CAPITAL ASSET PRICING MODEL

WATAN YAR

CAPM

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk

TOTAL RISK

The total variability in returns of a security represents the total risk of that security. Systematic risk and unsystematic risk are the two components of total risk. Thus Total risk = Systematic risk + Unsystematic risk

RISKS ASSOCIATED WITH INVESTMENTS

Risks

Systematic OR Non diversifiable

Non systematic OR diversifiable

SYSTEMATIC RISK
The portion of the variability of return of a security that is caused by external factors, is called systematic risk. It is also known as market risk or nondiversifiable risk. Economic and political instability, economic recession, macro policy of the government, etc. affect the price of all shares systematically. Thus the variation of return in shares, which is caused by these factors, is called systematic risk.

SYSTEMATIC RISKS:
War like situation Internation al events Industrial growth
Risk due to inflati on

Interest rate risk

Political risk
Market risk Risk due to govt. policies

monsoon scams Natural calamiti es

NON - SYSTEMATIC RISK:

The return from a security sometimes varies because of certain factors affecting only the company issuing such security. Examples are raw material scarcity, Labour strike, management efficiency etc. When variability of returns occurs because of such firm-specific factors, it is known as unsystematic risk.

NON-SYSTEMATIC RISKS:
Business risks

Disputes

Non systematic risks

Financial risks

Risks due to uncertainty

RISK RETURN RELATIONSHIP OF DIFFERENT STOCKS

Rate of Return Market Line E(r) Risk Premium Ordinary shares Preference shares Subordinate loan stock Unsecured loan Debenture with floating charge Mortage loan Government stock (risk-free) Degree of Risk Risk return relationship of different stocks

ASSUMPTIONS

Can lend and borrow unlimited amounts under the risk free rate of interest

Individuals seek to maximize the expected utility of their portfolios over a

single period planning horizon.

Assume all information is available at the same time to all investors The market is perfect: there are no taxes; there are no transaction costs; securities are completely divisible; the market is competitive.

The quantity of risky securities in the market is given.

IMPLICATIONS AND RELEVANCE OF CAPM

Investors will always combine a risk free asset with a market

portfolio of risky assets. Investors will invest in risky assets in proportion to their market value..

Investors can expect returns from their investment according to the risk. This implies a liner relationship between the

assets expected return and its beta.

Investors will be compensated only for that risk which they cannot diversify. This is the market related (systematic) risk

CAPM EQUATION
E(ri) = Rf + i(E(rm) - Rf)

E(ri) = return required on financial asset i

Rf = risk-free rate of return

i = beta value for financial asset i

E(rm) = average return on the capital market

BETA

A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and

expected market returns.

Also known as "beta coefficient."

Beta is calculated using regression analysis

VALUE OF BETA

= 1 <1

>1
For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.

Limitations
CAPM has the following limitations: It is based on unrealistic assumptions. It is difficult to test the validity of CAPM. Betas do not remain stable over time.

CONCLUSION
Research has shown the CAPM
to stand up well to criticism, although attacks against it have been increasing in recent years. Until something better presents itself, however, the CAPM remains a very useful item in

the financial management tool

kit.