CAPM

It was developed in mid 1960’s by three researchers, namely William Sharpe, John Linter and
Jan Mossin.

CAPM is based on the rational behaviour of the investors. Here, rationale behaviour implies
that the investors are risk averse by nature and they always prefer extra return known as ‘risk
premium’ for the risk assumed by them.

Therefore, an optimum portfolio for an investor is the one which provides optimum level of
return for the risk assumed by the investor.

CAPM provides a framework for establishing a relationship between risk and expected
return for a different investment avenue. The relationship between risk-return established
by the Security Market Line is known as CAPM. In other words, SML is a graphical
version of CAPM.

Returns are either ex-post or ex-anti returns from an investment avenue. Ex-post returns
means the returns that have been realised in the past whereas ex-anti returns are the returns
that are expected in future. CAPM talks about the genesis of ex-anti returns. Practically ex-
anti returns from an investment avenue will compensate a rational investor and such return
should provide for the following:

Time Premium: Compensation for time is the reward for waiting because of sacrifice of
current consumption for the money that has been invested. Many of the investors wish to be
compensated at or at least equal to the return associated with the risk free returns as this is the
minimum expectation that one can have from his investment.

Risk Premium: Every investor by nature is risk averse (he wants to avoid risk). Even if he
takes the risk, his desire for the return also increases accordingly. It implies that as soon as
the quantum of risk is increased, the ex-anti return from an investment avenue also increases
and vice-versa.

The extra return expected by an investor in nothing but the compensation for risk over and
above the risk contained in the risk free avenues. Thus the graph of expected return
increases with the increases in the level of risk, i.e., higher the risk, the higher the return.

Risk is the possibility of loss or injury or degree of probability of such loss. In risk the
probable outcome of all possible events can be listed out.

There are two components of risk:

Systematic Risks are caused by external factors and are uncontrollable by the companies. It
affects the market as a whole. Unsystematic risks are company specific risk and are related to
a particular company or the industry. [Systematic risk can be further classified as Market
Risk, Interest Rate Risk and Purchasing Power Risk and Unsystematic Risks are classified as
Business Risk and Financial Risk]
Security Market Line: It represents returns from individual securities and their systematic
risk which is much more important and needs a proper management. The other reason for
taking only the systematic risk is that it can never be eliminated or reduced whereas the
unsystematic risk can be eliminated or reduced through diversification.

Generally SML is used to represent risk-return relationship of individual securities. With its
help identification of overpriced and underpriced securities can be made. It assumes a
critical importance in portfolio selection and individual investment decisions.

Capital Market Line: It is a line representing various efficient portfolios created by

combining risk free and risky securities. All the portfolios lying on the line are efficient in
themselves as they provide maximum return for a given level of risk. This CML is
particularly used for portfolios.

Efficiency Frontier: A line joining all the efficient portfolios is called the Efficiency
Frontier. In CAPM, a line originating from the vertical axis and moving in a linear manner
with every increase in the level of risk is called Efficiency Frontier. It helps the investors and
portfolio mana gers in decision making.

Risk free and risky assets constitute the foundation stone of CAPM. Risk free avenues
are such investments in which a fixed percentage of return is promised and those are also
free from default risk while risky assets are those on which there is no promise for a fixed
return. Rather it depends on the market system or the level of efficiency in the market.

Investors are utility maximisers which imply that they wish to maximise the terminal wealth
of their investment and prefer more return for every additional unit of risk. Thus the formula
for CAPM:

R = Rf +(Rm – Rf) β

ASSUMPTIONS:
1. Securities have two attributes, risk and return.
2. Investors are risk averse.
3. Risk free and risky securities exist in the market.
4. There is an efficient capital market.
5. All investors have a homogeneous expectation.
6. There exists opportunity for borrowings and lending at risk free rate.
7. The time horizon is identical.
8. There are no taxes and transaction costs.

CONCEPT OF LENDING AND BORROWING:

Lending: Here an investor can invest his entire fund or a part of his funds in the risk free
assets. The return from such lending will be equal to the risk free rate.
Borrowing: CAPM provides that the investors have the freedom and opportunity to borrow
any amount at the given risk free rate.
The purpose of such borrowing is to invest these funds in the market portfolio and
generate more returns as compared to the risk free rate of return.

CONCEPT OF UNLEVERED AND LEVERED PORTFOLIO:

ERp = Rf + Wf + (1 – Wf) x ERm

Risk of unlevered portfolio: σp = (1 – Wf ) x σm

Levered Portfolio:
ERp = Rf + (ERm – Rf) x σp
σm
Risk of Levered Portfolio: σp = (1 – Wf) x σm

APPLICATION OF CAPM:

1. It is applied by portfolio planners in constructing efficient portfolios.

2. It helps in finding out the status of managed portfolios whether they are underpriced
or overpriced.
3. It also helps in generating efficient frontier which is a line representing all the
efficient portfolios on the graph of risk and return. [It is a line originating from the
vertical axis from the level of risk free return and moving in a proportionate manner
with the increase in risk unit by unit.]
4. It helps the investors and portfolio managers in decision making as it is constructed
before selecting the securities for a portfolio.
5. Its a useful tool for financial analysis.

LIMITATIONS OF CAPM:

1. The assumption that the investors have no transaction cost in buying and selling
securities is not realistic.
2. It measures only market risk and gives importance to Beta or systematic risk and
examines the historical returns of the market portfolios. Hence Beta is difficult to be
measured for future return until it is updated.
3. The theory assumes that the investor can borrow or lend at the risk free rate at any
time for any amount also appears to be unrealistic.
4. The theory assumes that every investor has equal information. Well, this is possible
only under conditions of efficient market hypothesis (in strong form of efficiency) which may
not always hold good.
 Figure 1
Security Market Line

Figure 2
Capital Market Line
 Figure 3
Diversification

Figure 4

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