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CAPM & Beta

Presented by Anita Singhal 1


Modern Portfolio Theory - MPT
A theory on how risk-averse investors can construct
portfolios to optimize or maximize expected return based on
a given level of market risk, emphasizing that risk is an
inherent part of higher reward.
Also called "portfolio theory" or "portfolio management
theory.
According to this theory, it's possible to construct an
"efficient frontier" of optimal portfolios offering the maximum
possible expected return for a given level of risk.
This theory was pioneered by Harry Markowitz in his paper
"Portfolio Selection," published in 1952 by the Journal of
Finance.
There are four basic steps involved in portfolio construction:
-Security valuation
-Asset allocation
-Portfolio optimization
-Performance measurement
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Efficient Frontier
A line created from the risk-reward graph, comprised of
optimal portfolios.

The optimal portfolios plotted along the curve have the


highest expected return possible for the given amount of risk.
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Capital Asset Pricing Model
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 - These are market risks that cannot be
diversified away. Interest rates, recessions and wars are
examples of systematic risks.
Unsystematic Risk - Also known as "specific risk,"
this risk is specific to individual stocks and can be
diversified away as the investor increases the number of
stocks in his or her portfolio. In more technical terms, it
represents the component of a stock's return that is
not correlated with general market moves.

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Capital Asset Pricing Model
Also called CAPM
an economic model for valuing stocks,
securities, derivatives and/or assets by
relating risk and expected return.
CAPM is based on the idea that investors
demand additional expected return (called
the risk premium) if they are asked to
accept additional risk.
This model was originally developed in
1952 by Harry Markowitz and fine-tuned
over a decade later by others, including
William Sharpe.
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CAPM
Security’s return expected to be commensurate
with its systematic risk (which cannot be avoided
by diversification)
The level of systematic risk that an individual
security possesses depends on how correlated it
is with the overall market. This is denoted by ‘beta’
Relationship between expected return and
systematic risk is essence of CAPM
Consider 2 types of investment opportunities
Risk free security – short term Treasury securities
Market portfolio of common stocks – generally a broad
based market index like the Nifty 50.

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Formula
The formula for the beta of an asset is
β = Cov (ra, rp)
var rp
where ra measures the rate of
return of the asset, rp measures the
rate of return of the market portfolio,
and cov(ra,rp) is
the covariance between the rates of
return.
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Covariance

Formula for covariance

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Illustration for beta calculation
PERIOD RETURN RETURN ON

ON STOCK A (%) MKT PORTFOLIO %

1 10 12

2 15 14

3 18 13

4 14 10

5 16 9

6 16 13

7 18 14

8 4 7

9 -9 1

10 14 12

11 15 -11

12 14 16

13 6 8

14 7 7

15 -8 10

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COVARIANCE

PERIOD RETURN DEVIATION RETURN ON DEVIATION PRODUCT OF


ON STOCK A (%) FROM MEAN MKT PORTFOLIO % FROM MEAN DEVIATIONS
1 10 0 12 3 0
2 15 5 14 5 25
3 18 8 13 4 32
4 14 4 10 1 4
5 16 6 9 0 0
6 16 6 13 4 24
7 18 8 14 5 40
8 4 -6 7 -2 12
9 -9 -19 1 -8 152
10 14 4 12 3 12
11 15 5 -11 -20 -100
12 14 4 16 7 28
13 6 -4 8 -1 4
14 7 -3 7 -2 6
15 -8 -18 10 1 -18

TOTAL 150 135 221

R'A 10 R'P 9

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COVARIANCE 221/14 15.79


VARIANCE OF MARKET PORTFOLIO

PERIOD RETURN ON DEVIATION SQUARE OF


MKT PORTFOLIO % FROM MEAN DEVIATIONS
1 12 3 9
2 14 5 25
3 13 4 16
4 10 1 1
5 9 0 0
6 13 4 16
7 14 5 25
8 7 -2 4
9 1 -8 64
10 12 3 9
11 -11 -20 400
12 16 7 49
13 8 -1 1
14 7 -2 4
15 10 1 1

TOTAL 135 624

R'P 9
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VARIANCE 624/14 44.57


Beta of stock A

Covariance (a)(p)/variance (p)


15.79/44.57
Beta for stock A = 0.354

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Problem 1
PERIOD RETURN RETURN ON
ON STOCK A (%) MKT PORTFOLIO %
1 -6 12
2 11 14
3 12 13
4 2 10
5 1 9
6 11 13
7 8 14
8 9 7
9 5 1
10 5 12
11 4 -11
12 9 16
13 3 8
14 2 7
15 -2 10

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Some more definitions of beta
Beta is the tendency of a security's returns to respond to
swings in the market.
A beta of 1 indicates that the security's price will move with
the market.
A beta of less than 1 means that the security will be less
volatile than the market.
A beta of greater than 1 indicates that the security's price will
be more volatile than the market. For example, if a stock's
beta is 1.2, it's theoretically 20% more volatile than the
market.
Many traditional Company stocks have a beta of less than 1.
Conversely, most high-tech stocks have a beta of greater
than 1, offering the possibility of a higher rate of return,
but also posing more risk.

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Beta
the Beta (β) of a stock or portfolio is a number
describing the relation of its returns with those of
the financial market as a whole
An asset has a Beta of zero if its returns change
independently of changes in the market's returns.
A positive beta means that the asset's returns
generally follow the market's returns,
A negative beta means that the asset's returns
generally move opposite the market's returns

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CAPM
Relationship between risk and expected return that is used in
the pricing of risky securities.

Using the CAPM model, we can compute the expected


return of a stock in this CAPM example: 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%, the stock is
expected to return 17% (3%+2(10%-3%)).

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CAPM
The general idea behind CAPM is that investors need to be
compensated in two ways: time value of money and risk.
The other half of the formula represents risk and calculates
the amount of compensation the investor needs for taking
on additional risk.
This is calculated by taking a risk measure (beta) that
compares the returns of the asset to the market over a
period of time and to the market premium (Rm-rf).
the expected return of a security or a portfolio equals the rate
on a risk-free security plus a risk premium. If this expected
return does not meet or beat the required return, then the
investment should not be undertaken.

Presented by Anita Singhal 17

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