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RISK MANAGEMENT

TERM PAPER ON RISK AND RETURN ANALYSIS WITH CAPM IN INDIAN MARKET

Submitted To:- Dr. Anita Yadav Faculty, Dept. of MBA, PESIT

Submitted By:- Rajneesh Thapa Sec:- F2 IV SEM Roll No.:- 3 USN:- 1PT11MBA64

Executive Summary
This summary provides a brief overview of Capital Asset Pricing Model (CAPM) as an alternative method for estimating expected returns. This paper also discusses the positive and negative effects of CAPM along with the risks of Beta and why this model has its share of drawbacks and critics in the marketplace. The first section will cover the basics of CAPM including its flaws and rewards. Next, the risks of beta and the strengths and weaknesses are discussed in conjunction with its relevance to CAPM and why its important to investors who are willing to take greater risks. Finally, an application is provided to show how beta affects CAPM from a financial managers perspective.

Main Conclusions
Despite the doubts about the validity of the CAPM formula, this model remains effective and widely used in the financial industry for determining expected returns and investment risk. There is only one beta used in the CAPM model and it serves as the full measurement of systematic risk and future cash flows. CAPM is not a perfect science nor do all investors agree on measuring the beta (risk) of an asset.

INTRODUCTION
The capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's nondiversifiable risk. The model takes into account the asset's sensitivity to nondiversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. The model was introduced by Jack Treynor (1961, 1962),[1] William Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory.

Systematic and Unsystematic Risk


There are generally two types of risk in CAPM. They are as follows Systematic risk : Risk that influences a large number of assets. Also called market risk. Uncontrollable; Undiversifiable Cannot be eliminated Unsystematic Risk : Risk that influences a single company or a small group of companies Controllable; Diversifiable Can be mitigated through diversification

Beta Coefficient

A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns. is the ratio of the movements of an individual stock relative to the movements of the overall market portfolio or a proxy such as the S&P500 index Assets with betas larger than 1.0 have more systematic risk than average, and vice versa Because assets with larger betas have greater systematic risks, they will have greater expected returns. Eg. Microsofts beta is 1.3; its stock price is supposed to rise or fall by 13%, when the whole market rises or falls by 10%

It is denoted by the formula

bi = COV (ri, rm) / Var(rm)

The formula
The CAPM is a model for pricing an individual security or portfolio. For individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-torisk ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

where, E(Ri) = The Required Rate of Return, (or just the rate of return). Rf = The Risk Free Rate (the rate of return on a "risk free investment", like Post office fixed deposits) i = Beta (see above) E(Rm) = The expected return on the overall stock market. (You have to guess what rate of return you think the overall stock market will produce.)

Security Market Line(SML)


The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between and required return is plotted on the securities market line (SML), which shows expected return as a function of . The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm) Rf. The securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed.

Graphical representation

Assumptions:
All investors aim to maximize economic utilities. Are rational and risk-averse. Are broadly diversified across a range of investments. Are price takers, i.e., they cannot influence prices. Trade without transaction or taxation costs. Assume all information is available at the same time to all investors.

Problems of CAPM
Assumes that the variance of returns is an adequate measurement of risk. Homogeneous expectations No taxes or transaction costs Assumes rational and risk-averse investors Does not adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict.

Present validity of CAPM


CAPM provides basic concepts which is truly fundamental Useful in SELECTION of securities and portfolios. Securities with higher returns are considered to be undervalued and attractive for BUY. Below normal expected return yielding securities are considered to be overvalued good for SALE. Expected return can be use as an estimate of cost of retained earnings. CAPM can serve as a benchmark for understanding the capital market phenomena that causeasset prices and investor behavior to deviate from the prescriptions of the model.

RISK AND RETURN ANALYSIS WITH CAPM IN INDIAN MARKET


So far, the thrust area of research in investment management was actually regarding how investment can be made positive? What are the factors to be considered? Which are the beneficial assets for the investment? How maximum profits can be earned? Etc were the questions. No one clearly ever discuss about the real risk involved in the asset investment market. The investor should firstly know or critically analyze how risk is related to the assets and how this risk deeply influence the assets , what are the risks should bear by the investor during the time of investment and so on .Now in order to satisfy these requirements a new area of research in the field of investment risk is being emerged .The area of research like CAPM is the best example which shows the relationship between risk and return involved in the capital asset investment. CAPM can be defined as a model that provides a frame work to determine the required rate of return on an asset and indicates the relationship between return and risk of the assets. In order to have a thorough idea of CAPM we should study of its assumptions also, why because every concept or theory should be approved if it has very precise and clear cut assumptions. The assumptions of CAPM includes:-

Market efficiency: The capital market efficiency implies that share prices
reflect all available information. Also, individual investors are not able to affect the price of securities. This means that there are large numbers of investors holding small amount of wealth.

Risk aversion and mean-variance optimization: Investors are risk averse.


They evaluate a securitys return and risk in terms of the expected return and variance or standard variance respectively. They prefer the highest expected returns for a given level of risk. This implies that investors are mean variance optimizers and they form efficient portfolios.

Homogeneous expectations: All investors have the same expectations about


the expected returns and risks of securities.

Single time period: All investors decisions are based on a single time period.

Risk free rate: All investors can lend and borrow at a risk free rate of
interest. They form portfolios from publicly traded securities like shares and bonds.

Testing of CAPM
According to the assumptions of CAPM the practicability will be in hinge, why because assumptions never constitute a theorys practicability. The practicability should be clearly tested with the data availability in the market and the result should lead to the correctness of the theorem. Under CAPM Beta is taken as the risk factor in the investments and how this beta is related to expected return, we have to prove this hypothesis. There has being using a lot of methods to test the hypothesis such as empirical testing, scientific testing etcAccording to the different studies the result is different. As per some studies it is considered as there is no relationship between beta and expected return, where as some other tests say that there should have a very good and strong relationship among these factors. But according to CAPM there exist a relationship between beta and rate of return but not in a very strong way .

TESTING OF CAPM OF BAJAJ HOLDINGS & INVESTMENT COMPANY


In order to get the better understanding the Bajaj holdings and Investment Company has been selected for a case study regarding CAPM. For doing the CAPM test three months data has been collected, i.e., from 1/April/2009 to the date of 31/June/2009. The closing prices of this company and whole market, treasury bill market etc. are collected for doing the test. Now there is a prescribed formula for calculating CAPM of any company. That is :-

BAJAJ HOLDINGS AND INVESTMENT COMPANY (01/04/2009--30/06/2009)


DATE CLOSING PRICE RI CLOSING NIFTY RM RF RM-RF BETA CAPM

01-Apr-09 02-Apr-09 06-Apr-09 08-Apr-09 09-Apr-09 13-Apr-09 15-Apr-09 16-Apr-09 17-Apr-09 20-Apr-09 21-Apr-09 22-Apr-09 23-Apr-09 24-Apr-09 27-Apr-09 28-Apr-09 29-Apr-09 04-May-09 05-May-09 06-May-09 07-May-09 08-May-09 11-May-09 12-May-09 13-May-09 14-May-09 15-May-09 18-May-09 19-May-09

297.05 298.1 300.75 310.3 315.9 318.8 318.7 311 315.05 329.65 350.6 416.3 374.55 365.85 366.5 345.9 339.5 355.2 368.4 367.6 365.6 369.3 363.9 356.25 353 363.65 366.7 398 383.3 0.0035348 0.0088896 0.0317539 0.0180471 0.0091801 -0.000314 -0.024161 0.0130225 0.0463419 0.0635523 0.187393 -0.100288 -0.023228 0.0017767 -0.056207 -0.018502 0.0462445 0.0371622 -0.002172 -0.005441 0.0101204 -0.014622 -0.021022 -0.009123 0.03017 0.0083872 0.0853559 -0.036935

3060.35 3211.05 3256.6 3342.95 3342.05 3382.6 3484.15 3369.5 3384.4 3377.1 3365.3 3330.3 3423.7 3480.75 3470 3362.35 3473.95 3654 3661.9 3625.05 3683.9 3620.7 3554.6 3681.1 3635.25 3593.45 3671.65 4323.15 4318.45 0.0492427 0.0141854 0.0265154 -0.000269 0.0121333 0.0300213 -0.032906 0.004422 -0.002157 -0.003494 -0.0104 0.0280455 0.0166633 -0.003088 -0.031023 0.0331911 0.0518286 0.002162 -0.010063 0.0162343 -0.017156 -0.018256 0.0355877 -0.012456 -0.011499 0.0217618 0.1774407 -0.001087 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1817 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.13246 0.16751 0.15518 0.18197 0.16957 0.15168 0.21461 0.17728 0.18386 0.18519 -0.1921 0.15365 0.16504 0.18479 0.21272 0.14851 0.14193 -0.1916 0.20382 0.17753 0.21092 0.21202 0.15817 0.20622 0.20526 -0.172 0.01632 0.19485 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.12961714 0.11583242 0.12068063 0.11014879 0.11502551 0.12205917 0.09731578 0.11199341 0.10940653 0.10888075 0.10616522 0.12128229 0.11680673 0.10904027 0.09805623 0.12330555 0.13795265 0.1184235 0.11361653 0.12395677 0.11082766 0.11039498 0.13156664 0.11267581 0.11305211 0.12613024 0.18734394 0.1171459

20-May-09 21-May-09 22-May-09 25-May-09 26-May-09 27-May-09 28-May-09 29-May-09 01-Jun-09 02-Jun-09 03-Jun-09 04-Jun-09 05-Jun-09 08-Jun-09 09-Jun-09 10-Jun-09 11-Jun-09 12-Jun-09 15-Jun-09 16-Jun-09 17-Jun-09 18-Jun-09 19-Jun-09 22-Jun-09 23-Jun-09 24-Jun-09 25-Jun-09 26-Jun-09 29-Jun-09 30-Jun-09

394.8 397 399.85 388.1 373.95 372.9 368.9 364.45 404.3 453.25 440.25 447.35 445.5 431.95 452.2 460.8 470.65 461.45 442.45 439.1 411.95 388.95 390.15 371.95 359.75 355.5 362.2 362.9 364.15 366.3

0.0300026 0.0055724 0.0071788 -0.029386 -0.03646 -0.002808 -0.010727 -0.012063 0.1093428 0.1210735 -0.028682 0.0161272 -0.004135 -0.030415 0.0468804 0.0190181 0.0213759 -0.019547 -0.041175 -0.007571 -0.061831 -0.055832 0.0030852 -0.046649 -0.0328 -0.011814 0.0188467 0.0019326 0.0034445 0.0059042

4270.3 4210.9 4238.5 4237.55 4116.7 4276.05 4337.1 4448.95 4529.9 4525.25 4530.7 4572.65 4586.9 4429.9 4550.95 4655.25 4637.7 4583.4 4484 4517.8 4356.15 4251.4 4313.6 4235.25 4247 4292.95 4241.85 4375.5 4390.95 4291.1

-0.01115 -0.01391 0.0065544 -0.000224 -0.028519 0.0387082 0.0142772 0.0257891 0.0181953 -0.001027 0.0012044 0.0092591 0.0031164 -0.034228 0.0273257 0.0229183 -0.00377 -0.011708 -0.021687 0.0075379 -0.035781 -0.024046 0.0146305 -0.018163 0.0027743 0.0108194 -0.011903 0.0315075 0.003531 -0.02274

0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.1937613 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633 0.2014633

0.20491 0.20767 0.18721 0.19399 0.22228 0.15505 0.17948 0.16797 0.18327 0.20249 0.20026 -0.1922 0.19835 0.23569 0.17414 0.17855 0.20523 0.21317 0.22315 0.19393 0.23724 0.22551 0.18683 0.21963 0.19869 0.19064 0.21337 0.16996 0.19793 -0.2242

0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205 0.393205

0.11318921 0.11210389 0.12015061 0.11748525 0.10635963 0.13279364 0.12318725 0.12771379 0.12940143 0.12184331 0.1227205 0.12588765 0.12347231 0.10878836 0.13299153 0.13125853 0.12076459 0.11764315 0.11371952 0.12521089 0.1081778 0.11279175 0.12799972 0.11510497 0.12333783 0.12650119 0.11756653 0.13463584 0.12363536 0.11330548

Findings:
1) If Nifty unit moves forward Re.1, then the Bajaj holdings and investment companys share moves 0.3932054 unit 2) This indicates that the unit value of Bajaj is much lesser than the market value 3) If we compare the RI and CAPM columns in the first table it shows that real value of shares is less than the market value 4) For shareholders this is the best time to sell out their shares in Bajaj holdings company 5) The CAPM calculation is very much effective to take the above said decisions. 6) Testing of CAPM clearly shows the relation ship between how much return receiving that much risk is also their with the investment. 7) Treasury bills are best examples for risk free investment.

Conclusion
Capm model is a useful financial tool. It provides a usable measure of risk that helps investors determine what return they deserve for putting their money at risk. Companies can use it as a tool to correct their capital structure to enhance profitability.

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