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Group 4 Sapm
Group 4 Sapm
Presented By:
Nithish Sebastian Vivian Subramanya Mahesh Vinod
CAPM Overview:
conclusions
CAPM
Practical Use of the CAPM CAPM formulae
Limitations of CAPM
Markowitz, William Sharpe, John Linter and Jan Mossim provided basic structure for CAPM model. The Capital Asset Pricing Model(CAPM) helps us to calculate investment risk and what return on investment we should expect. This model describes the relationship between risk and expected return This model starts with the idea that individual investment contains two types of risk: Systematic Risk (or Market risk) Unsystematic Risk (or Specific risk)
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CAPM considers only systematic risk and assumes that unsystematic risk can be eliminated by diversification. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves.
Beta
No of shares.
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Beta is used as a measure of systematic risk In this theory, The required rate of return of an asset is having a linear relationship with assets beta value All investor hold only the market portfolio and riskless securities. Market portfolio consists of the investment in all securities of the market. Each assets is held in proportion to its market value to the total value of all risky assts. For Say if Reliance industry share represents 20% of all risky assets, then the market portfolio of all individual investors contains 20% of Reliance industry shares CAPM is based on the idea that investors demand additional expected return (called the risk premium) if they are asked to accept additional risk. This model tells us the fair (risk-adjusted) expected return for every individual asset. Click Here
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The perfect market assumption There are no taxes or transaction costs or information costs Stocks can be bought and sold in any quantity (even fractions) There is one risk-free asset and all investors can borrow or lend at that rate
CAPM's starting point is the risk-free rate - typically a 10-year government bond yield. To this is added a premium that equity investors demand to compensate them for the extra risk they accept. This equity market premium consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta."
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Beta :
According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's relative volatality - that is, it shows how much the price of a particular stock jumps up and down compared with how much the stock market as a whole jumps up and down. If a share price moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10%, and fall by 15% if the market fell by 10%. Interpreting F
if F! asset is risk free if F! asset return = market return if F" asset is riskier than market index F asset is less risky than market index
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Rf
1.0
Beta Coefficient
Rf = 4%
1.0
Beta Coefficient
SML
Rf = 4%
1.0
Beta Coefficient
Return %
R(k) = 13.6% km =12%
SML
Rf = 4%
1.0
Limitations of CAPM It is not realistic in the world. This assumes that all investors are risk averse and higher the risk, the higher is the return. Investors ignore the Transactions cost, information cost. Brokerage, taxes etc and make decision on single period time horizon. The investor are given a choice on the basis of risk- return characteristics of an investment and they can buy at the going rate in the market. There are many buyers and sellers and the market is competitive and free forces of supply and demand determine the prices. CAPM Empirical tests and analyses used ex-post i.e Past data only. The historical data regarding the market return, risk free rate of return and betas vary differently for different periods. The various methods used to estimate these inputs also affect beta value. Since the inputs cannot be estimated precisely, the expected return found out through the CAPM model is also subjected to criticisms.
CAPM establishes a measure of risk premium and is measured by F(Rm Rf) Beta coefficient is the non diversifiable risk of the asset, relative to the risks of the asset. Suppose Tisco company has a beta equal to 1.5 and the risk free rate is say 6% .The required rate of return on the market (Rm) is 15%. Then adopting this equation, we have
If the market rate is 15% then the return on Tisco should 19.5% because the larger risk on tisco than on market. When return on market is zero this model doesn t work accurately .
Focuses on the Market Risk. Thus makes investors to think about riskiness of the assets in general. It has been useful in the selection of securities and portfolios. Securities with higher returns are considered to be undervalued and attractive for buy. The below normal expected return yielding securities are considered to be overvalued and suitable for sale. In the CAPM it has been assumed that investor consider only the market risk , Given the estimate of the risk free rate, the beta of the firm, stock and required market rate of return, one can find out the expected returns for the firms security. This expected return can be used as an the cost of retained earnings.
Conclusions: CAPM
It is called a pricing model because it can be used to help us determine appropriate prices for securities in the market. The CAPM suggests that investors demand compensation for risks that they are exposed to and these returns are built into the decision-making process to invest or not. The CAPM is a fundamental analyst s tool to estimate the intrinsic value of a stock. The analyst needs to measure the beta risk of the firm by using either historical or forecast risk and returns. The analyst will then need a forecast for the risk-free rate as well as the expected return on the market. These three estimates will allow the analyst to calculate the required return that rational investors should expect on such an investment given the other benchmark returns available in the economy.
Introduction
Assumptions
Arbitrage Portfolio
Introduction
This model developed in asset pricing by Stephen Ross Arbitrage pricing theory is one of the tools used by the investors and portfolio managers. The capital asset pricing theory explains the returns of the securities on the basis of their respective betas. The investor chooses the investment on the basis of expected return and variance.
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Arbitrage: Meaning
Arbitrage is a process of earning profit by taking advantage of differential pricing for the same asset. The process generates riskless profit. In the security market , it is of selling security at a high price and the simultaneous purchase of the same security at a relatively lower price. The profit earned through arbitrage is riskless. The buying and selling of the arbitrageur reduces and eliminates the profit margin. Thus bringing the market price to the equilibrium level.
Arbitrage Mechanism
For same risks Asset U has higher return than Asset O Asset U is underpriced and assets O is overpriced. Sell asset O or go short on O Buy asset U or go long on U @Investor makes Riskless profit Impact Demand on asset U goes up and supply of O also goes up @Price of U increases and price of O decreases Thus, Arbitrage goes on till prices are traded at same level.
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Assumptions
The investors have homogeneous expectation. The investors are risk averse and utility maximizes. Perfect competition prevails in the market and there is no transaction cost
Arbitrage Portfolio According to the APT theory an investor tries to find out the possibility to increase return from his portfolio without increasing the funds in the portfolio. He also likes to keep the risk at the same level. For eg:-, the investor holds A, B and C securities and he wants to change the proportion of the securities without any additional financial commitment. Now the change in proportion of securities can be denoted by by XA , XB , and XC. The increase in the investment in security A could be carried out only if he reduces the proportion of investment either in B or C because it has already stated that the investor tries to earn more income without increasing his financial commitment. Thus, the changes in different securities will add up to zero. This is the basic requirement of an arbitrage portfolio.
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APT
Ri =
+ . +
Pk Fik
Where, Ri = Expected Return on asset i.e. on well diversified portfolio = Expected Return on asset with zero systematic risk = The risk premium related to each of the common factor e.g. the risk premium related to interest rate risk. = the pricing relationship between the risk premium and asset i i.e. how responsive asset i is to this common factor j i.e. sensitivity or beta coefficient for security i that is associated with index j
P0 P1
Fij
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If the portfolio is well diversified one, unsystematic risk tends to be zero and systematic risk is represented by F 1 and F 2 F n in the equation.
Burmeister and McElroy have estimated the sensitivities with some other factors. They are Default risk Time premium Deflation Change in expected sales The market return not due to the first four variables.
Contn .
The default risk is measured by the difference between the return on long term government bonds and the return on long term bonds issued by corporate plus one half of one %. Time premium is measured by the return on long term government bonds minus one month treasury bill rate one month ahead. Deflation is measured by expected inflation at the beginning of the month minus actual inflation during the month.
Growth rate in gross national product Rate of interest Rate of change in oil prices Rate of change in defence spending.
In a single factor model, the linear relationship between the return Ri and sensitivity bi can be given in the following form.
Assume, there is only one factor which generates returns on asset i, APT Model boils down to E(ri) = Fio + FijP1 Fio = Risk Free Return or Zero Beta Security
Slope of arbitrage price line is P and intercept is Fio. The arbitrage price line shows the equilibrium relation between an assets systematic risk and expected return.
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The risk is measured along the horizontal axis and the return on the vertical axis. The A, B and C stocks are considered to be in the same risk class. The arbitrage pricing line interests the Y axis on lamda 0, which represents riskless rate of interest i e the interest offered for the treasury bills. Here, the investments involve zero risk and it is appealing to the investors who are highly risk averse. Lamda i stands for the slope of arbitrage pricing line. It indicates market price of risk and measures the risk return trade off in the security markets. The beta i is the sensitivity coefficient or factor beta that shows the sensitivity of the asset or stock A to the respective risk factor.
In APT model, factors are not well specified . Hence investors finds it difficult to establish equilibrium relationship. The well defined market portfolio is a significant advantage of the CAPM leading wide usage in the stock exchange. Lack of consistency in the measurements of the APT model. Further , the influence of factor are not independent to each other because it is difficult to identify the influence that corresponds exactly to each factor.
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