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Risk and Expected Return Standard Model (CAPM)

The document introduces the Capital Asset Pricing Model (CAPM) for tying risk and returns in pricing assets. It provides an example of how asset prices should adjust to equalize risk-reward ratios across all assets according to the CAPM. The example illustrates a process of how asset prices get priced and repriced in markets to satisfy the relationship proposed by the CAPM.

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42 views

Risk and Expected Return Standard Model (CAPM)

The document introduces the Capital Asset Pricing Model (CAPM) for tying risk and returns in pricing assets. It provides an example of how asset prices should adjust to equalize risk-reward ratios across all assets according to the CAPM. The example illustrates a process of how asset prices get priced and repriced in markets to satisfy the relationship proposed by the CAPM.

Uploaded by

Isse Nvrro
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Introduction to Investments

Risk and Expected Return Standard Model (CAPM) Prof S G Badrinath


Tying Risk and Returns in Pricing Assets

E(return)

SML (CAPM)

Risk (beta)

• E(Rj) = Rf + [E(Rm)-Rf] * j = 2 + 6 j
• Slope of line = 6 reward per unit risk
• Intercept of line = risk free rate = 2%
Introduction to Investments
Where Does This Come From? Prof S G Badrinath
Tying Risk and Returns in Pricing Assets

Asset Current Price Expected Return Beta Risk/reward


E(R) [E(R )- Rf]/Beta

A 15 14% 1.5 6.67

B 50 12% 1.0 8.00

Rf 4% 0.0 0

• For A, the expected return of 14% from current price levels implies an expected future price
of 15 * (1.14) = $17.1
• For B, expected return of 12% => expected future price of 50 * 1.12 = $56
Introduction to Investments
Case(i): Suppose B is priced correctly with a risk-reward of 8 Prof S G Badrinath
Tying Risk and Returns in Pricing Assets

• A is priced incorrectly. Investors will buy B, those owning A will sell it and move to B until A’s
risk-reward is same as B.
• A’s price will fall and its expected return will rise.
• What expected return for A is consistent with a risk-reward of 8?
• [E(R ) – 4]/1.5 = 8, E(R ) = 16% (increases)
• What current price (based on future expected price of 17.1?
• Current Price * (1.16) = 17.1, implies Current price for A = 14.74 (decreases from 15).
• NOTE: This is a bit contrived to make the point, we have to keep something fixed!
Introduction to Investments
Case (ii): Suppose instead that A is priced correctly Prof S G Badrinath
Tying Risk and Returns in Pricing Assets

• Then B is undervalued and its price will increase to 50.601, its expected return will drop to
10.67% and its risk-reward ratio will be 6.67. Confirm it!
• Often, both can happen especially if the market risk-reward is 7 (say). The example
illustrates a process of how assets get priced and repriced in markets.

The message is that prices will (should) move this way to equate risk/reward ratios across all
assets. Or, prices should be set so that the risk/reward ratio for all assets are equal.

Here the risk-reward ratio has a specific form and using it,
• [E(Rj) – Rf]/j = [E(Rm) – Rf]/1.0 = 8, Rearranging:
• E(Rj) = Rf + j [E(Rm) – Rf] or the CAPM.
Introduction to Investments
Prof S G Badrinath
Tying Risk and Returns in Pricing Assets

In life, the risk-reward is probably more complicated than that assumed for the
CAPM and other models for valuing assets exist.
© All Rights Reserved.
This document has been authored by Prof S G Badrinath and is permitted for use only within the course “Introduction to
Investments" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.

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