Capital Asset Pricing Model

CAPM provides that investors are rewarded for bearing systematic

risk which is attributed to stock’s response to a change in the
market. Systematic risk can not be eliminated and the investor has
to bear this risk. Though investors are generally risk averse but
they have to assume systematic risk and more they assume it the
higher will be the reward. Whereas, security’s individual risk or
unsystematic risk can be eliminated by diversification. So the
investors are actually rewarded for assuming systematic risk.
 Capital Asset Pricing Model

The CAPM can be explained like this that expected return on

a security is equal to its level of systematic risk. The capital
asset pricing model further provides that the beta of a stock
remains stable over a period of time.
 Capital Asset Pricing Model

Assumptions of Capital Asset Pricing Model

All investors are efficient investors who want to target points
on the efficient frontier.
Investors can borrow or lend any amount of money at the risk-
free rate of return (RFR).
All investors have homogeneous expectations; that is, they
estimate identical probability distributions for future rates of
return.
All investors have the same one-period time horizon such as
one-month, six months, or one year.
 Capital Asset Pricing Model

All investments are infinitely divisible, which means that it is

possible to buy or sell fractional shares of any asset or portfolio
There are no taxes or transaction costs involved in buying or
selling assets.
There is no inflation or any change in interest rates, or inflation is
fully anticipated.
Capital markets are in equilibrium.
This means that we begin with all investments properly priced in
line with their risk le
 Capital Asset Pricing Model

Risk
Risk is the result of variation in actual return of stock as
compared with the expected return. This variation is due to many
factors. These factors include stock specific factors and economy
specific factors. Hence, these are divided into two components.
(a) Systematic Risk
(b) Unsystematic Risk
 Capital Asset Pricing Model

Systematic risk
Systematic risk is the risk of overall economy. Every stock
share this risk. This risk is due to economic policies, inflation,
tax rate, foreign exchange results, political stability, supply of
money, terrorism and other factors which are beyond the
control of any company. Every one is exposed to this type of
risk and cannot avoid it as long as it is working in that
economy.
 Capital Asset Pricing Model

Unsystematic Risk
Unsystematic risk is company specific risk. It is due to the
policies of the company. It sales, cost of production, labor
cost, strike of the labor, raw material availability, advertising,
salesmanship, the plant capacity and its ability to mange
micro factors. The managerial skill contribute a lot towards
this risk. The management with superior managerial capability
can avoid this risk.
 Capital Asset Pricing Model

Total Risk = Systematic (Unavoidable) Risk +

Unsystematic (avoidable) Risk
 Capital Asset Pricing Model

Beta
 Measures a stock’s market risk, and shows a stock’s
volatility relative to the market.
 Indicates how risky a stock is if the stock is held in a well-
diversified portfolio
If beta = 1.0, the security is just as risky as the average stock.
If beta > 1.0, the security is riskier than average.
If beta < 1.0, the security is less risky than average.
Most stocks have betas in the range of 0.5 to 1.5
.
 Capital Asset Pricing Model
Beta of a Stock
 Capital Asset Pricing Model
Market Stock

Standard 0.12472191 0.06236095

Deviation 3 6
Correlation 1
Beta 0.5
 Capital Asset Pricing Model

 Risk Free Rate of Return (RFR)

 Market Rate of Return (MR)

 Risk Premium (RP)

 Capital Asset Pricing Model

Required Rate of Return = RFR +(MR-RFR)(BETA)

= 6 +(8 – 6) *(1.5)
= 9
 Capital Asset Pricing Model

Beta of a Portfolio:
The beta of a portfolio is the weighted average of each of the
stock’s betas
Sakina has Rs. 35,000 invested in a stock which has a beta of 0.8
and Rs. 40,000 in a stock with a beta of 1.4. If these are only
two investment in h portfolio what is his portfolio beta
 Capital Asset Pricing Model

Investment Beta
Rs. 35,000 0.8
40,000 1.4
Total 75,000
Portfolio Beta = (35,000/75,000)(0.8) + (40,000/75,000)(1.4)
= 1.12.
 Capital Asset Pricing Model

Suppose you are the money manager of a Rs 4 Million investment

fund. The fund consists of the following investments and betas:
Stock Investment Beta
A Rs 400,000 1.50
B 600,000 (0.50)
C 1,000,000 1.25
D 2,000,000 0.75
Total 4,000,000
If the market required rate of return is 14% and the risk free rate is
6%, what is the fund’s required rate of return.
Security CapitalExp.
Asset
Ret. PricingBeta
Model
HT 17.4% 1.30
Market 15.0 1.00
USR 13.8 0.89
T-Bills 8.0 0.00
Coll. 1.7 -0.87

Risk Free Rate of Return is 8%

Calculate (a) Required Rate of Return
(b) State whether the security is
undervalued or over valued
 Capital Asset Pricing Model
Security Exp. Ret. Req. Return Valuation
HT 17.4% 17.1 Under-Valued
Market 15.0 15.0 Fairly Valued
USR 13.8 14.2 Over Valued
T-Bills 8.0 8.0 Fairly Valued
Coll. 1.7 1.9 Over valued