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 Katapatan Subd. Banaybanay, City of Cabuyao, Laguna

COURSE:FINANCIAL MANAGEMENT 2
Course Code: ACC 121A
Course Description: Conceptual Frameworks and Accounting Standards
Course: BS Accountancy

MODULE 3

Capital asset pricing model and modern portfolio theory

Capital asset pricing model – is a model based on the preposition that any stock’s
required rate of return is equal to the risk free rate of return plus a risk premium
that reflects only the risk remaining after diversification. It provides a general
framework for analyzing risk-return relationships for all types of assets. In
evaluating these relationships, CAPM does not use total risk, which is measured
by standard deviation as a risk measure, but only one part of total risk called
systematic risk.

Total risk may be separated into two major components:

1. Diversifiable risk, also called unsystematic risk or company risk

2. Undiversifiable risk, also called systematic risk or market risk.

Diversifiable risk or unsystematic risk or company risk – is that part of a

security’s risk caused by factors unique to a particular firm, it can be diversified
away because it represents essentially random events. Negative events affecting
one firm can be offset by positive events affecting another firm. Sources of
diversifiable risk includes s lawsuits, strikes, successful and unsuccessful
marketing programs, winning or losing a major contract, company management,
marketing strategy, research and development program other events that are
unique to a particular firm. Because these events are random, their effects on a
portfolio can be eliminated by diversification—bad events in one firm will be
offset by good events in another.

Undiversifiable risk – is that part of a security’s risk caused by factors affecting

the market as a whole. It cannot be eliminated by diversification because it affects
all firms simultaneously. Systematic risk is therefore only relevant risk such as
wars, inflation, interest rates, business cycle, fiscal and monetary policies and
therefore cannot be eliminated by diversification.

CAPITAL ASSET PRICING MODEL ILLUSTRATED

If we know the risk(as measured by beta) of a particular share we can use the
capital asset pricing model to determine that security's required rate of return.
The capital asset pricing model to determine that security's required rate of
return. The capital asset pricing model known as CAPM, is a model developed to
help determine a share's required rate of return for a given level of risk. If an
individual chooses to invest her money, then she must postpone consumption.
What rate of return would our investor demand just to postpone her
consumption? We implicitly assume the investor takes on no risk whatsoever, but
merely postpone consumptions. He will want compensation for the wait plus an
additional return for any inflationary pressures (an inflation premium). So if our
investor demands a 3 % return to postpone consumptions, and other 2 % to cover
the expected rate of inflation, she would require a 5% rate of return. That is, the
risk free rate of return of 5%.

For now let us put her funds into a riskless security that pays a 5% rate of return.
We tend to think of Treasury securities as a good proxy for a riskless asset
because there is no default risk.

Required rate of return = risk-free rate =5%

Now, what would it take to get our investor to move from a risk free asset to a
risky asset? That would depend on the quantity of a risk or beta the asset had
and what price our investor charges for risk.

Additional compensation required for investment in a risky asset = (price per unit
of risk) Beta

We measure the price of risk as the difference between the rate of return on the
market as measured by the rate of return on the S & P 500 index and the risk-free
rate of return.

Price per unit of risk = (Return on the market - Risk free rate)

We can measure the quantity of risk with a stock's beta coefficient. Recall that by
definition, our riskless asset has a beta of 0.0, and the market has a beta
coefficient equal to 1.0. The market, therefore has one unit of risk. If we have
multiply the price of risk time the beta, we can determine what our investor is
charging per unit of risk.

Additional compensation required for investment in a risky asset = (price per unit
of risk) Beta

The required rate of return on that security is computed as follows:

Required rate of return = risk free rate + (return on the market - risk free rate)
Beta
What Is Beta?

Beta is a measure of the volatility—or systematic risk—of a security or portfolio

compared to the market as a whole. Beta is used in the capital asset pricing model
(CAPM), which describes the relationship between systematic risk and expected
return for assets (usually stocks). CAPM is widely used as a method for pricing
risky securities and for generating estimates of the expected returns of assets,
considering both the risk of those assets and the cost of capital.

How Beta Works

A beta coefficient can measure the volatility of an individual stock compared to

the systematic risk of the entire market. Beta effectively describes the activity of a
security's returns as it responds to swings in the market. A security's beta is
calculated by dividing the product of the covariance of the security's returns and
the market's returns by the variance of the market's returns over a specified
period.

The calculation for beta is as follows:

Beta coefficient(β) = Variance(Rm) / Covariance (Re, Rm)​

where:

Re​ = the return on an individual stock

Rm = the return on the overall market

Covariance = how changes in a stock’s returns are related to changes

in the market’s returns

Variance = how far the market’s data points spread out from their

average value​
 Understanding the Capital Asset Pricing Model (CAPM)

The formula for calculating the expected return of an asset given its risk is as
follows:

ERi​ =Rf​ + βi​ (ERm − Rf​ )

Where :

ERi​ = expected return of investment

Rf​ = risk-free rate

βi​ = beta of the investment

(ERm − Rf) = market risk premium​

Investors expect to be compensated for risk and the time value of money. The
risk-free rate in the CAPM formula accounts for the time value of money. The
other components of the CAPM formula account for the investor taking on
additional risk.
The beta of a potential investment is a measure of how much risk the investment
will add to a portfolio that looks like the market. If a stock is riskier than the
market, it will have a beta greater than one. If a stock has a beta of less than one,
the formula assumes it will reduce the risk of a portfolio.

A stock’s beta is then multiplied by the market risk premium, which is the return
expected from the market above the risk-free rate. The risk-free rate is then
added to the product of the stock’s beta and the market risk premium. The result
should give an investor the required return or discount rate they can use to find
the value of an asset.

The goal of the CAPM formula is to evaluate whether a stock is fairly valued when
its risk and the time value of money are compared to its expected return.
For example, imagine an investor is contemplating a stock worth $100 per share
today that pays a 3% annual dividend. The stock has a beta compared to the
market of 1.3, which means it is riskier than a market portfolio. Also, assume that
the risk-free rate is 3% and this investor expects the market to rise in value by 8%
per year.

The expected return of the stock based on the CAPM formula is 9.5%:

9.5% = 3% +1.3 × (8%−3%)​

The expected return of the CAPM formula is used to discount the expected
dividends and capital appreciation of the stock over the expected holding period.
If the discounted value of those future cash flows is equal to $100 then the CAPM
formula indicates the stock is fairly valued relative to risk.