Capital Asset Pricing Capital Asset Pricing

Model (CAPM) Model (CAPM)

2
Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM)
O The capital asset pricing model (CAPM) is a
model that provides a Iramework to determine the
required rate oI return on an asset and indicates
the relationship between return and risk oI the
asset.
CAPM is based on the following
assumptions:
All investors have identical expectations about expected
returns, standard deviations, and correlation coeIIicients
Ior all securities.
All investors have the same one-period investment time
horizon.
All investors can borrow or lend money at the risk-Iree
rate oI return (RF).
There are no transaction costs.
There are no personal income taxes so that investors are
indiIIerent between capital gains an dividends.
Capital markets are in equilibrium.
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Characteristics Line: Market Return vs. Characteristics Line: Market Return vs.
Securities Securities Return Return
O e plot the combinations oI
Iour possible returns oI
securities and market. They
are shown as Iour points. The
combinations oI the expected
returns points (22.5, 27.5
and 12.5, 17) are also
shown in the Iigure. e join
these two points to Iorm a line.
This line is called the
characteristics line. The slope
oI the characteristics line is the
sensitivity coeIIicient, is
reIerred to as beta.
-30.0
-25.0
-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
-20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0
Market
Return
Alpha's
Return
*
*
5
Financial Management, Ninth
Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Security Market Line (SML) Security Market Line (SML)
O For a given amount of systematic risk (., SML
shows the required rate of return.
. =
(covar
j,m
/9
2
m

SLM
E(R
j

R
m
R
f
1.0 0
%he CAPM and Market Risk %he CAPM and Market Risk
Number of Securities
Total Risk (o
&nique (Non-systematic Risk
Market (Systematic Risk
Market or
systematic
risk is risk
that cannot
be
eliminated
from the
portfolio by
investing
the
portfolio
into more
and
different
securities.
%he Beta Coefficient %he Beta Coefficient
O &nder the theory of the Capital Asset Pricing Model
total risk is partitioned into two parts:
Systematic risk
&nsystematic risk - diversifiable risk
O Systematic risk is non-diversifiable risk.
O Systematic risk is the only relevant risk to the
diversified investor
O The beta coefficient measures systematic risk
Systematic Risk &nsystematic
Risk
%otal Risk of the
Investment
%he Beta Coefficient %he Beta Coefficient
How is the Beta Coefficient Interpreted? How is the Beta Coefficient Interpreted?
O The beta oI the market portIolio is ALAYS 1.0
O The beta oI a security compares the volatility oI its returns to the
volatility oI the market returns:

s
= 1.0 - the security has the same volatility as
the market as a whole

s
> 1.0 - aggressive investment with volatility of
returns greater than the market

s
< 1.0 - defensive investment with volatility of
returns less than the market

s
< 0.0 - an investment with returns that are
negatively correlated with the returns of
the market
%he CAPM and Market Risk %he CAPM and Market Risk
%he Security Market Line (SML) %he Security Market Line (SML)
The SML is the hypothesized relationship between return
(the dependent variable and systematic risk (the beta
coefficient.
It is a straight line relationship defined by the following
formula:
Where:
k
i
the required return on security i`
ER
M
RF market premium Ior risk
B
i
the beta coeIIicient Ior security i`
) (
i M i
RF ER RF k .
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Implications of CAPM Implications of CAPM
O nvestors will always combine a risk-Iree asset with a
market portIolio oI risky assets. They will invest in risky
assets in proportion to their market value.
O nvestors will be compensated only Ior that risk which they
cannot diversiIy. This is the market-related (systematic) risk
.
O Beta, which is a ratio oI the covariance between the asset
returns and the market returns divided by the market
variance, is the most appropriate measure oI an asset`s risk.
O nvestors can expect returns Irom their investment
according to the risk. This implies a linear relationship
between the asset`s expected return and its beta.
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Limitations of CAPM Limitations of CAPM
O t is based on unrealistic assumptions.
O t is diIIicult to test the validity oI CAPM.
O Betas do not remain stable over time.
Priyanka Priyanka Chauhan Chauhan
Kanika Kanika Bhanot Bhanot