Capital Asset Pricing Model( CAPM)

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Capital asset model price(CAPM)
Presented by Tenzin Thinley
Investment and PortIolio management
Roll no. 22
MBA(insurance management)
CaplLal AsseL Þrlclng Model( CAÞM)
( ) ( )
where ( ) expected return on security
risk-Iree rate oI interest
beta oI Security
( ) expected return on the market
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2
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CAPM
W In Iinance, the capital asset pricing model (CAPM) is
used to determine a theoretically appropriate required
rate oI return oI an asset, iI that asset is to be added to an
already well-diversiIied portIolio, given that asset's non-
diversiIiable risk. The model takes into account the
asset's sensitivity to non-diversiIiable risk (also known
as systematic risk or market risk), oIten represented by
the quantity beta (µ) in the Iinancial industry, as well as
the expected return oI the market and the expected return
oI a theoretical risk-Iree asset.
Contd..
W It is concerned with two keys-
- what is the relationship between risk and
return Ior an eIIicient portIolio?
- what is the relationship between risk and
return Ior an individual security?
This relationship is useful in two
ways:-
I. It produces a benchmark Ior evaluating various
investments. For example, when we are
analyzing a security we are interested in
knowing whether the expected return Irom it is
in line with its Iair return as per the CAPM.
II. It helps us to make an inIormed guess about the
return that can be expected Irom an asset that
has not yet been traded in the market. For
example, how should a Iirm price in initial
public oIIering oI stock?
!s Basic Assumptions
'ariance oI return and mean return are all
investors care about
Investors are price takers
W They cannot inIluence the market individually
All investors have equal and costless access
to inIormation
There are no taxes or commission costs
! (cont/
nvesLors look only one perlod ahead
Lveryone ls equally adepL aL analyzlng securlLles
and lnLerpreLlng Lhe news
Inputs required to Ior applying CAPM
W Risk Iree rate
W Market risk premium
W Beta
Risk Iree rate (RI) I)
W Free Irom deIault risk and is uncorrelated with
returns Irom anything else in the economy.
W ZERO-BETA PORTFOLIO
W Two alternatives commonly used :
- rate on short-term government security
like the 365days T-bills
-rate on a long term government bond that
has a maturity oI 15-20years
Market Risk premium (Rmm) )
W Risk premium used in the CAPM is typically
based on historical data
W Calculated as diIIerence between the average
return on stocks and the average risk Iree rate.
W Three Iactors inIluence the market risk
premium:
'ariance in the underlying economy
Politically Risk
Market structure
W s way Lo measure rlsk uslng ºvolaLlllLy" compared Lo a commonly used
sysLem ( example general sLock markeL)
W Lhe 8eLa (Ē) of a sLock or porLfollo ls a number descrlblng Lhe relaLlon of
lLs reLurns wlLh Lhose of Lhe flnanclal markeL as a wholeŦ
W 1hree scenarlo
Ŵ 8eLa of Zero
Ŵ ÞoslLlve 8eLa
Ŵ negaLlve 8eLa
W An asseL has a 8eLa of zero lf lLs reLurns change lndepende
W A poslLlve beLa means LhaL Lhe asseLƌs reLurns generally follow Lhe
markeLƌs reLurnsţ ln Lhe sense LhaL Lhey boLh Lend Lo be above Lhelr
respecLlve averages LogeLherţ or boLh Lend Lo be below Lhelr respecLlve
averages LogeLherŦ
W A negaLlve beLa means LhaL Lhe asseLƌs reLurns generally move opposlLe
Lhe markeLƌs reLurnsť one wlll Lend Lo be above lLs average when Lhe
oLher ls below lLs averageŦ
Þroblem of CAÞM
Security market line
W The SML essentially graphs the results Irom the capital
asset pricing model (CAPM) Iormula. The x-axis
represents the risk (beta), and the y-axis represents the
expected return. The market risk premium is
determined Irom the slope oI the SML.
W The relationship between µ and required return is
plotted on the securities market line (SML) which
shows expected return as a Iunction oI µ. The intercept
is the nominal risk-Iree rate available Ior the market,
while the slope is the market premium, E(Rm) RI.
Contd..
W The securities market line can be regarded as
representing a single-Iactor model oI the asset price,
where Beta is exposure to changes in value oI the
Market. The equation oI the SML is thus:
Contd.
W It is a useIul tool in determining iI an asset being
considered Ior a portIolio oIIers a reasonable
expected return Ior risk. Individual securities are
plotted on the SML graph. II the security's expected
return versus risk is plotted above the SML, it is
undervalued since the investor can expect a greater
return Ior the inherent risk. And a security plotted
below the SML is overvalued since the investor
would be accepting less return Ior the amount oI risk
assumed.
1í·-í ¸··

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