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CAPM was introduced by Jack Treynor (1961, 1962),William Sharpe (1964), John Lintner(1965) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. Ri = Rf + (Rm - Rf) Ri= Expected return on security i Rf = Risk-free interest rate = beta for security i Rm = Expected rate of return on market portfolio Rm - Rf = Market risk premium
CAPM (contd.)
CAPM is that investors need to be compensated in two ways:
time value of money and risk
Time value of money is represented by the riskfree (Rf) rate compensating by placing money over a period of time Risk calculates the amount of compensation the investor needs for taking on additional risk Expected return = Price of time + Price of risk x Amount of risk
Risk
Total risk consists of two components:
Diversifiable Non-diversifiable
Risk (contd.)
Non-diversifiable (or Systematic)
External to an industry and/or business Attributed to broad forces, such as war, inflation and political and even sociological events Impact all investments and therefore are not unique to a given investment Each security possesses its owns level of non-diversifiable risk
This is measured as the beta coefficient
Beta
Beta measures non-diversifiable risk
Shows how the price of a security responds to market forces That is, the more responsive the price of a security is to changes in the market, the higher will be its beta Calculated by relating the returns on a security with the returns for the market
Beta
The beta of the market portfolio is ALWAYS = 1.0 The beta of a security compares the volatility of its returns to the volatility of the market returns: = 1.0 -the security has the same volatility as the market as a whole > 1.0 -aggressive investment with volatility of returns greater than the market < 1.0 -defensive investment with volatility of returns less than the market
It is the reward market offers for bearing average systematic risk in addition to waiting
Coefficient of correlation
Coefficient of correlation is another measure designed to indicate the similarity or dissimilarity in the behavior of two variables rxy = covxy/ x y, where: rxy = coefficient of correlation between X and Y covxy = covariance between X and Y x = standard deviation of X y = standard deviation of Y If correlation coefficient between two securities is -1.0, then a negative correlation exists (cannot be less than -1.0) If correlation coefficient is zero, then returns are said to be independent of one another If returns of two securities are perfectly correlated, the correlation coefficient will be +1.0, and perfect positive correlation is said to exist (cannot exceed +1.0) Also, the smaller the correlation between the securities, the greater the benefits of diversification A negative correlation would be even better
Efficient Frontier
Each point on this line represents an optimal combination of securities that maximizes the return for any given level of risk (standard deviation).
RP
. . . . . . .. . . .. . . . . . . .. . .. . ..
These dots represent portfolios that are inferior to the portfolios on the efficient frontier they either offer the same returns but with more risk, or they offer less return for the same risk.
P 2
More out of sync the securities in the portfolio, that is the lower their covariance, the smaller the risk of the portfolio that combines them
RF
. . . . . .M . . . . . . . . . . .. . . . .. . . .
P 2