Financial Management

Session - 12
CAPM

Measuring Risk
Variance:
Average value of the squared deviations from mean

Standard deviation
Positive square root of variance, a very common measure
for risk

Expected Return, Risk and Diversification

As managers, we are concerned about the overall risk
of the businesss portfolio of assets.
The return on a portfolio (rp) is the weighted average
of the returns on the assets in the portfolio, where the
weights are the proportion invested in each asset.

Portfolio Risk: Variance

Let cov1,2 represent the covariance of two assets
returns. We can write the portfolio variance as:

It can be shown that for a large portfolio of multiple

of assets, the portfolio variance depends more on the
covariances than on the respective variances of
individual assets.

Diversifiable and Non-diversifiable RisksContd

Modern Portfolio Theory

We see that the best portfolios are no longer those along the
entire length of the efficient frontier; rather, the best portfolios
are now the combinations of the risk-free asset and one and
only oneportfolio of risky assets on the frontier.

Estimating Beta
Beta measures the responsiveness of the securitys
return to movement in the market
For the average stock beta =1
If Beta>1 , it means that stock is contributing much to
the risk of the portfolio than the average stock
Beta<0 , means securities do well when market does
poorly and vice versa.

Security Returns

Estimating with Regression

Slope = i
Return on
market %

Ri = i + iRm + ei
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Beta and the portfolio risk

The contribution of an individual security to the risk
of a well diversified portfolio depends on two factors:
The importance (weight) of the security in the portfolio and
The sensitivity of the security to market movements (beta).

So, in a portfolio, the risk of individual security is

measured by its beta ().

Cov( Ri , RM )

( RM )
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Standard deviation Vs beta

Which provides better measure of risk?
If investor holds only one security then the SD of the
security is a true measure of risk
If investor holds a well diversified portfolio the SD of
the portfolio is a measure of risk of the whole
portfolio but for the individual security beta is an
appropriate measure

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Beta varies with time and within sector

Beta values have three firm specific drivers
Degree of Operating leverage
Degree of Financial leverage
Business risk

With time all these factors changes and hence beta

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Capital Asset Pricing Model

The model was introduced by Jack Treynor, William
Sharpe, John Lintner and Jan Mossin independently,
building on the earlier work of Harry Markowitz on
diversification and modern portfolio theory.
This model establish a relationship between risk and
expected return
Expected return and market
Expected return and individual securities

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Capital Asset Pricing ModelAssumptions

All investors have rational expectations.

There are no arbitrage opportunities.
Returns are distributed normally.
Perfectly efficient capital markets.

Investors are solely concerned with level and uncertainty of

future wealth
Risk-free rates exist with limitless borrowing capacity and
universal access.
The Risk-free borrowing and lending rates are equal.
No inflation and no change in the level of interest rate exists.
Perfect information, hence all investors have the same
expectations about security returns for any given time period.
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Capital Asset Pricing Model

William Sharpe took the idea that portfolio return and risk
are the only elements to consider and developed a model
that deals with how assets are priced.
This model is referred to as the capital asset pricing
model (CAPM).
All the assets in each portfolio, even on the frontier, have
some risk.
However, regardless of the level of risk one chooses, one
can get the highest expected return by a mixture of a
portfolio in the efficient frontier and a risk free asset
(lending or borrowing).
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CAPMContd
The CAPM uses this relationship between expected return
and risk to describe how assets are priced.
The CAPM specifies that the expected return on any asset
is a function of the return on a risk-free asset plus a risk
premium.
The return on the risk free asset is compensation for the
time value of money.
The risk premium is the compensation for bearing risk.
If we represent the expected return on each asset and its
beta as a point on a graph and connect all the points, the
result is the security market line (SML).
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CAPMContd

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Beta is dead!
Fama and French
The cross sections of expected stock returns (JoF)
Common risk factors in the return of stock and bonds (JFE)
Concluded that relationship between average reurns and beta is
weak over the period 1941 to 1960 and virtually non-existent from
1963-1990
Average return on a security is negatively related to both the firms
price earning ratio (P/E) and the firms market to book ratio (M/B)

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CAPM.Limitations
The CAPM includes some unrealistic assumptions. E.g.,
it assumes that all investors can borrow and lend at the
same rate.
The CAPM is really not testable. The market portfolio is
theoretical and not really observable.
(Risk Return and Equilibrium: Some Empirical Tests, JPE)

CAPM captures all market risk in one variable.

CAPM does not explain the differences in returns for
securities that differ over time, differ on the basis of
dividend yield, and differ on the basis of the market value
of equity (the so called size effect).

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Thank You!

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