Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

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  CAPITAL ASSET PRICING MODEL(CAPM) M.Vadivel
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  INTRODUCTION Willam F.Sharpe andjohn linter developed the CAPM. The model is based on the portfolio theory developed by Harry Markowitz. The model emphasises the risk factor in portfolio theory is a combination of two risks, systematic & unsystematic risk. The model used is for analyzing the risk-return implications of holding securities. A risk – averse investor prefer to invest in risk-free securities. The CAPM is a model, which derives the theoretical required return (i.e, discount rate) for an asset in a market, given the risk-free rate available to investors and risk of the market as a wohole.
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   CAPM assetsthat the selection of a portfolio will depend upon the risk free rate and the market return.  The capital asset model consists of a Capital Market Line and a Security Market Line.  The Capital Market Line relates expected return and risk for a portfolio securities.  The Security Market Line relates the expected return and risk of individual securities.
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  ASSUMPTIONS:  Individual risksare avoided  Individual seeks maximum expected return expectation  Borrow (or) lend freely at risk less rate of interest  Market is perfect  Quantity of risky security is given  No transaction cost and no taxes  All investors have the same time period as the investment horizon.  investors have homogeneous expectations  There is a riskless security in the world  All assets in the world are traded  All assets are infinitely divisible  Preferences are well described by simple utility functions  Investors are utility maximisers rather than return maximisers.
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  CAPITAL MARKET LINE TheCML sates that there is a risk rate that is provided by a security. The risk free security return has in other words, zero risk. This is also the rate available to all investors in the market, at which they can borrow or lend any amount in the market. Given this return at zero risk, and the opportunity to lend or borrow, investors will desire a mix of security with a specific risk and the risk free return at zero risk. The possibility of this risk free return modifies the efficient frontier into a straight line that begins with a risk free rate and touches the efficient front as a tangential line. This is the CML and gives all combinations of the risk assets and risky security portfolio to the investors.
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  CAPITAL MARKET LINE
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  Any investor canachieve the point along the straight line (CML) by combining the proportion of risky security portfolio(M) and risk free rate of return. Any point in the efficient frontier that is bellow the CML is not optimal since the investor has the option to borrow or lend at the free rate of return. The investor, instead of investing inn portfolio bellow the point M, can always opt for a higher point of return for the same risk level on the CML.
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  SECURITY MARKET LINE Ri= Rf+(Rm-Rf) Bi Ri = required rate of return on security I Rf = risk free rate of return (ex. Return on 90-day treasury bill) Rm = return on the market portfolio (ex. Return on S&P 500) Bi = beta of security i
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  Ri = Rf+(Rm-Rf)Bi (Rm-Rf) = market risk premium This is the amount of return over and above the risk free rate that investors require before they will invest in the market (where there is risk). (Rm-Rf)Bi = risk premium on security i This is the amount of return over and above the risk free that investors require before they will invest in security i.. Taking into account the systematic, non- diversifiable risk of security i.
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  Ri = Rf+(Rm-Rf)Bi So… required risk free risk premium to rate of return = rate of return + invest in the risky on security I security i
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  SECURITY MARKET LINE
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  The formula forthe capital asset pricing model is actually the equation of a line. When CAPM is graphed, the line is called the Security Market Line (SML). The SML shows the relationship between on asset’s systematic risk and the required rate of return. Assets with greater risk are expected to provide higher rate of return.
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  BENEFITS & LIMITATIONSOF CAPM Benefits: CAPM model of portfolio management can be effectively used to:  Investments in risky projects having real asset can be evaluated of its worth in view of expected return.  CAPM analysis the riskness of increasing the levels of gearing and its impact on equity shareholders return.  CAPM suggests the diversification of portfolio in minimization of risk.
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  LIMITATIONS: CAPM is criticizedfor the following reasons:  In real world, assumptions of CAPM will not hold good  In practice, it is difficult to estimate the risk-free return, market rate of return, and risk premium.  Investors can estimate the required rate of return on a particular investment in company’s securities.  CAPM is a single period model while most projects often available only as: large indivisible project. It is therefore, more difficult to adjust.
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   It isbased on unrealistic assumptions  It it difficult to test the validity of Capital asset pricing model  Betas do not remain stable over time