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CAPITAL ASSET PRICING MODEL

Modern portfolio theory on investments try to maximize portfolio expected returns for a
given amount of portfolio risk, or equivalently minimize risk for a given level of
expected return, by carefully choosing the proportions of various assets. Although it is
widely used in practice in the financial industry and several of its creators have won a
Nobel prizes for the theories, in recent years the basic assumptions of MPT have been
widely challenged by fields such as behavioral economics. Capital asset pricing model is
a modern portfolio theory.

Capital asset pricing model (CAPM) is a model that calculates expected return based on
expected rate of return on the market, the risk-free rate and the beta coefficient of the
stock. The model states that the price of a stock is tied to two variables - the time value of
money and the risk of the stock itself. It describes the difference between risk, expected
return and evaluates the performance of managed portfolios. It helps in analysing whether
a particular stock is performing and giving good returns or vice versa.

The model was developed by financial economist William Sharpe (1964) and John
Lintner (1965) and they received a Noble Price in 1990 for the asset pricing model.
CAPM is well entrenched and widely used by investors, managers and financial
institutions. According to CAPM, the expected return of a security or a portfolio equals to
the rate on a risk-free security plus a risk premium. If this expected return does not meet
the required return, then the investment should not be undertaken.
It is a single factor model based on the required rate of return predicting one factor i.e.,
systematic risk.An individual investment contains two types of risk:
1)Systematic Risk - These are market risks that cannot be diversified.Eg: Interest rates,
recessions and wars.

2) Unsystematic Risk - Risk specific to individual stocks and can be diversified away as
the investor increases the number of stocks in his or her portfolio.

CAPM helps portfolio managers to design and manage portfolios because it considers the
core factors like risk and return in its calculation in relation to the market returns, beta
(volatility) and risk free return. This helps them in designing individual portfolios
depending on every clients return expectations and risk appetite.

Formula
The standard formula for CAPM, which describes the relationship between risks,
expected returns and the pricing of risky securities is:

Where :

• - Expected return on the capital asset


• - Risk free rate of interest, i.e., Rate of return on an investment with zero risk
• - Beta , it measures the volatility of a portfolio in comparison to the whole
market

• - Expected return of the market

• - Market premium or risk premium


Example: If the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the
expected market return over the period is 10%, the stock is expected to return 17%

E (RI) = 3%+2 (10%-3%) = 17%

The expected required rate of return, E (Ri), is calculated using CAPM, then the required
rate of return is compared to the asset's estimated rate of return over a specific investment
horizon to determine whether it would be an appropriate investment. An asset is correctly
priced when its estimated price is the same as the required rate of return. A riskier
investment should earn a premium over the risk-free rate - the amount over the risk-free
rate is calculated by the equity market premium multiplied by its beta. If the estimated
price is higher than the CAPM valuation, then the asset is undervalued (and overvalued
when the estimated price is below the CAPM valuation).

Beta
According to CAPM, beta is the only relevant measure of a stock's risk. It measures a
stock's relative volatility - that is, it shows how much the price of a particular stock jumps
up and down compared with how much the stock market as a whole jumps up and down.
If a share price moves exactly in line with the market, then the stock's beta is 1. A stock
with a beta of 1.5 would rise by 15% if the market rose by 10%, and fall by 15% if the
market fell by 10%.

Equity Risk Premium


The excess return that an individual stock or the overall stock market provides over a
risk-free rate. This excess return compensates investors for taking on the relatively higher
risk of the equity market. The size of the premium will vary as the risk in a particular
stock, or in the stock market as a whole, changes; high-risk investments are compensated
with a higher premium.
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 (Rm-rf).

The Efficient Frontier


A line created from the risk-reward graph, comprised of optimal portfolios.

The portfolio with at minimum variance is an efficient portfolio because the risk and
return at the particular point is equal or it is optimal. According to CAPM, the risk-return
profile of a portfolio can be optimized—an optimal portfolio displays the lowest possible
level of risk for its level of return. Additionally, each additional asset introduced into a
portfolio further diversifies the portfolio. All such optimal portfolios, i.e., one for each
level of return, comprise the efficient frontier. CAL stands for the capital allocation line.

Capital market line


It specifies the relationship between expected return and risk for efficient portfolios. The
CML is derived by drawing a tangent line from the intercept point on the efficient
frontier to the point where the expected return equals the risk-free rate of return. It is
considered to be superior to the efficient frontier since it takes into account the inclusion
of a risk-free asset in the portfolio. The capital asset pricing model demonstrates that the
market portfolio is essentially the efficient frontier. This is achieved visually through the
security market line (SML).

Security market line:


It specifies the equilibrium position between the expected returns and systematic risk for
individual securities. It graphs the results from the capital asset pricing model (CAPM)
formula. The x-axis represents the risk (beta), and the y-axis represents the expected
return. The market risk premium is determined from the slope of the SML.

The relationship between β and required return is plotted on the securities market line
which shows expected return as a function of β. The intercept is the nominal risk-free rate
available for the market, while the slope is the market premium, E(Rm) − Rf. The
securities market line can be regarded as representing a single-factor model of the asset
price, where Beta is exposure to changes in value of the Market. The equation of the
SML is thus:
It is a useful tool in determining if an asset being considered for a portfolio offers a
reasonable expected return for risk. Individual securities are plotted on the SML graph. If
the security's risk versus expected return is plotted above the SML, it is undervalued
since the investor can expect a greater return for the inherent risk. And a security plotted
below the SML is overvalued since the investor would be accepting less return for the
amount of risk assumed.

An investor anticipates Newco's security will reach $30 by the end of one year. Newco's
beta is 1.3. Assuming the return on the market is expected to be 16% and the risk-free
rate is 4%. Calculate the expected return of Newco's stock in one year and determine
whether the stock is undervalued, overvalued or properly valued with a current value of
$25.
E(R)Newco = 4% + 1.3(16% - 4%) = 20%

Given the expected return of Newco's stock using CAPM is 20% and the investor
anticipates a 20% return, the security would be properly valued.

• If the expected return using the CAPM is higher than the investor's required
return, the security is undervalued and the investor should buy it.
• If the expected return using the CAPM is lower than the investor's required
return, the security is overvalued and should be sold.
Merits and demerits OF THE CAPM
The CAPM has its merits and demerits over other methods of calculating expected return
and risks.
Merits of CAPM
• It considers only systematic risk, reflecting a reality in which most investors have
diversified portfolios.
• It generates a theoretically-derived relationship between required return and
systematic risk.
• CAPM contributed to the rise in use of indexing - assembling a portfolio of shares
to mimic a particular market - by risk averse investors.

Demerits of CAPM

• There are other alternative asset pricing models used for calculations.

• It is difficult to predict from beta how individual stocks might react to particular
movements. Investors can probably safely deduce that a portfolio of high-beta
stocks will move more than the market in either direction, or a portfolio of low-
beta stocks will move less than the market.

• It is however frequently observed that returns in equity and other markets are not
normally distributed. As a result, large swings (3 to 6 standard deviations from the
mean) occur in the market more frequently than the normal distribution
assumption would expect this can affect the calculation of CAPM.

• All investors have access to the same information and agree about the risk and
expected return of all assets.
• The probability beliefs of investors match the true distribution of returns. A
different possibility is that investors' expectations are biased, causing market
prices to be informationally inefficient.
• The model assumes there are no taxes or transaction costs, although this
assumption may be relaxed with more complicated versions of the model.
• The model assumes just two dates, so that there is no opportunity to consume and
rebalance portfolios repeatedly over time.]
• CAPM assumes that all investors will consider all of their assets and optimize one
portfolio. This is in sharp contradiction with portfolios that are held by individual
investors.

While some studies raise doubts about CAPM's validity, the model is still widely used in
the investment community. CAPM is a modern portfolio theory used for pricing
securities. It’s important to emphasize that despite their many simplifying assumptions,
Modern Portfolio Theory still justifiably provides the cornerstones of portfolio
management. In particular, the adoption of the principle of portfolio diversification has
enabled fund managers to offer investors returns that are consistently higher than the risk
free rate.

With regard to CAPM, it does appear that the number of different security holdings tend
to increase as the fund size increases, i.e. fund managers are diversifying as far as they
possibly can.Investors can tailor their portfolios to their specific risk-return requirements,
aiming to hold securities with betas in excess of 1 while the market is rising, and
securities with betas of less than 1 when the market is falling. This is largely due to
CAPM's message that it is only possible to earn higher returns than those of the market as
a whole by taking on higher risk (beta). Until some new asset pricing model is developed,
CAPM remains a very useful item in the financial management.

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