Handout – 04

Programme : Bachelor of Commerce (Special) Degree

Fourth Examination in Commerce – 2008/2009
2nd Semester
Course Title : Investment and Portfolio Management
Course Code : BCOM 42542
Course Status : Elective
Handout Title : Systematic Risk & Capital Asset Pricing Model [CAPM]
Prepared By : B.Prahalathan, Dept.of Commerce & Financial Management
Issue Date : 3rd July 2010

Learning Objectives:

• define capital asset pricing model

• calculate systematic risk of a security
• understand security market line and its implication

Introduction
The risk that remains after diversification is market risk, or the risk that is inherent in
the market, and it can be measured by the degree to which a given stock tends to
move up or down with the market. The tendency of a stock to move up or and down
with the market is reflected in its beta coefficient – b. Beta is a key element of the
Capital Asset Pricing Model (CAPM). The capital asset pricing model [CAPM] is
really an extension of the portfolio theory. The CAPM derives the relationship
between the expected return and risk of individual securities and portfolios in the
capital markets if everyone behaved in the way the portfolio theory suggested.

Systematic Risk (Market Risk or Non - divertible Risk)

Systematic risk is the variability in security returns caused by changes in the economy
or market. All securities are affected by such changes to some extent, but all securities
do not have the same degree of non – diversible risk because the magnitude of
influence of economy wide factors tends to vary from one firm to another. Different
securities have different sensitivities to variations in market return.

Beta
The systematic risk of a security is measured by a statistical measure called beta. Beta
measures fluctuation of return on a financial asset with return on the market portfolio.
By definition the beta for the market portfolio (β) is 1. Individual securities beta
generally falls in the range 0.06 to 1.80. In using this beta for investment decision
making, the investors is assuming that the relationship between the security variability
and market variability will continue to remain the same in future also.

1|Page
Calculation of Beta

By using the following model, β can be calculated as follows.

Kj = αj + βj [ Km + ej]
Kj: return on security j
αj: intercept term alpha
βj: regression coefficient (beta)
ej: random error term
Km: return on market portfolio

Beta reflects the slope of the above regression relationship.

[Formula]

Portfolio Beta Coefficient

A stock’s beta coefficient shows how the stock would affect the riskiness of a
diversified portfolio. The beta of a portfolio is a weighted average of the individual
securities’ beta.
[Formula]

Capital Asset Pricing Model (CAPM)

The capital asset pricing model gives the nature of the relationship between the
expected return and the systematic risk of a security. The CAPM model is based on
the proposition that any shares’ required rate of return is equal to the risk free rate of
return plus its risk premium.
According to CAPM, following equation represents the relationship between risk and
return.

Kj = Rf + βj (Km - Rf)
Kj: required/expected rate of return on security j
Rf: risk free rate of return
βj: beta coefficient of security j
Km: expected rate of return on the market portfolio
βj(Km - Rf): Risk premium[the additional return required to compensate investors for
assuming a given level of risk]

According to the equation, required rate of return of a security consists of two

components.

1. risk free rate of return (Rf)

2. risk premium βj (Km - Rf)

The model assumes that the linear relationship exists between risk and return (the
higher the beta and the greater the required rate of return). The linear relationship is
defined by the security market line (SML).
Page | 2
Capital asset pricing model is mainly concerned
- How systematic risk is measured
- How systematic risk affects required rate of returns and share prices.

Implication of CAPM
1. Investors require return in excess of the risk free rate to compensate
them for systematic risk
2. Investors should not require a premium for unsystematic risk because
this can be diversified by wide range of portfolio.
3. Investors will require a higher return from shares when the systematic
risk is high.

Assumption of CAPM

1. Capital markets are efficient

2. Investors are risk averse
3. All investors have the same expectations
4. Decision based on single time period
5. All investors can lend or borrow at a risk – free rate of interest
6. There is a linear relationship between return obtained from an individual
security and the average return from all securities in the market.

Security Market Line (SML)

The graphical representation of CAPM is called the security market line.

Changes in Security Market Line

The two parameters defining the security market line are
1. intercept ((Rf)
2. Slope (Km - Rf)

The intercept represents the nominal rate of return on the risk free security (risk free
real rate of return plus inflation rate)

The slope represents the price per unit of risk and is a function of the risk – aversion
of investors. If the real risk – free rate of return and/or the inflation rate change, the
intercept of the security market line changes.

If the risk – aversion of investors’ changes, the slope of the security market line also
changes.

References
I.M.Pandey, Financial Management, 9th Ed, Vikas Publishing
House PvtLtd, 2008.

Page | 3