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The Capital Asset Pricing Model

Zohaib Ali Zahid – 12th May 2008

This model was presented by Nobel Prize winner William Sharpe in 1964 and has
since been considered as an appropriate method of pricing assets based on risk
they carry and return they can generate. Sharpe’s work can be viewed as
basically an extension of Markowitz’s Portfolio theory, which identified that risk,
calculated as standard deviation of returns, can be minimized by diversifying
investments i.e. forming a portfolio of assets.

Unsystematic Risk

CAPM argues that diversifying your investment can reduce risk but it cannot be
eliminated fully. This is because by forming a portfolio (of different shares) only
one type of risk can be eliminated, that which is particular to circumstances of a
company and is known as Unsystematic Risk. For example, decline in returns on
Tesco due to fall in quarterly profits, due to fall in demand for company products,
a lawsuit, equipment failure or wasteful research and development program or a
rise in return due to appointment of a reputable chief Executive, rise in profits
due to lower costs etc.

This risk can be eliminated because


a drop in returns of one share in the Risk
portfolio tends to be cancelled out
by rise in return of other. Portfolio
theory suggested that this way even
high risk assets can be held if they
have a lower correlation to other
assets in the portfolio. Correlation is
the degree to which returns move
Unsystematic Risk
together, it is the degree to which
return of A will change with a
change in return of B. Therefore, if A Systematic
has low correlation to B, a sharp Total
Risk Risk
decline in its prices will be
accompanied by only a slight decline No. Of shares in portfolio
in B’s value. A higher proportion of B
or addition of more assets in the portfolio can completely wipe out the
unsystematic risk on A.

Systematic Risk

Once unsystematic risk is eliminated the investor can now concentrate on


dealing with the other type of risk namely, Systematic risk. This is the area
where CAPM comes into play. Unlike unsystematic risk, which can be eliminated
by addition of securities to the portfolio, systematic risk remains unaffected
across all numbers of assets. There are risk factors that are common to all firms
in the market to a lesser or greater extent. For example, a decrease in national
income is likely to affect all firms but food and retail sector is likely to have
lesser impact of this macro-economic change.

Measurement of Unsystematic Risk ‘β’

Where portfolio theory gave us standard deviation, which is in fact a


measurement of unsystematic risk, the CAPM gives us β, which is a measure of
sensitivity of an asset’s (share)
returns to return on the overall market (measured for example by Stock
Exchange index). Therefore, asset that moves a lot when market moves will add
more risk to investor portfolio than those that move little with market movement.

For example; If Barclays has a β of 1.11 then when the market index return rises
by 10% Barclays return will rise by 11.1% and fall by 11.1% when FTSE return
falls by 10%. Shares with β of less than 1 will vary less than the market.

For a diversified investor the only risk is therefore β. Where Portfolio theory
studied the relation of return to overall risk of portfolio (measured by correlation
coefficient), CAPM studied the relation of returns to overall risk of the market
(measured by β). Hence we completed our journey from Capital market line
suggested by Portfolio theory to security market line, suggested by CAPM.

Expected Return
Security Market Line

The intercept of security market line Security Market


at y-axis is the expected return on Line
12%
risk-free securities. Therefore risk
free rate of return determines the 10%

position of security market line. SML 8%


tells us that return on any share can
6%
be calculated as risk free rate plus
the average market risk premium 4%
times beta. Therefore shares with
beta value of 1 will just move in line
with changes in market and will earn
0.5 1
returns equal to the risk premium f 1.5 2

share. A share with beta of 2 will


Risk Measured by Beta
amplify risk premium 2 times and
therefore its return will move greater
than movement in market.
Where is the expected return on security j, is the risk free return and
is the market risk premium. Enabling investors to calculate required
return is the essence of CAPM. Once required return is calculated it can be used
to discount the asset’s cash flows to arrive at its present price.

Criticism of CAPM:

• Variance of Beta over time; beta tends to change overtime, therefore it is


unclear how many weeks, years or decades data should be taken to
calculate beta.

• Market indices employed such as FTSE 100 are poor substitutes for real
market portfolios.

• Beta is calculated at one point in time, after which risk free rate might
change.

• Unrealistic assumptions

o Rational and risk averse investors

o No taxes

o Investors can borrow and lend at the same rate

o Everybody has equal access to information

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