk
Systematic

Risk Unsystematic Risk

Formula

Kc = Rf + (Km Rf) Kc = Common stock holders required rate of return. Rf = Risk free return. Km = Required rate of return on portfolio of all stocks, required return on average-risk stock. = Beta.

Formula

Beta

1
1
is this measure--gauges the tendency of a securitys return to move in tandem with the overall markets return.

Average systematic risk

High systematic risk, more volatile than the market

Low systematic risk, less volatile than the market

Betas for a Five-year Period (1987-1992)

Company Name (1987-1992) Beta 0.65 0.70 0.75 0.85 0.95 1.00 Tucson Electric Power California Power & Lighting Litton Industries Tootsie Roll Quaker Oats Standard & Poors 500 Stock Index

2006 Betas:

Procter & Gamble

General Motors Southwest Airlines Merrill Lynch Roberts Pharmaceutical

1.05
1.15 1.35 1.65 1.90

What CAPM Means for You

This model presents a very simple theory that delivers a simple result. The theory says that the only reason an investor should earn more, on average, by investing in one stock rather than another is that one stock is riskier. Not surprisingly, the model has come to dominate modern financial theory.

Assumptions of CAPM
All investors: Aim to maximize economic utilities. Are rational and risk-averse. Are broadly diversified across a range of investments. Are price takers, i.e., they cannot influence prices. Can lend and borrow unlimited amounts under the risk free rate of interest. Trade without transaction or taxation costs. Deal with securities that are all highly divisible into small parcels. Assume all information is available at the same time to all investors. Further, the model assumes that standard deviation of past returns is a perfect proxy for the future risk associated with a given security.

But does it really work?

PPT By Aaryendr