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CAPITAL ASSETS PRICING MODEL (CAPM)

The portfolio theory is a normative theory which prescribes how rational utility-
maximizing investors should behave. The diversifiable risk can be eliminated by
diversification whereas the remaining risk portion is the undiversifiable risk i.e. the
market risk. As a result, investors are interested in knowing the systematic or
market risk when they search for efficient portfolios. They would like to have
assets with low beta (a measure of systematic risk) co-efficient i.e. with less
systematic risk. Investors would opt for high beta co-efficient only if they provide
high rates of return. The risk averse nature of the investors is the underlying
factors for this behavior. The Capital Assets Pricing Model (CAPM) helps the
investors to understand the risk and return relationship of the securities.

The Capital Assets Pricing Model (CAPM) was developed to examine what
would be the relationship between risk and return in the capital market if investors
behaved in conformity with the prescription of the portfolio theory. Thus, the CAPM
may be viewed as an extension of the portfolio theory. CAPM is concerned with two
sets of questions:-

I. (a) What is the appropriate measure of risk for an efficient portfolio?

(b) What is the relationship between the risk and return for an efficient portfolio?

II. (a) What is the appropriate measure of risk for an individual security or an
inefficient portfolio?

(b) What is the relationship between risk and return for an individual security or
an inefficient portfolio?

Markowitz, provides the basic structure for the CAPM model. It is a model of linear
general equilibrium return. In the CAPM model theory, the required rate of return
of an asset is having a linear relationship with assets beta value i.e. undiversifiable
or systematic risk. CAPM postulates that in a perfect market where securities are
correctly priced, every security will give a return commensurate with its risk.
Higher the return, higher the risk. The CAPM gives a mathematical relationship for
the expected return from a security or portfolio. The expected return on the
combination of risky and risk-free securities is calculated as follows:-

Expected Return from a = {Risk Free Return} + {‘β’ of the Portfolio} *


{Market Return - Risk Security/Portfolio
Free Return}

OR

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RP = RF *XF + RM* (1-XF)
WHERE,

RP= Portfolio Return

RF =Risk-Free rate of Return

XF = Return on Risky Assets

RM = Proportion of Funds invested in risk-free assets

(1-XF)= Proportion of Funds invested in risky assets

For example:-

Let us suppose rate of lending or borrowing is 12.5% and the return from the risky
assets to be 20%. If he invest 50% in risk-free assets and 50% in risky assets, his
expected return of the portfolio would be:-

RP = RF * XF + RM (1-XF)
= 12.5 * 0.50 + 20(1-0.50)

= 6.25 + 10

= 16.25%

ASSUMPTIONS OF CAPM MODEL


Some of the assumptions on which CAPM model is based are as follows:-

1) An individual seller and buyer cannot affect the price of the stock. This
assumption is the basic assumption of the perfectly competitive market.

2) Investors make their decisions only on the basis of the expected returns,
standard deviation and covariance of all pairs of securities.

3) Investors are assumed to have homogenous expectation during the decision-


making period.

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4) The investors can lend or borrow any amount of funds at the riskless rate of
Interest. The riskless rate of interest is the rate of interest offered for the
treasury bills or government securities.

5) Assets are infinitely divisible. According to this assumption, investor could


buy any quantity of shares i.e. they can even buy ten rupees worth of Reliance
industry shares.

6) There is no transaction cost i.e. no cost involved in buying and selling of


stocks.

7) There is no personal income tax. Hence, the investors is indifferent to the


form of return either capital gain or dividend.

8) Unlimited quantum of short sales is allowed. Any amount of shares an


individual can sell short.

EXPLANATION WITH THE HELP OF THE DIAGRAM:-


If we have a portfolio that consists only of risk-free assets, the expected return
from such a portfolio will be the Risk-Free Return “Rf”. The Beta (β) of such a
portfolio is zero, since the return from such a portfolio will not get affected by
fluctuations in the returns of the market portfolio. A Market Portfolio is one
which contains all the securities available in the market in proportion of
their respective market capitalization. Market Capitalization of a security
is its market price multiplied by the number of that security outstanding
in the market. Beta (β) of the market portfolio is obviously 1.00.

If we draw a graph with “β” on the X-axis and the expected return from portfolio on
Y-axis, we get the graph as follow:-

RP

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B (SML)

Rm S

Rf (RETURN ON RISK-FREE SECURITIES)

0
L BETA

Rm:- Market Return Rf:- Risk-Free Return

The line “AB” is called the “Security Market Line” (SML). Thus, according to
CAPM, in an efficient market, all securities and all portfolios are expected to yield
returns commensurate with their riskiness measured by β. The β denotes the
undiversifiable market related risk. The “β” of a portfolio of securities is the
weighted average of the betas of the securities that constitute the portfolio, the
weights being the proportion of the investments in the respective securities.

For Example:- If a portfolio consists of three securities A, B and C with beta


values of 1.20, 0.95 and 1.50 respectively and if the proportion of investments in
the three securities are 35%, 45% and 20% respectively, the beta of the portfolio
will be 1.15, i.e. [(1.20*0.35) + (095*0.45) + (1.50* 0.20)].

INPUTS INVOLVED IN THE CAPM


To apply the CAPM, estimates of the following factors that determine the CAPM
needs to be required:-

• Risk-Free Rate

• Market Risk Premium

• Beta

 RISK-FREE RATE:- The Risk-Free Rate is the return on a security or a portfolio


of securities that is free from default risk and is uncorrelated with returns from
anything else in the economy. Theoretically, the return on a zero-beta portfolio is
the best estimate of the risk-free rate. Constructing zero-beta portfolios,

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however, is costly and complex. Hence the rate on a long-term bond is used
because the duration of a long-term bond is similar to that of the duration of a
stock market index.

 MARKET RISK PREMIUM:- The risk premium used in the CAPM is typically
based on the historical data. It is calculated as the difference between the
average return on stocks and the average risk-free rate. Two measurement
issues have to be addressed in this context:- How long should the measurement
period be? and Should arithmetic mean or geometric mean be used?

 BETA:- Modern portfolio theory gives the importance to the market risk since it is
a risk that cannot be eliminated at all. Modern portfolio theory recommends that
the riskiness of a security be measured by its vulnerability to market risk. The
Sensitivity of a security to the movements of the market is measured by “Beta
Coefficient” (β).

BETA COEFFICIENT:- Movement in the Security

Movement in the Market

A security with ‘β’ value greater than 1.00 is called as an “Aggressive Security”
while a security with ‘β’ value less than 1.00 is called as an “Defensive
Security”.

When the market moves by 1.00% and security moves by 1.60%, the Beta
coefficient is given by the ratio of movement of the Security to the movement of
the Market.

i.e. β = 1.60 = 1.60

1.00

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