Capital Asset Pricing CAPM

8/3/2019 Capital Asset Pricing CAPM

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Capital asset pricing

model(CAPM)



Introduction Under CAPM model the changes in prices of capital assets in

stock exchanges can be measured by using the relationship

between security return and the market return. So it is an

economic model describes how the securities are priced in

the market place.

By using CAPM model the return of security can be calculated

by comparing return of security with market place. The

difference of returns of security and market can be treated as

highest return and the risk premium of the investor is

identified. It is the difference between the return of securityand risk free rate of return

Risk premium = Return on security Risk free rate of return

So the CAPM attempts to measure the risk of a security in the

portfolio sense.



Assumptions

The CAPM model depends on the following assumptions, which are to beconsidered while calculating rate of return.

The investors are basically average risk assumers and diversification isneeded to reduce the risk factor.

All investors want to maximize the return by assuming expected return of

each security. All investors assume increase of net wealth of the security.

All investors can borrow or lend an unlimited amount of fund at risk freerate of interest.

There are no transaction costs and no taxes at the time of transfer of security.

All investors have identical estimation of risk and return of all securities.All the securities are divisible and tradable in capital market.

Systematic risk factor can be calculated and it is assumed perfectly by theinvestor.

Capital market information must be available to all the investors.



Efficient frontier with riskless

lending and borrowing The portfolio theory deals with portfolios of

risky assets. According to the theory, an

investor faces an efficient frontier containing

the set of efficient portfolios of risky assets.

Now it is assumed that there is existence of

riskless assets available for investment.

A riskless asset is one whose return is certain

such as government security.




lending and borrowing Since the return is certain, the variability of return or

risk is zero. The investor can invest a portion of his

funds in the riskless asset which would be equivalent

to lending at the risk free assets rate of return. Hewould then be investing in a combination of risk free

asset and risky assets.

Similarly, it may be assumed that an investor may

borrow at the same risk free asset for the purpose of

investing in a portfolio of risky assets. He would then

be using his own funds as well as some borrowed

funds for investment.




lending and borrowing The efficient frontier arising from feasible set

of portfolios of risky asset is concave in shape.

When an investor is assumed to use riskless

lending and borrowing in his investment

activity the shape of efficient frontier

transform into a straight line



Capital market line

All investors are assumed to have identicalexpectations. Hence, all of them will face the

same efficient frontier depicted in efficient

frontier with borrowing and lending.E

veryinvestor will seek to combine the same risky

portfolio B with different levels of lending and

borrowing according to his desired level of

risk.

All investors will hold combination of only two

assets, the market portfolio(risky one) and

riskless security



Capital market line

All these combinations will lie along the

straight line representing the efficient frontier.

This line formed by action of all investors

mixing the market portfolio with the risk free

asset is known as capital market line. All

efficient portfolios of all investors will lie along

this capital market line.



The security market line

The CML shows the risk-return relationship for

all efficient portfolios. They would all lie along

the capital market line and all other will lie

below the CML and CML does not describe the

risk return relationship of inefficient portfolios.

But CAPM specifies the relationship between

expected return and risk of all securities.



The security market line

The security market line provides the

relationship between the expected return and

beta of security or portfolio.



CAPM

The relationship between risk and return

established by security market line is known

as capital asset pricing model.



SML vs CML Both specify a relation between risk and Er :

Expected Return = Time Premi um + Risk Premi um

where

Risk Premi um = quant i ty of r isk ´ pr i ce of r isk

Measure of risk.

In the CML, risk is measured by .

In the SML, risk is measured by .

Applicability:

CML is applicable only to an investors final (Combined) portfolio (which is

efficiently diversified, with no unique risk) In the CAPM world, everybody

hold s portfol i os whi ch l i e on the CML. SML is applicable to any security, asset or portfolio (which may contain

both components of risk). In a CAPM world every asset l i es on the SML.



Limitations of CAPM

In practical purpose CAPM cant be applied due to the

following limitations.

± The calculation of beta factor is not possible in certain

situations due to more assets are traded in the market. ± The assumption of unlimited borrowings at risk free rate is

not certain. For every individual investor borrowing

facilities are restricted.

± The wealth of the shareholder or investor is assessed by

using security return. But it is not only the factor for

calculation of wealth of the investor.

± For every transfer of security transition cost is required on

every return tax must be paid.



Pricing of securities with CAPM

The capital asset pricing model can also be

used for evaluating the pricing of securities. It

provides the framework for assessing whether

a security is underpriced, overpriced or

correctly priced.

Documents

Capital Asset Pricing CAPM