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Capital Asset Pricing Model

Capital Asset Pricing Model

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04/12/2011

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CAPITAL ASSET PRICING MODEL

INTRODUCTION   

The Capital Asset Pricing Model (CAPM) is a model developed in an attempt to explain variation in yield rates on various types of investments CAPM is based on the idea that investors demand additional expected return (called the risk premium) if they are asked to accept additional risk The CAPM model says that this expected return that these investors would demand is equal to the rate on a risk-free security plus a risk premium

INTRODUCTION    The model was the work of financial economist (and. set out in his 1970 book "Portfolio Theory And Capital Markets" His model starts with the idea that individual investment contains two types of risk:  Systematic Risk (or Market risk)  Unsystematic Risk (or Specific risk) CAPM considers only systematic risk and assumes that unsystematic risk can be eliminated by diversification . later. Nobel laureate in economics) William Sharpe.

DIVERSIFICATION    A risk management technique that mixes a wide variety of investments within a portfolio The rationale behind this technique contends that a portfolio of different kinds of investments will. on average. yield higher returns and pose a lower risk than any individual investment found within the portfolio This only works for unsystematic risks .

It is only valid within a special set of assumptions:  Investors are risk averse individuals who maximize the expected utility of their end of period wealth  Investors have homogenous expectations (beliefs) about asset returns  Asset returns are distributed by the normal distribution  There exists a risk free asset and investors may borrow or lend unlimited amounts of this asset at a constant rate: the risk free rate .ASSUMPTIONS  The Capital Asset Pricing Model is a ceteris paribus model.

It is only valid within a special set of assumptions:  There is a definite number of assets and their quantities are fixed within the one period world  All assets are perfectly divisible and priced in a perfectly competitive marked  Asset markets are frictionless and information is costless and simultaneously available to all investors  There are no market imperfections such as taxes. or restrictions on short selling . regulations.ASSUMPTIONS  The Capital Asset Pricing Model is a ceteris paribus model.

yield rate on a specific security k rf.a measure of systematic risk for security k .yield rate on the market portfolio Fk.risk-free rate of interest rp.CAPM Formulation of CAPM is given by: where: rk.

Likewise.CAPM: Derivation Step 1. In the hypothetical world of the CAPM theory all that the investor bothers about is the values of the normal distribution. semiinterquartile range. This distribution is described completely by its two parameters: mean value (m) and variance (s2). However. The derivation of the CAP-model starts by assuming that all assets are stochastic and follow a normal distribution. the assumption may be seen as a reasonable approximation and it is needed in order to simplify matters. semivariance. mean absolute deviation. The mean value is a measure of location among many such as median and mode. . In the real world asset return are not normally distributed and investors do find other measures of location and dispersion relevant. the variance value is a measure of dispersion among many such as range.

Optimal portfolio choice for a risk averse investor in a world with risky assets .Figure 1.

. They perceive variance as a bad and mean as a good. The next assumption is that investors are risk averse and maximize expected utility. This is also illustrated in figure I where tree risk-averse indifference curves are drawn.CAPM: Derivation Step 2.

CAPM: Derivation Proposition 1: An individual investor will maximize expected utility of his end of period wealth where his subjective marginal rate of substitution between risk and return represented by his indifference curves is equal to the objective marginal rate of transformation offered by the minimum variance opportunity set: MRSspmp = MRTspmp. .

capital markets are assumed to be frictionless. Assume now that there in addition to the many risky assets exist a risk free asset and that investors may borrow or lend unlimited amounts of this asset at a constant rate: the risk free rate (rf). The effect on the shape of the portfolio production possibility area is profound as illustrated in figure 11 below. . Furthermore.CAPM: Derivation Step 3.

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Assume that all investors have homogeneous beliefs about the expected distribution of returns offered by all assets. capital markets are frictionless and information is costless and simultaneously available to all investors. Furthermore. there are no market imperfections. Also. .CAPM: Derivation Step 4. Taken together this implies that all investors calculate the same equation for the market capital line and that the borrowing rate equals the lending rate.

there is a definite number of assets and their quantities are fixed within the one period world. That is. Furthermore. each asset is equally attractive to investors. The reason is that equilibrium requires all prices to be adjusted so that the excess demand for any asset is zero. where Vi is the market value of asset i and SVi is the market value of all assets. Theoretically the reduction of variance from diversification increases as the number of risky assets included in the portfolio M rise.CAPM: Derivation Step 5. Therefore. Assume further that all assets are perfectly divisible and priced in a perfectly competitive marked. Then the portfolio M turns out to be the market portfolio of all risky assets. . all assets will be hold in the portfolio M in accordance to their market value weight: wi = Vi/SVi.

This is exactly what the capital asset pricing model (CAPM) does. What is more interesting is to develop an equation for pricing of individual assets. . The CAP-model does not requires any new assumptions only new algebraic manipulations within the framework of the CPP-model. The capital market line equation could rightly be called the capital portfolio pricing model (CPPM) since it prices efficient portfolios.CAPM: Derivation Proposition 2: With all the above assumptions in mind (step 15) the capital market line (8) shows the relation between mean and variance of portfolios (consisting of the risk free asset and the market portfolio) that are efficiently priced and perfectly diversified.

not one for efficient cost of capital for portfolios (mp. From CPPM to CAPM. What is wanted is a model for efficient pricing of capital for individual assets (E[k].CAPM: Derivation Step 6. Now. . the CPPM). the CAPM). imagine a portfolio consisting of a% in a risky asset I and (1 a)% in the market portfolio M from the CPP-model.

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Alternative Ways of Reflecting Risk Through a risk premium in the interest rate. and  Through an adjustment in the expected payments  .

Formulas Statistical definition of measure of systematic risk Called the market price of risk .

Find the implicit expected value of the price of this stock at the end of one year. The value of F for this stock in the recent past has been 1. The current risk-free rate of interest is 5.4%.Example #1 A common stock is currently selling for $50 and will pay a dividend of $2 at the end of one year. .5. It is assumed that the market risk premium for common stocks from the table is applicable.

8% 2.Table Type of Security Common stocks Corporate bonds Treasury bills Average nominal yield rate Average real yield rate Average risk premium 12.0% 5.4 8.5 8.1 3.1 .4% 1.7 0 .

Example #2 the dividend discount model to find the implied annual rate of dividend increase for the common stock in the previous example. if present values are computed at the rate of interest produced by the Capital Asset Pricing Model b)Is this implied annual rate of dividend increase consistent with the answer to the previous example? c)Assuming the real risk-free rate of interest is 3%. find the excess of the annual rate of dividend increase over the annual rate of inflation a)Use .

while project B has high risk with F!. find F for the combined project . If the two projects are combined into one project. Each project is expected to return the same dollar amount at the end of one year and nothing thereafter.Example #3 A business firm decides to use the CAPM to evaluate two projects A and B. Project A has normal risk with F! . The riskfree rate of interest is 5% and the market risk premium is 7%.

Example #4 Stock A has F! and investors expect it to return 7%. assuming equal correlation coefficients between the market portfolio and Stocks A and B Find . Stock B has F! and investors expect it to return  the risk free rate of interest Find WA/WB.

com/article. Stephen G. Inya.  CAPM Assumptions and Limitations: CAPM ± Where Market Theories Converge and Clash.suite101. http://www.encycogov.com/A2MonitorSystems/AppA2MonitorSy stems/AppBtoA2CAP_model/CAP_Model. Inya. http://investment. H.asp .com/article.cfm/capm_assumptions_a nd_limitations  Understanding the concept of CAPM. Ivkovic. Mathiesen.Sources  The Theory of Interest. Ivkovic. http://investment.cfm/understanding_the_co ncept_of_capm  The Capital Asset Pricing Model.suite101. Kellison.

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