Name:

AYSHA KHAN

Assignment Topic:

“Capital Asset Pricing Model Theory”

“Stock Valuation Theory”

Roll No:

“172010”

Subject:

“Econometrics”

Department:

Management Sciences

AIR UNIVERSITY ISLAMABAD (MULTAN CAMPUS)

 Capital Asset Pricing Model

 The Capital Asset Pricing Model was the work of William Sharpe, a student
of Harry Markowitz at the University of Chicago.
 The Capital Asset Pricing Model (CAPM) is a model to explain why capital
assets are priced the way they are.
 CAPM is a hypothesis.
 This model is an equilibrium based model.
 It is called a single-factor model because the slope of the SML (Security
Market Line) is caused by a single measure of risk….the beta.
 Although it is called a ‘pricing model’ there are not prices on that
graph…….only risk and return.
 It is called a pricing model because it can be used to help us determine
appropriate prices for securities in the market.

Derivation of Capital Asset Pricing Model

 This derivation follows from Jonathan Berks’ Lecture notes at Haas

Business School of UC Berkeley.
 Assume that the investors holds a portfolio of the market portfolio or the
risky asset I where
 Rm is the return on the market portfolio.
 Ri is the return on the risky asset I.
 Rf is the risk free security in the portfolio.
 So we can derive CAMP equation in that way:

Ri-Rf= Rf+ B (Rm-Rf)

 How to Develop Variables in CAPM
 CAPM equation depends on ‘X’ and ‘Y’ variable in that way:
 Ri-Rf=Y
 Rm-Rf=X
 ‘B’ (beta) associated with the systematic risk.

Measuring Systematic Risk and Beta

 We need a measure of systematic risk to analyze the relationship between
risk and expected return.
 A measure of systematic risk should capture the relationship between the
market return and the return on that asset.
 Beta coefficient is an important measure of an asset’s systematic risk,
measured relative to the market portfolio.
 Remember that risk premium of an asset depends only on the systematic
risk of that asset, hence higher the Beta, higher the systematic risk and
higher the expected return on that asset.
 Beta can be zero. Some zero-beta assets are risk free, such as treasury
bonds.
 However, simply because a beta is zero does not mean that it is risk free.
A beta can be zero simply because the correlation between the item’s
returns and the market’s returns is zero
 If B = 1
Asset return=market return
 If B > 1
Asset is riskier than market return
 If B < 1
Asset is less risky than market index
 A negative beta means that the stock is inversely correlated with the
market.
 According my assignment data that I have calculated on excel sheet, my
beta is “0” means that my asset or security‘s return and market‘s return is
zero.
 We can calculate beta with that formula:

B = Sigma (X-Avg X) (Y-Avg Y)/Sigma (X- Avg X) 2

Alpha and its interpretation

 If alpha is significantly positive, this is evidence of superior performance.

 If alpha is significantly negative, this is evidence of inferior performance.

 If alpha is insignificantly different from zero, this is evidence that that
portfolio manager matched the market on a risk adjusted basis.
 According my assignment data, I have calculated alpha on excel sheet,
the value of alpha is negative, this means that performance of company is
inferior.
 Calculation of Variables on Excel sheet

 According my assignment on Excel sheet, I have calculated different

elements according my formulas.
 Firstly, I have calculated Rt for variable ‘Y’. Rt depends on
Rt = p2-p1/p1
In which p2 is current price
P1 is previous share price
 Rf is risk free return. I have taken average Rf return on Rt which was
10.61%
 Then find Rt-Rf
 Secondly, I have calculated Rm for variable ‘X’. Rt depends on index
rate:
 Current index rate- previous index rate*100/previous index rate
 Then find Rm-Rf
 Then lastly calculated Beta.
 Assumptions of Capital Asset Pricing Model

 Investors all think in terms of a single holding period.

 All investors have identical expectations.
 Investors can borrow or lend unlimited amount at the risk free rate.
 All assets are perfectly divisible.
 There are no taxes and no transactions cost.
 All investors are price takers, that is, investors buying and selling won’t
influence stock prices.
 Quantities of all assets are given and fixed.

The Capital Asset Pricing Model

According to CAPM, the expected return on an asset depends on three

things.

 The pure time value of money as measured by the risk free rate.
 The reward for bearing systematic risk as measured by the market risk
premium.
 The amount of systematic risk measured by beta.
 Stock Valuation theory

Definition:

In financial markets, stock valuation is the method of calculating theoretical values

of companies and their stocks.

Types of Stock valuation:

Valuation methods typically fall into two main categories:

 Absolute Valuation Models

 Relative Valuation Models

Absolute Valuation Models

 Absolute valuation models attempt to find intrinsic or “true” value of an
investment based only on fundamentals.
 Looking at fundamentals simply mean you would only focus on such things as
dividend, cash flow and growth rate for a single company, and not worry about
any other companies.
 Valuation models that fall into this category include the dividend discount
model, discounted cash flow model, residual income models and asset-
based models.
 Relative Valuation Models

 Relative valuation models operate by comparing the company in question to

other similar companies.
 These methods generally involve calculating multiples or ratios, such as the
price to earnings multiple, and comparing them to the multiples of other
comparable firms.
 For instance, if the P/E of the firm you are trying to value is lower than the
P/E multiple of comparable firm, that company may be said to be relatively
undervalued.
 Generally, this type of valuation is a lot easier and quicker to do than the
absolute valuation methods.