Capital Asset Pricing Model (CAPM)

Asset Pricing Model

 CAPM: A great innovation in the field of finance
invented by William Sharpe (1963-1964)
and John Lintner (1965-1969)

IMPORTANT TERMS
 Systematic Risk
 Unsystematic Risk
 Efficient Frontier
 Portfolio risk
 Portfolio Return
 Standard Deviation
 Risk
Systematic Risk Unsystematic Risk

 Portion of total risk that  Portion of total risk that is

affects all the firms in
identical way.
 Interest rates
 Government policies
 EXIM policies
 Tax rates
unique to the firm, above &
beyond that affecting
securities market in
general.
 Business Risk
 Financial Risk
Example of Portfolio Combinations, Return,
Risk and Correlation
Expected Standard Correlation
Asset Return Deviation Coefficient
A 8.0% 8.7% -0.379
B 10.0% 22.7%

Portfolio Components Portfolio Characteristics

Expected Standard
Weight of A Weight of B Return Deviation
100% 0% 8.00% 8.7%
99% 1% 8.02% 8.5%
98% 2% 8.04% 8.4%
97% 3% 8.06% 8.2%
96% 4% 8.08% 8.1%
95% 5% 8.10% 7.9%
94% 6% 8.12% 7.8%
93% 7% 8.14% 7.7%
92% 8% 8.16% 7.5%
91% 9% 8.18% 7.4%
90% 10% 8.20% 7.3%
89% 11% 8.22% 7.2%
 Efficient Frontier
FIGURE 1

A B
C

E
%nr ut e R det ce px E

D
Standard Deviation (%)
 Capital Asset Pricing Model
 This theory explains how financial assets
should be priced in capital market.
 It is concerned with 2 key factors:
 What is the relationship between risk and
return for an efficient portfolio.
 What is the relationship between risk and
return for an individual security.
 In simple terms, CAPM predicts the
relationship between risk and expected return.
 Assumptions
 All investors have identical expectations about expected returns, standard
deviations, and correlation coefficients for all securities.
 All investors have the same one-period investment time horizon.
 All investors can borrow or lend money at the risk-free rate of return
(RF).
 There are no transaction costs.
 There are no personal income taxes so that investors are indifferent
between capital gains an dividends.
 There are many investors, and no single investor can affect the price of a
stock through his or her buying and selling decisions. Therefore,
investors are price-takers.
 Volatility (risk) of individual security returns are caused by two
different factors:
 Non-diversifiable risk (system wide changes in the economy and
markets that affect all securities in varying degrees)
 Diversifiable risk (company-specific factors that affect the returns of
only one security)

 Figure 2 illustrates what happens to portfolio risk as the portfolio is

first invested in only one investment, and then slowly invested,
naively, in more and more securities.
 The CAPM and Market Risk
Portfolio Risk and Diversification
FIGURE 2

Total Risk (σ)

Unique (Non-systematic) Risk

Market (Systematic) Risk

Number of Securities
 The Capital Asset Pricing Model
How is it Used?
 Uses include:
 Determining the cost of equity capital.
 The relevant risk in the dividend discount model to estimate a stock’s intrinsic
(inherent economic worth) value. (As illustrated below)

Estimate Investment’s Risk Determine Investment’s Estimate the Investment’s Compare to the actual
(Beta Coefficient) Required Return Intrinsic Value stock price in the market

COVi,M D1
βi =
σ M2
ki = RF + ( ERM − RF ) β i P0 = Is the
kc − g stock
fairly
priced?
 The Expression and Implication of the CAPM

The CAPM quantifies trade-off between risk and

expected return and yields the following
expression:

E(Ri) = Rf + [E(Rm) – Rf]β I

β i = cov( Ri , Rm ) / δ (2Rm )
 The Expression and Implication of CAPM

 The essence of CAPM is that the expected return on any

asset is a positive linear function of its beta and that beta
is the only measure of risk needed to explain the cross-
section of expected returns.
 The spirit of CAPM isβ . Noβ , no CAPM.
 Market Portfolio and Capital Market Line
 The assumptions have the following implications:
 The “optimal” risky portfolio is the one that is tangent to the
efficient frontier on a line that is drawn from RF. This portfolio
will be the same for all investors.
 This optimal risky portfolio will be the market portfolio (M)
which contains all risky securities.
 The Capital Market Line
FIGURE 3

ER

CML
The market
portfolio
The
TheCMLCML ishas
the
is that
 ER − RF  standard
optimal deviation
risky
set of achievable
k P = RF +  M σ P
ERM M of
portfolio,
portfolioit
portfolio
 σM  contains
returns all
as risky
combinations the that
independent
securities
are and lies
possible when
tangent
investing in the
variable.
(T) on only
efficient frontier.
two assets (the
RF market portfolio
and the risk-free
asset (RF).
σρ

σM
 The CAPM and Market Risk
The Security Market Line (SML)
 The SML is the relationship between return (the dependent variable)
and systematic risk (the beta coefficient).
 It is a straight line relationship defined by the following formula:

[9-9] ki = RF + ( ERM − RF ) β i

 Where:
ki = the required return on security ‘i’
ERM – RF = market premium for risk
Βi = the beta coefficient for security ‘i’
 The CAPM and Market Risk
The Security Market Line (SML)

FIGURE 4

ER ki = RF + ( ERM − RF ) βi The SML

uses the
The SML
M beta
ERM is used to
coefficient
predict
as the
required
measure
returns for
RF of relevant
individual
risk.
securities
β
βM = 1
The CAPM quantifies trade-off between risk and
expected return and yields the following
expression:

E(Ri) = Rf + [E(Rm) – Rf]β I

β i = cov( Ri , Rm ) / δ (2Rm )