Capital Asset Pricing Model presented by: Ryan Andrews and Amar Shah

Definition of CAPM  Capital Asset Pricing Model States that the expected return on a specific asset equals the risk-free rate plus a premium that depends on the asset’s beta and the expected risk premium on the market portfolio.

Assessing Risk  Two types of risk in securities Systematic Risk Unsystematic Risk  Risk can be reduced but not eliminated Diversification

The Purpose of CAPM  CAPM works to evaluate risk  The equation says how much of return you should earn depending upon risk exposure

CAPM Formula  E(R p ) = r f + β p (E(R m ) – r f ) E(R p ) : Expected return on capital asset r f : Risk-free rate of return β p : Sensitivity of the asset returns to market returns E(R m ) : Expected return of the market

Beta  The measure of a particular stock’s risk Relative Volatility  Market behavior = Beta of 1 Higher than 1: Capital asset is more volatile than the market Lower than 1: Capital asset is less volatile than the market

Security Market Line  Use to construct a portfolio of T-Bills and market portfolio to achieve the desired level of risk and return

Sample Problem Walkthrough  Currently the risk-free rate equals 5% and the expected return on the market portfolio equals 11%. An investment analyst provides you with the following information: Stock BetaExpected Return A1.3312% B0.710% C1.514%  Indicate whether each stock is overpriced, under priced, or correctly priced.

Stock A  E(R p ) = r f + β p (E(R m ) – r f ) 5% (11% - 5%) = 12.98% 12.98% > 12% so its underpriced

Stock B  E(R p ) = r f + β p (E(R m ) – r f ) 5% + 0.7(11% - 5%) = 9.2% 9.2% < 10% so its overpriced

Stock C  E(R p ) = r f + β p (E(R m ) – r f ) 5% + 1.5(11% - 5%) = 14% 14% = 14% so its correctly priced

Sample Problem A particular stock sells for $30. The stock’s beta is 1.25, the risk free rate is 4%, and the expected return on the market portfolio is 10%. If you forecast that the stock will be worth $33 next year (assume no dividends), should you buy the stock or not and what is the expected price? A.) Yes, it will be worth $33.45 B.) Yes, it will be worth $35.00 C.) No, it will be worth $32.50 D.) No, it will be worth $30.00

Solution E(R p ) = r f + β p (E(R m ) – r f )  r f = 4%  β p = 1.25  E(R m ) = 10%  E(R p ) = ? Plug in numbers and solve for E(R p )  E(R p ) = 4% (10% - 4%) = 11.5%

Solution Cont.  Use TVM functions on calculator to finish up the problem PV = $30 I/Y = 11.5% N = 1 PMT = 0 CPT, FV = $33.45  $33.45 > $33, so buy this stock

Conclusion  CAPM predicts E(r) on a stock using the stock’s beta, the risk-free rate, and the market risk premium  Offers insight into the future, but not a guarantee  Very useful, offers yet another way of investing safely