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Introduction To CAPM:: Strategy For Investing

The Capital Asset Pricing Model (CAPM) relates the expected return of an asset to its risk. It states that the expected return of an asset is equal to the risk-free rate plus a risk premium that is proportional to the asset's sensitivity to non-diversifiable market risk as measured by its beta. CAPM assumes investors are risk averse and require higher returns for taking on more systematic risk. It provides a formula for calculating the expected return of an asset based on its beta and the expected market risk premium. CAPM is used to determine if an asset is overvalued, undervalued or correctly priced relative to its risk.

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58 views

Introduction To CAPM:: Strategy For Investing

The Capital Asset Pricing Model (CAPM) relates the expected return of an asset to its risk. It states that the expected return of an asset is equal to the risk-free rate plus a risk premium that is proportional to the asset's sensitivity to non-diversifiable market risk as measured by its beta. CAPM assumes investors are risk averse and require higher returns for taking on more systematic risk. It provides a formula for calculating the expected return of an asset based on its beta and the expected market risk premium. CAPM is used to determine if an asset is overvalued, undervalued or correctly priced relative to its risk.

Uploaded by

pranjali shinde
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 DOCX, PDF, TXT or read online on Scribd
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Introduction to CAPM:

The CAPM was Developed in 1960s by Three Researchers William Sharpe, John Lintner & Jan
Mossin. CAPM is a relationship explaining how assets should be priced in Capital Markets.

What is CAPM?

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
the expected return and risk of investing in a security. It shows that the expected return on a
security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security.

Formula:

1. Expected Return (ER)=Rf + B(Rm- Rf)


ER= Expected Rate of Return
Rf= Risk Free Rate of Return
B= Beta of Security
Rm = Expected Return on Market

2. Expected Rate of Return on Market Portfolio (Rm)


Rm= Market Price – Initial Price + Dividend x 100
Initial Price
Assumptions of CAPM:

 Investors are expected to make decisions based solely on risk-return assessments.


 The purchase and sale transactions can undertake in infinitely divisible units.
 Investors can sell short any number of shares without limit.
 There is perfect competition and no single investor can influence prices, with no transaction
costs, involved.
 Personal income tax is assumed to be zero.
 Investors can borrow/lend the desired amount at riskless rates.
 Beta of Market Portfolio is "1”
 Beta of Risk Free Assets is Always “0”

Strategy for Investing:

 If ER > Return as per CAPM – Undervalued then Buy


 If ER < Return as per CAPM – Over valued then Sell
 If ER = Return as per CAPM – Correctly valued then Hold

Types of Investors according to Risk profile:


 Type A- Conservative Approach (Risk means “Danger” )
 Type B- Moderately Conservative (Risk means “Uncertainty”)
 Type C- Balanced (Risk means “Possibilities”)
 Type D- Moderate Growth (Risk Means “Opportunity”)
 Type E- Growth (Risk means “Thrill”)
 Type F- Shares (Risk means Very High “Thrill”)

Problems on CAPM:
Ex.1 Following are the details of three Portfolios:
Portfolio Average Standard Beta
Deviation
A 13% 0.25 1.25
B 12% 0.25 1.75
C 11% 0.20 1.00
Risk Free return is 8%. Compute Expected Return as per CAPM.

Ex.2 Following are the details of three Portfolios:


Portfolio Average Beta
Apple Ltd 17% 1.6
Wipro Ltd 10% 0.7
Birla Ltd. 16% 1.3
Risk Free return is 8% & Market returns are 15%. Compute Expected Return as per CAPM

Ex.3 Following are the details of Portfolios:


Portfolio Initial Price Dividend Market Price Beta
P 25 2 50 0.8
Q 35 2 60 0.7
R 45 2 135 0.5
S 1000 140 1005 0.99
Risk Free return is 14% .Compute Expected Return as per CAPM in each case & also calculate
the Avg. Return of Portfolio.

Ex.4 Following are the details of Portfolios


Securities A B C
Expected Return (%) 18 11 15
Beta 1.7 0.6 1.2
If Risk free return is 9% and Market return is 14%, which of the above securities are Over,
Under, Correctly Valued in the Market? What should be your strategy?

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