INVESTMENT THEORY & PORTFOLIO MANAGEMENT

(CAPM)

CAPITAL ASSET PRICING MODEL

CAPM can be used as an approach to measure the Cost of Equity Capital. CAPM provides a mechanism whereby investors could assess the impact of a proposed security investment on the overall portfolio risk and return. CAPM is based on 2 basic assumptions; (1) Efficiency of the Security Markets and (2) Investor Preferences. Efficiency of the Security Markets : (Imagine you have a fixed amount of funds for investment and you are considering investment in only 2 securities A & B, and are trying to develop a portfolio with the best possible return vs risk combination). The assumptions under this category are: (1) All investors have common expectations regarding the expected returns, correlations, & standard deviations from these expected returns among all securities. The table below shows a portfolio comprising of two(2) securities A & B shown in different mixes. First row shows 100% investment in A and zero in B, while the each rows thereafter shows how the portfolio characteristics change with the changing mix between A and B. Column 3 and 4 list the ER (expected return) vs Standard Deviation (sigma).

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(2) All investors have the same information about these securities (in other words all price sensitive information is made public). (3) There are no restrictions or barriers for investors. (4) There are no taxes on security investments. (5) There are no transaction costs. (6) No single investor can manipulate or influence the market price of the securities. Investors Preferences: (1) This matter stresses the fact that all investors are Risk-Averse. In other words, they prefer the securities that offer the highest return with the lowest possible risk factor. (2) It is assumed that no investor is whimsical, rather they are well informed and they research the investment options before setting up a portfolio of

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securities. Investors do not put their money into anything based on word of mouth or rumours.

(3) Bonds issued by the Government, such as Treasury Bonds are assumed to be the reference point in terms defining a RISK FREE investment. This point is denoted as R f . All security investments risks can be placed in two(2) groups as follows:

CAPM DEALS SOLELY WITH SYSTEMATIC / NON-DIVERSIFIABLE RISKS According to CAPM the non-diversifiable risk of a security investment is assessed in terms of the Beta Coefficient . Beta is a measure of the volatility of a securitys return relative to the returns of a broad-based market portfolio. Alternately it is an index of the degree of responsiveness of return on an investment with the market return. It is assumed that the value =1 for the

broad-based market (known as the CAPITAL MARKET LINE).

The following is a rule for Beta Coefficients:

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s = 1.0 -the security has the same volatility as the market as a whole s > 1.0 -aggressive investment with volatility of returns greater than the market s < 1.0 -defensive investment with volatility of returns less than the market s < 0.0 -an investment with returns that are negatively correlated with the returns of the market The SECURITY MARKET LINE (SML) shows the relationship between expected returns (ER) vs Beta Coefficient (), see the line in the graph below :

In this course we are interested in knowing how CAPM describes the relationship between the Required Rate of Return or Cost of Equity Capital and the nondiversifiable risk of the firm as reflected in its index of non-diversifiable risk, that is beta coefficient. Thus:

+ (K m R f )

Ke =
investments

Cost of Equity Capital

Rf = the required rate of return for Risk-Free Km = The required rate of return on the market
portfolio of

INVESTMENT THEORY & PORTFOLIO MANAGEMENT

average rate of return on all investment

investments that can be viewed as the

= Beta Coefficient
See the following Examples: 1. ABC Ltd wishes to calculate its cost of equity capital using CAPM model. The data available is that the risk-free return equals 10%, the firms beta = 1.50, and the return on the market portfolio is 12.5%. Find the cost of equity capital ?

2. As an investment adviser you are provided the following data:

Investment Beta Risk Factor in Securities () Initial Price per share Dividends per share Year-end market price per share

-------------------------------------------------------------------------------------------------------------------------Pharma Ltd 0.80 Steel Ltd. 0.70 Textile Ltd. 0.50 Govt. Bonds 0.99 You are to calculate: (a) Expected Rate of Return of Market Portfolio (Km) of whole portfolio ? (b) Expected Rate of Return of each security (Ke) of each item ? $ 1000 $ 140 $ 1,005 $ 45 $2 $ 135 $ 35 $2 $ 60 $ 25 $2 $ 50

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