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CAPM IN FINANCE WITH VARIOUS EXAMPLES.pptx
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- 2. What is CAPM? •Definition: A theoretical model that describes the relationship between the expected return of an asset and its systematic risk. • Purpose: Helps investors estimate the expected return they should demand for investing in a particular asset based on its inherent risk.
- 3. Key Assumptions OfCAPM • Efficient Market Hypothesis: All available information is reflected in asset prices, making it impossible to consistently beat the market. • Diversification Eliminates Unsystematic Risk: Unsystematic risk can be diversified away through holding a well-diversified portfolio, leaving only systematic risk as relevant. • Investors Seek Optimal Return-Risk Trade-off: Investors aim to maximize expected return for a given level of risk or minimize risk for a given expected return. • Risk-Free Rate and Market Return are Known: These values are used as benchmarks for the model.
- 4. Components Of CAPM •Risk-Free Rate (Rf): The return on an investment with no risk, typically represented by government bonds. • Market Risk Premium (Rm - Rf): The difference between the expected return of the market portfolio and the risk-free rate, representing compensation for taking on market risk. • Beta (β): A measure of an asset's systematic risk relative to the market. A β of 1 indicates the asset's movement aligns with the market, >1 means it's more volatile, and <1 means it's less volatile. • Security Market Line (SML): A graphical representation of the CAPM equation, showing the expected return for assets based on their beta
- 5. Equation Of CAPM •Equation: Ri = Rf + βi(Rm - Rf) • Ri: Expected return of individual asset • βi: Beta of individual asset • Rf: Risk-free rate • Rm: Expected return of the market portfolio • Explanation: The equation tells us the expected return of an asset is equal to the risk-free rate plus a risk premium based on its beta. The higher the beta, the higher the expected return to compensate for the higher systematic risk.