CAPM problems

The Capital Asset Pricing Model (CAPM) was developed in mid 1960s by three researchers
William Sharpe, John Linter and Jan MOssin independently. Consequently, the model is often
referred to as Sharpe-Lintner-Mossin Capital Asset Pricing Model.

CAPM measures the risk of a security in relation to the portfolio. It considers the required rate
of return of a security in the light of its contribution to total portfolio risk. It derives the
relationship between the expected return and risk of individual securities and portfolios in the
capital markets if everyone behaved in the way the ortfolio suggested.

The CAPM holds that only undiversifiable risk is relevant to the determination of expected
return on any asset.

Even though the CAPM is competent to examine the risk and return of any capital asset such
as individual security, an investment project or a portfolio asset, we shall be discussing CAPM
with reference to risk and return of a security
only.

1. Risk-averse investors
The investors are basically risk averse and diversification is necessary to reduce their risks.

2. Maximising the utility of terminal wealth

An investor aims at maximizing the utility of his wealth rather than the wealth or return. The
term ‘Utility’ describes the differences in individual preferences. Each increment of wealth is
enjoyed less than the last as each increment is less important in satisfying the basic needs of
the individual. Thus, the diminishing marginal utility is most applicable to wealth.

There are also other forms of utility functions. Some investors showing a preference for larger
risks are those who have increasing marginal utility for wealth. In such cases, each increase in
wealth prompts the individual to acquire more wealth. For a risk-neutral investor, each
increment in wealth is equally attractive. In other words, each increment would have the same
utility for him.

3. Choice on the basis of risk and return:

Investors make investment decisions on the basis of risk and return. Risk and return are
measured by the variance and the mean of the portfolio returns. CAPM assumes that the rational
investors put away their diversifiable risk, namely, unsystematic risk. But only the systematic
risk remains which varies with the Beta of the security.

Some investors use the beta only to measure the risk while other investors use both beta and
variance of returns as the sources of reward. As individuals have varying perceptions towards
risk and reward, CAPM gives a series of efficient frontlines.

4. Similar expectations of risk and return

All investors have similar expectations of risk and return. In other words, all investors’
estimates of risk and return are the same. When the expectations of the investors differ, the
estimates of mean and variance lead to different forecasts.
As a result, there will be innumerable efficient frontiers and the efficient portfolio of each will
be different from that of the others. Varying preferences also imply that the price of an asset
will be different for different investors.

5. Identical time horizon

The CAPM is based on the assumption that all investors have identical time horizon. The core
of this assumption is that investors buy all the assets in their portfolios at one point of time and
sell them at some undefined but common point in future. This assumption further implies that
investors form portfolios to achieve wealth at a single common terminal rate.

This single common horizon enables one to construct a single period model. This assumption
is highly unrealistic as investors are short-term speculators. Further, the horizon is chosen on
the basis of the characteristics of an asset. So investors have different time horizons and their
estimates of stock value vary even when the estimated earnings remain constant. Instead of
single period model, investors generally adopt continuous time models as if they make a series
of reinvestments.

6. Free access to all available information

One of the important assumptions of the CAPM is that investors have free access to all the
available information at no cost. Supposing some investors alone are able to have access to
special information which is not readily available to all, then the markets would not be regarded
efficient. In other words, if the available information has not reached all, it will be difficult to
draw a common efficient frontier line.

7. There is risk-free asset and there is no restriction on borrowing and lending at the risk free
rate
This is a very important assumption of the CAPM. The risk free asset is essential to simplify
the complex pairwise covariance of Markowitz’s theory. The risk free asset makes the curved
efficient frontier of MPT to the linear efficient frontier of the CAPM simple.

As a result, the investors will not concentrate on the characteristics of individual assets. By
adding a portion of risk-free assets to the portfolio and borrowing the additional funds needed
at a risk free rate, the risk is either decreased or increased.

8. There are no taxes and transaction costs

According to Roll, there must be either a risk free asset or a portfolio of short sold securities.
Then only the capital Market Line (CML) will be straight. When there are no risk free assets,
the investor could not create a proxy risk free asset. As a result, the capital market line would
not be linear and the direct linear relationship between risk and return would not exist.

9. Total availability of assets is fixed and assets are marketable and divisible
This assumption holds the view that the total asset quantity is fixed and all assets are
marketable. However, models have been developed to include unmarketable assets which are
more complex than the basic CAPM.

CAPITAL MARKET LINE

CML is a concept from the CAPM that depicts the level of additional return above the rf rate
for each change in the level of risk.
Plotted on the graph, expected return on the y axis and the SD onn the X axis, the CML starts
at rf in the y axis and moves upward from left to right. Line runs to a point usually depicted
with an m, which represents feasible region for risky assets.

This point is a point at which rational investors would hold a basket of Risky assets in the
same proportion as their weights in theoretical efficient mkt portfolio. When analysing
portfolio, CML is preferred as ef frontier. Because the cml takes in to account the rf assets
that are included in portfolio.
The steeper the slope of the CmL the more the expecte return must change for each unit of
change in the SD.
CML analysis is one of the many ways investors allocate their investment portfolios to
achieve the maximum amount of expected return for the minimum amount of risk.
CMP provides a risk return relationship and a measure of risk for efficient protfolios. The
appropriate measure of risk for an efficient portfolio is the standard deviation of return of the
portfolio. There is a linear relationship between the risk as measured by the standard
deviation and exected return of these efficient portfolios.
Security Market Line:
The CML shows the risk return relarionship of all efficient portfolios. They would all lie
along the capital market line. All portfolios other than the effiecient ones will lie below the
capital market line. The CML does not describe the risk return relationship of inefficient
portfolios or of individual securities. The CAPM specifies the relationship between expected
return and risk for all securities and all portfolios whether efficient or inefficient.
The SML provides the relationship between the expected return and beta of a security or
portfolio. This relationship can be expressed as Rf + βi (Rm – Rf)

CML and SML:

Both postulate a linear relationship between risk and return. In CML, risk is defiend as total
risk and is measured by standard deviation while in SML, the risk is defined as systematic
risk and is measured by beta. Capital market line is valid only for efficient portfolios while
security market line is valid for portfolios and all individual securities as well. CML is the
basis of capital market theory while SML is the basis of CAPM
Problems on CAPM
1. Security J has a beta of 0.75 while security K has a beta of .45. Calculate the expected
return for these securities, assuming that the risk free rate is 5 percent and the
expected return of the market is 14 percent
Solution:
Expected return under CAPM
= Rf + βi (Rm – Rf)
For security J = 5 + 0.75 (14-5) = 11.75 percent
For security K = 5 + 1.45 (14 – 5) = 18.05 percent
2. A security pays a dividend of Rs. 3.85 and sells currently at Rs. 83. The security is
expected to sell at Rs. 90 at the end of the year. The security has a beta of 1.15. The
risk free rate is 5 percent and the expected return on market index is 12 percent.
Assess whether the security is correctly priced.
Solution: To assess whether a security is correctly priced, we ned to calculate
1. The expected return as per CAPM formula
2. Estimated return on the security based on the dividend and increase in price over
the holding period.
Expected return: = Rf + βi (Rm – Rf)
= 5 + 1.15 ( 12-5 ) = 13.05 percent
Estimated return = [(90 – 83) + 3.85]/83 = 13.07 percent
As the estimated return on the security is more or less equal to the expected return,
the security can be assessed as fairly priced.