- CAPM

8/22/2019 - CAPM

1/17

CAPITAL ASSETS PRICING MODEL[CAPM]

8/22/2019 - CAPM

2/17

INTRODUCTION The Capital Assets Pricing Model is an extension of the

Portfolio Theory which tells us how a rational investorshould construct a portfolio on the basis of risk and return

The CAPM theory tells how assets should be priced in thecapital markets if all investors behave rationally

A risk averse investor construct an efficient portfolio(combination of market portfolio and risk freeinvestments) on the basis of analysis of risk and return ofsecurities

Significant contributions to the development of CAPMhave been made by William Sharpe, John Lintner and IanMossin

8/22/2019 - CAPM

3/17

USEFULNESS OF CAPM

The CAPM, when applied to the portfolio analysis,provides a useful techniques of measuring the riskfactor as well as the required rate of return of aportfolio

8/22/2019 - CAPM

4/17

SYSTEMATIC RISK It is also known as Market Risk

It is that part of risk, which cannot be eliminated bydiversification or precautions

This part of the risk arises because every security has abuilt-in tendency to move in line with the fluctuationsin the market

The systematic risk refers to the fluctuation in return

due to general factors in the market such as moneysupply, inflation, economic recession, industrialpolicy, interest rate policy, credit policy, tax policies,etc.

8/22/2019 - CAPM

5/17

UNSYSTEMATIC RISK It can be eliminated through effective diversification

This risk represents the fluctuations in return of a

security due to factors which are specific to theparticular firm and the market as a whole

These factors may be workers unrest, strike, change inmarket demand, change in competitive environment,

change in consumer preferences, etc. This is also called as diversifiable risk

8/22/2019 - CAPM

6/17

EFFICIENT PORTFOLIO The bifurcation of total risk into systematic and

unsystematic risks leads to conclusion that a portfoliomay be called an efficient portfolio, if it does not haveany unsystematic risk

The efficient portfolio or optimal portfolio is difficult,

if not impossible, to attain. But a portfolio which isnearly efficient or optimal can be constructed by acareful selection of only a handful of securities

8/22/2019 - CAPM

7/17

CAPM CAPM establishes that the required rate of return of a

security must be related to its contribution to the riskof the portfolio

CAPM stresses that only the systematic risk, theundiversifiable risk, is relevant for the expected rate ofreturn of a security

Since the diversificable risk, i.e., the unsystematic riskcan be eliminated, there is no reward for it

The graphical version of CAPM is called the SecurityMarket Line (SML)

8/22/2019 - CAPM

8/17

ASSUMPTIONS OF CAPM The investors are basically risk averse and diversification is needed to

reduce the risk All investors want to maximize the wealth and choose a portfolio solely

on the basis of risk and return

All investors can borrow or lend an unlimited amount of funds at risk-free rate of interest All investors have identical estimates of risk and return of all securities All securities are perfectly divisible and liquid There is no transaction costs There is no tax The security market is efficient and purchases and sales by a single

investor cannot affect the prices All investors are efficiently diversified and have eliminated the

unsystematic risk

8/22/2019 - CAPM

9/17

CAPM MODEL The risk of a diversified portfolio depends upon the

systematic risk of the securities included in theportfolio

All the securities available to an investor do not havesame level of systematic risk

The factors contributing to systematic risk do not

affect all the securities in the same way and themagnitude of the influence of these factors vary fromone security to another depending upon the sensitivityof the security to the market fluctuations

8/22/2019 - CAPM

10/17

MEASUREMENT OF SYSTEMATIC

RISK The investor will pay premium only for the systematic

risk as it is non-diversifiable. So, the question is howthis systematic risk can be measured?

William Sharpe has suggested that the systematic riskcan be measured by, the beta factor

The beta co-efficient is the relative measure ofsensitivity of an asset's return to change in the return

on the market portfolio Formula:

Beta = Percentage change in a particular sharePercentage change in the Index

8/22/2019 - CAPM

11/17

CAPM EQUATION

Rs = RF + (RM RF)

Rs = The expected return from a portfolio

RF = The risk free return

RM = The expected return on the market portfolio

= Measure of systematic risk

8/22/2019 - CAPM

12/17

CAPM THEORY The CAPM model depicts that the expected rate of return

of a security consists of two parts:(i) Risk free return (RF)

(ii) Risk premium = (RM RF)

[The risk premium is equal to the differencebetween the expected market return and the risk-free return multiplied by the beta factor ]

Evidently, the risk premium varies directly with the betafactor i.e., the systematic risk. Therefore, the higher thebeta, the greater is the expected rate of return and vice-

versa

8/22/2019 - CAPM

13/17

IMPORTANCE OF CAPM Required Rate of Return

= Price of Time + Price of Risk x Amount of RiskCAPM shows that the required rate of return for a

particular portfolio depends on three things:

a. The pure time value of money (RF)b. The reward for bearing systematic risk (RM RF)c. The amount of systematic risk ()

Just Assuming, the portfolio under consideration has therequired rate of return of 19.1%. Say, the average expected rate ofreturn (in view of the probability distribution) of the portfolio is19%. Therefore, the portfolio is correctly priced

8/22/2019 - CAPM

14/17

SML VS CML The basic difference between the SML and CML is the

measurement of risk:

The CML measures total risk of the portfolio ()whereas the SML measures the systematic risk of theportfolio ()

All the portfolio lying on the CML are the efficient

portfolios and the inefficient portfolios lie below theCML. However, the SML shows only those securitieswhich are correctly priced in view of the systematicrisk associated with the security

8/22/2019 - CAPM

15/17

LIMITATIONS OF CAPM The calculation of Beta factor is very tedious as lot of

data is required

The Beta factor cannot be expected to be constant overa period of time

The assumptions of CAPM are hypothetical and areimpractical

The required rate of return, Rs, specified by the modelcan be viewed only as a rough approximation of therequired rate of return

8/22/2019 - CAPM

16/17

SUMMARY The investors are risk averse and prefer to have higher

expected returns and lower risks. A portfolio whichhas the highest expected return for a given level of riskis known as Efficient portfolio

Some securities will increase the risk of a portfolio,and the investor will buy these securities only if theyincrease the expected return also. Other securitiesmay reduce the portfolio risk, so the investor may beready to buy even if these reduces the expected returnof the investor

8/22/2019 - CAPM

17/17

SUMMARY (CONTD.) Risk of any security need not be viewed in isolation but at

its marginal contribution to the portfolio risk

A securitys sensitivity to change in value of the market

portfolio is known as the beta factor, . The difference between expected returns of any two

securities is due to differences in

The securities having high , will provide higher returnsand vice-versa

The required rate of return of an investor is consisting of arisk-free return and a risk premium which depends uponthe contribution of a security to the portfolio risk