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