CAPITAL ASSETS PRICING MODEL (CAPM)

S.Y.B.A.F.

July 2011

Capital Asset Pricing Model (CAPM)

Method for predicting how investment returns are determined in an efficient capital market

CAPM
Meaning : A model that describes the relationship between risk and expected return ER = Rf + (Rm-Rf) ER = Expected Return Rf = Risk free return in % Rm = Return on Market securities in % = Risk factor The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium

Capital Asset Pricing Model

Return %
km Market Premium for risk Real Return Security Market Line Required return = Rf + s [kM - Rf]

Rf

BM=1.0

Beta Coefficient
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Assumption of CAPM
1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

All investors aim to maximize economic utilities. All investors make choice on the basic of Risk and Return. All investors have identical time horizons. All investors are price takers, i.e., they cannot influence prices. All the investor have homogeneous expectation. All investors can lend and borrow unlimited amounts under the risk free rate of interest. All investors trade without transaction or taxation costs. All investors deal with securities that are all highly divisible into small parcels. All investors assume all information is available at the same time to all investors Capital Markets are in equilibrium 5

Standard Deviation as measured of Risk

A measure of the dispersion of a set of data from its mean. Higher the risk higher the return, lower the risk lower the return. Variance of security = [Standard Deviation]2 Expected return = probability x rate of return

Calculation of Standard Deviation

Diversification

Is the process of spreading the total investment money available across different asset classes, countries, industries, and individual companies. It helps to reduce the unsystematic risk A price decrease in one security can be offset by a price increase in a different security, and the more securities you mix into a portfolio, the greater the probability of this offsetting price movement. Therefore, by mixing more securities into a portfolio of investments, the overall risk (measured in terms of portfolio variance) will be reduced by these offsetting price movements. However, the expected returns of each security, and thus the expected return of the portfolio remains unchanged. Thus diversification offers investors a way to obtain the same expected return with lower risk .

Diversification

Example: Suppose you live on an island, and you want to invest in toy companies for children. There are two extremely similar toy companies (Company A and Company B), selling similar toys, and both companies' toys are equally popular. If you do not diversify, you buy stock in only Company A. If a firm specific risk negatively impacts Company A, such as its factory burns down, then you will have a major loss, and investors in Company B will have a major gain since it would become the only toy company left. However, if you diversify and buy stock in both Company A and Company B, then the large loss in Company A will be offset by the equally large gain in Company B. Notice that by diversifying, an investor is able to reduce the unsystematic risk, the risk associated with only a single company (in this case the risk of fire). Systematic risk cannot be eliminated by diversification.

Systematic risk
Also known as Market risk", Non-diversifiable risk Systematic risk is due to risk factors that affect the entire market such as investment policy changes, foreign investment policy, change in taxation clauses, shift in socio-economic parameters, global security threats and measures etc. Systematic risk is beyond the control of investors and cannot be mitigated to a large extent. systematic risks are unavoidable and the market does compensate for taking exposure to such risks Examples Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification

Unsystematic Risk
Also known as "specific risk", "diversifiable risk Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through appropriate diversification. unsystematic risk affects a very specific group of securities or an individual security. Workers strike in Reliance industry.

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Difference
Systematic risk affects the entire market as a whole, while unsystematic risk may affect a certain company or sector. Therefore, unsystematic risk is avoidable, while systematic risk isn't. One can diversify an investment portfolio to eliminate the endemic or unsystematic risk that plagues a certain sector. However, one cannot eliminate systematic risk as its effects sweep the entire economy, as well as the market Unsystematic risk can be reduced by Diversification and Systematic risk can not reduced by diversification.

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Beta
Beta is a measure of a stock's volatility in relation to the market.. By definition, the market has a beta of 1.0. A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market. A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and market returns 12

Formulas for Beta Calculation

= Cov [Ri , Rm ] 2 m Cov [Ri , Rm ] = [Ri -- Ri] x [Rm Rm ] n-1 2 m = [Rm Rm ]2 n-1

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