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

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

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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

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