Capital Asset Pricing Model (CAPM) Dr. BALAMURUGAN MUTHURAMAN Chapter

INTRODUCTION A widely-used valuation model, known as the Capital Asset Pricing Model, seeks to value financial assets by linking an asset's return and its risk. Prepared with two inputs -- The market's overall expected return and an asset's risk compared to the overall market -- The CAPM predicts the asset's expected return and thus a discount rate to determine price

Capital Asset Pricing Model  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.  The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk  William F Sharpe developed the CAPM. He emphasized that risk factor in portfolio theory is a combination of two risk, systematic and unsystematic risk

ASSUMPTIONS  Can lend and borrow unlimited amounts under the risk free rate of interest  Individuals seek to maximize the expected utility of their portfolios over a single period planning horizon.  Assume all information is available at the same time to all investors  The market is perfect: there are no taxes; there are no transaction costs; securities are completely divisible; the market is competitive.  The quantity of risky securities in the market is given

The CAPM, despite its theoretical elegance, makes some heady assumptions. It assumes prices of financial assets (the model's measure of returns) are set in informationally-efficient markets. It relies on historical returns and historical variability, which might not be a good predictor of the future

CHARACTERISTICS - CAPM To work with the CAPM have to understand three things. (1)The kinds of risk implicit in a financial asset (namely diversifiable and non-diversifiable risk) (2) An asset's risk compared to the overall market risk -- its so-called beta coefficient (β) (3) The linear formula (or security market line) that relates return and β

How is the CAPM derived? The CAPM begins with the insight that financial assets contain two kinds of risk. There is risk that is diversifiable - it can be eliminated by combining the asset with other assets in a diversified portfolio. And there is non diversifiable risk - risk that reflects the future is unknowable and cannot be eliminated by diversification

Implications and Relevance of CAPM  Investors will always combine a risk free asset with a market portfolio of risky assets. Investors will invest in risky assets in proportion to their market value..  Investors can expect returns from their investment according to the risk. This implies a liner relationship between the asset’s expected return and its beta.  Investors will be compensated only for that risk which they cannot diversify. This is the market related (systematic) risk

BETA (β)  A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.  Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns.  Also known as "beta coefficient.“

CAPM Formula CAPM - R s = R f + β (R m – R f ) R s = Expected Return/ Return required on the investment R f = Risk-Free Return/ Return that can be earned on a risk-free investment R m = Average return on all securities β = The securities beta (systematic) risk factor

DIVERSIFIABLE RISK Diversifiable risk sometimes called unsystematic risk. That part of an asset's risk arising from random causes that can be eliminated through diversification. For example, the risk of a company losing a key account can be diversified away by investing in the competitor that look the account

NON-DIVERSIFIABLE RISK Non-diversifiable risk sometimes called systematic risk. The risk attributable to market factors that affect all firms and that cannot be eliminated through diversification. For example, if there is inflation, all companies experience an increase in prices of inputs, and generally their profitability will suffer if they cannot fully pass the price increase on to their customers

ADVANTAGES - CAPM There are numerous advantages to the application of CAPM, Ease-of-use: CAPM is a simplistic calculation that can be easily tested to derive a range of possible outcomes to provide confidence around the required rates of return. Diversified Portfolio: The assumption that investors hold a diversified portfolio, similar to the market portfolio, eliminates the unsystematic risk

Systematic risk (ß): CAPM takes into account systematic risk, which is left out of other return models. Business and Financial Risk Variability: When businesses investigate opportunities, if the business mix and financing differ from the current business, then other required return calculations

Drawbacks - CAPM Risk-free Rate (R f ): The commonly accepted rate used as the R f is the yield on short-term government securities. Return on the Market (R m ): The return on the market can be described as the sum of the capital gains and dividends for the market. A problem arises when at any given time, the market return can be negative. As a result, a long-term market return is utilized to smooth the return

Ability to Borrow at a Risk-free Rate: The minimum required return line might actually be less steep (provide a lower return) than the model calculates. Determination of Project Proxy Beta: Businesses that use CAPM to assess an investment need to find a beta reflective to the project or investment. Often a proxy beta is necessary. However, accurately determining one to properly assess the project is difficult and can affect the reliability of the outcome

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

Exercise The AT&T has an expected ß =.92, and Microsoft has a ß = 1.23 (both based on past stock price volatility). Further, assume that analysts are predicting the S&P 500 will go up 14.7% over the next year, and currently the return on a one-year Treasury bill is 5.2% both (AT&T and Microsoft. What return should investor expect for AT&T and Microsoft?