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Assumptions of CAPM
Key Issues
Essentially, the capital asset pricing model (CAPM) is concerned with two questions: What is the relationship between risk and return for an efficient portfolio? What is the relationship between risk and return for an
individual security?
Basic Assumptions
RISK - AVERSION
HOMOGENEOUS EXPECTATION
PERFECT MARKETS
Characteristics Line
STANDARD DEVIATION, p
CiM
E (R i ) = R f + [ E (R M) - R f ] i
EXPECTED RETURN 14%
P
SML
8%
0
ALPHA = EXPECTED - FAIR RETURN RETURN
1.0
RISK-FREE RETURN
RATE ON A SHORT-TERM GOVT SECURITY RATE ON A LONG TERM GOVT BOND
PERIOD
: AS LONG AS POSSIBLE
Calculation Of Beta
i =
iM M 2
Calculation Of Beta
Return on market portfolio, RM Deviation of return on stock A from its mean (RA - RA) 0 5 8 4 6 6 8 -6 -19 4 5 4 -4 -3 -18 Deviation of Product of the return on market deviation, portfolio from its (RA - RA) mean (RM - RM) (RM - RM) 3 5 4 1 0 4 5 -2 -8 3 -20 7 -1 -2 1 Square of the deviation of return on market portfolio from its mean (RM - RM)2 0 9 25 25 32 16 4 1 0 0 24 16 40 25 12 4 152 64 12 9 -100 400 28 49 4 1 6 4 -18 1 (RA - RA) (RM - RM) 2 (RM - RM) = 221 = 624
Period
Return on stock A, RA
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
10 15 18 14 16 16 18 4 -9 14 15 14 6 7 -8 RA = 150 RA =10
12 14 13 10 9 13 14 7 1 12 -11 16 8 7 10 RM = 135 RM = 9
= Cov(RA,RM) 2M Cov(RA,RM) = (RA - RA--) (RM RM--) = 221 = 15.79 n-1 14 Where, Cov(RA,RM) = covariance between A and Market M RA = return on security A RM = return on Market M RA-- = expected return on security A RM-- = expected return on Market M n = number of observations 2M = (RM RM--)2 = 624 = 44.57 n-1 14 = Cov(RA,RM) = 15.79 / 44.57 = 0.354 2M
Problem 1
The following table, gives the rate of return on stock of Apple Computers and on the market portfolio for five years Year 1 2 3 4 5 Return on the stock Apple Computers (%) -13 5 15 27 10 Return Market Portfolio (%) -3 2 8 12 7
(i) What is the beta of the stock of Apple Computers? (ii) Establish the characteristic line for the stock of Apple Computers.
Solution
Year 1 2 3 4 5 Sum Mean M2 RA -13 5 15 27 10 44 8.8 134.8 = 5-1 83.55 A = 33.7 = 2.48 = 33.7 Cov A,M = 5-1 RM -3 2 8 12 7 26 5.2 RA - RA -21.8 -3.8 6.2 18.2 1.2 RM - RM -8.2 -3.2 2.8 6.8 1.8 (RA - RA) (RM - RM) 178.76 12.16 17.36 123.76 2.16 334.2 (RM - RM)2 67.24 10.24 7.84 46.24 3.24 134.8
334.2 = 83.55
Solution (contd.)
(ii) Alpha = = RA A RM 8.8 (2.48 x 5.2) = - 4.1
Problem 2
The risk-free return is 8 percent and the return on market portfolio is 16 percent. Stock X's beta is 1.2; its dividends and earnings are expected to grow at the constant rate of 10 percent. If the previous dividend per share of stock X was Rs.3.00, what should be the intrinsic value per share of stock X?
Solution
The required rate of return on stock A is: RX = = = RF + X (RM RF) 0.08 + 1.2 (0.16 0.08) 0. 176
Intrinsic value of share = D1 / (r- g) = Do (1+g) / ( r g) Given Do = Rs.3.00, g = 0.10, r = 0.176 3.00 (1.10) Intrinsic value per share of stock X = 0.176 0.10 = Rs. 43.42