CAPITAL ASSETS PRICING MODEL [CAPM]

INTRODUCTION
The Capital Assets Pricing Model is an extension of the

Portfolio Theory which tells us how a rational investor should construct a portfolio on the basis of risk and return The CAPM theory tells how assets should be priced in the capital markets if all investors behave rationally A risk averse investor construct an efficient portfolio (combination of market portfolio and risk free investments) on the basis of analysis of risk and return of securities Significant contributions to the development of CAPM have been made by William Sharpe, John Lintner and Ian Mossin

USEFULNESS OF CAPM
The CAPM, when applied to the portfolio analysis,

provides a useful techniques of measuring the risk factor as well as the required rate of return of a portfolio

SYSTEMATIC RISK
It is also known as Market Risk It is that part of risk, which cannot be eliminated by

diversification or precautions This part of the risk arises because every security has a built-in tendency to move in line with the fluctuations in the market The systematic risk refers to the fluctuation in return due to general factors in the market such as money supply, inflation, economic recession, industrial policy, interest rate policy, credit policy, tax policies, etc.

UNSYSTEMATIC RISK
It can be eliminated through effective diversification
This risk represents the fluctuations in return of a

security due to factors which are specific to the particular firm and the market as a whole These factors may be workers unrest, strike, change in market demand, change in competitive environment, change in consumer preferences, etc. This is also called as diversifiable risk

EFFICIENT PORTFOLIO
The bifurcation of total risk into systematic and

unsystematic risks leads to conclusion that a portfolio may be called an efficient portfolio, if it does not have any unsystematic risk
The efficient portfolio or optimal portfolio is difficult,

if not impossible, to attain. But a portfolio which is nearly efficient or optimal can be constructed by a careful selection of only a handful of securities

CAPM
CAPM establishes that the required rate of return of a

security must be related to its contribution to the risk of the portfolio CAPM stresses that only the systematic risk, the undiversifiable risk, is relevant for the expected rate of return of a security Since the diversificable risk, i.e., the unsystematic risk can be eliminated, there is no reward for it The graphical version of CAPM is called the Security Market Line (SML)

ASSUMPTIONS OF CAPM
The investors are basically risk averse and diversification is needed to

reduce the risk All investors want to maximize the wealth and choose a portfolio solely on the basis of risk and return All investors can borrow or lend an unlimited amount of funds at riskfree rate of interest All investors have identical estimates of risk and return of all securities All securities are perfectly divisible and liquid There is no transaction costs There is no tax The security market is efficient and purchases and sales by a single investor cannot affect the prices All investors are efficiently diversified and have eliminated the unsystematic risk

CAPM MODEL
The risk of a diversified portfolio depends upon the

systematic risk of the securities included in the portfolio All the securities available to an investor do not have same level of systematic risk The factors contributing to systematic risk do not affect all the securities in the same way and the magnitude of the influence of these factors vary from one security to another depending upon the sensitivity of the security to the market fluctuations

MEASUREMENT OF SYSTEMATIC RISK

The investor will pay premium only for the systematic

risk as it is non-diversifiable. So, the question is how this systematic risk can be measured? William Sharpe has suggested that the systematic risk can be measured by , the beta factor The beta co-efficient is the relative measure of sensitivity of an asset's return to change in the return on the market portfolio Formula: Beta = Percentage change in a particular share Percentage change in the Index

CAPM EQUATION
Rs = RF + (RM RF) Rs = The expected return from a portfolio RF = The risk free return RM = The expected return on the market portfolio = Measure of systematic risk

CAPM THEORY
The CAPM model depicts that the expected rate of return

of a security consists of two parts: (i) Risk free return (RF) (ii) Risk premium = (RM RF)

[The risk premium is equal to the difference between the expected market return and the riskfree return multiplied by the beta factor ] Evidently, the risk premium varies directly with the beta factor i.e., the systematic risk. Therefore, the higher the beta, the greater is the expected rate of return and viceversa

IMPORTANCE OF CAPM
Required Rate of Return

= Price of Time + Price of Risk x Amount of Risk CAPM shows that the required rate of return for a particular portfolio depends on three things:

a. The pure time value of money (RF) b. The reward for bearing systematic risk (RM RF) c. The amount of systematic risk () Just Assuming, the portfolio under consideration has the required rate of return of 19.1%. Say, the average expected rate of return (in view of the probability distribution) of the portfolio is 19%. Therefore, the portfolio is correctly priced

SML VS CML
The basic difference between the SML and CML is the

measurement of risk: The CML measures total risk of the portfolio () whereas the SML measures the systematic risk of the portfolio () All the portfolio lying on the CML are the efficient portfolios and the inefficient portfolios lie below the CML. However, the SML shows only those securities which are correctly priced in view of the systematic risk associated with the security

LIMITATIONS OF CAPM
The calculation of Beta factor is very tedious as lot of

data is required The Beta factor cannot be expected to be constant over a period of time The assumptions of CAPM are hypothetical and are impractical The required rate of return, Rs, specified by the model can be viewed only as a rough approximation of the required rate of return

SUMMARY
The investors are risk averse and prefer to have higher

expected returns and lower risks. A portfolio which has the highest expected return for a given level of risk is known as Efficient portfolio Some securities will increase the risk of a portfolio, and the investor will buy these securities only if they increase the expected return also. Other securities may reduce the portfolio risk, so the investor may be ready to buy even if these reduces the expected return of the investor

SUMMARY (CONTD.)
Risk of any security need not be viewed in isolation but at

its marginal contribution to the portfolio risk A securitys sensitivity to change in value of the market portfolio is known as the beta factor, . The difference between expected returns of any two securities is due to differences in The securities having high , will provide higher returns and vice-versa The required rate of return of an investor is consisting of a risk-free return and a risk premium which depends upon the contribution of a security to the portfolio risk