CAPITAL ASSET PRICING

MODEL

By Dr. Ibha Rani

Kristu Jayanti College
( Autonomous)
 INTRODUCTION
Derived using principles of diversification with
simplified assumptions

William Sharpe, John Lintner and Jan Mossin are

researchers credited with its development
 Assumptions
a. Investors are risk averse.
b. Investors can’t affect prices by their individual trades.
c. Investors seek to maximize the expected utility of
portfolio over a single period planning horizon.
d. Investors have homogeneous expectations _identical
estimates of return and risk.
e. Investors have access to unlimited riskless lending
and borrowing.
f. Market is perfect: no tax, no transaction cost,
securities are divisible, market is competitive.
 Risky asset V/s Risk Free Asset

a. Risky Assets – future returns are uncertain.

b. Risk Free Asset – asset with zero variance in

return

Investors will hold combination of risky

portfolio and riskless asset.
 Implications for Portfolio Formation

a. When an investor is assumed to use riskless lending

and borrowing in his investment activity the shape of
efficient frontier transform to a straight line.[CML]
b. CML dominates all efficient portfolios along the
efficient frontier.
c. All efficient portfolios of all investors will lie along the
CML.
d. All investors will choose to hold the market portfolio.
 Market Portfolio

Portfolio that includes all risky assets is referred to

as market portfolio.

Market portfolio is a complete diversified portfolio

with no unsystematic risk.

All assets are included in this portfolio in proportion

to their market value.
 Capital Market Line

The line framed by the action of investors mixing

the market portfolio with riskless asset is called
CML

CML provides a risk return relationship and a

measure of risk for efficient portfolios.
 Capital Market Line

E(Rp) Capital Market Line

B
Q
E(RM)
M

Rf

σp
σM
 BETA

Beta is a measure of security’s sensitivity to changes

in market return.

The degree to which different portfolios are affected

by these systematic risks as compared to the effect
on the market as a whole, is different and is
measured by Beta.
 SECURITY MARKET LINE

For a well diversified portfolio, unsystematic risk tends to

become zero and the only relevant risk is systematic risk
measured by beta.

Beta is measure of securities sensitivity to changes in

market return.

SML provides the relationship between the expected

return and beta of a security.
 SECURITY MARKET LINE

E(Ri)
Security
Market
Line

E(RM) M

Rf

bM
 Beta Interpretation

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.
PRICING OF SECURITIES WITH CAPM
 CAPM

The relationship between risk and return established by the security

market line is known as Capital asset pricing model. Its basically a
simple linear relationship. (higher the value of beta higher would be
the risk of the security and therefore larger would be return expected)

CAPM serves as a model for the pricing of risky securities.

The CAPM asserts that the only risk that is priced by rational
investors is systematic risk, because that risk cannot be eliminated .

CAPM says that the expected return of a security or a portfolio is

equal to the rate on a risk-free security plus a risk premium multiplied
by the asset's systematic risk.
 CML V/S SML

CAPITAL MARKET LINE SECURITY MARKET LINE

Risk is defined as total risk and Risk is defined as systematic risk and
measured by SD measured by Beta

Valid only for efficient portfolios. Valid for all portfolios and individual
securities as well