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CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

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Page 1: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

CAPMCapital Asset Pricing Model

By Martin Swoboda and Sharon Lu

Page 2: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Introduction Modern Portfolio Theory and

diversification Beta vs. standard deviation Unsystematic vs. systematic risk Security Market Line (SML) The CAPM equation Asset pricing Assumptions behind using CAPM

Page 3: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Modern Portfolio Theory and diversification

Rational investors use diversification to optimize their portfolios

Diversification reduces portfolio risk (assets that are not perfectly correlated)

Efficient Portfolio

Page 4: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Beta vs. standard deviation Standard deviation includes systematic

and unsystematic risk; not used because unsystematic risk diversified away

Beta: A standardized measure of the risk of an individual asset, one that captures only the systematic component of its volatility; measures how sensitive an individual security is to market movements; measure of market risk

Page 5: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Unsystematic vs. systematic risk

Unsystematic risk: risk that can be eliminated through diversification a.k.a. Unique risk, residual risk, specific risk, or diversifiable risk

Systematic risk: risk that cannot be eliminated through diversification a.k.a, market risk or undiversifiable risk

Page 6: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Security Market Line

Line representing the relationship between expected return and market risk; shows expected return of an overall market as a function of systematic risk

Graphical representation of CAPM Compare a single asset to the SML (and

see if it falls below, above, or on the line)

Page 7: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Security Market Line

Page 8: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Capital Asset Pricing Model (CAPM)

The expected return on a specific asset equalsthe risk-free rate plus a premium that dependson the asset’s beta and the expected risk premium on the market portfolio.

Expected return of specific asset: E(Ri)Risk-free rate: Rf

Expected risk premium: E(Rm) - Rf

Page 9: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Practice Problem #1

If the risk-free rate equals 4% and a stock with a beta of 0.8 has an expected return of 10%, what is the expected return on the market portfolio?

Page 10: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Practice Problem #1: answer

If the risk-free rate equals 4% and a stock with a beta of 0.75 has an expected return of 10%, what is the expected return on the market portfolio?

10% = 4% + 0.75(market portfolio – 4%) 8% = market portfolio – 4% 12% = market portfolio

Page 11: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Practice Problem #2 A particular asset has a beta of 1.2 and an

expected return of 10%. Given that the expected return on the market portfolio is 13% and the risk-free rate is 5%, the stock is:

A. appropriately priced

B. underpriced

C. overpriced

Page 12: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Practice Problem #2: answer A particular asset has a beta of 1.2 and an

expected return of 10%. Given that the expected return on the market portfolio is 13% and the risk-free rate is 5%, the stock is:A. appropriately pricedB. underpricedC. overpriced; expected return should be 14.6% (5+1.2(13-5))

Page 13: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Asset pricing Future cash flows of the asset can be

discounted using the expected return calculated from CAPM to establish the price of the asset

If observed price > CAPM valuation overvalued (paying too much for that amount of risk)

If observed price < CAPM valuation undervalued

Page 14: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Assumptions behind the CAPM U.S. treasuries are risk-free Uncertainty about inflation Assumed that investors can borrow money

at same interest rate at which they lend, but generally borrowing rates are higher than lending rates

WHY we still use CAPM: benchmark portfolios used Treausry bills and market portfolio

Page 15: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Practice Problem #3Last year… Firm A: return: 10%, beta: 0.8 Firm B: return: 11%, beta: 1.0 Firm C: return: 12%, beta: 1.2 Given that the risk-free rate was 3% and

market return was 11%, which firm had the best performance?

Page 16: CAPM Capital Asset Pricing Model By Martin Swoboda and Sharon Lu

Practice Problem #3: answer

Firm A: 3% + 0.8(11%-3%) = 9.4% (over) Firm B: 3% + 1.0(8%) = 11% (same) Firm C: 3% + 1.2(8%) = 12.6% (under)

Firm A performed the best because it exceeded the expected return