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Unit II Capital Asset Pricing Model - CAPM

A overview of CAPM model

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13 views11 pages

Unit II Capital Asset Pricing Model - CAPM

A overview of CAPM model

Uploaded by

mbaft2023.aashiagarwal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Unit II

Capital Asset Pricing


Model
Capital Asset Pricing Model
(CAPM)
 The capital asset pricing model (CAPM)
is a model that provides a framework to
determine the required rate of return on an
asset and indicates the relationship
between return and risk of the asset.
 Developed in the early 1960s by William
Sharpe, John Lintner and Jan Mossin,
the model provided the first coherent
framework for relating the required return
on an investment to the risk of that
investment.
Assumptions of CAPM
• There are many investors
• They behave competitively
• All investors are looking ahead over the same (one
period) planning horizon
• All investors have equal access to all securities
• No taxes
• No commissions
• Each investor cares only about Er (return) and σ (risk)
• All investors have the same beliefs about the
investment opportunities: for the n risky assets.
• Investors can borrow and lend at the one risk-free rate.
• Investors can short any asset, and hold any fraction of
an asset.
RISK
Total Risk = Systematic +
Unsystematic Risk
Systematic Risk is also called
Nondiversifiable Risk or Market Risk
Unsystematic Risk is also called
Diversifiable Risk or Unique Risk
Diversification

Can eliminate some risk


Unsystematic risk tends to disappear in a large
portfolio
Systematic risk never disappears
Beta

Beta = How much systematic risk a particular


asset has relative to an average asset
For example:
A: 0.65
B: 1.22
C: 3.56
Portfolio X: 1.54
Capital Asset Pricing
Model

Er = Rf + B{E(Rm)-Rf}
Works for both individual
assets and portfolios
McIntire Investment
Institute
Example:
If Rf = 5.5%
Market Risk Premium = 7%
Then the Portfolio X should
return:
Er = 5.5% + 1.54(12.5%-
5.5%)
Er = 16.28%
Expected Return depends
on
3 things
The time value of money (risk-free rate, Rf)
The reward for bearing systematic risk (market risk
premium={E(Rm) - Rf}
The amount of systematic risk (Beta)
Implications of CAPM
 Investors will always combine a risk-free asset with a market portfolio of
risky assets. They will invest in risky assets in proportion to their market
value.

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

 Beta, which is a ratio of the covariance between the asset returns and the
market returns divided by the market variance, is the most appropriate
measure of an asset’s risk.

 Investors can expect returns from their investment according to the risk.
This implies a linear relationship between the asset’s expected return and
its beta
Limitations of CAPM

 It is based on unrealistic assumptions.


 It is difficult to test the validity of CAPM.
 Betas do not remain stable over time.

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