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Formulas For Chapter 8

This document discusses various models for calculating the risk and expected return of capital assets, including the Capital Asset Pricing Model (CAPM). It defines beta as the covariance of an asset's returns with the market portfolio divided by the variance of the market portfolio. An asset's expected return is equal to the risk-free rate plus its beta times the expected market risk premium. Multi-factor models incorporate additional risk factors beyond just the overall market. The arbitrage pricing theory and three-factor model relate an asset's expected return to multiple risk factors.

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33 views2 pages

Formulas For Chapter 8

This document discusses various models for calculating the risk and expected return of capital assets, including the Capital Asset Pricing Model (CAPM). It defines beta as the covariance of an asset's returns with the market portfolio divided by the variance of the market portfolio. An asset's expected return is equal to the risk-free rate plus its beta times the expected market risk premium. Multi-factor models incorporate additional risk factors beyond just the overall market. The arbitrage pricing theory and three-factor model relate an asset's expected return to multiple risk factors.

Uploaded by

Raa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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College of Applied Sciences, Nizwa

Department of International Business Administration

Chapter 8 – Capital Asset Pricing Model and


Multi factor Model
Calculating Beta:
Covariance of Asset j with the Market Portfolio
Beta of Asset, j 
Variance of the Market Portfolio

Cov R j , RM 
 j 
 M2

Neutral A 1 per cent change in the market index return generally leads to a 1
β=1
Shares per cent change in the return on a specific share.
β<1 Defensive A 1 per cent change in the market index return generally leads to a less
Shares than 1 per cent change in the returns on a specific share.
Aggressive A 1 per cent change in the market index return generally leads to a
β>1
Shares more than 1 per cent change in the returns on a specific share.

The equation for the Capital Asset Pricing Model is:


The Average Risk Premium for a Share
Expected Return = Risk Free Rate + Beta  (Expected Return on the Market Minus
The Risk Free Rate)

rj = rf + β (rm – rf)

Another Method of Calculating Beta


r j     j rm  e

where:

rj = rate of return on the j


rm = rate of return on the market index portfolio
α = regression line intercept
e = residual error about the regression line (in this simple case this has a value of
zero because all the plot points are on a straight line)
βj = the beta of security j

Formulas for “Chapter 8” Prepared by Rima Solanki – Course Coordinator for Finance (FINA3401) Page 1
College of Applied Sciences, Nizwa
Department of International Business Administration

Slope of the characteristic line is the beta for share j

Change in r j r j
 
Change in rm rm

One Factor Model


rj = a + b F1 + e

A two-factor model
rj = a + b1 F1 + b2 F2 + e

Where:

F1 = inflation rate,
b1 = sensitivity of j to inflation rate growth
F2 = price of oil,
b2 = sensitivity of j to price of oil

Multi-factor models
rj = a + b1 F1 + b2 F2 + b3 F3 + b4 F4 + b5 F5 + e

The arbitrage pricing theory


Expected Re turns  Risk Free Re turn  1 r1  r f    2 r2  rf    3 r3  rf  
 4 r4  r f   .......   n rn  r f   e

The three-factor model


Expected Re turns  Risk Free Rate  1 rm  r f    2 SMB    3 HML 

Where:

The excess return on a broad market portfolio (rm – rf)


The difference between the return on a portfolio of small shares and the return on
a portfolio of large shares (SMB)
The difference between the return on a portfolio of high book-to-market shares
and the return on a portfolio of low book-to-market shares (HML)

Formulas for “Chapter 8” Prepared by Rima Solanki – Course Coordinator for Finance (FINA3401) Page 2

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