Capm - M
Capm - M
Capm - M
"Cap-M" looks at risk and rates of return and compares them to the overall stock market.
If you use CAPM you have to assume that most investors want to avoid risk, (risk
averse), and those who do take risks, expect to be rewarded. It also assumes that investors
are "price takers" who can't influence the price of assets or markets. With CAPM you
assume that there are no transactional costs or taxation and assets and securities are
divisible into small little packets. Had enough with the assumptions yet? One more.
CAPM assumes that investors are not limited in their borrowing and lending under the
risk free rate of interest. By now you likely have a healthy feeling of skepticism. We'll
deal with that below, but first, let's work the CAPM formula.
Beta - Now, you gotta know about Beta. Beta is the overall risk in investing in a large
market, like the New York Stock Exchange. Beta, by definition equals 1.0000. 1 exactly.
Each company also has a beta. You can find a company's beta at the Yahoo!! Stock quote
page. A company's beta is that company's risk compared to the risk of the overall market.
If the company has a beta of 3.0, then it is said to be 3 times more risky than the overall
market.
Ks = Krf + B ( Km - Krf)
Using the CAPM model and the following assumptions, we can compute the expected
return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk
measure) of the stock is 2 and the expected market return over the period is 10%, the
stock is expected to return 17% (3%+2(10%-3%)).
Assumptions of the Capital Asset Pricing Model
Note! The Capital Asset Pricing Model is a ceteris paribus model. It is only valid within a
special set of assumptions. These are:
• Investors are risk averse individuals who maximize the expected utility of
their end of period wealth. Implication: The model is a one period model.
• Investors have homogenous expectations (beliefs) about asset returns.
Implication: all investors perceive identical opportunity sets. This means
everyone has the same information at the same time.
• Asset returns are distributed by the normal distribution.
• There exists a risk free asset and investors may borrow or lend unlimited
amounts of this asset at a constant rate: the risk free rate.
• There is a definite number of assets and their quantities are fixated within
the one period world.
• All assets are perfectly divisible and priced in a perfectly competitive
marked. Implication: e.g. human capital is non-existing (it is not divisible and it
can't be owned as an asset).
• Asset markets are frictionless and information is costless and
simultaneously available to all investors. Implication: borrowing rate equals the
lending rate.
• There are no market imperfections such as taxes, regulations, or restrictions on short
selling.