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CAPM Lecture 1

The document discusses capital market theory and the Capital Asset Pricing Model (CAPM). It introduces CAPM, which describes the relationship between risk and expected return of securities and portfolios. CAPM assumes investors lend and borrow at the risk-free rate and hold market portfolios. The Capital Market Line shows combinations of the risk-free asset and market portfolio that constitute efficient portfolios. Security Market Line describes the relationship between expected return and systematic risk (beta) of securities and portfolios. CAPM is used to determine if individual securities are underpriced, overpriced or correctly priced based on their expected and estimated returns.

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Amit Gupta
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42 views16 pages

CAPM Lecture 1

The document discusses capital market theory and the Capital Asset Pricing Model (CAPM). It introduces CAPM, which describes the relationship between risk and expected return of securities and portfolios. CAPM assumes investors lend and borrow at the risk-free rate and hold market portfolios. The Capital Market Line shows combinations of the risk-free asset and market portfolio that constitute efficient portfolios. Security Market Line describes the relationship between expected return and systematic risk (beta) of securities and portfolios. CAPM is used to determine if individual securities are underpriced, overpriced or correctly priced based on their expected and estimated returns.

Uploaded by

Amit Gupta
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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DR.

APJ ABDUL KALAM TECHNICAL UNIVERSITY

COURSE - MBA
SUBJECT NAME- INVESTMENT ANALYSIS AND
PORTFOLIO MANAGEMENT
Lecture – 3
Capital Market Theorem- Capital Asset Pricing Model
CAPITAL MARKET THEOREM
• The capital market theory is a major extension of
the portfolio theory of Markowitz.
• Portfolio theory is a description of how rational
investors should built efficient portfolios.
• Capital market theory tells how assets should be
priced in the capital markets if, indeed, everyone
behaved in the way portfolio theory suggests.
CAPITAL ASSET PRICING MODEL
• The capital asset pricing model was developed in
mid-1960s by three researchers William Sharpe,
John Lintner and Jan Mossin independently (Sharpe-
Lintner-Mossin Capital Asset Pricing Model)
• CAPM model describes the relationship between
the expected return and risk of individual
securities and portfolios in capital market.
• According to CAPM , the relevant risk is systematic
risk only.
CAPM Assumptions

• Securities are infinitely divisible


• Investors compare risk and return
• They can borrow or lend any amount of money
at the risk-free rate of return
• No transaction costs, no personal income taxes
• There is perfect competetion
• They can sell short any amount of shares
• They share homogeneity of expectations
Efficient frontier with Riskless lending
• It is assumed that there exists a riskless
asset available for investment.
• The investor can invest a portion of his
funds in the riskless asset which would
be equivalent to lending at the risk free
asset‘s rate of return, namely Rf
• He would then be investing in a
combination of risk free asset and risky
assets
Efficient frontier with Riskless
Borrowing
• Similarly, investor may borrow at the same
risk free rate for the purpose of investing in
a portfolio of risky assets. He will invest
his own funds as well as some borrowed
funds for investment at Risk free rate.
• The efficient frontier arising from a
feasible set of portfolios of risky assets is
concave in shape.(Markowitz Model)
• Here , shape of the efficient frontier
transforms into a straight line. (CML)
CAPITAL MARKET LINE(CML)
• All investors will have the same efficient
frontier by combining the same risky
portfolio B with different levels of lending
or borrowing according to their desired level
of risk.
• All these combinations will lie along the
straight line representing the efficient
frontier , known as the capital market line
(CML).
• All efficient portfolios of all investors will
lie along this capital market line.
• CML provides risk return relationship only for efficient
portfolios.
Relationship b/w return and risk of any efficient
portfolio on CML ⇒
• Re = Rf +[ (Ṝm-Rf)/σm] σe
Where Rf =risk free return
Rm =market risk
σe =risk of efficient portfolio
Thus, the expected return on an efficient portfolio is:
(Expected return) = (Price of time) + (Price of risk)
*(Amount of risk)
SECURITY MARKET LINE
• The CML does not describe the risk-return relationship
of inefficient portfolios or of individual securities.
• For a very well diversified portfolio, unsystematic risk
tends to become zero and the only relevant risk is
systematic risk measured by beta ( β)
• The security market line provides the relationship
between the expected return and beta of a security or
portfolio.
SML shows the relationship between the expected
return and systematic risk (beta) of a security or
portfolio whether efficient or not.
• Thus, Expected return on a security
= Risk free return + (Beta * Risk premium
of market)
• Expected return of security ⇒
 Ṝi = Rf +βi +[ Ṝm –Rf ]
• Expected return of portfolio ⇒
 Ṝp = Rf +βp+[ Ṝm –Rf ]
Pricing The Security With CAPM
CAPM is used for assessing whether a security is underpriced, overpriced
or correctly priced.
Calculate Expected Return as per CAPM and BUY
Estimated Return (Ri )=[ (P1- P0)+D ] / P0
Where P0=current mkt price SELL
P1=estimated price
D1=dividend per year
Rule- Expected < Estimated ⇒ underpriced, Buy
Expected > Estimated ⇒ overpriced, Sell
Expected = Estimated ⇒ actual return, Hold
• THANK YOU

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