CAPITAL ASSET

PRICING MODEL

DIVYA P KRISHNAN
REG NO:327
 CAPITAL ASSET PRICING MODEL

William F Sharp and John Lintner developed in

1960s, based on Markowitz model.
Model considers
• relationship between risk and return for an
efficient portfolio
• Relationship between risk and return for individual
security or asset
 Assumptions
• Investors are rational and risk averse
• Investors can borrow or lend any amount of money
at the risk free rate of return
• Investors have homogeneous expectations. They
estimate identical probability distributions for future
rates of return
• All investments are infinitely divisible
• There are no taxes or transaction costs involved in
buying or selling assets
• Capital markets are in equilibrium
• Purchase and sales by a single investor cannot affect
price
EFFICIENT FRONTIER WITH RISKLESS LENDING
AND BORROWING
• According to portfolio theory an investor faces an
efficient frontier containing the set of efficient
portfolios of risk assets
• If a riskless asset available for investment.
• Then investor can invest in a combination of risk free
assets and risky assets.
• The efficient frontier arising from set of portfolios of
risky assets is concave in shape.
• When an investor use risk less borrowing and
lending ,then the efficient frontier transforms to
straight line.
• Optimal portfolio with rate of return15 % and risk 8
% & Risk free asset with rate of return 7%.
• If investor invests 40% in risk free & 60% in risky
portfolio, then
Return of combined portfolio
Rc = ω Rm+(1- ω)Rf
Rm- expected return on risky portfolio
Rf = expected return on risk less portfolio
ω – proportion of funds invested in risky portfolio
(1-ω) - proportion of funds in riskless asset
Risk
σc = ωσm+(1-ω)σƒ

σc – standard deviation of combined portfolio

ωƒ – proportion of funds in risky portfolio
σm – standard deviation of risky portfolio
σƒ - standard deviation of riskless asset
• Optimal portfolio with rate of return 15% and
deviation 8%.risk free asset with rate of return
7 %.
• If an investor places 40% of his funds in risk free and
60 % in risky assets
Return= ω Rm+(1- ω)Rf
=0.60*15+0.40*7
=11.8%

Risk = ωσm+(1-ω)σƒ
=0.60*8
=4.8%
• If the investor borrows fund to invest in risky
portfolio
• If ω= 1 then investors funds are fully committed
to risky portfolio
• If ω < 1,a fraction of funds invested in risky
portfolio
• If ω > 1,investor borrows at risk free rate and
investing in risky portfolio.

Return of levered portfolio= ωRm -(1-ω)Rƒ

Risk=ωσm
• The line formed by action of all investors mixing
the market portfolio with the risk free asset is
known as Capital Market Line (CML)
• The relationship between the return and risk of any
efficient portfolio on the capital market line can be
expressed as
Re= Rf+[(Rm-Rf) ⁄ σm] σe

Rf - reward for waiting

[(Rm-Rf) ⁄ σm] - price of risk
• All portfolios other than efficient portfolio will lie
below the CML.
 SECURITY MARKET LINE
• CAPM specifies the relationship between
expected return and risk of all securities and all
portfolios, whether efficient or inefficient
• Total risk of security composed of two
components systematic and unsystematic risk
• Diversification will reduce the unsystematic risk.
• For a well diversified portfolio unsystematic risk
tends to zero, systematic risk measured by β.
β>1 higher sensitivity,β<1 lower sensitivity and β=1
security moves at the same rate as the market
• SML provides relationship between expected
return and β of portfolio.

Ri =Rƒ+βi (Rm-R ƒ)
• Model postulates that systematic risk is the only
important ingredient in determining expected
return.
 PRICING OF SECURITIES WITH CAPM

• CAPM can be used for evaluation of pricing of

securities.
• Underpriced, overpriced or correctly priced.
Real rate of return=[(P1 –P0)+D1]/P0
P0 – current market price
P1 – estimated market price
D1 – dividend of the year
• A security pays a dividend of Rs. 3.85 and sells
currently at Rs.83. The security is expected to sell at
Rs.90 at the end of the year. The security has βof 1.15.
the risk free rate is 5 % and the expected return on
market index is 12%. Assess whether the security is
correctly priced
Expected return Ri=Rƒ+βi(Rm-Rƒ)
=5+1.15(12-5)
=5+8.05 = 13.05
Estimated return = [(P1-P0)+D]/P0
=[ (90-83)+3.85]/83 =(7+3.85)/83=0.1307
13.07%