CAPITAL ASSET PRICING CAPITAL ASSET PRICING MODEL(CAPM) MODEL(CAPM)

CAPITAL ASSET PRICING CAPITAL ASSET PRICING MODEL(CAPM)MODEL(CAPM)

It is developed by Professors Sharpe It is developed by Professors Sharpe & Markowitz in 1960. Prof Sharp won & Markowitz in 1960. Prof Sharp won Nobel Prize in 1990Nobel Prize in 1990

Types of investorsTypes of investors

1)1) Risk taker: The investor who Risk taker: The investor who take risk.take risk.

2)2) Risk Aversor: The investor Risk Aversor: The investor who avoided risk and if he take who avoided risk and if he take risk he ask for more reward risk he ask for more reward and in this case it is risk and in this case it is risk premium.premium.

CAPM DefinedCAPM Defined

It is a model which describes the It is a model which describes the relationship between risk and relationship between risk and expected (required) return.expected (required) return.

In this model a security In this model a security expected (Required) return is expected (Required) return is equal to risk free rate and risk equal to risk free rate and risk premium based on the premium based on the systematic risk of the security.systematic risk of the security.

Mathematically CAPM is written as Mathematically CAPM is written as

Rj = Rf + Bj (Rm – Rf) Where:

Rj = Required (expected) rate of return of security jRf = Risk free rate of short term govt bondBj = It is the systematic risk of security “j” which can not be diversified.Rm = Required rate of return of market (KSE 100 index)(Rm – Rf) = Risk premium because of bearing risk “B” (beta)

Assumption of CAMPAssumption of CAMP

The capital market is efficient, in that The capital market is efficient, in that investor are well informed.investor are well informed.

No transaction cost.No transaction cost. Negligible restriction on investment.Negligible restriction on investment. No investment is large enough to effect the No investment is large enough to effect the

market price of a stock. market price of a stock. There is no taxes.There is no taxes. The quantities of all assets are given fixed.The quantities of all assets are given fixed. All assets are perfectly divisible and All assets are perfectly divisible and

perfectly liquid.perfectly liquid.

Investment OpportunitiesInvestment Opportunities

1)1) Investment in risk free Investment in risk free securities whose return are securities whose return are fixed. Short term rate is used is fixed. Short term rate is used is CAPM.CAPM.

2)2) Market portfolio of common Market portfolio of common stock.stock.

BetaBeta

It is a tendency of a Stock to move with the Market (or Portfolio of all Stocks in the Stock Market). it is the building block of CAPM.

Total Risk = Diversifiable Risk + Market Risk

Total Stock Return = Dividend Yield + Capital Gain Yield

Stock Risk Vs Stock Beta:

Stock Risk:

It is a statistical spread of possible returns (or Volatility) for that Stock

Stock Beta:

It is a statistical spread of possible returns (or Volatility) for that Stock relative to the market spread i.e. spread (or Volatility) of the fully diversified market portfolio or index.

Beta Coefficients of Individual Stocks are published in “Beta Books” by Stock Brokerages & Rating

Meaning of Beta for Share ABC in Karachi Stock Exchange (KSE):

If Share A’s Beta = +2.0 then that Share is Twice as risky (or volatile) as the KSE Market i.e. If the KSE 100 Index moved up 10% in 1 year, then based on historical data, the Price of Share B would move up 20% in 1 year.

If Share B’s Beta = +1.0 then that Share is Exactly as risky (or volatile) as the KSE Market

If Share C’s Beta = +0.5 then that Share is only Half as risky (or volatile) as the KSE Market

If you could find a Share D with Beta = -1.0 then that share would be exactly as volatile as the KSE Market BUT in the opposite way i.e. If the KSE 100 Index moved UP 10% then the price of the Share D would move DOWN by 10%!

The Beta of most Stocks ranges between + 0.5 and + 1.5 The Average Beta for All Stocks = Beta of Market = + 1.0

Always.