CAPITAL ASSET PRICING MODEL

CAPITAL ASSET PRICING MODEL (CAPM)

The capital asset pricing model (CAPM) is a model that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of the asset. The required rate of return specified by CAPM helps in valuing an asset. One can also compare the expected (estimated) rate of return on an asset with its required rate of return and determine whether the asset is fairly valued. Under CAPM, the security market line (SML) exemplifies the relationship between an assets risk and its required rate of return.

Assumptions of CAPM

Key Issues
Essentially, the capital asset pricing model (CAPM) is concerned with two questions: What is the relationship between risk and return for an efficient portfolio? What is the relationship between risk and return for an

individual security?

Basic Assumptions
RISK - AVERSION

MAXIMISATION . . EXPECTED UTILITY

HOMOGENEOUS EXPECTATION

PERFECT MARKETS

Characteristics Line

Security Market Line (SML)

Security market line

Security market line with normalize systematic risk

Capital Market Line

EXPECTED RETURN, E(Rp) L M K Rf E(Rj) = Rf + j E(RM) - Rf = M Z

STANDARD DEVIATION, p

Security Market Line

E(RM) - Rf E (R i ) = R f +
i = iM M

CiM

E (R i ) = R f + [ E (R M) - R f ] i
EXPECTED RETURN 14%

P
SML

8%

0
ALPHA = EXPECTED - FAIR RETURN RETURN

1.0

Inputs Required For Applying CAPM

RISK-FREE RETURN
RATE ON A SHORT-TERM GOVT SECURITY RATE ON A LONG TERM GOVT BOND

MARKET RISK PREMIUM

HISTORICAL DIFFERENCE BETWEEN THE AVERAGE RETURN ON STOCKS AND THE AVERAGE RISK - FREE RETURN

PERIOD

: AS LONG AS POSSIBLE

AVERAGE : A.M VS. G.M.

Calculation Of Beta

Rit = i + i RMt + eit

i =

iM M 2

Calculation Of Beta
Return on market portfolio, RM Deviation of return on stock A from its mean (RA - RA) 0 5 8 4 6 6 8 -6 -19 4 5 4 -4 -3 -18 Deviation of Product of the return on market deviation, portfolio from its (RA - RA) mean (RM - RM) (RM - RM) 3 5 4 1 0 4 5 -2 -8 3 -20 7 -1 -2 1 Square of the deviation of return on market portfolio from its mean (RM - RM)2 0 9 25 25 32 16 4 1 0 0 24 16 40 25 12 4 152 64 12 9 -100 400 28 49 4 1 6 4 -18 1 (RA - RA) (RM - RM) 2 (RM - RM) = 221 = 624

Period

Return on stock A, RA

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

10 15 18 14 16 16 18 4 -9 14 15 14 6 7 -8 RA = 150 RA =10

12 14 13 10 9 13 14 7 1 12 -11 16 8 7 10 RM = 135 RM = 9

 = Cov(RA,RM) 2M Cov(RA,RM) = (RA - RA--) (RM RM--) = 221 = 15.79 n-1 14 Where, Cov(RA,RM) = covariance between A and Market M RA = return on security A RM = return on Market M RA-- = expected return on security A RM-- = expected return on Market M n = number of observations 2M = (RM RM--)2 = 624 = 44.57 n-1 14 = Cov(RA,RM) = 15.79 / 44.57 = 0.354 2M

Problem 1
The following table, gives the rate of return on stock of Apple Computers and on the market portfolio for five years Year 1 2 3 4 5 Return on the stock Apple Computers (%) -13 5 15 27 10 Return Market Portfolio (%) -3 2 8 12 7

(i) What is the beta of the stock of Apple Computers? (ii) Establish the characteristic line for the stock of Apple Computers.

Solution
Year 1 2 3 4 5 Sum Mean M2 RA -13 5 15 27 10 44 8.8 134.8 = 5-1 83.55 A = 33.7 = 2.48 = 33.7 Cov A,M = 5-1 RM -3 2 8 12 7 26 5.2 RA - RA -21.8 -3.8 6.2 18.2 1.2 RM - RM -8.2 -3.2 2.8 6.8 1.8 (RA - RA) (RM - RM) 178.76 12.16 17.36 123.76 2.16 334.2 (RM - RM)2 67.24 10.24 7.84 46.24 3.24 134.8

334.2 = 83.55

Solution (contd.)
(ii) Alpha = = RA A RM 8.8 (2.48 x 5.2) = - 4.1

Equation of the characteristic line is RA = - 4.1 + 2.48 RM

Problem 2
The risk-free return is 8 percent and the return on market portfolio is 16 percent. Stock X's beta is 1.2; its dividends and earnings are expected to grow at the constant rate of 10 percent. If the previous dividend per share of stock X was Rs.3.00, what should be the intrinsic value per share of stock X?

Solution
The required rate of return on stock A is: RX = = = RF + X (RM RF) 0.08 + 1.2 (0.16 0.08) 0. 176

Intrinsic value of share = D1 / (r- g) = Do (1+g) / ( r g) Given Do = Rs.3.00, g = 0.10, r = 0.176 3.00 (1.10) Intrinsic value per share of stock X = 0.176 0.10 = Rs. 43.42