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Table of Contents
Particulars
Page No. 4 5
(i) (ii)
Assumptions underlying CAPM CAPM tools to make investment decisions - Security Market Line, Efficiency Frontier & Capital Market Line
6 7 9 11
3 4 5 6 7 8
CAPM Assumptions ; A realistic Approach Comparison of Expected Returns using CAPM and Actual Returns, based on Historic Data - and construction of SML for the same Consideration of taxes in CAPM Effect of inclusion of taxes on the SML and comparing with Actual Returns using graphs Findings & Interpretations Bibliography
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Research Design
a) Statement of Purpose: The basic assumption behind the CAPM model are Zero taxes and transaction costs, Homogenity, Riskfree borrowing and lending. Since these assumptions are unrealistic, we propose to examine how inclusion of taxes in the model will effect the Security Market Line - a decision making tool. b) Research objectives: To understand the CAPM and related tools(SML/CML). Realistic examination of its assumptions.
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Effect of relaxation of the assumptions on the SML and the change in the nature of the curve.
c) Research methodology: We performed primary as well as secondary research to better understand CAPM and its usefulness in predicting future security returns. We obtained the opinions of stock market traders on the value of CAPM in securities analysis, who guided us in our research. We also extensively studied material available on the internet. This project is a result of all we have understood of the subject from both these sources. d) Research Scope: This research gives an overview of the meaning, techniques and usefulness of CAPM. However, in depth study of possibility of a substitute new model has not been done. Just a few examples have been taken to understand how it works. More important is if it actually is an effective forecast for prices. e) Research limitations
Statistical figures may not be accurate as they are estimated and not released by official sources We've tried to be as extensive in our research as is possible, but, considering that the topic is controversial, there may be information on the topic that is not available in the public domain.
CAPM : An Introduction
The capital asset pricing model (CAPM) is the standard risk-return model used by most academicians and practitioners. The underlying concept of CAPM is that investors are rewarded for only that portion of risk which is not diversifiable. This non-diversifiable risk is termed as beta, to which expected returns are linked. The objective of the study is to test the validity of this theory in Indian capital market & the stability of this non diversifiable risk (i.e. systematic risk or beta). CAPM describes the relationship between risk and expected return and that is used in the pricing of risky securities. It is based on two parameter portfolio analysis developed by Markowitz (1952). It is the standard risk return model used by most academicians & practitioners. The underlying concept of CAPM is that, investors are rewarded for only that portion of risk which is not diversifiable. This non-diversifiable variance is termed as beta, to which expected returns are linked. Adapted from students assignment 2011. Page 3
The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).
Assumptions
The set of assumptions employed to develop CAPM can be summarized as follows: I. II. Investors are risk averse & they have a preference for expected return & dislike of risk. Investors make investment decision based on expected rate of return & the variance of the underlying asset return. i.e. assumptions of two-parameter. III. Investors desire to hold a portfolio that lies along the efficient frontier. (The efficient frontier is also known as diversification frontier) IV. V. There is a risk less asset & investors can lend or borrow at that risk free rate. All the investments are perfectly divisible. That is, the fractional shares for any investment can be purchased in any moment. Adapted from students assignment 2011. Page 4
VI.
All the investors have the homogeneous expectations regarding investment horizon or holding period and to forecasted expected return & level of risk on securities. At the same time, there is a complete agreement among investors as to the return distribution for each security & portfolio.
VII.
There are no imperfections in the market that prevent the investors to buying or selling the assets. More importantly, there are no commissions or taxes involved with the security transaction. That means, there are no costs involved in diversification & there is no differential tax treatment of capital gain & ordinary income.
VIII.
There is no uncertainty about expected inflation, or alternatively, all security prices are fully reflect all changes in future inflation expectations.
IX.
Capital market is in equilibrium. That is all the investment decisions have been made & there is no further trading without new information.
were indifferent between buying and selling it. Example : The following table contains information based on analysts forecasts for three stocks. The risk-free rate is 7 percent and the expected market return is 15 percent. Compute the expected and Adapted from students assignment 2011. Page 5
required return on each stock, determine whether each stock is undervalued, overvalued, or properly valued, and outline an appropriate trading strategy. Stock Price today Stock A Stock B 25 40 27 45 17 E(Price) in 1 year 1.00 2.00 0.49 E(Divid.) in 1 year 1.0 0.8 1.2 SML for stock C
SML
R(k) = 16.6% Rm=15%
Beta
Stock C 15
Answer: Expected and required returns are shown in the figure below:
Expected Return A B C (27 -25 +1) / 25 = 12.0% (45 - 40 + 2) / 40 = 17.5% (17 - 15 + 0.49) / 15 = 16.6% Required Return 0.07 + (1.0) (0.15 0.07) = 15.0% 0.07 + (0.8) (0.15 0.07) = 13.4% 0.07 + (1.2) (0.15 0.07) = 16.6%
Rf = 7%
A is overvalued. Its expected to earn 12%, but based on its systematic risk it should earn 15%. B is undervalued. Its expected to earn 17.5%, but based on systematic risk it should earn 13.4%. C is properly valued. It is expected to earn 16.6%, & based on systematic risk it should earn 16.6%.
1.0 1.2
Beta
The appropriate trading strategy is: Short sell A, buy B and buy, sell, or ignore C.
EFFICIENCY FRONTIER & CAPITAL MARKET LINE The efficient frontier consists of the set portfolios that has the maximum expected return for a given risk level.
80
For every level of standard deviation along the X axis, the efficient frontier records the portfolio with the highest expected return (e.g. B & D). No investor would choose Portfolio C because portfolio B has a Adapted from students assignment 2011.
70
rn
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higher expected return for the same level of risk. Asset allocation along the efficiency frontier changes to provide diff risk-return combos. D will correspond to & 70% equity & B 30 % equity. Higher return - higher risk. Capital Market Line (CML): is the line of tangency between the RFR point on the vertical axis and the efficient frontier.
Capital market Line
80 70 60 Rf 50 40 30 20 10 0 M standard deviation M
expected return
Efficiency frontier
The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The portfolio at the point of tangency is the market portfolio. Market portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market. The MP is the only risky portfolio anyone would hold and is the only source of risk. As per risk tolerance, all investors choose a combo of risk free asset and market portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line (SML).
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1. Differential borrowing and lending rates: There is only one risk free rate in the model. This is an unrealistic assumption. Investors cannot borrow and lend at the same rate. Two rates mean 2 CMLs (as shown in the graph below). One implication of differential borrowing and lending rates is that the borrowing portfolio is not as profitable as when it assumed investors could borrow at risk free rate.
E(R)
2. Heterogeneous expectations : If all investors have different expectations about risk and return, each would have a unique CML and/or SML, and the composite graph would be a band of lines with a breadth determined by the divergence of expectations. The CAPM assumes invests have the same beliefs about expected returns and risks of available investments. But we know that there is massive trading of stocks and bonds by investors with different expectations. 3. Differing planning periods : if one investor uses a one-year planning period and another uses a one-month planning period, then the two investors have different SML. 4. Taxes Exist : Zero taxes. The CAPM assumes investment trading is tax-free and returns are unaffected by taxes. Yet we know this to be false: (1) many investment transactions are subject to capital gains taxes, thus adding transaction costs; (2) taxes reduce expected returns for many investors, thus affecting their pricing of investments; (3) different returns (dividends versus capital gains, taxable versus tax-deferred) are taxed differently, thus inducing investors to choose portfolios with tax-favored assets; (4) different investors (individuals versus pension plans) are taxed differently, thus leading to different pricing of the same assets. 5. Transaction costs Exist: The cost trading the security may offset any potential excess return resulting from the trade securities will plot close to SML but not exactly on it (shown below). Adapted from students assignment 2011. Page 8
Transaction costs also limit diversification, because at some point , the additional cost of diversification would exceed its benefits
E(R)
SML
E(Rm)
6. Non availability of risk free assets : The CAPM assumes the existence of zero-risk securities, of various maturities and sufficient quantities to allow for portfolio risk adjustments. But we know even Treasury bills have various risks.
b) SML was constructed in the manner described in the previous pages for each period.
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3. Actual Returns are computed on the basis of historic prices (obtained from NSE) using the formula: AR = P1 - P0 P0 For example if Actual Returns for Jan 2008 are being computed: P1 = Market Price of Stock in Jan 2008 P0 = Market Price of Stock in Jan 2007 D1 = Dividend during period Jan 2007-08 Actual returns for the periods are specified next to the respective charts.
Stock 1: Suzlon
Year Risk Free rate 7.72 5.96 7.63 Beta Expected Market Rate of Return (NIFTY) -51.83 71.45 17.24 CAPM Return R(k) -54.8172 106.1597 22.045 Actual Returns -96.806 36.27451 -39.121
Return
20 10 Rf = 7.72 0 -10 -20 -30 -40 Rm = -51.84 -50 R( k ) = -54.81 -60
Jan 2008
1.05
Beta
0.5
1.5
SML
R(k)
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Re turn
120 R( k ) = 106.16 110 100 90 80 70 Rm = 71.45 60 50 40 30 20 10 0
Jan 2009
R(k)
SML
Rf = 5.96
1.53
Beta
0.5
1.5
Return
R(k) = 22.045 24 21
Jan 2010
Year
Rm = 17.24
Beta
Expected Market R(k) CAPM Rate of Return Return (NIFTY) R(k) -51.83 -45.28 71.45 51.1481 17.24 15.2219
Actual Returns
SML
Beta
0.5
1.5
Stock 2: ACC
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Return
20 10 0 -10 -20 -30
Jan 2008
R =7.72 f
0.89
Beta
0.5
1.5 SML
R =-45.28 (k)
R(k)
Rm=-51.84
Return
Jan 2009
80 70 60 50 40 30 20
R(k)
SML
Rf =5.9621
Rm=17.2418 R(k) =15.22
15 12 9 6 3
0
Return 10
Jan 2010
0.69 Beta
0.5
1
R(k)
1.5
SML
Rf =7.63
0.5
0.79
Beta
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1.5
Beta
Actual Returns
-25.9154 -54.11 9.3230
Return
20 Rf = 7.72 10 0 -10 -20 -30 -40 R( k ) = -45.28 -50 Rm = -51.839 -60
Jan 2008
0.89
Beta
0.5
1.5 SML
R(k)
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Return
80 Rm = 71.45 70 R( k ) = 66.2108 60 50 40 30 20 10 Rf = 5.96 0
Jan 2009
R(k)
SML
0.5
0.92
Beta
1.5
Return
21 Rm = 17.24 18
Jan 2010
15 R( k ) = 16.56 12 9 Rf = 7.63 6 3 0
R(k)
SML
Beta
0.5
0.93
1.5
Stock 4: ITC
Year Risk Free rate 7.72 5.96 7.63 Beta Expected Market Rate of Return (NIFTY) -51.83919271 71.45 17.24 CAPM Return R(k) -30.9935 41.3246 13.4921 Actual Returns -21.1519 46.44125 -30.7418 Page 14
Return
20 Rf = 7.72 10 0 -10 -20 -30 R( k ) = -30.99 -40 -50 Rm = -51.84 -60
Jan 2008
0.65
0.5
R(k)
1.5 SML
Beta
Return
80 Rm = 71.45 70 60 50 40 R( k ) = 41.32 30 20 Rf = 5.96 10 0
Jan 2009
R(k)
SML
Return
21 Rm = 17.24 18 15 R( k ) = 13.49 12 9 Rf = 7.63 6 3
0.5Jan 2010 1
0.54
Beta
1.5
R(k)
SML
0.61
Beta
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0.5
1.5
Return
20 Rf = 7.72 10 0 -10 -20 -30 R( k ) = -41.71 Return -40 80 R( k ) = 74.07 -50 70 Rm = -51.84 Rm = 71.45 -60 60
50 40 30 20
Jan 2008
0.83
0.5
1.5 SML
Jan 2009R(k)
R(k) Beta
SML
10
0.5
1.04
Beta
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1.5
Return
R( k ) = 19.45 21 18 Rm = 17.24 15 12 9 Rf = 7.63 6 3 0
Jan 2010
R(k)
SML
0.5
1.23
Beta
1.5
INTERPRETATION
As is seen in the charts and table above, there is a vast difference between the Expected returns calculated using the Capital Asset Pricing Model (CAPM) and the Actual Returns computed as per historic prices. One must keep in mind that in the 3 year period selected above - there was a global recession, following which the Stock Market Indices also took unpredictable paths.
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When one uses the CAPM, the Rm is calculated on the basis of historic Indices data and is only an estimate - and this variable can drastically change the expected returns as per CAPM. This is because the Beta, being a risk measure, is also calculated using historic Indices data. Thus, the recession can be considered as one of the reasons for variations. However, even allowing a margin for the unusual external factors mentioned above, the disparity is high enough to show that CAPM assumptions are unrealistic and its value as a practical tool must be questioned. Thus, we proceed to examine how considering taxes in the CAPM formula may impact the returns.
Year
Beta Expected Market Rate of Return (NIFTY) (Rm) 1.05 1.53 1.5 0.89 0.92 0.93 0.83 1.04 1.23 0.65 0.54 0.61 0.89
Tax rate
Difference
SUZLON Jan-08 Jan-09 Jan-10 Jan-08 Jan-09 Jan-10 Jan-08 Jan-09 Jan-10 Jan-08 Jan-09 Jan-10 Jan-08 7.72 5.96 7.63 7.72 5.96 7.63 7.72 5.96 7.63 7.72 5.96 7.63 7.72 -51.83 33.99% -54.8172 -36.1848 -96.806 71.45 33.99% 106.1597 70.07602 36.27451 17.24 33.99% 22.045 14.5519 -39.121 BHARTI AIRTEL -51.83 33.99% -45.2877 -29.8944 -25.9154 71.45 33.99% 66.2108 43.70575 -54.11 17.24 33.99% 16.5673 10.93607 9.323097 TATA MOTORS -51.83 33.99% 71.45 33.99% 17.24 33.99% ITC -51.83 33.99% 71.45 33.99% 17.24 33.99% ACC -51.83 33.99% -41.7141 -27.5355 4.835493 74.0696 48.89334 378.0882 19.4503 12.83914 60.46098 -30.9935 -20.4588 -21.1519 41.3246 27.27837 46.44125 13.4921 8.906135 -30.7418 -45.2877 -29.8944 -53.2389 60.6212 33.80151 53.6729 -3.97903 97.81576 1.612978 -32.371 -329.195 -47.6218 0.693112 -19.1629 39.64793 23.34455 Page 18
Jan-09 Jan-10
5.96 7.63
0.69 0.79
-45.5591 -9.62273
Thus, we observe that the inclusion of taxes in the formula in the formula makes a marginal difference.
Stock 1 : Suzlon
Return
20 10 Rf = 7.72 0 -10 -20 -30 -40 -50 -60 -70 -80 -90 -100 -110 AR = -96.806 Rm = -51.84 R( k ) = -36.1848
Jan 2008
Beta
0.5
1.05
1.5
SML AR
Return
80 70 60 50 40 30 20 10
Jan 2009
Rm = 71.45 R(k)= 70.07
AR = 36.27451
SML AR
Rf = 5.96
1.53
Beta
0.5
1.5
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Return
21 18 15 12 9 6 3 Rf = 7.63 0 -3 -6 -9 -12 -15 -18 -21 -24 -27 -30 -33 -36 -39 -42
Jan 2010
Rm = 17.24
R(k) =14.5
0.5
1.5
SML AR
AR = -39.121
Beta
Return
20 Rf = 7.72 10 0 -10 -20 -30 -40 -50 -60
Jan 2008
0.89
Beta
0.5
1
AR = --25.9154 -29.8944
1.5
SML AR
Rm = -51.839
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Return
80 70 60 50 40 30 20 10 0 Rf = 5.96 -10 -20 -30 -40 -50 -60 -70
Jan 2009
Rm = 71.45
R(k)= 43.70
Beta
0.92
SML AR
0.5
1
AR = -54.11
1.5
Return
21 18 15 12 9 Rf = 7.63 6
Jan 2010
Rm = 17.24
SML AR
Return 3
20 10 Rf = 7.72
Jan 2008
Beta
AR= 4.83 0.93 0.83
0.5
0.5
1
1
1.5
1.5 SML AR
R(k)=-27.5355
Beta
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Return
400 350 300 250 200 150 100 50 Rf = 5.96 0
Jan 2009
AR = 378.08
SML AR
Rm = 71.45 R(k)= 48.89 1.04
Beta
0
Return
70 60 50 40 30 20
0.5
Jan 2010
1.5
AR=60.46
SML AR
Rm = 17.24
Re turn 10
Rf = 7.63
Rf = 7.72 20
Jan 2008
R( k ) = 19.45 1.23
0
10 0 -10 -20 -30
Beta
0
0
1.5
1.5 SML AR
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0.5
1
AR = -21.1519 R(k)= -20.4588
-40
Beta
Return
80 70 60 50 40 30 20 Rf = 5.96 10 0 AR= 46.44
Jan 2009
Rm = 71.45
SML AR
R(k)=27.27
0.5
0.54
Beta
1.5
Return
20
Jan 2010
Rm = 17.24
0.5
0.61
1.5
SML AR
AR = -30.74
Beta
Return
20 10
Jan 2008
Stock 5 : ACC
0.89 Beta
Rf =7.72
0.5
1.5
R(k)=-29.8944
SML AR
-40
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Rm=-51.84
Return
90 80 70 60 50 40 30 20
Jan 2009
AR =79.32199
Rm=71.45
SML AR
R(k) =33.76286
Rf =5.96
10 0
0.69
Beta
0
Return
30
0.5
Jan 2010
1.5
20
AR =19.67071
Rm=17.24
10
SML AR
Rf =7.63
0
R (k)=10.04798
0.5
0.79
Beta
1.5
behaviour of returns at differing degrees of systematic risk. Capital Asset Pricing Model proves to be ineffective with or without taxes. The behaviour of the SML which we set out to study, changes drastically on inclusion of taxes in the model. There is no longer a linear relationship between market return and expected returns as per CAPM. Rather the nature of the curve itself changes to a non - linear curve showing the non - correlation of market returns to forecasted returns on inclusion of taxes. However, even on inclusion of the taxes in the model, the model was ineffective in forecasting the actual returns for the future periods. Many reasons can be attributed to the inadequacy of the model. The uncertainty in market conditions, and hence, difficulty in predicting the expected market return on historic index trends leads to variation between expected and actual returns. Furthermore, even Beta is computed on the basis of past historic data, and there is no reliability that if the market moves a certain percentage points upwards, the stock will also move as a multiple of that movement. Thus, on closer observation, we see that the assumptions of CAPM are not its only weakness, as was assumed at the beginning of the Research project. As a recommendation, we suggest that even if reasonably sound estimate of Market Return can be made, a study in finding an alternative to use of Beta as the measure of risk and measure of correlation to the market be made. A detailed analysis of an alternative to correlate the market and stock be made.
BIBLIOGRAPHY
Adapted from students assignment 2011. Page 25
www.nseindia.com : to obtain historic indices, stock prices www.tradingeconomics.com : to obtain 10 year Indian government bond yield www.wikipedia.com : to obtain theoretical understanding of CAPM
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