Scribd
Upload
37 views12 pages

Capital Asset Pricing Model

The document provides an overview of the Capital Asset Pricing Model (CAPM). It describes how CAPM was developed and its key assumptions, including that all investors have identical expectations and a one period investment horizon. It defines a risk-free asset and discusses the efficient frontier and how it changes with the addition of a risk-free rate. The capital market line depicts the relationship between risk and return for efficient portfolios, while the security market line specifies this relationship for individual securities based on their systematic risk, or beta.

Uploaded by

Ubaid Dar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
37 views12 pages

Capital Asset Pricing Model

The document provides an overview of the Capital Asset Pricing Model (CAPM). It describes how CAPM was developed and its key assumptions, including that all investors have identical expectations and a one period investment horizon. It defines a risk-free asset and discusses the efficient frontier and how it changes with the addition of a risk-free rate. The capital market line depicts the relationship between risk and return for efficient portfolios, while the security market line specifies this relationship for individual securities based on their systematic risk, or beta.

Uploaded by

Ubaid Dar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 12

Capital Asset Pricing Model

Prof Mahesh Kumar


Amity Business School
Introduction
 Capital Asset Pricing Model often referred as CAPM was
developed by William Sharpe, John Lintner and Jan
Mossin.
 This theory hypothesizes how investors do behave rather than
how investors should behave as in case of MPT.
 This theory deals with predictions concerning equilibrium
expected returns on the risky assets
 This model helps in two ways
1) allows us to measure the relevant risk of an individual security
as well as to assess the relationship between the risk and
returns expected from investing i.e. if we are analyzing
securities, we might be interested in whether the expected return
we forecast is more or less than its ‘fair return’ given its risk.
2) It also helps us to make an educated guess as to the expected
return on assets that have yet not been traded in the market
place.
Assumptions
 All investors can borrow or lend money at risk free rate of return.
 All investor have identical distributions for future rates of return
i.e. they have homogenous expectations with respect to the three
inputs of the portfolio model i.e. expected returns, the variance of
returns and the correlation matrix. Therefore, given a set of
security prices and a risk free rate, all investors use the same
information to generate an efficient frontier.
 All the investors have the same one period time horizon.
 There are no transaction costs.
 There are no personal taxes- investors are indifferent between
capital gains and dividend.
 There is no inflation.
 There are many investors, and no single investor can affect the
price of the stock through his or her buying and selling decisions.
Investors are price takers and are unaffected by their own trades.
 Capital Markets are in equilibrium
What is a risk free asset.
 A risk free asst can be defined as one with a certain-to-be-
earned expected return and variance of return as zero.
 Since the variance=0, the nominal risk-free rate in each period
will be equal to its expected value.
 The covariance between the risk free asset and risky asset will
be zero.
 The true risk-free asset is best thought of as Treasury security,
which has no risk of default, with a maturity matching the holding
period of the investor. In this case the amount of money to be
received at the end of the holding period is known with certainty
at the beginning of the period. The Treasury bill typically is taken
to be risk-free asset, and its rate of return is referred as risk free
return.
The Efficient Frontier : The Effect of a Risk-free
Rate
 When a risk-free investment complements the set of
risky securities, the shape of the efficient frontier
changes markedly.

Efficient frontier:
expected return

impossible Rf to M to C
portfolios M = Market portfolio
B
Rf = Risk-free rate
M
E
dominated
Rf portfolios
A

risk (standard deviation of returns)


Risk Free Borrowing and Lending
 Assume that efficient frontier as shown in the figure
has been derived by the investor. The arc AB
delineates the efficient set of portfolios of risky
assets.
 The return on risk free asset will be plotted on the
vertical axis because the risk is zero.
 Investors can combine this risk less asset with the
efficient set of the portfolios on the efficient frontier.
 The straight line Rf to the efficient frontier at point M,
RF-M, dominates all the straight lines below it and
contains the superior lending portfolio. This is also
known as risk free investing.
Risk Free Borrowing and Lending

 If extend this analysis to allow investors to


borrow money i.e. the investor is no longer
restricted to his or her wealth when investing
in risky assets implying thereby that we are
short selling the risky assets.
 Borrowing additional investable funds and
investing them together with investor’s wealth
allows investors to seek higher expected
returns while assuming greater risk.
Risk Free Borrowing and Lending
 If it is possible to buy stocks on margin, then the efficient
frontier gets expanded again

Efficient frontier : The ray from Rf


through M and beyond
impossible
expected return

ing
portfolios rro
w
bo

M
ding
len dominated
portfolios
Rf

risk (standard deviation of returns)


CAPM: The Equilibrium Return Risk
Tradeoff
 CAPM is an equilibrium model and
encompasses two important relationships.
a) The capital market line, line specifies the
relationship between expected return and
risk for efficient portfolios.
b) The security market line, line specifies the
equilibrium position between expected
returns and systematic risk.
Capital Market Line
 The straight line drawn from Rf to the efficient
frontier with M tangency point is referred as capital
market line.
 CML depicts equilibrium conditions that prevail in
the market for efficient portfolios consisting of the
optimal portfolio of risky assets and risk-free assets.
 The slope of CML is the market price of the risk.
 The equation for CML is
E(Rp)=RF+ E(RM)-RF *p
M
The Security Market Line
 Capital Market Line applies only to efficient portfolios and cannot
be used to assess the equilibrium expected return for single
portfolio or inefficient portfolios.
 Beta is a relative measure of risk-the risk of an individual stock
relative to the market portfolio of all the stocks.
 Securities with different slopes have different sensitivities to the
returns of the market index. If the slope for a particular security is
a 45-degree angle, the beta is 1.00. This implies that for every 1-
percent change in the market’s return, on average, this security
returns change 1 percent.
 More volatile stocks have betas larger than 1.00 and less volatile
stocks have beta lesser than 1.00.
The CAPM’s Expected Return- Beta Relationship:
Security Market Line

 The security market line (SML) is the CAPM specification of


how risk and required rate of return for any asset, security or
portfolio are related.
 This theory envisages a linear relationship between an asset’s

risk and its required rate of return and this linear relationship is
known as security market line.
 According to CAPM, the expected rate of return on an asset is

a function of two components of the required rate of return-the


risk free rate and the risk premium.
Thus, ki=Risk free rate+ Risk premium=RF+  i(E(RM)-RF)

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy