NIPA-AKS-CAPM

CAPITAL ASSET PRICING MODEL

What is Capital Asset Pricing Model?

Capital Asset Pricing Model(CAPM) is an economic model which describes how the securities are priced in the market.
This model was developed by William. F. Sharpe, John Lintner and John Mossin. This model emphasizes the presence of
the risk factor in the portfolio theory such as Systematic Risk and Unsystematic risk. The unsystematic risk of the security
can be fully diversified by making a portfolio but the systematic risks cannot be reduced. Hence, the return from a security
is directly related to its systematic risk. CAPM explains the behavior of the security prices and provides a mechanism by
which the investors can assess the impact of investment in a particular security on the total risk and return of a portfolio.
This model suggests that the prices of securities are determined in such a way that its risk premium is proportional to its
systematic risk.

This theory signifies that, the investors are risk averters and simply not interested to take any risk but may be preparing to
take risk if they get adequate premium for such risk. Hence, they would require a return in proportion of such risk
basically the systematic risk which cannot be diversified. Such systematic risk is measured with and indicated by Beta Co-
efficient. Therefore, the minimum return to be expected by an investor should be equal to the sum of risk free return and
beta co-efficient proportion of the systematic risk. This relationship can be explain as follows-

E(Ri)= Rf+βi(Rm –Rf )

Where, E(Ri) is the required return on the basis of CAPM model.

Rf = The risk free rate of return from the investment.

Rm = The return from the market portfolio, Hence, (Rm –Rf ) is the risk premium.

βi = The proportion of the systematic risk held by the investor.

It can be explained through the following diagram

Ri

SML

Rf

O Beta(βi)

Assumption of CAPM:

1. There is a risk free asset and investors can borrow and lend unlimited amount at the risk-free rate.
2. The investors objective to maximize the income.
3. They make choice on the basis of risk and return.
4. Investors have homogenous expectation of risk and return.
5. Investors have identical time horizon, only two period is considered.

1
NIPA-AKS-CAPM

6. All assets in the world are traded.

7. Asset can be divided into infinite division.
8. Security distributions are normal and described by two parameters such as risk and return.
9. No transaction cost is present.

CAPM is a theoretical solution to an optimal portfolio. It uses some ideal assumptions about the economy to argue that the
capital weighted world wealth portfolio is the most optimal portfolio and every investor will hold the same portfolio of
risky assets. Even though it is clear that they do not, the CAPM is still a very useful tool. It has been taken as a basis for
estimating the expected rate of return.

Criticism of CAPM.

The CAPM has been criticized and its application is questioned in several cases on the ground of its assumptions.

a) Unrealistic assumption of world wealth portfolio which cannot be practically made.

b) Unsystematic risks even though can be significantly reduced but cannot be completely nullified.
c) All assets cannot be possibly divided into infinite division.
d) Transaction cost cannot be completely ruled out.
e) Cannot helpful in risk management because it does not segregate the systematic risk into different components
and its risk premium.
These, limitations of the CAPM has forced to develop a more compatible which has given rise to the foundation
of Arbitrage Pricing Theory(APT).

What is Security Market Line(SML)?

SML is the relationship between total risk and the expected return from a security or from a portfolio. How is the
relationship between the individual assets defined in a capital market that is in equilibrium?. The CAPM identifies
security return net of the risk free rate as proportional to the expected net market return, where beta serves as the constant
of proportionality. As a consequence of this relationship, all securities in equilibrium plot along a straight-line called the
security market line. Hence, the SML indicates the straight line having all the combinations of risk-return equilibrium.
The slope of the SML indicates the proportion of systematic risk of the security and the risk premium.

Exp Return SML E(Ri)= Rf+βi(Rm –Rf )

Rf Risk free return

O Beta(β)

SML=>E(Ri)= Rf+βi(Rm –Rf )

The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a
reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus

2
NIPA-AKS-CAPM

expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the
inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the
amount of risk assumed.

What is Security Characteristic Line(SCL)?

Security characteristic line (SCL) is a regression line plotting performance of a particular security or portfolio against
that of the market portfolio at every point in time. The SCL is plotted on a graph where the Y-axis is the excess return on
a security over the risk-free return and the X-axis is the excess return of the market in general. The slope of the SCL is the
security's beta, and the intercept is its alpha.

This relationship can be explained through the following diagram.

Excess return from security SCL

α Slope of SCL(β)

Excess return from the market portfolio

SCL= Ri -Rf = α +βi (Rm –Rf )+εi α=Re - Ri

Where , Alpha(α) is the intercept of the SCL

β is the slope of the SCL which measures the systematic risk of the security.

Rf is the risk-free return and Rm is the return from market portfolio.

The SCL indicates whether the security is correctly priced?. When the security is correctly priced the value of alpha(α) is
zero. Hence, the positive or negative alpha shows the security is not correctly priced. Positive alpha shows the security is
under-priced provides an opportunity to give a higher return than the required return. On the other hand the negative value
of alpha indicates the security is overpriced.

What is Capital Market Line(CML)

Capital market line (CML) is the tangent line drawn from the point of the risk-free asset to the feasible region for risky
assets. The tangency point M represents the market portfolio, so named since all rational investors (minimum variance
criterion) should hold their risky assets in the same proportions as their weights in the market portfolio. The CML results
from the combination of the market portfolio and the risk-free asset (the point L). All points along the CML have superior
risk-return profiles to any portfolio on the efficient frontier, with the exception of the Market Portfolio, the point on the
efficient frontier to which the CML is the tangent. From a CML perspective, this portfolio is composed entirely of the
risky asset, the market, and has no holding of the risk free asset, i.e., money is neither invested in, nor borrowed from the
money market account.

3
NIPA-AKS-CAPM

Addition of leverage (the point R) creates levered portfolios that are also on the CML.

E(Rm) L

Rf

σm(standard deviation of market)

(𝑅𝑚−𝑅𝑓)
CML=E(R)=Rf + xσ
𝜎𝑚

What is Alpha (α) of a security?

In finance, the term alpha refers to the excess of the expected return from security over its required return. Required return
is the return in equilibrium with its risk. It indicates the correctness in pricing of a security. It is the inception of SCL.

α=Re - Ri

When the security is correctly priced the value of alpha(α) is zero. Hence, the positive or negative alpha shows the
security is not correctly priced. Positive alpha shows the security is under-priced provides an opportunity to give a higher
return than the required return. On the other hand the negative value of alpha indicates the security is overpriced.

What is Beta(β)?

Beta is the measure of systematic risk of a security. It signifies the proportion of risk premium required for an investor to
hold a certain level of risk. In the CAPM, beta measures the slope of the security market line(SML). A higher beta(β>1)
signifies the security is more riskier than the market risk, hence it requires more premium. Beta with equal to one(β=1)
signifies security risk is equal to market risk and beta with less than one (β<1) signifies the security is less riskier than the
market risk.

Calculation of Beta- βi=(Covim )/ Varm

Or, Beta=Corrim.σi/σm
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑎 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦
Or Beta= 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡

Beta of a portfolio- Beta of a portfolio is the weighted average beta of the securities of a portfolio where, the proportion
of amount invested in each security is considered as weight.. It is measured as follows.

βp= WAβA+WBβB+…………WNβN Or βp=⅀Wiβi

Where, Wi is the weight of security and βi is the beta if respective security.

4
NIPA-AKS-CAPM

What is Arbitrage Pricing Theory(APT)?

APT was introduced by Rose that provides another model for explaining the relationship between return and risk. The
theory relates the expected return of an asset to the return from the risk-free asset and a series of other common factors
that systematically enhance or detract from that expected return. In certain cases it is similar to the CAPM but there are
both substantive and subtle differences. Both the models assert that every asset must be compensated only according to its
systematic risk. One of the major differences is that, in CAPM the systematic risk of an asset is defined to be co-
variability of the asset with the market portfolio, whereas, in APT, the systematic risks are defined to be co-variability
with not only one factor but also possibly with several economic factors.

Another difference is that the CAPM requires the economy to be in equilibrium whereas the APT requires only that the
economy has no arbitrage opportunities. One of the key advantages of ATP is that it derives a simple liner pricing relation
approximating that in the CAPM without some of the objectionable assumptions. Thus APT is a more fundamental
relationship than the CAPM in the sense that a rejection of APT implies a rejection of CAPM but not vice-versa.

Assumptions of APT:

i) Investors seek return tempered by risk, they are risk averse and seek to maximize their wealth.
ii) Investors can borrow and lend at risk-free rate.
iii) There is no market friction such as transaction cost, taxes or restriction on short-selling.

ATP Model

According to APT , E(R)=Rf+b1R1+b2R2+---------+bnRn

Where, E(R ) is the expected return

R1,2,3 are the risk premium.

Rf is the risk-free rate of return

b1,2 is the sensitivity factor.

The APT model clearly indicates the type or component of risk held by the investor and the risk premium it gets for that
risk.

Practical Problems.

PP.1: X Ltd is an investment company has invested in different companies. Its risk-free rate of return if 10%, expected
return from the market portfolio is 16%. The market sensitivity index is 1.5. Calculate the expected rate of return.

PP.2: The return on security of a company and the market portfolio for 10 periods are given bellow.

Period Return from Return from

Security (x) % Market(%)
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 -5 8
5
NIPA-AKS-CAPM

7 17 -6 i) What is the Beta of the security X?

8 19 5 ii) What is the characteristic line of security X?
9 -7 6
10 20 11

PP.3: Wipro provides you the following information, calculate the expected rate of return of a portfolio.

Expected market return 15%

Risk-free rate of return 9%
Standard deviation of the asset 2.4%
Standard deviation of the market 2.0%
Correlation coefficient of portfolio with market 0.9

PP.4: The beta co-efficient of security A is 1.6. The risk-free rate of return is 12% and the required rate of return is 18%
on the market portfolio. If the investor expected a dividend of Rs2.50 and the growth rate of dividends and earnings is 8%,
at what price the security of A should be traded on the basis of CAPM?

PP.5: The following table gives an analysts expected return on two stocks for a particular market return.
Market return Aggressive Stock Defensive Stock
8% 5% 8%
22% 32% 8%

a) What are the betas of two stocks?

b) What is the expected return on each stock if the market return is equally likely to be 8% or 22%?
c) If the risk-free rate is 9% and the market return is equally likely to be 8% or 22% what is the SML.
d) What are the alphas of two stock?
PP.6: The expected return for the market is 15% with a standard deviation of 25%. The risk-free rate is 7%. The
following information is available for four mutual funds, all assumed to be efficient.
Mutual Fund Standard Deviation(%)
Prudent 15 a) Calculate Slope of the Capital Market Line
Calibre 22 b) Calculate the expected return for each mutual fund.
Obroi 26
Sacrunt 32
PP.7: After a thorough analysis of both the aggregate stock market and the stock of X company, you develop the
following opinion:
Economic condition Market return(%) Return from X(%) Probability
Good 16 20 0.4
Fair 12 13 0.4
Poor 3 -5 0.2
At present, the risk free rate is equal to 7%. Would an investment in X be wise?

6
NIPA-AKS-CAPM

PP.8: Management of a mutual fund has considered three alternate strategies:

Plan % of investment in
T-bond Stocks Beta of T-bonds Beta of stock Portfolio
1 0.0 100 0 1.0 ?
2 20 80 0 1.0 ?
3 30 70 0 1.0 ?

a) Which is the most risky strategy?

b) If T=7% and expected return under plan 1 is 14%, what is the market risk premium?
c) Management believes that the risk premium is too low and that the market will soon adjust it upward. Given this
which plan might the management wish to pursue?
d) Would this be a speculative or an investment strategy?
PP.9 Riskless securities are currently offering a return of 7.25% at a time when expected market return on all securities is
14.75%. The market standard deviation is 2.0%. An investor is seeking a portfolio with a correlation coefficient of 0.85
and a standard deviation of not more than 1.5%. What would be the required return on such portfolio.
PP.10 Annual rate of return on security X and the market rate of return are given bellow. Determine the beta coefficient of
stock X.
Year> 1 2 3 4 5
Return from X(%) (8) 15 12 13 18
Return from (10) 18 14 16 22
market(%)

PP.11: You have invested in four securities A,B,C and D the following sum.
A-Rs10,000 , B-Rs20,000 , C-Rs16,000 and D-Rs14,000.
The beta value of securities are: 0.80, 1.20,1.40 and 1.75 respectively. You are required to compute portfolio beta.
PP.12: MS Ltd has a debt-equity mix of 30:70. MS’s debt beta is 0.2 and of asset is 1.2. What is the beta of its equity?
PP.13: An investor is holding 1000 shares of Fatloss Company. Presently the rate of dividend being paid by the company
is Rs2 per share and the share is being sold at Rs25 per share in the market. However, several factors are likely to be
changed during the course of the year as indicated bellow.
Existing Revised In view of the above factors whether the investor should buy, hold or sell
Risk free Rate 12% 10% the share? And why?
Market risk premium 6% 4%
Beta Value 1.4 1.25
Expected growth rate 5% 9%

7
NIPA-AKS-CAPM

PP.14: Consider the following information and compute the expected return on the stock adopting the principles
underlying(i) Capital Market Line (ii) Security Market Line
Risk free rate 6%
Expected return from market 16%
Standard deviation of the security 2.15
Standard deviation of the market 1.75
Correlation between security and the market 0.72
PP.15:From the information given, compute return stocks of Fasteners Ltd. Estimates at the beginning of the year:
Inflation 5%, GNP 4.5% as against 4.5% and 6% respectively. Beta for the inflation is 1.7 and for GNP is 1.25, Risk free
rate of return is 5%.
PP.16:
A company has a choice of investments between several different equity oriented mutual funds. The company
has an amount of Rs.1 crore to invest. The details of the mutual funds are as follows:
Mutual Fund Beta
A 1.6
B 1.0
C 0.9
D 2.0
E 0.7
Required:
(i) If the company invests 20% of its investment in the first two mutual funds and an equal amount in the
mutual funds C, D and E, what is the beta of the portfolio?
(ii) If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance in equal amount in
the other two mutual funds, what is the beta of the portfolio?
(iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be the portfolios
expected return in both the situations given above?