FINANCIAL ENGINEERING

VALUATION
CAPM : SML, CML
KRIPA SHANKER Ph D (Cornell)
FNAE, FIE(I), FITEE(I), LMISTE, LMIIIE, MORSI, MORSA, SMIIE

Visiting Faculty
Department of Mechanical Engineering
Indian Institute of Technology (BHU) Varanasi
Former Emeritus Fellow
Industrial and Management Engineering Department
Indian Institute of Technology Kanpur
Former Vice Chancellor, Uttar Pradesh Technical University Lucknow
Former Deputy Director, Indian Institute of Technology Kanpur
 Financial Engineering

VALUATION
CONCEPTS
Concepts
Valuation Concepts

• 4.1 Risk and Returns

Valuation

• 4.2 Portfolios – CAPM :SML

• 4.3 Portfolios – CAPM : SML, CML
• 4.4 Discounted Cash Flow Analysis
• 4.5 Valuation Models

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 Financial Engineering

Capital Asset Pricing Model

(CAPM)

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 Capital Asset Pricing Model (CAPM)
 CAPM is based upon the concept that a stock’s
required rate of return is equal to
• the risk-free rate of return
plus (+)
• a risk premium that reflects the riskiness
of the stock after diversification.
 Primary Conclusion: The relevant riskiness of
an individual stock is its contribution to the
riskiness of a well-diversified portfolio. And ,
the relevant risk of a stock is much smaller
than its stand-alone risk.
• All stocks are not equally risky and thus do not have the same effect on the portfolio’s
riskiness. How to measure the relevant risk of an individual stock ?
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 Financial Engineering

Risk : PORTFOLIO (A Group of Assets)

 Small Group of Assets with Diversifiable Risk
remaining: interested in portfolio standard deviation.
 correlation ( ρ or r) between asset returns which
affects portfolio standard deviation
Large Group : Well-Diversified Portfolio
 Large Portfolio (10-15 assets) eliminates
diversifiable risk for the most part.
 Interested in Market Risk which is the risk that
cannot be diversified away.
 The relevant risk measure is Beta which
measures the riskiness of an individual asset in
relation to the market portfolio.
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 Financial Engineering

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 Financial Engineering

 Diversifiable risk (also known as unsystematic risk) represents the portion

of an asset’s risk that is associated with random causes that can be
eliminated through diversification. It’s attributable to firm-specific events,
such as strikes, lawsuit, regulatory actions, and loss of a key
account. Unsystematic risk is due to factors specific to an industry or a
company like labor unions, product category, research and development,
pricing, marketing strategy etc.
 While the non-diversifiable risk (also known as systematic risk) is the
relevant portion of an asset’s risk attributable to market factors that affect
all firms such as war, inflation, international incidents, and political events.
It cannot be eliminated through diversification and the combination of a
security’s non-diversifiable risk and diversifiable risk is called total risk.
 In the other word Systematic risk is due to risk factors that affect the
entire market such as investment policy changes, foreign investment
policy, change in taxation clauses, shift in socio-economic parameters,
global security threats and measures etc. Systematic risk is beyond the
control of investors and cannot be mitigated to a large extent. In contrast
to this, the unsystematic risk can be mitigated through portfolio
diversification. It is a risk that can be avoided and the market does not
compensate for taking such risks.

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 Measuring Systematic Risk
 How do we measure systematic risk?
 We use the beta coefficient to measure
systematic risk.
 What does beta tell us?
 A beta of 1 implies the asset has the same
systematic risk as the overall market
 A beta < 1 implies the asset has less
systematic risk than the overall market
 A beta > 1 implies the asset has more
systematic risk than the overall market
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Kripa Shanker IIT(BHU)Varanasi 10
 Total vs Systematic Risk

 Consider the following information:

Standard Deviation Beta
 Security C 20% 1.25
 Security K 30% 0.95
 Which security has more total risk?
 Which security has more systematic risk?
 Which security should have the higher
expected return?
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 Beta (β)
 The tendency of a stock to move up and
down with the market is reflected in its
beta coefficient (β).
 Measures a stock’s market risk, and
shows a stock’s volatility relative to the
market.
 Indicates how risky a stock is if the stock
is held in a well-diversified portfolio.
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 Calculating Betas
 Run a regression of past returns of a
security against past returns on the
market.
 The slope of the regression line
(sometimes called the security’s
characteristic line) is defined as the beta
(β)coefficient for the security.

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Illustrating the Calculation of Beta

_
ki

20
. . Year kM ki
1 15% 18%
15
2 -5 -10
10 3 12 16
5
_
-5 0 5 10 15 20 kM

-5 Regression line:

. Kripa Shanker ^ ^
ki = -2.59 + 1.44 kM
-10
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 Comments on Beta
 If beta = 0,
the security is risk free
 If beta = 1.0,
the security is just as risky as the average (market)
stock.
 If beta > 1.0,
the security is riskier than average (market).
 If beta < 1.0,
the security is less risky than average (market).
 Most stocks have betas in the range of 0.5 to 1.5.
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 Can the Beta of a Security
be Negative?
 Yes, if the correlation between Stock i and
the market is negative (i.e., ρi,m < 0).
 If the correlation is negative, the
regression line would slope downward,
and the beta would be negative.
 However, a negative beta is highly
unlikely.

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 Beta Coefficients for
A, B, and C
_
ki B : β = 1.30
40

20

A:β=0
_
kM
-20 0 20 40

C : β = -0.87
Kripa Shanker

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 Comparing Expected Return and
Beta Coefficients

Security Expected Return Beta

B 17.4% 1.30
E(Market) 15.0 1.00
D 13.8 0.89
A 8.0 0.00
C 1.7 -0.87

 Riskier securities have higher returns, so the

rank order is OK.

Business of Betas : Merril Lynch, Value Line, …..…

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Summary on CAPM
1. A stock’s risk consists of two components : market risk and diversifiable risk.
2. Diversifiable risk can be eliminated by diversification - by holding large portfolios or by
purchasing shares in mutual fund.
3. Investors must be compensated for bearing risk – the greater the riskiness of a stock, the
higher its required return.
4. The market risk of a stock is measured by its beta coefficient, which is an index of the
stock’s relative volatility. Some benchmark betas :
beta = 0.5, stock is only half as volatile, or risky, as the average stock.
beta = 1.0, stock is just as risky as the average (market) stock.
beta = 2.0, stock is twice as risky as the average stock
5. Since a stock’s beta coefficient determines how the stock affects the riskiness of a
portfolio, beta is the most relevant measure of any stock’s risk.

PORTFOLIO BETA COEFFICIENTS :

a weighted average of the individual securities’ betas.
β p  w1β1  w 2 β 2  ......  w n β n
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 RELATIONSHIP BETWEEN
RISK AND RATES OF RETURN

PORTFOLIO BETA COEFFICIENTS

β p  w1β1  w 2 β 2  ......  w n β n

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 Calculating Required Rates of Return
Security Market Line (SML)
-
ki = expected rate of return on the ith stock
^
ki = required rate of return on the ith stock
(Note that if expected rate of return is less than required rate of return, you would not
purchase this stock, or you would sell if you owned it . If expected rate of return were greater
than required rate of return, you would want to buy the stock, because it looks like a bargain.
You would be indifferent if both are equal.)
kRF = risk free rate of return (generally measured by the return on long-term
Government bond)
kM = the market portfolio (required rate of return on a portfolio
consisting of all stocks) = required rate of return on an
average (beta = 1.0) stock.
RPM = (kM – kRF)
Risk Premium on the market, and also on an average stock
(beta =1). This isKripa
additional
Shanker return over the risk-free rate
required to compensate an investor for assuming an average
amount of risk. [Average risk means beta = 1.0].
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 What is the Market Risk Premium
(RPM) ?
RPM = (kM – kRF)
Risk Premium on the market, and also on an average (beta
=1) stock. This is additional return over the risk-free rate
required to compensate an investor for assuming an
average amount of risk. [Average risk means beta = 1.0].

 Additional return over the risk-free rate needed to compensate

investors for assuming an average amount of risk.
 Its size depends on the perceived risk of the stock market and
investors’ degree of risk aversion.
 Varies from year to year, but most estimates suggest that it
ranges between 4% and 8% per year.

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 Calculating Required Rates of Return
Security Market Line (SML)
 RPi = Risk Premium on ith stock
The stock’s risk premium is less than, equal to, or greater than the
premium on average stock RPM depending upon whether its beta is
les than, equal to, or greater than 1.0.
= (kM - kRF )betai = (RPM)betai
• Risk Premium for stock i = RPi = (RPM )βi
 In general, the required return for any investment can be expressed
as
Required return = Risk-fee return + Premium for risk
Here the risk-free return includes a premium for expected inflation, and we assume
the assets under consideration have similar maturities and liquidities.
 The required return for stock i is found using Security Market Line
equation SML: KripakShanker i = kRF + (kM – kRF) βi
 Assume kRF = 8% and kM = 15%.
 IIT(BHU)Varanasi
The market (or equity) risk premium is RPM = kM – kRF = 15% – 8% = 7%. 23
Calculating Required Rates of Return
SML: ki = kRF + (kM – kRF) βi

 kB = 8.0% + (15.0% - 8.0%)(1.30)

= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1% = 17.10%
 kE = 8.0% + (7.0%)(1.00) = 15.00%
 kD = 8.0% + (7.0%)(0.89) = 14.23%
 kA = 8.0% + (7.0%)(0.00) = 8.00%
 kC = 8.0% + (7.0%)(-0.87)= 1.91%
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Expected vs. Required Returns

^ -
k k ^ -
B 17.4% 17.1% Undervalued ( k  k )
^ -
E(Market) 15.0 15.0 Fairly valued ( k  k )
^ -
D 13.8 14.2 Overvalued ( k  k )
^ -
A 8.0 8.0 Fairly valued ( k  k )
^ -
C 1.7 1.9 Overvalued ( k  k )
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Illustrating the Security Market Line
SML: Required rate of return for stock i
ki = kRF + (kM – kRF) βi
SML: ki = 8% + (15% – 8%) βi
ki (%)
SML

B
.
..
Relatively Risky Stock’s
Risk Premium
kM = 15 Market (Average Stock)
Risk Premium

kRF = 8 . A D
E Safe Stock’s
Risk Premium

.
Risk-Free
Rate
Kripa Shanker Risk, βi
C -1 0 0.5 1 1.5 2
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 An Example
Equally-weighted two-stock portfolio
 Create a portfolio with 50% invested in B
and 50% invested in C.
 The beta of a portfolio is the weighted
average of each of the stock’s betas.

βP = wBβB + wCβC
βP = 0.5 (1.30) + 0.5 (-0.87)
βP = 0.215Kripa Shanker
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Calculating Portfolio Required Returns
 The required return of a portfolio is the weighted
average of each of the stock’s required returns.
k P = wB k B + wC k C
kP = 0.5 (17.1%) + 0.5 (1.9%)
kP = 9.5%

 Or, using the portfolio’s beta, CAPM can be used to

solve for expected return.
kP = kRF + (kM – kRF) βP
kP = 8.0% + (15.0% – 8.0%) (0.215)
Kripa Shanker
kP = 9.5%
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}
Factors that change the SML
INFLATION

 What if investors raise inflation expectations

by 3%, what would happen to the SML?
ki (%)
D IP = 3% SML2
SML1
18
15

11
8
}
} Kripa Shanker Risk, βi

0 0.5 1.0 1.5

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 Factors that change the SML
RISK AVERSION
 What if investors’ risk aversion increased,
causing the market risk premium to increase
by 3%, what would happen to the SML?

ki (%)
D RPM = 3% SML2
SML1
18
15

11
8
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Risk, βi

0 0.5 1.0 1.5

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 Verifying the CAPM Empirically
 The CAPM has not been verified
completely.
 Statistical tests have problems that make
verification almost impossible.
 Some argue that there are additional risk
factors, other than the market risk
premium, that must be considered.
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 More thoughts on the CAPM
 Investors seem to be concerned with both
market risk and total risk. Therefore, the SML
may not produce a correct estimate of ki.
ki = kRF + (kM – kRF) βi + ???
 CAPM/SML concepts are based upon
expectations, but betas are calculated using
historical data. A company’s historical data may
not reflect investors’ expectations about future
riskiness. Kripa Shanker

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 Beta (b)
 variation in asset/portfolio return
relative to return of market portfolio
 mkt. portfolio = mkt. index

% change in asset return

b=
% change
Kripa Shanker
in market return
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 CAPITAL ASSET PRICING MODEL (CAPM)
Required return = Risk-fee return + Premium for risk
Here the risk-free return includes a premium for expected inflation,
and we assume the assets under consideration have similar maturities
and liquidities.
 The required return for stock i is found using Security
Market Line equation SML:
ki = kRF + βi (kM – kRF)

E( R )  R f  [ E( R m )  R f ]
or

E( R )  R f  [ E( R m )  R f ]
where

E( R )  R f is the portfolio risk premium

Kripa Shanker

E( R m )  R f is the market risk premium

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 E( R )  R f  [ E( R m )  R f ]
So if b >1
E( R )  R f > E( R m )  R f
E( R ) > E ( R m )
 Portfolio expected return is larger than
the expected market return.
 Riskier portfolio has larger expected
return
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 E( R )  R f  [ E( R m )  R f ]
So if b <1
E( R )  R f < E( R m )  R f
E( R ) < E ( R m )
 Portfolio expected return is smaller than
the expected market return.
 Less risky portfolio has smaller expected
return
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 E( R )  R f  [ E( R m )  R f ]
So if b =1
E( R )  R f = E( R m )  R f
E( R ) = E ( R m )
 Portfolio expected return is the same as
the expected market return.
 Equal risk portfolio means equal
expected return
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 E( R )  R f  [ E( R m )  R f ]
So if b = 0
E( R )  R f = 0
E( R ) = R f

 Portfolio expected return is equal to risk

free return.

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 The

CAPITAL ASSET PRICING MODEL

(CAPM)
The CAPITAL ASSET PRICING MODEL (CAPM) [1964, Sharpe, Linter]
specifies the relationship between risk and the required of return on assets
(and thus quantifies the risk/return tradeoff) when they are held in well
diversified portfolios.

Outcome/Implication : Security Market Line (SML)

Expected Return is a function of
Risk free Return
Market return
Beta

Required return = Risk-fee return + Premium for risk

Here the risk-free return includes a premium for expected inflation. Also, we assume the assets
under consideration have similar maturities and liquidities.

 The required return for stock i is found using Security Market Line
equation SML: ki = kRF + (kM – kRF) βi

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