CAPITAL ASSET

PRICING MODEL
 INTRODUCTION
 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) helps us to calculate
investment risk and what return on
investment we should expect.
 Birth of a Model
•WILLIAM SHARPE, SET OUT IN HIS 1970 BOOK
"PORTFOLIO THEORY AND CAPITAL MARKETS."
 Types of Risk
 Systematic Risk
 Unsystematic Risk
“Formula”
 “Formula”
Kc = Rf + (Km – Rf)
Kc = Common stock holders required rate of
return.
Rf = Risk free return.

Km = Required rate of return on portfolio of all

stocks, required return on average-risk
stock.
 = Beta.
 “Beta”
 is this measure--gauges the tendency of a security’s return to
move in tandem with the overall market’s return.

 1 Average systematic risk

 1 High systematic risk, more volatile than the market

 1 Low systematic risk, less volatile than the market

 Betas for a Five-year Period
(1987-1992)
Company Name (1987-1992) Beta

Tucson Electric Power 0.65

California Power & Lighting 0.70

2006 Betas:
Litton Industries 0.75

Tootsie Roll 0.85

Quaker Oats 0.95

Standard & Poor’s 500 Stock 1.00

Index

Procter & Gamble 1.05

General Motors 1.15

Southwest Airlines 1.35

Merrill Lynch 1.65

Roberts Pharmaceutical 1.90

 What CAPM Means for You
This model presents a very simple theory that
delivers a simple result. The theory says that the
only reason an investor should earn more, on
average, by investing in one stock rather than
another is that one stock is riskier. Not
surprisingly, the model has come to dominate
modern financial theory.
 Assumptions of CAPM
All investors:
 Aim to maximize economic utilities.
 Are rational and risk-averse.
 Are broadly diversified across a range of investments.
 Are price takers, i.e., they cannot influence prices.
Can lend and borrow unlimited amounts under the risk free
rate of interest.
 Trade without transaction or taxation costs.
Deal with securities that are all highly divisible into small
parcels.
 Assume all information is available at the same time to all
investors.
Further, the model assumes that standard deviation of past
returns is a perfect proxy for the future risk associated with
a given security.