Capital Asset Pricing Model

Capital Asset Pricing Model

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  CAPITAL ASSET PRICINGMODEL - Chintan Vadgama
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  MEANING  The CapitalAsset Pricing Model (CAPM) is used to determine a appropriate required rate of return of an asset, if that asset is to be added to an already well- diversified portfolio, given that asset's non- diversifiable risk.  Developed by Markowitz, Sharpe, and Lintner who are researchers credited with its development.  It attempts to measure the risk of a security in a portfolio sense.
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  CONT…  The modeltakes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk- free asset.  The core idea of CAPM is measure the undiversifiable risk of a security which is relevant to determine the expected return of an asset.
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  ASSUMPTIONS  All investorsare risk averse and diversification is needed.  All investors want to maximize wealth.  Funds are available at risk free rate.  Securities are perfectly divisible and liquid.  There is perfect competition in the market  Only systematic risk is relevant in determining the estimate returns.
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  . High Risk LowRisk High return May Be Definite Low Return No Investment May Be
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  THE CAPM MODEL It attempts to examine the impact of security on a portfolio’s risk & return.  The total portfolio can be bifurcated into systematic & unsystematic risk.  The latter can be eliminated by diversification and therefore only effect of systematic risk has to be examined.  The magnitude of the systematic risk varies from one security to another depending upon the sensitivity of the security to the market fluctuations.
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  (Β), THE BETAFACTOR  BETA:- William Sharpe has suggested that the systematic risk can be measured by beta factor. The Beta can be viewed as an index of the degree of the responsiveness of the security’s returns with the market return.  It is calculated by relating the returns of a security with the returns of the market.  The more responsive the price of a security is to the changes in the market, higher would be the Beta factor.
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  CAPM Rs = Irf+ (Rm-Irf)β Rs = the expected return from a security. IRF = risk free return RM = expected return on portfolio. β= Beta a measure of systematic risk
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  CONT…  The modeldepicts that the expected rate of return on a security consists of two parts a) Risk Free Rate b) Risk Premium  The risk premium varies directly with the beta factor and therefore higher the beta factor, greater is the expected rate of return and vice-a-versa.
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  GRAPHICAL REPRESENTATION
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  CONT…  The expectedreturn for a security depends upon three things:- 1. Time value of money 2. Reward for bearing the systematic risk 3. Amount of systematic risk.
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  SECURITY MARKET LINE The graphical version of CAPM is known as SML. It represents the relationship between the beta factor and the expected rate of return.  With the increase in risk the risk premium increases and so does the RRR. Therefore, the risk premium is lower for a low beta factor and is higher for a greater beta factor.
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  FAMA & FRENCHMODEL  A factor model that expands on the capital asset pricing model (CAPM) by adding size and value factors in addition to the market risk factor in CAPM.  This model considers the fact that value and small cap stocks outperform markets on a regular basis.  By including these two additional factors, the model adjusts for the outperformance tendency, which is thought to make it a better tool for evaluating manager performance.