CAPM

Made by Bhoomesh Chandola

 INTRODUCTION
• The Capital Asset Pricing Model (CAPM) describes the relationship between systematic
risk and expected return for assets, particularly stocks.
• CAPM is widely used throughout finance for pricing risky securities and generating
expected returns for assets given the risk of those assets and cost of capital.
• The model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan
Mossin independently, building on the earlier work of Harry Markowitz on
diversification and modern portfolio theory
 ASSUMPTIONS
• Aim to maximize economic utilities.
• Are rational and risk-averse.
• Are broadly diversified across a range of investments.
• Are price takers, i.e., they cannot influence prices.
• Can lend and borrow unlimited amounts under the risk free rate of interest.
• Trade without transaction or taxation costs.
• Deal with securities that are all highly divisible into small parcels.
• Assume all information is available at the same time to all investors.
• Further, the model assumes that standard deviation of past returns is a perfect proxy for
the future risk associated with a given security.
 CAPM’S FORMULA
• ERi​=Rf​+βi(ERm​−Rf​)
• where:
E Ri​=expected return of investment
Rf​=risk free rate
β​=beta of the investment
(E Rm​−Rf​)=market risk premium​
 BETA
• A measure of the volatility, or systematic risk, of a security or a portfolio
in comparison to the market as a whole.
• Beta is used in the capital asset pricing model (CAPM), a model that
calculates the expected return of an asset based on its beta and expected
market returns. Also known as "beta coefficient."
 IMPLICATIONS AND RELEVANCE OF
CAPM
• Investors will always combine a risk free asset with a market portfolio of
risky assets. Investors will invest in risky assets in proportion to their
market value..
• Investors can expect returns from their investment according to the risk.
This implies a liner relationship between the asset’s expected return and
its beta.
• Investors will be compensated only for that risk which they cannot
diversify. This is the market related (systematic) risk.
 EXAMPLE
• an investor is contemplating a stock worth $100 per share today that pays
a 3% annual dividend. The stock has a beta compared to the market of 1.3.
Also, assume that the risk-free rate is 3% and this investor expects the
market to rise in value by 8% per year.
• The expected return of the stock based on the CAPM formula is 9.5%:
• ERi = 3% + 1.3 ( 8% - 3% )