Professional Documents
Culture Documents
(CAPM)
DEFINITION
A model that describes the relationship
between risk and expected return and that
is used in the pricing of risky assets (stocks,
securities, derivatives) or Portfolio
History
CAPM was build on the earlier work of
Harry Markowitz on
Modern Portfolio Theory (MPT) and
Diversification
The CAPM was introduced independently by
Jack Trevnor (1961, 1962),
William F. Sharpe (1964),
Jhon Lintner(1965) and
Jan Mossin (1966)
History
Nobel Memorial Prize in Economics in 1990
Jointly received by Sharpe, Markowitz and Merton
Miller
(for CAPM contribution to field of Financial Economics)
Black CAPM or Zero-beta CAPM by Fischer Black
(1972)
another version of CAPM
that does not assume the existence of a riskless asset.
more robust version against empirical testing and was
influential in the widespread adoption of the CAPM.
Background of CAPM
Modern Portfolio
Theory
Capit
al
Mark
et
Theor
y
CAPM
Arbitrag
e
Pricing
Theory
Background of CAPM
CAPM is evolved by Markowitz after the
Modern Portfolio Theory (MPT) of
Markowitz,
MPT describes,
HOW investors should ACT in selecting
an Optimal Portfolio of Risky
securities based on using the full
information set about securities
Background of CAPM
(Modern Portfolio Theory)
Main Objective of MPT is
to maximize Profits and
Reducing the diversifiable risk
by selecting an efficient portfolio that
is also an Optimal Portfolio
Optimal portfolio
the one that provides the most
satisfaction the greatest return for
an investor based on his tolerance for
risk.
Background of CAPM
(Modern Portfolio Theory)
Efficient Portfolio has
the highest expected return for
a given level of Risk,
OR stated in another terms
The lowest level of risk for a
given level of expected return
Background of CAPM
(Modern Portfolio Theory)
for determining Efficient Portfolio, Inputs for
the securities being considered includes
Expected returns of individual securities,
Standard Deviations of individual securities,
Correlation Coefficient between securities
And therefore Securities Weights of
Portfolio are the variably manipulated based
on above statistical techniques to determine
efficient portfolios
Background of CAPM
(Modern Portfolio Theory)
Efficient Frontier:
the investment Opportunity Set
Construct a risk/return plot of all the
feasible portfolios-those that are
actually attainable.
consists of the set of all efficient
portfolios that yield the highest return
for each level of risk
Background of CAPM
(Modern Portfolio Theory)
Efficient Frontier:
Expected Return
All portfolios
on the line
are efficient
11
Background of CAPM
(Modern Portfolio Theory)
Indifference Curves:
describe an individual investors
preferences for Risk and Return
Investors have infinite number of
indifference curves.
Each curve is equally desirable to a
particular investor (i.e. They provide same
level of Utility)
Indifference curves cannot intersect since
they represent different levels of desirability
Background of CAPM
(Modern Portfolio Theory)
Indifference Curves:
Indifference Curves
Indifference Curves
The utility of these risk-indifference
curves is that they allow the
selection of the optimum portfolio
out of all of those that are attainable
by combining these curves with the
efficient frontier.
Selecting an Optimal
Portfolio
One of the attainable indifference curves
intersects the efficient frontier at a single
point, that single point is the Optimal
portfolio
(In other words),
The efficient frontier can be combined
with an investors utility function to find
the investors optimal portfolio, the
portfolio with the greatest return for the
risk that the investor is willing to accept.
Selecting an Optimal
Portfolio
Important Conclusions
about MPT
Two parameter model i.e.,
Risk-Return model OR
Mean-Variance model
(because investors are assumed to make
decisions on the basis of two parameters; Risk
and Return)
Does not addresses the issue of investors
using borrowed money along with their own
portfolio funds to purchase a portfolio of risky
assets i.e., investors are not allowed to use
Leverage (Risk Free Asset utilization)
Capita
l
Marke
t
Theor
y
Hypothesizes
that how
investors do
behave?
CML
rP
M
rfr
P
30
E(Rp ) = Rrf
mkt
E(Rmkt)Rrf. p
Criticism of CML
(and Evolution of CAPM)
CML applies only to Efficient Portfolios
(since only efficient portfolios are on Efficient
frontier)
CAPM
Capital Assets Pricing Model
The theory regarding asset prices and
markets
Model for valuation or pricing of Risky assets
Model that explain security prices under
conditions of market equilibrium
CAPM
It allows us :
To measure relevant risk of an
individual security
To assess the relationship between
Risk and Return expected from
Investing
Assumptions of CAPM
All investors will hold Market
Portfolio
The benchmark portfolio against which
other portfolios are measured
Well diversified portfolio
Has only market risk or systematic risk
Investors are interested in Portfolio risk
rather than individual security risk
CAPM Theory
Although all investors hold diversified
portfolios BUT
What happens when an Investor
adds a security to a large portfolio?
The contribution of individuals stock
risk to the riskiness of well diversified
portfolio leads to the formulation of
CAPM
CAPM Theory
When an investor adds security to a
large portfolio, what matters is
the securitys average covariance
with the other securities in a
portfolio
Major Conclusion of CAPM
Relevant risk of any security is the
amount of risk that security
contributes to a well-diversified
portfolio
Derivation of CAPM
Model
the Capital Market Theory Model is
E(Rp ) = Rrf + E(Rmkt)Rrf. p
mkt
If expected return of stock i is related to
its covariance with the Market Portfolio,
then
E(Ri ) = Rrf
2mkt
E(Rmkt)Rrf. Covi,mkt
Derivation of CAPM
Model
The new derived equation states that
,
The expected return on any
Security is the sum of Risk free
rate and Risk Premium
Risk premium reflects,
Assets covariance with the market
portfolio
Derivation of CAPM
Model
E(Ri ) = Rrf
E(Rmkt)Rrf. Covi,mkt
2mkt
Where,
Derivation of CAPM
Model
BETA
From the following model,
E(Ri ) = Rrf
Covi,mkt
2mkt
Beta = Covi,mkt
2mkt
E(Rmkt)Rrf.
Derivation of CAPM
Model
%) R
E ( R%
)
E
(
R
i
f
i
m
f
where E ( R%
i ) expected return on security i
R f risk-free rate of interest
i beta of Security i
E ( R%
m ) expected return on the market
Derivation of CAPM
Model
BETA
The relative measure of Systematic Risk of any stock
Measures the Risk of an Individual stock relative to
market portfolio of all stocks
Sensitivity of the securitys return relative to the
Market Return
Beta relates the covariance of an asset with the
market portfolio to the variance of the market
portfolio
Beta = Covi,mkt
2mkt
Derivation of CAPM
Model
BETA
Aggregate market has a beta of 1
More Volatile (Risky assets) have
betas larger than 1
Less Risky stocks have betas less
than one
E(R)
Market Portfolio
Rf
1.0
Beta
53
Implications of CAPM
SML has important implications for
security prices in equiblirium
In equiblirium expected return of
security should be that needed to
compensate investors for the
Systematic Risk
Knowing the beta for any stock , we
determine the required return for any
stock
Implications of CAPM
What happens if investors
determine that security does
not lie upon SML
Undervaluation
Security lies above SML
Overvaluation
Security lies below SML