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Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

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Published by Sourav Pandey

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Published by: Sourav Pandey on Jun 12, 2011
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Capital Asset Pricing Model (CAPM)
Method for predicting how investment returns are determined in an efficient capital market

What Does Capital Asset Pricing Model CAPM Mean?
A model that describe the relationship between risk and expected return and that is used in the pricing of risky securities.

Critical assumptions of CAPM .

Available riskfree assets Borrowing at risk-free rates Beta as full measure of risk .Assumptions Cont .

‡ Superior returns made possible with lending and borrowing. ‡ Borrowing (leverage) if more than 100% of portfolio is invested in risky assets.Lending & Borrowing Under the CAPM ‡ Assumption of unlimited lending and borrowing at risk-free rate. ‡ Lending if portion of portfolio held in risk-free assets. creates spectrum of risk preference for different investors. .

because they are achieved by investing in the Tangent Portfolio and lending funds to the government (purchasing a Tbill. the RF). Risk .Lending Portfolios Lending Portfolios ER T A RF Portfolios between RF and T are lending portfolios.

Risk . This is a levered investment that increases both risk and expected return of the portfolio.Borrowing Portfolios Lending Portfolios ER Borrowing Portfolios T A RF The line can be extended to risk levels beyond T by borrowing at RF and investing it in T.

FORMULA with ABBREVIATION Rp =Rf Xf + Rm(1-Xf) ‡ ‡ ‡ ‡ ‡ Rp = portfolio return Xf = portion of funds invested in risk free assets 1-xf = portion invested in risky assets. Rf = risk free rate of return Rm = return on risky assets .

5%.Question ‡ Assume that borrowing and lending rate to be 12. ‡ Return from risky asset to be 20% .

Invest 50 % in risk free and 50% in risky assets Rp =Rf Xf + Rm(1-Xf) =12. 0.5) =6.5 .25% .0.5 + 20(1 .25 + 10 =16.

0 in risk free asset 100% in risky asset ‡ The return isRp =Rf Xf + Rm(1-Xf) = 0+20% = 20% .

5 3.0 12.5 11.PORTFOLIO RETURN Rp RISK FREE RETURN Rf RISK PREMIUM PORTFOLIO RISK Rp-Rf STD DEVp FACTOR PROPORTIONA LITY (Rp-Rf)/STD DEV p 16.5 0.0 0.5 15.5 23.5 0.5 .75 7.25 22.75 12.25 12.5 7.5 20.

CAPITAL ASSET PRICING MODEL Three Linear Relationships .

5 .MARKOWITZ EFFICIENT FRONTIER PORTFOLIO EXPECTED RETURN (R) % RISK A B C D E F G H J 17 15 10 7 7 7 10 9 6 13 8 3 2 4 8 12 8 7.


CAPITAL ASSET PRICING MODEL Three Linear Relationships ‡ Capital Market Line: linear risk-return trade-off for all investment portfolios E(R) M Rf W = market W Standard Deviation (total portfolio risk) .

(CML) EQUATION ‡ ‡ ‡ ‡ ‡ E(Rp)=Rf +(Rm Rf / m) p E(Rp)=portfolio s expected rate of return Rm =expected return on market portfolio m=standard deviation of market portfolio p=standard deviation of the portfolio Rf =risk free rate of interest .



CAPITAL ASSET PRICING MODEL Three Linear Relationships ‡ Security Market Line: linear risk-return trade-off for all individual stocks E(R) M Rf F=1 Systematic Risk .

(SML) EQUATION ‡ ‡ ‡ ‡ E(Rj )=Rf +[E(Rm )-Rf ]Bj E(Rj )=expected return on security j Rf =the risk free rate Rm =the expected return on the market portfolio Bj =undiversifiable risk of security j .


35 .PROBLEM (SML) ‡ Calculate the expected rate of return for security I from the following information: ‡ The risk free rate is 10% .Bj=1.the market return is 18% .

The BETA Factor .

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 .

The Security Characteristic Line ‡ Linear relation between the return on individual securities and the overall market at every point in time. given by: Rit ! E i  Z Z RMt  i i Positive Abnormal Returns: above-average returns that can t abovebe explained as compensation for added risk Negative Abnormal Returns: below-average returns that Returns: belowcannot be explained by below-market risk below- .

‡ Relation between expected return and risk is linear for all portfolios and individual assets. . ‡ Stock price F measures relevant risk for all securities. ± High beta portfolios earn high risk premiums. ± Low beta portfolios earn low risk premiums.Empirical Implications of CAPM ‡ Optimal portfolio choice depends on market risk-return trade-offs and individual investors differences in risk preferences. ‡ Expected rate of return is risk-free rate plus relative risk (ßp) times market risk premium.

Limitations the model can only give approximate predictions. Capm has a number of unrealistic assumptions .

Unrealistic Assumptions Perfect capital market exists Investors: same expectations of return and risk unsystematic risk is not accounted for into capm Lending and Borrowing can take place at risk free rates Risk is measured on the basis of historic returns patterns .Limitations Cont ..

Arbitrage Pricing Theory (APT) ‡ According to this theory an investor tries to find out the possibilities to increase returns from his portfolio without increasing funds in the portfolio. ‡ Arbitrage: simultaneous buying and selling of the same asset at different maturities ‡ APT suggests that asset returns might be affected by N risk factors. .


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