Capital

Asset
Pricing
Model
Manuel Cervera 185184
Violetta

Prof. Dr. Kurt A. Hafner
International Banking
The model was introduce by William Sharpe, John Litner
and Jan Mossin.
No matter how much we diversify our investments, it's
impossible to get rid of all the risk. As investors, we
deserve a rate of return that compensates us for taking on
risk.
The capital asset pricing model (CAPM) is used in finance
to determine a theoretically appropriate price of an asset
given that assets to non-diversifiable risk.
The CAPM builds on the model of portfolio choice
developed by Harry Markowitz (1959).
The attraction of the CAPM is that it offers powerful and
intuitively pleasing predictions about how to measure risk
and the relation between expected return and risk.
This analysis implies to find securities with low
covariance (correlation) with the market.
Since investors will prefer securities with low covariance,
securities with low (high) covariance have a high (low)
price and therefor a low (high) E(r).

Is the only relevant measure of a stocks risk.
It measures the part of the assets statistical variance that
cannot be diversified.
It is found by statistical analysis of individual, daily share
price returns, in comparison with the market's daily
returns over precisely the same period.
Positive beta or negative beta?
Positive beta or negative beta?
If the stock has a high positive :
It will have large price swings driven by the market.
It will increase the risk of the investors portfolio.
The investor will demand a high E(r) in compensation.
If the stock has a negative :
It moves against the market.
It will decrease the risk of the market portfolio.
The investor will accept a lower E(r).
For individual securities, we make use of the security
market line (SML) and its relation to expected return and
systematic risk (beta).
The SML enables us to calculate the reward-to-risk ratio
for any security in relation to that of the overall market.
Therefore, when the expected rate of return for any
security is deflated by its beta coefficient, the reward-to-
risk ratio for any individual security in the market is equal
to the market reward-to-risk ratio, thus:
The market reward-to-risk ratio is effectively the market
risk premium and by rearranging the equation of last slice
and solving for E(Ri), we obtain the capital asset pricing
model (CAPM).
CAPM's starting point is the risk-free rate - typically a 10-
year government bond yield.
To this is added a premium that equity investors demand
to compensate them for the extra risk they accept.
This equity market premium consists of the expected
return from the market as a whole less the risk-free rate of
return. The equity risk premium is multiplied by a
coefficient that Sharpe called "beta."
All investors:

1. Aim to maximize economic utilities (Asset quantities are given and
fixed).
2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers, i.e., they cannot influence prices.
5. Can lend and borrow unlimited amounts under the risk free rate of
interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible into small parcels
(All assets are perfectly divisible and liquid).
8. Have homogeneous expectations.
9. Assume all information is available at the same time to all
investors.

1. We will choose a stock and a market.
2. We will calculate Beta.
3. We will find the risk-free return that we will use.
4. We will find the Risk Premium.
5. We will calculate the CAPM, and we will compare our
results.
The model does not adequately explain the variation in
returns of securities. Empirical studies show that assets
with low betas can offer the higher returns that the model
suggests.
The model assumes that all investors have access to the
same information, and agree on the risk and the expected
return for all assets.
The market portfolio consists of all assets in all markets,
where each asset is weighted by market capitalization.
This assumes that investors have no preference between
markets and assets, and picking only assets according to
their risk-return profile.
RESOURCES
Books:
Systematic Guide to Write a Research paper. S.S. Bhakar and
Seema Mehta.
Papers:
The Capital Asset Pricing Model: Theory and Evidence.
Eugene. F. Fama and Kenneth R. French. 2004. Journal of
Economic Perspective
An intertemporal Capital Asset Pricing Model. Robert C.
Merton. 1973. Econometrica, Vol. 41, No 5.
Website:
http://book.ivo-welch.info/ed3/chap09.pdf
http://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-
CAPM.pdf