Capital asset pricing model

SUBMITTED TO Mr. Liaqat Ali

SUBMITTED BY Navjot Kaur Mann (5601) & Jaipreet Dhanoa (5615) MBA -1 (A)

SCHOOL OF MANAGEMENT STUDIES PUNJABI UNIVERSITY, PATIALA

CAPITAL ASSET PRICING MODEL

The capital asset pricing model is a theory that explains how asset prices are formed in the market place. It is a logical and major extension of the portfolio theory of Markowitz by William Sharpe, John Lintner and Jan Mossin. The capital asset pricing model provides the framework to determine the required rate of return on the asset and indicates the relationship between return and risk of the asset. . It uses the results of capital market theory to derive the relationship between expected return and systematic risk of individual assets and portfolio. Capital market theory also referred to as assets pricing theories, deal with how asset prices are determined if investors behaved the way Markowitzs portfolio theory suggests. A price reflects the expected return and risk associated with an asset. Thus, the CAPM has implications for:
1. Risk- returns relationship for an efficient portfolio.

2. Risk-return relationship for an individual asset/security. 3. Identification of under-and over-valued assets traded in the market. 4. Pricing of assets not yet traded in the market. 5. Effect of the leverage on the cost of equity. 6. Capital budgeting decision and cost of capital 7. Risk of the firm through diversification of project portfolio. Assumptions Capital price model is based on a number of simplifying assumptions. The most important assumptions are: 1. All investors are price-takers. Their number is so large that no single investor can affect prices. 2. All investors use the mean-variance portfolio selection model of Markowitz. 3. Assets/securities are perfectly divisible. 4. All investors decisions are based on a single time period. 5. All investors have the same expectations about the expected returns and risk of securities. 6. Investors can lend or borrow at an identical risk-free rate. 7. There are no transaction costs and income taxes. Elements of the model The capital asset pricing model consists of two elements: the capital market line (CML) and the security market line (SML).

Capital market line: - The capital market line is a capital allocation line (CAL) provided by onemonth T-bills as a risk-free asset and a market-index portfolio like Dow Jones, standard and Poors and NYSE, as the risky asset. The CML indicates:
1. The locus of all efficient portfolios. Not all securities and portfolio lie along the CML.

2. Risk-return relationship and measure of risk for efficient portfolio. 3. The appropriate measure of risk for the portfolio is standard deviation of return on portfolio. 4. The relationship between risk and expected return for efficient portfolio. Security market line: - we know that risk averse investors seek risk premium to assume the risk embedded in risky assets. The risk is variability in return. The total risk consists of two components: systematic risk and unsystematic risk. In a portfolio of risky assets, the investors can eliminate unsystematic risk through diversification. Systematic risk is unavoidable; this is the contribution of an asset to the risk of market portfolio. According to the capital market theory, the market compensates or rewards for the systematic risk only. The level of systematic risk in an asset is measured by the beta coefficient. The CAPM link beta to the level of required return. Graphic depiction of the CAPM- the expected return beta relationship- is referred to as the security market line.

Where: Is expected or required rate of return on asset i Is risk-free rate of return , vertical axis intercept

Is systematic risk of the asset, bets

Is expected return on market portfolio The more familiar form of SML:

Risk-return relationship

In the CAPM the expected return on an asset varies directly with its systematic risk ( ) and the risk premium portfolio. In other words, the risk premium for an asset or portfolio is a function of its beta. The risk premium added to the risk-free rate is directly proportion to beta. The risk premium of a market portfolio, also referred to as reward depends on the level of risk-free return and return on the market portfolio. In short, information related to the following three aspects are needed to apply the CAPM: Risk-free rate:- The rate of return available on assets lie T-bills, money market funds or bank deposits is taken as the proxy for risk-free rate. The maturity period of T-bills and bank deposits is taken to be less than one year, usually 364 days. Such assets have very low or virtually negligible default risk and interest rate risk. However, under inflationary conditions, they are risk-less in nominal terms only. Risk premium on market portfolio:- market risk premium or the risk premium on market portfolio is the difference between the expected return on the market portfolio and the risk-free rate of return. The CAPM holds that in equilibrium, the market portfolio is the unanimously desirable risky portfolio. It contains all securities in exactly the same proportion in which they supplied that is, each security is held in proportion to its market value. It is an efficient portfolio, which entails neither lending nor borrowing. The risk premium on the market portfolio is proportional to its risk and the degree of risk aversion of the average investors. Beta: - it measures the risk of an individual asset relative to the market portfolio. According, beta is the covariance of the assets return with the market portfolio return, divided by the variance of market portfolio. It may be recalled that the covariance of two assets is the product of their correlation coefficient and respective standard deviation. The covariance of the market portfolio with itself the variance of the portfolio. Thus, the beta of the market portfolio is one this classifies all others portfolio and assets in two risk classes. Assets with beta less than one are called defensive assets. Assets with beta greater than one are called aggressive assets. Riskfree assets have a beta equal to zero.

Validity of the CAPM The capital asset pricing model is a rigorously derived equilibrium model. Like any other economic model it is an abstraction and simplification of reality. It has been widely used and hailed. Its popularity may be ascribed to a set of four factors. First, the risk-return trade off the direct proportional relationship between the two has a distinct intuitive appeal. Second, transition from CML to the SML shows that the undiversifiable nature of the systematic risk makes it the relevant risk for pricing of securities and portfolio. Third, beta the measure of systematic risk is easy to compute and use. Finally, model show that investors are content to put their money in a limited number of portfolios, namely, a risk-free asset like treasury bills and a risky asset like a market fund

However, CAPM suffers from a number of problems. CAPM has following limitation: CAPM is based on a number of assumptions that are far from the reality. For examples it is very difficult to find a risk-free security. A short term, highly liquid government will default, but inflation causes uncertainty about the real rate of return. The assumption of the lending and borrowing rates is also not correct. Beta is a measure of a security future risk. But investors do not have future data to estimate beta. What they have are past data about the share prices and the market portfolio. Thus, they can only estimate beta based on historical data. Investors can use historical beta as the measure of future risk only if it is stable over time. Most research has shown that the betas of individual securities are not stable over time. This implies that historical betas are poor indicators of the future risk of securities. CAPM is a useful device for understanding the risk-return relationship in spite of its limitations. It provides a logical and quantitative approach for estimating risk. It is better than many alternative subjective methods of determine risk and risk premium. One major problem in the use of CAPM is that many times the risk of an asset is not captured by beta alone.