Shitish Ahluwalia Vikram Rana

The model was introduced by Jack Treynor , William Sharpe , John Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. An investor deserve a rate of return that compensates him for taking on risk. The capital asset pricing model (CAPM) helps an investor to calculate investment risk and what return on investment he can expect. The capital asset pricing model (CAPM) is a model that calculates expected return based on expected rate of return on the market, the risk-free rate and the beta coefficient of the stock.

CAPM is based on the idea that investors demand additional expected return (called the risk premium) if they are asked to accept additional risk. It is based on the rational behavior of investors. Rational behavior implies that investors are risk averse by nature and always prefer extra returns known as risk premium for the risk assumed by them as compared to the returns expected from risk free avenues.

The CAPM model says that this expected return that these investors would demand is equal to the rate on a risk-free security plus a risk premium
The model starts with the idea that individual investment contains two types of risk: 1. Systematic Risk (or Market risk) 2.Unsystematic Risk (or Specific risk) CAPM considers only systematic risk and assumes that unsystematic risk can be eliminated by diversification.

Risk free assets- These are such assets in which a fixed amount or % of return is promised and these are also free from default risk. E.g. Treasury bill govt. securities. Risky assets- These are such assets in which there is no promise for a fixed returns; rather returns depend upon market system and level of efficiency in the market. E.g. equity share, corporate debentures

1. The investors are basically risk averse and diversification is needed to reduce the risk.

2. All investors want to maximize the wealth and choose a portfolio only on the basis of risk and return assessment.
3. All investors can borrow or lend an unlimited amount of funds at risk-free rate of interest. 4. All investors have identical estimates of risk and return of all securities. 5. All securities are perfectly divisible and liquid and there is no transaction cost or tax. 6. The security market is efficient & purchases and sales by a single investor cannot affect the prices. This means that there is perfect competition in the market.

7. All investors are efficiently diversified and have eliminated the unsystematic risk. Thus only the systematic risk is relevant in determining the estimated return.

RS = IRF + ( RM IRF ) b RS = The expected return from a security/asset. IRF = The risk-free interest rate. RM = The expected return on market portfolio. b = The beta factor , a measure of systematic risk of the security/asset. Example: CAPM model Determine the expected return on Newco's stock using the capital asset pricing model. Newco's beta is 1.2. Assume the expected return on the market is 12% and the risk-free rate is 4%. Answer: = 4% + 1.2(12% - 4%) = 13.6%. Using the capital asset pricing model, the expected return on Newco's stock is 13.6%

RS = IRF + ( RM IRF ) b The expected return for a particular security depends upon three things : 1. The pure time value of money: As measured by IRF this is reward for merely waiting for money, without taking any risk. 2. The amount of systematic risk: As measured by b this is the amount of systematic risk present in a particular security, in relation to that present in an average security. 3. The reward for bearing systematic risk: As measured by risk premium ( RM IRF ) b, this component is the reward, the market offers for bearing an average amount of systematic risk in addition to the waiting.

It is such a portfolio in which total funds is contributed by the investors from his own capital. This type of portfolio can have any one of following: a) 100% investment in risk free assets. b) 100% investment in risky assets by market portfolio. c) A combination of both
.

 It is the portfolio in which not only the own funds of the investors,
but also the borrowed funds are invested in the market portfolio. It is feasible because of the concept of borrowing at risk free rate. It is created to generate returns more than resulting from market portfolio.

CAPM

help in generating efficient frontier, which is a line representing all the efficient portfolios on the graph of risk and returns. Efficient portfolio has maximum returns for a given level of risk or minimum risk for a given level of returns. Under CAPM a line originating from the vertical axis and moving in a linear manner with every increase in the level of risk is called efficient frontier. It help investors and portfolio managers in decision making.

It shows the trade-off between the expected returns and risk for different portfolios and the risk is measured by the standard deviation of portfolio.

CAPM has the premises that investors have an option to either lend the funds at risk free rate or borrow the fund at risk free rate. Lending- It is defined as the investment of corpus at risk free rate of return. Here, an investor can either invest all his funds or a part of it in risk free assets. Borrowing- It means taking loan at risk free rate of interest for investment in risky assets.

CML, efficient portfolio and risk return of an investor

Undervalued Portfolios- It is the one, which generates more returns than the expected returns for the given level of risk. Overvalued Portfolios- It is the one, which generates less returns than the expected returns for the given level of risk.

SML E(R)

Beta = 1.0 implies as risky as market Securities A and B are more risky than the market
A

E(RM)
RF C

Beta > 1.0 Beta < 1.0

Security C is less risky than the market

0.5

1.0 1.5 BetaM

2.0

E(Ri ) = Rf + {E(RM ) Rf } b
Rf =Risk-free Rate {E(RM ) Rf } =Market Risk Premium b =Beta of security i

The risk-free rate is the return on a secuirty that is free from default risk and is uncorrelated with returns from anything else in the economy. Theoritically, the return on a zero-beta portfolio is the best estimate of the risk-free rate.

It is based on historical data. It is calculated as the difference between the average return on stocks and the average risk-free return.

The beta coefficient is the relative measure of sensitivity of an assets return to change in return on the market portfolio
It can be viewed as an index of the degree of responsiveness of the securities returns with the market return.

The beta coefficient , is calculated by relating the returns of a security with the returns for the market Mathematically, the beta of security is the securitys Co - Variance with the market portfolio divided by the variance of the market portfolio.

= cov( S,M) = iM 2M 2M When, > 1 = The security is more risky < 1 = The security is less risky

Period Return on Return on stock A Mkt port

1 10 12

RA - RA
0

RM - RM
3

(RA - RA ) (RM -RM )2 (RM - RM )

0 9

2
3 4 5 6 7 8 9 10 11 12

15
18 14 16 16 18 4 -9 14 15 14

14
13 10 9 13 14 7 1 12 -11 16

5
8 4 6 6 8 -6 -19 4 5 4

5
4 1 0 4 5 -2 -8 3 -20 7

25
32 4 0 24 40 12 152 12 -100 28

25
16 1 0 16 25 4 64 9 400 49

13
14 15

6
7 -8

8
7 10

-4
-3 -18

-1
-2 1

4
6 -18

1
4 1

Type equation here. RA = 150 RA =10 RM =9 (RA - RA )(RM - RM ) = 221 (RM -RM )2 =624

RM =135

Cov(RA, RM ) = (RA - RA )(RM - RM ) =221 =15.79 n-1 14 2M = (RM -RM )2 = 0.354 n-1 =624 = 44.57 14

1. The calculation of beta factor is very tedious as lot of

information is required and it may or may not reflect the future variability of return. 2. The assumptions of CAPM are hypothetical and are impractical . For example assumption of borrowing and lending at the same rate is imaginary. 3. The required rate of return that is specified by the model can be viewed only as a rough approximation of the required rate of return.