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CAPITAL ASSET PRICING MODEL

INTRODUCTION
The Capital Asset Pricing Model (CAPM) is a model
developed in an attempt to explain variation in yield rates on
various types of investments

CAPM is based on the idea that investors demand additional
expected return (called the risk premium) if they are asked to
accept additional risk

The CAPM model says that this expected return that these
investors would demand is equal to the rate on a risk-free
security plus a risk premium
INTRODUCTION
The model was the work of financial economist (and, later,
Nobel laureate in economics) William Sharpe, set out in his
1970 book "Portfolio Theory And Capital Markets"

His model starts with the idea that individual investment
contains two types of risk:
Systematic Risk (or Market risk)
Unsystematic Risk (or Specific risk)

CAPM considers only systematic risk and assumes that
unsystematic risk can be eliminated by diversification
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
ASSUMPTIONS
The Capital Asset Pricing Model is valid within a special set
of assumptions:-

Markets are in equilibrium./There are no market
imperfections(perfect Market)
There are many investors who behave competitively (price
takers).
Information is available to all such as covariance , variances,
mean rates of return of stocks
All investors have equal access to all securities
There are no taxes or transaction costs.
No commissions.
Continue.
All investors have identical opinions about expected returns,
volatilities and correlations of available investments.
Risk-averse rational investor.
Investors have homogenous expectations (beliefs) about asset
returns
There exists a risk free asset and investors may borrow or
lend unlimited amounts of this asset at a constant rate: the risk
free rate.Unlimited borrowing and lending are available at the
risk-free rate.


There is a definite number of assets and their quantities are
fixed within the one period world
All assets are perfectly divisible and priced in a perfectly
competitive marked
All investors are looking ahead over the same (one period)
planning horizon.


Formula
When an investor holds the market portfolio, each individual
asset in that portfolio entails specific risk, but through
diversification, the investor's net exposure is just the
systematic risk of the market portfolio.

Systematic risk can be measured using beta

According to CAPM, the expected return of a stock equals the
risk-free rate plus the portfolio's beta multiplied by the
expected excess return of the market portfolio.

CAPM
Formulation of CAPM is given by:


where: r
k
- yield rate on a specific security k
r
f
- risk-free rate of interest
r
p
- yield rate on the market portfolio
b
k
- a measure of systematic risk for security k


Q- if the risk-free rate is 3%, the beta (risk measure) of the stock
is 2 and the expected market return over the period is
10%,than calculate Expected rate of return.
Ans. The stock is expected to return E(R)
(3%+2(10%-3%)) =17%




For example
Q- suppose a stock has a beta of 0.8. The market has an
expected annual return of 0.12 (that is 12%) and the risk-
free rate is .02 (2%). Then the stock has an expected one-
year return of
Ans. E(rk) = .02 +.8[.12 .02] = 0.10

CAPITAL ASSET PRICING MODEL
Three Linear Relationships
Capital Market Line: linear risk-return trade-off for all
investment portfolios
Security Market Line: linear risk-return trade-off for individual
stocks
Security Characteristic Line: linear relation between the return on
individual securities and the overall market at every point in time
CAPITAL ASSET PRICING MODEL
Three Linear Relationships
Capital Market Line: linear risk-return trade-off for all
investment portfolios
Standard Deviation (total portfolio risk)
E(R)
M
R
f
o = market o
EXPECTED RETURN & RISK
The Capital Market Line (CML)
Linear risk-return trade-off for all investment portfolios given
by
( )
( )
( )
( )
( )
( )
( )
| |
E R R
E R R
SD R
SD R
R
SD R
SD R
E R R
P F
M F
M
P
F
P
M
M F
= +

= +
Security Market Line (SML)
Security Market Line: linear risk-return trade-off for individual
stocks
Systematic Risk: return volatility tied to overall market; also
called non diversifiable risk
Unsystematic Risk: return volatility tied specifically to an
individual company; also called diversifiable risk
Beta: sensitivity of a securitys returns to the systematic market
risk factor
CAPITAL ASSET PRICING MODEL
Three Linear Relationships
Security Market Line: linear risk-return trade-off for all
individual stocks -
Systematic Risk
E(R)
M
R
f
| = 1
The BETA Factor
Figure 13.5
The Security Characteristic Line
Linear relation between the return on individual securities and
the overall market at every point in time, given by:
Positive Abnormal Returns: above-average returns that cant
be explained as compensation for added risk
Negative Abnormal Returns: below-average returns that
cannot be explained by below-market risk
R R
it i i Mt i
= + + e o |
Security characteristic line (SCL) indicates the performance of a
particular security or portfolio against that of the market portfolio at
every point in time. The SCL is plotted on a graph where the Y-axis is
the excess return on a security over the risk-free return and the X-axis
is the excess return of the market in general. The slope of the SCL is
the security's beta, and the intercept is its alpha.
Empirical Implications of CAPM
Optimal portfolio choice depends on market risk-return trade-offs
and individual investors differences in risk preferences.
Relation between expected return and risk is linear for all
portfolios and individual assets.
Expected rate of return is risk-free rate plus relative risk (
p
)
times market risk premium.
High beta portfolios earn high risk premiums.
Low beta portfolios earn low risk premiums.
Stock price | measures relevant risk for all securities.
Application of CAPM
CAPM can test Efficient Market Hypothesis
To estimate the three key elements needed to apply the
CAPM: for the risk-free rate, an estimate of beta, and an
market risk premium.
For valuation of risky assets
For estimating required rate of return of risky projects.
To estimate the required premium to compensate for
Systematic risk.
To predict future required rate of return in perfect market
conditions.
Arbitrage Pricing Theory (APT)
Multifactor asset-pricing model that allows market s to
represent only one of the firms many risk factors.
Arbitrage: simultaneous buying and selling of the same asset at
different maturities
APT suggests that asset returns might be affected by N risk
factors.
APT vs. CPM
Volatile returns attributable to six-factor APT models are very
unstableexplain very little of variation in average returns.
Though both CAPM and APT theory and evidence confirm
relationship between risk and return, neither approach gives
precise estimates.
Neither provides foolproof test of EMF.
Sources
The Theory of Interest. Kellison, Stephen G.
CAPM Assumptions and Limitations: CAPM Where Market Theories
Converge and Clash. Ivkovic, Inya.
http://investment.suite101.com/article.cfm/capm_assumptions_and_lim
itations
Understanding the concept of CAPM. Ivkovic, Inya.
http://investment.suite101.com/article.cfm/understanding_the_concept
_of_capm
The Capital Asset Pricing Model. Mathiesen, H.
http://www.encycogov.com/A2MonitorSystems/AppA2MonitorSystem
s/AppBtoA2CAP_model/CAP_Model.asp