CAPM

Capital Asset Pricing Model
CAPM provides that investors are rewarded for bearing systematic risk which is attributed to stocks response to a change in the market. Systematic risk can not be eliminated and the investor has to bear this risk. Though investors are generally risk averse but they have to assume systematic risk and more they assume it the higher will be the reward. Whereas, securitys individual risk or unsystematic risk can be eliminated by diversification. So the investors are actually rewarded for assuming systematic risk.

The CAPM can be explained like this that expected return on a security is equal to its level of systematic risk. The capital asset pricing model further provides that the beta of a stock remains stable over a period of time.
Systematic risk is market-related risk that cannot be diversified away. Because systematic risk cannot be diversified away, investors are rewarded for assuming this risk. Each of the individual securities has its own risk (and return) characteristics, described as specific risk. By including a sufficiently large number of holdings, the specific risk of the individual holdings offset each other, diversifying away much of the overall specific risk and leaving mostly nondiversifiable or market-related risk.
Covariance measures the extent to which two securities tend to move, or not move, together. The level of covariance is heavily influenced by the degree of correlation between the securities (the correlation coefficient) as well as by each securitys standard deviation. As long as the correlation coefficient is less than 1, the portfolio standard deviation is less than the weighted average of the individual securities standard deviations. The lower the correlation, the lower the covariance and the greater the diversification benefits (negative correlations provide more diversification benefits than positive correlations).
The variance of an individual security is the sum of the probabilityweighted average of the squared differences between the securitys expected return and its possible returns. The standard deviation is the square root of the variance. Both variance and standard deviation measure total risk, including both systematic and specific risk. Assuming the rates of return are normally distributed, the likelihood for a range of rates may be expressed using standard deviations. For example, 68 percent of returns may be expressed using standard deviations. Thus, 68 percent of returns can be expected to fall within + or -1 standard deviation of the mean, and 95 percent within 2 standard deviations of the mean.

The capital asset pricing model (CAPM) asserts that investors will hold only fully diversified portfolios. Hence, total risk as measured by the standard deviation is not relevant because it includes specific risk (which can be diversified away). Under the CAPM, beta measures the systematic risk of an individual security or portfolio. Beta is the slope of the characteristic line that relates a securitys returns to the returns of the market portfolio. By definition, the market itself has a beta of 1.0. The beta of a portfolio is the weighted average of the betas of each security contained in the portfolio. Portfolios with betas greater than 1.0 have systematic risk higher than that of the market; portfolios with betas less than 1.0 have lower systematic risk. By adding securities with betas that are higher (lower), the systematic risk (beta) of the portfolio can be increased (decreased) as desired.

Risk Free Rate of Return (RFR)
Market Rate of Return (MR)
Risk Premium (RP)

Systematic Risk CAPM provides that investors are rewarded for bearing systematic risk which is attributed to stocks response to a change in the market. Systematic risk can not be eliminated and the investor has to bear this risk. Though investors are generally risk averse but they have to assume systematic risk and more they assume it the higher will be the reward. Whereas, securitys individual risk or unsystematic risk can be eliminated by diversification. So the investors are actually rewarded for assuming systematic risk.

The CAPM can be explained like this that expected return on a security is equal to its level of systematic risk. The capital asset pricing model further provides that the beta of a stock remains stable over a period of time.
Systematic Risk Political Economic

Economic Factors Change in Rate of Interest Foreign Exchange Rate Gross Domestic Product Inflation Balance of Trade Foreign Remittance International Portfolio Investment Foreign Direct Investment International Loans, grants and other assistance
Political Factors Strikes Agitations Political Unrest War War on Terror Change of Governemtn
Unsystematic Risk Each of the individual securities has its own risk (and return) characteristics, described as specific risk. By including a sufficiently large number of holdings, the specific risk of the individual holdings offset each other, diversifying away much of the overall specific risk and leaving mostly nondiversifiable or market-related risk.

Beta Under the CAPM, beta measures the systematic risk of an individual security or portfolio. Beta is the slope of the characteristic line that relates a securitys returns to the returns of the market portfolio. By definition, the market itself has a beta of 1.0. The beta of a portfolio is the weighted average of the betas of each security contained in the portfolio. Portfolios with betas greater than 1.0 have systematic risk higher than that of the market; portfolios with betas less than 1.0 have lower systematic risk. By adding securities with betas that are higher (lower), the systematic risk (beta) of the portfolio can be increased (decreased) as desired.

Beta Measures a stocks market risk, and shows a stocks volatility relative to the market. Indicates how risky a stock is if the stock is held in a welldiversified portfolio
If beta = 1.0, the security is just as risky as the average stock. If beta > 1.0, the security is riskier than average. If beta < 1.0, the security is less risky than average. Most stocks have betas in the range of 0.5 to 1.5 .

Beta Measures a stocks market risk, and shows a stocks volatility relative to the market. Indicates how risky a stock is if the stock is held in a welldiversified portfolio
If beta = 1.0, the security is just as risky as the average stock. If beta > 1.0, the security is riskier than average. If beta < 1.0, the security is less risky than average. Most stocks have betas in the range of 0.5 to 1.5 .

Beta of a Stock

Market Stock
Standard Deviation Correlation Beta
0.1247219 0.0623609 13 56 1 0.5

Market Return 10% 20% -10% Return of Stock L 10% 15% 0%
Year 2001 2002 2003 Calculate Beta
Year 2001 2002 2003 Calculate Beta
Market Return 10% 20% -10%
Return of Stock H 10% 30% -30%
Year 2001 2002 2003
Market Return 10% 20% -10%
Return of Stock A 10% 20% -10%
Calculate Beta
Beta =
(Cov of Stock or Portffolio with Market) Beta = Variance of Market
Excel Slope

Suppose you held a well-diversified portfolio with a very large number of securities, and that the single index model holds. If the W of your portfolio was 0.20 and WM was 0.16, what would be the F of the portfolio.
Beta of a Portfolio: The beta of a portfolio is the weighted average of each of the stocks betas
Stock A B C D
Beta 1.539 0.769 0.985 1.423
Portfolio Weight 0.25 0.15 0.4 0.2
Calculate Portfolio Beta
Stock A B C D
Beta 1.539 0.769 0.985 1.423
Portfolio Weight 0.25 0.15 0.4 0.2
Portfolio Beta 0.38475 0.11535 0.394 0.2846 1.179
Portfolio Beta = 1.179
Sakina has Rs. 35,000 invested in a stock which has a beta of 0.8 and Rs. 40,000 in a stock with a beta of 1.4. If these are only two investment in her portfolio what is her portfolio beta

Investment Rs. 35,000 40,000 Total 75,000 Beta 0.8 1.4
Portfolio Beta = (35,000/75,000)(0.8) + (40,000/75,000)(1.4) = 1.12.
Briefly explain whether investors should expect a higher return from holding Portfolio A versus Portfolio B under capital asset pricing theory (CAPM). Assume that both portfolios are fully diversified. ` Portfolio A Portfolio B Systematic risk (beta) 1.0 1.0 Specific risk for each individual security High Low

Under CAPM, the only risk that investors should be compensated for bearing is the risk that cannot be diversified away (systematic risk). Because systematic risk (measured by beta) is equal to one for both portfolios, an investor would expect the same return for Portfolio A and Portfolio B. Since both portfolios are fully diversified, it doesnt matter if the specified risk for each individual security is high or low. The specific risk has been diversified away for both portfolios

Risk Free Rate of Return (RFR)
Market Rate of Return (MR)
Risk Premium (RP)
Required Rate of Return = RFR+ (MR-RFR)(BETA)
= =
6 +(8 6) *(1.5) 9

You expect an RFR of 10 percent and the market return (RM) of 14 percent. Compute the expected (required) return for the following stocks. Stock U N D Beta 0.85 1.25 0.20

E(Ri) = RFR + Fi(RM - RFR) = .10 + Fi(.14 - .10) = .10 + .04Fi
Stock U N D
Beta 85 1.25 -.20
(Required Return) E(Ri) = .10 + .04Fi .10 + .04(.85) = .10 + .034 = .134 .10 + .04(1.25)= .10 + .05 = .150 .10 + .04(-.20) = .10 - .008 = .092

Calculate the required return for each of the following stocks when the risk-free rate is 0.08 and you expect the market return to be 0.14. Stock A B C D E F Beta 1.72 1.14 0.76 0.44 0.03 -0.79

E(Ri) = RFR + bi (RM - RFR) = .068 + bi (.14 - .08) = .08 + .06bi (a). (b). (c). E(RA) = .08 + .06(1.72) = .08 + .1050 = .1850 = 18.50% E(RB) = .08 + .06(1.14) = .08 + .0684 = .1484 = 14.84% E(RC) = .08 + .06(0.76) = .08 + .0456 = .1256 = 12.56%
(d). (e). (f).
E(RD) = .08 + .06(0.44) = .08 + .0264 = .1064 = 10.64% E(RE) = .08 + .06(0.03) = .08 + .0018 = .0818 = 8.18% E(RF) = .08 + .06(-0.79) = .08 - .0474 = .0326 = 3.26%

Suppose you are the money manager of a Rs 4 Million investment fund. The fund consists of the following investments and betas: Stock Investment A B C D Rs 400,000 600,000 1,000,000 2,000,000 Beta 1.50 (0.50) 1.25 0.75
Total 4,000,000 If the market required rate of return is 14% and the risk free rate is 6%, what is the funds required rate of return.

Security HT Market USR T-Bills Coll. Exp. Ret. 17.4% 15.0 13.8 8.0 1.7 Beta 1.30 1.00 0.89 0.00 -0.87
Risk Free Rate of Return is 8% Calculate (a) (b) Required Rate of Return State whether the security is undervalued or over valued

Security HT Market USR T-Bills Coll. Exp. Ret. 17.4% 15.0 13.8 8.0 1.7 Req. Return Valuation 17.1 15.0 14.2 8.0 1.9 Under-Valued Fairly Valued Over Valued Fairly Valued Over valued
Excess Stock Return = Stock Return Risk Free Rate of Return Exess Market Return = Market Return Risk Free Rate of Return
Excess Return = Exess Market Return * Beta Excess Return = C + Excess Market Return + Excess Return = 0+ Excess Market Return + 0
Required Rate of Return = RFR (MR-RFR)(BETA)
= =
6 +(8 6) *(1.5) 9

Suppose you are the money manager of a Rs 4 Million investment fund. The fund consists of the following investments and betas: Stock Investment A B C D Rs 400,000 600,000 1,000,000 2,000,000 Beta 1.50 (0.50) 1.25 0.75
Total 4,000,000 If the market required rate of return is 14% and the risk free rate is 6%, what is the funds required rate of return.

Security HT Market USR T-Bills Coll. Exp. Ret. 17.4% 15.0 13.8 8.0 1.7 Beta 1.30 1.00 0.89 0.00 -0.87
Risk Free Rate of Return is 8% Calculate (a) (b) Required Rate of Return State whether the security is undervalued or over valued

Security HT Market USR T-Bills Coll. Exp. Ret. 17.4% 15.0 13.8 8.0 1.7 Req. Return Valuation 17.1 15.0 14.2 8.0 1.9 Under-Valued Fairly Valued Over Valued Fairly Valued Over valued

The following information describes the expected return and risk relationship for the stocks of two of WAHs competitors.
Expected Return Stock X Stock Y Market Index Risk-free rate 12.00% 9 10 5
Standard Deviation 20% 15 12
Beta 1.3 0.7 1

Using only the data shown in the preceding table: a. Draw and label a graph showing the security market line and position stocks X and Y relative to it. b. Compute the alphas both for Stock X and for Stock Y. Show your work. c. Assume that the risk-free rate increases to 7 percent with the other data in the preceding matrix remaining unchanged. Select the stock providing the higher expected risk-adjusted return and justify your selection. Show your calculations.
(a). The security market line (SML) shows the required return for a given level of systematic risk. The SML is described by a line drawn from the risk-free rate: expected return is 5 percent, where beta equals 0 through the market return; expected return is 10 percent, where beta equal 1.0.

(b). The expected risk-return relationship of individual securities may deviate from that suggested by the SML, and that difference is the assets alpha. Alpha is the difference between the expected (estimated) rate of return for a stock and its required rate of return based on its systematic risk Alpha is computed as ALPHA (E) = E(ri) - [rf + b(E(rM) - rf)] where E(ri) rf bi E(rM) = expected return on Security i = risk-free rate = beta for Security i = expected return on the market
Calculation of alphas: Stock X: = 12% - [5% + 1.3% (10% - 5%)] = 0.5% Stock Y: = 9% - [5% + 0.7%(10% - 5%)] = 0.5% In this instance, the alphas are equal and both are positive, so one does not dominate the other.

Another approach is to calculate a required return for each stock and then subtract that required return from a given expected return. The formula for required return (k) is k = rf + bi (rM - rf ). Calculations of required returns: Stock X: k = 5% + 1.3(10% - 5%) = 11.5% = 12% - 11.5% = 0.5%
Stock Y: k = 5% + 0.7(10% - 5%) = 8.5% = 9% - 8.5% = 0.5%

(c). Calculations of revised alphas: Stock X = 12% - [7% + 1.3 (10% - 7%] = 12% - 10.95% = 1.1% Stock Y = 9% - [7% + 0.7(10% - 7%)] = 9% - 9.1% = -00.1%
By increasing the risk-free rate from 5 percent to 7 percent and leaving all other factors unchanged, the slope of the SML flattens and the expected return per unit of incremental risk becomes less. Using the formula for alpha, the alpha of Stock X increases to 1.1 percent and the alpha of Stock Y falls to -0.1 percent. In this situation, the expected return (12.0 percent) of Stock X exceeds its required return (10.9 percent) based on the CAPM. Therefore, Stock Xs alpha (1.1 percent) is positive. For Stock Y, its expected return (9.0 percent) is below its required return (9.1 percent) based on the CAPM. Therefore, Stock Ys alpha (-0.1 percent) is negative. Stock X is preferable to Stock Y under these circumstances.

An analyst expects a risk-free return of 4.5 percent, a market return of 14.5 percent, and the returns for Stocks A and B that are shown in the following table. Stock Beta Analysts Estimated Return A 1.2 16% B 0.8 14% a. Show on the graph (1) Where Stock A and B would plot on the security market line (SML) if they were fairly valued using the capital asset pricing model (CAPM) (2) Where Stock A and B actually plot on the same graph according to the returns estimated by the analyst and shown in the table b. State whether Stock A and B are undervalued or overvalued if the analyst uses the SML for strategic investment decisions.

(a). Security Market Line Fair-value plot. The following template shows, using the CAPM, the expected return, ER, of Stock A and Stock B on the SML. The points are consistent with the following equations: ER on stock = Risk-free rate + Beta x (Market return Risk-free rate) ER on stock = Risk-free rate + Beta x (Market return Risk-free rate) ER for A = 4.5% + 1.2(14.5% - 4.5%) = 16.5% ER for B = 4.5% + 0.8(14.5% - 4.5%) = 12.5%
Over vs. Undervalue Stock A is overvalued because it should provide a 16.5% return according to the CAPM whereas the analyst has estimated only a 16.0% return. Stock B is undervalued because it should provide a 12.5% return according to the CAPM whereas the analyst has estimated a 14% return.

Based on five years of monthly data, you derive the following information for the companies listed: Company Intell Ford Busch Merck S&P 500 ai(Intercept) 0.22 0.1 0.17 0.05 0 Wi 12.10% 14.6 7.6 10.2 5.5 riM 0.72 0.33 0.55 0.6 1

a. Compute the beta coefficient for each stock. b. Assuming a risk-free rate of 8 percent and an expected return for the market portfolio of 15 percent, compute the expected (required) return for all the stocks and plot them on the SML. c. Plot the following estimated returns for the next year on the SML and indicate which stocks are undervalued or overvalued. Intel20 percent Ford15 perent Anheuser Busch19 percent Merck10 percent
Bi !
COVi,m W
2 m
and ri,m !
COVi,m
W i W m
then COVi,m = (ri,m)(Wi)( sm)
.00479 .00479 Beta ! ! ! 1.597 .0030 (.055) 2
For Intel: COV i,m = (.72)(.1210)(.0550) = .00479
.00479 .00479 Beta ! ! ! 1.597 2 .0030 (.055)
For Ford: COV i,m = (.33)(.1460)(.0550) = .00265
.00265 Beta ! ! .883 .0030

For Anheuser Busch: COV i,m = (.55)(.0760)(.0550) = .00230
.00230 Beta ! ! .767 .0030
For Merck: COV i,m = (.60)(.1020)(.0550) = .00337
.00337 Beta ! ! 1.123 .0030
E(Ri) = RFR + Bi(RM - RFR) = .08 + Bi(.15 - .08) = .08 + .07Bi Stock Beta E(Ri) = .08 + .07Bi Intel 1.597 .08 + .1118 = .1918 Ford .883 .08 + .0618 = .1418 Anheuser Busch .767 .08 + .0537 = .1337 Merck 1.123 .08 + .0786 = .1586

CAPM

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Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Market Rate of Return (MR)

Risk Premium (RP)

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Systematic Risk Political Economic

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Standard Deviation Correlation Beta

0.1247219 0.0623609 13 56 1 0.5

Capital Asset Pricing Model

Year 2001 2002 2003 Calculate Beta

Capital Asset Pricing Model

Year 2001 2002 2003 Calculate Beta

Market Return 10% 20% -10%

Return of Stock H 10% 30% -30%

Capital Asset Pricing Model

Year 2001 2002 2003

Market Return 10% 20% -10%

Return of Stock A 10% 20% -10%

Capital Asset Pricing Model

(Cov of Stock or Portffolio with Market) Beta = Variance of Market

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Beta 1.539 0.769 0.985 1.423

Portfolio Weight 0.25 0.15 0.4 0.2

Calculate Portfolio Beta

Capital Asset Pricing Model

Beta 1.539 0.769 0.985 1.423

Portfolio Weight 0.25 0.15 0.4 0.2

Portfolio Beta 0.38475 0.11535 0.394 0.2846 1.179

Portfolio Beta = 1.179

Capital Asset Pricing Model

Capital Asset Pricing Model

Portfolio Beta = (35,000/75,000)(0.8) + (40,000/75,000)(1.4) = 1.12.

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Market Rate of Return (MR)

Risk Premium (RP)

Capital Asset Pricing Model

Required Rate of Return = RFR+ (MR-RFR)(BETA)

Capital Asset Pricing Model

Capital Asset Pricing Model

Beta 85 1.25 -.20

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model