CAPM Examples

The Capital Asset Pricing

Model
What is it?

An hypothesis by Professor William Sharpe

Hypothesizes that investors require higher rates of return for greater
levels of relevant risk.
There are no prices on the model, instead it hypothesizes the
relationship between risk and return for individual securities.
It is often used, however, the price securities and investments.

9-2

The Capital Asset Pricing

Model
How is it Used?

Uses include:
Determining the cost of equity capital.
The relevant risk in the dividend discount model to estimate a
stocks intrinsic (inherent economic worth) value. (As illustrated

below)
Estimate
Investments Risk
(Beta Coefficient)

COVi,M
M2

Determine
Investments
Required Return

ki RF ( ERM RF ) i

Estimate the
Investments
Intrinsic Value

Compare to the
actual stock price in
the market

D1
P0
kc g

Is the stock
fairly
priced?

9-3

Market Portfolio and Capital Market

Line
The assumptions have the following
implications:
1. The optimal risky portfolio is the one
that is tangent to the efficient frontier on
a line that is drawn from RF. This
portfolio will be the same for all
investors.
2. This optimal risky portfolio will be the
market portfolio (M) which contains all
risky securities.
9-4

The Capital Asset Pricing

Model
Assumptions

CAPM is based on the following assumptions:

1. All investors have identical expectations about expected
returns, standard deviations, and correlation coefficients
for all securities.
2. All investors have the same one-period investment time
horizon.
3. All investors can borrow or lend money at the risk-free
rate of return (RF).
4. There are no transaction costs.
5. There are no personal income taxes so that investors are
indifferent between capital gains an dividends.
6. There are many investors, and no single investor can
affect the price of a stock through his or her buying and
selling decisions. Therefore, investors are price-takers.
7. Capital markets are in equilibrium.
9-5

The Capital Asset Pricing Model - Definition

In finance, one of the most important things to

remember is that return is a function of risk.
This means that the more risk you take, the higher
your potential return should be to offset your
increased chance for loss.
One tool that finance professionals use to calculate
the return that an investment should bring is the
Capital Asset Pricing Model (CAPM from now on).
CAPM calculates a required return based on a risk
measurement. To do this, the model relies on a risk
multiplier called the beta coefficient, which we
will discuss in the next section.

Main Assumptions of CAPM

Model
All Investors are Efficient Investors - Investors follow Markowitz idea of
the efficient frontier and choose to invest in portfolios along the frontier.
Investors Borrow/Lend Money at the Risk-Free Rate - This rate remains
static for any amount of money.
The Time Horizon is equal for All Investors - When choosing
investments, investors have equal time horizons for the chosen investments.
All Assets are Infinitely Divisible - This indicates that fractional shares can
be purchased and the stocks can be infinitely divisible.
No Taxes and Transaction Costs -assume that investors' results are not
affected by taxes and transaction costs.
All Investors Have the Same Probability for Outcomes -When
determining the expected return, assume that all investors have the same
probability for outcomes.
No Inflation Exists - Returns are not affected by the inflation rate in a
capital market as none exists in capital market theory.
There is No Mispricing Within the Capital Markets - Assume the markets
are efficient and that no mispricings within the markets exist.

CAPM Formula
The capital asset pricing model (CAPM)
is a model that calculates expected
return based on expected rate of
return on the market, the risk-free rate
and the beta coefficient of the stock.
E(R) = Rf + ( Rmarket - Rf )

Measuring Systematic Risk

The Beta Coefficient
The Capital Asset Pricing
Model (CAPM)

The Beta Coefficient

What is the Beta Coefficient?

A measure of systematic (nondiversifiable) risk

As a coefficient the beta is a pure
number and has no units of measure.

CHAPTER 9 The Capital

Asset Pricing Model
(CAPM)

9 - 10

The Beta Coefficient

How Can We Estimate the Value of the Beta Coefficient?

There are two basic approaches to

estimating the beta coefficient:
1. Using a formula (and subjective forecasts)
2. Use of regression (using past holding
period returns)
(Figure 9 8 on the following slide illustrates the characteristic line used to
estimate the beta coefficient)
CHAPTER 9 The Capital
Asset Pricing Model
(CAPM)

9 - 11

The CAPM and Market Risk

The Characteristic Line for Security A
9 - 8 FIGURE
Security A Returns (%)

2
0
-6

-4

-2

0
-2

-4
-6

CHAPTER 9 The Capital

Asset Pricing Model
(CAPM)

9 - 12

Market Returns
(%)

The
The slope
plotted
of
points
the are
regression
the
line
coincident
is beta.
rates of
The
return
line of
earned
best fit on
is
known
the in
investment
finance as
and
the
the
characterist
market
portfolio
ic line.
over past
periods.

The Formula for the Beta Coefficient

Beta is equal to the covariance of the
returns of the stock with the returns of
the market, divided by the variance of
the returns of the market:
[9-7]

CHAPTER 9 The Capital

Asset Pricing Model
(CAPM)

COVi,M i , M i
i

2
M
M

9 - 13

The Beta Coefficient

How is the Beta Coefficient Interpreted?

The beta of the market portfolio is ALWAYS = 1.0

The beta of a security compares the volatility of its returns to the volatility
of the market returns:
s = 1.0

the security has the same volatility as the

market as a whole

s > 1.0

aggressive investment with volatility of returns

greater than the market

s < 1.0

defensive investment with volatility of returns

less than the market

s < 0.0

an investment with returns that are negatively

correlated with the returns of the market

CHAPTER 9 The Capital

Asset Pricing Model
(CAPM)

9 - 14

The Beta of a Portfolio

The beta of a portfolio is simply the weighted average of
the betas of the individual asset betas that make up the
portfolio.
[9-8]

P wA A wB B ... wn n

Weights of individual assets are found by dividing the

value of the investment by the value of the total
portfolio.
CHAPTER 9 The Capital
Asset Pricing Model
(CAPM)

9 - 15

The Security Market Line

The Capital Asset Pricing
Model (CAPM)

The CAPM and Market Risk

The Security Market Line (SML)

The SML is the hypothesized relationship between return

(the dependent variable) and systematic risk (the beta
coefficient).
It is a straight line relationship defined by the following
formula:
[9-9]

ki RF ( ERM RF ) i

Where:
ki = the required return on security i
ERM RF = market premium for risk

CHAPTER 9 The Capital

Asset PricingModel
i = the beta
(CAPM)

9 - 17security i
coefficient for

The CAPM and Market Risk

The Security Market Line (SML)
9 - 9 FIGURE
ER

ERM

ki RF ( ERM RF ) i
TheSML
SMLis
The
uses
usedthe
to
beta
predict
coefficient
required
as thefor
returns
measure
of
individual
relevant
securities
risk.

RF

M = 1
CHAPTER 9 The Capital
Asset Pricing Model
(CAPM)

9 - 18

The CAPM and Market Risk

The SML and Security Valuation
9 - 10 FIGURE

ki RF ( ERM RF ) i

ER

SML

Expecte
d Return
A
Required
Return A

A
B

RF

CHAPTER 9 The Capital

Asset Pricing Model
(CAPM)

9 - 19

Similarly,
Required
A
is an
B is
returns
undervalued
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security.
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because
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Investors
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Investors
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The CAPM in Summary

The SML and CML

The CAPM is well entrenched and widely used by

investors, managers and financial institutions.
It is a single factor model because it based on the
hypothesis that required rate of return can be
predicted using one factor systematic risk
The SML is used to price individual investments and
uses the beta coefficient as the measure of risk.
The CML is used with diversified portfolios and uses
the standard deviation as the measure of risk.
CHAPTER 9 The Capital
Asset Pricing Model
(CAPM)

9 - 20

Challenges to CAPM
Empirical tests suggest:
CAPM does not hold well in practice:
Ex post SML is an upward sloping line
Ex ante y (vertical) intercept is higher that RF
Slope is less than what is predicted by theory

Beta possesses no explanatory power for predicting

stock returns (Fama and French, 1992)

CAPM remains in widespread use despite the

foregoing.
Advantages include relative simplicity and intuitive
logic.

Because of the problems with CAPM, other models

have been developed including:
Fama-French (FF) Model
Abitrage Pricing Theory (APT)
CHAPTER 9 The Capital
Asset Pricing Model
(CAPM)

9 - 21

Examples CAPM
Determine the expected return on Newco's stock
using the capital asset pricing model.
Newco's beta is 1.2. Assume the expected return
on the market is 12% and the risk-free rate is 4%.
Answer:
E(R) = 4% + 1.2(12% - 4%) = 13.6%.
Using the capital asset pricing model, the
expected return on Newco's stock is 13.6%.

The Security Market Line

(SML)
Similar to the CML, the SML is derived
from the CAPM, solving for expected
return. However, the level of risk used
is the Beta, the slope of the SML.

The SML is illustrated below:

SML

Beta is the measure of a stock's

sensitivity of returns to changes in the
market. It is a measure of systematic
risk.
Beta = B =
Covariance of stock to the market
Variance of the market

Example: Beta
Assume the covariance between Newco's stock
and the market is 0.001 and the variance of the
market is 0.0008. What is the beta of Newco's
stock?
Answer:
BNewco = 0.001/0.0008 = 1.25

Determine Whether a Security is

Under-, Over- or Properly Valued
As discussed, the SML line can be derived using CAPM,
solving for the expected return using beta as the
measure of risk.
Given that interpretation and a beta value for a
specific security, we can then determine the expected
return of the security with the CAPM.
Then, using the expected return for a security derived
from the CAPM, an investor can determine whether a
security is undervalued, overvalued or properly valued.

CAPM Examples:
Example:Calculate the expected return on a security and evaluate
whether the security is undervalued, overvalued or properly valued.

An investor anticipates Newco's security will reach $30 by the end

of one year.
Newco's beta is 1.3.
Assume the return on the market is expected to be 16% and the
risk-free rate is 4%.
Calculate the expected return of Newco's stock in one year and
determine whether the stock is undervalued, overvalued or
properly valued with a current value of $25.
Answer:
E(R)Newco = 4% + 1.3(16% - 4%) = 20%

CAPM Examples
Given the expected return of Newco's stock
using CAPM is 20% and the investor anticipates
a 20% return, the security would be properly
valued.
If the expected return using the CAPM is higher
than the investor's required return, the
security is undervalued and the investor
should buy it.
If the expected return using the CAPM is lower
than the investor's required return, the security
is overvalued and should be sold.

SML
The Characteristic Line
The characteristic line is line that occurs when an
individual asset or portfolio is regressed to the
market.
The beta is the slope coefficient for the characteristic
line and is thus the measure of systematic risk for the
asset or portfolio.
Recall, a beta is the measure of a stock's sensitivity of
returns to changes in the market.
It is a measure of systematic risk.

Examples
You are interested in buying a security.
The current risk free rate is 6%. The
market return on this particular
security is expected to be 8.6%. The
beta of the security is 1.2.
What is the expected return of the
security according to the capital asset
pricing model?

If you were told that the expected return in the

next 12 months on the security was to be 12%.
Would the security be overpriced or underpriced?
How would this be depicted on the SML?
The expected return, 12% is greater than the
expected return given by the CAPM equation,
9.12%. Therefore, investors are likely to receive
higher returns than expected which therefore
makes the security worth investing into. The
security must therefore be underpriced.

CAPM Examples contd.

CAPM examples
What happens in the case of an
underpriced security? Does it always
remain underpriced? Of course not!
Once investors become aware that a
security is underpriced they purchase
the security therefore raising its price.
The price of the security will rise until
the security is forced downwards and it
sits on the SML like shown in the
diagram next page.

CAPM examples

Say that now the expected return in the next 12

months on the security was to be 9%. Would the
security be overpriced or underpriced? How would this
be depicted on the SML?
The expected return, 9%, is less than the expected
return given by the CAPM equation, 9.12%. Therefore,
investors are likely to receive lower returns than
expected which makes the security not worth investing
into. The security is therefore overpriced.
In the case of overpriced securities, investors will sell
them as they are providing expected returns less than
that predicted by the CAPM equation. (refer next page)

CAPM Examples

If Expected Return is more than the

Predicted CAPM return the securities
are underpriced, then the investors will
buy.
If the Expected Return is less than the
Predicted CAPM return, then the
securities is Overpriced, then the
investors will sell.