Unit II

Capital Asset Pricing Model

 Capital Asset Pricing Model
(CAPM)
• The capital asset pricing model (CAPM) is a model
that provides a framework to determine the required
rate of return on an asset and indicates the
relationship between return and risk of the asset.
• Developed in the early 1960s by William Sharpe,
Jack Treynor, John Lintner and Jan Mossin, the
model provided the first coherent framework for
relating the required return on an investment to the
risk of that investment.
 Assumptions of CAPM
• There are many investors
• They behave competitively
• All investors are looking ahead over the same (one period)
planning horizon
• All investors have equal access to all securities
• No taxes
• No commissions
• Each investor cares only about Er (return) and σ (risk)
• All investors have the same beliefs about the investment
opportunities: for the n risky assets.
• Investors can borrow and lend at the one risk-free rate.
• Investors can short any asset, and hold any fraction of an asset.
 RISK
Total Risk = Systematic + Unsystematic Risk
Systematic Risk is also called Nondiversifiable
Risk or Market Risk
Unsystematic Risk is also called Diversifiable
Risk or Unique Risk
 Diversification
Can eliminate some risk
Unsystematic risk tends to disappear in a
large portfolio
Systematic risk never disappears
 Beta
Beta = How much systematic risk a
particular asset has relative to an average
asset
For example:
A: 0.65
B: 1.22
C: 3.56
Portfolio X: 1.54
 Capital Asset Pricing Model

Er = Rf + B{E(Rm)-Rf}
Works for both individual assets
and portfolios
McIntire Investment Institute
Example:
If Rf = 5.5%
Market Risk Premium = 7%
Then the Portfolio X should return:
Er = 5.5% + 1.54(12.5%-5.5%)
Er = 16.28%
 Expected Return depends on
3 things
The time value of money (risk-free rate, R f)
The reward for bearing systematic risk
(market risk premium={E(Rm) - Rf}
The amount of systematic risk (Beta)
 Implications of CAPM
• Investors will always combine a risk-free asset with a
market portfolio of risky assets. They will invest in risky
assets in proportion to their market value.
• Investors will be compensated only for that risk which
they cannot diversify. This is the market-related
(systematic) risk.
• Beta, which is a ratio of the covariance between the asset
returns and the market returns divided by the market
variance, is the most appropriate measure of an asset’s
risk.
• Investors can expect returns from their investment
according to the risk. This implies a linear relationship
between the asset’s expected return and its beta
 Limitations of CAPM
• It is based on unrealistic assumptions.
• It is difficult to test the validity of CAPM.
• Betas do not remain stable over time.