The Capital Asset Pricing
Model
(CAPM)
Learning Objectives:
Define what is Capital Asset Pricing
Model(CAPM)
Explain the purpose of CAPM
Apply the formula in Investment/Portfolio
Formation
What IF…
Risky Company
Safely deposit with a 5% profit
in a bank with for investors per
a 5% interest year
per year
No Way!!!
If your business is RISKIER than the
Bank, then your friend would want an
average return much BIGGER THAN
5%
What IF…
Scary Company
Stock Market
High Risk
Medium Risk
8% per year
8% per year
No Way!!!
If your business is SCARIER than the
Stock Market, then your friend would
want an average return much
HIGHER THAN 8% to reward him
for his higher risk
So the question is…
Exactly how much average percentage
return should you offer to make his
investments worth his risk in your scary
company?
Cost of Equity CAPM
RISK and RETURN from other
investments
How much should expect in your riskier
company.
COST OF EQUITY is also called the
INVESTOR’S EXPECTED RETURN
Example of a Risk-Free
Rate
2% Return from US government securities
(US. Treasury Bills)
What is Risk-Free Rate?
theoreticalrate of return of an
investment with zero risk.
Example of Market Risk Premium?
If,
Risk-Free Rate= 2%
Average Stock Market Return= 7%
Then,
Risk Premium= 5%
What Is Market Risk
Premium?
Is the difference between the expected
return on a market portfolio and the risk-
free rate.
It provides a quantitative measure of the
extra return demanded by market
participants for the increased risk.
It is the expected reward for taking the
extra risk.
What Is Market Risk
Premium?
The risk premium reflects the required
returns, historical returns, and expected
returns. The historical market risk premium
will be the same for all investors. The
required and expected market premiums,
however, will differ from investor to investor
based on risk tolerance and investing
styles.
Example of Beta?
If,
Ave. Stock Market Return= -7%
Ave. Stock return Company A= -14%
Then,
Beta= 2
Beta
If,
Beta= 2
Then, Company A is twice as sensitive to
changes in price compared to the stock
market.
It means that if,
Ave. Stock Market Loss= -10%
Ave. Stock loss of Company A= -7.5%
What is Beta
Measures by how much the stock moves
when the market index moves up or down.
A beta of 1= the stock moves exactly like
the market in both direction
A beta > 1, shows that the stock moves
more aggressively than the market
A beta < 1 shows that the stock moves
more defensively than the market
The beta of a potential investment is a measure
of how much risk the investment will add to a
portfolio that looks like the market. If a stock is
riskier than the market, it will have a beta greater
than one. If a stock has a beta of less than one,
the formula assumes it will reduce the risk of
a portfolio.
Matching Type
A B
1.Risk-Free a. Expected yield
in excess of
guaranteed
2.Risk Premium b. Guaranteed
3.Beta c. Volatility
Summary
As we discussed, the “market” pays
investors for two services they provide:
(1) surrendering their capital and
forgoing current consumption and (2)
sharing in the total risk of the economy.
The first gets you the time value of money.
The second gets you a risk premium whose
size depends on the share of total risk you
take on.
CAPM Computation
For example, imagine an investor is
contemplating a stock valued at P100 per
share today that pays a 3% annual dividend. Say
that this stock has a beta compared with the
market of 1.3, which means it is more volatile
than a broad market portfolio (i.e., the S&P 500
index). Also, assume that the risk-free rate is 3%
and this investor expects the market to rise in
value by 8% per year.
Answer
The expected return of the stock
based on the CAPM formula is 9.5%:
9.5%=3%+1.3×(8%−3%)9.5%=3%
+1.3×(8%−3%)
Expected Return using
CAPM
It trades on the NYSE and its operations
are based in the United States
Current yield on a U.S. 10-year treasury is
2.5%
The average excess historical annual
return for U.S.
stocks is 7.5%
The beta of the stock is 1.25 (meaning it’s
average
weekly return is 1.25x as volatile as the
S&P500 over the last 2 years
Let’s break down the answer using the
formula
Expected return = Risk Free Rate + [Beta x
Market Return Premium]
Expected return = 2.5% + [1.25 x 7.5%]
Expected return = 11.9%
Goal of CAPM Formula
Isto evaluate whether a stock is fairly valued
when its risk and the time value of money are
compared with its expected return.
Example
You expect a return on the market of 15%
and the risk-free rate to be 3%. The Beta for
ZED Ltd. Is 0.89 and it is priced to return
14%.
The expected return for Zed Ltd based on
its level of systematic risk is 13.68%. The
company is currently priced to return 14%.
As this return is higher than would be
expected for the level of systematic risk,
Zed Ltd is underpriced.
Decision:
You would buy the shares of Zed and earn
a return higher than would be expected for
the level of systematic risk
Prepare for an Individual Quiz
Problems
The current risk free rate is 4% and the expected
risk premium on the market portfolio is 7%.
An asset has a beta of 1.2. What is the expected return
on this asset? Interpret the number 1.2.
An asset has a beta of 0.6. What is the expected return
on this asset?
If we invest ½ of our money in the first asset and ½ of
our money in the second, what is our portfolio beta and
what is its expected return?
Relative to the first asset our portfolio has a smaller
expected return, why?
Does this mean the first asset is better than the
portfolio?
Problem
The current risk free rate is 4% and the expected
risk premium on the market portfolio is 7%.
You work for a software company and have been asked
to estimate the appropriate discount rate for a proposed
investment project.
Your company’s stock has a beta of 1.3.
The project is a proposal to begin cigarette production.
RJR Reynolds has a beta of 0.22.
What is the appropriate discount rate and why?
