Capital Asset Pricing Model(CAPM)

CAPM was introduced by Jack Treynor (1961, 1962),William Sharpe (1964), John Lintner(1965) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. Ri = Rf + (Rm - Rf) Ri= Expected return on security i Rf = Risk-free interest rate = beta for security i Rm = Expected rate of return on market portfolio Rm - Rf = Market risk premium

CAPM (contd.)
CAPM is that investors need to be compensated in two ways:
time value of money and risk

Time value of money is represented by the riskfree (Rf) rate compensating by placing money over a period of time Risk calculates the amount of compensation the investor needs for taking on additional risk Expected return = Price of time + Price of risk x Amount of risk

Risk Free Rate

Theoretical rate of return of an investment with no risk of financial loss Since the risk free rate can be obtained with no risk
Implies that any additional risk taken by an investor should be rewarded with an interest rate higher than the risk-free rate

Risk
Total risk consists of two components:
Diversifiable Non-diversifiable

Diversifiable (or Unsystematic)

Can be eliminated by holding enough stocks Results from uncontrollable or even random events
That are unique to an industry and/or a company
E.g., management changes, labour changes, labour strikes, lawsuits and regulatory actions

Risk (contd.)
Non-diversifiable (or Systematic)
External to an industry and/or business Attributed to broad forces, such as war, inflation and political and even sociological events Impact all investments and therefore are not unique to a given investment Each security possesses its owns level of non-diversifiable risk
This is measured as the beta coefficient

Relevant risk is ONLY Non-diversifiable risk

Because any knowledgeable investor can eliminate diversifiable risk by holding a large enough portfolio of securities

Beta
Beta measures non-diversifiable risk
Shows how the price of a security responds to market forces That is, the more responsive the price of a security is to changes in the market, the higher will be its beta Calculated by relating the returns on a security with the returns for the market

Beta
The beta of the market portfolio is ALWAYS = 1.0 The beta of a security compares the volatility of its returns to the volatility of the market returns: = 1.0 -the security has the same volatility as the market as a whole > 1.0 -aggressive investment with volatility of returns greater than the market < 1.0 -defensive investment with volatility of returns less than the market

Market Risk Premium

This difference between the return on the market and the interest rate is termed as the:
Market Risk Premium RM RF

It is the reward market offers for bearing average systematic risk in addition to waiting

Coefficient of correlation
Coefficient of correlation is another measure designed to indicate the similarity or dissimilarity in the behavior of two variables rxy = covxy/ x y, where: rxy = coefficient of correlation between X and Y covxy = covariance between X and Y x = standard deviation of X y = standard deviation of Y If correlation coefficient between two securities is -1.0, then a negative correlation exists (cannot be less than -1.0) If correlation coefficient is zero, then returns are said to be independent of one another If returns of two securities are perfectly correlated, the correlation coefficient will be +1.0, and perfect positive correlation is said to exist (cannot exceed +1.0) Also, the smaller the correlation between the securities, the greater the benefits of diversification A negative correlation would be even better

Efficient Frontier
Each point on this line represents an optimal combination of securities that maximizes the return for any given level of risk (standard deviation).

RP

. . . . . . .. . . .. . . . . . . .. . .. . ..

These dots represent portfolios that are inferior to the portfolios on the efficient frontier they either offer the same returns but with more risk, or they offer less return for the same risk.

P 2

Efficient Frontier (contd.)

Allows investors to understand how a portfolios expected returns vary with the amount of risk taken Relationship securities have with each other is an important part of the efficient frontier
Some securities prices move in the same direction under similar circumstances, while others move in opposite directions

More out of sync the securities in the portfolio, that is the lower their covariance, the smaller the risk of the portfolio that combines them

Efficient Frontier (contd.)

Why is the efficient frontier curved?
Because there is a diminishing marginal return to risk i.e., Each unit of risk added to a portfolio gains a smaller and smaller amount of return

Capital Market Line

RP

RF

. . . . . .M . . . . . . . . . . .. . . . .. . . .
P 2

Capital Market Line

The straight line is referred to as the Capital Market Line (CML) Derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return All investors will end up with portfolios somewhere along the CML and all efficient portfolios would lie along the CML
However, not all securities or portfolios lie along the CML All portfolios, except those that are efficient, lie below the CML