CAPITAL ASSET

PRICING MODEL
AND MODERN
PORTFOLIO THEORY

Group 3

What is CAPM

(Capital Asset Pricing

Model)?

Is one of the major developments in modern

financial theory widely used in investment analysis.

Is a model based on the proposition that any stocks

required rate of return is equal to the risk-free rate
of return plus a risk premium that reflects only the
risk remaining after diversification.

What is CAPM

(Capital Asset Pricing

Model)?

General framework for analyzing risk-return

relationships for all types of assets.

In evaluating CAPM , only one part of total risk

called Systematic Risk.

Total Risk two major components:

1.Diversification Risk

also called unsystematic risk or company risk

Part of a securitys risk caused by factors unique

to a particular firm.

Sources of this risk include lawsuits, strikes,

company management , marketing strategies and
R&D programs, operating and financial leverage.

Can be eliminated by diversification

Total Risk two major components:

2. Undiversifiable Risk

also called as systematic risk or market risk

Part of a securitys risk caused by factors

affecting the market as a whole.

The only relevant risk and affected by such

factors such as wars, inflation , interest rates ,
business cycles, fiscal and monetary policies

cannot be eliminated by diversification.

THE BETA COEFFICIENT CONCEPT

BETA

Is a measure of the sensitivity of a securitys

return relative to the returns of a broad-based
market portfolio securities.

Defined mathematically as the ratio of the

covariance of returns of security and market
portfolio, to the variance of returns of the market
portfolio.

BETA COEFFICIENT
Y= a + bX + e
Where: Y = the dependent variable

a = constant
b = slope return on the stock given during a

given time

period

X = Km
e = error term (deviation) for the year; varies randomly
from year to year

depending on company specific factors

PORTFOLIO BETA COEFFICIENT

A portfolio consisting of low-beta securities will

itself have a low beta because the beta of any set
of securities is a weighted average of the
individual securities betas. The beta of the
portfolio reflects how volatile the portfolio is in
relation to the market.

RELATIONSHIP BETWEEN RISK AND RATE OF

RETURN

The CAPM expresses risk-return relationships

using beta as the relevant risk measure.

CAPM states that the required rate of return

on a risky asset consists of the risk-free rate
plus a premium for systematic risk.

The formula for the capital asset pricing model is:

Where: ri = required (or expected) return on security, i

rf = expected risk-free rate of return
rm = expected return on the market portfolio
bi = beta coefficient of security , i

Risk-free rate of return (rf) , is the return

required on a security having no systematic risk and
is generally measured by the yield on short-term
Treasury securities such as Treasury bills.

Risk premium bi(rf-rm ) , is the return required in

the excess of the risk-free rate and is due to
systematic risk.

SECURITY MARKET
LINE(SML)
- Represents the linear relationship between a
securitys required rate of return and its risk as
measured by beta. The slope of the SML is the
market risk premium (rf-rm ) and is constant.

HURDLE RATE
- Is the minimum rate of return required for a
project to be accepted. If an asset's expected rate
of return equals or exceeds the required return (falls
on or above the SML),

as computed by CAPM, the asset

is accepted; otherwise it is rejected. In the

equilibrium, the required return of an asset or
security equals its expected return.

CONCERNS ABOUT BETA

Assumptions about investor behavior:
a.

Investors are risk-averse and expect to be rewarded for

taking risk;

b.

Investors act rationally and prefer a security with the

highest return for a given level of risk, or the lowest risk
for a given level of return;

c.

Investors make their decision based on a single time

horizon.

d.

Investors share the same expectations about the risk and

return characteristics of securities.

CONCERNS ABOUT BETA

Assumption about the securities market:
a.

All investors can borrow or lend in unlimited amounts

at the risk-free rate;

b.

Financial markets are frictionless in that there are no

taxes or transactions costs;

c.

All assets are perfectly divisible and perfectly liquid;

and

d.

Information is freely available to all investors

THANK YOU
&
GOD BLESS