The Capital Asset

Pricing Model (CAPM)

Nathania Marshelia S.R - 195020401111012
Sukma Tri Kusuma Wardhani- 195020407111010
Table of contents

01 02
CAPM Beta Coefficient

03 04
Security Market Line Single Index Model
“Don’t Put All Your Eggs In One Basket.”

—Harry Markowitz
 Introduction
The CAPM was introduced by Jack Treynor, William F. Sharpe, John Lintner, and Jan
Mossin independently, building on the earlier work of Harry Markowitz on
diversification and modern portfolio theory.
 01
Capital Asset
Pricing Model
(CAPM)
 What is CAPM?

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between systematic risk
and expected return for assets, particularly stocks.
 Assumptions

● Investors are price takers.

● Investors have a single-period time horizon that is the same for all investors.
● Assume all information is available at the same time to all investors.
● Trade without transaction or taxation costs.
● Investors are rational and risk-averse.
● Investor expectations regarding the means, variances, and covariances of asset returns
are homogeneous
Formula Where:
E Ri = The expected return on the capital asset
Rf = The risk-free rate
βi = Beta of the Investment
(E (Rm) - Rf ) = The market premium (the expected market rate
of return - the risk-free rate of return)
Example
Imagine Ms. Nisa is contemplating a stock worth $200 per share today that pays a 2% annual dividend. The stock has a beta
compared to the market of 1.5, which means it is riskier than a market portfolio. Also, assume that the risk-free rate is 2% and
this investor expects the market to rise in value by 6% per year. How much return can Ms. Nisa expect from the stock?

Answer:

E Ri = 2% + 1.5 (6%-2%)
E Ri = 2% + 1.5 (4%)
E Ri = 2% + 6%
E Ri = 8%
 02
Beta Coefficient
What is Beta Coefficient?
Beta coefficient is a measure of sensitivity of a
company's stock price to movement in the market.
Formula Where:
Cov (Ri , Rm ) = Covariance of the stock rate of return and
market rate of return
Var Rm = Variance of the market rate of return

ρi,m = the correlation coefficient between the investment and

the market

σi = the standard deviation for the stock

σm = the standard deviation for the market
Example
1. Imagine Mr. Yuda wants to calculate the beta of Coca-Cola (CC) company in comparison to Pepsi (PS) company .
Based on recent five-year data, CC and PS have a covariance of 0.056, and the variance of PS is 0.020.

Answer:

βi = 0.056 / 0.020
βi = 2.8
Example
2. Because Mr. Yuda still have another time to decide, he also wants to calculate the beta of Fanta (FA) company as
compared to the Pepsi (PS). Based on recent five-year data, the correlation between FA and PS is 0.85. FA has a standard
deviation of returns of 24.15% and PS has a standard deviation of returns of 36.15%.

Answer:

βi = 0.85 x (0.2415 / 0.3615)

βi = 0.567842
 Situation Analysis

β>1 0<β<1
move in the same direction but larger move in the same direction but at lesser
degree

β=1 β=0
move in the same direction at the same It could be not correlated with those of
amount the market.
 03
Security Market
Line
 Overview of Info About Capital Market Line

Capital Market Line

L
Line from RF to L is capital
M market line (CML)
E(RM) x = risk premium
= E(RM) - RF
x
y = risk =  M
RF Slope = x/y
y
= [E(RM) - RF]/  M
y-intercept = RF
M
Risk Equation for CML:
 SECURITY MARKET LINE (SML)

Equation for expected return for an individual

stock similar to CML Equation

SML
E(R)

A
E(RM) B
Furthermore, the SML
equation for the I security C
can be written as follows: RF

r - rf = β (rm - rf)
0 0.5 1.0 1.5 2.0
BetaM
Example of Case
It is known that the return on risk-free assets
is known to be 12%. The market portfolio
return is 15%. Shares A has a Beta of 1.8.
The expected return of stock A is?

E(RA) = 12% + [(15% - 12%) x 1,8]

E(RA) = 12% + 5,4%
E(RA) = 17,4%
 04
Single Index Model
We will enter the formula, in the SIM formula there are two
main components, such as: Developed by William Sharpe (1963) to simplify
1. The unique return component represented by αi who computes in markowitz models.
have no relationship / independent of market return
2. The return component is represented by βi . RM that
has a relationship / dependent on market return
 Assumptions in the single index model

Second assumption: market index return

Main assumption: residual error of the i-stock
(RM) and residual error for each security (ei)
(ei) is not correlated with residual error of j-
are random variables - ei is not correlated
stock (ej)
with RM
 FORMULA & COMPONENTS

Ri = a i + β i . R M
ai = αi + ei
Ri = α i + β i . R M + e i

Ri = Return of the n stocks

ai =random variable that indicates the component of the return of the i-stock that is independent of market
performance
βi = Beta; coefficient that measures Ri changes as a result of RM changes
RM = return rate of the market index
αi = expectation value of an independent return of a security to a return
ei = residual errors that are random variables; expected the value is zero
 Additional Information for Formula &
Components!
αi affects only certain
companies (i) and does not
affect companies in general.
Related micro factors are,
for example, employee
strikes or factory
warehouse fires.

βi is the sensitivity of a stock's return (i) to market return. The market beta by
consensus is 1. For example, Beta A shares worth 1.5 then it is said that any
change in market return of 1% will be followed by a change in return of sajam
A by 1.5% (whether the value is up / positive or down / negative)
 EXAMPLE CASE

Return expectations for a driver's license can be stated as:

E(Ri) = αi + βi . E(RM)

Estimate the expected return of a stock when it is known (1) the

return expectation of the market index is 20% while (2) the return
expectation of a security that is independent of the market is 4%
and (3) Beta is 0.75

Answer : E(Ri) = 4% + (0,75) (20%) = 19%

 Stock Return Variant – Single Index Model

The formula of stock return variant based on SIM is:

Example:
The table below records the data of PT A stock return and market index
return for 7 time periods and Beta =1.7

σi2 = βi2 . σM2 + σei2

Period to Return of shares of PT Market return index (RM)
Acel (RA)
The stock risk (return variant) COMPUTATED 1 0,060 0,040
based on this model consists of two parts: 2 0,077 0,041
 Market-related risks (βi . σM ) and
2 2
3 0,095 0,050
 Unique risks of each company (σei2)
4 0,193 0,055
5 0,047 0,015
6 0,113 0,065
7 0,112 0,055
Mean 0,09957 0,04586
 ANSWER THE FOLLOWING QUESTION:
1. E(RA) = αA + βA . E(RM)
0,09957 = αA + (1,7)(0,04586)
αA = 0,0216
2. RA = αA + βA . RM + ei equal to eA = RA - αA – (βA .
RM)
3. Compute each residual error (eA) for each
period!
Period 1 = -0,0296 Period 5 = 0,0001
Period 2 = -0,0143 Period 6 = -0,0191
Period 3 = -0,0116 Period 7 = -0,0031
Period 4 = 0,0779
 ANSWER THE FOLLOWING QUESTION, CONT:

 
• σeA2 =
= 0,00768 ÷ 6 = 0,00128
• Note: why zero? Because it has been stated in the theory
that, constructively, the expected / expected residual error
value is equal to zero
• σ M2 =
= 0,00156 ÷ 6 = 0,00026
 Stock Return Covariance - Single Index Model

What if not only company A, but also company B in

our portfolio? So we use an additional variable called
Covariance in calculating the total risk of our portfolio later.

Mathematically, the covariance between stocks A and B which

relates only to market risk can be written as:

AB = A B 2M

The equation for calculating portfolio risk with a single index

model will be:
 Stock Return Covariance - Single Index Model (In Portfolio
Management)
In the context of portfolio management, covariance shows the extent to
which the returns of two securities have a tendency to move together.
Mathematically, the formula for calculating the covariance of two
securities A and B is:

In this case:
AB = covariance between security A and B
RA,i = return of securities A at time i
E(RA) = the expected value of the security's return A.
m = the amount of securities yield that may occur in a certain
period
pri = probability of occurrence of return it-i
 REVIEW QUESTION!!

Meanwhile, other stocks, such as B and C, have the same Beta as

stock A. Stock B has a realized return of 20% and C stock has a
realized return of 14%.From the information above, Stock B has the
status of undervalued (cheap) because with the same risk as stock
A, it is able to provide a higher realization of return. Meanwhile, C
shares are overvalued (expensive).
Draw the SML!
REWARD?
WE ARE PREPARE
MYSTERY GIFT!
ANSWER!
Time is Money