Introduction to CAPM:

The CAPM was Developed in 1960s by Three Researchers William Sharpe, John Lintner & Jan
Mossin. CAPM is a relationship explaining how assets should be priced in Capital Markets.

What is CAPM?

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
the expected return and risk of investing in a security. It shows that the expected return on a
security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security.

Formula:

1. Expected Return (ER)=Rf + B(Rm- Rf)

ER= Expected Rate of Return
Rf= Risk Free Rate of Return
B= Beta of Security
Rm = Expected Return on Market

2. Expected Rate of Return on Market Portfolio (Rm)

Rm= Market Price – Initial Price + Dividend x 100
Initial Price
Assumptions of CAPM:

 Investors are expected to make decisions based solely on risk-return assessments.

 The purchase and sale transactions can undertake in infinitely divisible units.
 Investors can sell short any number of shares without limit.
 There is perfect competition and no single investor can influence prices, with no transaction
costs, involved.
 Personal income tax is assumed to be zero.
 Investors can borrow/lend the desired amount at riskless rates.
 Beta of Market Portfolio is "1”
 Beta of Risk Free Assets is Always “0”

Strategy for Investing:

 If ER > Return as per CAPM – Undervalued then Buy

 If ER < Return as per CAPM – Over valued then Sell
 If ER = Return as per CAPM – Correctly valued then Hold

Types of Investors according to Risk profile:

 Type A- Conservative Approach (Risk means “Danger” )
 Type B- Moderately Conservative (Risk means “Uncertainty”)
 Type C- Balanced (Risk means “Possibilities”)
 Type D- Moderate Growth (Risk Means “Opportunity”)
  Type E- Growth (Risk means “Thrill”)
 Type F- Shares (Risk means Very High “Thrill”)

Problems on CAPM:
Ex.1 Following are the details of three Portfolios:
Portfolio Average Standard Beta
Deviation
A 13% 0.25 1.25
B 12% 0.25 1.75
C 11% 0.20 1.00
Risk Free return is 8%. Compute Expected Return as per CAPM.

Ex.2 Following are the details of three Portfolios:

Portfolio Average Beta
Apple Ltd 17% 1.6
Wipro Ltd 10% 0.7
Birla Ltd. 16% 1.3
Risk Free return is 8% & Market returns are 15%. Compute Expected Return as per CAPM

Ex.3 Following are the details of Portfolios:

Portfolio Initial Price Dividend Market Price Beta
P 25 2 50 0.8
Q 35 2 60 0.7
R 45 2 135 0.5
S 1000 140 1005 0.99
Risk Free return is 14% .Compute Expected Return as per CAPM in each case & also calculate
the Avg. Return of Portfolio.

Ex.4 Following are the details of Portfolios

Securities A B C
Expected Return (%) 18 11 15
Beta 1.7 0.6 1.2
If Risk free return is 9% and Market return is 14%, which of the above securities are Over,
Under, Correctly Valued in the Market? What should be your strategy?