Capital Asset Pricing Model

Learning Objectives : Explain the capital market relationship and the Security market Line relationship Develop the inputs required for applying the CAPM Calculate the beta of a security Describe the procedure used by researchers to test the CAPM Discuss the return generating process and the equilibrium risk-return relationship according to the APT (arbitrage pricing theory)

1 Prof.V.Maruthi Rao

CAPM
Harry Markowitz developed an approach that helps an investor to achieve his optimal portfolio position William Sharpe developed CAPM ( relation between risk and return in an rational investors optimal portfolio) CAPM is concerned with : (a) what is relationship between risk and return for an efficient portfolio (b) what is relationship between risk and return for an individual security

2 Prof.V.Maruthi Rao

CAPM

Basic assumptions: Individuals are risk averse Individuals seek to maximize the expected utility of their portfolio over a single period planning horizon Individuals have homogeneous( identical) expectations ( on means, variances, covariance among returns) Individuals can borrow and lend freely at risk free rates Market is perfect, there are no taxes, no transaction costs, securities are completely divisible, market is competitive Quantity of risky securities in the market is given
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CAPM

Capital market Line (CML) :rational investors would choose a combination of Rf and S Portfolios which have returns that are perfectly positively correlated with market portfolio are referred as efficient portfolios, and they lie on the linear segment ( line KML_ M is market portfolio- refer graph of efficient frontier) For efficient portfolios, which includes market portfolio, the relationship between risk and return is depicted by the straight line RfMZ, which is the CML Equation for this Capital market Line (CML) is, E (Rj) = Rf +j, where E(Rj) is expected return on portfolio j, Rf is risk-free rate, is the slope of the CML, and j is the Std. deviation of portfolio j. Given that market portfolio has an expected return of E(RM) and standard deviation of M, the slope of CML can be obtained as, =[E(RM) Rf]/ M Slope of CML, may be regarded as price risk in the market

Prof.V.Maruthi Rao

CAPM

Security Market Line (SML) : CML was linear relationship between expected return and standard deviation The expected return and standard deviation for individual securities will be below the CML reflecting the inefficiency of undiversified holdings, but there will be no well-defined relationship between them However, there is a linear relationship between their expected return and their co-variance with the market portfolio, which is the SML (Security market Line) SML, E(Ri)= Rf + { [E(RM)- Rf]/M2} iM , E(Ri) is expected return on security I, Rf is risk free return, iM is the covariance of returns between security I and market portfolio SML is also, Expected return on security I = Risk-free return + (price per unit of risk) Risk. The price per unit of risk =[ E(RM) Rf]/M2, and the measure of risk is iM In the above equation the risk of a security is expressed in terms of its covariance with the market portfolio, iM
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CAPM

A standardized measure of risk called , a measure of systematic risk,, is ( iM/M2)

reflects the slope of a linear regression relationship in which the return on security i is regressed on the return on the market portfolio
Thus, SML is popularly expressed as, E(Ri) = Rf + [E(RM) Rf] I Expected return on security i = risk free rate + Market risk premium x beta of security I SML is graphed, and slope of SML is market risk premium Assets which are fairly priced plot exactly on SML, and those overpriced ( like O) plot below SML, and underpriced ( like P) above SML The difference between actual expected return on a security and its fair return as per SML, is called ( alpha) CML is a special case of SML, for perfect markets ( perfectly positively correlated returns between security and market, iM is 1)

Prof.V.Maruthi Rao

CAPM

Benefits and Limitations of CAPM: Benefits: investments in risky projects having real assets can be evaluated of its worth in view of expected return CAPM analyses the riskiness of increasing the levels of gearing and its impact on equity shareholders returns CAPM suggests the diversification of portfolio in minimization of risk Limitations: in real world assumptions of CAPM will not hold good In practice, it is difficult to estimate the risk-free return, market return and risk premium CAPM is a single period model while most projects are often available only as large indivisible projects. It is therefore more difficult to adjust
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CAPM

Arbitrage Pricing Theory (APT): CAPM is a single factor model, but APT is a multifactor model Instead of a single beta, there is a whole set of beta values, one for each factor APT states that expected return on an investment is dependent upon how that investment reacts to a set of individual macro-economic factors( degree of reaction being measured by the betas) and risk premium associated with each of those macro-economic factors APM developed by Ross (1976), holds that there are 4 factors, which explain the risk/risk premium relationship of a particular security APM- E(Ri) = Rf+ 1i1 + 2i2 + 3i3+ 4i4, where s are the averare risk premium for each of the four factors in the model and s are measures of the sensitivity of the particular security ito each of the four factors
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CAPM
several factors appear to have been identified as being important Changes in the level of industrial production in the economy Changes in shape of yield curve Changes in default risk premium (changes in the return required on bonds) Changes in inflation rate Changes in real interest rate Level of personal consumption Level of money supply in the economy

Prof.V.Maruthi Rao 9

CAPM
APT as seen is a general theory of asset pricing APT holds that expected return of a financial asset is a linear function of various macro-economical factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor specific beta coefficient The model derived rate of return will then be used to price the asset correctly If price diverges arbitrage should bring it back in line

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CAPM

Relationship with CAPM: it assumes that each investor will hold a unique portfolio with its own array of betas as opposed to the identical market portfolio In some ways CAPM can be considered as a special case of APT in that the SML represents a single factor model of the asset price, where beta is exposure to changes in the value of the market APT can be seen as a supply side model, since its beta coefficients reflect the sensitivity of the underlying asset to economic factors, and hence factor shocks would cause structural changes in assets expected return or in case of stocks, in firms profitability CAPM is considered a demand side model. Its results, although similar to those in APT, arise from a maximization problem of each investors utility function, and from the resulting market equilibrium (investor are considered to be Prof.V.Maruthi Rao 11 consumers of the assets)

Modern Portfolio theory

Modern Portfolio Theory: Markowitz Mean-variance model: investors are mainly concerned with an asset risk-return, and by diversification a trade-off between the two is possible All investors are risk-averse, as he prefers for a given expected return minimum risk or given a level of risk maximum expected return Investors are assumed to be rational in so far as they prefer greater returns given equal or smaller risk Efficient frontier: Markowitz has developed this concept A portfolio is not efficient if there is another with (a) a higher expected value of return and a lower risk () (b) a higher EV of return and same the same EV but a lower
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Modern Portfolio theory

Markowitz has defined diversification as process of combining less than perfectly positively correlated in order to reduce portfolio risk If an investors portfolio is not efficient he may: (a) increase the EV of return without increasing risk (b) decrease risk without decreasing the EV of return obtain some combination of increase in EV of return and decreased risk The above is possible by switching to a portfolio on the efficient frontier Markowitz efficient frontier is graphed (Expected return on Y-axis and Risk, on Xaxis)and let us look at it Prof.V.Maruthi Rao 13

Modern Portfolio Theory

If all investments are plotted on the risk-return sphere, individual securities would be dominated by portfolios, and efficient frontier would take shape, indicating investments which yield max. return given risk etc. Figure depicts boundary of possible investments in securities A,B,C,D,E,F B,C,D are lying on efficient frontier The best combination of EV of return and risk depends on investors utility function The investor will want to hold that portfolio that places him on the highest indifference/utility curves, choosing from the set of available portfolios Optimal investment is achieved at a point where the indifference curve is at a tangent to the efficient frontier At B, level of risk and return is at optimum level, returns are highest at D, but carries higher risk Shaded area represents all attainable portfolios, that is all the combinations of risk and expected return Efficient portfolios on efficient frontier dominates all portfolios to the right
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Modern Portfolio Theory

Single index model: under the markowitz-model, if there are n securities, n(n-1)/2 covariance terms are required apart from n expected returns, n variance terms, and if there are many securities in a portfolio it becomes quite a task William Sharpe has developed single index model wherein returns on each security as a function of the return on a broad market index, as follows: Ri = ai+ biRM+ei, ai is the constant return, biis the measure of sensitivity of the security is return to return on market index, and ei is the error term Estimates ai and bi may be obtained by regressing the return on security i on the corresponding return on market index Single index model is based on following assumptions:
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Modern Portfolio Theory

Assumptions: (1) the error term ei has an expected value of zero and a finite variance (2) error term is not correlated with the return on market portfolio, Cov(ei, RM) = 0 (3) securities are related only through their common response to the return on market index which implies that error term for security i is not correlated with error term for any other security, say j : Cov( ei, ej) =0 Because ai(a constant) and biRM are uncorrelated, the variance of the return of the stock can be expressed as: Variance (Ri)= Variance (ai+ bi RM+ei) = Variance(bi RM)+ Variance (ei)= bi2M2 + 2(ei) Where bi2M2 represents the market risk or systematic risk and 2(ei) represents the unique or firm-specific or unsystematic risk

Prof.V.Maruthi Rao

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Modern Portfolio Theory

Generating inputs to Markowitz model: the single index model immensely helps in obtaining the following inputs required for applying the Markowitz model: (a) expected return on each security (b) variance of return on each security, and the covariance of return between each pair of securities. Following equations may be used for this purpose: E(Ri) = ai + bi E(RM) Var(Ri)= bi2[ Var(RM)]+ Var(ei) Cov(Ri, Rj)= bibj Var(RM) To apply these equations we need to know ai, bi, Var(ei), E(RM), and Var(RM), and all these may be estimated on the basis of historical analysis and/or judgmental evaluation
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