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Mazhar Hussain Consultant/ Assistant Professor FMS, IIU-Business School November 29, 2008

**Capital Market Theory: An Overview
**

Returns: Dividend and Capital Gain

**Purchased 100 shares of Tele Computers Public Limited Company at a price of Rs.37 per share
**

Total Investment = Rs.37 * 100=Rs.3700

**Suppose Company paid dividend of Rs.1.85 per share
**

Div = Rs.1.85 * 100= Rs.185

**After one week later, if the market price of the share is Rs.40 per share
**

Capital Gain = (Rs.40 – Rs.37) * 100 = Rs.300 Capital Loss = (Rs.35 – Rs.37) * 100 = - Rs.200

**Capital Market Theory: An Overview
**

Returns: Dividend and Capital Gain

Total Rupee Return = Dividend income + Capital Gain (or loss) Total Rupee Return = Rs.185 + Rs.300 = Rs.485 Total Cash if shares are sold = Initial Investment + Total Rupee Return = Rs.3700 + Rs.485 = Rs.4185 = Proceeds from Share sale + Dividends =Rs.40 * 100 + Rs.185 =Rs.4000 + Rs.185 = Rs.4185

**Capital Market Theory: An Overview
**

Returns: Dividend and Capital Gain Dividend Yield = Divt+1 / Pt = Rs.1.85/Rs.37 =5%

Capital Gain = (Pt+1 – Pt) / Pt =(Rs.40 – Rs.37)/Rs.37 = Rs.3/Rs.37 = 8.10 % Total Return on Investment= Rt+1

Rt+1= Divt+1 / Pt + (Pt+1 – Pt) / Pt

= 5% + 8.10% = 13.10%

**Capital Market Theory: An Overview
**

Holding- Period Returns (HPR)

(1+ R1) * (1+ R2) *…*(1+Rt)*…* (1+RT) If the returns were 11%, -5% and 9% in a three years period (1+ R1) * (1+ R2)*(1+ R3)= (Rs.1+0.11) * (Rs.1- 0.05) * (Rs.1+ 0.09) = Rs.1.11* Rs.0.95 * Rs.1.09 = Rs.1.15 Therefore the Total Return at the end of three years = 15%

**Capital Market Theory: An Overview
**

Return Statistics

Mean = R = (R1 +…..+RT)/ T If the returns on common stock from 2000 to 2003 are 0.1370, 0.3580, 0.4514 and – 0.0888 respectively, than return over these four years is R = 0.1370 + 0.3580+ 0.4514 – 0.0888/4= 0.2144

**Capital Market Theory: An Overview
**

Average Stock Returns and Risk-Free

Returns

Excess Return on the Risky Asset =Risk Premium = Risky Returns – Risk-Free Returns If

Average Risky Return = 13.3% and Average Risk-Free Return = 3.8% than Average Excess Return= (13.3% - 3.8%) = 9.5%

**Capital Market Theory: An Overview
**

Risk Statistics: How the risk can be measured

Variance:

**is a measure of the squared deviations of a security’s return from its expected return Var = 1/T-1 { (R1 – R)2 + (R2 – R)2 + (R3 – R)2 + (R4 –
**

R)2}

Standard Deviation:

the square root of the variance SD = σ = √ Var

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

Expected Return, Variance and Covariance

Expected Return : the average return per period a security has earned in the past Covariance: is a statistic measuring the interrelationship between two securities Correlation: the alternative approach, to determine the correlation between the two securities

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

Expected Return: RA = 17.5% and RB = 5.5% Recession Normal Boom 10% 20% 30% -12% 50% 9% States of Economy Depression RAT RBT

-20% 5%

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

State of Eco. Rate of Return RAT Depression Recession Normal Boom Total -0.20 0.10 0.30 0.50 Deviation from Squared Expected Return Value of Deviation (RAT - RA) (RAT - RA)2 (-0.20 – 0.175)= -0.375 -0.075 0.125 0.325 (-0.375)2= 0.140625 0.005625 0.015625 0.105625 0.267500

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

State of Eco. Rate of Return RBT 0.05 0.20 -0.12 0.09 Deviation from Squared Expected Return Value of Deviation (RBT - RB) (RBT - RB)2 (0.05 – 0.055)= (-0.005)2= -0.005 0.000025 0.145 0.021025 -0.175 0.030625 0.035 0.001225 0.052900

Depression Recession Normal Boom Total

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

Var (R )= 0.2675/4 = 0.066875

A

** SD (R )= √ 0.066875 = 0.2586= 25.86%
**

A

** Var (R )= 0.0529/4 = 0.013225
**

B

** SD (R )= √ 0.013225 = 0.1150 = 11.50%
**

B

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

State of Eco. Rate of Return Deviation from Expected Return (RAT - RA) -0.375 -0.075 0.125 0.325 Rate Deviation of from Return Expected Return RBT 0.05 0.20 -0.12 0.09 (RBT - RB) -0.005 0.145 -0.175 0.035 Product of Deviation

RAT Depression Recession Normal Boom -0.20 0.10 0.30 0.50

(RAT - RA) * (RBT - RB) 0.001875 -0.010875 -0.021875 0.011375

Total

- 0.0195

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

Covariance

σ = Cov (R , R )= (R

AB A B AB A B

AT

- R ) *(R

A

BT

-R)

B

**σ = Cov (R , R )= - 0.0195 = - 0.004875 Interpretation of Results
**

Positive relationship Negative relationship No relation = Zero Covariance

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

Correlation ρ = Corr (R ,R ) = Cov (R , R )/ σ * σ = - 0.004875/ 0.2586 * 0.1150 = - 0.1639

AB A B A B A B

Interpretation of Results

Positively Correlated,+1= Perfect Positive Correlation Negatively Correlated,-1= Perfect Negatively Correlation Uncorrelated, 0 = No correlation

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

Total Risk of Individual Security Total Risk of Individual Security (Var)= Portfolio Risk (Cov) or Systematic Risk + Unsystematic or Diversifiable Risk (Var – Cov)

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

Definition of Risk When Investor Hold the

Market Portfolio

Researchers argue that the best measure of the risk of a security in large portfolio is the Beta of the security Beta measures the responsiveness of a security to the movement in the market portfolio. β = Cov (R ,R ) / Var (R )

i i M M

**Risk and Return :Capital Asset Pricing Model (CAPM)
**

Sate Type of Eco. Bull Bull Bear Bear Return on Market % 15 15 -5 -5 Return on Jelco, Inc. % 25 15 -5 -15 Bear -5% Type of Eco. Return on Market % 15% Return on Jelco, Inc. % 20% = 25%½+ 15%½ -10% = -5%½ + (-15%½)

I II II IV

Bull

**The Capital Asset Pricing Model: The Relationship b/w Risk and Expected Return (CAPM)
**

Expected Return on Market RM = RF + Risk Premium Expected Return on Individual Security CAPM : R = RF + β * ( RM – RF ) R = Expected return on a security RF = Risk- free rate β = Beta of the Security ( RM – RF ) = Difference b/w expected return on market and risk-free rate

**The Capital Asset Pricing Model: The Relationship b/w Risk and Expected Return (CAPM)
**

Expected Return on Individual Security

CAPM :

R=R +β*(R –R )

F M F

If β = 0 , R = R If β = 1 , R = R

F

M

**In Diagram Form:
**

SECURITIES MARKET LINE

E ( Rm )

Rf

1

βi

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