Introduction and definition

A model that describes the relationship between risk and expected return and that is

used in the pricing of risky securities behind that investors need to be compensated
in two ways: time value of money and risk
CAPM is an framework for determining the equilibrium expected return for risky

assets.
Relationship between expected return and systematic risk of individual assets or

securities or portfolios

Introduction and definition

The model was introduced by Jack Treynor, William Sharpe, John Lintner

and Jan Mossin independently, building on the earlier work of Harry Markowitz
on diversification and modern portfolio theory.
Harry Markowitz is the father of the modern portfolio theory.

William F Sharpe developed the CAPM. He emphasized that risk factor in

portfolio theory is a combination of two risk , systematic and unsystematic risk.

Introduction and definition

Under CAPM,
This implies a liner relationship between the assets expected return and

its beta.
Investors will be compensated only for that risk which they cannot

diversify. This is the market related (systematic) risk

Assumptions
1.

Market is perfect

2.

Individuals are risk averse.

3.

Individuals seek maximizing the expected return

4.

Homogeneous expectations

5.

Borrow or Lend freely at risk less rate of interest.

6.

Quantity of risky securities in market is given.

7.

No transaction cost.

Elements of CAPM
Capital Market Line risk return relationship for efficient
portfolios.
Security Market Line Graphic depiction (representation) of CAPM
and market price of risk in capital markets.

1.
2.
a)
b)

Systematic Risk
Unsystematic Risk

Risk Return Relationship

Risk Free Rate
Risk Premium on market portfolios
Beta - - Measure the risk of an individual asset value to market
portfolio.
Assets.

3.
4.
5.
6.

a)
b)

Defensive Assets
Aggressive Assets.

STD DEV OF PORTFOLIO RETURN

Total Risk = Systematic Risk + Unsystematic Risk

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Systematic risk or Un diversifiable risk

It cannot be eliminated through diversification
It can be measured in relation to the risk of a diversified

portfolio or the market.

According to CAPM, the Non-Diversifiable risk of an
investment or security or asset is assessed in terms of the
beta co-efficient

Unsystematic or Diversifiable Risk

It cannot be eliminated through diversification
It can be measured in relation to the risk of a diversified

portfolio or the market.

According to CAPM, the Non-Diversifiable risk of an
investment or security or asset is assessed in terms of the
beta co-efficient

CAPM formula
E (ri) = Rf + i (E(Rm) Rf)
E(ri) = return required on financial asset i
Rf = risk-free rate of return
i = beta value for financial asset i
E(rm) = average return on the capital market

BETA
Also known as "beta coefficient."
Beta measures non-diversifiable risk, or volatility of a
security or a portfolio in comparison to the market as
a whole
It shows how the price of a security responds to market
forces.
In effect, the more responsive the price of a security is
to changes in the market, the higher will be its beta.

BETA
Investors will find beta helpful in assessing
systematic risk and understanding the impact
market movements can have on the return
expected from a share of stock.
CAPM uses beta to viewed both as a mathematical
equation and graphical, as the security market line
(SML).
Betas can be positive or negative however, all betas
are positive and most betas lie between 0.4 to 1.9.

BETA
VALUE OF BETA
= 1
<1
>1
For example, if a stock's beta is 1.2, it's theoretically 20% more

volatile than the market

The theory limitations

CAPM has the following limitations:
It is based on unrealistic assumptions.
It is difficult to test the validity of CAPM.
Betas do not remain stable over time.