Capital Asset Pricing Model

CAPM
Capital Asset Pricing Model

Introduction
• Modern Portfolio Theory and diversification
• Beta vs. standard deviation
• Unsystematic vs. systematic risk
• Security Market Line (SML)
• The CAPM equation
• Asset pricing
• Assumptions behind using CAPM
Measuring Risk-Return on Portfolio
Portfolio: Is a collection of securities (Financial assets generating
unpredictable returns as their prices change). Portfolio is investor specific
as the preference of investor regarding the risk-return gets reflected into
his/her portfolio.
VARIANCE
•Average value of squared deviations from mean (expected return). A
measure of volatility.
STANDARD DEVIATION
•Square root of variance. Another measure of volatility.
MEASURING THE VARIATION IN
STOCK RETURNS
• Table:3.12
Unsystematic vs. systematic risk
1. Unsystematic risk: risk that can be eliminated
through diversification
• a.k.a. Unique risk, residual risk, specific risk, or diversifiable risk
2. Systematic risk: risk that cannot be eliminated

through diversification
• a.k.a, market risk or undiversifiable risk
Modern Portfolio Theory and
diversification
• Rational investors use diversification to optimize their portfolios
• Diversification reduces portfolio risk (assets that are not perfectly
correlated)
• Efficient Portfolio
Beta vs. standard deviation
• Standard deviation includes systematic and unsystematic risk;
unsystematic risk not used because unsystematic risk diversified away
• Beta: A standardized measure of the risk of an individual asset, one that

captures only the systematic component of its volatility; measures how
sensitive an individual security is to market movements; measure of
market risk
Security Market Line
• Line representing the relationship between expected return and

market risk; shows expected return of an overall market as a function
of systematic risk
• Graphical representation of CAPM
• Compare a single asset to the SML (and see if it falls below, above, or
on the line)
Security Market Line (CAPM)
Assumptions behind the CAPM
• Govt. treasuries are risk-free
• Uncertainty about inflation
• Assumed that investors can borrow money at same interest rate at
which they lend, but generally borrowing rates are higher than lending
rates
• WHY we still use CAPM: benchmark portfolios used  Treasury bills and
market portfolio
Capital Asset Pricing Model
(CAPM)
The expected return on a specific asset equals

the risk-free rate plus a premium that depends
on the asset’s beta and the expected risk
premium on the market portfolio.
Expected return of specific asset: E(Ri)

Risk-free rate: Rf
Expected risk premium: E(Rm) - Rf
Asset pricing
• Future cash flows of the asset can be discounted using the expected
return calculated from CAPM to establish the price of the asset
• If observed price > CAPM valuation  overvalued (paying too much for
that amount of risk)
• If observed price < CAPM valuation  undervalued
Practice Problem #1
• If the risk-free rate equals 4% and a stock with a beta of 0.8 has an
expected return of 10%, what is the expected return on the market
portfolio?
Practice Problem #1: answer
• If the risk-free rate equals 4% and a stock with a beta of 0.75 has an
expected return of 10%, what is the expected return on the market
portfolio?
• 10% = 4% + 0.75(market portfolio – 4%)
• 8% = market portfolio – 4%
• 12% = market portfolio
Practice Problem #2
• A particular asset has a beta of 1.2 and an expected return of 10%.
Given that the expected return on the market portfolio is 13% and the
risk-free rate is 5%, the stock is:
A. appropriately priced
B. underpriced
C. overpriced
• A particular asset has a beta of 1.2 and an expected return of 10%.
Given that the expected return on the market portfolio is 13% and the
risk-free rate is 5%, the stock is:
A. appropriately priced
B. underpriced
C. overpriced; expected return should be 14.6% (5+1.2(13-5))
Practice Problem #3
Last year…
• Firm A: return: 10%, beta: 0.8
• Firm B: return: 11%, beta: 1.0
• Firm C: return: 12%, beta: 1.2
• Given that the risk-free rate was 3% and market return was 11%, which
firm had the best performance?
• Firm A: 3% + 0.8(11%-3%) = 9.4% (over)

• Firm B: 3% + 1.0(8%) = 11% (same)
• Firm C: 3% + 1.2(8%) = 12.6% (under)
Firm A performed the best because it exceeded the expected return

Important Instruction for students
Following material on 04 slides (i.e., from slide no. 20 to 24) is

based on Brealey, Myers Text Book Pp.412-422.
Students can easily relate the understanding of CAPM model’s to

their text book after going through the following slides.
However, Slides 1-18 have already been explained and should be

carefully understood. It is also CAPM explanation but slightly
more mathematically oriented.
You must do extensive readings of Brealey & Myers text book’s

Pp: 412 to 422 including solving Self test 4 to self test 7.
CAPM: Market portfolio and Beta values
• MARKET PORTFOLIO
• Portfolio of all assets in the economy. In practice a broad stock market
index, such as the Standard & Poor’s Composite, Nasdaq, Nikkei, or our
own BSE Sensex -is used to represent the market.
• BETA (β): Sensitivity of a stock’s return to the return on the market
portfolio. It is the measure of undiversifiable systematic risk and
represented by Greek letter ; β. Market portfolio is considered most risky
and has a β value of 1. Treasury Bills are considered safest and zero risk,
hence β=0
• Calculating Beta of Portfolio
• Beta of portfolio = (fraction of portfolio in first stock x beta of first stock)
+ (fraction of portfolio in second stock x beta of second stock)
• Exp: If stock of MCI has a beta 1.3 and Exxon 0.61 Then a portfolio
invested 50-50 in MCI and Exxon would have a portfolio beta of
=(0.5 × 1.3) + (0.5× 0.61) = 0.95.
How to Measure Risk and Return in
CAPM and definition of CAPM
• The least risky investment may be considered U.S. Treasury bills (TBs) or
Govt of India TBs. Since the return on Treasury bills is fixed, it is
unaffected by what happens to the market. Thus the beta of Treasury bills
is zero.
• The most risky investment that we can considered is the market portfolio
of common stocks. This has average market risk: its beta is 1.0.
• MARKET RISK PREMIUM
• Risk premium of market portfolio is the Difference between market
return and return on risk-free Treasury bills.
• CAPITAL ASSET PRICING MODEL (CAPM)

• Theory of the relationship between risk and return which states that
the expected risk premium on any security equals its beta times the
market risk premium
• This definition will be clearer to you after few slides.
Fig 4.10 Pp:415 Text Book: showing risk return
through SML
• a) Here we begin the plot of
expected rate of return against
beta. The first benchmarks are
Treasury bills (beta = 0) and the
market portfolio (beta = 1.0).
• We assume a Treasury bill rate of
5 percent and a market return of
14 percent.
• The market risk premium is 14 – 5
= 9 percent.
• (b) A portfolio split evenly
between Treasury bills and the
market will have beta = 0.5 and an
expected return of 9.5 percent
(point X).
• A portfolio invested 80 percent in
the market and 20 percent in
Treasury bills has beta =0.8 and an
expected rate of return of 12.2
percent (point Y).
• Note that the expected rate of return
on any portfolio mixing Treasury bills
and the market lies on a straight line.
The risk premium is proportional to the
portfolio beta.
CAPM Formulae with illustrated examples
Pp:416 Text Book
So now you understand CAPM!
• CAPITAL ASSET PRICING MODEL (CAPM)

• Theory of the relationship between risk and return which states that
the expected risk premium on any security equals its beta times the
market risk premium
BOND fundamental for students easy
understanding of bond trading
• BOND is a IOU or Promissory notes
• I promise to pay the bearer of this bond a fixed coupon (Interest rate)
annually or Semi-annually and principal on the redemption of the
Bond. (i.e., on the maturity of the bond).
• Face Value: Value or price at which the bod is issued Say Rs.100 or
1000
• Redemption Value: Price to be paid at the maturity by the issuer of
the bond
• Bonds are traded in the market at market rate which may be different
from the price of issuing the bond.

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CAPM

Capital Asset Pricing Model

2. Systematic risk: risk that cannot be eliminated

• Beta: A standardized measure of the risk of an individual asset, one that

• Line representing the relationship between expected return and

The expected return on a specific asset equals

Expected return of specific asset: E(Ri)

• Firm A: 3% + 0.8(11%-3%) = 9.4% (over)

Firm A performed the best because it exceeded the expected return

Following material on 04 slides (i.e., from slide no. 20 to 24) is

Students can easily relate the understanding of CAPM model’s to

However, Slides 1-18 have already been explained and should be

You must do extensive readings of Brealey & Myers text book’s

• CAPITAL ASSET PRICING MODEL (CAPM)

• CAPITAL ASSET PRICING MODEL (CAPM)

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