CAPITAL ASSET

PRICING MODEL
Group Members
Seemab Afzal
Maria Mumtaz
Kanwal Shafqat
Abeeha Akbar
INTRODUCTION
O The main problem in predicting the
behavior of capital market is the absence
of micro economic theory dealing with
risk.
O In order to determine the risk factor, we
study the price behavior, we take into
account the market risk premium as well.

O There are two type of investors:
O Risk averse
O Risk taker
O Risk averse want high return, but at low
risk, which is not certain, so they get
comparatively low return.
O Risk taker are ready to take higher risk for
higher returns.

O When market is in equilibrium, the capital
asset price have adjusted. so that the
investor is able to attain the desire point
along with capital market line. investors
may obtain a higher expected rate of
return on his holding only by incurring
additional risk.

The market presents with two prices:
O The price of time (pure interest rate)
O The price of risk (additional expected
return)
O Theory is missing in this aspect, that it
fails to show the actual relationship of the
price of single asset and its risk.
O This is because of diversification, when
the asset has been diversified into a
portfolio and the risk is minimized. Thus,
the actual risk remains unknown.
O In the last ten years, numerous
economists have worked on optimal asset
portfolio selection.
O Markowitz following two other economists,
develop a model, starting that all the
investors strive for utility maximization. He
proposed a solution for the problem of
portfolio selection.

O Further, Torim worked on the given solution of
Markowitz and showed that it can be broken
into two phase,
O The first phase dealing with the combination of
risk,
O and second phase deals with how assets will
be allocated into these combination of risk and
then compare it with a single risk free asset.
O Later on, Hick, Gordon and Gangoli worked
on similar model, but none of these authors
could extend it to construct a market
equilibrium theory of asset prices under
condition of risk.
Part 2 - OPTIMAL INVESTMENT
POLICY FOR THE INDIVIDUAL


O Individual preference function
O Investment opportunity curve
O Pure interest rate
Individual preference function
O Individual views the outcome of any
investment in terms of probability
distribution
O Two parameters of probability distribution
expected value
Standard deviation
O Author presented them in total utility
function
U = f (Ew , w)

O Assumption about the individual investor is
that they prefer higher value of Ew and
moreover individual investors prefer risk
aversion.
O These assumptions imply that indifference
curves relating Ew and w will be upward
sloping.
O To derive the relationship between terminal
wealth and rate of return
R = Wt Wi/ Wi
Wt = RWi + Wi
Investment opportunity curve
O From a set of investment opportunities
investors choose those investments that
give them maximum utility.
O The investor will choose among all the
possible plans the one placing him on the
indifference curve representing the
highest level of utility

O Desirability of an investment depends not
only on risk and return factors but the
coefficient of correlation is also an
important factor.
O If the proportion of an investment is
placed in plan A and remainder (1- ) in
B. the expected rate of return of the
combination will lie between the expected
returns of two plans




Pure interest rate
O If an investor invest portion of investment in
riskless asset P and remaining in risky asset A
the risk and return will be




O If money is loaned and borrowed at pure rate
of interest which is risk free rate or invested in
assets A and B both are risky assets then line
PA and PB is attainable but dominant
investment plan lies where a ray from point P
is tangent to investment opportunity curve

Part 3 Equilibrium in
the Capital Market
When Capital Market is in Equilibrium
O The capital asset prices have been
adjusted
O So the investor is able to attain the
desired point along CML
Conditions for Equilibrium
O Assumptions
O We assume a pure rate of interest (price of
time), at which all investors can
borrow/lend on equal terms
O Secondly, we assume that all investors
have the same expectations
A set of capital prices
Investor A
O Preferences are indicated by indifference
curves A1 through A4
O He would lend some of his funds at the
pure interest rate
O And invest the remaining in the
combination of asset
Investor B
O Preferences are indicated by indifference
curves B1 through B4
O He would invest all his funds in a
combination of asset
Investor C
O Preferences are indicated by indifference
curves C1 through C4
O He would invest all his funds plus
borrowed funds in combination of asset
O In all events, A, B and C would purchase
only those risky assets which enter
combination
O The lack of interest in holding assets not
in combination would lead to change in
prices
Revision of Prices
O The prices of assets in will rise as demand
is increasing, thus it will cause a decrease
in expected future returns
O The decrease in expected returns will
make the combination less attractive, thus
moving point to its original position
O On the other hand, the prices of assets
not held in combination would decrease,
thus increasing the expected future
returns
O This will make it more attractive and thus
the decision to invest in combination
would change
O The change in decision will cause the investment
opportunity curve to become more linear



O The prices will keep on changing until a
point is reached where every asset enters
at least one combination lying on the
capital market line
O This will be the equilibrium
The shaded area can be attained with
combination of all risky asset and all along
PZ by borrowing/lending at the pure
interest rate plus a investment in some
combination of risky assets
O Many alternative combinations of risky
assets are efficient, thus the theory does
not imply that all investors will hold the
same combinations
O On the other hand, all such combinations
must be perfectly correlated, which shows
the linear relationship between prices of
capital assets and different types of risk
Part 4 The Prices of Capital
Assets
O A linear relationship between expected
return and standard deviation for efficient
combination of risky assets has been
observed previously, BUT there has been
no relationship for individual assets
Individual Assets
O Given a set of capital assets, we assume
that expected return values for individual
assets exist above the CML
O These values can be scattered along the
region, because there exist no relation
between expected return and total risk
O However, there do exist a relationship
between expected return and systematic
risk
O For this, we see the relationship of point I
a single asset with combination of assets
g, of which it is a part
O From point i to g exist all ER values that
can be obtained with feasible combination
of i and g
O The combination can be denoted in terms
of a for i and 1-a for g
O If a = 1, it means pure investment in i
O If a = 0, it means investment in g
O If a = 0.5, it means a total investment of
more than half the funds in i and
remaining in g
O If a = -ve, it means that i does not appear
at all in a combination
O Under these conditions, a lack of
tangency would imply that the curve
intersects PZ.
O But then some feasible combination of
assets would lie to the right of the capital
market line, an obvious impossibility since
the CML represents the efficient boundary
of feasible values Er and risk.
O In diagram the igg be tangent to the
capital market line which leads to a
relatively relates the expected rate of
return to various elements of risk for all
assets which are included in
combination g.
O The standard deviation of a
combination of g and I will be:


O This interpretation states the relationship
derived from the tangency of curves such
as igg with the capital market line.

O The scatter of the R1 observations around
their mean (which will approximately Eri is
evidence of the total risk of the asset ri.
O The part of the scatter is due to an underlying
relationship with the return on combination g,
shown by Big.
O The response of R1 to changes in Rg (and
variation in Rg itself) account for much of the
variation in Ri. It is the component of the
assets total risk which we term systematic
risk.
O The remainder being uncorrelated with Rg
is the unsystematic component.
O Relationship between R1 and Rg can be
employed as a predictive model.
O B(ig) becomes the predicted response of
R1 to changes in Rg.
O (rg)[the predicted risk of Rg], the
systematic portion of the predicted risk of
each asset can be determined.
O All assets entering efficient combinations
g must have predicted B(ig) and Eri
values lying on the line PQ.
O Prices will adjust so that assets which are
more responsive to changes in Rg will
have higher expected returns than those
which are less responsive.
O Rates of return from all efficient
combinations will be perfectly correlated
provides the justification for arbitrary
selection one of them.
O All efficient combinations will be perfectly
correlated and relationship between an
individual assets expected rate of return
and its risk.
O This theory implies rates of return from efficient
combinations will be perfectly correlated and this
would be due to their common dependence on
the overall level of economic activity.
O So diversification enables the investors to
escape all but the risky resulting from swings in
economic activity this type of risks remains even
in efficient combinations.
O All other types can be avoided by diversification
only the responsiveness of an assets rates of
return to the level of economic activity is relevant
in assessing its risk. u
Thank you