Capital Asset Pricing Model

(CAPM)

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 Portfolio

• A collection of tradable/Investment
Securities

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 Efficient Portfolio

• An Efficient portfolio is one that has the

highest expected returns for a given level of
risk
• The Efficient frontier is the frontier formed by
the set of efficient portfolios

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 In-Efficient Portfolio

• All the other portfolios that lie outside the

efficient frontier are inefficient portfolios

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 Systematic Risk/ Non Diversifiable Risk
• Arises on account of the economy wide
uncertainties and the tendency of individual
securities to move together with changes in the
market
• Cannot be reduced through diversification
• Also called as Market Risk
• Eg: Interest rate changes, Inflation rate
increase, Taxation rate changes, Forex
changes, Govt. Policies, Central bank policies
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 Un-Systematic Risk/Diversifiable Risk
• Arises from unique uncertainties of individual
securities
• Also called as unique risk
• Uncertainties here are diversifiable if a large number of
securities are combined to form well-diversified
portfolios
• Uncertainties of individual securities in a portfolio
cancel out each others risk
• Eg: Firm Specific -Strike by workers, competition
among companies, Raw material related changes,
Company bidding losses for a project/deal etc
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 Total Risk of Individual Security

• Total Risk of a security= Systematic risk +

Unsystematic Risk

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 INTRODUCTION-CAPM
A widely-used valuation model, known as the
Capital Asset Pricing Model, seeks to value
financial assets by linking an asset's return and
its risk.
It has two inputs
-- The market's overall expected return and an
asset's risk compared to the overall market.
-- The CAPM predicts the asset's expected return
and thus a discount rate to determine price.
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 Capital Asset Pricing Model
CAPM is an framework for determining the
equilibrium expected return for risky assets.
Relationship between expected return and
systematic risk of individual assets or
securities or portfolios.

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 Capital Asset Pricing Model
The general idea behind CAPM is that
investors need to be compensated in two ways:
time value of money and risk
William F Sharpe developed the CAPM
 He emphasized that risk factor in portfolio
theory is a combination of two risks:
 Systematic Risk
Unsystematic risk
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 ASSUMPTIONS
• Market Efficiency
-The Capital Market efficiency implies that share
prices reflect all available information
-Individual investors are not able to affect price of
securities
-Large number of investors holding a small amount
of wealth

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 ASSUMPTIONS
• Risk Aversion and Mean Variance Optimization
- Investors are risk averse
- Evaluation of a securities return based on ER
(Expected Return) and Variance or S.D. by investors
- Investors prefer highest ER for a given level of risk
- Investors- Mean-Variance optimizers , forming
efficient portfolios

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 ASSUMPTIONS

Homogeneous expectations
- Common expectations for all investors for ER
and risks of securities

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 ASSUMPTIONS

Single time period

- Investors decision is based on a single time
period
- Decision taken for a particular time period
only

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 ASSUMPTIONS

Risk free rate

- Investors can lend and borrow at Rf (Risk-
free) rate of Interest
- Investors create portfolios from publicly traded
securities like shares and bonds

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• The CAPM, despite its theoretical elegance, makes
some heady assumptions.
• It assumes prices of financial assets (the model's
measure of returns) are set in informationally-
efficient markets.
• It relies on historical returns and historical
variability, which might not be a good predictor of the
future.

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 CHARACTERISTICS - CAPM
To work with the CAPM we have to understand
three things.
(1)The kinds of risk implicit in a financial asset
(namely diversifiable and non-diversifiable
risk)
(2) An asset's risk compared to the overall market
risk -- its so-called beta coefficient (β)
(3) The linear formula (or security market line)
that relates return and β.
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 How is the CAPM derived?
• The CAPM begins with the insight that
financial assets contain two kinds of risk.
• There is risk that is diversifiable - it can
be eliminated by combining the asset with
other assets in a diversified portfolio.
• And there is non diversifiable risk - risk that
reflects the future is unknowable and cannot be
eliminated by diversification.

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 Implications and Relevance of CAPM

 Investors will always combine a risk free asset with a market

portfolio of risky assets. Investors will invest in risky assets
in proportion to their market value..

 Investors can expect returns from their investment according

to the risk. This implies a liner relationship between the
asset’s expected return and its beta.

 Investors will be compensated only for that risk which they

cannot diversify. This is the market related (systematic) risk

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 BETA (β)
 A measure of the volatility, or systematic risk, of a security or
a portfolio in comparison to the market as a whole.

 Beta is used in the capital asset pricing model (CAPM), a

model that calculates the expected return of an asset based on
its beta and expected market returns.

 Also known as "beta coefficient.“

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 CAPM Formula
CAPM - Rs = Rf + β (Rm – Rf)
Rs = Expected Return/ Return required on the investment

Rf = Risk-Free Return/ Return that can be earned on a

risk-free investment

Rm = Average return on all securities

β = The securities beta (systematic) risk factor.

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 ADVANTAGES - CAPM
There are numerous advantages to the application
of CAPM,
Ease-of-use: CAPM is a simplistic calculation that
can be easily tested to derive a range of possible
outcomes to provide confidence around the required
rates of return.

Diversified Portfolio: The assumption that investors

hold a diversified portfolio, similar to the market
portfolio, eliminates the unsystematic risk.
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 Systematic risk (ß): CAPM takes into account
systematic risk, which is left out of other
return models.
Business and Financial Risk Variability:
When businesses investigate opportunities, if
the business mix and financing differ from the
current business, then other required return
calculations.

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 Drawbacks - CAPM
Risk-free Rate (Rf): The commonly accepted rate
used as the Rf is the yield on short-term government
securities.

Return on the Market (Rm): The return on the

market can be described as the sum of the capital
gains and dividends for the market. A problem arises
when at any given time, the market return can be
negative. As a result, a long-term market return is
utilized to smooth the return.

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 Ability to Borrow at a Risk-free Rate: The minimum
required return line might actually be less steep
(provide a lower return) than the model calculates.

Determination of Project Proxy Beta: Businesses that

use CAPM to assess an investment need to find a beta
reflective to the project or investment. Often a proxy
beta is necessary. However, accurately determining one
to properly assess the project is difficult and can affect
the reliability of the outcome.

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 Limitations of CAPM

CAPM has the following limitations:

It is based on unrealistic assumptions.

It is difficult to test the strength of CAPM.

Betas do not remain stable over time.

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