CAPITAL ASSET PRICING MODEL(CAPM)

Submitted to Prof. Sadaf Khan

Group Members
Afrin Shaikh Harshal Kamble Gazal Ansari Pooja Soni Sachin Talekar

The capital assets pricing model (CAPM ) as the name suggests, is a theory that explains how assets prices are formed in the market place. CAPM is the model that provides a framework to determine the required rate of return on an asset and indicates the relationship between risk and return of the assets. It uses the results of capital market theory to derive the relationship between expected return and systematic risk of individual assets/ securities and portfolios.

Assumptions of CAPM
All investors are price taker. Assets/ securities are perfectly divisible. All investors plan for one identical holding period. There are no transaction costs and incomes taxes. Single time period. Market efficiency. Homogeneous expectations. Risk-free rate.

Elements of the Model

Capital market line (CML) It depicts the risk-return relationship for efficient portfolios available to investors.

Expected return on an asset varies directly with its B (systematic risk) and the risk premium on market portfolio, where risk premium is the difference between expected return and the risk-free rate of return.

It shows that the appropriate measure of risk for an efficient portfolio is the standard deviation of return on the portfolio.

Security Market Line (SML) It is a graphic depiction of CAPM and describes the market price of risk in capital markets. Total Risk consists of 2 components: Systematic risk Unsystematic risk

The level of systematic risk in an asset is measured by the beta co-efficient. The CAPM links beta to the level of required return.

E(ri)= rf + B[E(rm)- rf], where E(ri)- Expected or required rate of return on asset i rf Risk-free rate of return B-Systematic risk of the asset E(rm)- Expected return on market portfolio.

The major factors that effect securitys expected return

1.

2.
3. 4. 5.

Taxes Inflation Liquidity Market Capitalisation size Price earnings and market to book value ratio

Taxes
Tax liability of investors is of two types; 1. Tax on dividend income and 2. Tax on capital gains.

Example
The Investor is expected to have return of 15%(10% dividend and 5% capital gain) by holding securities in company X. Company Y is expected to provide dividend yield of 11% and capital gain of 3.5%(total return is 14.5%) Assume tax rate for dividend is 30% and for capital gain is 20% .

Inflation
Hedge against inflation Unpredictable inflation

LIQUIDITY
It refers to the ability to transform a security readily into cash without loss or negligible loss if any. The spread between the bid price and ask price of a security may be regarded as a useful measure of its liquidity. Unforeseen events in future may require early redemption/conversion of securities into cash.

Market Capitalization Size

It is the product of the number of shares outstanding and the market price of the share. Higher the market capitalization of a corporate firm, the more secured the investor feels in investing in securities of such company.