SAPM Chapter 7

CAPM Model
CAPM Model
 Capital Asset Pricing Model (CAPM)
Ω It is the equilibrium model that underlies all modern
financial theory
Ω The model gives us the precise prediction of
relationship that we should observe between the risk
of an asset and its expected return
Ω This relationship serves two vital functions
¤ Provides benchmark rate of return for evaluating possible
investments
¤ Make an educated guess about the return of an asset that
have yet not been traded in market place
 Assumptions
Ω Individual investors are price takers
Ω Single-period investment horizon
Ω Investments are limited to traded financial assets
Ω No taxes and transaction costs
Ω All investors are rational
Ω All investors analyze the securities in the same way
Ω Investors may borrow and lend any amount at fixed risk
free rate
Ω Information is costless and available to all investors
Ω There are homogeneous expectations
 Resulting Equilibrium Conditions
Ω All investors will hold a portfolio of risky assets that
duplicate the representation of assets in market
portfolio (M)
Ω Market portfolio contains all securities and the
proportion of each security is,
Market Value of the Stock
Market Value of all the Stocks
Ω Market Portfolio will be on efficient frontier
Ω CML for Market portfolio is also the best attainable CAL
 Resulting Equilibrium Conditions Cont…

Ω Risk premium on the market portfolio depends on its

risk and the degree of average risk aversion

E (rM )  rf  A M2
where  M2 is the variance of the market portolio and
A is the average degree of risk aversion across investors
 Resulting Equilibrium Conditions Cont…

Ω Risk premium on an individual security depends

upon on,
¤ Risk premium on market portfolio and,
¤ Beta coefficient of security relative to market portfolio

Cov (ri , rm )
i 
 m2

Cov (ri , rm )
E (ri  rf ) 
 2
E (rm )  rf 
m


E (ri  rf )  i E (rm ) r 
f
 The risk Premium on Market Portfolio
Ω How individual investors decide about how much to
invest in the risky portfolio
E (rm )  rf
y
0.01A m2
Where y = Proportion of risky assets in portfolio
Ω If 100% portfolio is invested in risky asset, y = 1
E (rm )  rf
y
0.01A m2

E (rm )  rf 0.01A m2
 Example - 1
Ω Data from the period 1990 to 2004 for the S&P CNX
Nifty index yield the following statistics:
ő Average excess return  10.15%
ő Standard deviation  27.91%
Ω To the extent that these averages approximated
investors expectations for the period, what must have
been the average coefficient of risk aversion?
Ω If the coefficient of risk aversion were actually 2.5, what
risk premium would have been consistent with markets
historical standard deviation?
 Example - 1
E (rm )  rf 10.15  m2 27.912
a) Coefficient of risk aversion

E (rm )  rf 0.01A m2

E (rm )  rf
A
0.01 m2
10.15
A 2
1.3
0.0127.91
 Example - 1
b) Risk premium on market portfolio if coefficient of risk
aversion is 2.5,
E (rm )  rf 0.01A m2

2
E (rm )  rf 0.012.5 27.91

19.47%
Capital Market Line (CML)
 Capital Market Line (CML)
Ω A line showing relationship between risk and return
of market portfolio
Ω For the efficient portfolios the relationship between
risk and return is depicted by a straight line known as
a Capital Market Line (CML)
 CML
Ω CML can be stated as under

E (rP ) rf   p

E (rP ) Expected Return on Portfolio

 p Standard Deviation of Portfolio
 Slope of CML

E (rm )  rf

m
The Efficient Frontier and the Capital Market
Line

As per CML there is a linear relationship between standard

deviation of portfolio and its expected return
 Example - 2
Ω The expected return for the market is 15%, with the
standard deviation of 25%.The risk free rate is 8%.
Calculate the slope of Capital Market Line (CML) and
expected return on portfolio.
ő Slope of capital market line

E (rm )  rf 15  8
  0.28
m 25
ő Expected Return on Portfolio

E ( rP ) r f   p E (rP ) 8  0.28 25 15%

Security Market Line (SML)
 Security Market Line (SML)
Ω Relevant risk measure for individual risky assets is its
covariance with market portfolio (Cov i,m)
Ω There is a linear relationship between the expected
return on individual securities and their covariance with
market portfolio
Ω This relationship is depicted by Security Market Line
(SML) as under,

E (ri ) rf   i rm  rf 

 Figure 9.2 The Security Market Line

As per SML there is a linear relationship between beta of

portfolio and its expected return
 Example – 3
Ω The risk free rate is 8% and expected return on
market portfolio is 14%. The beta of the stock Q is
1.25. Investors believe that stock will provide an
expected return of 17%.
a) Calculate the fair return on stock as per SML
b) Find out the alpha of the stock
 Example
a) Fair return on stock as per SML

E (ri ) rf   i rm  rf 

E (ri ) 8  1.25(14  8)

E (ri ) 15.5%
 Example
b) The alpha of stock
ő Alpha of the stock is the difference between actual
expected return on security and its fair return as per
SML
Alpha of stock = Expected Return – Return as per CAPM
ő Alpha of the stock = 17 – 15.5 = 1.5%
ő Return as per CAPM is the return required to
compensate the systematic risk
ő So alpha is the return required to compensate the
unsystematic risk
 Example – 4
Ω The risk-free return is 9 percent and the expected return
on a market portfolio is 12 percent. If the required
return on a stock is 14 percent, what is its beta?
 Example – 5
Ω Stock XYZ Ltd. has an expected return of 12% and beta
of 1. Stock ABC has expected return of 13% and beta of
1.5. The market’s expected return is 11% and risk free
rate is 5%.
a) What is the alpha of each stock?
b) According to CAPM which stock is better buy?
c) Plot the SML and each stocks risk return point on one graph.
 Example
a) According to CAPM which stock is better buy?

E (ri ) rf   i rm  rf 

E (rxyz ) 5  1(11  5) 11%
E (rabc ) 5  1.5(11  5) 14%
b) Alpha for stocks

 xyz 12  11 1%

 abc 13  14  1%
Ω Stock xyz is better buy
 Example
E (r )

14 SML
13 ABC
12
XYZ
11

rf 5

1 1.5 
 Example – 6
Ω The risk free rate is 8% and expected return on market
portfolio is 16%. A firm considers a project that is
expected to have a beta of 1.3.
a) What is the required rate of return for the project?
b) If the expected IRR of the project is 19%, should it be
accepted?
a) Required rate of return for the project
E (ri ) rf   i rm  rf 
E (ri ) 8  1.3(16  8) 18.4%
b) 18.4% is the hurdle rate for the project, therefore if IRR is
19% then it is desirable to accept the project
 Expected Return Beta Relationship

Ω Beta is the measure of systematic risk

Ω Higher beta leads to higher expected return
Ω If everyone holds an identically risky portfolio then
everyone will find that beta of each asset with their
own portfolio is equal to beta of asset with market
portfolio
 Expected Return Beta Relationship
Ω Portfolio Return

E (rp )  wi E (ri )
Ω Portfolio Beta

B p  wi  i
 Expected Return Beta Relationship
Ω Required Return on Market Portfolio


E (rm ) rf   m E (rm )  rf 
Ω Beta of Market Portfolio

Cov (rm , rm )  2
Bm   m
 2
m  2
m
Ω Beta of market portfolio is always 1
 Example – 7
Ω Suppose that the risk premium of a market portfolio is
estimated at 10% with standard deviation of 28%. What
is the risk premium on a portfolio invested 25% in
Infosys and 75% in HLL, if they have betas of 1.45 and
0.74 respectively?
 inf 1.45 winf 0.25
E (rm )  rf 10
 HLL 0.74 wHLL 0.75


E (rp )  rf  p E (rm )  rf 
B p  wi  i
B p (0.25 1.45)  (0.75 0.74) 0.9175
E (rp )  rf 0.9175 10 9.175%
 Example – 8
Ω The market price of a security is Rs.50. Its expected rate
of return is 14%. The risk free rate is 6% and market risk
premium is 8.5%. What will be the market price of
security if its correlation coefficient with market portfolio
doubles? Assume that stock is expected to pay constant
dividend.
Ω Current dividend:

D
p0 
r
D
50 
0.14
D 7
 Example
Ω New Discount rate
ő If the security’s correlation coefficient with the market portfolio
doubles then beta, and therefore the risk premium, will also
double
ő The current risk premium is: 14 – 6 = 8%
ő The new risk premium would be 16%,
ő new discount rate for the security would be: 16 + 6 = 22%
Ω Price of stock
D
p0 
r
7

0.22
31.82
 Example – 9
Ω You are consultant to a large manufacturing corporation
that is considering a project with following net after tax
cash flows
Year Cash Flow
0 -40
1-10 15

Ω A project’s beta is 1.8. Assuming that risk free rate is

8%and market return is 16%, what is the net present value
of the project
Ω What is the highest possible beta estimate for the project
before its NPV becomes negative? (Assume that IRR of the
project is 35.75%)
 Example
Ω The appropriate discount rate for the project is:
rf + b[E(rM ) – rf ] 8 + [1.8  (16 – 8)] = 22.4%
Ω NPV using this discount rate:
= -40+ (15×Annuity Factor 22.4%, 10 years)
= 18.09
Ω NPV is zero if IRR = discount rate
Ω So the highest value that beta, will be the value of beta
if discounting rate = 35.75%
35.75 = 8 + b(16 – 8)  b = 27.75/8 = 3.47
 Example -10
Ω Consider the following table which gives a security analysts
expected return on two stocks for two particular market
returns in two different scenarios
Market Return Aggressive Stock Defensive Stock
5% -2% 6%
25% 38% 12%

Ω What are the betas of two stock ?

Ω What is the expected rate of return on each stock if the market
return is equally likely to be 5% or 25%
Ω If the treasury bill rate is 6% and the market return is equally likely
to be 5% or 25% draw the SML for this economy
Ω Plot the two securities on SML graph. What are the Alphas of each
stock?
Ω What are the betas of two stock
Change in Stock return
Beta 
Change in Market return

 2  38 6  12
A  2 D  0.30
5  25 5  25
What is the expected rate of return on each stock if the market
return is equally likely to be 5% or 25%

ERA 0.5 ( 2)  0.5 38 18%

ERD 0.5 6  0.5 12  9%

Ω If the treasury bill rate is 6% and the market return is equally
likely to be 5% or 25% draw the SML for this economy

Ω The SML is determined by the market expected return of

ERm 0.5 5 0.5 25 15%

Expected Return - Beta Relationship

40
35 SML
30
Expected Return

25
20

15 A
D M
10

5
0
0 0.5 1 1.5 2 2.5 3
Beta
Ω Alpha for two stock
Alpha = actually expected return – required return (given risk)

E(rA ) = 6 + 2.0(15 – 6) = 24%

Alpha = 18% – 24% = –6%

E(rB ) = 6 + 0.3(15 – 6) = 8.7%

Alpha = 9 – 8.7 = +0.3%