Chapter 9

Setting the risk premium:

the Capital Asset Pricing
Model
 Learning Objectives
• To explain what risk is relevant for valuing capital assets.
• To explain what a ‘Beta coefficient’ is.
• To determine the appropriate risk premium to incorporate into a discount rate,
whether for investment in securities or in capital projects.
SECURITY VALUATION AND DISCOUNT RATES
Any discount rate is an amalgam of three components:

1 Allowance for the time value of money – the compensation required by

investors for having to wait for their payments.

2 Allowance for price level changes – the additional return required to

compensate for the impact of inflation on the real value of capital.

3 Allowance for risk – the promised reward that provides the incentive for
investors to expose their capital to risk.
 CONCEPTS OF RISK AND RETURN
The returns from holding shares

Return = (D1+P1-P0)/P0
 CONCEPTS OF RISK AND RETURN
The risks of holding ordinary shares

Not all risk of individual securities is relevant for assessing the risk of a
portfolio of risky shares.
 CONCEPTS OF RISK AND RETURN
The risks of holding ordinary shares
 CONCEPTS OF RISK AND RETURN
The risks of holding ordinary shares

The total risk of securities (and also of portfolios) has two components:

Specific risk: Variability in return due to factors unique to the individual firm.

Systematic risk: the variability in return due to dependence on factors that

influence the return on all securities traded in the market.
 CONCEPTS OF RISK AND RETURN
Implications:

Risk-averse investors should diversify

Investors should not expect rewards for bearing specific risk

Securities have varying degrees of systematic risk

 Measuring Systematic Risk
Capital Market Line
 Measuring Systematic Risk

Systematic risk: Beta measurement

 Measuring Systematic Risk
Security Market Line
 Measuring Systematic Risk
USING THE CAPM: ASSESSING THE REQUIRED RETURN
End of chapter