Sanjivani College of Engineering, Kopargaon

SC06- 402 FIN-CORPORATE FINANCE

Topic No 3 :
Capital Asset Pricing Theory: CAPM And Its
Use In Corporate Finance
Presented By:
Dr. S.P. Ghodake
HOD-MBA, SCOE
Dept. of www.sanjivanimba.org.in
MBA, Sanjivani COE, Kopargaon 1
 Content
❑ The role of CML in pricing models derivation.
❑ Assumptions for capital asset pricing model.
❑ The market portfolio. Security market line (SML): the
slope, the comparison to CML.
❑ The stock's beta: true beta, factors affecting true beta.
Improving the beta estimated from regression (top down
beta).
❑ The problem of adjusted beta.
❑ Estimating the market risk premium. Critiques of the
CAPM.

Dept. of MBA, Sanjivani COE, Kopargaon

 What is CAPM?
The Capital Asset Pricing Model (CAPM) is a model that
describes the relationship between the expected return and
risk of investing in a security. It shows that the expected
return on a security is equal to the risk-free return plus a risk
premium, which is based on the beta of that security.
CAPM Formula and Calculation

Where:
Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market
Note: “Risk Premium” = (Rm – Rrf)
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Dept. of MBA, Sanjivani COE, Kopargaon
• Expected Return
• The “Ra” notation above represents the expected return of a capital asset over time, given all
of the other variables in the equation. “Expected return” is a long-term assumption about how
an investment will play out over its entire life.
• Risk-Free Rate
• The “Rrf” notation is for the risk-free rate, which is typically equal to the yield on a 10-year
US government bond. The risk-free rate should correspond to the country where the
investment is being made, and the maturity of the bond should match the time horizon of the
investment.
• Beta
• The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk (volatility of
returns) reflected by measuring the fluctuation of its price changes relative to the overall
market. In other words, it is the stock’s sensitivity to market risk. For instance, if a company’s
beta is equal to 1.5 the security has 150% of the volatility of the market average. However, if
the beta is equal to 1, the expected return on a security is equal to the average market return.
A beta of -1 means security has a perfect negative correlation with the market.

Dept. of MBA, Sanjivani COE, Kopargaon

 CAPM Example – Calculation of Expected Return

Calculate the expected return on a stock, using the Capital Asset Pricing Model
(CAPM) formula.
• Using following information calculate expected returns:
• Mr. A trades on the NYSE and its operations are based in the United States
• The Current yield on a U.S. 10-year treasury is 3.5%
• The average excess historical annual return for U.S. stocks is 7.0%
• The beta of the stock is 1.25 (meaning its average return is 1.25x as volatile as the S&P 500
over the last 2 years)
• What is the expected return of the security using the CAPM formula?
Answer :
• Expected return = Risk Free Rate + [Beta x Market Return Premium]
• Expected return = 3.5% + [1.25 x 7.0%]
• Expected return = 12.25%

Dept. of MBA, Sanjivani COE, Kopargaon

 Example Of CAPM
• Consider a stock that only transacts on the New York Stock Exchange
(NYSE), as several components of this formula are affected by exchange
rates and the risk of overseas investments. Our hypothetical stock has a
beta of 1.75, making it extremely volatile and potentially more profitable.
The risk-free rate is currently 3.4% based on returns on 10-year US
Treasury bonds. For stocks traded in the US, the average market risk
premium is 7.5%.
• Using the CAPM equation, we have the following:
• Ra = 3.4% (risk-free rate) + (1.75 (beta) x 7.5% (risk premium))
• Our expected rate of return is: 16.5%

Dept. of MBA, Sanjivani COE, Kopargaon

 Capital Market Line (CML):
1. The CML represents portfolios that optimally combine risk and return. It’s a
theoretical concept that encompasses all portfolios formed by combining
the risk-free rate of return and the market portfolio of risky assets.
2. Under the CAPM, investors choose a position on the CML by
either borrowing or lending at the risk-free rate. This choice maximizes
return for a given level of risk.
3. The CML is a special case of the Capital Allocation Line (CAL), where the
risk portfolio is the market portfolio.
4. The slope of the CML is the Sharpe ratio of the market portfolio.
5. Portfolios falling on the CML theoretically optimize the risk-return
relationship, maximizing performance.

Dept. of MBA, Sanjivani COE, Kopargaon

 Formula for Calculating the CML:
• The CML is expressed as:
• [ R_p = r_f + \frac{{R_T - r_f}}{{\sigma_T}} \sigma_p ]
• where:
• (R_p) is the portfolio return.
• (r_f) is the risk-free rate.
• (R_T) is the market return.
• (\sigma_T) is the standard deviation of market returns.
• (\sigma_p) is the standard deviation of portfolio returns

Dept. of MBA, Sanjivani COE, Kopargaon

 Capital Asset Pricing Model Assumptions

• The CAPM model bases its predictions on the following

assumptions:
1. Investors are given the same amount of time to assess the
information.
2. Investments can be broken up into countless shapes and sizes.
3. By nature, all investors are risk-averse.
4. Risk and reward are correlated linearly.
5. Taxes, inflation, and transaction costs do not exist.
6. At the risk-free rate of return, limitless capital is available for
borrowing.

Dept. of MBA, Sanjivani COE, Kopargaon

 Security Market Line (SML)
• The Security Market Line (SML) is a graphical
representation of the capital asset pricing model (CAPM),
which reflects the linear relationship between a security’s
expected return and beta, i.e. its systematic risk.

Expected Return, E(Ri) = Risk Free Rate + β (Market Return – Risk Free Rate)
Equity Risk Premium (ERP) = Market Return – Risk Free Rate

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 Security Market Line Formula (SML)
• There are three components to the CAPM formula, which are the risk-free rate (rf),
the beta (β) and the equity risk premium (ERP).
1. Risk Free Rate (rf) → The yield received on risk-free securities, which is most
often the 10-year treasury bond issued by the government for companies based in
the U.S.
2. Beta (β) → The non-diversifiable risk resulting from market volatility (i.e. the
systematic risk) of a security relative to the broader market (S&P 500).
3. Equity Risk Premium (ERP) → The difference between the expected market
return (S&P 500) and the risk-free rate, i.e. the excess return received from
investing in public equities over the risk-free rate.
• The CAPM equation starts with the risk-free rate (rf), which is subsequently added
to the product of the security’s beta and the equity risk premium (ERP) in order to
calculate the implied expected return on the investment.

Dept. of MBA, Sanjivani COE, Kopargaon

 How Does the Security Market Line (SML) Work?

• In corporate finance, the security market line (SML) visually illustrates the capital
asset pricing model (CAPM), one of the fundamental methodologies taught in
academia and used in practice to determine the relationship between the expected
return on a security given the coinciding market risk.
• While the chance of encountering the security market line on the job is practically
zero, the capital asset pricing model (CAPM) — from which the SML is derived —
is commonly utilized by practitioners to estimate the cost of equity (ke).
• The cost of equity (ke) represents the minimum required rate of return
expected to be received by common shareholders given the risk profile of the
underlying security.
• The required rate of return, or “discount rate”, is one of the primary determinants
that guide the decision-making process of an investor on whether to invest in the
security.

Dept. of MBA, Sanjivani COE, Kopargaon

 Understanding Beta
• Beta (β) is a measure of a stock’s sensitivity to market
movements. It quantifies the relationship between the stock’s
returns and the returns of the broader market.
• Types of Beta: Beta can be classified as follows:
• Beta equal to 1: The stock moves in the same direction and magnitude
as the market.
• Beta less than 1: The stock moves in the same direction but with less
volatility compared to the market.
• Beta greater than 1: The stock moves in the same direction with higher
volatility than the market.

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 Factors Affecting True Beta
Several factors influence a stock’s true beta:
1. Company-Specific Characteristics:
1. Industry: Different industries exhibit varying sensitivities to market
fluctuations. For example, technology stocks may have higher betas than utility
stocks.
2. Financial Leverage: Companies with higher debt levels often have higher
betas due to increased financial risk.
2. Market Conditions:
1. Volatility: During volatile market periods, betas may fluctuate more.
2. Economic Cycles: Betas can change based on economic expansion or
contraction.
3. Time Horizon:
1. Short-term and long-term betas may differ due to changing market dynamics.
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 The Capital Asset Pricing Model (CAPM)
• CAPM is a widely-used model for calculating the expected return of an asset. It links the
expected return to the asset’s beta, the expected return of the market, and the risk-free rate.
• CAPM Equation: The CAPM equation is as follows: Expected Return = Risk-Free Rate +
Beta * (Market Return – Risk-Free Rate)
• To understand the derivation of the linear regression model, let’s start with the simple form of
linear regression:
• Y = α + βX + ε
• Y represents the dependent variable (e.g., stock returns).
• X represents the independent variable (e.g., benchmark index returns).
• α is the intercept, which represents the expected value of Y when X is zero.
• β is the slope coefficient, indicating the change in Y for a unit change in X.
• ε represents the error term, accounting for the variability in Y that cannot be explained
by the linear relationship with X.

Dept. of MBA, Sanjivani COE, Kopargaon

 • The goal of linear regression is to estimate
the values of α and β that best fit the data,
minimizing the sum of squared differences
between the observed Y values and the
predicted values based on the regression
line.
• The estimation of β in the context of beta
estimation involves taking the stock returns
(Y) as the dependent variable and the
benchmark index returns (X) as the
independent variable.
• By fitting the linear regression model, we
can determine the value of β, which
quantifies the sensitivity of the stock returns
to the market returns.

Dept. of MBA, Sanjivani COE, Kopargaon

Estimating Beta using Linear Regression in CAPM
• Data Collection:
• Retrieve historical price data for the stock and a benchmark index (such as Nifty 50)
using the y finance library.
• Define the desired time period and adjust the data for accurate analysis.
• Calculating Returns:
• Calculate the daily returns for both the stock and the benchmark index. Returns measure
the percentage change in price from one day to another.
• Preparing the Data:
• Combine the stock returns and the benchmark index returns into a single data frame
using the pandas library.
• Align the returns based on their dates and handle any missing or NaN values
appropriately.
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• Performing Linear Regression:
• Utilize the stats models library to perform linear regression between the stock returns and the
benchmark index returns.
• Add a constant term to the independent variable and fit the regression model using Ordinary Least
Squares (OLS) methodology.
• Analyzing the Results:
• Extract the beta coefficient from the regression results. Beta represents the stock’s sensitivity to
market movements.
• Calculate the intercept, which denotes the expected excess return when the market return is zero.
• Checking Significance
• Assess the statistical significance of the beta coefficient using hypothesis testing.
• Calculate the standard error and t-value for the beta coefficient to determine its significance.

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 Importance of CAPM and Beta Calculations for Trading

• Portfolio Diversification: Beta aids in diversifying a portfolio by including stocks with different levels of market
sensitivity, thus reducing overall risk.
• Trading Decisions: Beta calculations influence trading decisions, as stocks with higher betas may offer greater profit
potential but also higher volatility. Traders can adjust their strategies based on the risk-return tradeoff.
• Risk Assessment: Beta provides insights into the risk associated with a stock relative to the overall market. It helps
investors understand how the stock’s price movements may behave in different market conditions.
• Portfolio Optimization: By considering stocks with different beta values, investors can construct a diversified
portfolio. Combining stocks with low, moderate, and high betas allows for a balance between risk and potential
returns.
• Volatility Forecasting: Beta serves as a proxy for volatility. High-beta stocks tend to exhibit more significant price
fluctuations, presenting opportunities for higher returns but also higher risk. Traders can adjust their strategies based
on their risk tolerance and the volatility expectations associated with different betas.
• Performance Comparison: Comparing the beta values of different stocks in the same industry or sector can help
identify outliers and gauge how well a stock performs relative to its peers. It allows traders to evaluate whether a
stock is more or less volatile than its counterparts.
• Risk-Adjusted Returns: Adjusting returns based on beta allows for a better understanding of a stock’s risk-adjusted
performance. By calculating the excess returns over the risk-free rate, traders can assess whether a stock has
generated returns that adequately compensate for the level of risk undertaken

Dept. of MBA, Sanjivani COE, Kopargaon

• The Capital Asset Pricing Model
(CAPM) is a widely used tool in
finance for estimating the expected
return on an asset.

Dept. of MBA, Sanjivani COE, Kopargaon

 Adjusted Beta:
• The CAPM assumes that beta, a measure of
systematic risk, accurately reflects the risk of an
asset.
• However, beta is often adjusted to account for factors
such as size, value, momentum, and liquidity.
• Critics argue that adjusting beta introduces
subjectivity and can lead to inconsistencies in risk
assessment.

Dept. of MBA, Sanjivani COE, Kopargaon

 Market Risk Premium Estimation:
• One of the fundamental components of the CAPM is the
market risk premium, which represents the excess return
investors expect from investing in the market portfolio
compared to a risk-free asset. Estimating the market risk
premium accurately is challenging and can lead to significant
variations in expected returns. Critics argue that historical
estimates may not be indicative of future expectations, and
different methodologies can yield different results.

Dept. of MBA, Sanjivani COE, Kopargaon

 Critiques of the CAPM.
• Assumptions:
• Market Portfolio:
• Risk-Free Rate:
• Beta as Sole Risk Measure:
• Empirical Evidence:
• Time-Varying Risk Premia:
• Arbitrage Pricing Theory (APT):

Dept. of MBA, Sanjivani COE, Kopargaon

 Critiques of the CAPM.
• Assumptions: CAPM relies on several assumptions that are often criticized for being
unrealistic. For instance, it assumes that investors have homogenous expectations, perfect
information, and frictionless markets. In reality, investors have diverse expectations,
information is not always perfect, and markets may not operate smoothly.
• Market Portfolio: CAPM assumes that investors can hold a well-diversified portfolio
consisting of all available assets in the market. However, constructing such a portfolio is
practically impossible, leading to challenges in applying CAPM in real-world situations.
• Risk-Free Rate: CAPM uses a risk-free rate as a benchmark, typically represented by
government bonds. Critics argue that the choice of the risk-free rate is arbitrary and may not
accurately reflect investors' actual opportunities for risk-free returns.
• Beta as Sole Risk Measure: CAPM relies heavily on beta as the sole measure of systematic
risk. Beta measures an asset's sensitivity to market movements but may not capture all
relevant sources of risk. Critics argue that other factors such as liquidity risk, credit risk, and
geopolitical risk are also important determinants of asset returns and should be considered.

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• Empirical Evidence: Empirical studies have shown mixed results regarding the ability of
CAPM to accurately predict asset returns. Some studies find that CAPM performs poorly in
explaining asset returns, especially during periods of market turmoil or financial crises.
• Market Efficiency: CAPM assumes that markets are efficient, meaning that asset prices fully
reflect all available information. However, critics argue that markets may not always be
efficient, leading to mispricing of assets and undermining the validity of CAPM.
• Time-Varying Risk Premia: CAPM assumes that risk premia remain constant over time.
However, empirical evidence suggests that risk premia may vary over different market
conditions and economic cycles, challenging the static nature of CAPM.
• Arbitrage Pricing Theory (APT): APT, an alternative asset pricing model, addresses some
of the limitations of CAPM by allowing for multiple factors to determine asset returns. Critics
argue that APT provides a more flexible framework that can better capture the complexities of
real-world markets compared to CAPM.

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Thank You

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