CAPM

AMBUJA RAJ GUPTA SAURABH PRIYADARSHI SHYAM SINGH SIDDHARTH NIRMAL

Capital Asset Pricing Model (CAPM)

Method for predicting how investment returns are determined in an efficient capital market

What Does Capital Asset Pricing Model CAPM Mean?

A model that describe the relationship between risk and expected return and that is used in the pricing of risky securities.

Critical assumptions of CAPM

Assumptions Cont .

Available riskfree assets

Borrowing at risk-free rates

Beta as full measure of risk

Lending & Borrowing Under the CAPM

Assumption of unlimited lending and borrowing at risk-free rate. Lending if portion of portfolio held in risk-free assets. Borrowing (leverage) if more than 100% of portfolio is invested in risky assets. Superior returns made possible with lending and borrowing; creates spectrum of risk preference for different investors.

Lending Portfolios
Lending Portfolios ER

T A

RF

Portfolios between RF and T are lending portfolios, because they are achieved by investing in the Tangent Portfolio and lending funds to the government (purchasing a Tbill, the RF).
Risk

Borrowing Portfolios
Lending Portfolios ER Borrowing Portfolios

T A

RF

The line can be extended to risk levels beyond T by borrowing at RF and investing it in T. This is a levered investment that increases both risk and expected return of the portfolio.

Risk

FORMULA with ABBREVIATION

Rp =Rf Xf + Rm(1-Xf) Rp = portfolio return Xf = portion of funds invested in risk free assets 1-xf = portion invested in risky assets. Rf = risk free rate of return Rm = return on risky assets

Question
Assume that borrowing and lending rate to be 12.5%. Return from risky asset to be 20%

Invest 50 % in risk free and 50% in risky assets

Rp =Rf Xf + Rm(1-Xf) =12.5 . 0.5 + 20(1 - 0.5) =6.25 + 10 =16.25%

0 in risk free asset 100% in risky asset

The return isRp =Rf Xf + Rm(1-Xf) = 0+20% = 20%

PORTFOLIO RETURN Rp

RISK FREE RETURN Rf

RISK PREMIUM PORTFOLIO RISK Rp-Rf STD DEVp

FACTOR PROPORTIONA LITY (Rp-Rf)/STD DEV p

16.25

12.5

3.75

7.5

0.5

20.0

12.5

7.5

15.0

0.5

23.75

12.5

11.25

22.5

0.5

CAPITAL ASSET PRICING MODEL

Three Linear Relationships

MARKOWITZ EFFICIENT FRONTIER

PORTFOLIO EXPECTED RETURN (R) % RISK

A B C D E F G H J

17 15 10 7 7 7 10 9 6

13 8 3 2 4 8 12 8 7.5

CAPITAL ASSET PRICING MODEL

Three Linear Relationships

Capital Market Line: linear risk-return trade-off for all investment portfolios
E(R) M Rf
W = market W

Standard Deviation (total portfolio risk)

(CML) EQUATION

E(Rp)=Rf +(Rm Rf / m) p E(Rp)=portfolio s expected rate of return Rm =expected return on market portfolio m=standard deviation of market portfolio p=standard deviation of the portfolio Rf =risk free rate of interest

CAPITAL ASSET PRICING MODEL

Three Linear Relationships

Security Market Line: linear risk-return trade-off for all individual stocks
E(R) M Rf
F=1

Systematic Risk

(SML) EQUATION
E(Rj )=Rf +[E(Rm )-Rf ]Bj E(Rj )=expected return on security j Rf =the risk free rate Rm =the expected return on the market portfolio Bj =undiversifiable risk of security j

PROBLEM (SML)
Calculate the expected rate of return for security I from the following information: The risk free rate is 10% ;the market return is 18% ;Bj=1.35

The BETA Factor

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

The Security Characteristic Line

Linear relation between the return on individual securities and the overall market at every point in time, given by:

Rit ! E i 
Z Z

RMt  i i

Positive Abnormal Returns: above-average returns that can t abovebe explained as compensation for added risk

Negative Abnormal Returns: below-average returns that Returns: belowcannot be explained by below-market risk below-

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 F measures relevant risk for all securities.

Limitations

the model can only give approximate predictions.

Capm has a number of unrealistic assumptions

Limitations Cont ..

Unrealistic Assumptions
Perfect capital market exists
Investors: same expectations of return and risk
unsystematic risk is not accounted for into capm

Lending and Borrowing can take place at risk free rates

Risk is measured on the basis of historic returns patterns

Arbitrage Pricing Theory (APT)

According to this theory an investor tries to find out the possibilities to increase returns from his portfolio without increasing funds in the portfolio. 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 CAPM