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    Capital Asset Pricing Model: Watan Yar

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    Ameer B. Baloch
    The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return for pricing risky securities. It was introduced in the 1960s and suggests that the expected return of an asset is determined by its sensitivity to non-diversifiable risk (beta) rather than its diversifiable risk. CAPM assumes that investors will hold a combination of a risk-free asset and the market portfolio. The CAPM equation states that the expected return of an asset is equal to the risk-free rate plus the product of the asset's beta and the market risk premium.

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    Capital Asset Pricing Model: Watan Yar

    Uploaded by

    Ameer B. Baloch
    41 views17 pages
    The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return for pricing risky securities. It was introduced in the 1960s and suggests that the expected return of an asset is determined by its sensitivity to non-diversifiable risk (beta) rather than its diversifiable risk. CAPM assumes that investors will hold a combination of a risk-free asset and the market portfolio. The CAPM equation states that the expected return of an asset is equal to the risk-free rate plus the product of the asset's beta and the market risk premium.

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    CAPM

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    The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return for pricing risky securities. It was introduced in the 1960s and suggests that the expected return of an asset is determined by its sensitivity to non-diversifiable risk (beta) rather than its diversifiable risk. CAPM assumes that investors will hold a combination of a risk-free asset and the market portfolio. The CAPM equation states that the expected return of an asset is equal to the risk-free rate plus the product of the asset's beta and the market risk premium.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    41 views17 pages

    Capital Asset Pricing Model: Watan Yar

    Uploaded by

    Ameer B. Baloch
    The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return for pricing risky securities. It was introduced in the 1960s and suggests that the expected return of an asset is determined by its sensitivity to non-diversifiable risk (beta) rather than its diversifiable risk. CAPM assumes that investors will hold a combination of a risk-free asset and the market portfolio. The CAPM equation states that the expected return of an asset is equal to the risk-free rate plus the product of the asset's beta and the market risk premium.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 17

    CAPITAL ASSET PRICING MODEL

    WATAN YAR

    CAPM

    A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

    The model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory

    The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk

    TOTAL RISK

    The total variability in returns of a security represents the total risk of that security. Systematic risk and unsystematic risk are the two components of total risk. Thus Total risk = Systematic risk + Unsystematic risk

    RISKS ASSOCIATED WITH INVESTMENTS


    Risks

    Systematic OR Non diversifiable

    Non systematic OR diversifiable

    SYSTEMATIC RISK
    The portion of the variability of return of a security that is caused by external factors, is called systematic risk. It is also known as market risk or nondiversifiable risk. Economic and political instability, economic recession, macro policy of the government, etc. affect the price of all shares systematically. Thus the variation of return in shares, which is caused by these factors, is called systematic risk.

    SYSTEMATIC RISKS:
    War like situation Internation al events Industrial growth
    Risk due to inflati on

    Interest rate risk

    Political risk
    Market risk Risk due to govt. policies

    monsoon scams Natural calamiti es

    NON - SYSTEMATIC RISK:

    The return from a security sometimes varies because of certain factors affecting only the company issuing such security. Examples are raw material scarcity, Labour strike, management efficiency etc. When variability of returns occurs because of such firm-specific factors, it is known as unsystematic risk.

    NON-SYSTEMATIC RISKS:
    Business risks

    Disputes

    Non systematic risks

    Financial risks

    Risks due to uncertainty

    RISK RETURN RELATIONSHIP OF DIFFERENT STOCKS


    Rate of Return Market Line E(r) Risk Premium Ordinary shares Preference shares Subordinate loan stock Unsecured loan Debenture with floating charge Mortage loan Government stock (risk-free) Degree of Risk Risk return relationship of different stocks

    ASSUMPTIONS

    Can lend and borrow unlimited amounts under the risk free rate of interest

    Individuals seek to maximize the expected utility of their portfolios over a


    single period planning horizon.

    Assume all information is available at the same time to all investors The market is perfect: there are no taxes; there are no transaction costs; securities are completely divisible; the market is competitive.

    The quantity of risky securities in the market is given.

    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

    assets expected return and its beta.

    Investors will be compensated only for that risk which they cannot diversify. This is the market related (systematic) risk

    CAPM EQUATION
    E(ri) = Rf + i(E(rm) - Rf)

    E(ri) = return required on financial asset i

    Rf = risk-free rate of return


    i = beta value for financial asset i

    E(rm) = average return on the capital market

    BETA

    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."

    Beta is calculated using regression analysis

    VALUE OF BETA

    = 1 <1

    >1
    For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.

    Limitations
    CAPM has the following limitations: It is based on unrealistic assumptions. It is difficult to test the validity of CAPM. Betas do not remain stable over time.

    CONCLUSION
    Research has shown the CAPM
    to stand up well to criticism, although attacks against it have been increasing in recent years. Until something better presents itself, however, the CAPM remains a very useful item in

    the financial management tool


    kit.

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