CHRIST CHURCH BUSINESS SCHOOL

BA/BSC: BSc (Hons) Business Management

Level 6 (top-up)
Year 3:

D.W. Sajith Niroshana Kumarasiri, Kalindu

Student Name: Surath, Kusal Niraj Warnajeewa, T.R. Ravihara,
N.PN. Perera

Student CCCCU NIR20194172, LAZ20194182, WAR20194156,

ID: THA20194234, PER20194235

Module: Financial Strategy

Module Code: MSCMD3FSY

Tutor’s Name: Mrs. Hiruni Rathwatta

Assessment No: Group Assessment 02

Assessment
Evaluating the CAPM on the Share Market
Topic:

Submission
04.05.2020
Date:

Word Count: ………………2145…………….…………… (Excluding abstracts, appendices,

direct quotes, bibliography, diagrams and illustrations)
We, Sajith, Kalindu, Kusal, Ravihara, Pasindu have read and adhered to the University plagiarism
regulations as stated in the student handbook.

Signature: …Sajith……… Date: 03.05.2020……

Please read these instructions carefully:

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For electronic submission through Turnitin, please insert this page at the front of your assessment. (Page break and insert.) Copies
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Table of Contents

01. A Critical Analysis of the Capital Asset Pricing Model.......................................................3

02. A comparative analysis of the overall performance of both portfolios, including reference
to specific share price fluctuations that occurred following events that affected the entire Stock
Market or events that affected individual companies......................................................................7
Portfolio 01..................................................................................................................................7
Portfolio 02..................................................................................................................................9
03. Recommendations as to what you would do differently in the future in order to improve
the performance of your portfolios................................................................................................14
References......................................................................................................................................15
Bibliography..................................................................................................................................16
Appendix........................................................................................................................................17

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 1. A Critical Analysis of the Capital Asset Pricing Model.

The Capital Asset Pricing Prototypical was first developed by William Sharpe in 1964 based on
Markowitz’s Portfolio theory. According to Sharpe the CAPM shows the relationship between
systematic risks and the expected return. Furthermore, he states that to gain more returns it is
essential to face higher risks. (Michelle, 2019)
After Sharpe economist like Jack Treynor, John Lintner and Jan Mossin developed this theory in
the early 1960’s. (Perold, 2004) There are subtle differences in the CAPM than the Portfolio
Theory.
CAPM Portfolio Theory
CAPM uses market risk of shares to control This theory basically considers about the
potential share prices. CAPM eradicates entire risks and reappearance of the portfolios.
systematic risks. It gives advices to the investors to what
portfolio to invest in eradicating unsystematic
risk by holding diversified portfolios.

The assumptions the CAPM based on are as follows,

 Most of the investors are risk averse. They consider diversified of portfolios is a necessity
to reduce the risks on investments. They use Expected Rate of Return and the Standered
Deviation of return are necesery measures of risk and return for the portfolio. They want
to maximize their utility.
 All the investors do the decision makings based on a single period Horizon.
 Transactions costs are extremely low, and investors can buy and sell shares in any
quantity. Only wealth and the Price of the Assets will be affecting the buying and selling
power of the investors.
 Investors can trade in a risk-free rate.
 The capital markets are perfectly competitive. There will be considerable number of
buyers and sellers which just a one person won’t be able to influence the market. Entry or
exit barriers are not there with a tax transaction cost free market. (Diksha, 2020)

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This model completely changed the people’s perspective of finance and it influences them. From
the business point of view CAPM helps to calculate the cost of capital for the firm. For investors
it shows the profit for the investments they can made.

Advantages of the Capital Asset Pricing Method

 CAPM considers about the systematic risks only. Investors already use diversified
portfolios eradicating unsystematic risks. CAPM helps to eradicate systematic risks also.
 It is a theoretical approach that shows the relationship between systematic risks and the
required return giving investors the information regarding the investment decisions.
 Clearly reflects about the level of systematic risk of the company relative to the share
market. Therefor it considered as a much better technique to get the final result of cost of
equity.
 Better than WACC in providing discounting amounts for venture appraisals.
(ACCA,2020)

Disadvantages of the Capital Asset Pricing Method.

 Some argue that beta values of the shares may not have a connection to the returns of
stocks because there are many other influences that determine the returns of a share.

The base for the Capital Asset Pricing Method is the direct relationship between risk and return.
This is defined by the Security Market Line (SML). This serves as a graphical representation for
CAPM. The logical threat of a share is linked with the risk and profit of the market and the risk-
free rate of the market to estimate a fair potential profit of the shares that is invested in.

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 (Figure 1.1)

The SML is calculated using following formula.

Ri = Rf + Ɓi (Rm – Rf)
Ri = Rate of return of the share predicted using the model.
Rf = The Risk-Free Rate of Return
Ɓi = The Beta Coefficient of the Share.
Rm = The Return of the Market

The Risk-Free Rate of Return (Rf)

This shows the percentage of profit made by capitalizing in a risk-free benefit which is the rates
of government bonds of a country with a stable economy. The yields of the short-term
government bonds are taken for this.

The Beta Coefficient of the Share (Ɓi)

The Beta value shows how much of a risk the potential investments are going to add to the
portfolio. It the stock has a beta value above 01 it will have a risk rate more than the market risk.
If the Beta value is less than 01 the formula assumes that it will reduce the risk on the portfolio.
(Kenton, 2020)

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The Return of the Market (Rm)
This is frequently calculated by using share market guides such as FTSE 100. The studies show
that the market risk is between 8%-9% yet some argue that a market premium about 5% is more
realistic. More the market is unstable the market risk rate will also go higher.

There are quite a few ways that the Capital Asset Pricing Model be applied.

 Portfolio Selection

The investors which are risk averse may chose a low beta value portfolio to invest in. On the
other hand, if the investor decided to make a high beta value portfolio, we can expect it to
outperform the market is rising but it will underperform when the market starts to go back down.

 Mis- Priced Shares

If the share has an unusual higher expected rate of return when comparing with its beta values it
considered as a “Buy” opportunity. If it has an extraordinarily low expected return compared to
its beta value, it considered as a “sell” opportunity.

 Cost of Capital Calculation.

As the investors calculate the required rate of return using the module, then the businesses can
use the same module to find their budget of investment.

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 2. A comparative analysis of the overall performance of both portfolios,
including reference to specific share price fluctuations that occurred
following events that affected the entire Stock Market or events that
affected individual companies.

We were given two portfolios on “Virtual Trader” to invest with an initial capital of £100,000 for
each portfolio. The company which our group members formed is “Purchasing Lana
International (Pvt)Ltd. For the first portfolio we didn’t have use any theories to invest, but for
the second portfolio we had to imply the theories we learned to the portfolio when making the
investment decisions. The detailed analysis of both the portfolios are as follows.

Portfolio 01

For the Portfolio one the group did not use any of the theories about investing in the share
market. When starting to invest the only fact we looked at was the share price fluctuations over
the year of each company and the highest and the lowest share prices recorded. An example is as
follows.

(Figure 2.1)
Given above in the figure 2.1 is the share price fluctuation pattern of the HSBC Holdings PLC
for an year. Looking at this we predicted that the share prices will increase. This method wasn’t a
success as it occurs more losses than we expected. For this company we had to bear a 17.98%

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loss. We have invested in about 10 companies in the beginning which gives average £ 10,0000
investment for each company and it won’t be profitable investing a smaller value as we had to
pay a commison for each transaction. There for we decided to invest in handful of companies
around 5 to 6 companies. To choose these companies we considered about following factors.
 Background of the company.
 Performance in the sharemarket.
 Annuals reports of the respective companies.
 Reputation in the market.

Based on the above factors we have chosen companies such as;

BP PLC
AstraZeneca PLC
Pennon Group PLC
Aveva Group PLC
Glaxo Smith Kline PLC
HSBC Holdings PLC

To predict the future values of the shares we studies the share fluctuations for one week and
based on those studies we sold the shares we bought of Pennon Group PLC, AstraZeneca PLC
and Glaxo Smith Kline PLC earning a profit with the transactions. Even thou the other share
prices has gone down we were manged to gain a profit of 0.94% as shown in the figure given
below at the time of writing this report. (01.05.2020)

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 (Figure 2.2)
The Covid-19 outbreak affected heavily to LSE. With the announcement on the 27.03.2020 that
the UK Prime Minister is also affected by the virus made the LSE go drastically down.
Sample of the transactions done in the Portfolio one is shown below.

(Figure 2.3)

Portfolio 02

To invest in the Portfolio 02, we used the Portfolio Theory and the Capital Asset Pricing Model
trying to remove systematic and unsystematic risks.

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Between 02nd January 2020 – 23rd March 2020 FTSE100 all share index fell by 35% over the
given period. The hardest affected industries and the overperformed industries during that period
are as follows.

Hardest Affected Industries Overperformed Industries

o Tourism  Food & Drugs Manufactures and
o Leisure Retailers.
o Fossil Fuel Production  Utilities

o Insurance  High Tech Manufacturing

 Tobacco
o Retailers (Excluding Food & Drugs)
 Medical and Biotech
(Table 2.1)

These outperformed industries have also fallen by 16% but the situation is better when compared
to the fall of 35% of the other hardest affected industries. (Londonstockexchange, 2020)

Based on the above information we have chosen few industries that we’ll be best to invest in.
According to the Markowitz Portfolio Theory it is better to diverse our investments to eradicate
unsystematic risks. So, we have chosen the fields of,
 Health & Safety
 Defence and Database
 Financial Sector
 FMCG Market
 Oil & Gas
UKs current yield for short-term government bonds was taken as the risk-free rate. The market
risk rate was estimated by using FTSE100 Ordinary Market Keys.

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When choosing the shares to be invested in we have used the Capital Asset Pricing Model to
eradicate systematic risk by choosing the companies with the higher beta value with a higher
CAPM value. The companies that were chosen are.
 Diageo PLC
 Intertek Group PLC
 BAE Systems PLC
 Prudential PLC
 GlaxoSmithKline PLC
 British American Tobacco PLC
 BP PLC
(Referee appendix 01)

Higher beta value of shares was considered as a buy opportunity and lower value considered
as selling opportunity. We kept record of the daily beta values and the security market line
for each company. We sold the shares of Diageo PLC with a profit of 3.97% which was
expected to be 3.94% and the shares of Prudential PLC with the profit of 8.09% which is
greater than the estimated return of 6.81%.

The Portfolio 02 was performing well with an overall return of above 3% within a week on
30.05.2020. But by the 1st of May 2020 with the Covid-19 is spreading in the UK the people
are panic selling in the share market afraid of obtaining losses. This panic selling caused a
huge reduction of the share prices. (thetelegraph, 2020) This also affected to our Portfolio 02
making an overall loss of -3.66% by 01st May 2020. This because there are high marked beta
values which are British American Tobacco PLC with a beta value of 1.1133 and BP PLC
with a beta value of 1.1671. See the figure 2.3 for the current situation of the Portfolio 02.

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 (Figure 2.4)

The share price fluctuations occurred in the last week of the high beta value companies of
The British American Tobacco PLC and The BP PLC shows how the panic selling has
affected the share prices.

(Figure 2.5)

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 (Figure 2.6 )

The transaction history shows how we were able to sell the shares of Prudential PLC, Diageo
PLC to earn profits before the panic selling of stocks happened.

(Figure 2.7)

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3. Recommendations as to what you would do differently in the future in
order to improve the performance of your portfolios.

Purchasing Sri Lanka internationals didn’t use any theoretical knowledge when investing in
the portfolio 0usi1. Even there is a 0.94% profit that is not enough and it’s not stable. For the
Portfolio 02 the Capital Asset Pricing Model (CAPM) was used in the beginning it was
performing well and a small change in market made a huge loss.

As per the outcomes of the two portfolios Purchasing Sri Lanka has come into the conclusion
of that it is always better to have diversified portfolios to eradicate the unsystematic errors
and CAPM should be followed to eradicate systematic errors. Both kind of errors must be
prevented. To improve the performance of the portfolios our members have given following
recommendations.
 Other than using the CAPM model it is must to check the background of the company
and it’s share price fluctuations before investing.
 Be patient and stay alert on the beta value changes.
 Don’t engage in panic selling of shares. The shares that are under a loss now will
automatically be profitable with time.
 Compare more companies using the CAPM to choose the best investment options in
the market.
 Purchasing Higher Beta value shares (beta > 1) are risky. Give constant attention for
those shares as it is the main reason for the loss of the Portfolio 02.

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References

Economics Discussion. n.d. CAPM: Assumptions and Limitations | Securities | Financial

Economics. [online] Available at: <http://www.economicsdiscussion.net/portfolio-
management/capm/capm-assumptions-and-limitations-securities-financial-
economics/29904> [Accessed 2 May 2020].

https://www.accaglobal.com, A., 2020. CAPM: Theory, Advantages, And Disadvantages | F9

Financial Management | ACCA Qualification | Students | ACCA Global. [online]
Accaglobal.com. Available at: <https://www.accaglobal.com/uk/en/student/exam-support-
resources/fundamentals-exams-study-resources/f9/technical-articles/CAPM-theory.html>
[Accessed 2 May 2020].

Kenton, W., 2020. Capital Asset Pricing Model (CAPM). [online] Investopedia. Available at:
<https://www.investopedia.com/terms/c/capm.asp> [Accessed 2 May 2020].

Londonstockexchange.com. 2020. Prices and Markets - London Stock Exchange. [online]

Available at: <https://www.londonstockexchange.com/prices-and-
markets/markets/prices.htm> [Accessed 27 March 2020].

Markets Hub - Live financial updates from The Telegraph. 2020. Markets Hub - Live
Financial Updates from The Telegraph. [online] Available at:
<https://www.telegraph.co.uk/markets-hub/share/S1291/LSE/LondonStockExchange>
[Accessed 1 May 2020].

Mitchell, C., 2019. William F. Sharpe Definition and History. [online] Investopedia.
Available at: <https://www.investopedia.com/terms/w/william-f-sharpe.asp> [Accessed 2
May 2020].

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Bibliography

Watson, D. and Head, A., 2010. CORPORATE FINANCE: Principles & Practice. 5th ed.
Pearson Education Limited, pp.224-250.

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Appendix

Appendix 01 (CAPM Calculation)

Health and Safety

Date Company Name Rf Ɓi Rm (Rm-Rf) Ɓi(Rm-Rf) Rf+Ɓi(Rm-Rf) Ri % Actual Return
22.04.2020 Smith & Nephew PLC 0.0013 0.6812 0.058 0.0567 0.0386 0.0399 3.99%
Intertek PLC 0.0013 0.9049 0.058 0.0567 0.0513 0.0526 5.26% -7.80%
23.04.2020 AstraZeneca PLC 0.0009 0.5847 0.058 0.0571 0.0334 0.0343 3.43%
GlaxoSmithKline PLC 0.0009 0.7637 0.058 0.0571 0.0436 0.0445 4.45% -4.72%
Defence and Database
23.04.2020 BAE Systems PLC 0.0010 0.9135 0.058 0.0570 0.0521 0.0531 5.31% -1.78%
Relx PLC 0.0010 0.6539 0.058 0.057 0.0373 0.0383 3.83%
Financial Sector
23.04.2020 Prudential PLC 0.0010 1.1775 0.058 0.0570 0.0671 0.0681 6.81% 8.09%
Schroders PLC 0.0010 0.6664 0.058 0.057 0.0380 0.0390 3.90%
Oil and Gas
28.04.2020 Royal Dutch Shell PLC 0.0005 1.0883 0.058 0.0575 0.0626 0.0631 6.31%
BP PLC 0.0005 1.1671 0.058 0.0575 0.0671 0.0676 6.76% -5.25%
FMCG Market
22.04.2020 Unilever PLC 0.0013 0.5178 0.058 0.0567 0.0294 0.0307 3.07%
Diageo PLC 0.0013 0.6728 0.058 0.0567 0.0381 0.0394 3.94% 3.97%
28.04.2020 British American Tobacco PLC 0.0005 1.1133 0.058 0.0575 0.0640 0.0645 6.45% -4.88%

= Companies that were chosen to invest in

= Actual > Expected

= Actual < Expected, currently a loss.

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